How does overstating ending inventory affect cost of goods sold and net income?
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Importance of proper inventory valuationA 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. Since the cost of goods sold figure affects the company’s net income, it also affects the balance of retained earnings on the statement of retained earnings. On the balance sheet, incorrect inventory amounts affect both the reported ending inventory and retained earnings. Inventories appear on the balance sheet under the heading “Current Assets”, which reports current assets in a descending order of liquidity. Because inventories are consumed or converted into cash within a year or one operating cycle, whichever is longer, inventories usually follow cash and receivables on the balance sheet. Recall that in each accounting period, the appropriate expenses must be matched with the revenues of that period to determine the net income. Applied to inventory, matching involves determining (1) how much of the cost of goods available for sale during the period should be deducted from current revenues and (2) how much should be allocated to goods on hand and thus carried forward as an asset (merchandise inventory) in the balance sheet to be matched against future revenues. Net income for an accounting period depends directly on the valuation of ending inventory. This relationship involves three items:
Thus, in contrast to an overstated ending inventory, resulting in an overstatement of net income, an overstated beginning inventory results in an understatement of net income. If the beginning inventory is overstated, then cost of goods available for sale and cost of goods sold also are overstated. Consequently, gross margin and net income are understated. Note, however, that when net income in the second year is closed to retained earnings, the retained earnings account is stated at its proper amount. The overstatement of net income in the first year is offset by the understatement of net income in the second year. For the two years combined the net income is correct. At the end of the second year, the balance sheet contains the correct amounts for both inventory and retained earnings. Exhibit 3 summarizes the effects of errors of inventory valuation: AccountInventory ErrorCost of goods soldOverstatedUnderstatedNet IncomeUnderstatedOverstatedEnding InventoryUnderstatedOverstatedExhibit 3: Inventory errors A Open Assessments element has been excluded from this version of the text. You can view it online here: pb.libretexts.org/llfinancialaccounting/?p=130 CC licensed content, Shared previously
6.4: Impacts of Inventory Errors on Financial Statements is shared under a not declared license and was authored, remixed, and/or curated by LibreTexts. How does overstated ending inventory affect net income?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.
What happens when ending inventory is overstated?If the ending inventory is overstated, cost of goods sold is understated, resulting in an overstatement of gross margin and net income. Also, overstatement of ending inventory causes current assets, total assets, and retained earnings to be overstated.
What happens if ending inventory increases?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.
Does ending inventory increase cost of goods sold?The cost of inventory that's sold during each period is subtracted from ending inventory and added to the company's COGS. This directly affects the gross profit reported on the income statement, which is calculated by subtracting COGS from net sales revenue.
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