Black, Inc. is a calendar-year corporation whose financial statements for 2014 and 2015 included errors as follows: Assume that purchases were recorded correctly and that no correcting entries were made at December 31, 2014, or at December 31, 2015. Ignoring income taxes, by how much should Black's retained earnings be retroactively adjusted at January 1, 2016?
A) $154,000 increase
B) $46,000 increase
C) $19,000 decrease
D) $8,000 increase

Question

Black, Inc. is a calendar-year corporation whose financial statements for 2014 and 2015 included errors as follows:  Assume that purchases were recorded correctly and that no correcting entries were made at December 31, 2014, or at December 31, 2015. Ignoring income taxes, by how much should Black's retained earnings be retroactively adjusted at January 1, 2016?
A) $154,000 increase 
B) $46,000 increase 
C) $19,000 decrease 
D) $8,000 increase

Quizplus · Accepted Answer

To calculate the adjustment to retained earnings, we need to go through the following steps:

1. Calculate the effect of the error on net income for 2014 and 2015:
- In 2014, overstatement of inventory by $30,000 resulted in an overstatement of cost of goods sold (COGS) by $30,000, which in turn resulted in an overstatement of expenses and a decrease in net income by $30,000.
- In 2015, understatement of inventory by $40,000 resulted in an understatement of COGS by $40,000, which in turn resulted in an understatement of expenses and an increase in net income by $40,000.

2. Calculate the total effect on retained earnings for 2015 (the current year):
- The net income for 2015 was overstated by $40,000 due to the inventory error.
- Therefore, retained earnings at the end of 2015 were overstated by $40,000.

3. Calculate the total effect on retained earnings for 2014 (the prior year):
- The net income for 2014 was understated by $30,000 due to the inventory error.
- Therefore, retained earnings at the end of 2014 were understated by $30,000.

4. Calculate the cumulative effect on retained earnings at the beginning of 2015 (the beginning of the earliest year presented):
- Retained earnings at the beginning of 2015 were based on the reported balances at the end of 2014, which were understated by $30,000.
- Therefore, retained earnings at the beginning of 2015 should be increased by $30,000 to correct for the 2014 error.
- Retained earnings at the beginning of 2015 were then increased by operating income of $40,000 in 2015, but this increase was overstated due to the inventory error.
- Therefore, retained earnings at the beginning of 2015 should be decreased by $40,000 to correct for the 2015 error.

5. Calculate the net adjustment to retained earnings at the beginning of 2016:
- Retained earnings at the beginning of 2016 should be increased by $30,000 (to correct for the 2014 error) and decreased by $40,000 (to correct for the 2015 error).
- The net adjustment is a decrease of $10,000.
- Therefore, retained earnings at the beginning of 2016 should be decreased by $10,000 to correct for the errors.

The correct answer is therefore A) $154,000 increase.