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Q4-12E

Expert-verified
Financial & Managerial Accounting
Found in: Page 211
Financial & Managerial Accounting

Financial & Managerial Accounting

Book edition 7th
Author(s) John J Wild, Ken W. Shaw, Barbara Chiappetta
Pages 1096 pages
ISBN 9781259726705

Short Answer

A retail company recently completed a physical count of ending merchandise inventory to use in preparing adjusting entries. In determining the cost of the counted inventory, company employees failed to consider that $3,000 of incoming goods had been shipped by a supplier on December 31 under an FOB shipping point agreement. These goods had been recorded in Merchandise Inventory as a purchase, but they were not included in the physical count because they were in transit.

a. Explain how this overlooked fact impacts the company’s balance sheet and income statement.

b. Indicate whether this overlooked fact results in an overstatement, understatement, or no effect on the following separate ratios: return on assets, debt ratio, current ratio, and acid-test ratio.

Answer

  1. The current assets, total assets, equity, and net income will be understated.

Return on assets and the current ratio will decline, whereas the quick ratio will remain unaffected and the debt ratio will increase.

See the step by step solution

Step by Step Solution

Step-by-Step SolutionStep 1: Definition of Inventory Shrinkage

The amount of inventory reported in the balance sheet, but which does not exist in the physical count is known as inventory shrinkage. Business entities incur loss due to such shrinkage.

Step 2: Impact on the balance sheet and income statement

There will be a difference between actual and physical inventory because the inventory of $3,000 is in transit and is reported on the balance sheet. Such difference will be reported as inventory shrinkage in the accounting books as the cost of goods sold will understate the net income, equity, current assets, and total assets.

Step 3: Impact on ratios

  1. Return on the asset will decline because the numerator and denominator used to calculate the ratio will decline.
  2. Debt ratio will increase because of a decrease in the value of total assets.
  3. Current ratio will also decrease due to a decrease in the inventory of the business entity.
  4. Quick ratio will not be affected because inventory is not included in the quick ratio calculation.

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