In a period of rising sales, utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma financial statements will tend to
A) overstate costs and understate profits.
B) understate costs and understate profits.
C) understate costs and overstate profits.
D) overstate costs and overstate profits.

Question

Quizplus · Accepted Answer

Past cost and expense ratios are based on historical data. In a period of rising sales, these ratios are likely to underestimate the actual costs and expenses that will be incurred. This is because costs and expenses tend to increase at a slower rate than sales. As a result, using past cost and expense ratios will lead to an overstatement of costs and an understatement of profits.

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