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Chapter 14: Problem 58

Why would a change from FIFO, or some other inventory method, to LIFO not require a retroactive adjustment of a firm's financial statements? What would be the cumulative effect of such an adjustment?

Short Answer

Expert verified
The change from FIFO to LIFO does not require a retroactive adjustment since the change only applies on a go-forward basis, rather than rewriting past transactions. As such, there is no cumulative effect to consider for the past years before the switch, as the change only applies to future financial statements.

Step by step solution

01

Understand Inventory Accounting Methods

There are three primary inventory accounting methods used by companies to measure the cost of goods sold and remaining inventory. They are First-In-First-Out (FIFO), Last-In-First-Out (LIFO), and Average Cost Method. Each method is based on a different assumption about the flow of inventory costs in a business.
02

FIFO to LIFO Switch

When a company switches from FIFO to LIFO, the LIFO method only impacts the income statement and balance sheet from the time the decision to switch is made going forward. It does not affect the historical cost of goods sold or inventory before the switch.
03

Why Retroactive Adjustment is Not Required

Because the change in method does not affect the transactions in the past, a retroactive adjustment is not required. Firms are not allowed to revise their previously issued financial statements for the effects of the new method. Instead, they report the effect of the change on those periods' income in the year of change.
04

Cumulative Effect of such an Adjustment

The cumulative effect of an adjustment is the total impact of the new accounting method on the net income from past years, assuming the new method had been in place. However, since retroactive adjustments are not made when switching to LIFO, there is no cumulative effect to consider for the past years before the switch. The effect would only apply to future financial statements after the change to LIFO.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

FIFO
FIFO stands for First-In, First-Out, a common inventory accounting method.
This method assumes that the oldest inventory items are sold first. This approach results in the cost of the goods sold reflecting the cost of the oldest inventory on hand.
  • FIFO often aligns closely with the actual physical flow of inventory, especially for products with expiration dates, like food items.
  • This method generally leads to higher net income during periods of rising prices because older stock tends to have a lower cost.
  • Inventory left at the end of the period reflects the cost of the most recent purchases.
When prices are increasing, FIFO can result in higher taxes due to increased reported profit.
However, it provides a clear picture of the inventory's market value at the end of an accounting period.
LIFO
LIFO, short for Last-In, First-Out, is another method of inventory management.
With this approach, the most recent inventory items are recorded as sold first.
  • In an environment where prices are rising, LIFO reflects higher cost of goods sold (COGS) and lower taxable income.
  • This method can result in tax savings during inflationary periods due to lower reported earnings.
  • However, LIFO may not always reflect the physical flow of goods; for example, perishables like fresh produce.
LIFO is permitted under the Generally Accepted Accounting Principles (GAAP) but not allowed for tax purposes outside of the United States.
Using LIFO can lead to lower profits being displayed on financial statements but offers tax advantages during times of inflation.
Financial Statements
Financial statements are records that outline the financial performance and position of a company.
Key financial statements include the income statement, balance sheet, and cash flow statement.
  • The income statement shows company revenues and expenses over a specific period, leading to net profit or loss.
  • The balance sheet provides a snapshot of assets, liabilities, and equity at one point in time.
  • The cash flow statement details the inflows and outflows of cash, helping to assess liquidity and cash management.
When a company changes its inventory accounting method, like from FIFO to LIFO, these statements will reflect the change only moving forward.
Past statements will not be adjusted, avoiding any confusion with historical financial performance.

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Most popular questions from this chapter

Review the prior chapters in this text and compile a list of at least five areas where estimates are required as part of the accounting measurement process. Determine through your review or through interviews with accounting professionals whether these estimates can generally be made in a reliable manner that requires limited adjustments in later years. In other words, what is the general long-term effect of using these types of estimates?

Under what circumstances are prior years' financial statements retroactively restated? Why do you suppose these exceptions exist?

Why does the FASB require that firms make retroactive adjustments when a new reporting standard has been issued?

Assume that a firm changes from FIFO to LIFO during a period of rising prices. Would a proponent of the EMH predict an increase or decrease in the firm's share price as a result of the change in inventory valuations? Why?

The Sisters Coffee Emporium has been researching and developing new exotic coffee flavors and innovative coffee equipment. During \(1998,\) it spent over 250,000 dollars on \(R \& D\) costs. It is now year-end and the company is preparing its balance sheet. Sisters would like the most relevant information to be reported to investors because the company is considering whether or not to capitalize the \(R \& D\) costs. a. Advise Sisters on the concepts of relevance and reliability and how the \(R\&D\) expenditures should be handled. b. Discuss the two primary concepts of accounting in the context of sisters Coffee Emporium.
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