Merchandise inventory at the end of the year is overstated. Which of the following statements correctly states the effect of the error?

A) Owner's equity is overstated.
B) Cost of merchandise sold is overstated.
C) Gross profit is understated.
D) Net income is understated.

When merchandise inventory at the end of the year is overstated, it means that the cost of goods sold (COGS) is understated because the ending inventory is subtracted from goods available for sale to calculate COGS. This understatement of COGS leads to an overstatement of gross profit and, consequently, net income. Since net income contributes to owner's equity, an overstatement of net income results in an overstatement of owner's equity.