Question

If inventory is overstated at the end of Year 1, what effect does it have on Year 2’s account balances, assuming there is no inventory error in Year 2?

a. Overstating inventory

b. Understating cost of goods sold

c. Overstating net income

d. Overstating beginning retained earnings

If you could explain why the right answer is correct and why the other answers are incorrect, I would really appreciate it. Thank you!

Answer 1

• The correct answer is Option ‘d’: Overstating beginning retained earnings for Year 2 will be the result of overstatement of Year 1 ending inventory.
• Let’s understand the reason:

--When year 1 ending inventory got overstated, this means its cost of goods sold got UNDER stated.

--Now, Sales – Cost of Goods Sold = Gross profits. If Cost of Goods Sold is under stated, GROSS PROFIT for Year 1 will be overstated.

--Over stated Gross profits = Overstated Net Income = Overstated ending balance of retained earnings for Year 1.

--This overstated ending balance of Retained earnings for year 1 will become Beginning Retained earnings for Year 2 which will be OVERSTATED.

• Other options are wrong because:

--‘A’there is no overstating inventory as there is no inventory error in year 2.

--‘B’ Cost of goods sold will remain unaffected as inventory error is no where in year 2.

--‘C’Net Income for year 2 wont be overstated, rather Year 1 Net Income got overstated.