Question

If ending inventory for the year ended December 31, 2016, is understated, this error will cause owners' equity to be:

a) understated at the end of 2016 and overstated at the end of 2017
b) overstated at the end of 2016 and understated at the end of 2017
c) correctly stated at the end of 2016 and overstated at the end of 2017
d) understated at the end of 2016 and correctly stated at the end of 2017

Answer 1

The following year, the sequence leads to an overstatement of owners' equity since beginning inventory and COGS will be understated, resulting in an overstated net income. The correct option is A.

Step-by-step explanation:

When ending inventory is understated, it means that the cost of goods sold (COGS) is overstated, because the ending inventory is subtracted from the goods available for sale to determine COGS.

When COGS is overstated, net income is understated because COGS is an expense and higher expenses reduce net income.

Since net income is understated, and net income increases owners' equity through retained earnings, owners' equity at the end of 2016 is also understated.

In the next year, the beginning inventory for 2017 is understated as it is carried over from the ending inventory of 2016. This will lead to the understatement of the COGS for the year 2017 (assuming no further errors).

As a result, net income for 2017 will be overstated because COGS is an expense and lower expenses lead to higher net income. Consequently, the owners' equity at the end of 2017 will be overstated. The correct option is A.