Question

Ann M. Martin Company makes the following errors during the current year.

(Evaluate each case independently and assume ending inventory in the following year is correctly stated.)

1. Ending inventory is overstated, but purchases and related accounts payable are recorded correctly.

2. Both ending inventory and purchases and related accounts payable are understated. (Assume this purchase was recordedand paid for in the following year.)

3. Ending inventory is correct, but a purchase on account was not recorded. (Assume this purchase was recorded and paidfor in the following year.)

Instructions

Indicate the effect of each of these errors on working capital, current ratio (assume that the current ratio is greater than 1), retained earnings, and net income for the current year and the subsequent year.

Short answer

Purchases have a negative relation with net income, retained earnings, working capital, and current ratio. In contrast, the ending inventory has a positive relation.

Step-by-step solution

Ending Inventory is overstated

As the ending inventory is overstated, the current ratio value and working capital would for the current year also be overstated. Because ending inventory is a part of current assets.

For the current year, the value of COGS would be understated, due to which the net income would be overstated retained earnings would also be higher.

In the subsequent year, opening inventory would be overstated, overestimating the COGS value, and the net income and retained earnings would be lower. There would be no effect on the current ratio and working capital in the subsequent year.

Both Ending inventory and purchases are understated

Ending inventory and purchase would have different effects. Understand purchase would overstate the net income and understated inventory would underestimate the net income. So the variable having a higher degree of error would have a relevant effect on net income and retained earnings.

Working capital and current ratio would be overestimated as the accounts payable are understated.

Purchases are unrecorded

Unrecorded purchases would lower the COGS value. As a result, the net income would be overestimated and the retained earnings would also overstate.

The unrecorded purchase would have understated accounts payable. So the working capital and current ratio would be overestimated as current liabilities would be lower.