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Problem 16-171.When the current year’s ending inventory is overstateda.The current year’s cost of goods sold is overstated.b.The current year’s total assets are understated.c.The current year’s net income is overstated.d.The next year’s income is overstated.
2.If the beginning inventory in the current year is overstated, and that is the only errorin the current year, the income for the current year would be.
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3.Which of the following would result if the current year’s ending inventory isunderstated in the cost of goods sold calculation?
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4.Which of the following is a counterbalancing error?
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5.Which error will not self-correct in the next year?a.Accrued expense not recognized at year-endb.Accrued revenue not recognized at year-end
In the business world, inventory plays a vital role in success and can impact financial statements. If the ending inventory is incorrect, it can impact many different areas of your business and profitability. Because of this, focusing on getting the inventory correct should be one of your top priorities as a business owner.
Cost of Goods Sold
When the amount of inventory at the end of an accounting period is overstated, it has a direct impact on the cost of goods sold. The cost of goods sold can be found on the income statement and is used when calculating gross profit. You can see this clearly by looking at Accounting Tools' formula for calculating the cost of goods sold:
Cost of goods sold = Beginning inventory + purchases - ending inventory
Suppose Acme Corp has a beginning inventory of $500, purchases of $3,000 and an ending inventory of $1,000. Its cost of goods sold is:
$500 + $3,000 - $1,000 = $2,500
Now suppose that Acme incorrectly states the ending inventory as $1,500. The cost of goods sold now becomes $2,000 ($500 + $3,000 - $1,500). The overstatement of ending inventory in the current year would cause cost of goods sold appear lower than it really is.
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. 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. When this happens, it increases the tax liability for the company. You will then essentially pay taxes on income that you should not have to.
Impact of Corrections
An overstatement of ending inventory in one period results in errors in future periods, unless this is corrected at a later date, reports Accounting Coach. 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.
Things to Consider
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.