Final answer:
When ending inventory is underestimated, the cost of goods sold is overstated while net earnings are understated due to higher COGS resulting in lower gross profit and subsequently lower net income.
Step-by-step explanation:
If ending inventory is underestimated due to an error in the physical count of items on hand, cost of goods sold will be overstated and net earnings will be understated.
Here's why: Inventory valuation plays a crucial role in determining the cost of goods sold (COGS) and, consequently, the net income. When the ending inventory is underestimated, there are fewer goods on hand at the end of the period, which means that more goods are presumed to have been sold. Consequently, the COGS will be higher than it actually is because the calculation assumes that more inventory was sold at the cost of acquiring or producing it. With a higher COGS, the gross profit will be lower. Since net earnings are calculated by subtracting expenses, including COGS, from revenues, the net earnings will also be lower due to the higher reported COGS.