An analyst notes the following about a company: • Beginning inventory was reported as $5,000. • Costs of goods sold was reported as $8,000. • Ending inventory was $7,000 (the analyst has physically verified this amount). Which of the following statements about this situation is most likely correct? A. Purchases must have been $8,000. B. The company must be using LIFO. C. If the analyst discovered that beginning inventory was overstated by $1,000 then COGS must have been understated by $1,000. D. If the analyst discovered that beginning inventory was understated by $2,000 then earnings before taxes must have been overstated by $2,000. Can anybody why D is correct? If an example can be provided, that will be great!
Ending Inventory = Beginning Inventory - COGS + Purch 7,000 = 5,000 - 8000 + 10,000 (Purchases has to equal 10k to balance equation) A - No B - Irrelevant C - Does not make sense D - BI 3k, Then purchases equals 12k, and EBT would likely be overstated since it appears more was purchased to be sold than reality. (help here)
^ Not quite. Do the equation this way: COGS = Beginning Inventory + Purchases - Ending Inventory. Now COGS is a P&L item. (All other things equal, the higher COGS is, the lower EBT is). From the equation, if you increase beginning inventory by $2000, then COGS increases by $2000 and so EBT decreases by $2000 (ie it was overstated). OK?
Beginning inventory + Purchases - Ending inventory = COGS, 5+X-7=8, so purchases = 10k, A is not true. I cannot say if B is correct, I don’t have enough data (ending inventory could be higher because of FIFO use, or because of physical increase in number of units / quantity of raw material purchased). Say the real beginning inventory was 4k, not 5k. Calculate COGS using the above formula: 4+10-7=7, so the real COGS should have been 7k, not 8k. I see an overstatement of COGS (stated 8 instead of real 7) not an understated COGS. Bi and COGs ae on different sides of the inventory equation, considering P and Ei are not over/understated, BI and COGS should both be over/understated to keep the equation in balance. Considering the above, when Bi is understated, the COGS is understated, so less is deducted from Revenues to get to EBT, so EBT is overstated.
You guys are great. Thanks so much!