Multiple Choice
Which of the following statements best describes the effect of using the FIFO (First-In, First-Out) inventory costing method during a period of rising prices?
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5. Inventory
Financial Statement Effects of Inventory Costing Methods
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Which of the following would cause net income to be overstated when accounting for inventory?
A
Overstating beginning inventory
B
Recording purchases at a higher cost than actual
C
Understating ending inventory
D
Overstating ending inventory
Verified step by step guidance1
Understand the relationship between inventory and net income: Net income is calculated as Revenue - Expenses. In the context of inventory, the Cost of Goods Sold (COGS) is a key expense, and it is calculated as: COGS = Beginning Inventory + Purchases - Ending Inventory.
Analyze the impact of overstating ending inventory: If ending inventory is overstated, the COGS will be understated because the formula subtracts ending inventory. A lower COGS results in higher net income.
Compare the other options: Overstating beginning inventory increases COGS, which reduces net income. Recording purchases at a higher cost than actual also increases COGS, reducing net income. Understating ending inventory increases COGS, reducing net income as well.
Conclude that overstating ending inventory is the only option that causes net income to be overstated because it reduces COGS artificially.
To verify, revisit the COGS formula and recalculate the impact of each scenario on net income to ensure the reasoning aligns with the formula.
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