CASE- Inventory & distribution management

Introduction

It was late Wednesday afternoon and Sarah Metcalfe was sitting in her office reviewing the inventory valuation on the company balance sheet. She believed it was understated and the figure was meaningless since the company had adopted a Last in First out (LIFO) Inventory valuation.

Background

Eastern Fine China president Sarah Metcalfe had initially agreed with her accountant rationale for adoption of the LIFO method of inventory valuation as it would influence net income and reduce taxes. Currently though, Sarah is discounting the fundamental reason for the acceptance of the method as she feels it does not reflect current prices on the balance sheet.

Eastern is a growth company, producing and selling fine quality china and stemware in Canada and exports 25% of its production to Western Europe. Due to steady expansion and the company policy of maintaining considerable levels of safety stock, especially in raw materials, the inventory accounts are steadily increasing. Coincidental with the total dollar value increases in inventory is an undervaluation of current assets. Metcalfe felt that the enormous increases in the fine china industry were to blame for this.

Besides the inflationary effects on the inventory accounts Metcalfe was concerned with the obsolete stock still being carried in inventory. The obsolete stock was due to discontinued lines that are still being carried in the inventory valuation. The discontinued lines inventory is used to fill replacement orders, but at a discounted rate which makes their existence and relative market value impacts the inventory valuation on the balance sheet which makes Sarah concerned even more.

Eastern Fine China has an additional complication, the distrust between management and stockholders. The major stockholders in the company feel that management is manipulating net income so that it decreases the distributable earnings. They also feel that management is manipulating the cost of goods sold and are also suspicious that net decrease in income from foreign sales. The major stockholders are openly disputing management’s claim the decrease in foreign sales income is attributed to the devaluation of the Canadian dollar.

Since these problems had arose, Sarah had been contemplating a change in the method of valuing inventory. Sarah recognized for financial reasons that The Canadian Revenue Agency (CRA) accepts LIFO as a valuation almost without qualification. She understood the agency would not allow an inventory method based on replacement costs for reporting purposes, but would allow it for internal use. Sarah also knew that Eastern would have to undergo federal “red tape” to make an inventory valuation change, and in practice it could only be done once.

Still, Sarah has asked her accounting and tax manager to check the ramifications of reversing the LIFO decision. Metcalfe wants to adopt a Generally Accepted Accounting Practice (GAAP) that is more conservative, feeling that if the company was to switch to First in First out (FIFO) the balance sheet would reflect current prices, but there would be poorer matching of current costs with revenues on the income statement. Because Sarah wanted to have both a realistic current asset account and theoretically close match between costs and revues she is suggesting that Eastern look at either an average cost method or a specific cost method. In her review and pending analysis she does not want to neglect implementation problems.

Questions to Consider

1. Considering the operating environment at Eastern and Sarah Metcalfe’s concerns, analyze the suitability of the various inventory valuation methods mentioned?

2. What points must be kept in mind when choosing a valuation method for Eastern?

3. What qualitative factors could impact on the choice?