[Anonymous]

This really makes my head spin! I have a question that asks how Retained Earning is affected be a 2 year understatement of Inventory. I understand the effect of the first year of inventory understatement, but I don’t see how they calculated the Net Income for Year 2

Question: Durring Year 4 Olsen Company discovered that the ending inventories reported on its financial statements were understated as follows:

Year Understatement

Year 1 $50,000

Year 2 $60,000

Year 3 $0

Olsen ascertains year – end quantities on a periodic inventory system. These quantities are converted to dollar amounts using the FIFO cost flow methos. Assuming no other accounting errors, Olsen’s retained earnings at December 31, Year 3 will be

A, $60,000 understated

B. $110,000 understated

C. Correct

D. $60,000 overstated

ANSWER:

If ending inventory is understated, cost of goods sold is overstated, and net income is, therefore, understated. The opposite is true for beginning inventory. Since ending inventory of one period is the beginning inventory of the next period, errors in inventory determination affect income for only two consecutive periods. Thus, the error in year 1 will be offset in year 2, and the error in year 2 will be offset in year 3. Since ending inventory is correct in year 3, retained earnings for year 3 will be correct even though year 3 net income was overstated. This is summarized in the following table:

year 1

year 2

year 3

Net Income

50,000 under

*10,000 under

60,000 over

Retained Earnings

50,000 under

60,000 under

-0-

* year 2 NI $10,000 under = $50,000 over + $60,000 under 3