CFA Practice Question

CFA Practice Question

Tasty Food, Inc.'s statements have overstated accounts payable by 400 and understated the accounts receivables by 225. Then, which of the following is (are) true?

I. Its income is correctly stated.
II. Its income is overstated by 175.
III. Its current assets are overstated by 225.
IV. Its operating cash flows are overstated by 625.
A. I & IV
B. II & IV
C. II, III and IV
Explanation: Current assets are understated by 225, and current liabilities are overstated by 400. The reported income is not affected since the errors are in the balance sheet items. The operating cash flow is overstated by 400 + 225=625.

User Contributed Comments 9

User Comment
sireklove Maybe my mind is just going fuzzy at this point in the day, but isn't operating cash flow derived from period to period positions in the balance sheet? Just an over or understatement in the account wouldn't necessarily indicate a cash inflow or outflow. For example, if there was no change in receivables period to period there would be no corresponding cash flow. It wouldn't matter whether the account was correct or not. (I don't have an accounting background so this is somewhat hazy for me.)
Ebenezer For every debit there is a credit and vice versa. There must be an impact on income because the difference cannot stand alone as it is.
gastel Yes there must be a credit for every debit or vice versa. However, this does not mean for every entry in the balance sheet there must be an entry in the income statement. for example, if you receive money from a customer, you debit cash and credit receivables. This does not impact income at all.
anricus When you prepare operating cash flow

Net Income
Add Depreciation
Add/Subtract Increase/Decrease in Debtors
Subtract/Add Decrease/Increase in Creditors

Therefore the cash flow from operations will be misstated if the Debtors and creditors are misstated.
Munyoli 1)Where is the corresponding Cr. for the overstated liabs.- i would expect the extra accrual to hit the Income stmt.
2) where is the correspinding cr. for the understated AR bal. - excess w/o?
StanleyMo For AR, lets say we have sales 100, and you record wrongly for AR 50, oops, you find out customer only own you 30, so you change it back, but the sales still the same.

same situation for AP.
manju79 The other side of the entry hits cash balance(also part of balance sheet)
HolzGe1 This question is very unclear. Depending on the reason for the under-/overstatement, income statement could very well be expected to be affected. If it was just a misclassification, it would not be affected.

Still, in this particular case, net income would be UNDERSTATED, if any. Since that is no choice given, it must be I.
bonsuet Paying accounts payable that are already included in a company's accounting records will not affect the company's net income
Collecting accounts receivable that are in a company's accounting records will not affect the company's net income
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