Purpose: To help you understand the importance of cash flows in the operation of a small business.
It’s the end of the year and your warehouse manager just finished taking a physical count of the inventory on hand. Because you are utilizing the perpetual inventory method with a relatively sophisticated inventory software program, you expect that the ending inventory balance will be fairly close to the balance on your general ledger. In the past, you’ve had to make some pretty large adjustments for inventory shrinkage, but with the new security measures you’ve installed to safeguard your inventory, you’re hoping that any shrinkage adjustment this year will be minimal. At least you hope that’s the case, because your net income can’t take many more adjustments. This year’s financial statements are very important to your banker because of the loan renewal coming up early next year.
You look at the amount from the final inventory count and it reads $467,450. You go to the general ledger Merchandise Inventory account and it reads $498,500. You look at the preliminary income statement, which doesn’t reflect any of these adjustments yet, and the net income is $128,400. You remember that the banker said that he really wanted to see a net income of at least $100,000 this year.

Requirements

1. Calculate the effect that the required inventory adjustments will have on the net income for the year. Would your banker be happy or not so happy when you presented the financial statements to him after these adjustments?
2. If the adjustment you made for inventory shrinkage last year was only about $10,000, should that cause you any concern for the amount of adjustment you have to make this year?
3. In addition to the impact that the inventory adjustment might have on your loan renewal, what effect did it have on your cash flow during the year?