A is corrent. 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:
B is incorrect. 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:
B is incorrect. 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:
D is incorrect. 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:
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