Aaron Company uses the periodic inventory cost flow method. If Aaron's ending inventory is understated due to an accounting error, what is the effect on net income and the ending balance of retained earnings?

Net Income Retained Earnings

(A) Understated Understated

(B) Understated Overstated

(C) Overstated Understated

(D) Overstated Overstated

(A) Understated Understated

Explanation:

If there is an error in presentation of ending inventory and the value is understated, it will understate the net income as gross profit will be understated.

Further net income is part of retained earnings, and therefore, it will also be understated.

Since in a T shape income statement, Closing stock is presented on the right side that means credited and added as an income.

Thus, if understated the income will also be understated.

Thus, correct option is:

(A) Understated Understated