[Anonymous]

On December 31, year 2, Foster appropriately changed to the FIFO cost method from the weighted-average cost method for financial statement and income tax purposes. The change will result in a $150,000 increase in the beginning inventory at January 1, year 3. Assuming a 30% income tax rate, the period-specific effect of this accounting changed for the year ended December 31, year 2, is:

1) $0

2) $45,000

3) $105,000

4) $150,000

I am having trouble understanding the relationship between inventory and net income. I do understand, for example, that if ending inventory in a period is overstated, then COGS in that period is understated and accordingly net income is overstated. However, in this problem (for which the answer is #3 – $105,000), how does a simple change in accounting method that increases year 3 beginning inventory (and therefore year 2 ending inventory) by $150,000 result in an increase to net income in year 2?

Please help me to wrap my mind around this – FAR is driving me 100% insane. Part of me wants to fast-forward the next 10 days to get this over with, while the other part feels like I need an entire additional month to prepare. Ugh. =(

Thank you!

[sbarkerACPA]

This a change in accounting principle, that happens in year 2 and therefore the increase in inventory is for year 2 beginning year 3. This would be adjustment to Retained Earnings in the earliest period. Also, net of income tax.

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[Whopper Warrior]

“if ending inventory in a period is overstated, then COGS in that period is understated and accordingly net income is overstated”

Invetory……….150k

COGS…………………150k

Tax Effect

Income Tax Epense (150*.3) 45k

Income Tax payable…………………….45k

You reasoned it out already.

Cogs 150k

Income Statement 105k

Income Tax Expense 45k

The change in accounting principle is retrospective.

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[NYCaccountant]

Well you would have to restate year 2 financials anyway because of the change in accounting principle which requires retrospective application. If I remember correctly, your financials presented for each year should reflect the new method you are using. This would make your financials comparable year over year. Long story short, the new method would result in an increase of Net Income of 150,000, which when you adjust for the extra income tax you would owe, leaves you with a net increase of $105,000.

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[Author]

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