Question

5. In the pro-forma income statements that James Colburn prepared for Rick Martino, the costs of the reel mower units and transportation were rising for 2007 and 2008. Discuss how the balance sheet and income statement would be affected if Merrimack changed from LIFO to FIFO and inventory purchase prices and transportation costs had been stable over the two-year period. What would happen to the income statement and balance sheet if Merrimack changed from LIFO to FIFO and inventory purchase prices and transportation costs had been falling over the two-year period? Give an example of an industry where inventory prices might fall over time.

6. Is James Colburn suggesting to Rick Martino that they should be managing earnings rather than managing the company and its business? Although such changes are clearly permitted under GAAP, do you consider these changes to be ethical? Assume you are Rick Martino and have decided to switch from LIFO to FIFO. How would you explain your decision to the Board of Directors?

Answer 1

5. LIFO is not a good indicator of valuing inventory because the leftover inventory might be extremely old, perhaps obsolete, which results in a valuation much lower than today's prices. Under the LIFO method, the most recent costs are included in cost of goods sold, while earlier costs remain in inventory.  This results in the matching of the most recently incurred costs with current revenues in the determination of gross profit and an inventory valuation at the earliest costs.  

The LIFO method enables management to manipulate profit by delaying purchases or liquidating inventory.  Alternatively, management may manipulate profit by avoiding a liquidation of inventory through a purchase at the end of the period.  

The inventory's purchase price is the key determining factor on the LIFO-to-FIFO switch's impact on a financial statement.

In time of stable costs, The LIFO method results in less net income because COGS is greater.

In times of cost increases, LIFO will result in a higher cost-of-goods expense, but lower end-of-period inventory values.

In times of cost decreases, LIFO will result in a lower cost-of-goods expense, but higher end-of-period inventory values. This will mean that the profitability ratios will be smaller under LIFO than FIFO. The profitability ratios include profit margin, return on assets, and return on stockholders' equity. The inventory turnover ratio will be higher when LIFO is used during periods of increasing costs.

There are various factors that affect COGS and consequently inventory value -

• Obsolescene
• Perishable goods
• Use of certain technology can reduce the overall time and cost

6. As mentioned above, LIFO method enables management to manipulate profit, which is considered unethical.

IFRS do not allow the use of LIFO because it is clearly inconsistent with any presumed physical flow of the inventory. Also, LIFO is not permitted to be used for income tax purposes in most countries.  

Reasons for switching to FIFO are-

• FIFO gives us a good indication of ending inventory value
• FIFO moves the first/oldest costs from inventory and leaves the last/more recent costs in inventory.
• Avoids manipulation of financial statement and gives a correct picture
• Accepted method of valuing inventory by US GAAP and IFRS