- The understatement of the beginning inventory balance causes: A)Cost of goods sold to be understated and net income to be understated
B)Cost of goods sold to be overstated and net income to be understated
C)Cost of goods sold to be overstated and net income to be correct
D)Cost of goods sold to be understated and net income to be overstated
E)Cost of goods sold to be overstated and net income to be overstated
Hope you can tell me the correct answer and kinda explain it. Thank you so much.
The correct answer and explanation is:
The correct answer is B) Cost of goods sold to be overstated and net income to be understated.
Explanation:
The beginning inventory is an essential component in calculating the Cost of Goods Sold (COGS), which is part of the overall calculation of net income. The formula for COGS is: COGS=Beginning Inventory+Purchases−Ending Inventory\text{COGS} = \text{Beginning Inventory} + \text{Purchases} – \text{Ending Inventory}
If the beginning inventory is understated, it affects the COGS calculation. Here’s the breakdown:
- Effect on COGS:
- When the beginning inventory is understated, the initial inventory value is lower than it should be.
- Since COGS includes the beginning inventory, understating it results in COGS being understated at first.
- However, for the next period, the beginning inventory becomes the ending inventory of the previous period. If this inventory is understated, the goods that were initially accounted for as sold (at a lower cost) will end up affecting future cost calculations in a way that COGS is overstated. This leads to a higher cost of goods sold than necessary, as the goods are written off too quickly or inaccurately.
- Effect on Net Income:
- Net income is derived from revenue minus expenses (including COGS). Since the COGS is overstated, it leads to a higher expense figure.
- With higher COGS, the resulting net income will be understated because the company’s expenses are inflated, leaving a smaller profit margin.
In summary:
- The understatement of beginning inventory causes COGS to be overstated in the following period (due to incorrect cost accounting).
- The overstated COGS causes net income to be understated, as the company records unnecessary costs.
This situation can lead to inaccurate financial reporting, and the true profitability of the company might not be reflected until the inventory discrepancy is corrected.