If the ending inventory for 2011-2012 was overstated by 25,000, which of the following conclusions is accurate?
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Answer: C. The retained earnings was overstated during 2011-2012 and retained earnings will be understated during 2012-2013
Explanation
Overstating ending inventory overstates net income and retained earnings for that year. In the subsequent year retained earnings will be understated due to reversed inventory effects. Ending inventory errors automatically reverse their impact on income over two periods. Ending inventory is subtracted in the cost of goods sold calculation formula. An inflated ending inventory reduces cost of goods sold which artificially inflates profit. Next year beginning inventory becomes inflated which increases cost of goods and lowers profit.
Accountants must correct inventory count errors immediately to ensure financial accuracy. Tax authorities penalize companies that misstate inventory values to alter tax liabilities. Auditors carefully examine inventory valuation consistency across consecutive accounting periods. Cost of goods sold was understated during the first year rather than overstated. Closing inventory for the second year is not automatically overstated by the prior error. Retained earnings in the subsequent year is affected by the inventory reversal.
- Subject
- Accounting and Finance
- Category
- Accounting
- Topic
- —
- Difficulty
- medium
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