How Does Overinflated Inventory Affect Net Income?

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.

You 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.

You 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.

Shrinkage 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.

Some 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.