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Hallo,
Here is an example and I am trying to understand the solution of Part B as per the authors’ explanation:
Example:
After calculating your company’s profi t for 20X3, you discover that
a non-current asset costing $50,000 has been included in the purchases account;
stationery costing $10,000 has been included as closing inventories of raw materials,
instead of as inventories of stationery.
These two errors have had the effect of:
Answer: understating gross profit by $40,000 and understating net profi t by $50,000.
The explanation as given to the answer:
A) No Q – this is clear:
Including a non-current asset in the purchases account has overstated purchases,
and hence has overstated cost of goods sold; this has the effect of understating gross
profi t. Including stationery inventories with closing inventories of raw materials
has the effect of increasing closing inventories of raw materials, which then understates
the cost of goods sold, and hence overstates gross profi t. So, gross profi t has
been understated by $50,000 and overstated by $10,000 – a net understatement of
$40,000.
B) Q?
ok – >Inventory of stationery should reduce the total of stationery expenses in the
income statement.
Not ok -> Omitting to consider the closing inventories will have overstated
the expenses.
My Q1: The example says nothing about closing inventory being omitted, why do we consider what would happen if we omit it?
Not ok -> An overstatement of gross profit and an overstatement of expenses by
the same amount (because of the stationery error) will have no effect on net profit.My Q2: Why the gross profit and stationery are overstated, so far they have been understated, no clue here?
Therefore, the only effect on net profit will be the understatement due to the non-current
asset error. The result, therefore, is that gross profit has been understated by $40,000 and the net profit understated by $50,000.There is a major point that I’m missing here.
Thank you!
Subtracting inventory from purchases reduces the cost of sales, which increases profit – so gross profit at the moment is overstated.
Subtracting the inventory from stationery expense will reduce stationery. At the moment it has not been subtracted and so the expense is overstated.
Hallo,
May I ask:
1. ” Omitting to consider the closing inventories will have overstated the expenses”
-are we talking about assets of inventory of stationery or expenses? Because opening and closing balances are relevant to assets, not to expenses?2. Referring to your statement: “Subtracting inventory from purchases reduces the cost of sales, which increases profit – so gross profit at the moment is overstated” – but the answer says the gross profit is understated?
Thank you!
1. We are talking about inventory of stationery.
For example, if you pay 1,000 for paper and have 100 left at the end of the year, then the expense for the year (the cost of the paper that was used) is 900.2. The answer certainly does not say that the gross profit is understated with regard to the stationery inventory!!
What you typed was this “So, gross profit has been understated by $50,000 and overstated by $10,000 – a net understatement of $40,000”. This is correct.You wrote that you understood the understatement of 50,000 because of the non-current assets, but that you did not understand the overstatement of 10,000 for stationery. The error on the stationery inventory means that the gross profit is over-stated just as I said and as the answer that you typed says.
Hallo,
But I don’t understand, how the gross profit can be overstated and understated at the same time, we are talking about the same figures, and in one case it is understated in the other overstated, is this possible?
Thank you!
Of course it is possible!
There are two separate errors – one results in the profit being understated and the other results in it being overstated. The net effect of the two of them in this case is that the profit is understated.
Hallo,
My Q is at the end…but before that here is how I understand this example:
Ok, the gross profit is understated with regard to the Purchases, due to the NCA included and overstated with regard to the cl. inv, the net effect is understatement.
But, next, we assume we have opening inventory of stationery, which is an asset a/c, we have no cl. inv, so this a/c is left with it’s opening inv, which is more than if we had subtracted cl. inv. from it, so, what is the connection to this with the expenses, the expenses, if we have no expenses, as we had no cl. inv., this means for the authors hypothetically that we have an overstatement of expenses, as we have no expenses, so the opposite of having no expenses is an overstatement of expenses.
And, as the GP is overstated by 10000, and because stationery expenses are not there at all, they are being overstated, so the net profit is understated by 50000, because of the net effect of the two times +/-10000.
So, there is a very thin line, which I don’t understand the logic of:
My Q: how when we have no expenses they can be overstated, I would say that the inventory of stationery asset a/c is overstated, but it isn’t, as it hasn’t changed?
Thank you!
The inventory has not been overstated.
The problem is that the inventory had been subtracted from the purchases, but it should have been subtracted from the stationery expense.
This means that the cost of sales was understated (and therefore the gross profit overstated), but it also means that the stationery expense was overstated (and therefore the net profit understated).
The net effect of both is that the net profit is not changed, but the gross profit needs reducing.Hallo,
You said that the expense for the I/S is created when we subtract the cl. inv. from the op. inv., well since we have no cl. inv. as it went to be subtracted from purchases, we have no expense, we are only left with the opening balance of the inventory of stationery a/c and this is an asset a/c, which amount doesn’t go to the I/S, and since it hasn’t decreased by 10000, I would say the asset a/c is overstated, but not the expense a/c, why is the expense a/c at all involved here?
