A small chain of grocery stores made a reporting error and understated its ending inventory. What effect would this have on the income statement for the following year?

An understatement of ending inventory in Year 1 causes the Cost of Goods Sold (COGS) for Year 1 to be overstated, thus understating Year 1's net income. This understated ending inventory from Year 1 becomes the beginning inventory for Year 2. A lower beginning inventory in Year 2 results in an understated COGS for Year 2 (COGS = Beginning Inventory + Purchases – Ending Inventory). An understated COGS leads to an overstatement of gross profit and, consequently, an overstatement of net income for Year 2.

A. Net income would be understated in the year of the error (Year 1), not the following year. The effect reverses in Year 2.
B. The error directly impacts the COGS calculation for two consecutive periods, so net income is affected in both years.
D. The effect is an overstatement or understatement, not necessarily a negative result, which depends on the overall profitability.

1. Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate Accounting (17th ed.). Wiley. Chapter 8, "Valuation of Inventories: A Cost-Basis Approach," explains the impact of inventory errors. Specifically, it details how an understated ending inventory in one period leads to an overstated net income in the subsequent period.

2. Libby, R., Libby, P. A., & Hodge, F. (2017). Financial Accounting (9th ed.). McGraw-Hill Education. Chapter 6, "Reporting and Interpreting Cost of Goods Sold and Inventory," illustrates that an error in ending inventory has an opposite financial effect on net income in the next period.