You are in your second year as an auditor with Jones and Johnson, a regional CPA

Question

You are in your second year as an auditor with Jones and Johnson, a regional CPA firm. One of the firm’s long-time clients is ABC Corporation, a national company involved in the manufacturing, marketing, and sales of hydraulic devices used in specialized manufacturing applications. Early in this year’s audit, you discover that ABC Corporation has changed its method of determining inventory from LIFO to FIFO. Your client’s explanation is that FIFO is consistent with the method used by some other companies in the industry. Upon further investigation, you discover an executive stock option plan whose terms call for a significant increase in the shares available to executives if net income this year exceeds $44 million. Some quick calculations convince you that without the change in inventory methods, the target will not be reached; with the change, it will.

Required:

Do you perceive an ethical dilemma? What would be the likely impact of following the controller’s suggestions? Who would benefit? Who would be injured?

Explanation / Answer

Generally,the Companies use the Inventory method that best fits their Individual Circumstances.However,this freeedom of choice cannot be used simply if the goal is to report higher income.

The FIFO method does obviously carry a lot of advantages, of which the major ones include-:

1.Easy application of Method

2.The assumed flow of cost corresponds with the normal physical flow of goods.

3.No manipulation of Income is possbile if the method is applied consistenly.

4.Lastly,The Balance Sheet amount for Inventory is likely to approximate the Current market value.

But, there are disadvantages to the FIFO method as well. Even though the method does increase the revenue of the company, but this also brings the possibility of recognition of Paper profits only and also adds up to the higher tax burden.

If a company wants to match the sales with current cost of goods sold and reduce its Tax burden, it would use LIFO method.

The circumstances mentioned in the question will inargubly increase the companies revenues thereby increasing its share values.But, if this change in method of inventory valuation is not consistant with the actual sale practice that the comapny is following, then in the long run it would be dangerous for the company as this might bring out the possibility that the actual profits and the book profits might be entirely differing.

So, to conclude one would suggest that if there is a change in the method of Inventory, then the change must be consistent and must be followed indespensively in the years to come. Also, if we switch the Inventory methods, we must reinstate all years prensented on the financial statements using the same method.

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