Karen's  retail  store sells apparel. The store is in the third year of operations and is struggling financially. Part of the problem is that the cost of inventory has increased. The store assigns inventory costs using LIFO. A loan agreement with the bank requires the store to maintain a certain profit margin. Karen is reviewing the current year financial statements and sees that results are not favorable. The only way that the store can meet the required profit margin is to change inventory costing from LIFO to FIFO. Karen redoes the financial statements using FIFO and submits them to the bank without disclosing the change. How is it that FIFO improves the profit of the store? Did Karen make a good ethical choice by changing to FIFO? Why or why not? What alternatives did Karen have in this situation?

Question
Asked Oct 29, 2019

Karen's  retail  store sells apparel. The store is in the third year of operations and is struggling financially. Part of the problem is that the cost of inventory has increased. The store assigns inventory costs using LIFO. A loan agreement with the bank requires the store to maintain a certain profit margin. Karen is reviewing the current year financial statements and sees that results are not favorable. The only way that the store can meet the required profit margin is to change inventory costing from LIFO to FIFO. Karen redoes the financial statements using FIFO and submits them to the bank without disclosing the change. How is it that FIFO improves the profit of the store? Did Karen make a good ethical choice by changing to FIFO? Why or why not? What alternatives did Karen have in this situation? 

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Step 1

Under LIFO method, the inventory received first are despatched first and the closing inventory consists of the oldest received inventory. FIFO is exactly opposite when in the goods received first is despatched first and the closing inventory consists of the inventory received last.  When the inventory prices are increasing, adopting LIFO method would inflate the cost of goods sold and reduce the closing inventory. However in FIFO, the closing inventory would be higher when prices are increasing and cost of goods sold would be lower than LIFO. When cost of goods sold is reduced, the profitability of the company is reduced and closing inventory is increased.

Step 2

Changing the method of valuation of inventory is permissible if the management feels that the valuation method is most suitable for presenting the  true and fair value of the books of accounts. However, when the change in method is done to fabr...

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