Question

In 2020, the controller of the Guerin Co. discovered the following three material errors related to the 2018 and 2019 financial statements.

1. Inventory at the end of 2018 was overstated by $100,000.
2. Late in 2019, a $300,000 inventory purchase was incorrectly recorded as a $100,000 inventory purchase. The invoice has not yet been paid.
3. Inventory at the end of 2019 was understated by $300,000.

The company uses a periodic inventory system.

Assuming that the errors were discovered after the 2019 financial statements were issued, analyze the effect of the errors on 2018 and 2019 retained earnings (R/E). Ignore income taxes.

2018 RE: Understated by 100,000; 2019 RE: Understated by 100,000

2018 RE: Overstated by 100,000; 2019 RE: Understated by 100,000

2018 RE: Understated by 100,000; 2019 RE: Understated by 200,000

2018 RE: Overstated by 100,000; 2019 RE: No error

Answer 1

2018 RE: Overstated by 100,000; 2019 RE: No error

For 2018, the closing stock was overstated by 100,000. Hence the profits are overstated and hence the retained earnings are also overstated by 100,000.

For 2019, the closing stock of 2018 would be the opening stock for 2019. Hence here the opening stock is overstated which means profits and hence retained earnings are understated by 100,000.

The inventory purchase is recorded less by 200,000 and hence the profits and retained earnings are overstated by 200,000.

The closing stock for 2019 is understated by 300,000 which means that the profits and retained earnings are overstated by 300,000. But since 200,000 considered above, we would consider 100,000 here.  

Hence total change in retained earnings would be 0. Hence no error in retained earnings for 2019.