Summit Distributor Case Study
1. If you were Kathy Hutton, what would you do?
If I was Kathy Hutton, I would have agreed with Dave Flander’s recomendation to switch from LIFO to FIFO inventory valuation method for the following reasons:
Switching to FIFO would increase the values of the income being reported. The higher earnings would protect Summit Distributors from violating the financial covenants with the bank and maintain a net worth of above 12 million, and thus avoid bankruptcy. Switching to FIFO would increase the value of inventory by $4,802,000 and earnings by $4,215,000 which will increase the company’s taxable income. A good number on the balance sheet would also help maintain a good position in the market. The downside is that, FIFO …show more content…
Refundable taxes would decline by $825,000 and deferred taxes would increase by only $238,000. Switching to FIFO in financial reports would require the same switch in the company's income tax returns (including amendments to tax returns in earlier years) and would result in less of a loss than LIFO. The current refund would be $825,000 less under FIFO than it was forecasted to be under LIFO.
3. If there were no cash-flow consequences associated with the accounting change, would you change your answers to questions 1 or 2?
Even If there were no cash-flow consequences, I would still probably switch to FIFO. Under FIFO, the gross profits will be higher and the cost of inventory will be more accurate given an inflationary market situation with rising inventory prices. The balance sheet will report the ending inventory at an amount that is about the same as its current replacement cost. FIFO will also result in a change in financial reports. Financial reports would require the same switch in the company's income tax returns (including amendments to tax returns in earlier years) and would thus result in less of a loss than LIFO.
4. How does the decision facing Kathy Hutton impact Summit Distributors' other constituencies, such as Prime Trust Bank, shareholders, auditors, and the company's internal financial reporting …show more content…
Summit would have a chance to recover and continue to make all payments to Prime Trust. With the implementation of FIFO in place, there would be an improvement in the balance sheet which would keep shareholders happy (given the economic condition in the U.S., a smaller loss is better than a major one) and this would avoid credit default or possible bankruptcy. FIFO can protect shareholder’s interests through as a temporary strategy.
Considering that the company switched from FIFO to LIFO just a few years back and is now switching to FIFO again may raise some eyebrows. However in this case, if it is being done in accordance with GAAP there should not be any major problems. The internal financial group will need to revert to the accounting systems prior to the switch to LIFO again and that could be a