Chapter 5, Problem 5.36P

To determine

(A)

Recast the 2016 and 2017 income statement

Answer to Problem 5.36P

  $\begin{array}{lll} \hfill & \underset{\_}{2017}\hfill & \underset{\_}{2016}\hfill \\ \text{Sales}\hfill & 405100\hfill & 393200\hfill \\ \text{Cost of goods sold}\hfill & \left(285500\right)\hfill & \left(287500\right)\hfill \\ \text{Gross profit}\hfill & 119600\hfill & 105700\hfill \\ \text{Operating expenses}\hfill & \left(78400\right)\hfill & \left(71800\right)\hfill \\ \text{Net income}\hfill & 41200\hfill & 33900\hfill \end{array}$

Wrong statement

  $\begin{array}{lll} \hfill & \underset{\_}{2017}\hfill & \underset{\_}{2016}\hfill \\ \text{Sales}\hfill & 405100\hfill & 393200\hfill \\ \text{Cost of goods sold}\hfill & \left(303000\right)\hfill & \left(270000\right)\hfill \\ \text{Gross profit}\hfill & 102100\hfill & 123200\hfill \\ \text{Operating expenses}\hfill & \left(78400\right)\hfill & \left(71800\right)\hfill \\ \text{Net income}\hfill & 23700\hfill & 51400\hfill \end{array}$

  $\begin{array}{l}\text{Overstated inventory in }2016=17500\hfill \\ \text{Actual inventory in }2016=270000+17500\hfill \\ =287500\hfill \\ \begin{array}{l}\text{Actual inventory in }2017=303000-17500\\ =285500\end{array}\hfill \end{array}$

Actual statement

  $\begin{array}{lll} \hfill & \underset{\_}{2017}\hfill & \underset{\_}{2016}\hfill \\ \text{Sales}\hfill & 405100\hfill & 393200\hfill \\ \text{Cost of goods sold}\hfill & \left(285500\right)\hfill & \left(287500\right)\hfill \\ \text{Gross profit}\hfill & 119600\hfill & 105700\hfill \\ \text{Operating expenses}\hfill & \left(78400\right)\hfill & \left(71800\right)\hfill \\ \text{Net income}\hfill & 41200\hfill & 33900\hfill \end{array}$

Explanation of Solution

Given:

Concept Used:

If a corporation overstates its inventory, it will also be overstating its gross profit and net income as well as its current assets, total assets, retained earnings, stockholders' equity, and all of the related financial ratios.

The gross profit and net income are overstated as a result of overstating inventory because not enough of the cost of goods available is being charged to the cost of goods sold. The higher amount of net income means that the reported amount of retained earnings and stockholders' equity is also too high.

Since the overstated amount of inventory at the end of one accounting period becomes the beginning inventory of the following period, the following period's cost of goods sold will be too high and will result in the period's gross profit and net income being too low. (The retained earnings and other balance sheet amounts will be correct at the end of the second period.)

Conclusion:

Since the overstated amount of inventory at the end of one accounting period becomes the beginning inventory of the following period, the following period's cost of goods sold will be too high and will result in the period's gross profit and net income being too low. (The retained earnings and other balance sheet amounts will be correct at the end of the second period.)

To determine

(B)

Calculate the combine net worth for 2016 and 2017 before and after correction

Answer to Problem 5.36P

  $\begin{array}{l}\text{For wrong statement }=75100\\ \text{For actual statement }= 75100\end{array}$

The actual net income doesn't change but it has large impact on shareholders capital and decision.

Wrong statement

  $\begin{array}{lll} \hfill & \underset{\_}{2017}\hfill & \underset{\_}{2016}\hfill \\ \text{Sales}\hfill & 405100\hfill & 393200\hfill \\ \text{Cost of goods sold}\hfill & \left(303000\right)\hfill & \left(270000\right)\hfill \\ \text{Gross profit}\hfill & 102100\hfill & 123200\hfill \\ \text{Operating expenses}\hfill & \left(78400\right)\hfill & \left(71800\right)\hfill \\ \text{Net income}\hfill & 23700\hfill & 51400\hfill \end{array}$

