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.

However, the ending inventory was undercounted by $30,000, so the ending inventory balance should have been $130,000, which means that the cost of goods sold should have been $870,000. The result is reported profits that are $30,000 lower than is really the case. For example, if you incorrectly overstated an inventory purchase, debit your cash account by the amount of the overstatement and credit your inventory for the same amount.

Taxes

In each accounting period, any applicable expenses must correspond with revenue earnt to determine the business’ net income. When applied to inventory, the cost of goods available for sale during the period should be deducted from current revenues. 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). Understated inventory balances will inflate the company’s cost of goods sold relative to sales. If the cost of goods sold is overstated, that means that the overall expense will be too high as well.

Even so, there have been cases where executives deliberately opted to understate it.

Understated inventory may be caused by inventory record keeping errors, as well as by an inadequate count of the ending inventory. It can also be triggered by an incorrect extension of inventory unit counts to derive the final inventory valuation. Consequently, a business should use cycle counting to continually verify whether its inventory records match its physical inventory. It can also review inventory valuations on a trend line to see if there are any unusual spikes or dips in the valuation amounts over time, which may be worthy of further investigation. Overstating assets and revenues falsely reflects a financially stronger company by inclusion of fictitious asset costs or artificial revenues.

Distorting Revenue

Various other additions and subtractions turn gross income into net income. Our review course offers a CPA study guide for each section but unlike other textbooks, ours comes in a visual format. Article by Melanie Chan in collaboration with our team of Unleashed Software inventory and business specialists.

Inventory Obsolescence Income Statement Classification

If there is an understatement of an inventory purchase, debit inventory in the amount of the understatement and credit cash for an equal amount. If there is an overstatement of inventory, increase COGS by the dollar amount, which produces a lower net income. On the balance sheet reduce the ending inventory to reflect lower-ending inventory, and decrease retained earnings by the dollar change to net income. Income includes cash sales and credit sales, which are accounts receivable as credit sales are income you’ve earned but haven’t received yet. Some of that debt may never be paid, for example when customers refuse to pay or go bankrupt.

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.

How to Take a Reserve Against Your Inventory

Another account will also have an error, due to the requirements for double-entry accounting. If ending inventory is overstated, the cost of goods sold is too low or understated, and when an expense is understated, net income is overstated. If both purchases and ending inventory are overstated by the same amount, net income is not affected. The figure for gross profit is achieved by deducting the cost of sale from net sales during the year. An increase in closing inventory decreases the amount of cost of goods sold and subsequently increases gross profit.

What Will Happen if Sales Are Overstated or Expenses Are Understated?

Overstating inventory Overstated inventory records will indicate more inventory stock is held, rather than the true, physical stock numbers. The formula for calculating cost of goods sold would just be sales x (1 – gross profit %). So what happens if the company overstates the gross profit % used in the calculation?

Overstating inventory When inventories are overstated it lowers the COGS, because the excess stock in accounting records translates to higher closing stock and less COGS. When ending inventory is overstated it causes current assets, total assets, and retained earnings to also be overstated. A merchandising company can prepare accurate income statements, statements of retained earnings, and balance sheets only if its inventory is correctly valued. 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. Inventories appear on the balance sheet under the heading “Current Assets”, which reports current assets in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet. When inventories are overstated it lowers the COGS, because the excess stock in accounting records translates to higher closing stock and less COGS.

sampling risk in audit 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. You will then essentially pay taxes on income that you should not have to. Investors and lenders study financial statements to decide if your business is a good risk. The income statement, which shows how much you earned in a given period, is particularly important to investors.

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