Question 17

Overstatement of working capital and current ratio

Overestimating the ending inventory leads to an increase in the total current assets on the balance sheet, which in turn inflates both working capital and the current ratio. This misrepresentation affects the company's financial position positively, despite not reflecting the actual situation.

A) Understatement of working capital and current ratio

This option is incorrect because overestimating ending inventory would not lead to an understatement of working capital or the current ratio. Instead, it increases current assets, leading to an inflated working capital and current ratio.

B) Understatement of working capital and overstatement of current ratio

This choice is also incorrect. While the current ratio might be overstated due to the inflated inventory figures, working capital cannot be understated if current assets are overestimated. Therefore, this option fails to accurately describe the situation.

C) Overstatement of working capital and current ratio

This option is correct. An overestimate of ending inventory results in a higher current assets figure, which directly leads to an overstatement of both working capital (current assets minus current liabilities) and the current ratio (current assets divided by current liabilities).

D) Overstatement of working capital and understatement of current ratio

This option is incorrect. While working capital is overstated due to the inflated ending inventory, the current ratio cannot be understated as a result; rather, it should also be overstated. This choice contradicts the financial implications of overestimating inventory.

Conclusion

The correct answer is C, as overestimating ending inventory leads to both an overstatement of working capital and the current ratio, reflecting an inflated financial position. All other options fail to accurately capture the relationship between ending inventory estimates and their impact on these financial metrics.