Final answer:
The balance of retained earnings is correct at the end of year 2 after an inventory miscount in year 1 and correct reporting in year 2.
Step-by-step explanation:
If a company understates its count of ending inventory in year 1 and reports inventory correctly in year 2, the most accurate statement is that the balance of retained earnings is correct at the end of year 2. This is due to the fact that any overstatement or understatement in inventory in one year self-corrects by the end of the next year, assuming that the ending inventory is correctly reported in that subsequent year.
In year 1, if ending inventory is understated, cost of goods sold (COGS) will be overstated, which in turn will understate net income for the year. However, because the ending inventory for year 1 becomes the beginning inventory for year 2, and assuming no error occurs in year 2, the accounts self-adjust.
Therefore, choices like 'costs of goods sold is understated at the end of year 1' or 'the balance of retained earnings is overstated at the end of year 1' are incorrect because the understatement of inventory would actually lead to an overstatement of COGS and an understatement of retained earnings. Additionally, the statement that 'net income is correct in year 2' aligns with the accurate reporting of inventory in that year and does not directly address the retained earnings balance from the previous error.