Question

I am preparing the working papers for the December 31, 2018 year-end audit to present to the company’s auditors when they arrive late next week. In reviewing the draft financial statements and other information, I have identified a number of issues that need to be addressed:

1. Inventory Errors: in reviewing the documentation obtained during the December 31, 2018 inventory count for the heavy equipment division, I discovered a number of errors. The details are provided below.

1. We received an invoice from a supplier on January 3, 2019 for goods purchased with a cost of $61,000. This invoice was entered into our accounts payable system on that date. The goods were shipped by the supplier on December 26, 2018 and were received by us on January 3, 2019. The invoice terms were 2/10, n30, FOB shipping. These goods were a special order for one of our customers, and we sold the goods to the customer on January 7, 2019 for $93,000. These goods were not included in the December 31 inventory count.
2. During the inventory count, the supervisor noticed a box labeled “Return for Credit” sitting in the receiving bay. These goods were not included in the inventory count, as the box was sealed and the supervisor did not know what to do with them. On January 4, 2019, the box was opened and the goods were counted. Goods with a total cost of $16,000 were returned to inventory, but additional goods with a cost of $2,000 had to disposed, as they were damaged beyond repair. Credit memos were issued to customers on January 4, 2019 for $24,000.
3. Included in the inventory count were goods with a cost of $11,000, which were waiting to be picked-up by the freight company for delivery to a customer. The terms were 1/10 net 30, FOB shipping. The goods had been invoiced to the customer on December 31, 2018 at $14,000.
4. An invoice from a supplier for $6,000 was received and entered into the accounts payable system on December 31, 2018. The terms of the invoice were 2/10 n30, FOB destination, and the goods were not received until January 2, 2019. The goods were not included with the inventory count.

Before I finalize the working papers for the auditor, the Chief Financial Officer has requested I summarize the key financial reporting issues. Where possible, he would also like to know the potential impact of the issue on the balance sheet and income statement, and he would like an explanation why an adjustment is required. If there are areas where judgment is involved, or the accounting treatment is not clear, he would like to know the alternatives that are available and factors that need to be considered in choosing an alternative.

Answer 1

Key financial reporting issues

a. Revenue recognition

Ideally, in a FOB terms scenario, revenue is typically recognised by the seller at the time of dispatch from the seller's premises and at the same time inventory is recorded by the buyer as it is when the risk and rewards of the goods transfer from seller to the buyer.

The adjustment would require our Company to include the inventory shipped by seller on 26-Dec-18 as at 31-Dec-18 and the purchases earlier booked in FY19 would now be booked in FY18 (on 26-Dec-18). No adjustment is required for sale made to ultimate customer with customisation as the accounting treatment is correct.

This is a case of incorrect accounting treatment, no judgement is involved. Without this adjustment, as at 31-Dec-18 payables will be understated by $61,000 and inventory would be understated by $61,000 and there would be no impact on the overall profit but purchases and closing stock would be understated by $61,000.

b. Ommision to include returned items and book loss on damages

The adjustment would require our Company to book the sales return ($24,000) and damages ($2,000) in FY18 in the P&L, reduce the receivables amount to the extent of return credit ($24,000) and increase the inventory value by $16,000 in the balance sheet as at 31-Dec-18.

This is a case of incorrect accounting treatment, no judgement is involved. Without this adjustment, the profit in FY18 would be overstated by $6,000 ($24,000 in sales - $2,000 in damages - $16,000 in closing stock). On the balance sheet, as at 31-Dec-18, receivables will be overstated by $24,000 and inventory would be understated by $16,000 and retained earnings will be overstated by $6,000 (the profit amount).

c. Incorrect inclusion of sold stock in the inventory

The adjustment would require our company to reduce the inventory by $11,000. This would reduce the gross profit. It would not have any impact on sales ($14,000) as the same is booked on 31-Dec-18.

This is a case of an accounting error, no judgement is involved. Without this adjustment, the profit in FY18 would be overstated by $11,000. On the balance sheet, as at 31-Dec-18, inventory would be overstated by $11,000 and retained earnings will be overstated by $11,000 (the profit amount).

d. Overstatment of account payables and purchases

Ideally, in a FOB destination terms scenario, revenue is typically recognised by the seller at the time of receipt of goods at buyer's premises and at the same time inventory is recorded by the buyer as it is when the risk and rewards of the goods transfer from seller to the buyer. The risk of loss in transit is borne by the seller.

While the Company is correct in not including the inventory in the count, the Company would be required to reduce the payables by $6,000 and reduce the purchases by $6,000.

This is a case of incorrect accounting treatment, no judgement is involved. Without this adjustment, the profit in FY18 would be understated by $6,000. On the balance sheet, as at 31-Dec-18, payables would be overstated by $6,000 and retained earnings will be understated by $6,000 (the profit amount).