Question

John's sports Jerseys is a retail store that sells vintage sports apparel and accessories. The store is in its third year of operations and is struggling financially. Part of the problem is that the cost of inventory has increased dramatically over the past two years. The store assigns inventory costs using LIFO. A loan agreement with the bank requires the store to maintain a certain profit margin. John is reviewing the current year financial statements and sees that results are not favorable. The only way that the store can meet the required profit margin is to change inventory costing from LIFO to FIFO. John redoes the financial statements using FIFO and submits them to the bank without disclosing the change.

1. How is it that FIFO improves the profit of the Sports Jerseys?

2. Did John make an good ethical choice by changing to FIFO? Why or why not?

3. What alternative(s) did John have in this situation?

Answer 1

1. Generally Cost of Merchandise keeps increasing over the years. So, by choosing FIFO, Costs of goods will be recorded at lower value than under LIFO method, thus increasing the profit margin. Hence, FIFO improves the profit of the Sports Jerseys.

2. Legally, Inventory is to be recorded at FIFO or weighted average methods and LIFO is discouraged as it hides the profit than what it actually is suppose to be. However, switching from LIFO to FIFO is an accounting change and accounting changes requires full disclosure in the footnotes of the financial statements along with necessary justification as well as the financial impact caused due to this change. Hence, partially John's have indulged into unethical activity.

3. Instead of switching to FIFO, he could have switched to Weighted average methods to valuate inventory. however this again is a accounting change and requires full disclosures with justifications for the selection.