Question

A car manufacturer recognizes the sale of 40,000 cars in its income statement. All cars have been prepaid but not yet shipped to the customer. Assuming that sale is profitable, the accelerated recognition of this sale as revenue is likely to lead to the distortions in the following ratios:

• Net Income higher – no effect – lower

• Asset turnover higher – no effect- lower

• Debt-to-equity higher – no effect - lower

Answer 1

The sales revenues should be recognised only when the risk of ownership of assets is transferred to the buyer. Since in the given case, revenue is being recognisedbefore the cars are shipped to the customers. It implies sales are overvalued.

Effect on net income- Net income ratio= Net profit after tax/ Net sales

The ratio should remain unchanged assuming the net profit margin on these 40000 cars is same as the profit of the cars sold throughout the year

Assets Turnover ratio-

Assets turnover ratio= Net sales/Average Total assets.

If sales are overvalued, the numerator will be higher and hence the ratio will be higher.

Debt to Equity ratio-

Debt to equity= Total outside liabilities/ Shareholder's equity

Apparently it seems that the ratio will remain unchanged because sales is not directly involved in the formula. But if we analyse deeply, higher sales will result in higher profit after tax and higher profit after tax lead to an increase in equity.

Therefore higher equity in the balance sheet will decrease the debt to equity ratio as they have an inverse relationship (See formula)