Karen\'s Dress Boutique is a retail store that sells vintage apparel and accesso
ID: 2553783 • Letter: K
Question
Karen's Dress Boutique is a retail store that sells vintage apparel and accessories. The store is in its third year of operations and is struggling financially. Part of the problem is that the cost of inventory has increased dramatically over the past two years. The store assigns inventory costs using LIFO. A loan agreement with the bank requires the store to maintain a certain profit margin. Karen is reviewing the current year financial statements and sees that results are not favorable. The only way that the store can meet the required profit margin is to change inventory costing from LIFO to FIFO. Karen redoes the financial statements using FIFO and submits them to the bank without disclosing the change. 1. How is it that FIFO improves the profnt of the Dress Boutique? 2. Did Karen make an good ethical choice by changing to FIFO? Why or why not? 3. What alternative(s) did Karen have in this situation?Explanation / Answer
Sol-1. The first in, first out (FIFO) method of inventory valuation is a cost flow assumption that the first goods purchased are also the first goods sold. In most companies, this assumption closely matches with the actual flow of goods, and is therefore considered the most theoretically correct inventory valuation method.
In case of rising prices i.e. inflationary trend, under FIFO method the cost of the inventory purchased in the beginning of the period will be relatively lower as compared to inventory purchased near the end of the period. As FIFO method assumes inventory first to be received will be the first to be applied in production therefore, low cost material will be used in production. Due to this, cost of production will decline and relatively high cost material will be held as closing stock leading to increase in the value of closing stock.This in turn will increase the profits and gross profits will be higher.
2.You may find It is beneficial for your store's financial statements to change from one inventory cost method to another, whether due to the state of the economy or other reasons.Moving from the LIFO to FIFO method can reflect a larger inventory at the close of the year,it increase your store's income and the taxes you owe. Also, in order to maintain consistency in evaluating your operations, you may have to apply the new method to previous years' financial statements.
Accounting policies are principles, bases, conventions, rules and practices applied by an entity to portray the financial effects of business transactions and other events.
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.
3.There are three alternatives to valuing inventory -
(a) FIFO: Under FIFO, the cost of goods sold is based upon the cost of material bought earliest in the period, while the cost of inventory is based upon the cost of material bought later in the year. This results in inventory being valued close to current replacement cost. During periods of inflation, the use of FIFO will result in the lowest estimate of cost of goods sold among the three approaches, and the highest net income.
(b)LIFO: Under LIFO, the cost of goods sold is based upon the cost of material bought towards the end of the period, resulting in costs that closely approximate current costs. The inventory, however, is valued on the basis of the cost of materials bought earlier in the year. During periods of inflation, the use of LIFO will result in the highest estimate of cost of goods sold among the three approaches, and the lowest net income.
(c) Weighted Average: Under the weighted average approach, both inventory and the cost of goods sold are based upon the average cost of all units bought during the period. When inventory turns over rapidly this approach will more closely resemble FIFO than LIFO.
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