FAR SEC 7

Question 1

What is inventory? (5 elements)

Answer 1

1) Inventory consists of the tangible goods intended to be sold to produce revenue. Inventory is the total of tangible personal property
2) Held for sale in the ordinary course of business,
3) In the form of work-in-process to be completed and sold in the ordinary course of business, or
4) To be used up currently in producing goods or services for sale.
5) Inventory does not include long-term assets subject to depreciation.

Question 2

What is retailing as a source of inventory?

Answer 2

A trading (retailing) entity purchases merchandise to be resold without substantial modification. Such entities may also have supplies inventories.

Question 3

What is retail cost of goods sold?

Answer 3

For a retailer, cost of goods sold essentially equals beginning merchandise inventory, plus purchases for the period, minus ending merchandise inventory (purchases adjusted for the change in inventory).

Question 4

What is manufacturing inventory?

Answer 4

An entity that acquires goods for conversion into substantially different products has inventories of goods consumed directly or indirectly in production (direct materials and supplies), goods in the course of production (work-in-process), and goods awaiting sale (finished goods).

Question 5

What is manufacturer’s cost of goods sold?

Answer 5

For a manufacturer, cost of goods sold essentially equals beginning finished goods inventory, plus the cost of goods manufactured, minus ending finished goods inventory.

Question 6

What is cost of goods manufactured?

Answer 6

Cost of goods manufactured equals beginning work-in-process, plus current manufacturing costs (Direct materials + Direct labor + Production overhead), minus ending work-in-process (current manufacturing costs adjusted for the change in work-in-process).

Question 7

What are the two main inventory systems? Which circumstances determine which system is preferred?

Answer 7

Entities that require continuous monitoring of inventory use a perpetual system. Entities that have no need to monitor continuously use a periodic system.

Question 8

How does the perpetual inventory system work? (5 elements)

Answer 8

1) In a perpetual system, purchases, purchase returns and allowances, purchase discounts, and freight-in (transportation in) are charged directly to inventory.
2) Inventory and cost of goods sold are adjusted as sales occur.
3) A physical count is needed to detect material misstatements in the records.
4) The amount of inventory on hand and the cost of goods sold can be determined at any moment in time.
5) Inventory over-and-short is debited (credited) when the physical count is less (greater) than the balance in the perpetual records.
6) This account is either closed to cost of goods sold or reported separately under (a) other revenues and gains or (b) other expenses and losses.
Journal Entries in a Perpetual Inventory System
JOURNAL ENTRIES SHOWN IN IMAGE

Question 9

How does the periodic inventory system work? (5 elements)

Answer 9

Periodic System
1) In a periodic system, the inventory and cost of goods sold accounts are updated at specific intervals, such as quarterly or annually, based on the results of a physical count.
2) The beginning inventory balance remains unchanged during the accounting period.
3) Goods bought from suppliers, freight-in, and adjustments usually are tracked in a separate temporary account (i.e., purchases).
4) Changes in inventory and cost of goods sold are recorded only at the end of the period, based on the physical count.
5) After the physical count,
i)The inventory balance is adjusted to match the physical count and
ii) Cost of goods sold is calculated.
JOURNAL ENTRIES SHOWN IN IMAGE FILE

Question 10

For items counted in inventory, how are items in transit accounted for? (3 elements)

Answer 10

Items in Transit
1) Not all inventory is on hand. Most sales are recorded by the seller at the time of shipment and by the buyer at the time of receipt.
-However, this procedure may misstate inventory, receivables, payables, and earnings at the end of the period.
2) Proper cut-off is observed by determining when control has passed under the FOB (free on board) terms of the contract.
-FOB shipping point means control over goods passes to the buyer when the seller makes a proper tender of delivery of the goods to the carrier. The buyer then includes the goods in inventory.
-FOB destination means control over goods passes to the buyer when the seller makes a proper tender of delivery of the goods at the destination. The seller should include the goods in inventory until that time.
3) Shipping services performed before control over the goods is transferred to the customer are activities to fulfill the contract. Thus, revenue from shipping activities is recognized when control over the goods transfers to the customer.
-Shipping services performed after control over the goods is transferred to the customers may be accounted for as either of the following:
-An additional promised service. In this case, revenue from shipping activities is recognized when shipping services occur.
-A contract fulfillment activity. In this case, revenue from shipping activities is recognized when control over the goods transfers to the customer.

Question 11

What is FOB shipping point?

