Purchase Cutoff Errors: Why the Current Ratio Changes
A purchase cutoff error happens when a purchase, the supplier balance, or the purchased goods land in the wrong accounting period, usually around year-end. If a business omits both an unpaid purchase and the same unsold goods from its count, the errors cancel in cost of goods sold (COGS). Profit stays correct, but inventory and accounts payable are too low.
Because current assets and current liabilities fall by the same amount, working capital does not change. A current ratio above 1 rises, though, so the business can look more liquid than it really is.
A year-end reviewer may spot this problem even when the gross profit margin looks reasonable. The question is whether the company reported all the resources it owned and all the bills it owed on the reporting date. The examples use a periodic inventory system, where the business updates inventory only when it counts the goods at the end of the period. They also assume all other amounts are correct.
Watch the inventory error walkthrough
Start at 3:01, where Professor Farhat walks through the COGS formula. That formula is the key to seeing why an omitted invoice and an omitted count cancel out.
Watch the same segment on YouTube
How to identify purchase cutoff errors at year-end
Start with ownership. Did the merchandise belong to the business at the reporting date? Next, check the purchasing records. If the company bought the goods on credit, it should record the purchase and a liability to the supplier. Finally, determine how much of that merchandise was unsold and included in the final count.
Consider a hypothetical retailer, Alder Lamp Supply. It receives and accepts 60 lamps at $80 each on December 30. The supplier’s terms are FOB destination, so ownership passes to Alder when the goods arrive. All 60 lamps are still boxed at year-end. The receiving clerk puts the shipment in a side room, the count team skips it, and the invoice goes into January’s purchase records. The shipment cost is $4,800.
| Check | Correct treatment | What Alder reported |
|---|---|---|
| Purchase | Include $4,800 in December | Omitted until January |
| Supplier balance | Include $4,800 in accounts payable | Omitted at December 31 |
| Physical count | Include 60 lamps at $80 | Omitted all 60 |
Which purchases belong before year-end? Check the shipping terms
Ownership decides the period, not the invoice date. The shipping terms on the purchase order tell you when ownership moves from the supplier to the buyer. FOB stands for ‘free on board,’ and the words after it name the point where ownership changes hands.
| Shipping terms | Who owns goods still in transit at December 31? | When the buyer records the purchase and the payable |
|---|---|---|
| FOB shipping point | The buyer | When the supplier ships the goods, even if they arrive in January |
| FOB destination | The supplier | When the goods arrive at the buyer |
Here is the classic trap. Say a supplier ships $3,000 of goods FOB shipping point on December 29, and they arrive on January 3. Those goods belong to the buyer at year-end. The buyer should include $3,000 in December purchases, accounts payable, and ending inventory, even though nobody at its warehouse has seen the boxes yet.
Goods held on consignment work the other way. If a supplier places goods in your store to sell but still owns them, they stay out of your count and out of your payables.
Why an omitted credit purchase can leave profit correct
Alder’s correct beginning inventory is $21,000, net purchases are $84,000, and ending inventory is $26,000. Correct COGS is $21,000 + $84,000 − $26,000 = $79,000. The books show purchases of $79,200 and ending inventory of $21,200. Substituting the reported amounts gives $21,000 + $79,200 − $21,200 = $79,000.
Leaving out the invoice removes $4,800 from the goods available for sale. Leaving out the lamps also reduces the deduction for goods still on hand by $4,800. One error lowers COGS by $4,800 and the other raises it by $4,800, so they cancel out. With sales and other expenses recorded correctly, gross profit, net income, and retained earnings are correct for December.
Change just one fact: suppose the count team included all 60 lamps. Purchases alone would be too low. Alder would report $74,200 of COGS instead of $79,000, overstating profit by $4,800. If only the count was wrong, the direction would reverse. The two-year inventory errors example follows that count-only case.
How a purchase cutoff error distorts the current ratio
Suppose Alder’s correct current assets are $96,000 and its correct current liabilities are $48,000. Inventory is a current asset. The unpaid invoice belongs in accounts payable, a current liability. Omitting both reduces each total by $4,800. The SEC’s guide to financial statements explains how current assets and liabilities relate to working capital.
| Measure | Correct | With the omission |
|---|---|---|
| Current assets | $96,000 | $91,200 |
| Current liabilities | $48,000 | $43,200 |
| Working capital | $48,000 | $48,000 |
| Current ratio | 2.00 | 2.11 (rounded) |
Working capital is a dollar difference. Subtracting $4,800 from both balances preserves the $48,000 difference. The current ratio divides one balance by the other. Alder now appears to have $2.11 of current assets per dollar of current liabilities, although it actually has $2.00. The omission creates that appearance without supplying a dollar of cash.
