[Anonymous]

Tack, Inc. reported a retained earnings balance of $150,000 at December 31, Year 1. In June Year 2, Tack discovered that merchandised costing $40,000 had not been included in inventory in its Year 1 financial statements. Tack has a 30% tax rate. What amount should Tack report as adjustment beginning retained earnings in its statement of retain earning at December 31, Year 2?

a. 190,000

b. 178,000

c. 150,000

d. 122,000

The answer is B and I don’t get why. I thought if you forget to include inventory cost in your financial statement, it would cause your cost of goods sold to be understated and in turn it would cause your income statement to be overstated.To correct the overstatement of prior period net income, beginning retained earnings must be decreased on an after-tax basis for the amount of ending inventory. As a result, the answer should be D??

For example:

IF RECORDED:

Beginning Inventory: 0

+Purchases: 40,000 ( if recorded)

Cost of goods Available for sale: 40,000

– Ending Inventory: 0

COGS = 40,000

IF HAVE NOT BEEN RECORDED

Beginning Inventory: 0

+Purchases: 0 (purchased 40k but did not record)

Cost of goods Available for sale: 0

– Ending Inventory: 0

COGS = 0

The example above mean that if you forget to record inventory, your cogs will be understated. Please help?

[Anonymous]

Remember that when Ending Inventory is understated, COGS is overstated, RE is understated. And when Ending Inventory is overstated, COGS is understated, RE is overstated . . . in year one.

So, they forgot to record $40,000 in inventory but they DID record the cost of that inventory in COGS, COGS is overstated. They recorded too much expense (COGS) in year one which decreased profit which in turn decreased retained earnings. They are making the adjustment in year 2, so they will increase retained earnings, net of tax.

I believe the crux of this question is testing your knowledge on how inventory errors effect retained earnings and how they cycle out and correct themselves eventually. The answer would be different is they asked what adjustment would be made in year 3.

This is not intuitive to me either. Memorize the R/E, COGS, and Ending Inventory relationship. Jeff makes a note of this in the Ninja notes.

[soxfancpa]

It doesn't say the purchase wasn't recorded, it says that it wasn't recorded in ending inventory. Using your example,

IF RECORDED:

Beginning Inventory: 0

+Purchases: 40,000

Cost of goods Available for sale: 40,000

– Ending Inventory: 40,000

COGS = 0

IF HAVE NOT BEEN RECORDED

Beginning Inventory: 0

+Purchases: 40,000

Cost of goods Available for sale: 40,000

– Ending Inventory: 0 (meaning they did a year end count and no inventory on hand)

COGS = 40,000

So COGS was overstated by 40,000, income was understated by 28,000 net of taxes. 150,000+28,000=178,000

[Workinonit]

You have to take into account the tax rate of 30%. Multiply $40,000*.7 and you get $28,000. This is the amount left after tax. $150,000 plus $28,000 is $178,000. Don't think I can explain it better than that, so hopefully someone else will help out.

BEC - passed - Oct 2012
AUD - passed - May 2012
REG - passed - Dec 2012
FAR - passed - Nov 2012

[Maverick]

From what I understand with the fact pattern is that $40,000 worth of inventory was purchased but not recorded in inventory; also, the problem did not state that these items were sold, therefore, there is no $40,000 COGS. Thus, the ending inventory is understated. The goods were purchased but no statement that they were sold, so they remain in ending inventory.

IF RECORDED:

Beginning Inventory: 0

+Purchases: 40,000 ( if recorded)

Cost of goods Available for sale: 40,000

– Ending Inventory: 40,000

COGS = 0

Therefore, the Income Statement is understated because 40,000 was deducted when it should not have been.

F - Passed...THANK YOU, LORD. GLORY TO GOD.
B - Passed...THANK YOU, LORD. GLORY TO GOD.
A - Passed...THANK YOU, LORD. GLORY TO GOD.
R - Passed...THANK YOU, LORD. GLORY TO GOD.

Ethics - 95

Licensed CPA

I COULD NOT HAVE DONE THIS WITHOUT MY LORD. THANK YOU.

"According to your faith will it be done to you." Matthew 9:29

[g_freeman]

As others said:

It's an error. The proper treatment of an error is to restate the F/S, and in turn include an adjustment to the R/E balance.

It's telling you that it forgot to include inventory in its YEAR 1 FINANCIAL STATEMENTS. When do we prepare our Financial Statements? At the end of the period! Therefore we know they are referring to Ending Inventory.

If we UNDERSTATE ending inventory by $40,000, it's just math. It means we think we sold MORE than we actually did, because it appears to not be there! Therefore, our COGS is going to be too high, and (revenues – expenses) will be too low.

Knowing to adjust R/E net of tax is simply knowledge of the financial statements. We know NI is after-tax, and those are the effects we're dealing with.

Now ask yourself this: What if we didn't notice this error at all? Well, when we count inventory in Year 2, we will magically find that inventory we missed last year (assuming we didn't sell it, but if we did it that would be okay too!) We will include it in ending inventory, thus UNDERSTATING our COGS, and the error will correct itself! Still, better to catch it and correct it!

FAR - 94
AUD - 99
REG - 88
BEC - TBD

[Anonymous]

Thanks! I get it now.

[Author]

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