Question

In taking a physical inventory at the end of year 2017, Grant Company forgot to count certain units. Explain how this error affects the following: (a) 2017 cost of goods sold, (b) 2017 gross profit, (c) 2017 net income, (d) 2018 net income, (e) the combined two-year income, and (f) income for years after 2018.

Short answer

Item	Effect of Error
(a) 2017 cost of goods sold	Overstated
(b) 2017 gross profit	Understated
(c) 2017 net income	Understated
(d) 2018 net income	Overstated
(e) The combined two-year income	No-effect
(f) Income for years after 2018	No effect

Step-by-step solution

Step-By-Step SolutionStep 1: Definition of Inventory Errors

Actions that lead to reporting an incorrect amount of inventory on the balance sheet are known as inventory errors. Such errors get compensated automatically in the next year.

Effect of inventory error

(a) If the company does not count certain units, it will understate the ending inventory, consequently leading to an overstatement of the cost of goods sold.

(b) Due to the understatement of the ending inventory, the cost of goods sold will be overstated, consequently understating the gross profit.

(c) Understatement of gross profit will lead to an understatement of net income because the net income is calculated using gross profit.

(d) Understated ending inventory of the year 2017 will understate the beginning inventory of the year 2018, and it will consequently understate the cost of goods sold in the year 2018. Due to the understatement of the cost of goods sold, gross profit and net income for 2018 will be overstated.

(e) Combined two-year income will not have any effect because inventory errors get auto-adjusted in the next year. The understatement of net income for 2017 will be compensated by the overstatement of net income for 2018.

(f) Error made in 2017 will only affect the years 2017 and 2018.