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. In these cases, there are a variety of tools for fraudulent inventory overstatement, such as reducing any inventory loss reserves, overstating the value of inventory components, overcounting inventory items, overallocating families first coronavirus response act and adp run 2020 overhead, and so forth. 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. When the inventory is corrected, it makes the cost of goods sold appear higher than what it actually is.
- If ending inventory is overstated, then cost of goods sold would be understated.
- If you are tempted to overstate inventory to appear more attractive, think again as it is against the law and an unethical business practice.
- Although many inventory errors are honest mistakes, some companies overstate any inventory on purpose.
- Inventory and cost of goods sold are inversely related, so if inventory is overstated, cost of goods sold would be understated.
- To calculate the income, the cost of goods sold is subtracted from the revenue.
If ending inventory is overstated, then cost of goods sold would be understated. As you can see in the visual below, the incorrectly stated inventory balance is $25 higher than the correct ending inventory balance. Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of goods sold. Inventory and cost of goods sold are inversely related, so if inventory is overstated, cost of goods sold would be understated.
Impact of an Inventory Correction
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 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. Our review course offers a CPA study guide for each section but unlike other textbooks, ours comes in a visual format.
When an ending inventory overstatement occurs, the cost of goods sold is stated too low, which means that net income before taxes is overstated by the amount of the inventory overstatement. However, income taxes must then be paid on the amount of the overstatement. Thus, the impact of the overstatement on net income after taxes is the amount of the overstatement, less the applicable amount of income taxes. So now that we know cost of goods sold is understated, you can see how that impacts the income statement in the visual below. When cost of goods sold is understated, gross profit is overstated, and net income is overstated (as well as retained earnings). If ABC has a marginal income tax rate of 30%, this means that ABC must now pay an additional $150 ($500 extra income x 30% tax rate) in income taxes.
If ending inventory is overstated, would cost of goods sold be overstated or understated?
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. In the business world, inventory plays a vital role in success and can impact financial statements.
What Happens if Ending Inventory Is Overstated?
Overstating ending inventory will overstate net income, since this is directly related to the cost of goods sold. To calculate the income, the cost of goods sold is subtracted from the 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. You will then essentially pay taxes on income that you should not have to. Although many inventory errors are honest mistakes, some companies overstate any inventory on purpose.