8-14 (Evaluating the significance of misstatements) You are concluding the audit of Sun Island
Apparel, Inc. as of December 31, 20x1. You believe that you can tolerate $675,000 in misstatements
to pretax income. You have noted only three issues that may affect the financial
statements based on evidence found during the audit. They are:
1. When auditing accounts receivable, you investigated every sales transaction between
December 26th 20x1 and January 5th 20x2. You have problems with revenue recognition
on two shipments that were ordered in December of 20x1, recorded in revenue as of
December 31, 20x1 but the customer did not pick the items up until January 4, 20x2.
These shipments had a retail value of $240,000 and a cost of $130,000. The inventory was
held aside as the company expected customers to pick up the inventory prior to year-end,
and it was not counted as part of inventory. These were the only sales cutoff problems
discovered. Tolerable misstatement for accounts receivable and sales was $260,000.
2. When auditing inventory, you determined that the company still had $395,000 of last
year's designs and inventory on hand. Based on past history you believe that the com
pany can realize approximately $175,000 on the sale of this inventory. No other problems
were noted associated with the not realizable value audit objective. Tolerable misstatement
for inventory was $250,000.
3. In performing a search for unrecorded liabilities, you audited every cash purchase
between January 2, 20x2 and January 20, 20x2. The only problems you noted are described
as follows. You find $200,000 in invoices that were received from subcontractors who
manufacture apparel in mid-January. The invoices were dated December 21, 20x1.
Inventory was shipped on December 27, 20x1 (FOB shipping point), received on December
31, 20x1, and was counted in inventory. In addition, you found one invoice in the
amount of $150,000 for the purchase of new equipment that was dated December 29,
20x1 but was not received from the vendor until January 10, 20x2 when it was paid in
cash. The goods were shipped FOB shipping point. No accrual was made for these
invoices. Tolerable misstatement for accounts payable was $240,000.
a. Propose adjusting journal entries for the three items noted above.
b. Make an overall determination about what journal entries you believe that the client
should book in order for the financial statements to present fairly in all material respects.
See Excel attached.
Accounts receivable 240,000
Cost of Goods sold 130,000
To reverse the entries to record sales on 12-31-20x1. The
transactions did not meet revenue recognition principles: no transfer,
no legal obligation to pay, etc.
Obsolete Inventory 220,000
The write-down of inventory is required to report inventory
at the lower of cost or market
The solution presents proposed adjusting entries including explanations for the entries together with the logic of making them. Next, the effect of the entries is summarized both by category and in total followed by a conclusion as to whether the proposed entries should be recorded in the accounting records of Sun Island Apparel.