Question

match Point is a retail sports store carrying tennis 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 Match Point’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.

Required:

1. How does Match Point’s use of FIFO improve its net profit margin and current ratio?
2. Is the action by Match Point’s owner ethical? Please justify your answer with an explanation.

Answer 1

"A major problem is that its cost of inventory has continually increased in the past two years"

Cost of items purchased were increasing.

In LIFO method, the items Purchased last are used first. Hence, the items having highest cost are used first. Cost of goods sold will be high and the closing inventory value will be low. Hence, Profit will be low.

If FIFO method is used, the items Purchased first  are used first. Hence, the items having lowest  cost are used first. Cost of goods sold will be low and the closing inventory value will be high. Hence, Profit will be high . Since closing inventory will be higher,Current Ratio will also be higher.

For example :

Item purchased on January,10 at $1000

Same item purchased on January 30 at $1020

If the item is sold on February 1,

As per LIFO , the cost of goods sold will be $1020

As per FIFO, the cost of goods sold will be $1000

Is the action by Match Point’s owner ethical?

The action by Match Point's owner is not ethical. The loan was approved based on Accounts where LIFO was used. If the method is changed, the same should be informed to the banker