When a company understates its ending inventory balance, it can lead to several significant consequences. Firstly, the cost of goods sold (COGS) will be overstated because ending inventory is subtracted from the sum of beginning inventory and purchases to calculate COGS. This means that the expenses shown on the income statement will be higher than they actually are, resulting in a lower net income.
Additionally, an understated ending inventory can also affect key financial ratios. For example, since net income is lower, the return on equity (ROE) ratio will be negatively impacted. This may lead to a misinterpretation of the company’s financial health by investors or creditors.
Moreover, tax obligations may increase due to the understatement of income, affecting cash flow. In the long run, consistent understatement of inventory can indicate operational issues, poor inventory management, or intentional misrepresentation of financial information.
In summary, understating the ending inventory balance can distort a company’s financial statements and ratios, leading to poor decision-making and potential legal issues.