Question

Martin, Brown and Grant (MBG) Company have reported net income of S150,000 for the years ended 12-31-17 and 12-31-18 respectively. Upon the audit of the books it was discovered that the 12-31-17 ending inventory was in $90,000. It should have been valued at $120,000. The ending inventory at 12-31-18 was correetly reported. Based on this information, compute the correct net income figures correctly valued at for 2017 and 2018. 2018 2017 $150,000 Net Income as reported $110,000 Corrected Net Income If the error was never found and never corrected, what can you say about the 12-31-18 Balance Sheet? Explain clearly and explain why?!! If ending inventory errors self-correct themselves after two years, why worry about correcting them? Be clear! Please do not say because it is the right thing to do!

Answer 1

	Particulars		2017	2018
	Net income		$ 110000	$ 150000
Add:	Undervaluation of		$ 30000
	closing inventory
	($ 120,000 - $ 90,000)
Less:	Undervaluation of			($ 30000)
	opening inventory
	($ 120,000 - $ 90,000)
	Corrected net income		$ 140000	$ 120000

If the mistake was never found and never corrected, the reserves and surplus would've shown an excess profit of $ 30,000. This is because the closing stock of previous year is the opening stock for the current year, and if the closing stock of previous year is understated by $ 30,000, the same mistake would've been carried forward to current year as undervalued opening stock, which would've resulted in an untrue increased gross/net profit, and the same would get transferred to reserves and surplus ultimately.

Even if the mistake correct itself after two years, it'd have affected the decision of the external users of financial statements of the company. Moreover, in preparation of cash flow statements for the relevant years, it'd have resulted in showing the wrong amount of cash flow from operations, which would've hampered the whole cash flow statement.