When ending inventory is overstated, this reduces the amount of inventory that would otherwise have been charged to the cost of goods sold during the period. The result is that the cost of goods sold expense declines in the current reporting period. You can see this with the following formula to derive the cost of goods sold: Show
Beginning inventory + purchases - ending inventory = Cost of goods sold Example of Overstated Ending InventoryIf 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 as follows: $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 overstatement is directly translated into a reduction of the cost of goods sold in the same amount. Impact of an Inventory CorrectionIf 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, which increases the cost of goods sold in whichever future period the change occurs. Impact of an Inventory Overstatement on Income TaxesWhen 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. 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. Fraudulent Inventory OverstatementsEnding 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. This preview shows page 1 - 3 out of 10 pages. ACC304 Week 1 Practice Chapter 81.If ending inventory for 20x5 is understated because certain items weremissed in the count, then:Net income for 20x5 will be understated and CGS for 20x6 will beunderstated.Use the equation BI + PUR = EI + CGS. When EI is understated, CGS must beoverstated to maintain the equation. Net income, therefore, is understated(20x5). Then next year, BI is also understated because BI for 20x6 is EI for20x5. Using the equation, if BI is understated, CGS is also understated tomaintain the equation.2.Generally, which inventory costing method approximates most closelythe current cost for each of the following?Cost ofgoodssoldEndinginventoryLIFOFIFOLIFO assumes the sale of the most recent purchases first and thus results incost of goods sold that is the most current value. FIFO assumes the sale ofthe earliest purchases first (and beginning inventory before any purchases)and thus results in ending inventory that is the most current value. FIFO issometimes called LISH: last in still here.3.During periods of inflation, a perpetual inventory system would result in thesame dollar amount of ending inventory as a periodic inventory system underwhich of the following inventory valuation methods?FIFOLIFOYesNoUnder a perpetual inventory system, the cost of goods sold (COGS) isdetermined at the time of each sale. In a perpetual FIFO inventory system,the cost of each sale (COGS) would be based on the cost of the earliestacquired goods on hand at the time of the sales. The cost of the mostrecently acquired goods would remain in ending inventory. In a perpetualLIFO inventory system, the cost of each sale (COGS) would be based on thecost of goods acquired just prior to the sale. The cost of the earlier acquiredgoods would remain in inventory.Under a periodic inventory system, the costs of goods sold (COGS) andending inventory are determined only at the end of the period. In a periodicFIFO inventory system, the cost of sales for the period (COGS) would bebased on the cost of the earliest acquired goods available during the period.The cost of the most recently acquired goods would remain in ending ACC304 Week 1 Practice Chapter 8inventory. In a periodic LIFO inventory system, the cost of sales for the period(COGS) would be based on the last goods acquired during the period. Thecost of the earliest acquired goods would remain in ending inventory. Theabove descriptions can be summarized as follows for determination of COGS:InventorySystem/MethodCost of goods solddetermined using FIFOCost of goods solddetermined using LIFOPerpetualEarliest goods acquiredLatest goods acquired priorto each salePeriodicEarliest goods acquiredLatest goods acquiredduring the periodSince cost of goods sold for the period would be the same under bothperpetual FIFO and periodic FIFO, ending inventory would be the same Upload your study docs or become a Course Hero member to access this document Upload your study docs or become a Course Hero member to access this document End of preview. Want to read all 10 pages? Upload your study docs or become a Course Hero member to access this document Tags FIFO and LIFO accounting, COGS What happens if ending inventory is understated?If ending inventory is understated, that means that the cost of goods sold, which is an expense, is overstated. As a result, net income will be understated. Expenses reduce net income so if too many expenses were recorded then this would cause net income to be understated.
Which is true if the ending inventory is overstated quizlet?True, If ending inventory is overstated, cost of goods sold will be understated and thus net income and retained earnings are overstated.
When the current year's ending inventory is overstated the current year's cost of goods sold is overstated?The correct option is (c) the current year's net income is overstated. So, if the ending inventory is overstated, we will reduce the overstated amount while calculating the cost of goods sold. Therefore the cost of goods sold will be understated, and thus the net income will be overstated.
What happens if beginning inventory is overstated?When beginning inventory is overstated, COGS will be overstated and gross margin will be understated. If the error is large, gross margin may be low enough that a company may conclude it needs to increase prices or even eliminate the low margin product.
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If ending inventory for 20x5 is understated because certain items were missed in the count, then:
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