Question

Merchandiser Corp. has been in business for 40 years and values its cost of goods sold and ending inventory using the LIFO costing method. The current year has been particularly unprofitable and Merchandiser Corp. is under significant investor pressure to finish the year with some good news.

Merchandiser Corp's chief financial officer (CFO) has approached the president about a way to substantially increase earnings. She suggest that LIFO stop purchasing inventory the last couple months of the year. Since Merchandiser Corp. uses the LIFO method, this will force the liquidation of inventory cost layers from 20+ years back. Since costs of inventory has increased substantially over this period, Merchandiser will be reporting cost of goods sold at 1/4 current costs.

This will result in a substantial increase in gross profit and "juice up net income," allowing the company to meet inventor expectations. Is this ethical? Explain your answer. Is it ok per GAAP? Is it ok per international accounting standards? Explain your answers. Will savvy investors catch and understand Merchandiser's "trick?"

Please explain in the ethics of this discussion?

Answer 1

LIFO (Last in first out) is one of the method of inventory account method, in which the recently produced items are sold first. This method is suitable during the times of rising prices, through which firms can save on taxes as well as better match their revenue to their latest costs. But this method is very difficult to manage for a long time because, it can result in older inventory never being shipped or sold. LIFO also results in more complex records and accounting practices because the unsold inventory costs do not leave the accounting system. LIFO is not recommended if you have perishable products, since they may expire on the shelf before they are sold or shipped. LIFO also is not an ideal method for businesses expanding globally because a number of international accounting standards do not allow LIFO valuation.

The Last-In-First-Out (LIFO) method of inventory valuation, while permitted under the U.S. Generally Accepted Accounting Principles (GAAP), is prohibited under the International Financial Reporting Standards (IFRS). As IFRS rules are based on principles rather than exact guidelines, usage of LIFO is prohibited due to potential distortions it may have on a company’s profitability and financial statements. In principle, LIFO may create a distortion to net income when prices are rising (inflation); LIFO inventory amounts are based on outdated and obsolete numbers, and LIFO liquidations may provide unscrupulous managers with the means to artificially inflate earnings.

Here Merchandiser Corp. is using LIFO method for the last 40 years and in this era of high costs, their inventory values will not be the original costs of the period as the most items will be from the old stocks. This will result in a substantial increase in gross profit and "juice up net income," and also the investors are having high expectations also. The company opted this method as a means to window dressing, to attract more investors by showing flowered results. The inventories of the company are now in a low cost, and they must have to revalue it and revise their accounting policies related to it.

The investors may oppose or resist it when hearing the same and negative impacts will be there. But for the company's long life it is better to change. If they are not ready then at any recent point, they might find it difficult to meet the investor expectations and high taxes and all.