ExpertHard1 markMultiple Choice
CPA · Question 60 · Area III: Performing Procedures
Scenario: An auditor is testing the allocation of overhead to inventory. The client uses a standard costing system. The auditor notes that production volume dropped significantly this year, but the overhead absorption rate remained the same as the prior year. <br/><br/>What is the likely impact on the financial statements?
Scenario: An auditor is testing the allocation of overhead to inventory. The client uses a standard costing system. The auditor notes that production volume dropped significantly this year, but the overhead absorption rate remained the same as the prior year. <br/><br/>What is the likely impact on the financial statements?
Answer options:
A.
Inventory is understated and Cost of Goods Sold is overstated.
B.
Inventory is overstated and Cost of Goods Sold is understated.
C.
There is no impact if the standard rate is based on normal capacity.
D.
Accounts Payable is understated.
How to approach this question
Cost Accounting Logic: Low production = Idle capacity. Idle capacity costs = Period Expense (COGS). If you capitalize them (put them in Inventory), you overstate Assets and understate Expense.
Full Answer
B.Inventory is overstated and Cost of Goods Sold is understated.✓ Correct
When production drops significantly (idle capacity), fixed overhead costs per unit effectively rise. However, GAAP requires that overhead be allocated based on *normal* capacity. The unallocated fixed overhead (variance) due to idle capacity must be expensed as a period cost (COGS). If the client simply capitalizes all overhead or misallocates the variance to inventory, Inventory will be overstated and COGS understated.
Common mistakes
Thinking all overhead must be capitalized regardless of volume.
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