Question

In taking a physical inventory at the end of Year 1, Grant Company forgot to count certain units and understated ending inventory by $10,000. Determine how this error effects each of the following. (a) Year 1 cost of goods sold. Overstates Year 1 cost of goods sold. Understates Year 1 cost of goods sold. None of the above. (b) Year 1 net income. Understates Year 1 net income Overstates Year 1 net income None of the above. (c) Year 2 cost of goods sold. Understates Year 2 cost of goods sold. Overstates Year 2 cost of goods sold. None of the above.

Answer 1

Answer:

a. Overstates Year 1 cost of goods sold.

b. Understates Year 1 net income

c. Understates Year 2 cost of goods sold

Explanation:

a. The formula for Calculating the Cost of Goods sold is;

Cost of Goods Sold = Opening inventory + Purchases - Closing inventory.

If the closing inventory is understated, it will reduced the amount being subtracted from Purchases and Opening inventory which would means that Cost of Goods sold will be overstated.

b. The Cost of goods sold is deducted from sales to give Gross profit. If Cost of goods is overstated, it will reduce Gross Profit higher than it should. A lower Gross Profit equates to a lower Net Income.

c. Going by the formula in a;

Cost of Goods Sold = Opening inventory + Purchases - Closing inventory.

In Year 2, the understated Year 1 closing stock will become the understated Year 2 Opening stock. With the opening stock understated, the Cost of goods will be understated as well because Opening stock is meant to increase Cost of goods sold as the formula shows. If it is understated, the amount that it will add will be understated as well.