If the beginning inventory exceeds the ending inventory, the net income is overstated
Definition of Overstating InventoryOverstating inventory means that the reported amount for the cost of a company's inventory is greater than the actual true cost based on accounting rules. In other words, the reported amount is: Show
Examples of the Effect of Overstating InventoryIf a corporation overstates its inventory, it will affect the following reported amounts on the corporation's income statement:
The overstating of inventory will also affect the following reported amounts on the corporation's balance sheet: Since the overstated amount of inventory at the end of one accounting period becomes the beginning inventory of the following period, the following period's cost of goods sold will be too high and will result in the following period's gross profit and net income being too low. (The retained earnings and other balance sheet amounts will be correct at the end of the second period.) Definition of Inventory is UnderstatedIf inventory is understated at the end of the year, it means that the amount of inventory being reported is less than the true or correct amount. Some reasons for reporting too little ending inventory could be any or all of the following:
When the ending inventory is understated, the following financial statement information will be incorrect:
Example of Understated InventoryThe formula for the cost of goods sold is: Assume that the cost of goods available for the year 2021 was $240,000. If the company shows too little of that cost as its ending inventory (say $15,000 instead of $25,000), it will mean that too much cost will appear on the 2021 income statement as the cost of goods sold ($225,000 instead of $215,000). The formula for the gross profit is: Net sales - cost of goods sold = gross profit. If net sales for 2021 were $300,000, the gross profit will be incorrectly reported as $75,000 ($300,000 - $225,000) instead of the true amount of $85,000 ($300,000 - $215,000). In 2022, the amount of the beginning inventory is the amount reported as the ending inventory of 2021 ($15,000 instead of $25,000). If the net purchases during 2022 are $270,000, the cost of goods available will be $285,000 (instead of $295,000). After subtracting the 2022 ending inventory of $30,000, the cost of goods sold will be $255,000 (instead of $265,000). This means that the cost of goods sold for 2022 will be too low by $10,000. 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). This means the gross profit will too low. Recap: the gross profit in 2021 was understated by $10,000 ($75,000 instead of the true $85,000). The gross profit in 2022 was overstated by $10,000 ($70,000 instead of the true $60,000). One error in calculating the ending inventory of 2021 caused the individual income statements of 2021 and 2022 to report incorrect gross profits and incorrect net incomes. (In our example, only the balance sheet for December 31, 2021 reported the incorrect amounts of inventory and owner's equity.) Recommended textbook solutions
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What happens when beginning inventory is overstated?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.
Does overstated inventory affect net income?Overstatement of Income
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.
What happens if net income is overstated?If a company overstates assets or understates liabilities it will result in an overstated net income, which carries over to the balance sheet as retained earnings and therefore inflates shareholders' equity.
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