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6.7 In preparing its financial statements for the current year, a company’s closing inventory was understated by $300,000.
What will be the effect of this error if it remains uncorrected?
A The current year’s profit will be overstated and next year’s profit will be understated.
B The current year’s profit will be understated but there will be no effect on next year’s profit.
C The current year’s profit will be understated and next year’s profit will be overstated.
D The current year’s profit will be overstated but there will be no effect on next year’s profit.Cost of sales is opening inventory plus purchases less closing inventory.
So if the closing inventory this year is understated (i.e. too low) then the cost of sales will be too high and therefore the profit will be too low.
This years closing inventory is next years opening inventory. So next year the opening inventory will be too high and so the cost of sales will be too low, and therefore the profit next year will be too high.
If you are still unsure, make up a few numbers and see what happens if you reduce the closing inventory this year 🙂
i understand if closing inventory is too low/understated then the profit wil be low but
if closing inventory of this year is too low how come the opening inventory of next year becomes too high or am missing something hereOoops – sorry I was typing too fast. Everything I wrote was correct except for just one word 🙂
If this years closing inventory is too low, then next years opening inventory will also be too low (not too high!). If next years opening inventory is too low, then cost of sales next year will be too low and therefore profit next year will be too high.
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