Case 07-2 Western Aluminum In conjunction with the annual audit, the controller of Western Aluminum, Inc. ( W or the Company ), provided the audit engagement team with background information about the Company s proposed change in accounting principle from the last-in, first-out (LIFO) method to the first-in, first-out (FIFO) method of valuing inventory. MEMO To: Engagement Team From: Controller, Western Aluminum, Inc. Subject: Accounting for the Change in Accounting Principle From LIFO to FIFO Date: December 31, 2006 Company W, an SEC registrant, is the leading producer of aluminum in the world. Since W s inception in January 2004, W s divisions have accounted for their raw-material, work-in-process, and finished-goods inventories ( inventories or inventory ) under the LIFO method. Meanwhile, W s recently acquired smelter, N, accounts for its inventory under the FIFO method. Smelter N currently produces 15 percent of W s inventories; however, N is projected to produce 30 percent of W s inventories by the end of 2007. Company W s principal output, primary aluminum, and a significant portion of its major input, alumina, are subject to large valuation swings over the business cycles depending on the price of aluminum as traded on the London Metal Exchange. The combination of high-value LIFO layers and business-cycle commodity price swings has led W to make large, noncash adjustments to its inventory. For example, under Statement 5 in Accounting Research Bulletin No. 43, Chapter 4, Inventory Pricing, W makes lower-of-cost-or-market (LCM) adjustments when inventory at LIFO cost exceeds market. Thus, if W s LIFO cost is $0.70 per pound while market prices are at $0.65 per pound, the inventory is overvalued by $0.05 per pound and W records an LCM charge. These adjustments do not align with the actual cost flows or match current costs against revenues. Because the cycle time from acquisition of alumina to sale of primary aluminum is about three months (or less), switching to FIFO will result in inventory values at period end that more closely approximate replacement cost; at the same time, revenue and expenses will be more closely matched. Furthermore, W s research shows that the industry has acknowledged the impact of these aluminum fluctuations. Company W noted that Competitor A, in its 2005 annual report, stated that 55 percent of its inventory is reported on a FIFO basis while the rest is reported on an average-cost basis. Similarly, Competitor B stated that it uses the monthly-average-cost method to determine most of its inventories. The results of such average-cost valuation methods more closely match FIFO than LIFO. Company W s effective tax rate for 2004, 2005, and 2006 is 40 percent.
Case 07-2: Western Aluminum Page 2 Under the circumstances, W believes that changing to the FIFO method for its domestic operations would be preferable. Company W proposes to make this accounting change in the fourth quarter of calendar year 2006 (December 31, 2006). The following table presents the effects of the proposed change in accounting principle on inventory and cost of sales: Inventory Determined by Cost of Sales Determined by Date LIFO Method FIFO Method LIFO Method FIFO Method 1/1/2004 $ - $ - $ - $ - 12/31/2004 100 90 300 310 12/31/2005 150 125 350 365 W has not filed audited financial statements with the SEC for the year ended December 31, 2006. Company W s audited financial statements as of, and for, the years ended December 31, 2005, and 2004, as originally reported under the LIFO method, are as follows: Income Statement 2005 2004 Sales $ 700 $ 650 Cost of goods sold 350 300 Selling, general, and administrative expenses 100 80 Income before income taxes 250 270 Income taxes 100 108 Net income $ 150 $ 162 Balance Sheet 2005 2004 Cash $ 10 $ 20 Inventory 150 100 Prepaid assets 5 15 Total Current Assets 165 135 Property, plant, and equipment (net) 1,065 630 Total Assets $ 1,230 $ 765 Accounts payable 268 100 Income tax payable 100 108 Total Current Liabilities 368 208 Long-term liabilities 455 300 Paid-in capital 95 95 Retained earnings 312 162 Total Equity 407 257 Total Liabilities and Equity $ 1,230 $ 765
Case 07-2: Western Aluminum Page 3 Cash Flow Statement 2005 2004 Net income $ 150 $ 162 Adjustments to reconcile net income to net cash provided by operating activities (Increase)/decrease in inventory (50) (100) Increase/(decrease) in income tax liability (8) 108 Other operating, investing, and financing cash flow activities: (102) (150) Net increase/(decrease) in cash (10) 20 Beginning cash balance 20 - Ending cash balance $ 10 $ 20 NOTE: For simplicity, the cash flow statements for the years ended December 31, 2005, and 2004, are condensed, highlighting only those line items affected by the accounting change. This summarized presentation does not comply with the requirements of FASB Statement No. 95, Statement of Cash Flows, and related interpretations. In addition, the statement of shareholders equity has intentionally been omitted. Required: What factors should the Company and the audit engagement team consider in determining whether the proposed accounting change from LIFO to FIFO is preferable? If the change in accounting principle is preferable and indirectly results in a $100 increase in accrued bonuses by December 31, 2005, how should the Company report the indirect effects due to retrospective application in the financial statements as of, and for, the year ended December 31, 2005? Please explain. Assume that the change in accounting principle is determined to be preferable, but the Company concludes that it is impracticable to determine the period-specific effects of the change in financial reporting periods at and before December 31, 2005. How should the Company report the retrospective application for the change in accounting principle in its annual report for December 31, 2006? Assume that the change in accounting principle is determined to be preferable and that retrospective application is deemed practicable. Use the forms below to adjust the financial statements as of, and for, the years ended December 31, 2005, and 2004, to reflect the retrospective application of the change in accounting principle that will be reported in the Company s December 31, 2006, annual report on Form 10-K.
Case 07-2: Western Aluminum Page 4 NOTE: No cumulative adjustments need to be made to January 1, 2004, retained earnings since the Company s business inception was January 2004. Financial statements as of, and for, the year ended December 31, 2006, are not provided since they have not previously been issued. Income Statement 2004 2004 2004 Sales $ 650 Cost of goods sold 300 Selling, general, and administrative expenses 80 Income before income taxes 270 Income taxes 108 Net income $ 162 Balance Sheet 2004 2004 2004 Cash $ 20 Inventory 100 Prepaid assets 15 Total Current Assets 135 Property, plant, and equipment (net) 630 Total Assets $ 765 Accounts payable 100 Income tax payable 108 Total Current Liabilities 208 Long-term liabilities 300 Paid-in capital 95 Retained earnings 162 Total Equity 257 Total Liabilities and Equity $ 765
Case 07-2: Western Aluminum Page 5 Cash Flow Statement 2004 2004 2004 Net income $ 162 Adjustments to reconcile net income to net cash provided by operating activities (Increase)/decrease in inventory (100) Increase/(decrease) in income tax liability 108 Other operating, investing and financing cash flow activities: (150) Net increase/(decrease) in cash 20 Beginning cash balance - Ending cash balance $ 20 NOTE: For simplicity, the cash flow statements for the years ended December 31, 2005, and 2004, are condensed, highlighting only those line items affected by the accounting change. This summarized presentation does not comply with the requirements of Statement 95 and related interpretations. In addition, the statement of shareholders equity has intentionally been omitted.