The effect of overstated ending inventory

When you overstate ending inventory, this reduces the amount of inventory that would otherwise have been charged to the cost of goods sold during the period, so that the cost of goods sold expense declines in the current reporting period. You can see this with the following formula that is used to derive the cost of goods sold:

Beginning inventory + purchases - ending inventory = Cost of goods sold

Thus, 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:

$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 overstated is directly translated into a reduction of the cost of goods sold in the same amount.

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 and overstating the cost of goods sold in whichever future period the change occurs.

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, you then have to pay income taxes 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.

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.