The effect of overstated ending inventory
/When ending inventory is overstated, this reduces the amount of inventory that would otherwise have been charged to the cost of goods sold during the period. The result is that the cost of goods sold expense declines in the current reporting period. You can see this with the following formula to derive the cost of goods sold:
Beginning inventory + purchases - ending inventory = Cost of goods sold
Example of Overstated Ending Inventory
If ABC Company has beginning inventory of $1,000, purchases of $5,000, and a correctly counted ending inventory of $2,000, then its cost of goods sold is as follows:
$1,000 Beginning inventory + $5,000 Purchases
- $2,000 Ending inventory = $4,000 Cost of goods sold
But if the ending inventory is incorrectly stated too high, at $2,500, the calculation becomes:
$1,000 Beginning inventory + $5,000 Purchases
- $2,500 Ending inventory = $3,500 Cost of goods sold
In short, the $500 ending inventory overstatement is directly translated into a reduction of the cost of goods sold in the same amount.
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Impact of an Inventory Correction
If the ending inventory overstatement is corrected in a future period, this problem will reverse itself when the inventory figure is dropped, thereby shifting the overstatement back into the cost of goods sold, which increases the cost of goods sold in whichever future period the change occurs.
Impact of an Inventory Overstatement on Income Taxes
When an ending inventory overstatement occurs, the cost of goods sold is stated too low, which means that net income before taxes is overstated by the amount of the inventory overstatement. However, income taxes must then be paid on the amount of the overstatement. Thus, the impact of the overstatement on net income after taxes is the amount of the overstatement, less the applicable amount of income taxes.
To go back to the preceding example, if ABC Company would otherwise have had a net profit before tax of $3,500, the overstatement of ending inventory of $500 now reduces the cost of goods sold by $500, which increases ABC's net profit before tax to $4,000. If ABC has a marginal income tax rate of 30%, this means that ABC must now pay an additional $150 ($500 extra income x 30% tax rate) in income taxes.
Fraudulent Inventory Overstatements
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. In these cases, there are a variety of tools for fraudulent inventory overstatement, such as reducing any inventory loss reserves, overstating the value of inventory components, overcounting inventory items, overallocating overhead, and so forth.
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