Which of the following statements regarding closing out overapplied or underapplied overhead is correct?

• A. Overapplied overhead increases the balance of Cost of Goods Sold when closed.
• B. Underapplied overhead is always carried forward to the next accounting period.
• C. Overapplied overhead is typically closed to Cost of Goods Sold, reducing its balance.
• D. Both overapplied and underapplied overhead are closed directly to retained earnings.

Answer: (C)

Verified step by step guidance

1. Understand the concept of overapplied and underapplied overhead: Overapplied overhead occurs when the allocated overhead costs exceed the actual overhead costs incurred, while underapplied overhead occurs when the allocated overhead costs are less than the actual overhead costs incurred.
2. Recognize the typical treatment of overapplied and underapplied overhead: These amounts are usually adjusted at the end of the accounting period to ensure accurate financial reporting. They are not carried forward to the next period but are closed to specific accounts.
3. Analyze the impact on Cost of Goods Sold (COGS): Overapplied overhead reduces the balance of COGS when closed because it represents an excess allocation that needs to be subtracted. Conversely, underapplied overhead increases the balance of COGS because it represents a shortfall that needs to be added.
4. Understand why these adjustments are made: Closing overapplied or underapplied overhead to COGS ensures that the financial statements reflect the actual costs incurred during the period, providing a more accurate representation of profitability.
5. Clarify the incorrect statements: Overapplied and underapplied overhead are not carried forward to the next accounting period, nor are they closed directly to retained earnings. Instead, they are typically closed to Cost of Goods Sold or allocated between COGS, inventory, and other accounts depending on the company's policy.