Impact of incorrect Revenue recognition?

If a company recognizes revenue earlier than is justified under accrual accounting, which of the following best describes the impact on ==Accounts Receivable====================Inventory========= A)==Overstated========================Overstated== B)==Overstated========================Understated== C)==Understated=======================Overstated== D)==Understated=======================Understated==

Accts Receivable : Company recognized revenue that should otherwise still be in accts receivable, so this is now understated. Inventory : If revenue is improperly recognized, then COGS are recognized that shouldn’t have been recognized, implying inventory is stated less than it should be. D?

I would say B… If you recognized rev. early it can still go to AR under Accrual acct. … I understand the question as… you claim you have sold something without knowing for sure if it is surely purchased… (could be wrong here)… if this is the case… your AR will be overstated as there is 0 CF and your inventory will be understated, as you claim you sold something that u still have…

agree with chadtap: even though the goods are still inventory, it is being recognised as a sale thus generatng AR. Inventory understated, AR overstated .answer B

Ahh, thanks Chadtap, I think I’m messing up the definition of accounts receivable. Okay, can someone clarify this? This is how I determined the problem. Say we have Percentage of Completion method for recognizing revenue of a long term project, and we know the total selling price to be $100. If we expect total costs to be $80, and in the first year we have accumulated costs of $20. According to the Percentage of Completion method our revenue for this year is (20/80)*100 - 20, or $5. So far so good, but I’m not confused how this would come into play regarding accounts receivable? Meaning, if we (as the contracting company) sign the contract to build the thing for $100 for the customer, are initial accounts receivable immediately $100 at the time of signing of the contract? This is why I said understated above, if we incorrectly estimated costs and overstated revenues, I think this would lead to understated accounts receivable in the example above. But I’m probably confused regarding Accounts receivable.

im saying B… just intuitively, increasing revenues generally means increased SALES which would increase AR and decrease inventories…

B for me too

B for me too although you could record revenue earlier and not need to increase accounts receivable just think of it you start building something, the constructions is not completed but you receive the whole amount of record the revenue and cash increases not account receivable

Why not A? The revenue increase accounts receivable. So it is now overstated. But I think that the costs are not currently included in the inventory. It is not matching at the moment. We have recognized the revenue, but not the costs. So inventory is overstated.

Correct answer is B The early recognition of revenue results in Increased AR Increased COGS–> decrease in inventory