Question

E8.7 (LO 3) (Inventory Errors—Periodic) Salamander Limited makes the following errors during the current year. Each error is an independent case.

1. Ending inventory is overstated by $1,020, but purchases are recorded correctly.
2. Both ending inventory and a purchase on account are understated by the same amount. (Assume this purchase of $1,500 was recorded in the following year.)
3. Ending inventory is correct, but a purchase on account was not recorded. (Assume this purchase of $850 was recorded in the following year.)
Instructions
Show the effect of each error on working capital, current ratio (assume that the current ratio is greater than 1), retained earnings, and net income for the current year and the following year.

Answer 1

1.THE EFFECT OF OVERSTATED ENDING INVENTORY

A.          COST OF GOODS SOLD IS LOW.

B.          NET INCOME BEFORE TAX IS ALSO OVERSTATED.

C.          NEED TO PAY INCOME TAX ON THE AMOUNT OF OVERSTATEMENT.

D.         CURRENT ASSETS WILL INCREASE. SO THE CURRENT RATIO WILL ALSO BE RAISED.

E.          WORKING CAPITAL WOULD BE HIGHER, WHEN THE CLOSING STOCK IS OVERSTATED.

2. THE EFFECT OF BOTH ENDING INVENTORY AND PURCHASE ON ACCOUNT ARE UNDERSTATED.

A.       THERE IS NO CHANGE IN WORKING CAPITAL. BECAUSE BOTH ARE UNDERSTATED BY THE SAME AMOUNT.

B.         THERE IS NO CHANGE IN THE NET INCOME BECAUSE IT IS A CONTRA EFFECT.

C.        RETAINED EARNINGS WILL HAVE NO EFFECT.

3.      THE EFFECT OF NOT RECORDING THE PURCHASE BUT THE ENDING INVENTORY IS CORRECT

A.        NO INCREASE IN THE CURRENT LIABILITY.

B.        THE CASH WILL INCREASE IN CURRENT ASSETS. THEREFORE THERE IS A INCREASE IN CURRENT RATIO.

C.       IF THE COMPANY PURCHASED STOCK WITH CASH, THERE WOULD BE NO CHANGE IN THE WORKING CAPITAL.