Berkshire Inc. uses a periodic inventory system. At the end of 2017, it missed counting some inventory items, resulting in an inventory understatement by $600,000. Assume that Berkshire has a 30% income tax rate and that this was the only error it made. v
-If undetected, what is the effect of this error on Berkshire's December 31,2017 balance sheet?
A) Assets understated by $600,000 and shareholders' equity understated by $600,000.
B) Assets understated by $420,000 and shareholders' equity understated by $420,000.
C) Assets understated by $600,000, liabilities understated by $180,000, and shareholders' equity understated by $420,000.
D) None of these answer choices are correct.

Question

Quizplus · Accepted Answer

Since the inventory was understated by $600,000, this means that assets will be understated by the same amount, leading to a balance sheet error of $600,000. However, since the error was not detected, the company did not record the corresponding tax benefit of $180,000 (30% of $600,000) that would arise from the inventory understatement. Therefore, liabilities will also be understated by $180,000, resulting in a total balance sheet error of $780,000. Shareholders' equity will be understated by the difference between the two, which is $420,000.