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Example in the F7 BPP text book.
“A company has always valued inventory on a FIFO (first in, first out) basis. In 20X9 it decides to switch to the weighted average method of valuation. Gross profit in the 20X8 financial statements was calculated as follows.
$’000
Revenue 869
Cost of sales:
Opening inventory 135
Purchases 246
Closing inventory (174) (207)
Gross profit 662In order to prepare comparative figures for 20X8 showing the change of accounting policy, it is necessary to recalculate the amounts for 20X7, so that the opening inventory for 20X8 is valued on a weighted average basis.
It is established that opening inventory for 20X8 based on the weighted average method would be $122,000 and closing inventory would be $143,000. So the 20X8 gross profit now becomes:
$’000
Revenue 869
Cost of sales:
Opening inventory 122
Purchases 246
Closing inventory (143) (225)
644This shows $18,000 lower gross profit for 20X8 which will reduce net profit and retained earnings by the same amount. The opening inventory for 20X9 will be $143,000 rather than $174,000 and the statement of changes in equity for 20X9 will show an $18,000 adjustment to opening retained earnings. ”
My question is that what accounting treatments (double entry) do we have to make for those changes?
Let’s start with a pretend figure for Retained Earnings of $800,000 after the 2007 financial statements had been finalised and therefore before these change in accounting policy adjustments are made
In 2007 there will be an adjustment to Retained Earnings of $13,000 decrease and a fall in the value of inventory in the 2007 statement of financial position
So:
Dr Inventory on SoPL 13,000
Cr Inventory on SoFP 13,000and our pretend adjusted Retained Earnings carried forward into 2008 are now $787,000
Before the change in policy the financial statements for 2008 showed a profit of $662,000 so, before the adjustments for 2008 the retained earnings figure would have been $1,449,000 ($787,000 + $662,000)
But in 2008 there will be a further adjustment to Retained Earnings of $18,000 decrease and a fall in the value of inventory in the 2008 statement of financial position
In total, Retained Earnings will have been reduced in 2007 by $13,000 and in 2008 by a further $18,000. The credit side of these reductions is in the value of the 2008 closing inventory that has fallen in value by $31,000
and the adjusted Retained Earnings carried forward into 2009 are now $1,431,000
Had none of these adjustments been necessary, our pretend Retained Earnings would have been $800,000 brought forward + $662,000 as per the 2008 financial statements giving us a carry forward figure into 2009 of $1,462,000
With the adjusted figure of $1,431,000 I think you should be able to recognise the fall in the Retained Earnings of $31,000 as corresponding with the equal amount of the fall in the value of the 2008 closing inventory
OK?
“In 2007 there will be an adjustment to Retained Earnings of $13,000 decrease and a fall in the value of inventory in the 2007 statement of financial position”
“In total, Retained Earnings will have been reduced in 2007 by $13,000 and in 2008 by a further $18,000. The credit side of these reductions is in the value of the 2008 closing inventory that has fallen in value by $31,000”
What I was missing is the adjustment to RE in the 2007 so it did not add up.
Understood. Thank you, Sir.
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