A company reports its gross profit as $200,000 in Year One and $260,000 in Year Two. However, an independent auditor discovers that mistakes were made in each year in determining ending inventory. At the end of Year One, merchandise costing $18,000 was omitted from the year-end physical inventory count. At the end of Year Two, merchandise costing $7,000 was accidentally counted twice. What does the auditor believe the gross profit should be for Year Two?

At 12/31/X1, EI was understated by $18,000. On 1/1/X2, that is going to reverse itself and become BI overstated by $18,000 and if inventory is overstated, CGS is understated($18,000).

In Year 2, inventory was double-counted resulting in the overstating of EI. That means, CGS was understated($7,000). It looks like you sold less than what you actually did resulting in a lower CGS.

$18,000(U)+$7,000(U) = $25,000 understated

When CGS is understated, that means GP is overstated. Take the $25,000 CGS was understated by and subtract it from your Year 2 GP to get $235,000. 

This is the kind of problem you have to work over and over and again because trying to wrap your head around understated/overstated at first is very difficult. It was for me.

lukez wrote: I understand how if ending inventory is overstated then this effects CGS by understating it which effects gross profit.  The one thing I am a little confused on is at the end of 12/31/X1 18,000 is left out.   How does this reverse itself resulting in BI being overstated by 18,000 on 1//1/X2?   Isn't the EI on 12/31 and BI on 1/1 the same figure?      For example if inventory is suppose to be 118,000 on 12/31/X1 and EI is recorded as 100,000.  Wouldn't the BI on 1/1/X1 be 100,000 and still be understated?

I use Yaeger CPA Review and this was explained in great detail. Unfortunately, I can't remember the rationale as to why the understated/overstated for the $18,000 changes but I just know that it is something you need to know to get a question like this correct. This question is similar to a question in the Wiley book.