In the financial year 2011-2012, the closing inventory was recorded with an overstatement of 25,000. Which statement below correctly describes the impact of this error?

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Cost of goods sold was reported higher in 2011-2012, causing profits to be lower in 2012-2013.Profits were inflated in 2011-2012 and the closing inventory remains overstated in 2012-2013.Retained earnings were inflated in 2011-2012 but will be understated in 2012-2013 due to this error.Cost of goods sold was understated in 2011-2012, yet retained earnings remain unaffected in 2012-2013.None of the above.

Explanation

When closing inventory is overstated, it artificially increases profit and retained earnings for the current year (2011-2012). However, since this overstated closing inventory becomes the opening inventory for the following year (2012-2013), profits and retained earnings in that next year are reduced. Therefore, retained earnings are overstated in 2011-2012 and understated in 2012-2013.