Does omitting equal amounts always raise the ratio?
Check the starting point. When the correct ratio exceeds 1, an equal omission raises it. If the correct ratio is below 1, an equal omission lowers it. At exactly 1, it stays at 1. These comparisons assume positive current liabilities after the omission. For example, $36,000 ÷ $48,000 = 0.75. Remove $4,800 from both amounts and $31,200 ÷ $43,200 is about 0.72.
What if both amounts were recorded too early?
In a separate scenario, suppose Alder counted a shipment it would own only in January and accrued the supplier invoice in December. If both errors are $4,800, the year-end balance sheet overstates inventory and accounts payable equally. COGS and working capital still calculate correctly. With the original $96,000 and $48,000 balances, the reported ratio falls to $100,800 ÷ $52,800, or about 1.91.
How to correct a purchase cutoff error
If Alder finds the error before closing the books for December, it makes three fixes:
- Record the purchase: debit Purchases $4,800 and credit Accounts Payable $4,800.
- Add the 60 lamps to the count, so ending inventory is $26,000 instead of $21,200. Use this corrected amount in the year-end inventory and COGS adjustment; changing the count sheet alone does not correct the ledger balances.
- Remove the invoice from January’s purchase records, so the $4,800 is not counted twice.
COGS stays at $79,000 ($21,000 + $84,000 − $26,000), and the balance sheet now shows both the lamps and the $4,800 Alder owes its supplier.
What if nobody catches it? The income effect washes out next year too. The January entry adds the $4,800 to next year’s purchases, while next year’s beginning inventory starts $4,800 too low. Those two misstatements also offset, so next year’s COGS is correct as long as next year’s count is right.
The December 31 balance sheet stays wrong, though. If those financial statements were already issued and the amount is material, the fix follows the error-correction rules in FASB ASC 250 (Accounting Changes and Error Corrections).
How auditors test purchase cutoff
Unrecorded payables make a company look stronger than it is, so auditors test purchase cutoff near year-end. In audits under AICPA standards, AU-C 315 lists cutoff as an assertion about classes of transactions: transactions are recorded in the correct accounting period. PCAOB standards for public company audits (AS 1105, Audit Evidence) group the assertions differently and do not list cutoff separately.
A typical purchase cutoff test has three steps:
- Pull the last receiving reports before year-end and the first ones after it. Trace each one to the purchase records and the inventory count to confirm it landed in the right period.
- Compare each receiving report and the shipping terms with the supplier invoice date. A January invoice for goods received in December, or shipped FOB shipping point in December, belongs in December.
- Search for unrecorded liabilities. Review supplier invoices and cash payments processed after year-end and ask whether each amount was owed at December 31.
In the Alder case, the December 30 receiving report would point the auditor to a January invoice and a count sheet with no lamps on it.
Want to practice this procedure? The Farhat Lectures Auditing course includes an accounts payable and inventory cutoff test example.
Purchase Cutoff Errors: Interactive Exercise
How do understated purchases and ending inventory affect financial statements? Match each item with its effect in the scenario below.
Scenario: Use the Alder Lamp Supply example above. Under a periodic inventory system, the company omits a $4,800 purchase on account and excludes all of those unsold goods from ending inventory. The same $4,800 is missing from accounts payable. Assume beginning inventory, sales, and all other amounts are correct. Correct current assets are $96,000 and correct current liabilities are $48,000, so the correct current ratio is 2.00.
Select Understated, Overstated, or No effect for each item in the current-year financial statements. Each correct answer earns one point. Complete all nine items, then select Check answers. Open the answer key after your attempt to review the reasoning.
Answer key and explanation
What happens when purchases and ending inventory are both understated? In this scenario, inventory, accounts payable, and purchases are understated. Retained earnings, working capital, cost of goods sold, gross profit, and net income are unaffected. The current ratio is overstated because the correct ratio is above 1.
| Category | Item | Effect |
|---|---|---|
| Balance sheet | Inventory | Understated |
| Balance sheet | Retained earnings | No effect |
| Balance sheet | Accounts payable | Understated |
| Liquidity measure | Working capital | No effect |
| Liquidity measure | Current ratio | Overstated |
| COGS calculation | Purchases | Understated |
| Income statement | Cost of goods sold | No effect |
| Income statement | Net income | No effect |
| Income statement | Gross profit | No effect |
Why is net income unaffected? Purchases and ending inventory are understated by the same amount. Their effects offset in cost of goods sold, leaving net income unchanged.
