What is the impact on assets and equity when ending inventory is overstated?

What is the impact on assets and equity when ending inventory is overstated?

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

Answer: (A)

Overstating ending inventory boosts reported assets because inventory is an asset on the balance sheet. It also reduces the cost of goods sold, since COGS = Beginning Inventory + Purchases − Ending Inventory. With a higher ending inventory, COGS is lower, which increases gross profit and thus net income. Higher net income raises retained earnings, a component of shareholders’ equity, so equity is overstated too. Liabilities aren’t affected by this error, so they stay the same. In short, the misstatement makes both assets and equity appear higher than they actually are.

Overstating ending inventory boosts reported assets because inventory is an asset on the balance sheet. It also reduces the cost of goods sold, since COGS = Beginning Inventory + Purchases − Ending Inventory. With a higher ending inventory, COGS is lower, which increases gross profit and thus net income. Higher net income raises retained earnings, a component of shareholders’ equity, so equity is overstated too. Liabilities aren’t affected by this error, so they stay the same. In short, the misstatement makes both assets and equity appear higher than they actually are.