Question

Which financial statements will be misstated if the year 1 ending inventory balance is understated? (check all that apply)

1) year 1 income statement
2) year 2 income statement
3) year 2 balance sheet
4) year 1 balance sheet

Answer 1

The financial statements that will be misstated if the year 1 ending inventory balance is understated are the Year 1 Income Statement, the Year 1 Balance Sheet, the Year 2 Income Statement, and the Year 2 Balance Sheet.

Step-by-step explanation:

If the year 1 ending inventory balance is understated, the following financial statements will be misstated:

• Year 1 Income Statement
• Year 1 Balance Sheet
• Year 2 Income Statement
• Year 2 Balance Sheet

An understated ending inventory in year 1 will cause the cost of goods sold to be overstated on the Year 1 Income Statement, which results in lower net income than what should have been reported. Lower ending inventory in year 1 also causes the total assets to be understated on the Year 1 Balance Sheet. In year 2, the understated inventory from year 1 becomes the beginning inventory, which results in an understated cost of goods sold (since the starting point was too low), leading to an overstatement of net income on the Year 2 Income Statement. Concurrently, the carryover effect of the understated inventory means the Year 2 opening inventory is incorrectly low, resulting in the Year 2 Balance Sheet also being misstated.