Inventory errors and decision analysis

Learning goals

• Trace an ending-inventory error through two reporting periods.
• Calculate and interpret inventory turnover and days in inventory.
• Separate record differences from physical shrinkage and obsolescence.
• Recommend a control or pricing response using evidence.

Prerequisite check

Because COGS = beginning inventory + net purchases − ending inventory, overstating ending inventory understates current COGS and overstates current profit. In the next year, that same amount becomes overstated beginning inventory and reverses the profit effect.

Vocabulary

• Cut-off error: transaction recorded in the wrong period.
• Shrinkage: physical inventory shortfall from theft, loss, damage, or record error.
• Obsolescence: loss of usefulness or saleability.
• Inventory turnover: cost of goods sold divided by average inventory.
• Days in inventory: approximately 365 divided by turnover.
• Lower measurement: reduction when inventory's recoverable selling value falls below cost.

Core idea

An inventory error changes both the statement of financial position and cost of goods sold. Some errors self-correct in total over two years, but each year's profit and trend remain wrong. Turnover helps ask questions; it does not by itself prove excellent operations or obsolete stock.

Why this treatment makes sense

Ending inventory is the unsold portion of cost available. If too much cost is left as an asset, too little becomes expense. Average inventory in turnover reduces the distortion caused by comparing an annual flow with only one day's balance.

A repeatable method

1. Write the COGS formula and mark the wrong inventory amount.
2. Determine the direct COGS effect, then reverse the direction for profit/equity.
3. Carry the same amount into next year's beginning inventory.
4. For ratios, use average inventory = (opening + closing) ÷ 2.
5. Compare with prior periods and business context: stockouts, markdowns, seasonality, and margins.
6. Investigate exceptions before recommending action.

Worked example

Algonquin Outfitters accidentally overstates December 31, 2025 inventory by $6,000.

Table: Two-year error chain when the 2026 ending count is correct

The two-year combined profit is correct, but both annual results and any bonus, tax estimate, covenant, or trend based on them may be wrong.

For 2026, COGS is $480,000, opening inventory $92,000, and closing inventory $108,000. Average inventory = $100,000. Turnover = 4.8 times; days in inventory ≈ 365/4.8 = 76.0 days. A fall from 6.2 turns needs investigation: slower demand, planned stock, new product launch, purchasing problems, or obsolete items could all contribute.

Journal, ledger, and statement connection

For a perpetual shortage where records show $31,400 but a verified count is $30,100, debit Inventory Shrinkage or Cost of Goods Sold $1,300 and credit Inventory $1,300. Assets, profit, and equity fall $1,300. Preserve count sheets and approval in the audit trail.

Common mistakes

• Reversing the sign: overstated ending inventory means understated COGS.
• Saying an error is harmless because it self-corrects next year.
• Dividing sales, rather than COGS, by inventory when the course formula uses turnover at cost.
• Using ending inventory instead of average inventory without explaining the limitation.
• Assuming faster turnover is always better despite stockouts or lost sales.

Guided practice

Ending inventory is understated $2,500. Current COGS is overstated and profit/assets/ equity understated $2,500. Next year's beginning inventory is understated, so next year's COGS and profit move in the opposite directions if ending inventory is correct.

Independent practice

1. COGS is $720,000; opening inventory $140,000; closing $160,000. Compute turnover and days.
2. A count finds $900 less inventory than the perpetual record. Record the adjustment.
3. Name two reasons turnover might improve for the wrong reason.
4. Explain the effect of an omitted year-end purchase and omitted related inventory when ownership had transferred.

Self-check and solutions

1. Average inventory = $150,000; turnover = 4.8; days ≈ 76.0.
2. Debit Inventory Shrinkage/COGS $900; credit Inventory $900.
3. Examples: chronic stockouts, deep discounting with weak margins, or failing to record owned inventory. Ratio direction needs context.
4. Accounts Payable and Inventory are both understated by the same amount; current profit is unaffected if both purchase and ending inventory are omitted, but assets and liabilities are understated and cut-off is wrong.

Retrieval practice

1. What is the denominator in inventory turnover?
2. What happens to current profit if ending inventory is understated?
3. Name one document used in an inventory cut-off test.

Answers: average inventory; it is understated; receiving report, shipping record, sales invoice, purchase invoice, or contract terms.

Exam-style application

Turnover improved from 5.0 to 7.5 while gross margin fell from 38% to 24% and stockouts tripled. Recommend one action and identify one further data need.

Model response: Do not celebrate turnover alone; test whether aggressive markdowns or insufficient safety stock caused lower margins and lost sales. Review item-level margin, stockout, lead-time, and obsolete-stock data, then reset reorder points or pricing by product rather than applying a company-wide target.

Lesson summary

Inventory errors flow through COGS, profit, equity, and two reporting periods. Turnover becomes useful only when reconciled records, margins, stockouts, and business conditions explain the movement.