On December 31, 2018, Grantham, Inc., appropriately changed its inventory valuation method to FIFO cost from weighted-average cost for financial statement and income tax purposes. The change will result in a $2,000,000 increase in the beginning inventory at January 1, 2018. Assume a 30% income tax rate. The cumulative effect of this accounting change on beginning retained earnings is _________.

 

a. $0

 

b. $600,000

 

 

c. $1,400,000

This answer is correct.

 

d. $2,000,000

 

(Computation: $2,000,000 × (1 - .3) = $1,400,000)

 

Please help me understand why the $2,000,000 was multipled by 70% instead of 30%? Thank you.

Ans:

Firstly to make your doubt clear I want to take one example for your clarity only-

suppose you have a profit of $ 100 M in this year now on this you will have to pay the Tax 30% therefore the profit after tax will come $ 70 M, on the other hand after all above calculation you forget to add inventory which you have forgot to add say $ 100 M now this will affect your profit i.e the profit will go high by 100 M i.e total profit before tax is $ 200 M this is because Inventory is directly proportionate to profit which means if inventory rises profit will rise ,viceversa.

Post this the Profit will be $ 200 M &

tax thereon 30 % = 60 M

therefore profit after Tax will be $ 140 M & now this 140 M will be transferred to retained earnings

Clarity :- Hope you understand that with increase in Inventory- profit after tax also increased in same proportionate.

Now coming to your question-

increase in the beginning inventory at January 1, 2018  $2,000,000 will change the opening profit therefore here profits means profit after taxes which we have already transferred to Retained earings therefore the at retained earnings is taken to 2000000*70%= $ 1400000

Step-by-step explanation

Kindly let me know if you have any doubt.