Inventories: Additional Issues

CHANGE IN INVENTORY METHOD AND INVENTORY ERRORS

Change in Accounting Principle
Basic Rule
A change in accounting principle is reported in the current year income statement as a
separate item after discontinued operations and extraordinary items, as the cumulative effect
(after-tax) of the change. The previous financial statements are not restated. Pro forma EPS
disclosure is required.

Exception to Basic Rule

Change in inventory method to LIFO
If is virtually impossible to calculate the cumulative effect of the change in accounting
principle when the inventory method is change to LIFO. Therefore, there is no special
accounting. The year of adoption becomes the first LIFO layer. Financial statement
disclosure is necessary.
Change in inventory method from LIFO
The change in accounting principle which involves a change in inventory method from
LIFO to some other method requires retroactive restatement of the prior year financial
statements.

Inventory Errors
Ending Inventory Misstated
When ending inventory is misstated there is a cascading effect throughout the financial
statements. If ending inventory is understated
Income Statement
Cost of goods sold will be overstated
Net income will be understated
Balance sheet
Inventory is understated
Retained earnings will be understated
Working capital will be understated
Current ratio will be understated
Example: The financial statements for Spencer Company for the year ended December 31, 2000
are as follows:

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Inventories: Additional Issues

Spencer Company
Statement of Income and Retained Earnings
December 31, 2000
Sales
Cost of goods sold:
Beginning inventory
Purchases
Purchase returns and allowance
Purchase discounts
Net purchases
Freight-in
Total merchandise available for sale
Less: ending inventory
Cost of goods sold
Gross profit
Operating expenses
Income before income taxes
Income taxes
Net income
Beginning retained earnings
Ending retained earnings

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$2,000,000

$400,000
$1,200,000
150,000
24,000
1,026,000
40,000

1,066,000
1,466,000
500,000
966,000
1,034,000
600,000
434,000
43,400
390,600
159,400
$550,000

Inventories: Additional Issues

After the financial statements were prepared and published it was discovered that there was an
error made in counting the ending inventory. The ending inventory should have been $600,000.
The following is a restatement of the financial statements reflecting this correction of the error.

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Inventories: Additional Issues

Spencer Company
RESTATED Statement of Income and Retained Earnings
December 31, 2000
Sales
Cost of goods sold:
Beginning inventory
Purchases
Purchase returns and allowance
Purchase discounts
Net purchases
Freight-in
Total merchandise available for sale
Less: ending inventory
Cost of goods sold
Gross profit
Operating expenses
Income before income taxes
Income taxes
Net income
Beginning retained earnings
Ending retained earnings

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$2,000,000

$400,000
$1,200,000
150,000
24,000
1,026,000
40,000

1,066,000
1,466,000
600,000
866,000
1,134,000
600,000
534,000
53,400
480,600
159,400
$640,000

Inventories: Additional Issues

The following schedule provides an analysis of the impact of the errors on the various accounts
in the income statement and the balance sheet.

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Inventories: Additional Issues

Purchases and Inventory Misstated

Assuming the periodic inventory system is being used, if a purchase at year-end was not
recorded nor counted in ending inventory the financial statements would be misstated as
follows:
Income Statement
Purchases would be understated
Ending inventory would be understated
Cost of goods sold would not be affected
Net income would not be affected
Balance sheet
Inventory would be understated
Accounts payable would be understated
Retained earnings would not be affected
Working capital would not be affected
Current ratio would be overstated

Financial Statement Reporting

Errors discovered after the issuance of financial statements require restatement. For all years
reported the financial statements are restated to correct for the error. The beginning balance of
retained earnings of the earliest year reported is restated by reporting a prior period adjustment.
A prior period adjustment adjusts the beginning balance of retained earnings to account for the
correction of the error in all years prior to those reported in the financial statements.

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