What happens to assets and equity when ending inventory is understated?

What happens to assets and equity when ending inventory is understated?

• A. Assets and equity are overstated
• B. Assets and equity are understated
• C. Liabilities are overstated
• D. Liabilities are understated

Answer: (B)

Understating ending inventory directly reduces assets, since inventory is an asset on the balance sheet. It also changes the income statement: with a smaller ending inventory, cost of goods sold goes up, which lowers gross profit and net income. That lower net income reduces retained earnings, a component of equity, so equity is understated as well. Liabilities aren’t affected by this specific error, so they stay the same. Because assets shrink and liabilities are unchanged, equity must also shrink to keep the accounting equation balanced. In short, this misstatement pulls both assets and equity down.

Understating ending inventory directly reduces assets, since inventory is an asset on the balance sheet. It also changes the income statement: with a smaller ending inventory, cost of goods sold goes up, which lowers gross profit and net income. That lower net income reduces retained earnings, a component of equity, so equity is understated as well. Liabilities aren’t affected by this specific error, so they stay the same. Because assets shrink and liabilities are unchanged, equity must also shrink to keep the accounting equation balanced. In short, this misstatement pulls both assets and equity down.