In a period of rising sales, utilizing past cost and expense ratios (percent-of-sales method), when preparing pro forma financial statements and planning financing, will tend to
A) overstate retained earnings and understate the financing needed.
B) overstate retained earnings and overstate the additional financing needed.
C) understate retained earnings and overstate the financing needed.
D) understate retained earnings and understate the additional financing needed.

Question

Quizplus · Accepted Answer

Utilizing past cost and expense ratios based on percent-of-sales method tends to understate retained earnings and overstate the financing needed during a period of rising sales. This is because as sales increase, the cost and expense ratios may not remain constant, leading to overestimation of expenses and underestimation of earnings. Therefore, it is important to adjust the ratios when preparing pro forma financial statements and planning financing.

In a Period of Rising Sales, Utilizing Past Cost and Expense