If an entity overstates its ending inventory for the current year, what are the effects on assets, cost of goods sold, income before taxes, and retained earnings for the current year?

Answer 1

An overstatement of ending inventory for the current period results in an understatement of cost of goods sold and an overstatement of income before taxes for the same period. Cost of goods sold is understated because the overstated ending inventory figure is deducted from the cost of goods available for sale to determine cost of goods sold. Thus, a larger portion of the cost of goods available for sale is assigned to inventory and a smaller portion is assigned to cost of goods sold than should be. The overstated inventory figure also overstates the amount reported as an asset on the balance sheet. The overstatement of income results in an overstatement of retained earnings when net income is transferred to retained earnings through a closing entry.