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 a given market. Short-term success can be attained by 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 its cost of goods sold are discussed below.
Increase in Income
The cost of goods sold is subtracted from revenues to determine a company’s gross profit. The lower the cost of goods sold, the higher the gross profit. Consequently, lower cost of goods sold makes an organization look more effective and efficient. A company stating the lower cost of goods sold can create the appearance of a more sustainable business model in a competitive market. A company looking to increase the cost of goods sold may underrepresent the cost of goods sold to impress potential investors.
However, this does not provide an accurate presentation of 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 that the cost of goods sold 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 needed to impress a bank loan officer. Businesses may be tempted to 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. This 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, investors can be convinced 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 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. Even still, although understating the 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. Using the first-in-first-out (FIFO) method determines the COGS by using the costs of your oldest inventory first. 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 one. If the business then sells that coin for $900 as part of a promotion, the FIFO method would result in the company showing an $800 profit, taking the coin that cost $100 to acquire out of inventory. The first-in, first-out inventory value method would record the same transaction as a $100 loss by removing the $1,000 coin from inventory.
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