Question

If the ending inventory of a firm is overstated by $50,000, by how much and in what direction (overstated or understated) will the firm's operating income be misstated? (Hint: Use the cost of goods sold model, enter hypothetically "correct" data, and then reflect the effects of the ending inventory error and determine the effect on cost of goods sold.)

Answer 1

50,000 overstated.

Step-by-step explanation:

As the ending inventory is overstated by 50,000 we can conclude the implications using the inventory identity:

Beginning + Purchase = COGS + Ending

As the left side will be the correct display they will have no error.

Therefore the COGS will compensate the mistake in the ending ivnentory

0 = COGS + 50,000

COGS = -50,000

The COGS are 50,000 lower than it should be therefore the gross profit is overstated as

Sales - COGS = Gross Profit

0 - (-50,000) = Gross Profit

+ 50,000 = Gross Profit

This also makes the operating income which, derives from gross profit to be overstated as well.