During the fiscal period just ended some of the inventory in the warehouse of Jamie Ltd. wasn’t counted. Jamie Ltd. uses a periodic inventory control system. Explain how the following are affected by the error:
• Net income
• Current ratio
When some of the inventory in the warehouse isn't counted during the fiscal period, it affects both the net income and the current ratio for Jamie Ltd. Let's explore how:
1. Net Income:
Net income is calculated by subtracting the cost of goods sold (COGS) from the company's total revenue. In a periodic inventory control system, COGS is determined by taking the beginning inventory, adding purchases or production costs, and subtracting the ending inventory.
Since the uncounted inventory wasn't included in the ending inventory, it won't be deducted from the COGS. As a result, the COGS will be lower than it should be, leading to higher net income. This happens because the uncounted inventory is essentially treated as if it was sold when it actually wasn't. Consequently, the net income will be overstated.
2. Current Ratio:
The current ratio is a measure of a company's liquidity and short-term solvency. It is calculated by dividing current assets by current liabilities. Current assets typically include cash, accounts receivable, inventory, and other assets that are expected to be converted into cash within the next year. Current liabilities include obligations that are due within the next year.
When the uncounted inventory is excluded from the ending inventory, the current assets are understated since inventory is one of the key components of current assets. Consequently, the numerator in the current ratio calculation is smaller than it should be. As a result, the current ratio decreases, indicating lower liquidity and potentially raising concerns about the company's ability to meet its short-term obligations.
In summary, when some of the inventory isn't counted in a periodic inventory control system, it leads to an overstatement of net income and a decrease in the current ratio for Jamie Ltd.