Question

Situation Klaus Corporation had $580,000 in inventory, which was based on a physical count at December 31, year 1. The inventory was priced at cost. In February year 2, it was determined that the inventory cost was overstated by $50,000. Indicate the effects of the inventory overstatement in the year 1 and year 2 financial statements by completing the following table. Mark each item overstate, understate, or OK. Year 1 Effects Year 2 Effects E OK Inventory on balance sheet Overstate Cost of goods sold Understate Overstate E Understate Net income Overstate Retained earnings Overstate OK !!

May I know why the year 1 effects of the inventory on balance sheet is overstate?

It sounds that since the price is higher, then the ending inventory should be less than the correct.

What's more, I am also confused for the other parts.

Answer 1

Okay so let me take few more numbers to explain
Year 1
I am assuming
Let sales be	$            100,000
Opening Inventory	$            500,000
Purchases	$            100,000
Closing inventory	$            580,000
(this is given in first line of question)
Inventory Balance which should have been	$            530,000
(580000-530000)
Now we make a few calculations
	Wrong	Correct
Inventory Balance	$            580,000	$     530,000
(This is clearly overstated because the actual balnce in balance sheet
should have been 530)000 but we have shown 580000
Cost of goods sold	Wrong	Correct
Opening Inventory	$            500,000	$     500,000
Add:Purchases	$            100,000	$     100,000
Less:Closing inventory balance	$         (580,000)	$   (530,000)
Cost of goods sold	$              20,000	$        70,000
(As you can see if take 580000 as our inventory balance my cost of goods
sold is understated)
Net Income	Wrong	Correct
Sales	$            100,000	$     100,000
Less:Cost of goods sold	$            (20,000)	$     (70,000)
Net Income	$              80,000	$        30,000
(Again you can see that if we take 580000 as our inventory
balance net income is overstated and hence the retained earnings is overstated)
This whole process is done for year 1
now for year 2 because your corrected opening inventory balance will be 530000
your cost of goods sold will be higher than year 1 (overstated)
and hence net income will be less (understated)
For any more information or clarification please comment