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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 LIFOThe 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 overstatedNet income will be understated

Balance sheetInventory is understatedRetained earnings will be understatedWorking capital will be understatedCurrent 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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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.





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



Purchases and Inventory MisstatedAssuming 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 understatedEnding inventory would be understatedCost of goods sold would not be affectedNet income would not be affected

Balance sheetInventory would be understatedAccounts payable would be understatedRetained earnings would not be affectedWorking capital would not be affectedCurrent 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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