You have been hired as the new controller for the Ralston Company. Shortly after

Question

You have been hired as the new controller for the Ralston Company. Shortly after joining the company in 2016, you discover the following errors related to the 2014 and 2015 financial statements:

On 12/31/15, inventory was purchased for $3,300. The company did not record the purchase until the inventory was paid for early in 2016. At that time, the purchase was recorded by a debit to purchases and a credit to cash.

The company uses a periodic inventory system.

Assuming that the errors were discovered after the 2015 financial statements were issued, analyze the effect of the errors on 2015 and 2014 cost of goods sold, net income, and retained earnings. (Ignore income taxes.)

Prepare a journal entry to correct the errors. (If no entry is required for a transaction/event, select "No journal entry required" in the first account field.)

a. Inventory at 12/31/14 was understated by $6,300. b. Inventory at 12/31/15 was overstated by $9,300. c.

On 12/31/15, inventory was purchased for $3,300. The company did not record the purchase until the inventory was paid for early in 2016. At that time, the purchase was recorded by a debit to purchases and a credit to cash.

Explanation / Answer

1. Since the errors were discovered after closure of 2015 financials, the impact will be made in 2016 ignoring any tax implication.

You can see this with the following formula that is used to derive the cost of goods sold:

Beginning inventory + purchases - ending inventory = Cost of goods sold

So for 2014, since the ending inventory was undervalued in 2014 the Cost of goods sold was higherr by $6300 impacting a lower net income and retained earning by same amount.

Now in 2015, there are 3 impacts : 1. 2014 understated inventory ($6300) 2. Inventory overstated by $9300 and 3. Purchase entry missed to be recorded $3300.

So the net impacts are :

1). Due to 2014 understatement of inventory the opening stock value will be lower by $6300 so will improve net income and retained earning by same amount.

2). Due to overstatement of closing inventory the cost of goods sold will be lower by $9300, will reduce cost of goods sold and increase margin as well as retained earning by $9300

3) Due to purchase being missed, this will also reduce cost of goods sold as well as inventory value by $3,300 but will have no impact on margin or retained earning as the same would have been part of closing inventory.

in 2016 :

The 2014 understatement of inventory will have no impact as the same would be corrected automatically in 2015.

However the understatement / overstatement of 2015 will be corrected during inventory valuation in 2016, so I do not see any journal entry to posted in system as it will correct automatically with reversal of closing as opening on a life time date basis.

Hope my explanation helps. Thanks

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