Question

The Smart Dresser Company operates a chain of 35 clothing stores that have traditionally targeted baby boomers working in the business world. Two years ago, the board of directors of The Smart Dresser, experiencing declining sales and profits recognized that the demographics were changing and they needed to adapt to a more youthful shopper. The Smart Dresser Company is considering a large-scale remodeling of its stores and a change in its clothing line. Before undertaking this change across the entire company, 2 of the 35 stores were remodeled as a test at the start of the year and the line of clothing was changed to appeal to the more youthful shopper. Linda Perlman, assistant controller, and her team were asked to oversee the remodeling and change over in these 2 stores. They were also responsible for the financial reporting for the 2 stores. She and other management personnel are in line to get big bonuses if the 2 test stores show sales growth and increased profitability.2 weeks later Linda discovered an error. The smart dresser company uses the physical inventory method for computing COGS and she discovered end inventory included significant amounts of items that were damaged. The items were included in the inventory count and cost @ the original purchase price. Thus the ending inventory was overstated by $100,000 for each store. EXPLAIN THE IMPACT THE $100,00 OVERSTATEMENT IN THE ENDING INVENTORY WILL HAVE ON THE STORE'S NET INCOME AND WHAT ACCOUNTING CONCEPT REGARDING INVENTORY IS BEING VIOLATED. PLEASE DISCUSS IN DETAIL.

Answer 1

Effect of misstatement of inventory on Net income:

If ending inventory is overstated, it increases net income and inventory-asset by the amount of overstatement.

Here the ending inventory is overstated by $100,000 for each store. There are two such stores.

As the ending inventory is overstated by $100,000 for each store so the net income of each store is overstated by $100,000

Accounting concepts:

As per Prudence concept of accounting a loss is immediately recognized. Therefore if the net realizable value of inventory is lower than its original cost, then it should be valued at its net realizable value. If if the net realizable value of inventory is higher than its original cost, then it should be valued at its original cost. This means inventory should be valued at lower of cost or net realizable value.

As per Matching concept of accounting also any reduction in the value of inventory is to be reflected in the income statement of the year in which the loss occurred rather than in the year in which the goods are sold.

Here ending inventory included significant amounts of items that were damaged. Therefore the market value of these items will be very much lower as compared to the normal items. It may happen that the market value of these items could be 0 , as the products are damaged. Product type is cloth which people generally do not buy if they are damaged, not even at a lower price.

In such a situation damaged inventory should be either written off as it may not be possible to sell it in the market or if there are chances of selling such damaged inventory then it should be valued at lower of cost or net realizable value.

Valuing damaged inventory at its cost the smart dresser company has violated Prudence concept of accounting and Matching concept of accounting.