Question

Assume that Morrison Company used cash to acquire machinery expected to contribute to the generation of revenues over a three-year period and the company erroneously expensed the cost to acquire the machine.

Required:

a. Describe the effects on ROA of the error over the three-year period.

b. Explain how the error would affect the statement of cash flows.

Answer 1

A. Description of the effects on ROA of the error is as under :

In this case for Morrison company an asset is the item of the balance sheet that explains the financial position of the entity. If the cost of acquiring the asset is wrongly considered as an expense in the income statement(as it is mentioned), then there is no asset in the balance sheet(no actual existence) and also the profit for the year is underinflated. Hence the Returns on the Asset obtained during the three year period will only result in covering up for the profit under inflated in the year of purchase showing a wrong balance in the balance sheet, whereas the cash balance is reduced accordingly in the balance sheet in the year of the purchase.

B. Effect on the statement of cash flows because of the error can be as under :

Because there is no accounting of the asset in the balance sheet, there will also be no depreciation calculated on the asset(as it should not be calculated), which shall be added back to the profit and loss account in order to arrive at the cash flow from operating activities. The cash outflow will be recognized as cash flow from operating activities instead of cash flow from investing activities.