Difficulty: Easy

Average Score: 93%

It is determined that a year's ending inventory is overstated by $15,000. Which statement accurately reflects the impact of this error?

Rationale

Net income is overstated by $15,000.

When the ending inventory is overstated, it leads to a lower cost of goods sold (COGS) than it should be, which in turn inflates the net income reported for that year. An inflated ending inventory results in more profits being shown, creating a misleading financial picture of the company's performance.

A (Cost of goods sold is overstated by $15,000.) YOUR ANSWER

This statement is incorrect because an overstatement of ending inventory actually results in an understatement of cost of goods sold. If inventory at year-end is higher than it should be, the cost of goods sold decreases, leading to an increase in net income, not a decrease.

B (Net income is overstated by $15,000.) CORRECT

This choice is accurate, as an overstatement of ending inventory reduces the cost of goods sold, making the net income higher than it really is. The inflated profit figure misrepresents the company's actual financial performance, thereby misleading stakeholders.

C (Current ratio is understated by $15,000.) YOUR ANSWER

This statement is incorrect because an overstatement of ending inventory increases current assets on the balance sheet. Since the current ratio is calculated as current assets divided by current liabilities, an increase in current assets would actually lead to an overstated current ratio, not understated.

D (Working capital is understated by $15,000.) YOUR ANSWER

This option is also incorrect. An overstatement of ending inventory leads to an increase in working capital, which is calculated as current assets minus current liabilities. Therefore, working capital would be overstated rather than understated due to the higher asset figure.

Conclusion

In summary, an overstatement of the ending inventory by $15,000 results in net income being overstated by the same amount due to the resulting decrease in cost of goods sold. This accounting error not only misrepresents profitability but also affects financial ratios and the overall financial health portrayed in the company's reports. Understanding these impacts is crucial for accurate financial analysis and reporting.

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