Question

During 2016, P Company discovered that the ending inventories reported on its financial statements were incorrect by the following amounts:

2014 $120,000 understated
2015 150,000 overstated

P uses the periodic inventory system to ascertain year-end quantities that are converted to dollar amounts using the FIFO cost method. Prior to any adjustments for these errors and ignoring income taxes, P's retained earnings at January 1, 2016, would be:

Answer 1

P's retained earnings are overstated by $150,000.

Step-by-step explanation:

First of all, the $120,000 inventory understatement would cause the 2014 cost of goods sold to be overstated. In other words, profits and consequently retained earnings were understated because COGS were too high.

Because the 2014 ending inventory was understated, the beginning inventory in 2015 would be understated also. Since the initial inventory was understated, the COGS would be too low during 2015, which would end up correcting the previous error during 2015 (both profits and retained earnings should level up).

By the end of 2015, an error happened again and this time the ending inventory was overstated by $150,000, which understates COGS and overstates profits (and retained earnings). This should also be corrected during 2016, but since we are asked about January 1, 2016, then the correction hasn't occurred yet.

The problem with a periodic inventory system is that COGS is determined at the end of the accounting period, unlike a perpetual inventory system that records COGS immediately. Any variation in final inventory will change profits and directly affect retained earnings.

Answer 2

$150,000 overstated

Step-by-step explanation:

Given

2014 $120,000 understated

2015 150,000 overstated

Using the FIFO cost method, the retained earnings would be $150,000 overstated.

The understated earnings of $120,000 would affect the earnings of 2014 cost of goods sold to be entered as overstated. At the same time, this would understate the net income and the retained earnings.

Having mentioned the above, this would also affect the beginning Inventory of 2015 cost of goods sold to be understated. By the same virtue, this would overstate the net income and the retained earnings by the same amount the net income and retained earnings is understated, effectively correcting the balance of the retained earnings.

Lastly, The $150,000 overstated ending inventory would then affect the 2015 cost of goods sold to beunderstated; this would overstate the Net Income and Retained Earnings.