Inventory errors at the end of a reporting period affect both the income statement and the balance sheet. Overstatements of ending inventory result in understated cost of goods sold, overstated net income, overstated assets, and overstated equity. 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.
Variations in COGS will have a direct impact on a company’s income statements because the COGS is subtracted from sales to get the gross profit. An overstated inventory will inflate gross profits and conversely understating inventory will have a negative impact on gross profits. Proper inventory valuation is important when accounting for inventory through financial reporting. If inventory is not correctly valued inventory discrepancies will impact financial statements such as balance sheets, income statements and statements of retained earnings. 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, that period’s COGS will be overstated, net income will be understated, and the errors of the previous period will be self-correcting.
- A periodic inventory method works on a system that calculates the cost of the goods sold (COGS).
- Inventory is an asset held by a business for sale, and it adds to the total capital of a business.
- Lower inventory volume in the accounting records reduces the closing stock and effectively increases the COGS.
- The result would be an overstatement of ending inventory and an understatement of cost of goods sold.
- 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.
- 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.
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 reconciliation when accounting for inventory is not simply an adjustment of the book balance to match the physical count. The overstatement of ending inventory in the current year would cause cost of goods sold appear lower than it really is. A company will often use the gross profit method to estimate cost of goods sold and ending inventory during an interim period.
4: Impacts of Inventory Errors on Financial Statements
The inventory team can miscount items or misclassify them in the files, or inventory in transit isn’t entered into the computer properly. In some cases, managers will deliberately overstate inventory to pad net income. Now, let’s assume that a mistake was made during the inventory count and the actual ending inventory was $60,000, not $70,000. Inventory adjustments are used to correct these differences to avoid overstating or understating the income statement. After you write the revenue on your statement, you subtract the cost of goods sold to determine your gross income.
- Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.
- Matching Principle If expenses are incurred in 2019 but paid in 2020, omitting the adjusting entry will cause net income to appear higher in 2019 due to the expenses not being recorded.
- Melanie has been writing about inventory management for the past three years.
- This is done so that it looks like the company is more profitable than it actually is.
The gross profit and net income are overstated as a result of overstating inventory because not enough of the cost of goods available is being charged to the cost of goods sold. The higher amount of net income means that the reported amount of retained earnings and stockholders’ equity is also too high. This can happen due to errors in counting or pricing the inventory, data entry mistakes, theft, or in more extreme cases, fraudulent reporting.
Overstatement Effects of Ending Inventory
By looking at how many bills went unpaid in the past, an accountant can estimate how many current debts will also go unpaid. 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.
Even so, there have been cases where executives deliberately opted to understate it.
How to Calculate Net Income With Ending Inventory
In the business world, inventory plays a vital role in success and can impact financial statements. 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.
The Net Income Effect of Overstating & Understating
A company would use this method if they do not have a perpetual inventory system and they only perform a physical inventory count at the end of a period. If you overstate net income, you inflate retained earnings and owner’s equity, because you add net income to retained earnings at the end of the period. If the big concern is the company’s tax bill, the incentives are reversed. The same kind of errors and frauds exist, but they work in the opposite direction. For example, understating inventory to make net income less makes for a smaller tax bill. Understating the amount of bad debt makes both your income statement and your balance sheet look stronger and healthier.
As you can see, if we use a gross profit % of 40% on sales of $1,000, that results in cost of goods sold of $600. If the gross profit % should have been 30%, then cost of goods sold would have been $700. When we plug those figures into an inventory rollforward, we can see that ending inventory ends up being overstated when we overstate the gross profit % used.
At the end of an accounting period, the total value of items to be sold, often acknowledged as stock-in-hand, is recorded as inventory under current assets. When the inventory asset is understated at the end of the year, then income for that year is also understated. The reason is 17 advantages and disadvantages of zero based budgeting that, if costs are not included in inventory, then by default they must have been included in the cost of goods sold. When this happens, costs are transferred from the balance sheet to the income statement, so that some of the inventory asset is incorrectly charged to expense.
Overstatements of beginning inventory result in overstated cost of goods sold and understated net income. Conversely, understatements of beginning inventory result in understated cost of goods sold and overstated net income. When beginning inventory is overstated, COGS will be overstated and gross margin will be understated. If the error is large, gross margin may be low enough that a company may conclude it needs to increase prices or even eliminate the low margin product. 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.
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When the inventory is corrected, it makes the cost of goods sold appear higher than what it actually is. When a business overstates the inventory, the reduced cost of goods sold will increase the business’s bottom line and tax liability. This error translates into an overstatement of net income before taxes and ultimately may cause the business to overpay taxes.
The result would be an overstatement of ending inventory and an understatement of cost of goods sold. The example below assumes that the gross profit % used is 40%, but the correct gross profit % is actually 30%. 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 good sold.
Although many inventory errors are honest mistakes, some companies overstate any inventory on purpose. 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. An understated inventory indicates there is less inventory on hand than the actual stock amount. This can arise from errors in receipting stock, failure to reconcile the movement of raw materials and finished goods from one location to another and unrecorded transactions.
Likewise, if you understate the number of returns you anticipate, that makes the revenue and net income figures higher. The cost of goods sold is based on the difference between your beginning and ending inventory. If you overstate inventory, indicating you’ve sold fewer items, cost of goods sold shrinks and your net income gets larger. If you understate inventory, your net income becomes smaller than it really is.