Question

During 2016 (its first year of operations) and 2017, Segura LLC used the FIFO inventory costing method. At the beginning of 2018, Segura changed to the average cost method.

                Components of income before tax for 2018, 2017, and 2016 were as follows ($ in millions):

                                                                                2018                       2017                       2016

                Revenues                                            $420                       $390                       $380

                Cost of goods sold (FIFO)              (46)                         (40)                        (38)

                Cost of goods sold (average)       (62)                         (56)                        (52)

                Operating expenses                       (254)                      (250)                     (240)

Dividends of $20 million were paid each year. Segura’s fiscal year ends December 31. Ignore income taxes.

Required:

1. Determine the balance in retained earnings at December 31, 2017 (before the change to average cost).

2. Prepare the journal entry at the beginning of 2018 to record the change in inventory accounting method.

3. Prepare the 2018 comparative income statements (including 2017 amounts).

4. What was the effect of the change in inventory method on the company’s 2018 net income?

5. Determine the balance in retained earnings at December 31, 2018.

Answer 1

	1. Determine the balance in retained earnings at December 31, 2017 (before the change to average cost).
	Particulars			Amount
	Revenues	380
	Less: Cost of Goods Sold	-38
	Less: Operating Expenses	-240
	Net Income	102
	Retained Earnings, January 1, 2014	0
	Add: Net Income	102
	Deduct: Dividends	-20
	Retained Earnings, December 31, 2014	82
	2&4. Prepare the journal entry at the beginning of 2018 to record the change in inventory accounting method.
		2017	2016
	Cost of Goods Sold (FIFO)	40	38
	Cost of Goods Sold (average)	56	52
	Difference	16	14
	As a result of the change in inventory method, cost of goods sold for 2015 and 2014 is $30 higher ($16 + $14) under the average method. Since cost of goods sold is an expense, this means that net income would be $30 lower. When the net income is closed into retained earnings, the retained earnings would be $30 lower. Since cost of goods sold is higher under the average method, the asset inventory would be $30 lower. Therefore, the journal entry in 2016 would be
Particulars	General Journal	Debit	Credit
01-01-18	Retained earnings	30
	Inventory		30
3. Prepare the 2018 comparative income statements (including 2017 amounts).
	2018	2017
Revenues	420	390
Less: Cost of Goods Sold	-62	-56
Gross Margin	358	334
Less: Operating Expenses	-254	-250
Net Income	104	84