Inventory Overstatement Self-Corrects in Retained Earnings

Steps:

• Overstating closing inventory at 31 May 2020 reduces COGS for 2020 (COGS = opening inventory + purchases - closing inventory), increasing profit and retained earnings by $20,000.
• This overstated amount carries forward as opening inventory for the year ending 31 May 2021.
• Opening inventory overstatement increases COGS for 2021 by $20,000, reducing profit and retained earnings addition by$20,000.
• Retained earnings at 31 May 2021 thus reflect overstated prior RE offset by understated current profit, resulting in no net effect.

Why A is correct:

• Per the COGS formula, inventory errors self-correct over two periods as the overstatement reverses in the next year's calculation.

Why the others are wrong:

• B: Reverses the 2020 overstatement effect on RE.
• C: Reverses both 2020 and 2021 effects.
• D: Correctly identifies 2020 overstatement but incorrectly states 2021 understatement instead of no net effect.

Final answer: A