Q-mart failed to include inventory that was kept in a separate warehouse in its 12/31 end-of-the-period inventory count. Consequently, the ending inventory on 12/31 was understated on the balance sheet. Explain how this error will effect the income statement. Asset understatedEquity understated

a. The gross profit. net income and retained earnings at the end of year will be overstated.

b. Assets will be understated especially the current assets.

c. Equity will be overstated.

Explanation:

a. Explain how this error will effect the income statement income statement

When the income statement is being prepared, cost of goods sold must be computed and then deducted from the net sales revenue to arrive at the gross profit. The formula for calculating the cost of goods sold and gross profit is as follows:

Cost of goods sold = Beginning inventory + Net purchases - Ending inventory

Gross profit = Net sales revenue - Cost of goods sold

From the cost of goods sold, it can be seen that ending inventory is a deduction. Also, cost of goods sold is a deduction from the gross profit equation.

As a result these, the failure of Q-mart to include inventory that was kept in a separate warehouse in its 12/31 end-of-the-period inventory count will make the cost of goods sold to be understated, while the gross profit and the net income for the year as well as retained earnings at the end of the year will be be overstated by the amount of the omitted ending inventory.

b. Explain how this error will effect the Asset

Ending inventory is a component of the current assets in the balance sheet. As a result of this, the failure of Q-mart to include inventory that was kept in a separate warehouse in its 12/31 end-of-the-period inventory count will make the asset to be understated by the amount of the omitted ending inventory.

c. Explain how this error will effect the Equity

From part a. above, it can be seen that retained earnings at the end of the year will be be overstated by the amount of the omitted ending inventory.

Since the retained earnings for the year is a component of the stockholders equity in the balance sheet, equity will therefore be overstated by the amount of the omitted ending inventory as the gross profit and the net income for the year as well as retained earnings for the year were already overstated in the income statetement.

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