Answer 11

FOB shipping point means control over goods passes to the buyer when the seller makes a proper tender of delivery of the goods to the carrier. The buyer then includes the goods in inventory.

Question 12

What is FOB destination?

Answer 12

FOB destination means control over goods passes to the buyer when the seller makes a proper tender of delivery of the goods at the destination. The seller should include the goods in inventory until that time.

Question 13

What does FOB mean?

Answer 13

Free on board.

Question 14

What are two ways that shipping services performed after control over the goods is transferred can be accounted for?

Answer 14

Shipping services performed after control over the goods is transferred to the customers may be accounted for as either of the following:
1) An additional promised service. In this case, revenue from shipping activities is recognized when shipping services occur.
2) A contract fulfillment activity. In this case, revenue from shipping activities is recognized when control over the goods transfers to the customer.

Question 15

To account for the transfer of products with a right of return at the time of the sale, an entity should recognize all of the following: (4 elements)

Answer 15

1) Sales revenue is recognized only for the amount of consideration to which an entity expects to be entitled. Thus, no sales are recognized for the products expected to be returned.
2) A refund liability is recognized for the amount of consideration expected to be returned to customers. The refund liability is estimated at each reporting period to reflect the changes in the expectations about the refund amount. The adjustments to the refund liability are recognized as revenue (or reductions of revenue).
3) A return asset is recognized for the entity’s right to recover products from customers. The return asset is measured initially at the former carrying amount of the products expected to be returned minus any expected costs to recover those products. The return asset is presented separately from (1) the refund liability and (2) inventory.
4) Cost of goods sold is measured at the carrying amount of the products sold minus the return asset recognized.

Question 16

How does right of return relate to inventory accounting?

Answer 16

When sales are made with the understanding that unsatisfactory goods may be returned, the consideration in the contract is variable. Sales revenue then is recognized only to the extent that it is probable that a significant reversal will not occur when the uncertainty is resolved.

Question 17

How do certain entities differentiate between the gross sales amount and the sales amount that will probably be returned?

Answer 17

Some entities differentiate between the gross sales amount and the sales amount that probably will be returned. In this situation, sales are recorded at their gross amount and sales returns, a contra sales revenue account, is recognized.

Question 18

Are goods out on consignment included in items counted in inventory?

Answer 18

Yes.

Question 19

What happens if the entity is unable to make an estimate of the probability and amount of a refund? (3 elements)

Answer 19

1) The entity may not be able to make a reasonable estimate of the probability and the amount of a refund. If the entity also cannot conclude that a significant reversal of revenue recognized is not probable, no revenue or cost of goods sold is recognized until the right of return expires.
2) The entire consideration received is recognized as a contract liability.
3) The decrease in inventory is recognized as a contract asset to reflect the right to recover products from customers on settling the refund liability.

Question 20

What is the cost basis of inventory (initial measurement? (4 elements)

Answer 20

1) The cost of inventories includes all costs incurred in bringing them to their existing condition and location.
2) The cost of purchased inventories includes
i)The price paid or consideration given to acquire the inventory, net of trade discounts, rebates, and other similar items;
ii)Import duties and other unrecoverable taxes; and
ii) Handling, insurance, freight-in, and other costs directly attributable to (a) acquiring finished goods and materials and (b) bringing them to their present location and condition (salable or usable condition).
3) The cost of manufactured inventories (work-in-process and finished goods inventories) includes the cost of direct materials used, direct labor costs, and production overhead.
-Abnormal production costs are not inventoriable costs. They are expensed as incurred.
4) Period costs, such as (1) general and administrative expenses or (2) selling expenses, should be expensed as incurred. They are not inventoriable costs.

Question 21

Which three items are included in the cost of purchased inventories?

Answer 21

The cost of purchased inventories includes
1) The price paid or consideration given to acquire the inventory, net of trade discounts, rebates, and other similar items;
2) Import duties and other unrecoverable taxes; and
3) Handling, insurance, freight-in, and other costs directly attributable to (a) acquiring finished goods and materials and (b) bringing them to their present location and condition (salable or usable condition).

Question 22

What are purchases, freight costs, and discounts?

Answer 22

1) Purchased inventory is measured at invoice cost net of any discounts taken.
2) Trade discounts are usually subtracted prior to invoicing.
-A chain discount applies more than one trade discount. The first discount is applied to the list price, the second is applied to the resulting amount, etc.
3) Cash discounts are offered to induce early payment and improve cash flow.
4) The buyer’s transportation (freight) costs for purchased goods are inventoried.
i) In a perpetual system, these costs can be assigned to specified purchases.
ii) In a periodic system, transportation costs are usually debited to purchases.

