Question

 

The ending inventory for year one is understated by $4000 because the items in one wing of the warehouse were not counted. The effects of this error, ignoring tax effect are;

Year 1. Year 2.

Beginning inventory:

Ending inventory:

Cogs:

Net income:

Retained earnings:

Answer 1

		Year 1	Year 2
Note 1	Beginning inventory	Not affected	Understated by $4,000
Note 2	Ending inventory	Understated by $4,000	Not affected
Note 3	COGS	Overstated by $4,000	Understated by $4,000
Note 4	Net income	Understated by $4,000	Overstated by $4,000
Note 5	Retained earnings	Understated by $4,000	gets corrected

• Note 1 & Note 2; As we know that ending inventory of one year is the beginning inventory of the following year vice versa , thus ending inventory of Year 1 is understated that means beginning inventory of Year 2 is also understated. And there is no effect on beginning inventory of Year 1 & ending inventory of Year 2
• Note 3 : Again as we know, COGS + Ending Inventory = Beginning Inventory + Purchases during the period. Thus , in Year 1 , understated ending inventory & no impact in beginning inventory & purchases means COGS of Year 1 are overstated (to balance the equation). Same logic is applied for COGS being understated in Year 2.
• Note 4: Increase in cost results in decrease in net income thus overstated COGS results in understatement of net income in Year 1 & with same logic is applied for understated COGS results in overstatement of net income in Year 2.
• Note 5 : Decrease in net income results in decrease in retained earnings . Thus understatement of net income in Year 1 means retained earnings of that year is also understated. In Year 2 beginning retained earnings are understated (as beginning retained earnings in Year 2 = Ending retained earnings of Year 1) .But since net income in Year 2 is overstated , the understatement & overstatement with the same amount cancel out each other effects as a results ending retained earnings balance in Year 2 get corrected automatically.