Question

During the year 1 year-end physical inventory count at Tequesta Corporation, $40,000 worth of inventory was counted twice. Assuming that the year 2 year-end inventory was correct, the result of the year 1 error was that:

a) Year 1 retained earnings was understated, and year 2 ending inventory was correct.
b) Year 1 cost of goods sold was overstated, and year 2 income was understated.
c) Year 1 income was overstated, and year 2 ending inventory was overstated.
d) Year 1 cost of goods sold was understated, and year 2 retained earnings was correct.

Answer 1

The double counting of inventory in year 1 at Tequesta Corporation led to an understatement of the cost of goods sold, which caused an overstatement of year 1's net income and retained earnings. However, year 2's figures are unaffected by the year 1 error assuming the inventory was counted correctly and adjustments were made.

Step-by-step explanation:

If $40,000 worth of inventory was counted twice in year 1 at Tequesta Corporation, this means that the ending inventory for year 1 would have been overstated by $40,000. Since the cost of goods sold (COGS) is calculated by subtracting ending inventory from the sum of beginning inventory and purchases, an overstated inventory would result in the understatement of COGS. Therefore, if COGS is understated, the net income for the year would be overstated since expenses are being underreported. Given that year 2's inventory was counted correctly, the mistake doesn't carry over, so there are no direct implications for year 2's figures on account of the year 1 error. This means that for year 1, retained earnings was overstated due to the overstatement of net income, while year 2's retained earnings would not be affected by this prior year error provided corrections were made. Hence, the correct answer is: (d) Year 1 cost of goods sold was understated, and year 2 retained earnings was correct.