During year 4, Olsen Company discovered that the ending inventories reported on its financial statements were understated as follows:

 During year 4, Olsen Company discovered that the ending inventories reported on its financial statements were understated as follows:

Year    Understatement
Year 1    $50,000
Year 2    $60,000
Year 3    $0
Olsen ascertains year-end quantities on a periodic inventory system. These quantities are converted to dollar amounts using the FIFO cost flow method.  Assuming no other accounting errors, Olsen’s retained earnings at December 31, Year 3, will be

Correct.
$ 60,000 understated.
$ 60,000 overstated.
$110,000 understated.

Answer

Correct.

 You Answered Correctly!
This answer is correct. If ending inventory is understated, cost of goods sold is overstated, and net income is, therefore, understated. The opposite is true for beginning inventory. Since ending inventory of one period is the beginning inventory of the next period, errors in inventory determination affect income for only two consecutive periods. Thus, the error in Year 1 will be offset in Year 2, and the error in Year 2 will be offset in Year 3. Since ending inventory is correct in Year 3, retained earnings for Year 3 will be correct even though Year 3 net income was overstated. This is summarized in the following table:

Year 1    Year 2    Year 3
Net Income      50,000 under      *10,000 under      60,000 over
Retained Earnings      50,000 under      60,000 under             -0-
* Y2 NI $10,000 under = $50,000 over + $60,000 under 3