Thank you!
I did not say that at all.
I said that we should subtract the closing inventory from the stationery expense – I even typed a little example to show you what I meant.
Using stationery is an expense. If you buy stationery you credit cash and debit the stationery expense account. If you do not use all of the stationery then your expense is lower – you subtract the closing inventory from the stationery to reduce the expense.
Hallo,
Ok, using the stationery is an expense, but what a/c is the a/c that holds the opening and closing inventory of stationery, is that also an expense a/c or an asset a/c?
Thank you!
That is an asset account.
So……we credit stationery (to reduce the expense for the SOPOL) and debit stationery inventory (an asset for the SOFP).
Hallo,
I am trying to see this through numbers, and I get that the NP is understated by 30000, not 50000, could you check and correct where I am wrong:
e.g. Before correction we have:
Sales 100
(Op. inv. 0
Purchases 80 (includes the 50 NCA)
Cl. inv. 30 (includes the 10 Stat. exp.))
– CoGS 50
=GP 50
– Stat.exp. 0 (excludes the 10 Stat. exp. as it went above to the cl. inv.)
= NP 50After correction
Sales 100
(Op. inv. 0
Purchases 30 = 80 – 50 (excludes the 50 NCA)
Cl. inv. 20 = 30 – 10 (excludes the 10 Stat. exp.))
– CoGS 10
=GP 90
– Stat.exp. 10 (includes the 10 Stat. exp. as it should be)
= NP 80If I compare the GP before correction 50 and after correction 90, yes the GP is understated by the difference 40.
But, if I compare the NP before correction 50 and after correction 80, the NP is understated by 30, not by 50, so why don’t I get a 50 as difference, as I see clearly the difference of 40 with the GP?
Thank you!
It is because you have adjusted the stationery expense the wrong way round.
Suppose they spent 30 on stationery during the year, but 10 of it was left in inventory at the end.
Before correction there would be an expense of 30.
After correction there would be an expense of 20 (because 10 was left in inventory and not used this year).So the expense would be lower and the new profit would be higher by 10.
Hallo,
following your explanation I tried to write it again, is it correct, the GP difference between “before and after” is 40, and the NP difference between “before and after” is 50:
Before correction
Sales 100
(Op. inv. 0
Purchases 80 (includes the 50 NCA)
Cl. inv. 20 (includes the 10 Stat. exp.))
– CoGS 60
= GP 40
– Stat.exp. 30 (includes the 10 Stat. exp., i.e. not reduced by 10)
= NP 10After correction:
Sales 100
(Op. inv. 0
Purchases 30 (excludes the 50 NCA)
Cl. inv. 10 (excludes the 10 Stat. exp.))
– CoGS 20
= GP 80
– Stat.exp. 20 (excludes the 10 Stat. exp. now reduced by 10)
= NP 60Thank you!
Hallo,
Coming again to this example, I am trying to understand it in terms of the entries themselves concerning the stationery part, and using your little example, are these entries correct?
Inventory of stationery (I/S a/c – expense)
Dr Cash 1000
Cr I/S 900 (what we use for the year)
Cr Inventory of stationery (B/S a/c – asset) 100Then:
Inventory of stationery (B/S a/c – asset)
Dr Op. Bal. Inventory of stationery (I/S a/c – expense) 100 (coming from above)1. And a question, comparing with the text of the example the 10000 stationery is equivalent to the 900 or to the 100 from your example, should be the 900, as it is the real expense for the year, as the 10000 stationery is?
2. So, when you say inventory should have been subtracted from the stationery expense, you talk about the 100, the closing bal. of the expense a/c, which goes as op. bal. of the inventory asset a/c?
Thank you!
The expense is the amount that was used during the year, which is the amount purchased (and paid for) less whatever is still in inventory.
What you write in (20 is correct.
You should not spend so much time on the double entries – there is very little testing of dr’s and cr’s in the exam – in real life the debits and credits are done by computer. The accounts job is to sort out things like the calculation of accruals, depreciation etc (which the computer cannot do), and that is what the exam concentrates on.
Hallo,
If 2 is correct, how about the entry:
Inventory of stationery (I/S a/c – expense)
Dr Cash 1000
Cr I/S 900 (what we use for the year)
Cr Inventory of stationery (B/S a/c – asset) 100is it correct as well?
I know that we are not required to know the entries, but I understand it better when I know them.
It’s good to know what the exam concentrates on now, gives the focus.Thank you!
Cr Cash 1000
Dr Stationery expense 1000
With the inventory purchasedAt the end of the year:
Cr Stationary expense 100
Dr Inventory of Stationery 100
With the inventoryCr Stationary expense 900
Dr Income Statement 900
With the expense for the year
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