You are currently working hard at your first job and hope to move up in the firm

Question

You are currently working hard at your first job and hope to move up in the firm. Periodically, you meet with some of your former classmates over lunch and discuss how your and their businesses and careers are doing. During one of these discussions, one of your former classmates mentions that the firm she is working for is doing poorly and may not show a profit for the current year. To make the financial statements look better, she recommended to the President of the firm that they switch their inventory costing method from LIFO to FIFO. By doing this, Cost of Goods Sold will decrease enough for the firm to show a small profit in the current year. This is more important than the slightly lower ending merchandise inventory. She also mentions that because the firm will be profitable after the switch, they will have to pay more income taxes than if they did not make the change. Despite the inventory valuation method used, they will have the same physical items in ending inventory. Your friend also explains that since the firm enjoys the tax advantages of LIFO, they can switch back next year when the business is more profitable. Since the firm that you work for is also experiencing temporary economic difficulties and expects next year to be much more profitable, she recommends that you make the same recommendation to the management of your firm and get the “pat on the back” and possible raise that may result from your excellent advise.

How is the switch reported on the financial statements (remember the Full Disclosure Principle)? Does making the switch serve the needs of the users of the financial statements? Explain.

Explanation / Answer

First, Change in inventory valuation method from LIFO to FIFO is mainly change in accounting policy of an entity.

Further, there is specific provision regarding change in accounting policies or accounting estimates in International Financial Reporting standards (IFRS).

It is fundamental accounting assumption that an entity will consistently follow the accounting policies for preparation of financial statement. But change in accounting policies is permitted by IFRS if:

However any changes in accounting policies must be disclosed in financial statement.

Note: Effect of change in accounting policy may be disclosed retrospectively, if it is practicable to determine the change and it should be adjusted through equity.

Disclosure related to change in accounting policy:

for each financial statement line item affected and

for basic & diluted EPS

Hence in our case, inventory valuation method change from LIFO to FIFO may be change in the following way (suppose not retrospective):

Note no… “The company has changes its inventory valuation method from last-in-first-out (LIFO) to first-in-first-out (FIFO) during the year reflecting the value of inventory of $.... by FIFO. If company would have continued the LIFO method then value of closing inventory would be $.... The figure of cost of sales decreased by $.... accordingly profit before tax (PBT) and tax thereon increased by $.... & $.... respectively.”

Does making the switch serve the needs of the users of the financial statements?

FIFO method is best practicable method assuming that oldest inventory doesn’t carry the value in the financial statement and closing inventory is valued at a cost closest to the current cost. Hence user will definitely expect the fair valuation of inventory in the financial statement.

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