Ethics Challenge

Golf Mart – retail sports store.

End of second year of operation and is struggling.

Cost of inventory continuously increased in past 2 years.

First year: LIFO used to assign cost to inventory because of tax advantage

Loan from bank sole source of financing: requires store to maintain profit margin and current ratio.

Considering change from LIFO to FIFO to meet bank’s expectation to maintain the financial ration as numbers are not favorable.

Owner now uses FIFO to recalculate ending inventory and submits to loan officer .

Change of inventory costing method: Is that an ethical choice?

1. How did the net profit margin and current ratio improve under FIFO?

2. Is this method ethical?

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1. FIFO assumes costs flow in the order incurred and LIFO assumes costs flow in the reverse order occurred. Cost flow assumptions can heavily impact gross profit and inventory numbers.

Gross profit = nets sales – cost of goods sold.

Current ratio = current assets/current liabilities

FIFO assigns the lowest amount to cost of goods sold- yielding the highest gross profit and net income whereas LIFO assigns the highest amount to cost of goods sold- yielding the lowest gross profit and net income which also yield a temporary tax advantage by postponing payment of some income tax. That is why in case of Golf Mart, owner inititally used LIFO to take advantage of cost benefit. But when he changed to FIFO, he assigned lowest amount of COGS, thus showing higher net profit margin.

Effect on current ratio: As FIFO increases value of the inventory, it increases retained earnings and in turn current assets to current liabilities ratio will show up higher than what it is when LIFO is used. This would be give an overstated value which can be mistaken.

2. This is not an ethical apporoach by the owner. The IRS mandates that if LIFO has been used for tax benefit purpose, the same method should be stuck to while...