Question

Firm X wants to raise $10 million to grow and attract new investors. Firm X operates in an inflationary environment and has been using the LIFO inventory valuation method to minimize their net earnings and thereby reduce their taxes. The CEO asks you to estimate the change in net earnings that would happen if they switched to FIFO.

After reviewing Firm X’s finances, you estimate that pre-tax income would increase by $1.2 million if the company adopted the FIFO method. However, the switch would result in approximately $400k of additional taxes. The overall effect would result in an increase of $800k in net earnings. The CEO tells you to prepare the tax return on a LIFO basis for inventory, but to prepare statements on a FIFO basis to be sent to potential investors.

1. How will the switch to FIFO affect the Balance Sheet?
2. What are the legal and ethical implications of the CEO’s recommendation?
3. If you switch to FIFO for taxes as well as financial reporting purposes, net income will increase by $800k. Comment on the possibility of paying $400k in income taxes to obtain an additional $800k of net income.

Answer 1

A. The valuation of ending inventory as per FIFO would be higher than that prepared under LIFO. That would cause an increase in the value of total assets by $ 1.2 million..

B. Evasion of taxes is unlawful. Secondly, both the tax returns and the financial statements are to be prepared using the same accounting policies / estimates. Preparing the tax return as per LIFO, and the financial statements as per FIFO is not allowed by law, and the company would be indulging in an unlawful practice.

The reason for switching to a different accounting method or estimate should be that the switch would facilitate a more appropriate presentation of the financial reports. But in the given situation, the purpose of the proposal to switch to FIFO from LIFO for financial reporting is only to attract potential investments. This would be unethical, since, in an inflationary environment, using FIFO for inventory valuation would lead to overstatement of both net income and total assets, and hence can be misleading.

C. Switching to FIFO for taxes as well as financial reporting would be a better approach, as

• The company would not be doing something unlawful.
• Though inventory valuation increases substantially, the effect is mitigated by higher taxes. This has a moderating effect on net income.
• The good thing about switching to FIFO is that the ending inventory is valued at the most recent purchase prices, thereby approximating current market values.