One of the most important reasons a company may understate its cost of goods sold is to increase its chances of short-term success in each market. You can attain short-term success by getting financing or impressing outsiders to finance the company. However, understating the cost of goods sold can be dangerous for the long-term survival of a company if authorities find the fraud. Moreover, understating the cost of goods sold directly opposes bookkeeping standards and rules. The different reasons a company would understate the cost of goods sold are below.
Increase in Income
The cost of goods sold subtracts from revenues to determine a company’s gross profit. The lower the price of goods sold, the higher the gross profit. Consequently, a lower cost of goods sold makes an organization look more effective and efficient. A company stating the lower price 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 represent the cost of goods sold to impress potential investors.
However, this does not accurately present an entity’s balance sheet and, therefore, 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 the cost of the goods is understated.
Get Financing
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 necessary to impress a bank loan officer. Businesses may understate their COGS to make their business model look more attractive and their profit more sustainable, making them better loan candidates. A lower COGS makes the financial statements more attractive until it comes time to pay taxes on the earnings.
You may impress potential investors and analysts who look only at the documents and do not delve deeper into the data. The analysis based on provided data – that is, understated cost of goods sold – can provide positive remarks regarding the performance and sustainability of an organization. Therefore, you can convince investors to invest their money in the company. Hence, some companies falsely understate the cost of goods sold to present their efficiency in managing costs and achieving higher profits.
Considerable Risk
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 increasingly focus 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 underlying cost of goods sold is illegal and risky, some companies do so to 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. The first-in, first-out (FIFO) method determines the COGS by manipulating the prices of the oldest inventory first. This may or may not objectively be the optimum strategy, depending on the kind of business.
For example, a company 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 then sells that coin for $900 as part of a promotion, the FIFO method would show an $800 profit, taking the cash that costs $100 to acquire out of inventory. The last-in, first-out inventory value method would record the same transaction as a $100 loss by removing the $1,000 coin from stock.
Conclusion
In conclusion, while understating the cost of goods sold may offer short-term benefits such as increased income and improved prospects for financing, it poses significant long-term risks. Violating accounting standards and rules can lead to legal troubles, fines, and loss of trust from stakeholders. Despite the temptation to manipulate financial data, companies must prioritize transparency and integrity in their reporting practices to ensure sustainable growth and compliance with regulations. Additionally, while there are legal ways to minimize the cost of goods sold, such as using inventory valuation methods like FIFO, companies must exercise caution and ensure they adhere to ethical and legal standards in their financial reporting.
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