Question

An executive in a merchandising company receives an annual bonus equal to 5% of net income. Historically, the company has calculated cost of goods sold and ending inventory using LIFO and has maintained 30,000 of units in inventory for the last ten years. The executive is recommending the company reduce the number of units in year-end inventory to 1,000. Over the ten-year period, the cost per unit of inventory has increased from $60 per unit to $110 per unit.

Respond to the following in a minimum of 175 words:

• In what ways would a reduction in inventory help the company?
• In what ways would the change from LIFO to FIFO help the executive personally?
• Would you approve the proposal to move from LIFO to FIFO? Why, or why not?

Answer 1

Answer-

The reduction in inventory can help the firm by reducing the working capital requirement and also inventory days on hand. Inventory is part of the current assets for the firm and hence it is used in calculation of working capital. Working capital is the difference between current assets and current liabilities. The lower the inventory the lower is the working capital needed and it’s financing costs.

Changing from LIFO to FIFO during price increasing time will increase the net income for the period. The reason being FIFO uses the latest lot purchased in inventory valuation and earlier lower price purchased lots are charged to cost of goods sold. The higher the net income it helps the executive personally since he gets annual bonus equal to 5% of net income.

The accounting method for inventory valuation is part of the accounting policy of the firm. The accounting policy should be applied consistently from one period to another period. The change in inventory valuation method has to be accounted retrospectively and all material disclosures should be made in notes to account. Hence the proposal to move from LIFO to FIFO can be approved as one time. It cannot be changed year on year basis.