Question 23

What is a chain discount?

Answer 23

A chain discount applies more than one trade discount. The first discount is applied to the list price, the second is applied to the resulting amount, etc.

Question 24

What is a consignment sale? (3 elements)

Answer 24

1) A consignment sale is an arrangement between the owner of goods and a sales agent. Consigned goods are not sold but rather transferred to an agent for possible sale.
2) The consignor (owner) records sales only when the goods are sold to third parties by the consignee (agent).
3) Goods out on consignment are included in inventory at cost. Costs of transporting the goods to the consignee are inventoriable costs, not selling expenses.

Question 25

How are goods out on consignment treated in terms of inventory accounting?

Answer 25

Goods out on consignment are included in inventory at cost. Costs of transporting the goods to the consignee are inventoriable costs, not selling expenses.

Question 26

What are three indicators that a contract is a consignment sale?

Answer 26

The following are examples of indicators that the contract with an agent is a consignment arrangement:
1) The product is controlled by the entity until a specified event occurs, such as the sale of the product to a third party, or until a specified period expires.
2) The entity is able to require the return of the product or transfer the product to a third party.
3) The dealer does not have an unconditional obligation to pay for the product.

Question 27

For consignment sales inventory, how does the consignor’s accounting work? (5 elements)

Answer 27

1) The consignor records the initial shipment by a debit to consigned goods out (a separate inventory account) and a credit to inventory at cost.
2) Consigned goods out is used in a perpetual or periodic inventory system when consignments are recorded in separate accounts.
3) If the consignor uses a perpetual system, the credit on shipment is to inventory.
4) If a periodic system is used, the credit is to consignment shipments, a contra cost of goods sold account. Its balance is then closed at the end of the period when the inventory adjustments are made.

Question 28

For consignment sales inventory, how does the consignee’s accounting work? (

Answer 28

1) The consignee never records the consigned goods as an asset.
2) The basic account used in consignee accounting is consignment-in, a receivable (payable). Its balance is the amount payable to the consignor (a credit) or the amount receivable from the consignor (a debit).
3) Before consigned goods are sold, expenses chargeable to the consignor (e.g., freight-in or service costs) are recorded in the consignment-in account as a receivable. After the consigned goods are sold, the credit balance reflects the consignee’s net liability to the consignor.
4) Sales are recorded with a debit to cash (or accounts receivable) and credits to consignment-in (a payable) and commission income.
5) Payments to the consignor result in a debit to consignment-in and a credit to cash.

Question 29

What is specific identification? (2 elements)

Answer 29

1) Specific identification requires determining which specific items are sold and therefore reflects the actual physical flow of goods. It can be used for special inventory items, such as automobiles or heavy equipment.
2) A practical weakness of specific identification is the need for detailed records.

Question 30

Regarding inventory cost-flow methods, what is average cost? (3 elements)

Answer 30

1) The assumption in an average cost system is that goods are indistinguishable and are therefore measured at an average of the costs incurred.
2) The moving-average method requires determination of a new weighted-average cost after each purchase and thus is used only in a perpetual system.
The weighted-average method is used under the periodic inventory accounting system. The average cost is determined only at the end of the period. The weighted-average cost per unit is used to determine the ending inventory and the cost of goods sold for the period. It is calculated as follows:
SEE IMAGE

Question 31

Regarding inventory cash-flow methods, what is the fundamental assumption in an average cost system?

Answer 31

The assumption in an average cost system is that goods are indistinguishable and are therefore measured at an average of the costs incurred.

Question 32

Regarding inventory cash-flow methods, what is the moving-average method?

Answer 32

The moving-average method requires determination of a new weighted-average cost after each purchase and thus is used only in a perpetual system.

Question 33

Regarding inventory cash-flow methods, what is the weighted-average method?

Answer 33

The weighted-average method is used under the periodic inventory accounting system. The average cost is determined only at the end of the period. The weighted-average cost per unit is used to determine the ending inventory and the cost of goods sold for the period. It is calculated as follows:
SEE IMAGE

Question 34

What is FIFO? (4 elements)

Answer 34

1) First-in, First-out (FIFO)
2) This method assumes that the first goods purchased are the first sold. Thus, ending inventory consists of the latest purchases.
3) Cost of goods sold includes the earliest goods purchased.
4) Under the FIFO method, year-end inventory and cost of goods sold for the period are the same regardless of whether the perpetual or the periodic inventory accounting system is used.