Why is working capital unchanged? Equal amounts are omitted from inventory and accounts payable. Current assets minus current liabilities remains $48,000: $96,000 − $48,000 = $91,200 − $43,200.
Why is the current ratio overstated? The correct ratio is $96,000 ÷ $48,000 = 2.00. After the omission, $91,200 ÷ $43,200 ≈ 2.11. Equal omissions raise a ratio that starts above 1, lower a ratio that starts below 1, and leave a ratio of 1 unchanged, provided current liabilities remain positive.
Review the current-ratio explanation or continue to the practice questions.
Key takeaways
- A purchase cutoff error puts a purchase, the supplier balance, or the goods in the wrong accounting period.
- When a purchase and the same goods are both omitted, the errors offset in COGS, so net income and retained earnings are correct.
- Inventory and accounts payable are both understated, so the balance sheet hides an obligation.
- Working capital does not change, but a current ratio above 1 rises (2.00 to about 2.11 for Alder), and a ratio below 1 falls.
- Shipping terms decide ownership: under FOB shipping point, goods in transit belong to the buyer.
Practice questions
1. A store omits a $6,000 credit purchase and all the unsold goods from its count. Which balance is understated besides inventory?
Accounts payable is $6,000 too low. The store still owes the supplier. The equal errors in purchases and ending inventory offset in COGS.
2. The invoice for ten $90 lamps is omitted. The count misses only four lamps. What happens to COGS?
Purchases are $900 too low and ending inventory is $360 too low. Reported COGS is $540 too low (−$900 + $360). Profit is $540 too high. An offset is complete only when the two errors are equal.
3. An equal omission reduces both current assets and current liabilities from $25,000 to $22,000 each. What happens to liquidity measures?
Working capital is zero and the ratio is 1.00 under either set of figures. Both balances still require correction even though the measures give the same answers.
Frequently asked questions
Does the invoice date determine the reporting period?
The invoice helps identify the transaction. Check when the business acquired the goods under the purchase terms and whether it owed the supplier at year-end. A January invoice can document a December obligation.
Why specify that the purchase was on credit?
The unpaid bill is what makes accounts payable too low. If Alder had paid cash and also left the payment out of the books, cash would be $4,800 too high instead. Inventory would still be $4,800 too low, so total current assets, working capital, and the current ratio would all be correct. Only the split between cash and inventory would be wrong.
What is the difference between a purchase cutoff error and an inventory count error?
A purchase cutoff error puts the purchase and the supplier balance in the wrong period, and the goods are often missed along with them. A count-only error misses goods but leaves the invoice recorded correctly. A count-only error changes COGS and net income. When a purchase and the same goods are both left out, the two errors offset and net income stays correct.
Does a purchase cutoff error always change net income?
No. Net income changes only when purchases and ending inventory are misstated by different amounts. If Alder had counted all 60 lamps but missed the invoice, COGS would be $4,800 too low and profit $4,800 too high.
How do FOB terms affect purchase cutoff?
Under FOB shipping point, the buyer owns the goods once they ship, so goods in transit at year-end belong in the buyer’s purchases, accounts payable, and inventory. Under FOB destination, the buyer records the purchase when the goods arrive.
Is purchase cutoff tested on the CPA exam?
It can show up from two angles. FAR questions ask how misstated purchases and inventory affect COGS, net income, and ratios. AUD questions ask how auditors test cutoff, such as tracing receiving reports and searching for unrecorded liabilities.
Continue your accounting practice
Practice connecting merchandise purchases to the income statement and balance sheet in the free sample course.
Related lessons
See why missing goods have a different effect when the supplier invoice was recorded correctly.
Merchandising Company Financial Statements: A Worked Example
See how purchases and inventory flow into a retailer’s income statement and balance sheet.
Liquidity Ratios: Formulas, Examples, and How to Interpret Them
Review the current ratio and other liquidity measures with worked examples.
View the full Intermediate Accounting course
About the author
Mansour Farhat, CPA, CIA, DBA, creates the lectures, exercises, and exam practice on Farhat Lectures, covering accounting, auditing, and CPA, CMA, and EA exam topics. His YouTube lectures, including the inventory errors walkthrough above, are built around worked examples like the Alder Lamp Supply case.
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