Question

For each of the following inventory errors occurring in 2024, determine the effect of the error on 2024's cost of goods sold, net income, and retained earnings using understated, overstated, or no effect. Assume that the error is not discovered until 2025 and that a periodic inventory system is used. Ignore income taxes.

a) Beginning inventory understated in 2024.

Cost of goods sold: Understated
Net income: Overstated
Retained earnings: Overstated
b) Ending inventory overstated in 2024.

Cost of goods sold: Understated
Net income: Overstated
Retained earnings: Overstated
c) Purchases understated in 2024.

Cost of goods sold: Understated
Net income: Overstated
Retained earnings: Overstated

Answer 1

When beginning inventory is understated, COGS is understated, net income is overstated, and retained earnings are overstated. When ending inventory is overstated, COGS is understated, net income is overstated, and retained earnings are overstated. When purchases are understated, COGS is understated, net income is overstated, and retained earnings are overstated.

Step-by-step explanation:

a) When beginning inventory is understated in 2024, it means that the inventory at the start of the year is recorded at a lower value than it should be. This leads to a lower cost of goods sold (COGS) because there is less inventory to be subtracted from purchases. As a result, COGS is understated, and since COGS is deducted from revenue to calculate net income, net income will be overstated. Retained earnings are also overstated because net income is a component of retained earnings.

b) When ending inventory is overstated in 2024, it means that the inventory at the end of the year is recorded at a higher value than it should be. This leads to a higher ending inventory value, which reduces the cost of goods sold. As a result, COGS is understated, net income is overstated, and retained earnings are overstated.

c) When purchases are understated in 2024, it means that the purchases made during the year are recorded at a lower value than they actually were. This leads to a lower cost of goods sold because there appears to be less inventory to be deducted. As a result, COGS is understated, net income is overstated, and retained earnings are overstated.