Question

Evaluating inventory cost flow changes (LO 9-4)

The following is an excerpt from the financial statements of Talbot Industries:

Effective September 30, 2016, the Company changed its method of accounting for inventories from the LIFO method principally to the Specific Identification method, because, in the opinion of management, there is a better matching of revenues and expenses, better correlation of accounting and financial information with the method by which the Company is managed, and better presentation of inventories at values that more fairly present the inventories’ cost.

During 2017, Chaney Technologies changed its inventory cost flow assumption from LIFO to the average cost method. The following is an excerpt from Chaney Technologies financial statements.

The change to the average cost method will conform all inventories of the Company to the same method of valuation. The Company believes that the average cost method of inventory valuation provides a more meaningful presentation of the financial position of the Company since it reflects more recent costs in the balance sheet. Under the current economic environment of low inflation and an expected reduction in inventories and low production costs, the Company believes that the average cost method also results in a better matching of current costs with current revenues.

Required:

1. Evaluate each of the justifications provided by Talbot for changing its inventory cost flow assumption.

2. Evaluate each of the justifications provided by Chaney Technologies for changing its inventory cost flow assumption.

Answer 1

1. Evaluate each of the justifications provided by Talbot for changing its inventory cost flow assumption.

Answer :

“Better matching of revenues and expenses . . .”

•           Matching does not refer to the physical flow of goods, but rather to cost-flow assumptions.

•           LIFO better matches current costs to current sales.

•           Unless customers have a choice of which particular unit to buy (as in the case of, say, used cars), management may be able to

•           Manipulate cost recognition to produce desired earnings and balance sheet presentations.

“Better correlation of accounting and financial information . . .”

•           This is a very ambiguous statement. Without additional explanation of “the method by which the company in managed,” it is difficult to gauge its validity.

•           Overall, it is difficult to believe that a product line for which LIFO was deemed applicable in the past would be better served now by specific identification.

“Better presentation of inventories . . .”

•           LIFO provides more information because of the requirement to disclose LIFO reserve.

•           Under specific identification, financial statement users will not know whether the inventory balance contains new costs, old costs, or a mixture.

•           As noted under point 1), the opportunity for managerial

•           Manipulation exists. If customers are able to choose which unit(s) they buy, why was LIFO used in the past?

2. Evaluate each of the justifications provided by Chaney Technologies for changing its inventory cost flow assumption.

Answer :

“Conform all inventories . . . to the same method of valuation.”

•           This would simplify the analyst’s task.

“Reflects more recent costs in the balance sheet . . .”

•           If input costs are changing, the average cost method will reflect more recent costs than LIFO would.

•           However, if the objective is to reflect more recent costs on the balance sheet, then FIFO is superior to the average cost method.

“Better matching of current costs with current revenues . . .”

•           If the company expects to reduce its inventory levels, LIFO liquidation would distort margins, so the average cost method would be preferable.

•           In “an economic environment of low inflation,” the average cost method would presumably lead to minimal margin distortion.