Question

Respond to the following questions:

1. Is Golf Challenge's change from LIFO to FIFO ethical? Consider whether such a change would be misleading to investors.
2. Under what type of circumstance should a company be permitted to change inventory costing methods?  

Feel free to share a personal experience with the class.

Hint: The Ethics Challenge assumes inventory costs are rising. As you learned in the chapter, FIFO results in the higher cost of the most recent inventory purchases remaining on the balance sheet, in the inventory asset account. The lower cost of the earliest inventory purchases are recorded as expense in cost of sales on the income statement. Under LIFO, however, the higher cost of the most recent inventory purchases are recorded as expense, reducing net income. No wonder a switch from LIFO to FIFO is beneficial for Golf Challenge!

Answer 1

The FIFO and LIFO valuation methods are examples of accounting principles that measure the value of inventory. FIFO and LIFO value inventory very differently, so the same inventory can have different balances depending on the method. Therefore, switching from FIFO to LIFO can have a significant impact on all financial statements. A business switching from FIFO to LIFO will need to consider whether it needs to restate its financial data for prior years to reflect the new method or only apply the new method to the current and future years.

What method is used depends on the circumstances. However, the business will always have to disclose the change in the footnotes to the financial statements.

Inventory Valuation Methods

Inventory is an asset that measures the amount of goods that are available for sale. As inventory is produced or purchased, the value of each new good is added to inventory. The value of each item is determined by the total cost to either manufacture or purchase the good. When an item is sold, it increases cost of goods sold.

Cost of goods sold is calculated by taking beginning inventory, adding all inventory purchases for the financial period in question, and then subtracting the ending inventory. Cost of goods sold is then subtracted from revenues to help determine the business’s profit for the year. Valuation methods are used to calculate the beginning and ending balances of inventory.

FIFO vs. LIFO

FIFO stands for first-in, first-out. Under this method, items that go into inventory first are considered to be the items that are sold first for valuation purposes. LIFO stands for last-in, first-out. This valuation method assumes that the latest inventory items are the first sold.

To illustrate the difference in methods, assume that you started your business this year with no inventory and acquired three lots of goods during the financial year. The first 1,000 units cost $3, the second lot of 1,000 cost $2 and the last lot cost $3. Prior to this year, you had no inventory. If you sold 2,500 units, your ending inventory balance per LIFO would be $1,500 and $500 under FIFO.

Retrospective vs. Prospective

Financial statements generally show several years of activity to allow investors to evaluate the business over time. Normally under generally accepted accounting principles (GAAP), when there is a shift in accounting principles the asset balances and income amounts for the prior years are adjusted to what they would have been if they had been calculated under the new standard. However, adjusting prior-year inventory balances to be based on a LIFO calculation is generally impractical.

Impractical for GAAP purposes means that it is impossible for the business to make inventory adjustments for prior years based on independently substantiated criteria and objective information about past market and managerial conditions. Because of this impracticality, businesses are generally not required to adjust prior-year inventory balances. If prior-year inventory balances can be easily adjusted, those amounts should be altered to reflect the new valuation method.

Change in Inventory Valuation Method Disclosure Requirements

Financial statements are required to disclose all significant changes in accounting policies. This is done to comply with accounting’s full-disclosure principle. As a result, the business’s financial statements would need to inform prospective investors that there was a shift from LIFO to FIFO as well as detail what the effect of that shift could be.

Federal Tax Changes

If you plan on changing from LIFO to FIFO for tax purposes, you are required to complete Form with IRS and comply with all requirements listed in the form. You must file the form with the return for the first tax year you plan on using FIFO. Switching to FIFO is irrevocable unless you gain permission from the IRS to switch to another method.