Additional chapter 8 questions on inventory error corrections
Topics
Brief Exercise
Inventory errors
11
Exercise
Problem
1, 2, 3, 7, 8, 9, 10,
11
4, 6
BRIEF EXERCISE 8.11
Cost of goods sold as reported
$2,500,000
Overstatement of 12/31/19 inventory
(150,000)
Overstatement of 12/31/20 inventory
50,000
Corrected cost of goods sold
$2,400,000
12/31/20 Retained Earnings as reported
$4,000,000
Overstatement of 12/31/20 inventory
(50,000)
Corrected 12/31/20 retained earnings
$3,950,000
LO 3 BT: C Difficulty: S Time: 10 min. AACSB: None CPA: cpa-t001 CM: Reporting
EXERCISE 8.1
a.
1.
Raw Materials .........................................
8,100
Accounts Payable ..........................
2.
No adjustment necessary.
3.
Raw Materials .........................................
8,100
28,000
Accounts Payable ..........................
4.
Accounts Payable ...................................
28,000
7,500
Raw Materials ................................
5.
Raw Materials .........................................
Accounts Payable ..........................
7,500
19,800
19,800
Item 6 represents a special sales agreement between the supplier and
Ogale Equipment Corporation. In this arrangement, the supplier has
simply ‘parked’ its inventory with Ogale for a short time and has agreed
to buy it back in January (presumably after the supplier’s year end).
The risks and rewards of ownership have not passed to Ogale, and this
inventory should remain in the supplier’s books at December 31, 2020.
See further discussion below under (b) regarding the ethics.
Item 7 represents consignment inventory. Ogale does not record this
as inventory on its books at December 31, 2020. The inventory belongs
to P. Perry and should be recorded on its books at December 31, 2020.
Item 1 should be reversed, since the journal entry was also made on
Jan 2. Item 4 also has to be reversed. The invoice was entered in
December in error, so the entry above reverses it. The original entry
therefore has to be re-established in January – a reversal of the entry
above.
EXERCISE 8.1 (CONTINUED)
b.
With respect to item 4, it is possible that Ogale’s supplier has
made a clerical error in this case by issuing an invoice dated
December 30, 2020, prior to the shipment of the goods on January
2, 2021. Ogale should point out this error, particularly if discount
terms apply to the purchase. One must also consider the
possibility that Ogale’s supplier is trying to manipulate its
financial results for its fiscal year ended December 31, 2020. They
may be attempting to include a sale in their fiscal year while at the
same time including the merchandise inventory on their SFP. This
would indicate that the supplier is not acting legally and ethically
and Ogale should reconsider whether or not they wish to do
business with this supplier.
With respect to item 5, Ogale should contact its supplier about
the earlier-than-contracted delivery of materials. On this
occasion, Ogale has accepted delivery so it appears that they are
Ogale’s goods at December 31. However, the supplier should be
informed that this practice is not acceptable in the future. Here
the ethical issue may be with the supplier: did they arrange for an
early delivery in order to increase their current year sales, for
example, or was it in error?
With respect to item 6, Ogale should ensure that there is a valid
business reason for holding these items (i.e., that the supplier
warehouse was indeed full). They should also question why a sale
and repurchase agreement has been issued. If they are indeed
just helping out with storing the goods, there is no need to
formally record a sale and repurchase.
LO 2,3 BT: AP Difficulty: M Time: 25 min. AACSB: Ethics CPA: cpa-t001 cpa-e001 CM: Reporting and Ethics
EXERCISE 8.2
a.
Inventory December 31, 2020 (unadjusted)
$234,890
Transaction 2
10,420
Transaction 3
-0-
Transaction 4
-0-
Transaction 5
8,540
Transaction 6
(10,438)
Transaction 7
(11,520)
Transaction 8
1,500
Transaction 9
12,500
Inventory December 31, 2020 (adjusted)
$245,892
Transaction 9 represents a special sales agreement. If Jaeco cannot
make a reasonable prediction for the amount of potential returns from
Simply, then the sale is not valid and the goods cannot be considered
sold, irrespective of the shipping terms. The inventory will remain on
Jaeco’s books at December 31, 2020.
b.
