A periodic inventory system calculates cost of goods sold (COGS) using the formula:
COGS=Beginning Inventory+Purchases−Ending InventoryCOGS = \text{Beginning Inventory} + \text{Purchases} - \text{Ending Inventory}COGS=Beginning Inventory+Purchases−Ending Inventory
If beginning inventory is understated, it causes COGS to be understated, which in turn overstates net income because expenses are lower than they should be.
Understated Beginning Inventory → Understated COGS
Since COGS is too low, fewer expenses are deducted from revenue.
Understated COGS → Overstated Net Income
If COGS is too low, the company's profit (net income) is artificially inflated.
(A) COGS will be understated and net income will be overstated (Correct Answer):
Since the beginning inventory was understated, COGS is lower than it should be, making net income higher than it should be.
(B) COGS will be overstated and net income will be understated:
This would be true if beginning inventory was overstated, but in this case, it was understated, making this incorrect.
(C) COGS will be understated and there will be no impact on net income:
Since COGS affects net income, this statement is incorrect. Understated COGS overstates net income.
(D) There will be no impact on COGS and net income will be overstated:
This is incorrect because COGS is directly affected by an inventory misstatement.
IIA GTAG 3: Continuous Auditing – Discusses the importance of accurate financial reporting in preventing misstatements.
COSO Internal Control Framework – Financial Reporting Component – Highlights the impact of inventory errors on financial accuracy.
IIA Standard 2330 – Documenting Information – Requires auditors to evaluate financial calculations for accuracy and completeness.
Step-by-Step Impact on Financial Statements:Analysis of Each Option:IIA References:Conclusion:Since COGS is understated and net income is overstated, option (A) is the correct answer.
