[vodrldnr]

Before year 2, Droit Co. used the cash basis of accounting. As of December 31, year 2, Droit changed to the accrual basis. Droit cannot determine the beginning balance of supplies inventory. What is the effect of Droit’s inability to determine beginning supplies inventory on its year 2 accrual-basis net income and December 31, year 2 accrual-basis owners’ equity?

Year 2 net income 12/31/Y2 owners’ equity
A. No effect No effect
B. No effect Overstated
C. Overstated No effect
D. Overstated Overstated

(c) Prior to year 2, Droit Co. used the cash basis of accounting. Accordingly, Droit would have expensed all purchases of supplies as incurred. In contrast, under the accrual basis of accounting, the cost of unused supplies at each year-end would have been carried as an asset and, therefore, excluded from the current year’s supplies expense. In year 2, the year Droit adopted the accrual basis of accounting, Droit would have inventoried unused supplies at December 31 and excluded those costs from year 2 net income. Since the cost of year 2’s beginning balance of supplies was expensed during year 1, even though the supplies were not used until year 2, Droit’s inability to determine the beginning supplies inventory would result in an understatement of supplies expense and overstatement of year 2 net income. However, since Droit properly inventoried supplies at December 31, year 2, its cumulative (inception-to-date) supplies expense would be properly stated. Therefore, Droit’s inability to determine year 2’s beginning supplies expense would have no impact on Droit’s December 31, year 2 retained earnings.

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I do understand the net income will be overstated … then why there is no effect on Equity ???

my basic understanding is net income is one that increase equity

…and totally do not understand the part of explanation “However, since Droit properly inventoried supplies at December 31, year 2, its cumulative (inception-to-date) supplies expense would be properly stated. Therefore, Droit’s inability to determine year 2’s beginning supplies expense would have no impact on Droit’s December 31, year 2 retained earnings.”

is this prior period adj and counter balancing error ????

[livealittle]

it states that while Y1 Net Income is overstated, it implies Y2 will be understated, thus making the cumulative effect – or effect on Retained Earnings to be nothing. RE is correct for cumulative, which includes the overstate NI for Y1 AND the (implied) understated NI for Y2 wash each other out making effect of not being able to reach a 12/31/Y1 number nothing.

BEC - 8/8/16
REG - 66, 77
AUD - 81
FAR - 9/8/16

[vodrldnr]

livealittle> so basically you are saying counterbalancing error thing comes to play ?

[ys]

Supplies Expense = Beginning Supplies + Purchases – Ending Supplies

So if you don't know the amount of Beginning Supplies, just put in a zero to replace it in the formula for now.
Plug in some numbers like below:

Beg. Supplies = 100
then 100+50-25 = 125 Supplies Expense

Beg. Supplies = 0
then 0+50-25 = 25 Supplies Expense

As you can see, if you don't know the Beginning Supplies (=0), then the Supplies Expense will be understated.
And if your expense for the period is understated, that means your income is overstated.

Now on to the second portion of the question.

Total Supplies Expense in Y2 = Total Purchases – Ending Supplies
We know both of the components in this formula, and thus we know the retained earning since Total Supplies Expense is what is needed in calculating the net income for the period.

[Author]

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