Question

Question content area inventory at the end of the year is overstated. Which of the following statements correctly states the effect of the error?

1) Owner's equity is overstated.
2) Cost of goods sold is overstated.
3) Gross profit is understated.
4) Net income is understated.

Answer 1

When inventory at the end of the year is overstated, owner's equity is overstated, cost of goods sold is understated, gross profit is overstated, and as a result, net income is also overstated.

Step-by-step explanation:

If inventory at the end of the year is overstated, it has several impacts on financial statements:

• Owner's equity is overstated. When inventory is overstated, assets are overstated, and since Owner's Equity = Assets - Liabilities, the equity is also overstated.
• Cost of goods sold (COGS) is understated. If the ending inventory is overstated, this means that less inventory has been recorded as being sold. Thus, COGS, which is opening inventory plus purchases minus closing inventory, is lower than it should be.
• Gross profit is overstated. Because COGS is understated, the gross profit, which is sales minus COGS, is higher than it should be.
• Net income is overstated. Overstated gross profit leads to overstated net income, because net income is calculated by subtracting expenses from gross profit.

Thus, the correct statement is that Owner's equity is overstated when year-end inventory is overstated.