Question 35

What is LIFO? (4 elements)

Answer 35

1) Last-in, First-out (LIFO)
2) This method assumes that the newest items of inventory are sold first. Thus, the items remaining in inventory are recognized as if they were the oldest.
3) Under the LIFO method, the perpetual and the periodic inventory accounting systems may result in different amounts for the cost of year-end inventory and cost of goods sold.
4) Increasing inventory results in the creation of LIFO layers.

Question 36

What is LIFO periodic?

Answer 36

In a periodic system, a purchases account is used. Cost of goods sold and ending inventory are determined only at the end of the period.

Question 37

What is LIFO perpetual?

Answer 37

In a perpetual system, purchases are directly recorded in inventory. Cost of goods sold is calculated when a sale occurs and consists of the latest purchases.

Question 38

What is the LIFO conformity rule?

Answer 38

An IRS regulation requires LIFO to be used for financial reporting if it is used in the tax return.

Question 39

What is the LIFO valuation allowance? (3 elements)

Answer 39

1) Entities that use a different inventory costing method for internal purposes must convert to LIFO for reporting purposes if they use LIFO for tax purposes.
2) To adjust the inventory to LIFO, an allowance, sometimes called the LIFO reserve, is created. This account is reported as a contra to inventory account.
3) At period end, this allowance is adjusted to reflect the difference between LIFO and the internal costing method.
Journal Entry for (3)
Cost of goods sold $XXX
Allowance to reduce inventory to LIFO $XXX

Question 40

What is the criterion for selecting an inventory cost flow model?

Answer 40

The cost flow model selected should be the one that most clearly reflects periodic income.

Question 41

How does FIFO compare to LIFO? (5 elements)

Answer 41

1) An advantage of FIFO is that ending inventory approximates the market value.
-A disadvantage is that current revenues are matched with older costs.
2) Under LIFO, management can affect net income with an end-of-period purchase that immediately alters cost of goods sold.
-An end-of-period FIFO purchase has no such effect.
3) In a time of rising prices (inflation), use of the LIFO method results in the lowest year-end inventory, the highest cost of goods sold, and the lowest gross profit.
4) LIFO assumes that
i) The earliest (and therefore the lowest-priced) goods purchased are in ending inventory and
ii) Cost of goods sold consists of the latest (and therefore the highest-priced) goods purchased.
5) The results for the FIFO method are opposite of those for the LIFO method.

Question 42

How does FIFO compare to LIFO during a period of inflation?

Answer 42

Question 43

What are pools of specific goods? (3 elements)

Answer 43

1) The previous discussion of LIFO has assumed that the method is applied to specific units of inventory with specific unit costs. Dollar-value LIFO is applied to groups (pools) of inventory items that are substantially identical.
2) Recordkeeping is simplified because all goods in a beginning inventory pool are presumed to have been acquired on the same date and at the same cost.
i) Using the pooling method, beginning inventory is costed at a weighted-average unit price (Total cost ÷ Unit quantity).
ii) Usually, purchases of goods in a pool also are recorded at a weighted-average cost (Total cost ÷ Unit quantity). If the quantity of units in the pool increases during the year, a new
3) LIFO layer will be formed at the new weighted-average cost.
Each period’s inventory layer equals the total change in inventory during that period. The example below illustrates this concept.

Question 44

For LIFO accounting, how is a price index derived? (4 elements)

Answer 44

1) Under dollar-value LIFO, changes in inventory are measured in terms of dollars of constant purchasing power rather than units of physical inventory. This calculation uses a specific price index for each year.
2) Selecting an appropriate price index is crucial to dollar-value LIFO accounting.
i) An entity may choose to use published indexes. Examples are the Consumer Price Index for All Urban Consumers (CPI-U) and indexes published by trade associations.
ii) Most often, an index is generated internally for each year.
3) The double-extension method is the most common technique for internally generating a price index.
i) Extending inventory is the process of multiplying the quantity of each good on hand by the unit cost to arrive at a total amount for inventory.
ii) To enable the calculation of price indexes, this operation must be performed twice: once using current-year cost and once using base-year cost.
4) A price index can be computed for each year with the following ratio:

Price index = (Ending inventory at current-year cost)/(Ending inventory at base-year cost)

Question 45

How are dollar-value LIFO calculations done? (3 elements)

Answer 45

1) To arrive at dollar-value LIFO ending inventory, each layer must be inflated by the relevant price index.
2) In any year when the balance declines, a portion of the most recent year’s layer must be removed.
3) Once liquidated, layers cannot be replaced.

