Does Overstating Inventory Affect Equity?

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Inventory and equity can be two sizable elements on a manufacturing entity’s balance sheet. Inventory represents the assets available for sale, while equity represents the owners’ past investment and retained earnings. While it may appear that the two are not directly related, overstating inventory can artificially inflate equity. When evaluating or preparing financial statements, consult with a certified public accountant.

Inventory Definition

The term "inventory" is actually used to express several types of assets that a business holds. Some inventory includes the raw materials used to produce the goods that are to be sold. Another component of inventory is goods that are partially constructed but are not complete. The final part of inventory is completed goods that are ready to be sold but have not been yet. Inventory is listed as a current asset on the balance sheet. When an item is sold, the corresponding value is subtracted from inventory and added to cost of goods sold, which is subtracted from total sales to determine the business’s income.

Equity Definition

Equity is the account on the balance sheet that represents the total value of the company to the owners. If the assets represent everything the business’s owns and liabilities represents everything the business owes, equity is what remains after all debts are settled. Therefore, a business’s equity equals its assets minus its liabilities. Equity is composed of two basic units. The first represents the owners’ initial investment in the business. The second represents all of the business’s income that it had earned in the past but did not pay out to its owners.

Overstating Inventory

Inventory can be overstated in several ways. One way of valuing inventory is by counting how many goods you have in your warehouse and multiplying that amount by a set price for each item. So, if you have 1,000 widgets and each widget is valued at $10, inventory would be valued at $10,000. So, two ways of overvaluing inventory is to claim you have more goods in inventory than you actually have or by increasing the per-unit value of the inventory items. Another issue is that some items in inventory can no longer be sold after a time due to damages or obsolescence. When an asset can no longer be sold, it should be taken out of inventory. If damaged or obsolete items are included in inventory, the asset is overvalued.

Overstating Inventory Affecting Equity

Cost of goods sold is calculated by taking the value of the business’s inventory at the beginning of the year, adding the value of all related purchases and subtracting the value of the business’s inventory at the end of the year. So, if inventory is overstated at the end of the year, the cost of goods expense will decrease. This will cause net income to increase. At the end of every year, net income is added to retained earnings, an element of equity. Therefore, overstated income artificially increases equity.

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