Question

A company’s beginning inventory for 2005 was overstated by $37,000, and the ending inventory for 2005 was understated by $16,000. The income tax rate for the company is 30%. These errors will cause the 2005 net income to be...

A. Understated by $14,700

B. Understated by $37,100

C. Overstated by $14,700

D. Overstated by $37,100

The answer key says that B. $37,100 is the answer, but I don't know how to get that. Please help!

Answer 1

Answer = B. Understated by $37,100

Note:

The opening inventory is overstated by $ 37,000 which means that the cost of goods sold is also overstated by $37,000.

The ending inventory is understated by $ 16,000 which means that the cost of goods sold is also overstated by $16,000.

Total overstated cost of goods sold = $ 37,000 + $ 16,000

= $ 53,000

Taxes erroneously saved on the overstated cost of goods sold = overstated cost of goods sold * tax rate

= $ 53,000 * 30%

= $ 15,900

Net overstatement of cost of goods sold = Total overstated cost of goods sold - taxes saved

= $ 53,000 - $ 15,900

= $ 37,100

Since, the cost of goods sold is overstated by $ 37,100 , the net income is understated by the same amount of $ 37,100