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.

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

Solution:

a. An asset is the item of the balance sheet that explains the financial position of the entity. If the cost of acquisition of the asset is wrongly considered as expense in income statement, then there shall be no asset in the balance sheet and also the profit for the year is under inflated. 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. Since there is no accounting of asset in balance sheet, there shall also be no depreciation calculated on the asset, which shall be added back to the profit and loss acoount to arrive at cash flow from operating activities. The cash outflow will get recognised as cash flow from operating activities instead of cash flow from investing activities.