Audit and Assurance Practice Exam

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What is the result of overstated ending inventory on financial statements?

Higher cost of goods sold.
Lower net income.
Higher net income.
No effect on the financial statements.

The correct answer is: Higher net income.

When ending inventory is overstated, it leads to a miscalculation in the cost of goods sold (COGS). COGS is determined by the formula: Beginning Inventory + Purchases - Ending Inventory. Therefore, if the ending inventory is overstated, it results in a lower COGS calculation. Since net income is calculated as revenues minus expenses, and COGS is an expense, a lower COGS effectively increases net income. This is why overstating ending inventory results in higher net income on the financial statements. In this scenario, the implications for the financial statements are significant. Higher net income may give a misleading impression of profitability, potentially influencing management decisions and investor perceptions.