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.

ORIGINAL ANSWERS ONLY I DONT WANT A GOOGLED ANSWER PLEASE. THANK YOU!

Required

1. How does the 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

A FIFO method of inventory valuation considers the latest purchase of lots in its closing inventory. The initial purchase of inventory lots is issued to cost of goods sold based on first come first served basis. When the prices of inventory are raising the closing stock is valued at latest purchase lot which has highest price. Hence the closing stock is valued higher compared to LIFO method. LIFO method values the closing stock at earlier purchased lower prices since it considers the latest purchase lot as issued to cost of goods sold. The higher closing stock value as per FIFO method increases the net profits for the period and current assets value in balance sheet since closing stock is part of current assets. The higher current assets give higher current ratio. Current ratio is the ratio which indicates the current assets available to meet the short term obligations that is current liabilities. A higher current ratio is preferred by bankers since it is a liquidity measure of the firm.

The action of owner to show better profitablity and current ratio is not ethical. The method of inventory valuation is an accounting policy. As per principle of consistency an accounting policy should be consistently followed from one period to another period. Inventory valuation method cannot be changed year on year basis as per convenience or as per requirement. Hence a onetime change of inventory method can be done as per principles of accounting. It cannot be changed year on year basis.