Question

Grants Corporation prepared the following two income statements (simplified for illustrative purposes):

	First Quarter						Second Quarter
Sales revenue			$	12,500							$	19,100
Cost of goods sold
Beginning inventory	$ 3,700						$	3,200
Purchases	2,800							12,300
Goods available for sale	6,500							15,500
Ending inventory	3,200							9,900
Cost of goods sold				3,300								5,600
Gross profit				9,200								13,500
Expenses				4,900								5,500
Pretax income			$	4,300							$	8,000

During the third quarter, it was discovered that the ending inventory for the first quarter should have been $3,670.

Required:

1. What effect did this error have on the combined pretax income of the two quarters?

2. Which quarter's or quarters' (if any) EPS amounts were affected by this error?

3. Prepare corrected income statements for each quarter.

4. Prepare the schedule to reflect the comparative effects of the correct and incorrect amounts on the income statement.

Answer 1

Let us first calculate the amount by which the ending inventory was reduced in the income statement:

Ending Inventory of the first quarter as per the statement = $ 3200

Correct Ending Inventory of the first quarter = $ 3670

Difference in Ending Inventory due to the error in recording = $ 470

Now let us prepare the corrected income statements of the two quarters:

	First Quarter						Second Quarter
Sales Revenue			$	12500							$	19100
Cost of Goods Sold
Beginning Inventory	$ 3700						$	3670
Purchases	$ 2800						$	12,300
Goods Available for Sale	$ 6500						$	15970
Ending Inventory	$ 3670						$	9,900
Cost of Goods Sold			$	2830							$	6070
Gross Profit			$	9670							$	13030
Expenses			$	4,900							$	5,500
Pretax Income			$	4770							$	7530

Ending inventory of the first quarter and beginning inventory of the second quarter both will be affected due to the error.

1. The effect on combined pretax income of the two quarters:

Combined pretax income from incorrect income statements = $ 4300 + $ 8000 = $ 12300

Combined pretax income from corrected income statements = $ 4770 + $ 7530 = $ 12300

As we can see, the combined pretax income of the two quarters is same in both the cases, hence there is no effect of the error on the combined pretax income.

2. The effect on individual quarters' pretax income:

Pretax income in quarter 1 from incorrect income statement = $ 4300

Pretax income in quarter 1 from corrected income statement = $ 4770

Difference in the pretax income of quarter 1 = $ 470

Pretax income in quarter 2 from incorrect income statement = $ 8000

Pretax income in quarter 2 from corrected income statement = $ 7530

Difference in the pretax income of quarter 2 = $470

As we can see from above calculations that the pretax income of quarter 1 is increased by $470 and pretax income of quarter 2 is decreased by the exact amount due to the error in recording ending inventory of quarter 1 by a decreased amount of $470

3. We have already prepared a corrected income statement of both the quarters.

4. An schedule to reflect comparative effects in quarter 1 is prepared in below table.

	Incorrect amount						Correct Amount						Effect +/-
Sales Revenue			$	12500							$	12500
Cost of Goods Sold
Beginning Inventory	$ 3700						$	3700
Purchases	$ 2800						$	2800
Goods Available for Sale	$ 6500						$	6500
Ending Inventory	$ 3200						$	3670					-470
Cost of Goods Sold			$	3300							$	2830	+470
Gross Profit			$	9200							$	9670	-470
Expenses			$	4,900							$	4,900
Pretax Income			$	4300							$	4770	-470

An schedule to reflect comparative effects in quarter 2 is prepared in below table.

	Incorrect amount						Correct Amount						Effect +/-
Sales Revenue			$	19,100							$	19100
Cost of Goods Sold
Beginning Inventory	$ 3200						$	3670					-470
Purchases	$ 12300						$	12300
Goods Available for Sale	$ 15500						$	15970					-470
Ending Inventory	$ 9900						$	9900
Cost of Goods Sold			$	5600							$	6070	-470
Gross Profit			$	13500							$	13030	+470
Expenses			$	5500							$	5500
Pretax Income			$	8000							$	7530	+470

Note : Effect is calculated of the incorrect statements for which correct amounts are subtracted from the incorrect amount.