One of the most important reasons that a company may understate its cost of goods sold is to increase its chances of short-term success in a given market. Short-term success can be attained by getting financing or impressing outsiders to finance the company. However, understating the cost of goods sold can be dangerous for a company’s long-term survival if authorities find the fraud. Moreover, understating the cost of goods sold is in direct opposition to bookkeeping standards and rules. The different reasons why a company would understate its cost of goods sold have been discussed below.
Increase in Income
To determine the gross profit of a company, the cost of goods sold is subtracted from revenues. The lower the cost of goods sold, the higher the gross profit. Consequently, the lower cost of goods sold makes an organization look more effective and efficient. A company stating the lower cost of goods sold can create a more sustainable business model in a competitive market. A company looking to increase the cost of goods sold may under-represent the cost of goods sold to impress potential investors. However, this does not provide an accurate presentation of an entity’s balance sheet and can bring legal trouble. Sure, a firm can increase its income by attracting more investors, but the investors and other authorities can sue the company if they find out that the cost of goods sold was understated.
Small businesses often need outside financing to survive and grow in the market. A lower cost of goods sold (COGS) and a more appealing balance sheet may be needed to impress a bank loan officer. Businesses may be tempted to understate their COGS to make their business model look more attractive and profit more sustainable, making them better candidates for loans. A lower COGS makes the financial statements more attractive – at least until it comes time to pay taxes on the earnings. This may impress potential investors and analysts who look only at the documents and do not delve any deeper into the data. The analysis based on provided data – that is, understated cost of goods sold – can provide positive remarks regarding an organization’s performance and sustainability. Therefore, an investor can be convinced to invest their money into the company. Hence, some companies falsely understate the cost of goods sold to present their efficiency in managing costs and achieving higher profits.
Knowingly filing false financial statements puts a company, the signatory to the documents, and perhaps the business owner in legal jeopardy. State and federal agencies watch for irregularities in balance sheets and are increasingly focusing on the raw data used to compile those numbers. Fraudulently lowering the COGS, or altering anything on financial documents, carries a considerable risk of fines, prison terms, or both. Although the understating cost of goods sold is illegal and risky, some companies attract different stakeholders.
Legally Minimizing COGS
Companies can value their inventory in a way that legally minimizes the cost of goods sold, depending on the nature of their business. Using the first-in, first-out (FIFO) method determines the COGS by first using your oldest inventory costs. Depending on what kind of business it is, this may or may not objectively be the optimum strategy. For example, a business that sells rare coins may have won a particular item for $100 at auction and later spent $1,000 to acquire another. If the business sells that coin for $900 as part of a promotion, the FIFO method will show an $800 profit, taking the coin that costs $100 to acquire out of inventory. Using the last-in, first-out inventory value method would record the same transaction as a $100 loss by removing the $1,000 coin from inventory.About Complete Controller® – America’s Bookkeeping Experts Complete Controller is the Nation’s Leader in virtual bookkeeping, providing service to businesses and households alike. Utilizing Complete Controller’s technology, clients gain access to a cloud-hosted desktop where their entire team and tax accountant may access the QuickBooks™️ file, critical financial documents, and back-office tools in an efficient and secure environment. Complete Controller’s team of certified US-based accounting professionals provide bookkeeping, record storage, performance reporting, and controller services including training, cash-flow management, budgeting and forecasting, process and controls advisement, and bill-pay. With flat-rate service plans, Complete Controller is the most cost-effective expert accounting solution for business, family-office, trusts, and households of any size or complexity.