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What is the impact on cost of goods sold, gross profit, net income before taxes and...

What is the impact on cost of goods sold, gross profit, net income before taxes and retained earnings, respectively, if inventory is understated?

a) overstated; understated; understated; understated.

b) overstated; understated; overstated; overstated.

c) understated; overstated; understated; overstated.

d) understated; overstated; overstated; overstated.

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Answer #1

The correct answer is option a.

If inventory at the year end is understated, it means that the cost of goods will be overstated. As more cost will be assigned, resulting in a higher cost of goods sold.

This will result in a understated gross profit as cost of goods sold is higher. The gross profit will result in a understatement of net income. The net income is further closed off to retained earnings, hence retained earnings will be understated.

Hence, cost of goods sold = overstated

Gross profit = understated

Net income = understated

Retained earnings = understated.

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