Transaction 3
Sales Revenue ................................
12,800
Accounts Receivable ............
12,800
(To reverse sale entry in 2020)
Transaction 4
Purchases .......................................
15,630
Accounts Payable .................
15,630
(To record purchase of merchandise in 2020)
Transaction 8
Refund Liability ..............................
2,600
Accounts Receivable ............
2,600
(To record sales return)
Transaction 9
Sales Revenue .................................
Accounts Receivable ............
(To reverse sale entry in 2020)
21,000
21,000
EXERCISE 8.2 (CONTINUED)
a.
Transaction 3
Sales Revenue .................................
12,800
Accounts Receivable ............
12,800
(To reverse sale entry in 2020)
Transaction 4
Purchases ........................................
15,630
Accounts Payable .................
15,630
(To record purchase of merchandise in 2020)
Transaction 8
Sales Returns
and Allowances ...........................
2,600
Accounts Receivable ............
2,600
(To record sales return)
Transaction 9
Sales Revenue .................................
21,000
Accounts Receivable ............
(To reverse sale entry in 2020)
LO 2,3,5,11 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting
21,000
EXERCISE 8.3
a.
Items 1, 3, 5, 81, 10, 13, 15, 16, 18, 19, 20, 22, 23, and 26 would be
reported as inventory in the financial statements.
Explanations
23. Normal waste or spoilage of raw materials during production
would be included in the material cost of the product; i.e.,
inventoriable cost.
26. These costs can be capitalized since storage is a necessary
part of the production process.
27. Under ASPE, decommissioning or restoration costs are
added to the cost of the related natural resource asset
(discussed further in Chapters 10 and 13).
These costs may be capitalized if a company elects to do so:
11. Interest costs incurred for inventories may be capitalized.
The following items would not be reported as inventory:
1
2.
Cost of goods sold in the income statement
4.
Not reported in the financial statements as not yet received
6.
Cost of goods sold in the income statement
7.
Cost of goods sold in the income statement
Freight charges costs are not always allocated between inventory and cost of
goods sold. They are sometimes expensed completely in the year incurred out of
expediency.
9.
Selling expense for freight out
12. Advertising expense in the income statement
14. Supplies in the current asset section of the SFP
17. Not reported in the financial statements as not owned
EXERCISE 8.3 (CONTINUED)
a. (continued)
21.
Temporary investments in the current asset section of the SFP.
24.
Abnormal levels of waste of raw materials cannot be included in
the carrying amount of inventory; i.e., these must be expensed as
incurred as a period cost.
25.
Storage costs to store excess inventory cannot be inventoried;
i.e., these charges must be expensed as a period cost.
b.
Under IFRS, the treatment for borrowing costs differs from ASPE.
Interest expenses are considered product costs if the inventory
takes a long time to produce or manufacture. Capitalization is not
required for interest expenses relating to inventories
manufactured in large quantities or produced on a repetitive
basis; a company can choose to capitalize as an accounting
policy choice.
Additionally, under IFRS, decommissioning costs incurred as part
of the production process are treated as product costs and are
inventoriable.
LO 2,3,4,11 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting
EXERCISE 8.7
Current Year
Subsequent Year
1. Working capital
Overstated by $1,020
No effect
Current ratio
Overstated
No effect
Retained earnings
Overstated by $1,020
No effect
Net income
Overstated by $1,020
Understated by $1,020
2. Working capital
No effect
No effect
Current ratio
Overstated
No effect
Retained earnings
No effect
No effect
Net income
No effect
No effect
3. Working capital
Overstated by $850
No effect
Current ratio
Overstated
No effect
Retained earnings
Overstated by $850
No effect
Net income
Overstated by $850
Understated by $850
LO 3 BT: AN Difficulty: M Time: 20 min. AACSB: Analytic CPA: CPA: cpa-t001 cpa-t005 CM: Reporting and Finance
EXERCISE 8.8
a.
b.
1.
Net income for 2019 is overstated by $51,000 because
beginning inventory is understated.
2.
Net income for 2019 is overstated by $2,400 because
purchases are omitted.
