In the current year, if ending inventory is overstated (and beginning inventory is correct), what is the effect on cost of goods sold and net income for the year?

• A. Cost of goods sold is overstated, and net income is overstated.
• B. Cost of goods sold is understated, and net income is overstated.
• C. Cost of goods sold is understated, and net income is understated.
• D. Cost of goods sold is overstated, and net income is understated.

Answer: (B)

Verified step by step guidance

1. Understand the relationship between inventory, cost of goods sold (COGS), and net income. The formula to remember is: \(\text{COGS} = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}\).
2. Since beginning inventory is correct, focus on the effect of an overstated ending inventory. If ending inventory is overstated, it means the value of inventory reported is higher than it actually is.
3. Substitute the overstated ending inventory into the COGS formula. Because ending inventory is subtracted in the formula, a higher ending inventory will reduce the calculated COGS: \(\text{COGS} \downarrow\).
4. Next, consider the impact on net income. Net income is calculated as: \(\text{Net Income} = \text{Revenues} - \text{Expenses}\). Since COGS is an expense, a lower COGS means expenses are understated, leading to an overstated net income: \(\text{Net Income} \uparrow\).
5. Summarize the effects: Overstated ending inventory causes COGS to be understated and net income to be overstated for the current year.