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
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Inventories: Additional Issues
Spencer Company
Balance Sheet
December 31, 2000
ASSETS
Cash
Accounts receivable
Inventory
Total current assets
Property, plant and equipment
Accumulated deprecation
Total property, plant and equipment
Total assets
$200,000
400,000
500,000
$1,100,000
500,000
200,000
700,000
$1,800,000
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable
200,000
Accrued liabilites
100,000
Total current liabilities
$300,000
Long-term debt
600,000
Total liabilites
900,000
Shareholders' equity:
Common stock
100,000
Additional paid-in capital
250,000
Retained earnings
550,000
Total shareholders' equity
900,000
Total liabilities and shareholders' equity
$1,800,000
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
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Inventories: Additional Issues
Spencer Company
RESTATED Balance Sheet
December 31, 2000
ASSETS
Cash
Accounts receivable
Inventory
Total current assets
Property, plant and equipment
Accumulated deprecation
Total property, plant and equipment
Total assets
$200,000
400,000
600,000
$1,200,000
500,000
200,000
700,000
$1,900,000
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable
200,000
Accrued liabilites
100,000
Total current liabilities
$300,000
Long-term debt
600,000
Total liabilites
900,000
Shareholders' equity:
Common stock
110,000
Additional paid-in capital
250,000
Retained earnings
640,000
Total shareholders' equity
1,000,000
Total liabilities and shareholders' equity
$1,900,000
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
INCOME STATEMENT
Cost of goods sold
Income tax expense
Net income

Overstated
100,000
Understated
10,000
90,000
BALANCE SHEET
Inventory
100,000
Accrued liabilities (additional income tax payable)
10,000
Retained earnings
90,000
Working capital
Current assets less current liabilities:
90,000
Original $800,000
Restated $890,000
Current ratio
0.20
Current assets divided by current liabilities:
Original .3.67
Restated 3.87
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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