3.
Net income is overstated by $1,000 because ending inventory
is overstated.
1.
No effect.
2.
Accounts payable understated, retained earnings overstated,
$2,400.
1. Inventory is overstated by $1,000 and retained earnings are
overstated, $1,000.
LO 3 BT: C Difficulty: S Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting
EXERCISE 8.9
a.
Errors in Inventories
Year
Net
Income
Per
Books
Add
Overstatement
Jan. 1
2015
$ 50,000
2016
52,000
$5,000
2017
54,000
9,000
2018
56,000
2019
58,000
2020
60,000
Deduct
Understatement
Jan. 1
Deduct
Over statement
Dec. 31
Add
Understatement
Dec. 31
Corrected
Net
Income
$5,000
$ 45,000
9,000
48,000
$11,000
$11,000
45,000
2,000
2,000
74,000
10,000
60,000
48,000
$330,000
$320,000
b.
Balance
Revised
Original
Retained
Corrected
Retained
Net Income
Earnings
Net Income
Earnings
2015
$ 50,000
$ 50,000
2016
52,000
102,000
48,000
93,000
2017
54,000
156,000
74,000
167,000
2018
56,000
212,000
45,000
212,000
2019
58,000
270,000
60,000
272,000
2020
60,000
$ 330,000
48,000
$ 320,000
$330,000
$ 45,000
$ 320,000
$ 45,000
c.
The original data shows a steadily increasing net income. The
revised data is much more variable. It appears that income was
manipulated by adjusting the ending balance of the inventory
account.
LO 3 BT: AP Difficulty: M Time: 20 min. AACSB: None CPA: cpa-t001 CM: Reporting
EXERCISE 8.10
1. Reporting under ASPE:
a.
Net realizable value
$50 – $19 = $31
Cost
$45
Lower of cost and NRV
$31
$35 figure used – $31 correct value per unit = $4 per unit.
$4 X 1,000 units = $4,000.
If ending inventory for 2019 is overstated, net income for 2019 will
be overstated.
b.
Net income for 2020 is understated by $4,000 because the
beginning inventory was overstated by $4,000 causing a
corresponding overstatement in cost of goods sold.
c.
The current ratio at December 31, 2019 would be overstated since
the inventory would be overstated. The inventory turnover for the
year ended December 31, 2019 would be understated because the
numerator, Cost of goods sold, is understated and the
denominator in the ratio calculation would be overstated (divided
by 2). The debt to total assets ratio at December 31, 2019 would
be understated since the denominator, total assets in the ratio
would be overstated.
The current ratio at December 31, 2020 would not be affected by
an error in inventory at the end of fiscal 2019. The effect on the
inventory turnover for the year ended December 31, 2020 cannot
be determined. The numerator would be overstated by $4,000 and
the denominator in the ratio calculation would be overstated by
$2,000. But, depending on the original numbers, the ratio could
get smaller, larger, or stay the same. Because most inventory
turns over more than twice a year (i.e., $4,000/$2,000), it is likely
that the error would make the turnover lower than it actually was.
The debt to total assets ratio at December 31, 2020 would not be
affected by an error in inventory at the end of fiscal 2019.
EXERCISE 8.10 (CONTINUED)
d.
If the error is discovered before closing entries are made and the
release of the financial statements, then it must be corrected by
management and a corresponding reduction of inventory
recorded.
If we assume that the financial statements have already been
released, the opportunity to correct the error is denied.
Management must then follow the correction of error treatment
and adjust the opening balance of retained earnings for the effect
of the error, net of applicable taxes. The correction of the error
would be shown in the following year’s financial statements.
e.
Reporting under IFRS:
Response would remain unchanged.
LO 3,7,10,11 BT: AN Difficulty: C Time: 25 min. AACSB: Analytic CPA: CPA: cpa-t001 cpa-t005 CM: Reporting and
Finance
EXERCISE 8.11
a.
Sales
$ 2,750,000
Gross profit based on pricing 35% of sales
Cost of goods sold - calculated
1,787,500
Total goods available for sale
2,200,000
Expected ending inventory
b.
