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.

• Your ending inventory for the period has a direct effect on your COGS and thus your profit.
• 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.
• Thus, the impact of the overstatement on net income after taxes is the amount of the overstatement, less the applicable amount of income taxes.
• In the next accounting period, if the error is not corrected, the beginning inventory (which is the same as the previous period’s ending inventory) will be overstated.
• 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 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).

How to Take a Reserve Against Your Inventory

In the business world, inventory plays a vital role in success and can impact financial statements. If the company is going through hard times, this could help attract investors and boost the company’s value. In the next accounting period, if the error is not corrected, the beginning inventory (which is the same as the previous period’s ending inventory) will be overstated. Consequently, 6 secrets to surviving on little or no sleep that period’s COGS will be overstated, net income will be understated, and the errors of the previous period will be self-correcting. However, this doesn’t eliminate the need to correct the error as soon as it is identified, to maintain the integrity and reliability of the financial statements. If you overstate sales or understate expenses, you’ll pay more income tax than necessary.

• This can happen due to errors in counting or pricing the inventory, data entry mistakes, theft, or in more extreme cases, fraudulent reporting.
• Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of goods sold.
• This is done so that it looks like the company is more profitable than it actually is.
• If the ending inventory is incorrect, it can impact many different areas of your business and profitability.

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.

If ending inventory is overstated, would cost of goods sold be overstated or understated?

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.

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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, 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 understanding current assets on the balance sheet 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.

Earnings Management

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.

4: Impacts of Inventory Errors on Financial Statements

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.

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.