In the earlier article, any overstatement of the closing stock valuation will lead to an overstatement of the gross profit and consequently the net profit for the CURRENT period.
The next thing we need to understand is that the closing stock of one period is the opening stock for the subsequent period. So, what will the impact on the Income Statement.
As the overstated closing stock is CARRIED FORWARD to the subsequent period as the OPENING STOCK, this will result in the understatement of gross profit and net earning/profit (opposite impact for the first year where profits are overstated)
Illustration:
Year 1: Closing Stock was wrongly valued as $3,000 should only be $1,000, therefore overstated closing stock by $2,000
| Year 1 |
REMARKS |
|
| Revenues | 10,000 | |
| Cost of Goods Sold: | ||
| Purchases | 5,000 | |
| Less :Closing Stock | 3,000 |
Assuming the correct stock valuation should be $1,000, hence closing stock overvalued by $2,000 |
| Cost of Goods Sold: | 2,000 | |
| Gross Profit Margin |
8,000 |
Overstated by $2,000 |
Year 2: Closing Stock C/F as Opening Stock as $3,000 which is overvalued in Year 1 by $2,000
| Â Â
  |
Impact to Year 2 |
OPENING STOCK FOR YEAR 2 OVERSTATED BY $2,000 |
| Â | Â | Â |
| Revenues | 10,000 | |
| Cost of Goods Sold: | Â | |
| OPENING STOCK |
3,000 |
Opening stock =Last Year’s Closing stock (overvalued by $2,000) |
| Purchases | 5,000 | Â |
| Less :Closing Stock | 1,000 | Assuming there is nothing wrong with this closing stock for Year 2. |
| Cost of Goods Sold: | 7,000 | Cost of Goods Sold is OVERSTATED due to Overstated opening stock c/f from last year’s closing stock |
| Gross Profit Margin |
3,000 |
Gross Profit margin now is UNDERSTATED BY $2,000 DUE TO OVERVALUATION OF OPENING STOCK |