I'm having trouble understanding this question, does anyone know why the answer is a $5000 decrease and not a $3000 increase? I don't get why we only consider 2004 and not the differences from 2002 and 2003.
Goddard has used the FIFO method of inventory valuation since it began operations in 2002. Goddard decides to change to the weighted-average (WA) method for determining inventory costs at the beginning of 2005.
The following schedule shows year-end inventory balances under the FIFO and weighted-average methods:
Year FIFO Weighted-average
2002 $45,000 $54,000
2003 $78,000 $71,000
2004 $83,000 $78,000
What amount, before income taxes, should be reported in the 2005 financial statements as the cumulative effect of the change in accounting principle?
Solution:
The cumulative effect is computed as of the beginning of the year of change (2005), because the new method (WA) is used in 2005 to compute cost of goods sold and ending inventory. The pre-tax effect of the change on the previous three years is the difference between ending 2004 inventory under the two methods. The only income account affected by the method change is cost of goods sold. The cumulative effect adjusts the beginning of 2005 retained earnings balance.
At the beginning of operations in 2002, there was no beginning inventory. Purchases are the same under either method. Therefore, the difference in cost of goods sold and therefore pre-tax income for the three years between the two methods is $5,000 = ($83,000 – $78,000). WA recognizes more cost of goods sold. Therefore, the cumulative effect reduces 2005 pre-tax income by $5,000.
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