[Anonymous]

My fried brain can’t seem to figure out what I’d doing wrong with my Return on Equity ratio. My AUD practice SIM asked to select whether a ROE & Inventory Turnover ratio increases of decreases based on the changes given. I got all of the ROE ratios wrong so could someone please help by explaining where I’m going wrong in my way of thinking? I thought ROE was Net Income/Equity. Equity = Assets – Liabilities.

Starting Ratios (this is where you start and below that are the client errors)

Inventory turnover: Cogs: 438,000/inventory 100,000, ratio 4.38

ROE: Net income 1,753,000/equity 100,000, ratio 17.53

1st error: Inventory is understated by 50,000

So I said my net income would increase and my equity would increase since retained earnings rolls into equity. Plus by the basic A=L+E formula wouldn’t my equity have to increase by the same asset increase?

my ROE calc: Net income 1,803,000, equity 150,000, ratio 12.02

So I selected with the increase in inventory the ROE ratio decreases but the answer is it increases. What am I doing wrong?

[Iggy_1985]

stumped me.. is it ending inventory understated? what explanation do they give?

FAR - 89 (8/19/14) Wiley TB, Wiley Book, Books from School, Ninja Audio/Notes
AUD - 92 (10/14/14) Wiley TB, Wiley Book, Ninja Audio/Notes
BEC - 82 (5/8/15) Ninja MCQ, A few Becker lectures during commute
REG - 84 (8/14/15) Ninja MCQ, A few Becker lectures during commute

Letters after my name soon!

[Lucky11189]

ROE would increase. With an understatement of inventory, you have an overstatement of cost of goods sold, and therefore an understatement of net income. Also, with the understatement of inventory you have an understatement in equity by the same amount as your understatement in net income. With an understatement of net income and equity, you have an overstatement of ROE.

Therefore with your numbers, original ROE = 17.53. New ROE = 1,703,000 / 50,000 = 34.06.

FAR- 84 (August 2014)
REG- 85 (November 2013)
AUD- 85 (January 2014)
BEC- 83 (May 2014)

[Anonymous]

Lucky, in your ROE calc aren't you decreasing NI by 50,000? If the original NI is 1,753,000 but the client overstated COGS wouldn't my entry be to credit COGS therefor increasing NI to 1,803.000? I would think equity would have a similar credit since equity has a normal credit balance.

[Iggy_1985]

I think the problem here is that if you are increasing equity by the $50,000 understatement because Net Income is $50,000 understated, but you don't have the whole Net income included in the equity number.. it would have started at something like 1,853,000 right,

so it should be something like

1,753,000/1,853,000 = .946

after adjusting cogs

1,803,000/1,903,000 = .947

increase

lol.. I know that doesn't really make sense but I'm still trying to figure it out, see what I'm saying though? Your equity shouldn't be lower than your N/I since N/I is closed to equity

FAR - 89 (8/19/14) Wiley TB, Wiley Book, Books from School, Ninja Audio/Notes
AUD - 92 (10/14/14) Wiley TB, Wiley Book, Ninja Audio/Notes
BEC - 82 (5/8/15) Ninja MCQ, A few Becker lectures during commute
REG - 84 (8/14/15) Ninja MCQ, A few Becker lectures during commute

Letters after my name soon!

[Lucky11189]

@CPAtoBe

unless I am misunderstanding the question…I understand what you are saying, but in your entry you are correcting the clients books. We're not trying to correct the clients books were are trying to tell what they did wrong. An overstatement of COGS would be a higher COGS, an expense and debit account so you would debit COGS not credit it. An overstatement of an expense creates an understatement of net income.

FAR- 84 (August 2014)
REG- 85 (November 2013)
AUD- 85 (January 2014)
BEC- 83 (May 2014)

[Iggy_1985]

I took it as, the inventory was understated so find the correct ratio, which would been increasing the numerator and denominator. I guess it would help to post the actual question.

FAR - 89 (8/19/14) Wiley TB, Wiley Book, Books from School, Ninja Audio/Notes
AUD - 92 (10/14/14) Wiley TB, Wiley Book, Ninja Audio/Notes
BEC - 82 (5/8/15) Ninja MCQ, A few Becker lectures during commute
REG - 84 (8/14/15) Ninja MCQ, A few Becker lectures during commute

Letters after my name soon!

[Author]

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