Question 46

What is the rule for measurement of inventory subsequent to initial recognition? (4 elements)?

Answer 46

1) The subsequent measurement of inventory depends on the cost method used.
i) Inventory accounted for using LIFO or the retail inventory method is measured at the lower of cost or market (LCM).
ii) Inventory accounted for using any other cost method (e.g., FIFO or average cost) is measured at the lower of cost or net realizable value.
2) The loss on write-down of inventory to market or net realizable value (NRV) generally is presented as a component of cost of goods sold. However, if the amount of loss is material, it should be presented as a separate line item in the current-period income statement.
-A write-down of inventory below its cost may result from damage, deterioration, obsolescence, changes in price levels, changes in demand, etc.
3) A reversal of a write-down of inventory recognized in the annual financial statements is prohibited in subsequent periods.
-Once inventory is written down below cost, the reduced amount is the new cost basis.

4) Depending on the nature of the inventory, the rules for write-down below cost may be applied either directly to each item or to the total of the inventory (or in some cases, to the total of each major category). The method should be the one that most clearly reflects periodic income.

Question 47

What is the process for the measurement of inventory at the lower of cost or market (LCM)? (3 elements)

Answer 47

1) Inventory accounted for using the LIFO or retail inventory method must be written down to market if its utility is no longer as great as its cost.
-The excess of cost over market is recognized as a loss on write-down in the income statement.
2) Market is the current cost to replace inventory, subject to certain limitations. Market should not (1) exceed a ceiling equal to net realizable value (NRV) or (2) be less than a floor equal to i) NRV reduced by an allowance for an approximately normal profit margin.
ii) NRV is the estimated selling price in the ordinary course of business minus reasonably predictable costs of completion, disposal, and transportation.
Thus, current replacement cost (CRC) is not to be greater than NRV or less than NRV minus a normal profit (NRV – P).
3) LCM by item always will be equal to or less than the other LCM measurements, and LCM in total always will be equal to or greater than the other LCM measurements.
-Most entities use LCM by item. This method is required for tax purposes.
i) If dollar-value LIFO is used, LCM should be applied to pools of items.
ii) An entity may not use LCM with LIFO for tax purposes.

Question 48

What is the rule for measurement of inventory at the lower of cost or NRV? (3 elements)

Answer 48

1) Inventory measured using any method other than LIFO or retail (e.g., FIFO or average cost) must be measured at the lower of cost or net realizable value.
2) Net realizable value (NRV) is the estimated selling price in the ordinary course of business minus reasonably predictable costs of completion, disposal, and transportation.
3) The excess of cost over NRV is recognized as a loss on write-down in the income statement.

Question 49

What is the rule for inventory measurement at interim dates?

Answer 49

1) A write-down of inventory below cost (to market for LIFO and retail and to NRV for all other methods) may be deferred in the interim financial statements if no loss is reasonably anticipated for the year.
2) But inventory losses from a nontemporary decline below cost must be recognized at the interim date.
3) If the loss is recovered in another quarter, it is recognized as a gain and treated as a change in estimate. The amount recovered is limited to the losses previously recognized.

Question 50

How is current replace cost (CRC) calculated?

Answer 50

Thus, current replacement cost (CRC) is not to be greater than NRV or less than NRV minus a normal profit (NRV – P).

Question 51

For special topics in inventory accounting, what are the methods for estimating inventory? (3 elements)

Answer 51

1) The estimated gross profit method is used to determine inventory for interim statements.
2) Because of its imprecision, GAAP and federal tax law do not permit use of the gross profit method at year end. But other applications are possible.
i) If inventory is destroyed, the method may be used to estimate the loss.
ii) External auditors apply the gross profit method as an analytical procedure to determine the fairness of the ending inventory balance.
iii) The method may be used internally to generate estimates of inventory throughout the year, e.g., as a verification of perpetual records.
3) The gross profit method calculates ending inventory at a given time by subtracting an estimated cost of goods sold from the sum of beginning inventory and purchases (or cost of goods manufactured).
i) The estimated cost of goods sold equals sales minus the gross profit.
ii) The gross profit equals sales multiplied by the gross profit percentage, an amount ordinarily computed on a historical basis.
Gross profit percentage = (Gross profit)/(Sales)

Question 52

What are the three possible applications for the gross profit method in inventory accounting? (4 elements)

Answer 52

1) Because of its imprecision, GAAP and federal tax law do not permit use of the gross profit method at year end. But other applications are possible.
2) If inventory is destroyed, the method may be used to estimate the loss.
3) External auditors apply the gross profit method as an analytical procedure to determine the fairness of the ending inventory balance.
4) The method may be used internally to generate estimates of inventory throughout the year, e.g., as a verification of perpetual records.

