If beginning inventory is understated by $15,000, the effect of this error in the current period is Cost of Goods Sold Net Income Understated Overstated Overstated Understated Overstated Overstated Understated Understated
The Correct Answer and Explanation is:
Correct Answer:
Cost of Goods Sold: Understated
Net Income: Overstated
Explanation:
When beginning inventory is understated by $15,000, it causes a ripple effect on the Cost of Goods Sold (COGS) and ultimately on Net Income. To understand why, recall the basic formula used to calculate COGS:
COGS = Beginning Inventory + Purchases – Ending Inventory
If the Beginning Inventory is understated, it means we are starting the period with a lower amount of inventory than we actually had. As a result, the COGS calculated will also be lower than it should be, since the starting figure in the equation is too small.
Let’s illustrate with numbers:
Suppose the correct figures are:
- Beginning Inventory: $50,000
- Purchases: $100,000
- Ending Inventory: $30,000
Then,
COGS = 50,000 + 100,000 – 30,000 = $120,000
Now, suppose the beginning inventory is understated by $15,000 (reported as $35,000 instead of $50,000). Then,
COGS = 35,000 + 100,000 – 30,000 = $105,000
This means COGS is understated by $15,000. Since COGS is an expense on the income statement, understating an expense causes net income to be overstated. This is because lower expenses result in higher profits.
In summary:
- An understatement of beginning inventory leads to COGS being too low.
- Because expenses are understated, Net Income appears too high.
- This error will also affect the following period—beginning inventory of the next period will be incorrect, and it could reverse or compound the error.
Understanding these relationships is crucial for accurate financial reporting and informed decision-making.
