The Effect of Overstating Beginning Inventory

by Teresa Nguyen

Whether you are Jeff Bezos running or a local shop on Main Street, an effective inventory management system is essential to maintaining accurate inventory counts. Inventory records are critical not only for planning purchases, but also for preparing accurate financial statements. An error in your records, such as overstating beginning inventory, can trickle down through your financial statements and affect multiple areas.

Cost of Goods Sold and Gross Margin

Cost of goods sold is an expense calculated by adding the beginning inventory amount with purchases during the period and then subtracting the ending inventory amount. Gross margin, the difference between revenues and COGS, is an important measure of the profitability of an item or service. 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.

Pre-Tax Income and Income Tax

Pre-tax income is the difference between revenues and expenses, not including income tax expense. When COGS is inflated because beginning inventory is overstated, pre-tax income will appear lower than actual. In turn, income tax expense will be reduced because the income upon which the tax is calculated is lower. If the inventory overstatement and resulting financial statement errors are not identified in a timely manner, the company will underpay its income taxes and be subject to penalties and interest imposed by the Internal Revenue Service once the errors are identified.

Net Income

Net income is the difference between revenues and total expenses, including income tax expense. When beginning inventory is overstated, net income will be understated. Because it is the final tally on the income statement, it accumulates all errors that have trickled down. Even small errors can be compounded into significant misstatements.

Example Calculation

ABC Co. started January with $50 of inventory. It purchased inventory of $100 and ended the month with $100 of goods in inventory; its cost of goods sold was $50, and its gross margin, based on January revenues of $75, was $25. Other expenses were $10, yielding a pre-tax income of $15. An income tax rate of 40 percent meant a tax of $6, so ABC Co.’s net income for January was $9. However, if ABC Co. overstated its beginning inventory by $10, or 20 percent, its COGS would be $60, gross margin would be $15, pre-tax income would be $5 and income tax would be $2. Therefore, ABC Co. would show a net income of $3, a 67 percent reduction caused by overstating beginning inventory.

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