What happens if inventory is overstated

Another common cause of periodic inventory errors results from management neglecting to take the physical count. Example 1 shown in Figure depicts the balance sheet and income statement toggle when no inventory error is present. Example 2.

Assume these values to be incorrect with inventory error. Users of financial statements make important business and personal decisions based on the data they receive from the statements and errors of this sort provide those users with faulty information that could negatively affect the quality of their decisions. In these examples, the combined net income was identical for the two years and the error worked itself out at the end of the second year, yet year 1 and year 2 were incorrect and not representative of the true activity of the business for those periods of time.

Extreme care should be taken to value inventories accurately. Figure Which of the following financial statements would be impacted by a current-year ending inventory error, when using a periodic inventory updating system? Figure Which of the following would cause periodic ending inventory to be overstated? Figure How long does it take an inventory error affecting ending inventory to correct itself in the financial statements? Figure What type of issues would arise that might cause inventory errors?

Causes of inventory errors might be related to consigned goods, goods delivered before or after the title transfers, sloppy inventory counts, lost records, calculation errors, and any other circumstance that causes inaccuracy in the counts.

However, errors in inventory were discovered after the reports were issued. Figure Company Elmira reported the following cost of goods sold but later realized that an error had been made in ending inventory for year The correct inventory amount for was 32, Once the error is corrected, a how much is the restated cost of goods sold for ?

Figure Company Edgar reported the following cost of goods sold but later realized that an error had been made in ending inventory for year The correct inventory amount for was 12, Figure Consider the dilemma you might someday face if you are the CFO of a company that is struggling to satisfy investors, creditors, stockholders, and internal company managers.

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. This makes the company look less profitable than it truly is. Because of this, investors may form negative opinions about the company.

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.

Cost of goods sold is an expense calculated by adding the beginning inventory amount with purchases during the period and then subtracting the ending inventory amount. Gross margin, the difference between revenues and COGS, is an important measure of the profitability of an item or service. 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. Pre-tax income is the difference between revenues and expenses, not including income tax expense. When COGS is inflated because beginning inventory is overstated, pre-tax income will appear lower than actual. In turn, income tax expense will be reduced because the income upon which the tax is calculated is lower.

If the inventory overstatement and resulting financial statement errors are not identified in a timely manner, the company will underpay its income taxes and be subject to penalties and interest imposed by the Internal Revenue Service once the errors are identified. Net income is the difference between revenues and total expenses, including income tax expense.