Berkshire Inc. uses a periodic inventory system. At the end of 2015, it missed c

Question

Berkshire Inc. uses a periodic inventory system. At the end of 2015, it missed counting some inventory items, resulting in an inventory understatement by $510,000. Assume that Berkshire has a 30% income tax rate and that this was the only error it made. If undetected, what is the effect of this error on Berkshire's 12/31/2015 balance sheet?

Assets understated by $510,000 and shareholders' equity understated by $510,000.

Assets understated by $357,000 and shareholders' equity understated by $357,000.

Assets understated by $510,000, liabilities understated by $153,000 and shareholders' equity understated by $357,000.

None of the above is correct.

Explanation / Answer

Answer : Assets understated by $510,000, liabilities understated by $153,000 and shareholders' equity understated by $357,000.

The closing inventory has been understated by $510000 due to the counting error, and consequently the net profit before tax will be understated by $510000. The tax rate is 30%. The net profit after tax will be understated by $510000 (1 - 0.30) = $357000. The net profit after tax increases the equity of the shareholders. As the net profit after tax is understated by $357000, the equity will be understated by $357000.

The inventory (current asset ) on the asset side of the accounting equation will be understaed by $510000, whereas the liabilities side of the accounting equation will be understated by 510000 * 0.30 = $153000 (the income tax liability which would have been paid had the there been no counting error) apart from the understatement of the equity by $357000.

The effect of the error on the accounting equation could be shown as:

Asset = Liabilites + equity

-510000 - 153000 -357000

(understatement of inventory) (understatement of income tax liability) (understatement of net income after tax)

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