Question

Earnings Management You are the accountant for the South-Western Division of HiValue Grocery Stores. Late in December, Kelly Cholak, the CEO of the division, stops by your office and says, “I have a couple of questions. I recently received a report from the head office on the first 11 months of the year. We are not doing as well as we budgeted, and they are not happy with the gross profit we have earned. But the good news is that I just got off the phone with a big supplier who has excess inventory and could sell us enough of their products to last us three months. Then I remembered we have a perpetual inventory system and that you use that funny LIFO inventory method where you play with such confusing numbers. Will the purchase increase cost of goods sold, because that would only make us look worse? Alternatively I thought we might be able to either switch to the FIFO method OR I thought that we could delay this purchase until after January 1, and we would recognize some of those profits from liquidation of inventory and make ourselves look good for the year’s results. Give these issues some thought and let’s have a drink after work today to discuss them.” Required: From financial reporting objectives of financial reporting, how would you reply to Kelly?

Answer 1

Answer to Kevin Kelly's Questions:
Sr.No.	Particulars
1.	As explained in the question, company is currently following LIFO inventory method. In the given case, if the entity makes purchases right now i.e. before year end, a) it will sell some of the inventory recently bought, or b) all of the inventory bought in this purchase gets sold. In both the cases inventory sold will be from latest stock and will not be there in closing stock. This means that inventory bought and sold will have both dr. and cr. impact and therefore it will not affect cost of goods sold. In case where entity is not able to sell all the units bought in latest purchases, units remaining in stock will be valued at cost or net realisable value whichever is lower, again this will not impact cost of goods sold because all the inventory bought will be reflected in closing stock. This will not increase cost of goods sold.
2.	Switching to FIFO method or delaying purchases: If the entity plans to switch to FIFO method, cost of goods sold will get impacted. Because in the FIFO convention, it is assumed that inventory bought first is sold first and inventory bought latest is in stock. If the cost of goods bought in latest purchase bill is higher and these goods are in stock, this will reduce cost of goods sold. On the contrary, if the cost of goods bought in latest is lower and these goods are in stock, this will increase cost of goods sold.
3.	If the entity switches to FIFO method and simulataneously delays the purchase, it will not impact the cost of goods sold. Because the latest bought in goods will come in closing stock after period end and value of inventory will be determined by already purchased goods. This will not affect the cost of goods sold for current period end.
Conclusion:	Following LIFO method will not increase cost of goods sold. On the other hand following FIFO method will either reduce or increase cost of goods sold depending on purchase price of latest lot. If the entity follows FIFO method and delays the purchase of latest lot it will not impact cost of goods sold.