Question

Management of the Singer Company is currently considering the possibility of changing from the FIFO method to the LIFO method of inventory valuation for income tax and financial reporting purposes. The company’s president, Diane Singer, is concerned that using LIFO will tend to distort the company’s balance sheet over time. She believes that the difference between the current cost of the company’s inventory and the reported LIFO valuation will tend to grow larger each year, and that the company’s reported LIFO inventory valuation will be progressively understated in relation to current cost. Singer Company relies heavily on short-term bank credit, and Ms. Singer feels that the company’s bankers will tend to downgrade the company’s short-term debt-paying ability if a switch to LIFO is made.

Required:

1.	Discuss the major factors that, over time, will affect the magnitude of the difference between the current cost of the company’s inventory and the reported LIFO amount.
2.	Evaluate the merit of Ms. Singer’s concern that bankers may be misled by the company’s balance sheet if LIFO is used.

Answer 1

1. The major factors which will affect the magnitude of the difference between the current cost of the company's inventory and the reported LIFO amount are:

-LIFO method refers to the last in first out method of valuation.

- While using the LIFO method, inventory is always valued at the earliest prices.

-Generally, due to inflation, the price of the products tend to increase. In such a scenario, if LIFO method is used there will be a large gap which will be created in inventory valuation due to the growing difference between the current price at which material is purchased and the earliest price at which inventory shall be valued.

2. Ms. Singer's concern that the bankers may be misled by the company's balance sheet if LIFO is used is well found. Banker's generally use the current ratio to assess a company's ability to service its debt. Current ratio is calculated by using the following formula:

Current assets/ Current liabilitites

Since inventory valuation will be lower when LIFO will be used, the current assets will be lower resulting in a lower current ratio.This will lead to the banker's questioning the company's short term debt paying ability.