What is the effect of an overstatement of closing inventory on the financial statements?
Practice Questions
1 question
Q1
What is the effect of an overstatement of closing inventory on the financial statements?
Understates net income
Overstates net income
No effect on net income
Increases liabilities
An overstatement of closing inventory leads to an overstatement of net income because it reduces the cost of goods sold.
Questions & Step-by-step Solutions
1 item
Q
Q: What is the effect of an overstatement of closing inventory on the financial statements?
Solution: An overstatement of closing inventory leads to an overstatement of net income because it reduces the cost of goods sold.
Steps: 6
Step 1: Understand what closing inventory is. Closing inventory is the value of unsold goods at the end of an accounting period.
Step 2: Know that closing inventory is used to calculate the cost of goods sold (COGS). COGS is the total cost of producing goods that were sold during the period.
Step 3: Realize that if closing inventory is overstated, it means we are saying we have more unsold goods than we actually do.
Step 4: When closing inventory is overstated, COGS is calculated as lower than it should be because COGS = Opening Inventory + Purchases - Closing Inventory.
Step 5: A lower COGS means that the expenses are lower, which leads to a higher net income on the income statement.
Step 6: Higher net income can make the company look more profitable than it really is, which can mislead investors and stakeholders.
