Question

If the ending inventory of a firm is overstated by $55,000, by how much and in what direction (overstated or understated) will the firm's operating income be misstated?

(use the cost of goods sold model, enter hypothetically "correct" data, ann then reflect the effects of the ending inventory error, and determine the effect on cost of goods sold

Answer 1

If inventory overstated then cost of goods sold are understated. By understating expense operating income is overstated.

In a perpetual inventory model where inventory is counted at some period end then cost of goods are detemined. Suppose a company had sales of $500,000 and the entity had opening inventoy of $50,000, purchases of $250,000 and ending inventory of $50,000 but due to some error they found ending inventory at $105,000 in such a situation the effect is captured below:

Particulars	Correct	Mistake	Effect on net income
Sales	5,00,000	5,00,000
Less cost of goods sold	2,50,000	1,95,000
Gross profit	2,50,000	3,05,000	55,000
Cost of goods sold:
Opening inventory	50,000	50,000
Add purchases	2,50,000	2,50,000
Goods available	3,00,000	3,00,000
Less ending inventory	50,000	1,05,000
Cost of goods sold	2,50,000	1,95,000