We first look into the reasons why working capital, retained earnings and net income are both no effect.1. Working capital: there will be an offsetting

effect of accounts payable and closing inventory. So, there will be no effect in working capital by both understatements.

2. Net income: Because the Purchase and related closing stock are understated by the same amount, the understated amount of purchase will be offset by that of closing stock. Because they have contra effect in the cost of goods sold. So, it won’t have any effect for the net income.

3. When the net income has no effects, retained earnings will have no effects as well.

Let’s see why the current ratio will be overstated. First, the inventory in current asset is understated. Second, the accounts payable in current liabilities is understated too. They r understated by the

same amount! To interpret the result of this changes, Let’s take a look in the example in the bottom right corner. In case 1, all the figures are corrected stated. In case 2, both C.A. and C.L. are understated by the same amount $40,000. The current ratio will become overstated.

The second case is that while ending inventory is overstated, purchases and related accounts payable are recorded correctly. I will explain it step by step.1. W orking capital will be higher if the closing

stock, which is a part of current asset, is overstated.

2. C urrent ratio will be overstated too when the current asset is overstated.

3. Retained earnings will be overstated. Before looking into retained earnings, we have to deal with the net income first.

4. The net income is overstated because the higher the closing stock, the lower the cost of goods sold, the higher the net income.

5. Then, we get that the net income is overstated. The higher the net income in the current year, the higher the retained earnings.

6. Finally, the net income in subsequent year is understated because the higher the opening stock, the higher the costs of goods sold, the lower the net income.

Do you guys still remember the formula of retained earnings? I am afraid u guys forgot. So, I’ve written down here. So, we can sum up that when the net income has been overstated, the retained earnings in the same year will have the same effect.

1. Working capital: it’s simply because the accounts payable was not recorded, so it understated the current liability. The working capital will thus be overstated.

2. Because of the omission in accounts payable while the ending inventory is recorded correctly. Only the current liabilities are understated. So, the lower the current liability, the higher the ratio. Current ratio is overstated.

3. I first talk abt Net income. For the same reason, the purchase has not been recorded, so the cost of goods sold (that is the costs) is understated. It turns out that the net income is overstated.

4. But why does the net income in the subsequent year is understated? It’s because the question said purchase of this year will be recorded in the subsequent year. It’s not matched the revenue of the subsequent year. So, the cost of goods sold is overstated. Then, net income will be understated.

5. For the retained earnings of this year, the higher the net income, the higher the retained earnings. Thus, the overstatement of net income will lead to the same effect in retained earnings in this year!

6. As I have said if net income in the same year has been overstated, why the retained earnings in subsequent year have no effect? It’s because the overstatement of net income in current year is offset by the understatement of net income in subsequent year.