When inventory is understated (not included in the physical count) at year-end, the financial impact affects both cost of sales (COGS) and net income as follows:
Correct Answer (C - Cost of Sales is Understated and Net Income is Overstated)
The ending inventory is part of the formula used to calculate the cost of goods sold (COGS): COGS=BeginningInventory+Purchases−EndingInventoryCOGS = Beginning Inventory + Purchases - Ending InventoryCOGS=BeginningInventory+Purchases−EndingInventory
If ending inventory is understated, then:
COGS will be understated (because inventory that should have been counted as sold was omitted).
Net income will be overstated because COGS is lower than it should be, making profits appear higher.
This error causes financial misstatements, violating IIA auditing standards for financial accuracy.
Why Other Options Are Incorrect:
Option A (Cost of sales and net income are understated):
Net income would not be understated—it would be overstated because the cost of goods sold is too low.
Option B (Cost of sales and net income are overstated):
COGS would be understated, not overstated. If COGS were overstated, net income would be understated.
Option D (Cost of sales is overstated and net income is understated):
The opposite happens—COGS is understated and net income is overstated.
IIA GTAG 8: Audit of Inventory Management – Covers financial impact of inventory misstatements.
IIA Practice Guide: Auditing Financial Statements – Addresses common inventory errors and financial reporting impacts.
Step-by-Step Explanation:IIA References for Validation:Thus, C is the correct answer because an understated inventory reduces COGS and inflates net income.
