A closing-inventory error moves profit by the same amount and in the same direction: overstate closing inventory and profit is overstated, understate it and profit is understated. The following year, the same amount affects profit the opposite way.
Questions on this skill ask you to correct a profit figure or explain the effect in words. It builds directly on calculating cost of sales and valuing closing inventory, both in inventory and cost of sales.
Why does the error move profit?
Closing inventory is subtracted when working out cost of sales. A higher closing inventory means less cost is charged against sales, so profit goes up. A lower one means more cost is charged, so profit goes down.
Next year, that same closing inventory becomes opening inventory, which is added in cost of sales. The effect flips: an overstated opening inventory reduces next year’s profit.
How to explain it, step by step
- State the direction of the error. Closing inventory overstated or understated.
- Say what happens to cost of sales (lower if overstated, higher if understated).
- Say what happens to gross profit and net profit by the same amount.
- Say what happens in the statement of financial position: inventory and capital are wrong by that amount.
- Say what happens next year, when the wrong figure becomes opening inventory.
Worked example
Toko Anggerik has these figures for year 1, in RM: sales 62,000, opening inventory 6,000, purchases 40,000, expenses 15,000. The correct closing inventory is 8,000, but it was recorded as 7,000.
| Correct (RM) | As recorded (RM) | |
|---|---|---|
| Opening inventory | 6,000 | 6,000 |
| Purchases | 40,000 | 40,000 |
| Closing inventory | (8,000) | (7,000) |
| Cost of sales | 38,000 | 39,000 |
| Gross profit | 24,000 | 23,000 |
| Expenses | 15,000 | 15,000 |
| Net profit | 9,000 | 8,000 |
Closing inventory was understated by RM 1,000, so profit is understated by RM 1,000. Inventory and capital are also RM 1,000 too low in the statement of financial position.
In year 2, sales are 70,000, purchases 44,000, expenses 16,000, and the correct closing inventory is 9,000.
Correct year 2: cost of sales = 8,000 + 44,000 − 9,000 = 43,000. Gross profit = 27,000. Net profit = 27,000 − 16,000 = RM 11,000.
With the wrong opening inventory of 7,000: cost of sales = 7,000 + 44,000 − 9,000 = 42,000. Gross profit = 28,000. Net profit = RM 12,000, which is RM 1,000 too high.
Over the two years, correct profit is 9,000 + 11,000 = 20,000, and recorded profit is 8,000 + 12,000 = 20,000. The error cancels out over two years but misreports each year.
The mistake to watch for
A common slip is to say the error “affects only that year” or to apply the wrong direction.
Mistaken explanation: “Closing inventory was understated by RM 1,000, so cost of sales is understated and profit is overstated.”
The student reversed the cause. A lower closing inventory leaves more cost in cost of sales.
Understated closing inventory gives a higher cost of sales, so profit falls. Keep the chain in order: closing inventory, then cost of sales, then profit. Check each link before moving to the next.
Check yourself
1. Closing inventory is overstated by RM 500. What is the effect on profit?
Show answer
Cost of sales is RM 500 too low, so profit is overstated by RM 500.
2. Opening inventory is overstated by RM 700 in a later year. What is the effect on that year’s profit?
Show answer
Opening inventory is added in cost of sales, so cost of sales is RM 700 too high and profit is understated by RM 700.
3. Closing inventory of RM 13,200 was recorded as RM 12,300. State the effect on profit, current assets and the following year’s profit.
Show answer
The error is 13,200 − 12,300 = RM 900. Closing inventory is understated, so profit is understated by RM 900 and current assets are understated by RM 900. The following year opening inventory is too low, so that year’s profit is overstated by RM 900.
Where this leads next
Errors often come from the count itself, so the next lesson covers how to reconcile physical and accounting quantities. The cash versus profit bridge lets you see how profit and cash can move differently.
If written explanations lose you marks even when your numbers are right, online one-to-one Accounting tuition can help you practise a clear chain of reasoning.