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. 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.
- Despite your best intentions, mistakes can be made while preparing company financial records.
- This error not only affects the income statement (by overstating profits) but also the balance sheet where inventory is overstated in current assets by $10,000.
- If you overstate sales or understate expenses, you’ll pay more income tax than necessary.
- To maintain accuracy in financial reporting, it’s crucial for companies to correct any inventory errors as soon as they’re discovered.
Now, let’s assume that a mistake was made during the inventory count and the actual ending inventory was $60,000, not $70,000. This means ABC Retailers has overstated its ending inventory by $10,000. John Freedman’s articles specialize in management and financial responsibility. He is a certified public accountant, graduated summa cum laude with a Bachelor of Arts in business administration and has been writing since 1998. His career includes public company auditing and work with the campus recruiting team for his alma mater. Teresa Nguyen has more than 10 years of experience in corporate finance and accounting.
Balance Sheet
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. 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).
- However, a correction will also have an effect on the cost of goods sold, except this time it will be in the opposite direction.
- In short, the $500 ending inventory overstatement is directly translated into a reduction of the cost of goods sold in the same amount.
- However, knowing more about ways that inventory can be understated can help you identify situations where you may need to look closer at your financial statements.
- On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings.
As a result, ABC Retailers understates its COGS by $10,000, and if we assume they made sales of $300,000, their gross profit should have been $110,000 ($300,000 – $190,000). However, because of the error, the gross profit is calculated as $120,000 ($300,000 – $180,000). If you sell products (that you purchase or manufacture), and the cost of your products tends to increase over time, using the LIFO method will typically result in a lower taxable income compared to FIFO.
Error
Employee or customer theft can cause inventory to go missing, which is known as shrink. If the differences are found and corrected during the company’s annual inventory count at the end of the is unearned revenue a liability year, then inventory will be properly stated on an accounting basis. Even though it may seem like this should be considered an understatement of inventory, the equity balance will be correct.
Income includes cash sales and credit sales, which are accounts receivable as credit sales are income a company has earned but haven’t received yet. Some of that debt may never be paid, for example when customers refuse to pay or go bankrupt. By looking at how many bills went unpaid in the past, a company can estimate how much of current debts will also go unpaid. Understating the amount of bad debt makes both the income statement and balance sheet look stronger and healthier.
How to Adjust Entries for a Merchandise Inventory
The overstatement of ending inventory in the current year would cause cost of goods sold appear lower than it really is. In the business world, inventory plays a vital role in success and can impact financial statements. To maintain accuracy in financial reporting, it’s crucial for companies to correct any inventory errors as soon as they’re discovered. Depending on when the error is discovered, corrections might involve adjustments to the inventory account, retained earnings, or the cost of goods sold. Overstating ending inventory will overstate net income, since this is directly related to the cost of goods sold.
What is an Overstated Ending Inventory?
Consequently, that period’s COGS will be overstated, net income will be understated, and the errors of the previous period will be self-correcting. However, this doesn’t eliminate the need to correct the error as soon as it is identified, to maintain the integrity and reliability of the financial statements. If inventory is miscounted during the company’s annual inventory count, this could cause inventory to be understated.
What Will Happen if Sales Are Overstated or Expenses Are Understated?
This website is using a security service to protect itself from online attacks. There are several actions that could trigger this block including submitting a certain word or phrase, a SQL command or malformed data. Loss of financing – A buyer who is relying on outside financing or investors to raise funds for a purchase might lose their opportunity to obtain funds, causing the deal to collapse.
Overstated Sales
She has worked with companies in the software, real estate and restaurant industries. Nguyen holds a license as a certified public accountant, as well as a B.A. Brian Bass has written about accountancy-related topics and accounting trends for “Account Today.” He works as a senior auditor specializing in manufacturing and financial services companies for one of the Big 5 accounting firms. Harold Averkamp (CPA, MBA) has worked as a university accounting instructor, accountant, and consultant for more than 25 years.