On the income statement, the cost of inventory sold is recorded as cost of goods sold. Since the cost of goods sold figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading “Current Assets”, which reports current assets in a descending order of liquidity.
- Based in Greenville SC, Eric Bank has been writing business-related articles since 1985.
- The overstatement of ending inventory in the current year would cause cost of goods sold appear lower than it really is.
- Consequently, that period’s COGS will be overstated, net income will be understated, and the errors of the previous period will be self-correcting.
- Although many inventory errors are honest mistakes, some companies overstate any inventory on purpose.
- Overstatements in inventory accounting records will have financial implications that will impact your business’s bottom line and tax liability.
All businesses should avoid and put mechanisms in place to minimize the likelihood of overstating their ending inventories. Inventory errors affect your company’s bottom line by painting an inaccurate picture of its financial performance and net worth. To maintain accuracy in financial reporting, it’s crucial for companies to correct any inventory errors as soon as they’re discovered.
Example of Understated Inventory
Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of good sold. Since we can assume paid family leave that beginning inventory and purchases would be the same, the difference would impact cost of goods sold. Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of goods sold.
You begin by calculating your gross income, which is sales minus cost of goods sold, or COGS. Your ending inventory for the period has a direct effect on your COGS and thus your profit. As a result, ABC Retailers understates its COGS by $10,000, and if we assume they made sales of $300,000, their gross profit should have been $110,000 ($300,000 – $190,000). However, because of the error, the gross profit is calculated as $120,000 ($300,000 – $180,000). Now, let’s assume that a mistake was made during the inventory count and the actual ending inventory was $60,000, not $70,000. Teresa Nguyen has more than 10 years of experience in corporate finance and accounting.
What Happens if Ending Inventory Is Overstated?
Our review course offers a CPA study guide for each section but unlike other textbooks, ours comes in a visual format. Below is the related income statement that shows the impact from overstating inventory. As you can see, cost of goods would be overstated which understates gross profit and net income.
She has worked with companies in the software, real estate and restaurant industries. Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
If ending inventory is overstated, would cost of goods sold be overstated or understated?
Ending income may be overstated deliberately, when management wants to report unusually high profits, possibly to meet investor expectations, meet a bonus target, or exceed a loan requirement. An overstatement of ending inventory in one period results in errors in future periods, unless this is corrected at a later date, reports Accounting Coach. However, a correction will also have an effect on the cost of goods sold, except this time it will be in the opposite direction.
How Does Overstating Inventory Overstate Revenue?
If the cost of goods sold is too low compared to what it should be, this makes the net income appear larger than it actually is. Although many inventory errors are honest mistakes, some companies overstate any inventory on purpose. This error not only affects the income statement (by overstating profits) but also the balance sheet where inventory is overstated in current assets by $10,000. This can give a misleading impression of the company’s profitability and financial health to shareholders, creditors, and other stakeholders. A merchandising company can prepare accurate income statements, statements of retained earnings, and balance sheets only if its inventory is correctly valued.
This can happen due to errors in counting or pricing the inventory, data entry mistakes, theft, or in more extreme cases, fraudulent reporting. If your business must manage inventory, you might run into situations that cause you to misstate the value of your inventory. Overstated inventory can arise from various causes, including inaccurate counting, off-the-mark estimates, undetected damage or theft and, in some cases, management policy. Inventory is an asset held by a business for sale, and it adds to the total capital of a business. The control of your inventory is an important aspect of managing the finances of a business. Overstatements in inventory accounting records will have financial implications that will impact your business’s bottom line and tax liability.
If the ending inventory is incorrect, it can impact many different areas of your business and profitability. Because of this, focusing on getting the inventory correct should be one calculating marginal cost of your top priorities as a business owner. In short, the $500 ending inventory overstatement is directly translated into a reduction of the cost of goods sold in the same amount.
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Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet. This is done so that it looks like the company is more profitable than it actually is. If the company is going through hard times, this could help attract investors and boost the company’s value. If you are tempted to overstate inventory to appear more attractive, think again as it is against the law and an unethical business practice. The overstatement of ending inventory in the current year would cause cost of goods sold appear lower than it really is.