As we discussed, the ending physical inventory determines the ending (adjusted)
merchandise inventory reported on the balance sheet. Thus, on the December 31, 2008,
balance sheet, merchandise inventory, current assets, and total assets are understated
by $10,000 ($125,000 $115,000).
The effects of the misstatement on Sapra Company’s 2008 financial statements are
summarized below.Amount of Misstatement
2008 Financial Statements Overstated (Understated)
Balance sheet as of December 31, 2008:
Merchandise inventory $(10,000)
Current assets (10,000)
Total assets (10,000)
Total stockholders’ equity (retained earnings) (10,000)
Income statement for year ended December 31, 2008:
Cost of merchandise sold $ 10,000
Gross profit (10,000)
Net income (10,000)If the $10,000 understatement of merchandise inventory at the end of 2008 is not de-
tected, the misstatement will also affect the 2009 financial statements. This is because
the merchandise inventory at the end of 2008 becomes the beginning merchandise in-
ventory for 2009. Thus, the book inventory during 2009 will be understated throughout
the year, and as a result, the unadjusted book inventory on December 31, 2009, will be
understated by $10,000. Assuming that the physical inventory count at the end of 2009
is correct, the merchandise shrinkage will be understated by $10,000, as shown below.Amount of Misstatement
Overstated (Understated)
December 31, 2009, unadjusted book inventory $ (10,000)
Less December 31, 2009, physical inventory Correct
Inventory shrinkage (cost of merchandise sold) $(10,000)Since inventory shrinkage is understated by $10,000, the cost of merchandise sold
will be understated and gross profit will be overstated by $10,000 for 2009. Because the
December 31, 2009, physical inventory is correct and the accounting records are ad-
justed to the physical count, the adjusted balance of merchandise inventory will be cor-
rect on the December 31, 2009, balance sheet. Likewise, the 2009 overstatement of net
income offsets the 2008 understatement of net income, with the result that the December
31, 2009, stockholders’ equity (retained earnings) is correct. Thus, the effects of inven-
tory misstatements if not detected reverse themselves in the following period, and the
balance sheet at the end of the second period will be correct, as shown below.Amount of Misstatement
2009 Financial Statements Overstated (Understated)
Balance sheet as of December 31, 2009:
Merchandise inventory Correct
Current assets Correct
Total assets Correct
Total stockholders’ equity (retained earnings) Correct
Income statement for year ended December 31, 2009:
Cost of merchandise sold $(10,000)
Gross profit 10,000
Net income 10,000232 Chapter 5 Accounting for Merchandise Operations
Q.If the ending physical
inventory is understated by
$6,000, what is the effect
on total assets, retained
earnings, the cost of
merchandise sold, and
gross profit?A.Total assets: under-
stated $6,000; Retained
earnings: understated
$6,000; Cost of merchan-
dise sold: overstated
$6,000; Gross profit:
understated $6,000.