A $25,000 overstatement of the 2018 ending inventory was discovered after the financial statements for 2018 were prepared.Which of the following describes the effect of the inventory error on the 2019 financial statements?

A) Net income and stockholders' equity are both understated.
B) Net income is understated and stockholders' equity is correct.
C) Net income and stockholders' equity are both overstated.
D) Net income and stockholders' equity are both unaffected.

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Ulysses Mladosich · Accepted Answer

Final Answer : B, Explanation :  The overstatement of ending inventory in 2018 caused an understatement of cost of goods sold and an overstatement of gross profit and net income. Since cost of goods sold flows into retained earnings and affects stockholders' equity, this error will result in an understatement of stockholders' equity for 2018. However, since the error was discovered in 2019, correcting the 2018 ending inventory will result in an adjustment to cost of goods sold for 2018, which will also affect net income for 2019 (because the error was discovered in 2019). Therefore, the 2019 financial statements will show an understatement of net income due to the adjustment, but stockholders' equity will be correct.

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