Change in Inventory Method
Accounting principles should be applied consistently from period to period to allow for comparability of operating results. However, changes within a company as well as changes in the external economic environment may require a company to change an accounting method. As we mentioned in Chapter 8, high inflation in the 1970s motivated many companies to switch to the LIFO inventory method.
Specific accounting treatment and disclosures are prescribed for companies that change accounting principles. Chapter 4 introduced the subject of accounting changes and Chapter 20 provides in-depth coverage of the topic. Here we provide an overview of how changes in inventory methods are reported.
Most Inventory Changes
Recall from our discussion in Chapter 4 that most voluntary changes in accounting principles are reported retrospectively. This means reporting all previous periods' financial statements as if the new method had been used in all prior periods. Changes in inventory methods, other than a change to LIFO, are treated this way. We discuss the to LIFO exception in the next section. In Chapter 4 we outlined the steps a company undertakes to account for a change in inventory method. We demonstrate those steps using a real world example in Illustrations 9-8 and 9-8A.
Changes in inventory methods, other than a change to LIFO, are accounted for retrospectively.
Change in Inventory Method—McKesson Corporation
Real World Financials
McKesson Corporation is a Fortune 100 company producing products and services in the healthcare industry. In a note accompanying its 2009 financial statements, the company disclosed that it uses the LIFO inventory method for 88% of its inventories and FIFO for the remainder. The company's balance sheets reported inventories of $8,527 million and $9,000 million at the end of 2009 and 2008, respectively. The inventory disclosure note reports that if the FIFO method had been used to value the entire inventory, instead of just 12% of it, inventories would have been $8,612 million and $9,077 million at the end of 2009 and 2008, respectively. Partial income statements for 2009 and 2008 are as follows:
Let's suppose that in 2009 McKesson decided to value all of its inventories using the FIFO method.
Income statements—100% FIFO
McKesson would report 2009 cost of goods sold by its newly adopted method, 100% FIFO.
McKesson would increase the amount it reported last year for its cost of goods sold as if 100% FIFO had been used.
The cost of goods sold of $101,246 million in 2009 is $8 million lower on a 100% FIFO basis. Here's why. McKesson's note reported that beginning inventory is $77 million higher ($9,077 − 9,000), and ending inventory also is higher by $85 million ($8,612 − 8,527). An increase in beginning inventory causes an increase in cost of goods sold, but an increase in ending inventory causes a decrease in cost of goods sold. The net effect of the two adjustments ($85 − 77) is the $8 million decrease in cost of goods sold.
In a similar manner, the 2008 cost of goods sold would be adjusted to $96,708 million. A note included in McKesson's 2008 financial statements reports that 2007 ending inventory of $8,153 million would have been $8,244 million on an all FIFO basis. 2008's beginning inventory would have been $91 higher ($8,244 − 8,153) and ending inventory for 2008 would be $77 million higher ($9,077 − 9,000). The net effect of the two adjustments ($91 − 77) is that cost of goods sold would be $14 million higher.
The first step is to revise prior years' financial statements. That is, for each year reported in the comparative statements, McKesson makes those statements appear as if the newly adopted accounting method (100% FIFO) had been applied all along. In its balance sheets, McKesson would report 2009 inventory by its newly adopted method, 100% FIFO, and also would revise the amounts it reported last year for its 2008 inventory. In its income statements, cost of goods sold also would reflect the new method in both 2009 and 2008 as shown in Illustration 9-8A.
Step 1: Revise Comparative Financial Statements
In its statements of shareholders' equity, McKesson would report retained earnings each year as if it had used FIFO all along, and for the earliest year reported, it would revise beginning retained earnings that year to reflect the cumulative income effect of the difference in inventory methods for all prior years. We see this step illustrated in Chapter 20 after you have studied the statement of shareholders' equity in more depth.
McKesson also would create a journal entry to adjust the book balances from their current amounts to what those balances would have been using 100% FIFO. Since differences in cost of goods sold and income are reflected in retained earnings, as are the income tax effects, the journal entry updates inventory, retained earnings, and the appropriate income tax account. We ignore the income tax effects here and include those effects in an illustration in Chapter 20. The journal entry below, ignoring income taxes, adjusts the 2009 beginning inventory to the 100% FIFO basis amount of $9,077 million.
Step 2: The appropriate accounts are adjusted.
Inventory at the beginning of 2009 would be $77 million higher if FIFO is used to value the entire inventory.
