Question

Refer to the information in Exercise 4-12 and indicate whether the failure to include in-transit inventory as part of the physical count results in an overstatement, understatement, or no effect on the following separate ratios: (a) gross margin ratio and (b) profit margin ratio.

Short answer

Answer

Bothgross margin ratio and profit margin ratio will decrease.

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.

Effect on ratios

1. Gross margin ratio: The gross margin ratio will decline because the increase in the cost of goods sold will consequently reduce the gross profit. The cost of goods sold will increase because of the inventory shrinkage resulting from goods in transit.
2. Profit margin ratio: The profit margin ratio will also decline because the overall expenses will increase due to the increased cost of goods sold.