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Inventory Errors quiz #1

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  • What is an inventory error in the context of financial accounting?
    An inventory error occurs when the ending inventory is incorrectly counted, leading to an overstatement or understatement of inventory on the financial statements.
  • How do inventory errors typically self-correct over time?
    Inventory errors usually self-correct after two years if the error is not repeated, as the incorrect ending inventory in one year becomes the incorrect beginning inventory in the next year.
  • What is the effect of an overstated ending inventory on cost of goods sold (COGS) in the year the error occurs?
    An overstated ending inventory causes COGS to be understated in the year the error occurs.
  • How does an understated ending inventory affect gross profit in the year of the error?
    An understated ending inventory causes COGS to be overstated, which reduces gross profit in that year.
  • If ending inventory is overstated by $5,000, what is the impact on net income for that year?
    Net income will be overstated by $5,000 because COGS is understated by the same amount.
  • What happens to the beginning inventory of the following year if an inventory error is made in the current year?
    The beginning inventory of the following year will reflect the incorrect ending inventory from the previous year, carrying the error forward.
  • In the second year after an inventory error, what is the effect on cost of goods sold if the error is not repeated?
    COGS in the second year will be adjusted in the opposite direction, correcting the previous year's error.
  • How does an inventory error affect the total cost of goods sold over two years?
    The total COGS over the two years remains the same, as the error in the first year is offset by the correction in the second year.
  • What is the formula for calculating cost of goods sold (COGS)?
    COGS = Beginning Inventory + Purchases - Ending Inventory.
  • If a company’s ending inventory is overstated, what is the effect on assets and equity on the balance sheet?
    Both assets and equity will be overstated because inventory (an asset) and net income (which affects equity) are both overstated.
  • What is the impact of an inventory error on the income statement in the year the error occurs?
    The income statement will show incorrect COGS, gross profit, and net income due to the inventory error.
  • How does an inventory error in one year affect the financial statements of the following year?
    The error affects the beginning inventory and COGS in the following year, causing the opposite effect on net income compared to the year of the error.
  • If the ending inventory is understated, what happens to the cost of goods sold and net income?
    COGS is overstated and net income is understated.
  • Why do inventory errors not affect the total net income over two years?
    Because the error reverses in the second year, the total net income over the two years is correct.
  • What is the effect of an inventory error on gross profit in the year the error is made?
    Gross profit is either overstated or understated depending on whether ending inventory is overstated or understated.
  • How does an inventory error impact the calculation of goods available for sale?
    Goods available for sale is not directly affected by the error; the error affects the allocation between ending inventory and COGS.
  • If a company overstates its ending inventory in year one, what will be the effect on beginning inventory in year two?
    Beginning inventory in year two will also be overstated by the same amount.
  • What is the relationship between ending inventory in one year and beginning inventory in the next year?
    Ending inventory of one year becomes the beginning inventory of the next year.
  • How does an inventory error affect the balance sheet at the end of the year the error occurs?
    The balance sheet will show an incorrect inventory amount, affecting total assets and equity.
  • What is the impact on retained earnings if ending inventory is overstated?
    Retained earnings will be overstated because net income is overstated.
  • If an inventory error is not corrected, what is the long-term effect on the company’s financial statements?
    If not corrected, the error will self-correct after two years, but the financial statements for the years affected will be misstated.
  • How can a company detect an inventory error?
    A company can detect an inventory error by reconciling physical counts with inventory records and reviewing COGS calculations.
  • What is the effect of an inventory error on the statement of cash flows?
    Inventory errors do not directly affect cash flows, but they can affect reported net income, which is used in the operating activities section.
  • If a company’s ending inventory is understated by $10,000, what is the effect on COGS and net income?
    COGS is overstated by $10,000 and net income is understated by $10,000.
  • Why is it important to accurately count ending inventory?
    Accurate ending inventory is essential for correct calculation of COGS, gross profit, net income, and for accurate financial reporting.
  • What is the effect of an inventory error on the calculation of gross margin?
    An inventory error causes gross margin to be misstated in the year of the error.
  • How does an inventory error affect the calculation of net income in the year after the error?
    Net income in the year after the error will be misstated in the opposite direction, correcting the previous year’s error.
  • If a company makes an inventory error in year one but corrects it in year two, what is the effect on total COGS over the two years?
    Total COGS over the two years will be correct, as the error is offset in the second year.
  • What is the impact of an inventory error on the calculation of income tax expense?
    Income tax expense will be misstated in the year of the error due to incorrect net income.
  • How does an inventory error affect the calculation of retained earnings at the end of the second year?
    Retained earnings will be correct at the end of the second year if the error is not repeated, as the error self-corrects.
  • What is the effect of an inventory error on the calculation of total assets at year-end?
    Total assets will be overstated or understated depending on whether ending inventory is overstated or understated.
  • If a company’s ending inventory is overstated in year one, what is the effect on COGS in year two?
    COGS in year two will be overstated, correcting the previous year’s understatement.
  • How does an inventory error affect the calculation of working capital?
    Working capital will be misstated in the year of the error due to incorrect inventory values.
  • What is the effect of an inventory error on the calculation of current ratio?
    The current ratio will be misstated because inventory is a component of current assets.
  • How does an inventory error impact the calculation of return on assets (ROA)?
    ROA will be misstated because both net income and total assets are affected by the inventory error.
  • What is the effect of an inventory error on the calculation of debt-to-equity ratio?
    The debt-to-equity ratio will be misstated because equity is affected by the error in net income.
  • If a company discovers an inventory error from a prior year, what should it do?
    The company should restate prior period financial statements to correct the error.
  • How does an inventory error affect the calculation of earnings per share (EPS)?
    EPS will be misstated in the year of the error due to incorrect net income.
  • What is the effect of an inventory error on the calculation of gross profit percentage?
    Gross profit percentage will be misstated in the year of the error.
  • How does an inventory error impact the calculation of inventory turnover ratio?
    Inventory turnover ratio will be misstated because both COGS and average inventory are affected.