The accountant for the Bay Company made an error, which understated the ending inventory for Year 1 by $7,000. Bay Company uses the perpetual inventory system. Assuming that this error is not caught and corrected, indicate the effect of the error on each of the following items. Write U (understated), O (overstated) or N (not affected) next to each item. a. Year 2 Beginning Inventory: ________ b. Year 2 Purchases: ________ c. Year 1 Goods Available for Sale: ________ d. Year 1 Net Income: ________ e. Year 1 Retained Earnings ending balance: ________ f. Year 1 Total Assets at end of year: ________ g. Year 2 Net Income: ________ h. Year 2 Retained Earnings ending balance: ________ i. Year 1 Cost of Goods Sold: ________ j. Year 1 Gross Margin: ________

Question

What will be an ideal response?

Answer 1

a. Year 2 Beginning Inventory: U 
b. Year 2 Purchases: N 
c. Year 1 Goods Available for Sale: N 
d. Year 1 Net Income: U 
e. Year 1 Retained Earnings ending balance: U 
f. Year 1 Total Assets at end of year: U 
g. Year 2 Net Income: O 
h. Year 2 Retained Earnings ending balance: N 
i. Year 1 Cost of Goods Sold: O 
j. Year 1 Gross Margin: U 

Effect of error on elements of Year 1 financial statements:
Understating ending inventory understates total assets (inventory) and stockholders' equity (retained earnings). It overstates expenses (since ending inventory is subtracted in the calculation of cost of goods sold), which understates gross margin and net income. It does not affect purchases or the statement of cash flows.
Effect of error on elements of Year 2 financial statements:
The Year 1 ending inventory becomes the Year 2 beginning inventory. Understating beginning inventory does not impact total assets or stockholders' equity (retained earnings). It understates expenses (since beginning inventory is added in the calculation of cost of goods sold), which overstates gross margin and net income. It does not affect the statement of cash flows.