Final answer:
Understatement of ending inventory results in an overstatement of COGS. This is because the formula for COGS subtracts the ending inventory from the sum of beginning inventory and purchases, and understating the ending inventory means a smaller subtraction, leading to higher COGS. An example was provided to illustrate this effect.
Step-by-step explanation:
The question is asking about the effect of an understatement of ending inventory on the calculation of Cost of Goods Sold (COGS). If ending inventory is understated, it means that the inventory balance is reported as less than its actual amount. This has a direct impact on the calculation of COGS using the following formula:
Beginning Inventory + Purchases - Ending Inventory = COGS
With an understated ending inventory, the COGS is overstated. That's because you are subtracting a smaller number (the understated ending inventory) from your total goods available for sale, which results in a larger COGS. Overstating COGS will in turn result in lower gross profit, as it is calculated by subtracting COGS from sales revenue.
To illustrate this, let's use an example. Assume a company has a beginning inventory of $10,000, purchases of $5,000, and an actual ending inventory of $7,000. The correct COGS would be calculated as follows:
$10,000 (Beginning Inventory) + $5,000 (Purchases) - $7,000 (Ending Inventory) = $8,000 COGS
If the ending inventory is understated by $2,000, reported as $5,000 instead of the actual $7,000, the COGS would be calculated as:
$10,000 (Beginning Inventory) + $5,000 (Purchases) - $5,000 (Understated Ending Inventory) = $10,000 COGS
This shows a COGS that's $2,000 higher than it should be, demonstrating how the understatement of ending inventory leads to an overstatement of COGS.