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If a company understates its ending Merchandise Inventory in the physical count, what is the effect on cost of merchandise sold and on net income for that period?
ACost of sales overstated; net income understated
BCost of sales understated; net income overstated
CCost of sales overstated; net income overstated
DCost of sales understated; net income understated
Answer & Solution
Correct answer: A. Cost of sales overstated; net income understated
1. A lower ending inventory leaves more cost to be charged to expense.
2. Cost of merchandise sold is therefore overstated.
3. Higher cost of sales reduces gross profit, so net income is understated.
4. Rule out option B, which is the effect of overstating, not understating, inventory.
_Source: Jonick, Principles of Financial Accounting (CC BY-SA 4.0), §4.1.4 "Physical Inventory Count", p.126_
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