Thursday, August 4, 2011

Identify the financial statement effects of an overstatement

Errors occasionally occur when physically counting inventory items on hand. Identify the financial statement effects of an overstatement of the ending inventory in the current period. If the error is not corrected, how does it affect the financial statements for the following year?


  • An error in the beginning inventory will have a reverse effect on net income
    • Overstatement of inventory results in understatement on net income
  • An error in ending inventory will have a similar effect on net income
    • Overstatement of inventory results in overstatement of net income


If ending inventory errors are not corrected in the next period, their effect on net income for that period is reversed, and total net income for the two years will be correct.

If inventory is overstated during a period, the net affect is that shareholder equity is also overstated. When inventory is overstated, it implies that the cost of goods sold is understated since less inventory was sold compared to the whole. When cost of good sold is understated then net income would be overstated, which would be included in the share equity account. The result is that shareholder equity is overstated. This account is not zero out at the end of the period; it carries it's balance from one period to the next. Therefore, in the next period shareholder equity would still be overstated if the error was not corrected.

Wednesday, August 3, 2011

Mary Bolton believes revenues from credit sales may be earned before they are collected in cash

Mary Bolton believes revenues from credit sales may be earned before they are collected in cash.

In basic accrual accounting: revenue is recognized when it is earned and this could be before or after payment is received from a customer or company. In a basic transaction, like a purchase in a store, the income is earned at the time the sale while at the cash register. When merchandise is shipped the invoice will dictate if the revenue is earned at time of shipment or at the time of receipt by the customer. There’s COD, prepaid, and payment when fulfilled.

According to the revenue recognition policy, revenue must be realized or realizable and earned to be recognized on the income statement as income. Realization is when cash or the right to cash is received. Therefore, revenue can be accrued to match the expenses that were incurred to render the service but not recognized on the income statement until payment is received. Mary is correct but it an accrued revenue that is accounted for and not income.

"Financial Times" Guide to Personal Tax 2007-2008

Identify the contra accounts that have normal debit balances and explain why they are not considered expenses


A contra account is an account that is matched or paired to a related account and subtracted from it. Therefore, its normal balance is the opposite of the related account. Contra-revenue accounts are where you enter transactions that reduce gross earnings. Examples are Sales Discounts and Sales Returns and Allowances. Contra-revenue accounts have a normal debit balance. Sales Returns and Allowances is a contra revenue account and the normal balance is a debt. Sales Discounts is a contra-revenue account to Sales. Contra revenue accounts are offset against a revenue account on the income statement. Contra accounts always have a normal balance that is opposite to what they are contra to.

Tuesday, August 2, 2011

Why are LIFO and FIFO so popular?

A survey of major U.S. companies revealed that 77% of those companies used either last in, first out (LIFO) or first in, first out (FIFO) cost flow methods, whereas 19% used average cost, and only 4% used other methods. Why are LIFO and FIFO so popular?


When prices are rising, FIFO results in lower cost of goods sold and higher net income than the LIFO method. LIFO results in the lowest income taxes because of lower net income. In the balance sheet, FIFO results in an ending inventory that is closest to the current value. LIFO is farthest from the current value.


For example, in a period of rising prices the FIFO method would provide the highest net income. Since FIFO uses the flow of goods to account for the cost of goods sold, the first goods that were in finished goods are the first expenses to be expensed in cost of goods sold. When prices are rising, the oldest goods would the lowest costs; therefore, net income would be high. Sometimes companies do not want high net income because that would incur higher taxes for that period. Therefore during times of rising prices, the LIFO method provides the lowest net income because it uses the most recent expenses in cost of good sold. Using weighed average has no real benefit because it falls in the middle of both LIFO and FIFO. Weighted average would never provide the highest or lowest net income.
The Key Concepts of Accountancy

Monday, August 1, 2011

Identify the contra accounts that have normal debit balances and explain why they are not considered expenses

A contra account is an account that is matched or paired to a related account and subtracted from it. Therefore, its normal balance is the opposite of the related account. Contra-revenue accounts are where you enter transactions that reduce gross earnings. Examples are Sales Discounts and Sales Returns and Allowances. Contra-revenue accounts have a normal debit balance. Sales Returns and Allowances is a contra revenue account and the normal balance is a debt. Sales Discounts is a contra-revenue account to Sales. Contra revenue accounts are offset against a revenue account on the income statement. Contra accounts always have a normal balance that is opposite to what they are contra to.

(WCS) Intermediate Accounting 12th edition Strayer