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Hi,
Ref: past exam question Tunshill (12/10)
Please explain the numerical calculation (answer), I can’t get my head around these workings.
Question, part ii:
Most of Tunshill’s competitiors value their inverntory using the average cost (AVCO) basis, whereas T uses the FIFO basis. the value of T’s inventory at 30 Sep 20X3 (on FIFO basis) is 20 million, however on the AVCO basis it would be valued at $18 million. By adopting the same method (AVCO) as its competitors, the assistant accountant says says the compamy would improve its profit for the year ended 30 Sep 20X3 by $2 million. T’s inventory at 30 Sep 20X2 was reported as $15 million, however on the AVCO basis it would have been reported as $13.4 million.
Required:
quantify how they would affect the financial statementsFirst of all I understand the written explanation that under AVCO actually profit would be lower. I remember from my taxation studies that some companies valued their inventory under LIFO basis (now this treatment is not allowed), to value their closing inventory as high as possible to lower the profit and pay less tax.
Anyway what confuses me is the numerical answer:That net effect at 30 Sep 20X3 of this proposal will be to reduce current year profits by $400.000 and to reduce retained earnings by $2m.
Please help to understand the effect on current year profit and retained earnings.
Regards
AliciaCost of sales this year will fall by the 1.6 lower value as at the start of this year, so this year’s profits would increase by that 1.6
However, the lower value at the year end will increase cost of sales for the year by 2 million
The net effect is an improvement of 1.6 and a fall of 2 = a net fall for this year of 400,000.
Inventory at this year end is “overvalued” by 2 million – so that needs to be reduced on the S of FP
Retained earnings brought forward are “overstated” by the higher valued inventory amount of 1.6 and are FURTHER “overstated” by the additional 400,000. The net effect on retained earnings is therefore a cumulative”overstatement” of 2 million
Is that clearer?
The inventory at the end of last year is “overvalued” by 1.6m, so last year’s cost of sales needs to be increased by that overvaluation.
But that has the effect on this year of reducing cost of sales by that same 1.6m so this year’s profits will increase by that amount
However, this year’s closing inventory is also “overvalued” by 2m and that means that cost of sales this year will increase by 2m and profits will therefore be reduced.
The net effect is an increase of 1.6 and a fall of 2 = a net fall of 400,000 in this year’s profits.
Last year, with that “overvaluation” of inventory, last year’s retained earnings are overstated by 1.6m and they are FURTHER overstated by the 400,000. That equates to a reduction in retained earnings of 2m and the value of the inventory on the SofFP will also fall by that same 2m
Is that clearer?
Thank you for your explanation.
It is now clearer indeed.
I am a bit down at the moment, limping through my revision. I find questions on deffered tax difficult to understand, hard to stay motivated.
But tomorrow will be another day and hope things will improve.
Many thanks
Do those mini-exercises from the back of the notes on deferred tax. And, if you can’t get your head round the subject – move on! It’s only a probable two marks in the exam
I know it is already 2021 but I’m stumbling on this. You said last year cost of sale was “overvalued”. Doesn’t that mean an adjustment would be made to reduce COS of last year (since it was too high, or, “overvalued”), and therefore increase COS of this year. Im so confused
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