Effect of inventory errors on financial statements

Problem 5-24A Effect of inventory errors on financial statements

The following income statement was prepared for Frame Supplies for Year 1:

FRAME SUPPLIES Income Statement For the Year Ended December 31, Year 1
Sales	$250,000
Cost of goods sold	$(140,000)
Gross margin	$110,000
Operating expenses	$(69,500)
Net income	$40,500

During the year-end audit, the following errors were discovered:

A $2,500 payment for repairs was erroneously charged to the Cost of Goods Sold account. (Assume that the perpetual inventory system is used.)
Sales to customers for $1,800 at December 31, Year 1, were not recorded in the books for Year 1. Also, the $980 cost of goods sold was not recorded.
A mathematical error was made in determining ending inventory. Ending inventory was understated by $2,150. (The Inventory account was mistakenly written down to the Cost of Goods Sold account.)

Required:

Determine the effect, if any, of each of the errors on the following items. Give the dollar amount of the effect and whether it would overstate (O), understate (U), or not affect (NA) the account. The first item for each error is recorded as an example.

Error No. 1	Amount of Error	Effect
Sales, Year 1	NA	NA
Ending inventory, December 31, Year 1
Gross margin, Year 1
Beginning inventory, January 1, Year 2
Cost of goods sold, Year 1
Net income, Year 1
Retained earnings, December 31, Year 1
Total assets, December 31, Year 1
Error No. 2	Amount of Error	Effect
Sales, Year 1	$1,800	U
Ending inventory, December 31, Year 1
Gross margin, Year 1
Beginning inventory, January 1, Year 2
Cost of goods sold, Year 1
Net income, Year 1
Retained earnings, December 31, Year 1
Total assets, December 31, Year 1
Error No. 3	Amount of Error	Effect
Sales, Year 1	NA	NA
Ending inventory, December 31, Year 1
Gross margin, Year 1
Beginning inventory, January 1, Year 2
Cost of goods sold, Year 1
Net income, Year 1
Retained earnings, December 31, Year 1
Total assets, December 31, Year 1

Problem 5-25A: Using Ratios to Make Comparisons

The following accounting information pertains to Boardwalk Taffy and Beach Sweets. The only difference between the two companies is that Boardwalk Taffy uses FIFO, while Beach Sweets uses LIFO.

Item	Boardwalk Taffy	Beach Sweets
Cash	$120,000	$120,000
Accounts receivable	$480,000	$480,000
Merchandise inventory	$350,000	$300,000
Accounts payable	$360,000	$360,000
Cost of goods sold	$2,000,000	$2,050,000
Building	$500,000	$500,000
Sales	$3,000,000	$3,000,000

Required

a. Compute the gross margin percentage for each company and identify the company that appears to be charging the higher prices in relation to its cost.

b. For each company, compute the inventory turnover ratio and the average days to sell inventory. Identify the company that appears to be incurring the higher financing cost.

c. Explain why a company with the lower gross margin percentage needs to have a higher inventory turnover ratio assuming a period of inflation.

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Effect of inventory errors on financial statements

Problem 5-24A Effect of inventory errors on financial statements

Problem 5-25A: Using Ratios to Make Comparisons

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