Question

During 2015, Crop-Paper-Scissors, a craft store, began operations and chose to use the FIFO inventory costing method.

After creating their financial statements for 2015, the company realized that it would prefer to use the LIFO inventory costing method instead.

So, Crop-Paper-Scissors switched to the LIFO method in 2016.

Due to a change in the economy, the company realized that it would, in fact, be better for them to use the FIFO method.

So, in 2017 they switch back to FIFO. After analyzing the swing in the numbers over the past few years, they decide to smooth things out a bit by trying average costing in 2018.

1. What impact(s) will these actions have on the company’s financial statements? Be sure to discuss the balance sheet and the income statement separately, and be specific about the impacts on each statement (i.e. overstatement/understatement of account balances and net income).

2. How does FIFO impact the balance sheet? The income statement?

3. How does LIFO impact the balance sheet? The income statement?

4. What are the advantages of switching inventory methods (i.e. why is Crop-Paper-Scissors doing this)?

5. Discuss the role that accounting should play in this situation. Which GAAP principle(s) are being violated?

6. Discuss the ethical issues in this case (be sure to identify each party involved and whether or not they are acting in an ethical manner). Identify who could be harmed and how they could be harmed (be specific). Do not include the individuals at Crop-Paper-Scissors who made the decision, created the financial statements, or filed the taxes. As a personal friend, what advice would you give to the accountant who works for Crop-Paper-Scissors?

Answer 1

FIFO and LIFO are two different methods of inventory valuation which a company can adopt to value its inventories. The method adopted by the company has to be consistently followed from year to year.

1) In the given case, the company kept on switching the method from year to year. Inconsistent valuation of inventory can give misleading information to the investors thereby affecting the credibility of the company.

Switching from FIFO to LIFO method can result in understatement/Overstatement of the year end profits depending on the inventory prices. The income statement can show a trend of inconsistent net incomes and comparison of different years' net incomes becomes pointless.

The users of the financial statements like the investors, rely on the balance sheet to make their investing decisions. When the company follows an inconsistent method to value its inventory, it surely depicts in its balance sheet.

2) Under First In and First Out (FIFO) method, the closing inventory is valued as per the rate in the last lot purchased. When the last purchase was during a peak time of the year, the prices paid for the last lot of inventory will be high and the company will value its inventory based on this peak price which in effect will boost up the net income and vice versa. So, in the Income statement, this will show a high net income and in the balance sheet, the shareholders will expect a higher return because of high profits.

3) Under Last In First Out (LIFO) Method, the company values its inventory on the basis of the first lot of inventory purchased. Like the same case of LIFO method, it can boost up or crop down the profits according to the price of the inventory prevailing at that point of time. In the income statement, the net income can be high or low and in the balance sheet, the investor decision could be affected due to this.

4) Switching of Inventory valuation very regularly is not at all advisable as it can lead to inconsistent financial information. But, once in a while, switching of the method of inventory valuation can give the following benefits:-

• Better presentation of financials as per the latest accounting frameworks.
• To comply with any law or statute.

5) The accountant should insist the management to follow consistent method to value its inventories. Incorrect valuation causes the financial information to be uncomparable and misleading for the investors.

The GAAP that is being voilated is 'Consistency' which says that an entity should consistently follow the accounting policies from one year to another year.

6) Ethical Issues involved:- Misleading information to the investors

parties involved:

• Management - The management can be involved to show a better net income in order to attract the investors.
• Investors - Investors might be affected due to their incorrect decisions.

Advise to the accountant:- Always try to stick on to one inventory valuation method and ask the management not to change the inventory valuation method from time to time.