Golf Challenge Corp. is a retail sports store carrying golf apparel,and equipmen

Question

Golf Challenge Corp. is a retail sports store carrying golf apparel,and equipment. The store is at the end of its second year of operation and is struggling. A major problem is that its cost of inventory has continually increased in the past two years. In the first year of operations, the store assigned inventory costs using LIFO. A loan agreement the store has with its bank, its prime source of financing, requires the store to maintain a certain profit margin and current ratio. The store's owner is currently looking overGolf Challenge's preliminary financial statements for its second year. The number are not favorable. The only way the store originally decided on LIFO because of its tax advantage to the loan officer at the bank for the required bank review. The owner thankfully reflects on the available latitude in choosing the investory costing method. How does Golf Challenge's use of FIFO improve its net profit margin and current ration ? Is the action by Golf Challenge's ower ethical? Explain.

Explanation / Answer

If prices are always increasing there will in fact be a tax advantage using LIFO.

Why?: Using LIFO the cost of inventory that was most recently purchased will be the cost of goods sold even if the inventory actually sold was originally purchased at a lower cost. Therefore, higher cost of inventory = lower net income = lower profit margin = lower earning per share = lower taxes payable = tax advantage.

The issue with LIFO is that your ending inventory will valued (on the balance sheet) at a lower cost: by the cost of the beginning inventory (inventory first purchased) since LIFO makes the inventory last purchased = Cost of goods sold (therefore not in the ending inventory anymore). As a result, since the ending inventory will have a lower value, your current ration = (current assets/current liabilities) will be lower since your inventory (asset) is a lower value. In addition, the profit margin ratio (net profit after tax / sales) will be affected as well since the cost of good sold = inventory last purchased = higher cost = lower profit margin.

Taking the above into consideration, Using FIFO will have the reverse effect. The cost of goods sold will be calculated by using the cost of the inventory that was FIRST purchased (as opposed to Last purchased when using LIFO). Therefore, as indicated in the problem, since the inventory first purchased had a lower cost than the inventory last purchased, using FIFO will result in the following: lower cost of inventory = lower cost of goods sold = higher net income = higher profit margin = higher earning per share = higher taxes payable = no tax advantage.

Therefore, by using FIFO, your ending inventory will be valued (on the balance sheet) at a Higher cost: by the cost of the ending inventory (inventory most recently purchased) since FIFO makes the inventory earliest purchased = Cost of goods sold (therefore not in the ending inventory anymore leaving the inventory most recently purchased in the ending inventory). As a result, since your ending inventory will have a higher value, your current ratio = (current assets/current liabilities) will be higher since your inventory (asset) is a higher $ value. In addition, the profit margin ratio (net profit after tax / sales) will be affected as well since the cost of good sold = inventory earliest purchased = lower cost = higher profit margin.

The only drawback of FIFO is that when prices are increasing, there is not tax advantage.

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