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. Overstated inventory records will indicate more inventory stock is held, rather than the true, physical stock numbers. This discrepancy can be caused by theft, damage, fraud or incorrect inventory counts and administrative errors.
- 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.
- The value of this inventory must be calculated correctly because it accounts for a significant share of the business’s current assets.
- A periodic inventory method works on a system that calculates the cost of the goods sold (COGS).
- Therefore, it is necessary and often a legal requirement, for one method to be chosen and applied consistently across future reporting periods to maintain accuracy.
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. In https://www.quick-bookkeeping.net/who-files-schedule-c-profit-or-loss-from/ short, the $500 ending inventory overstatement is directly translated into a reduction of the cost of goods sold in the same amount. Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists.
The Impact of Overstating Accounts Receivable on Financial Statements
Inventory and cost of goods sold are inversely related, so if inventory is overstated, cost of goods sold would be understated. An adjustment entry for overstated inventory will add the omitted stock, increasing the amount of closing stock and reduces the COGS. Conversely, in understated inventory, an adjustment entry needs to be made to remove the surplus stock, which in turn reduces closing stock to the correct level and increases the COGS. 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.
Since 2008, federal rules say you have to value assets at the probable price they’d fetch when sold. In 2012, KCAP Financial paid $50,000 to settle charges that it valued assets at cost instead of at sale value. The Minnesota Society of CPAs said in 2011 that roughly half of all financial-statement frauds may be the result of asset overstatement.
When applied to inventory, the cost of goods available for sale during the period should be deducted from current revenues. 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. 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. 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. To maintain accuracy in financial reporting, track jobs and projects with xero projects 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.
What are the effects of overstating inventory?
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. Proper inventory valuation is important when accounting for inventory through financial reporting.
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. In each accounting period, any applicable expenses must correspond with revenue earnt to determine the business’ net income.
As you can see, cost of goods would be overstated which understates gross profit and net income. 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. Any of the four costing approaches in the periodic inventory method will produce a different result over the same accounting period. Therefore, it is necessary and often a legal requirement, for one method to be chosen and applied consistently across future reporting periods to maintain accuracy. 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).
Overstated Ending Inventory
The value of this inventory must be calculated correctly because it accounts for a significant share of the business’s current assets. 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.
When not writing about inventory management, you can find her eating her way through Auckland. Inventory discrepancies occur between the value of inventory captured in records and the value of the actual inventory held. Since then he’s researched and written newspaper and magazine stories on city government, court cases, business, real estate and finance, the uses of new technologies and film history.