Armstrong Inc. is a calendar-year corporation. Its financial statements for the

Question

Armstrong Inc. is a calendar-year corporation. Its financial statements for the years ended 12/31/12 and 12/31/13 contained the following errors:

2012
Ending inventory $20,000 overstatement

Depreciation expense 8,000 understatement

2013
Ending Invintory: $32,000 understatement

Depreciation Expense: $16,000 overstatement

5. Assumethatnocorrectingentriesweremadeat12/31/12,or12/31/13.Ignoringincometaxes,byhowmuch will retained earnings at 12/31/13 be overstated or understated?

A) $32,000 overstatement

B) $28,000 overstatement

C) $40,000 understatement

D) $12,000 understatement

.....I know the anser is "C". I just would like to be explained the rational behind how to get "C"

Explanation / Answer

As, depreciation was understated by 8000, last year, that means retained earnings were overstated by 8000 because of depreciation of 2012.

Now, depreciation is overstated by 16000. that means retained earning is understated by 16000 this year.
So, if we correct both of these errors, we will come to know that retained earning are overall understated by 8000 (16000-8000).

Here come the tricky part, you must be confused in this. Closing inventory of last year was overstated by $20000, that means retained earnings were overstated by 20000 last year because of Ending inventory. Now if u see, same ending inventory of last year becomes opening inventory of this year, so it will understate the retained earning by 20000, hence there is no effect of this in current year retained earning (20000-20000) = 0

Lastly, we have Ending Inventory of 32000 is understated by 32000, so it will understate the retained earning by 32000.

So, in total there is understatment of retained earnings by 40000(32000+8000)

The correct ans is:

C) $40,000 understatement

Hope u got it.

Feel free to ask if u still have doubts

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