Question

Merchandise inventory at the end of the year was understated. Which of the following statements correctly states the effect of the error?a. net income is understatedb. net income is overstatedc. cost of merchandise sold is understatedd. merchandise inventory reported on the balance sheet is overstated

Answer 1

Answer:b. net income is overstated

Explanation:

The cost of inventory which is a constituent of cost of goods sold will have an impact on the income, an higher cost of inventory means low net income and lower cost of inventory means an higher net income. Therefore if the inventory is understated it leads to profit overstatement.

Net income will not be understated because a cost item has been understated but it will only be overstated, cost of merchandise sold is understated but this is the action and not the effect, merchandise on the balance sheet will be understated and not overstated.

Answer 2

Answer:

a. net income is understated

Explanation:

Using the formula

Revenue - cost of sales - operating expense =  net income

opening inventory + purchases - closing inventory = cost of goods sold

From the formulas above,

Understating closing inventory results an overstatement of cost of goods sold which invariably results in an understatement of net income.

The right option is a. net income is understated.