Question

Berkshire Inc. uses a periodic inventory system. At the end of 2015, it missed counting some inventory items, resulting in an inventory understatement by $510,000. Assume that Berkshire has a 30% income tax rate and that this was the only error it made. If undetected, what is the effect of this error on Berkshire's 12/31/2015 balance sheet?

Assets understated by $510,000 and shareholders' equity understated by $510,000.

Assets understated by $357,000 and shareholders' equity understated by $357,000.

Assets understated by $510,000, liabilities understated by $153,000 and shareholders' equity understated by $357,000.

None of the above is correct.

Answer 1

Assets understated by $510,000, liabilities understated by $153,000 and shareholders' equity understated by $357,000.

Step-by-step explanation:

An understatement of closing inventory will have the following effects,

First of all the inventory as an asset is understated by $510,000

Second, this inventory was subject to deduction from the Cost of goods sold as, Cost of goods sold = Opening Inventory + Purchases - Closing Inventory.

Since this amount was not subtracted from the CGS, the gross profit and ultimately the Net profits were understated by $510,000.

This will be added in the net profits.

With an increase in net profits, the tax payable amount also increases. This is calculated as 510,000 * 0.30 = $153,000

So total change in profits is = 510,000 - 153,000 = $357,000

While $153,000 is still payable and is recorded as a tax payable liability.

Thus,

Assets understated by $510,000

Liabilities Understated by $153,000 (tax payable)

Share holders equity understated by $357,000 (part of retained profits)

Hope that helps.