Question

Aaron Company uses the periodic inventory cost flow method. If Aaron's ending inventory is understated due to an accounting error, what is the effect on net income and the ending balance of retained earnings?a. net income= understated, retained earnings= understated
b. net income= understated, retained earnings overstated
c. net income= overstated, retained earnings= understand
d. net income= overstated, retained earnings= overstated
A) option a
B) option b
C) option c
D) option d

Answer 1

Answer:

a. net income= understated, retained earnings= understated

Explanation:

In accounting and auditing it is established that ending inventory and net income moves in the same direction when it comes to being overstated or understated. That implies that if ending inventory is understated,  then cost of goods sold will be overstated by the same amount, and when costs are overstated it finally leads to net income and gross profit being understated.

Furthermore, since it is the net income that will be added to retained earnings thereafter, it implies that the lesser the net income the lesser will be retained earnings. Hence, understatement of ending inventory is understatement of net income and also retained earnings.