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If ending inventory is overstated, then cost of goods sold would be understated. As you can see in the visual below, the incorrectly stated inventory balance is $25 higher than the correct ending inventory balance. Since we can assume that beginning inventory and purchases would be the same, the difference would impact cost of good sold. Inventory and cost of goods sold are inversely related, so if inventory is overstated, cost of goods sold would be understated.  Below is the related income statement that shows the impact from overstating inventory. As you can see, cost of goods would be overstated which understates gross profit and net income.
Below is an example multiple choice explanation video that provides further explanation: Back To All Questions You might also be interested in... Discontinued Operations on the FAR CPA ExamOverview of Discontinued Operations In financial reporting, discontinued operations refer to a component of a company’s core business or product line that have been divested or shut down. Discontinued operations will be reported (net of tax) separately from continuing operations on the income statement. The reason that discontinued operations are reported separately is so that... Equity Method Excel WorkbookIf you would like to use the Excel workbook that was used to create the Universal CPA lecture on the equity method, please click the link below to download the Excel workbook: Equity Method Lecture Example https://youtu.be/QE4flnmuSkw How Hard is the CPA Exam?So you’re thinking about taking the CPA exam? Whether you have a dream of becoming a tax advisor, feel as though you need public accounting experience, or just want to solidify your business acumen, the CPA license is one of the most prestigious and well respected licenses in the business world. The exam itself is... A business that sells inventory might misstate the value of ending inventory. The mistake might be innocent, but at other times it might represent earnings management or worse. The Internal Revenue Service requires companies to take physical inventory counts at reasonable intervals to adjust inventory value. Overstated inventory hurts shareholders, because it increases taxable income -- the company will pay more income tax than it should. Financial ReportingYou report net income at the bottom of the income statement. At top, you report sales revenues and then subtract the cost of goods sold to figure gross profits. COGS is equal to beginning inventory plus inventory purchases minus ending inventory. If you overstate ending inventory, COGS will be too low. This increases gross profits, net income and taxes. The effect shows up on the balance sheet as well. Inventory is a current asset -- if you overstate it, you also overstate owner’s equity, which is the difference between assets and liabilities. Overstated InventoryYou can overstate inventory through miscounting and by applying the wrong costs to inventory on hand. Miscounting can occur through human error or deliberate action. For example, inventory counted on one day might move to another location where it is double counted on a subsequent day. If you maintain a perpetual inventory, you might not become aware of stolen or damaged inventory until you take a physical count. You might also overstate inventory by failing to recognize when the net realizable value of inventory drops because of reasons such as damage, obsolescence or government recall. ShrinkageShrinkage is the loss of inventory due to shoplifting, employee theft, supplier fraud and paperwork errors. The National Retail Security Survey estimated U.S. shrinkage at $34.5 billion in 2011, representing 1.41 percent of retail sales. Although this represents an improvement over 2010 figures, shrinkage clearly is a substantial problem that, if not discovered, can lead to overinflated inventory. Companies that rarely take physical inventory may need to make significant adjustments after conducting a count. Earnings ManagementSome companies set up compensation incentives that reward managers for achieving profit targets. Morally challenged managers might overstate inventory to increase net income through a number of ploys, including fictitious goods, manipulated counts and non-recorded purchases. Auditors look for signs of ghost inventory, such as inventory increasing faster than sales or total assets. Other tip-offs are fraudulent inventory count sheets, fairy-tale shipments and bogus purchase orders. If not caught, then inventory overstatement scams not only increase earnings, they line the pockets of complicit executives. References Resources Writer Bio Based in Greenville SC, Eric Bank has been writing business-related articles since 1985. He holds an M.B.A. from New York University and an M.S. in finance from DePaul University. You can see samples of his work at ericbank.com. Image Credit Jupiterimages/Comstock/Getty Images What is the effect of overstated inventory?Overstating inventory
When inventories are overstated it lowers the COGS, because the excess stock in accounting records translates to higher closing stock and less COGS. When ending inventory is overstated it causes current assets, total assets, and retained earnings to also be overstated.
How will inventory overstatement affect the balance sheet?You must also restate the prior year's income statement and balance sheet when you find an inventory error. Inventory balance was overstated – increase COGS on the income statement, which will decrease net income; decrease ending inventory and decrease retained earnings on the balance sheet.
What is the effect of inventory in financial statement?Reporting of Inventory on Financial Statements
An increase in inventory will be subtracted from a company's purchases of goods, while a decrease in inventory will be added to a company's purchase of goods to arrive at the cost of goods sold.
How would the overstatement of inventory affect liabilities?The tax liability of a business depends on the gross profit. When a business overstates the inventory, the reduced cost of goods sold will increase the business's bottom line and tax liability. This error translates into an overstatement of net income before taxes and ultimately may cause the business to overpay taxes.
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