(962,500)
$ 412,500
The difference between the inventory estimate per the gross profit
method and the amount per physical count may be due to several
types of errors or omissions in the gross profit calculation:
1.
2.
3.
4.
5.
6.
Theft losses (shoplifting or pilferage).
Spoilage or breakage above normal.
Accounting errors in recording purchases or sales.
Error in the beginning inventory.
Errors in taking the physical count.
Errors in applying planned mark-up percentage.
The first two reasons are not applicable in this instance since the
physical amount is higher than the amount estimated with the gross
profit method.
LO 3,9 BT: AP Difficulty: S Time: 15 min. AACSB: None CPA: cpa-t001 CM: Reporting
PROBLEM 8.4
a.
Inventory is generally reported at lower of cost and net realizable value.
This works well for most industries. However, there are a few industries
where reporting inventories at net realizable value – that is the amount
that will be collected in the future – even if it above cost, is more
appropriate. In such cases, the following criteria are necessary:
The sale is assured or there is an active market for the product.
The disposal costs are estimable.
Some examples include industries where there is a controlled market
such as raw metals or other minerals; agricultural produce or forestry
products that have been harvested; additionally, it would be also be
appropriate for the minor marketable by-products where cost would be
too difficult to obtain.
These circumstances do not appear to exist for Halm. Halm’s
procedure for valuing inventories violates the historical cost principle.
As well, the application of the lower of cost and net realizable value
rule has also been ignored. The financial statements have therefore
not been prepared in accordance with GAAP.
PROBLEM 8.4 (CONTINUED)
b.
Effect on Ending Inventory ($’000):
2017
2018
2019
2020
$ 150
$147
$170
$ 175
Inventory at NRV
160
$160
$170
189
Increase (Reduction)
(10)
(13)
0
(14)
Effect on Beginning Inventory
0
(10)
(13)
0
Effect on Cost of Goods Sold
10
3
(13)
14
Current Cost of Goods Sold
560
590
630
650
Revised Cost of Goods Sold
$ 570
$ 593
$617
$ 664
2019
2020
Inventory - lower of Cost & NRV
Revised Income Statements ($’000)
2017
Sales
2018
$ 850
$ 880
$950
$ 990
Cost of Goods Sold
570
593
617
664
Gross Profit
280
287
333
326
Operating Expenses
190
180
200
210
$ 90
$ 107
$ 133
$ 116
2017
2018
2019
2020
$ 100
$ 110
$120
$ 130
Income Before Taxes
c.
Income as previously reported
Revised income
Net change
90
$( 10)
107
133
116
$( 3)
$13
$( 14)
PROBLEM 8.4 (CONTINUED)
d.
Cumulative effect on balance of Retained Earnings ($’000)
Prior years' income
Current year's income
Cumulative effect on balance
e.
2017
2018
2019
2020
$0
$(10)
$(13)
$0
(10)
(3)
13
(14)
$(10)
$(13)
$0
$(14)
From the tables above, we observe that, in the three years where there
appeared to be an increasing cost trend, (all years except 2017), the
effect of using the net realizable value overstated income, since ending
inventories were overstated (except in 2019). There is also a reduction
in the cumulative balance of retained earnings in all years except 2019.
The effect on ending inventory is somewhat reduced by the offsetting
effect of the costing method on the opening inventory in the
immediately following year.
The income statements as originally issued show a consistent increase
in income before taxes from 2017 to 2020. This trend gives the
appearance of a low-risk business from the perspective of a potential
investor. When one looks at the revised income statements, one can
see the dramatic ups and downs, which impact directly the stability of
profitability. This would be cause for concern to an investor or creditor.
LO 7 BT: AP Difficulty: M Time: 25 min. AACSB: None CPA: cpa-t001 CM: Reporting
PROBLEM 8.6
a.
Based on the unadjusted SFP of Langford Landscaping Ltd. at
December 31, 2020:
Working capital:
Current assets - current liabilities
$5,000+$39,000+$79,000 -$75,000
= $48,000
Current ratio:
Current assets divided current liabilities
($5,000+$39,000+$79,000) / $75,000
= 1.64 to 1
Debt to equity ratio:
Total liabilities divided by total equity
($75,000+$62,000) / ($60,000+$51,000)
= 1.23 to 1
PROBLEM 8.6 (CONTINUED)
b.
