Question

Sound Electronics is a retail electronics store carrying home theater equipment. The store is at the end of its fifth year of operations and is struggling. A major problem is that its cost of inventory has continually increased for the past three years. In the first year of operations, the store decided to assign inventory costs using LIFO.

A loan agreement the store has with its bank, requires the store to maintain a certain profit margin and current ratio. The store’s owner is currently looking over Sound Electronics’ financial statements for its fifth 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 asks the accountant to recalculate ending inventory using FIFO and submit those numbers and statements to the loan officer at the bank for the required bank review.

How would the use of FIFO improve Sound Electronics' profit margin and current ratio? Is the request by Sound Electronics' owner ethical? How should the accountant proceed? Explain. Justify your answer by referencing accounting principles and/or concepts.

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 because 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. Higher current assets are a sign of good liquidity in business and favorable to the business.

The action of owner to show better profitablity and current ratio is not ethical in the given case. The method of inventory valuation followed by the firm 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 of the firm. Hence a onetime change of inventory method can be done as per principles of accounting by making suitable disclosures in notes to financial statements. It cannot be changed year on year basis.