Closing inventory at the end of year 1 was overstated by £5,000. Which statement describes the effect on profit?
Answer and explanation
Correct answer: A. Year 1 profit is overstated by £5,000 and year 2 profit is understated by £5,000
- Step 1: Closing inventory reduces cost of sales in year 1, so an overstatement raises year 1 profit by £5,000.
- Step 2: The same figure becomes opening inventory in year 2, which increases year 2 cost of sales by £5,000.
- Step 3: Year 2 profit is therefore understated by £5,000, so the error reverses.
Answer
Year 1 profit is overstated by £5,000 and year 2 profit is understated by £5,000.
Why not the others: The directions are the wrong way round; an overstated closing figure inflates the first year. The error does not repeat; it reverses in the second year. Opening inventory is part of cost of sales, so year 2 is affected.
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