  $\begin{array}{l}\text{Overstated inventory in }2016=17500\hfill \\ \text{Actual inventory in }2016=270000+17500\hfill \\ =287500\hfill \\ \begin{array}{l}\text{Actual inventory in }2017=303000-17500\\ =285500\end{array}\hfill \end{array}$

Actual statement

  $\begin{array}{lll} \hfill & \underset{\_}{2017}\hfill & \underset{\_}{2016}\hfill \\ \text{Sales}\hfill & 405100\hfill & 393200\hfill \\ \text{Cost of goods sold}\hfill & \left(285500\right)\hfill & \left(287500\right)\hfill \\ \text{Gross profit}\hfill & 119600\hfill & 105700\hfill \\ \text{Operating expenses}\hfill & \left(78400\right)\hfill & \left(71800\right)\hfill \\ \text{Net income}\hfill & 41200\hfill & 33900\hfill \end{array}$

Explanation of Solution

Given:

Concept Used:

If a corporation overstates its inventory, it will also be overstating its gross profit and net income as well as its current assets, total assets, retained earnings, stockholders' equity, and all of the related financial ratios.

The gross profit and net income are overstated as a result of overstating inventory because not enough of the cost of goods available is being charged to the cost of goods sold. The higher amount of net income means that the reported amount of retained earnings and stockholders' equity is also too high.

Since the overstated amount of inventory at the end of one accounting period becomes the beginning inventory of the following period, the following period's cost of goods sold will be too high and will result in the period's gross profit and net income being too low. (The retained earnings and other balance sheet amounts will be correct at the end of the second period.)

Conclusion:

For both the statement net income doesn't change but it has very large impact on shareholder equity and decision.

To determine

(C)

Effect of error on net income and equity shareholders net worth

Answer to Problem 5.36P

The effect it will have on the shareholders is that the net income will be low. That will attract the focus of shareholders toward the company and will make them go there decision to invest in the company once again.

Wrong statement

  $\begin{array}{lll} \hfill & \underset{\_}{2017}\hfill & \underset{\_}{2016}\hfill \\ \text{Sales}\hfill & 405100\hfill & 393200\hfill \\ \text{Cost of goods sold}\hfill & \left(303000\right)\hfill & \left(270000\right)\hfill \\ \text{Gross profit}\hfill & 102100\hfill & 123200\hfill \\ \text{Operating expenses}\hfill & \left(78400\right)\hfill & \left(71800\right)\hfill \\ \text{Net income}\hfill & 23700\hfill & 51400\hfill \end{array}$

  $\begin{array}{l}\text{Overstated inventory in }2016=17500\hfill \\ \text{Actual inventory in }2016=270000+17500\hfill \\ =287500\hfill \\ \begin{array}{l}\text{Actual inventory in }2017=303000-17500\\ =285500\end{array}\hfill \end{array}$

Actual statement

  $\begin{array}{lll} \hfill & \underset{\_}{2017}\hfill & \underset{\_}{2016}\hfill \\ \text{Sales}\hfill & 405100\hfill & 393200\hfill \\ \text{Cost of goods sold}\hfill & \left(285500\right)\hfill & \left(287500\right)\hfill \\ \text{Gross profit}\hfill & 119600\hfill & 105700\hfill \\ \text{Operating expenses}\hfill & \left(78400\right)\hfill & \left(71800\right)\hfill \\ \text{Net income}\hfill & 41200\hfill & 33900\hfill \end{array}$

Explanation of Solution

Given:

Concept Used:

If a corporation overstates its inventory, it will also be overstating its gross profit and net income as well as its current assets, total assets, retained earnings, stockholders' equity, and all of the related financial ratios.

The gross profit and net income are overstated as a result of overstating inventory because not enough of the cost of goods available is being charged to the cost of goods sold. The higher amount of net income means that the reported amount of retained earnings and stockholders' equity is also too high.

Since the overstated amount of inventory at the end of one accounting period becomes the beginning inventory of the following period, the following period's cost of goods sold will be too high and will result in the period's gross profit and net income being too low. (The retained earnings and other balance sheet amounts will be correct at the end of the second period.)

Conclusion:

The effect it will have on the shareholders is that the net income will be low. That will attract the focus of shareholders toward the company and will make them go there decision to invest in the company once again.