Question 53

How is the gross profit method used to calculate ending inventory? (3 elements)

Answer 53

1) The gross profit method calculates ending inventory at a given time by subtracting an estimated cost of goods sold from the sum of beginning inventory and purchases (or cost of goods manufactured).
2) The estimated cost of goods sold equals sales minus the gross profit.
3) The gross profit equals sales multiplied by the gross profit percentage, an amount ordinarily computed on a historical basis.
Gross profit percentage = (Gross profit)/(Sales)

Question 54

What is the inventory accounting for purchase commitments? (3 elements)

Answer 54

1) A commitment to acquire goods in the future is not recorded at the time of the agreement, e.g., by debiting an asset and crediting a liability.
i) But a loss is recognized on a firm, noncancelable purchase commitment (unconditional purchase obligation) if the market price of the goods is less than the commitment price.
ii) The reason for current loss recognition is the same as that for inventory. A decrease (not an increase) in future benefits should be recognized when it occurs even if the contract is unperformed on both sides.
iii) Material losses expected on purchase commitments are measured in the same way as inventory losses, recognized, and separately disclosed.
2) The journal entry is
Unrealized holding loss – earnings $XXX
Liability – purchase commitment $XXX
3) Disclosure of commitments to transfer funds for fixed or minimum amounts of goods or services at fixed or minimum prices is required.
i) A take-or-pay contract requires one party to purchase a certain number of goods from the other party or else pay a penalty.
ii) Sinking-fund requirements for the retirement of noncurrent debt also are affected by the provisions of this pronouncement.
iii) Disclosure of the aggregate amount of payments for unconditional purchase obligations is required for recorded obligations for each of the 5 years following the date of the latest balance sheet presented.

Question 55

Which disclosures are required for inventory accounting for purchase commitments? (4 elements)

Answer 55

1) Disclosure of commitments to transfer funds for fixed or minimum amounts of goods or services at fixed or minimum prices is required.
2) A take-or-pay contract requires one party to purchase a certain number of goods from the other party or else pay a penalty.
3) Sinking-fund requirements for the retirement of noncurrent debt also are affected by the provisions of this pronouncement.
4) Disclosure of the aggregate amount of payments for unconditional purchase obligations is required for recorded obligations for each of the 5 years following the date of the latest balance sheet presented.

Question 56

What is the retail method for inventory accounting? (2 elements)

Answer 56

1) Some entities, such as major retailers, have a high volume of transactions in relatively low-cost merchandise. They often use the retail method because it is applied to the dollar amounts of goods, not quantities. The result is easier and less expensive estimates of ending inventory and cost of goods sold.
2) Records of the beginning inventory and net purchases are maintained at both cost and retail. Sales at retail and any other appropriate items are subtracted from goods available for sale at retail (the sum of beginning inventory and net purchases at retail) to provide ending inventory at retail.

Question 57

What are the inventory errors? (6 elements)

Answer 57

1) These errors may have a material effect on current assets, working capital (Current assets – Current liabilities), cost of goods sold, net income, and equity. A common error is inappropriate timing of the recognition of transactions.
2) If a purchase on account is not recorded and the goods are not included in ending inventory, cost of goods sold (BI + Purchases – EI) and net income are unaffected. But current assets and current liabilities are understated.
3) If purchases and beginning inventory are properly recorded but items are excluded from ending inventory, cost of goods sold is overstated. Net income, inventory, retained earnings, working capital, and the current ratio are understated.
4) If the goods are properly included in ending inventory but the purchase is not recorded, net income is overstated because cost of goods sold is understated. Also, current liabilities are understated and working capital overstated.
5) Errors arising from recording transactions in the wrong period may reverse in the subsequent period.
-If ending inventory is overstated, the overstatement of net income will be offset by the understatement in the following year that results from the overstatement of beginning inventory.
6) An overstatement error in year-end inventory of the current year affects the financial statements of 2 different years.
-The first year’s effects may be depicted as follows:
IMAGE NOT INCLUDED
-At the end of the second year, retained earnings is correctly stated:
IMAGE NOT INCLUDED

Question 58

How does an overstatement error in year-end inventory affect 2 different years? (2 elements)

Answer 58