During the preparation of the current year's financial statements, the company discovered that the closing inventory for the previous year was overstated by 50,000. What is the effect of this error on the profits of the previous and current years?

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Both the previous year's and current year's profits are overstated.The previous year's profit is understated, while the current year's profit is overstated.The previous year's profit is overstated, whereas the current year's profit is understated.There is no effect on the profits of either the previous or the current year.Insufficient information to determine the impact.

Explanation

If the closing stock of the previous year is overstated, it causes the profit for that year to be overstated as well, since closing stock is an asset and part of the cost of goods sold calculation. However, this overstatement becomes the opening stock for the current year, which is then overstated, leading to an understatement of the current year's profit. Therefore, the previous year's profit is inflated, and the current year's profit is reduced.