In Year 2, Company X discovered it overstated Year 1 ending inventory by $10,000. The tax rate is 30%. What is the adjustment to the Year 2 beginning Retained Earnings?

Answer options:

Decrease by $7,000

Increase by $7,000

Decrease by $10,000

No adjustment needed as it self-corrects.

How to approach this question

Trace the error: Inv Up -> COGS Down -> NI Up -> RE Up. Correction: RE Down. Apply tax rate.

Full Answer

A.Decrease by $7,000✓ Correct

Overstating ending inventory understates COGS and overstates Net Income/Retained Earnings. The correction requires a debit (decrease) to Retained Earnings for the after-tax amount ($10,000 * 70% = $7,000).

Common mistakes

Ignoring tax effect; getting the direction wrong.

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