If closing stock is understated what affect will this have on the Profit and loss Statement?

Question

BlackTom AI · Accepted Answer

Let’s break down what happens when closing stock (ending inventory) is understated in the calculation of cost of goods sold (COGS) and the resulting effect on the income statement.

Option a: COGS overstated, Gross Profit understated, Net Profit understated
- This is correct reasoning. If ending inventory is understated, the cost of goods available for sale minus a smaller ending stock yields a higher COGS. Higher COGS reduces Gross Profit (Sales minus COGS), and since Net Profit is Gross Profit minus expenses, Net Profit will also be understated.

Option b: No affect as closing stock is presented on the Balance Sheet
- This is incorrect. While closing stock indeed appears on the Balance Sheet, its valuation directly affects the calculation of COGS in the income statement. Understating closing stock will overstate COGS and thus affect both Gross Profit and Net Profit.

Option c: COGS understated, Gross Profit understated, Net Profit understated
- This is incorrect. Understating closing stock does not reduce COGS; it increases COGS. Therefore both Gross Profit and Net Profit would not be understated in this direction; instead they would be overstated or remain inconsistent with the actual numbers.

Option d: COGS understated, Gross Profit overstated, Net Profit overstated
- This is also incorrect for the same reason as option c. Understating closing stock would not lead to understated COGS; it leads to overstated COGS, which then reduces Gross Profit and Net Profit, not increases them.

In summary, the key point is that ending inventory acts as a deduction in the COGS calculation. If that ending inventory is undervalued, COGS goes up, which lowers Gross Profit and then Net Profit accordingly. The other options either ignore this linkage or invert the direction of the effect, creating inconsistent results with the fundamental formulae for COGS, Gross Profit, and Net Profit.

FNDN Accounting 2025 STD O2

If closing stock is understated what affect will this have on the Profit and loss Statement?

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