Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of goods sold. 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.

• Overstating ending inventory will overstate net income, since this is directly related to the cost of goods sold.
• 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.
• 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.
• If your business must manage inventory, you might run into situations that cause you to misstate the value of your inventory.

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. An overstated ending inventory refers to a situation where the recorded value of the ending inventory (the inventory that remains unsold at the end of an accounting period) is higher than its actual value. This can happen due to errors in counting or pricing the inventory, data entry mistakes, theft, or in more extreme cases, fraudulent reporting. Overstating ending inventory will overstate net income, since this is directly related to the cost of goods sold.

Overstatement Effects of Ending Inventory

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. Although many inventory errors are honest mistakes, some companies overstate any inventory on purpose.

If the company is going through hard times, this could help attract investors and boost the company’s value. To maintain accuracy in financial reporting, it’s crucial for companies to correct any inventory errors as soon as they’re discovered. Depending on when the error is discovered, corrections might involve adjustments to the inventory account, retained earnings, or the cost of goods sold. Inventory errors affect your company’s bottom line by painting an inaccurate picture of its financial performance and net worth. When mistakes are made in counting inventory, you don’t get an accurate figure of your cost of goods sold, and you also wind up with wrong information regarding the value of inventory on the balance sheet. In 2023, the amount of the beginning inventory is the amount reported as the ending inventory of ($15,000 instead of $25,000).

• You begin by calculating your gross income, which is sales minus cost of goods sold, or COGS.
• As you can see, cost of goods would be overstated which understates gross profit and net income.
• 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 income statement, the cost of inventory sold is recorded as cost of goods sold.

If you overstate sales or understate expenses, you’ll pay more income tax than necessary. In some cases, financial misstatements are due to errors or incomplete information. However, when executives deliberately manage earnings to meet a desired goal, their actions may be considered unethical or even fraudulent. If the ending inventory how puerto ricans are fighting back against using the island as a tax haven 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.

Overstatement of Income

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.

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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.

How Does Overstating Inventory Overstate Revenue?

If the net purchases during 2023 are $270,000, the cost of goods available will be $285,000 (instead of $295,000). After subtracting the 2023 ending inventory of $30,000, the cost of goods sold will be $255,000 (instead of $265,000). If net sales are $325,000, the gross profit will be $70,000 ($325,000 – $255,000) instead of $60,000 ($325,000 – $265,000). 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.

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. 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, then cost of goods sold would be understated.

What Is the Cumulative Effect of an Inventory Error on Gross Profit?

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.