McKesson must provide in a disclosure note clear justification that the change to 100% FIFO is appropriate. The note also would indicate the effects of the change on (a) items not reported on the face of the primary statements, (b) any per share amounts affected for the current period and all prior periods, and (c) the cumulative effect of the change on retained earnings or other components of equity as of the beginning of the earliest period presented.
Step 3: A disclosure note provides additional information.
We see an example of such a note in a recent annual report of Chromcraft Revington, Inc., a residential and commercial furniture company, when it changed its inventory method from LIFO to FIFO. Graphic 9-8 shows the disclosure note that described the change.
Disclosure of Change in Inventory Method—Chromcraft Revington, Inc.
Real World Financials
Change in Accounting Method (in part)
In 2008, the Company changed its method of accounting for inventory from the last-in, first-out (“LIFO”) method to the first-in, first-out (“FIFO”) method. Prior to the change in accounting method, the percentage of inventory accounted for under the LIFO method represented approximately 60% of total inventories at December 31, 2007.
The Company's management believes the new method of accounting for inventory is preferable because the FIFO method better reflects the current value of inventories on the Consolidated Balance Sheet; provides better matching of revenue and expense under the Company's business model; and provides uniformity across the Company's operations with respect to the method of inventory accounting for both financial reporting and income tax purposes.
All prior periods presented have been retrospectively adjusted to apply the new method of accounting. The cumulative effect of the change in accounting principle on periods prior to those presented has been reflected as an adjustment to the opening balance of retained earnings as of January 1, 2007. Accordingly, retained earnings as of January 1, 2007 was increased by $2,054,000, which is net of the related income tax expense of $1,369,000.
Chromcraft Revington's note also disclosed the effect of the change on various financial statement items, including net income and earnings per share.
Change to the LIFO Method
When a company changes to the LIFO inventory method from any other method, it usually is impossible to calculate the income effect on prior years. To do so would require assumptions as to when specific LIFO inventory layers were created in years prior to the change. As a result, a company changing to LIFO usually does not report the change retrospectively. Instead, the LIFO method simply is used from that point on. The base year inventory for all future LIFO determinations is the beginning inventory in the year the LIFO method is adopted.12
Accounting records usually are inadequate for a company changing to LIFO to report the change retrospectively.
A disclosure note is needed to explain (a) the nature of and justification for the change, (b) the effect of the change on current year's income and earnings per share, and (c) why retrospective application was impracticable. When Seneca Foods Corporation adopted the LIFO inventory method, it reported the change in the note shown in Graphic 9-9.
Change in Inventory Method Disclosure—Seneca Foods Corporation
Real World Financials
10. Inventories (in part)
The Company decided to change its inventory valuation method from the lower of cost; determined under the FIFO method; or market, to the lower of cost; determined under the LIFO method or market. In the high inflation environment that the Company is experiencing, the Company believes that the LIFO inventory method is preferable over the FIFO method because it better compares the cost of current production to current revenue. Selling prices are established to reflect current market activity, which recognizes the increasing costs. Under FIFO, revenue and costs are not aligned. Under LIFO, the current cost of sales is matched to the current revenue.
The Company determined that retrospective application of LIFO for periods prior to fiscal 2009 was impracticable because the period-specific information necessary to analyze inventories, including inventories acquired as part of the fiscal 2008 Signature acquisition, were not readily available and could not be precisely determined at the appropriate level of detail, including the commodity, size and item code information necessary to perform the detailed calculations required to retrospectively compute the internal LIFO indices applicable to fiscal 2008 and prior years. The effect of this change was to reduce net earnings by $37,917,000 and $18,307,000 in 2009 and 2008, respectively, below that which would have been reported using the Company's previous inventory method. The reduction in earnings per share was $3.12 ($3.09 diluted) and $1.50 per share ($1.49 diluted) in 2009 and 2008, respectively.
As we discussed in Chapter 8, an important motivation for using LIFO in periods of rising costs is that it produces higher cost of goods sold and lowers income and income taxes. Notice in the Seneca Foods disclosure note that the switch to LIFO did cause a decrease in income and therefore income taxes in the year of the switch indicating an environment of increasing costs.
When changing from one generally accepted accounting principle to another, a company must justify that the change results in financial information that more properly portrays operating results and financial position. For income tax purposes, a company generally must obtain consent from the Internal Revenue Service before changing an accounting method. A special form also must be filed with the IRS when a company intends to adopt the LIFO inventory method. When a company changes from LIFO for tax purposes, it can't change back to LIFO until five tax returns have been filed using the non-LIFO method.