Question

A company issued financial statements for the year ended March 31, 2020. Three months later, management discovered that net income was overstated (too high) by $10,000.  

1. There was no fraud involved.

2. The accountants at the company were all competent.  

What could have caused the error?

Please answer in two paragraphs with clear explanation and good reasoning.   

Answer 1

Answer: If Net income was overstated but there is no fraud then there may be two reasons-

Inaccurate & Overstate Inventory- If Cost of goods sold amount is lower and it is subtracted from Sales then Gross income will increase (go up) and operating expenses and other expenses are deducted from Gross profit to get the Net Income. Cost of goods sold may be less because of Overstate inventory. COGS is based on the difference between beginning and ending inventory. If inventory is overstated, it indicates that you have sold fewer items then cost of goods sold shrinks and income/profit increases. So overstating inventory may be one of the reasons.

Overstate Revenues- Some companies are aggressive to recognize revenues. As per revenue recognition principle in accrual accounting, revenue is realized when earned and not when the cash is received so companies overstates revenue figures that may lead to higher net income.