Question

Question: Hallam Company’s financial statements show the following. The company recently discovered that in making physical counts of inventory, it had made the following errors: Inventory on December 31, 2016, is overstated by \(18,000 and inventory on December 31, 2017, is understated by \)26,000.

For the year ended December 31	2016	2017	2018
(a) Cost of goods sold	\(207,200	\)213,800	\(197,030
(b) Net income	175,800	212,270	184,910
(c) Total Current assets	276,000	277,500	272,950
(d) Equity	314,000	315,000	346,000

Required

Explain why the overstatement of inventory by \)18,000 at the end of 2016 results in an overstatement of equity by the same amount in that year.

Short answer

Answer

Overstatement of ending inventory will overstate the net income, which will overstate the business’s equity.

Step-by-step solution

Definition of Overstatement

When the figures of the financial statements are reported as higher than their actual value is known as overstatement. Such a statement misguides the decisions of the users of the financial information.

Relation Between Overstatement of Inventory and Equity of Same Year

Due to the overstatement of the ending inventory in 2016, the cost of goods sold for 2016 is understated, consequently overstating the business entity's gross profit and net income.