Net income fiscal year 2020 (unadjusted)
$ 53,000
Add:
Overstatement of ending inventory 2019
$ 13,000
Understatement of purchases 2019
1,700
Understatement of inventory 2020
17,000
Prepaid expenses omitted 2020
750
Remove dividend expense 2020
500
32,950
Less:
Accrued revenue 2019 omitted
(2,500)
Prepaid expenses omitted 2019
(2,400)
Omission of salary accrual 2020
(1,800)
Omission of unearned income 2020
(2,300)
Corrected net income fiscal year 2020
c.
(9,000)
$ 76,950
Correction of Retained Earnings balance at December 31, 2020
Retained earnings (unadjusted)
$ 51,000
Correction of opening balance errors:
Overstatement of ending inventory 2019
Understatement of purchases 2019
Prepaid expenses omitted 2019
$(13,000)
(1,700)
2,400
Accrued revenues 2019 omitted
Add corrections in current year income
2,500
32,950
(9,000)
Less dividends
Revised ending balance
(9,800)
23,950
(500)
$ 64,650
PROBLEM 8.6 (CONTINUED)
c. (continued)
Langford Landscaping Ltd.
Statement of Financial Position
December 31, 2020
Assets
Unadj.
Cash
Adj.
Revised
$ 5,000
$ 5,000
Accounts and notes receivable
39,000
39,000
Inventory
79,000
Prepaid expense
Property, plant, and equipment
(net)
17,000
96,000
750
750
125,000
125,000
$ 248,000
$ 265,750
Liabilities and Shareholders’ Equity
Accounts and notes payable
$ 75,000
(20,000)
$ 55,000
Accrued liabilities
1,800
1,800
Unearned income
2,300
2,300
20,000
20,000
Long-term accounts payable
Long-term debt
62,000
62,000
Common shares
60,000
60,000
Retained earnings
51,000
13,650*
64,650
$ 248,000
* Amount can be derived from the accounting equation
$ 265,750
PROBLEM 8.6 (CONTINUED)
d.
Working capital:
Current assets - current liabilities
$5,000+$39,000+$96,000+$750-$55,000-$1,800-$2,300)
= $81,650
Current ratio:
Current assets divided by current liabilities
($5,000+$39,000+$96,000+$750) / ($55,000+$1,800+$2,300)
= 2.38 to 1
Debt to equity ratio:
Total liabilities divided by total equity
($55,000+$1,800+$2,300+$20,000+$62,000) / ($60,000+$64,650)
= 1.13 to 1
All three have improved, especially the current ratio and the amount of
working capital reported, and these are related. Between corrections that
increased current assets and decreased current liabilities, a net amount of
$33,650 was added to the unadjusted amount of working capital. This could
only increase the current ratio and it did – a $17,750 increase in current
assets and a $15,900 decrease in current liabilities. Because the amount of
working capital was only $48,000 before correction, the addition of $33,650
has a significant effect.
PROBLEM 8.6 (CONTINUED)
d. (continued)
Many adjustments were required to determine the corrected debt to equity
ratio because errors as at the end of 2020 ($17,000 + $750 - $1,800 - $2,300
= $13,650) affect the equity (through net income and then retained earnings).
Errors from 2019 have self-corrected by December 31, 2020. Note that the
ending inventory error at December 31, 2020 affects 2020 net income
reported and would affect 2021’s if not corrected now.
The debt/equity ratio has been reduced from 1.23 to 1.13. (Whether the
revised ratio is “better” than the adjusted ratio really depends on the industry,
the company’s desired capital structure, and other factors.) The reduction is
due to a significant increase in the denominator (equity) of $13,650 with only
a small adjustment to the numerator (debt) of + $4,100.
LO 3,10 BT: AP Difficulty: C Time: 50 min. AACSB: Analytic CPA: CPA: cpa-t001 cpa-t005 CM: Reporting and
Finance