Question

Golf Challenge Corp. is a retail sports store carrying golf apparel and equipment. The store is at the end of its second year of operation and is struggling. A major problem is that its cost of inventory has continually increased in the past two years. In the first year of operations, the store assigned inventory costs using LIFO. A loan agreement the store has with its bank, its prime source of financing, requires the store to maintain a certain profit margin and current ratio. The store’s owner is currently looking over Golf Challenge’s preliminary financial statements for its second year. The numbers are not favorable. The only way the store can meet the required financial ratios agreed on with the bank is to change from LIFO to FIFO. The store originally decided on LIFO because of its tax advantages. The owner recalculates ending inventory using FIFO and submits those numbers and statements to the loan officer at the bank for the required bank review. The owner thankfully reflects on the available latitude in choosing the inventory costing method.

1. How does Golf Challenge’s use of FIFO improve its net profit margin and current ratio?
2. Is the action by Golf Challenge’s owner ethical? Explain.

Answer 1

FIFO or First in first out method assumes that inventory bought first will be used first and bought later will be used later. LIFO or last in first out method assumes that the inventory purchased later will be used first. The choice of method makes a huge difference in the figures of Cost of Goods Sold, Gross Profit and closing inventory, especially in inflationary situation when the cost of inventory increases over time or deflationary situations when cost decreases over time.

In the current case, the cost of inventory is increasing and hence using FIFO leads to lower cost of goods sold and hence higher gross profit. On the other hand, it raises the value of closing inventory since it contains the units purchased later at a higher price. Hence, changing method from LIFO to FIFO improves both the gross profit margin as well as the current ratio.

This action is not ethical since the change is method is being done just for the purpose of obtaining loan and not because it reflects the correct pattern of use of inventory. Hence, this action is unethical.