Question

What is the effect on the cost of goods sold, gross profit, and net income if ending merchandise inventory is understated?

Short answer

If the ending inventory has been undervalued, the COGS would be overvalued and the gross profit and net profit would be undervalued.

Step-by-step solution

Effect of understated inventory on the cost of goods sold

If the cost of ending inventory is understated then the cost of goods sold would be overstated as the cost of goods sold is the difference between the cost of goods available and the cost of ending inventory.

The cost of goods sold is computed as follows –

COGS = Cost of opening inventory + Purchases – Cost of ending inventory

So, from the above equation if the cost of ending inventory is undervalued so the Value of cogs would be overvalued.

Effect of understated inventory on the gross profit

Gross profit is the difference between the total revenue and the cost of goods sold. As discussed above, if the ending inventory is undervalued then the COGS would be overvalued. In this case, the gross profit would be overvalued.

Effect of understated inventory on the net profit

Net income is the difference between gross profit and operating expenses. In the case of undervalued inventory, the gross profit is also undervalued and thus there would be the same effect on the net income too.