Explain the effects of an understatement of ending inventory on both the present year's net income and the following year's net income. What is the effect of this error on the inventory balance at the end of the following year?
What will be an ideal response?
Understating ending inventory would cause the following effects in the first year: an overstatement of cost of goods sold and an understatement of gross margin, net income, retained earnings and total assets. In the following year the error would reverse itself. Beginning inventory would be understated, cost of goods sold would be understated and gross margin and net income would be overstated. Retained earnings and total assets would be correctly stated at the end of the second year.
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