ACC 317 Module 7 Project Two Example

Keep FIFO or Switch? Inventory Cost Flow and Net Realizable Value at a Composite Hot Tub Manufacturer

[Student Name]

Southern New Hampshire University

ACC 317: Intermediate Accounting I

Project Two

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Keep FIFO or Switch? Inventory Cost Flow and Net Realizable Value at a Composite Hot Tub Manufacturer

Introduction

The hot tub manufacturer studied in this course uses FIFO for all inventory. Prices for acrylic sheet, resin and steel rose through the year, and the owners have asked whether switching to LIFO would lower taxes. At the same time, 38 tubs of a discontinued model sit in the warehouse at a cost that may exceed what they will sell for. This project compares FIFO and LIFO for the company's largest raw material, estimates the effect across all inventory, tests the discontinued tubs against what they can still fetch and recommends a course of action.

Acrylic Shell Data

Acrylic shells, formed in-house from purchased sheet, are tracked as units. The year's data are in Table 1.

Table 1. Acrylic Shell Units and Costs

FIFO and LIFO Compared

Under FIFO, the oldest costs go to cost of goods sold first. Under periodic LIFO, the newest costs of the year go first, and ending inventory carries the oldest costs.

Table 2. Cost of Goods Sold and Ending Inventory

LIFO raises cost of goods sold by $48,000, lowering pretax income by the same amount and income tax at 25 percent by $12,000. The $48,000 difference in ending inventory is the LIFO reserve for shells after one year.

Across all raw materials and parts, which total about $11.9 million at FIFO, the purchasing manager estimates price increases of 3 to 4 percent. A first-year LIFO reserve of about $415,000 is a reasonable midpoint, which would defer roughly $104,000 of federal and state income tax.

The Conformity Rule and Other Effects

The tax saving comes with a condition. The tax code's conformity requirement ties the two sets of books together: once LIFO is elected on the tax return, the statements handed to the bank and the family shareholders must report LIFO as well (Kieso et al., 2019). Reported net income would therefore fall by about $311,000 after tax in the first year, and inventory on the balance sheet would be lower by $415,000.

Those changes matter for this company. Under its loan agreement the company must keep current assets at no less than twice current liabilities; the ratio is now 2.22, and lowering inventory by $415,000, partly offset by about $104,000 less tax payable, would reduce it to about 2.20, still compliant but with less room. Earnings-based bonuses for managers would also fall unless the plan is amended. Investors and lenders can look through LIFO by using the disclosed LIFO reserve, and Guenther and Trombley (1994) found evidence that the market treats the LIFO reserve as part of firm value, but this company's users are a bank and family shareholders who read the statements as reported.

LIFO also adds complexity. Each year adds a new layer, and if inventory levels fall in a slow year, old low-cost layers are liquidated, raising taxable income in the year the company can least afford it. And as Module Six noted, IFRS prohibits LIFO. If the German acquirer completes its purchase, its results would reach the parent on a FIFO or average-cost basis, and keeping LIFO for tax would require separate records.

Net Realizable Value Test

Since the FASB simplified the rule in 2015, inventory carried at FIFO or average cost is tested only against net realizable value: what the goods should sell for, minus the predictable costs of finishing, selling and shipping them (Financial Accounting Standards Board, 2015). The company holds 38 completed tubs of a model discontinued in October, each costing $6,400.

Table 3. Net Realizable Value of Discontinued Tubs

The company should record a $17,100 loss, usually included in cost of goods sold, and carry the tubs at $226,100. Under GAAP the write-down cannot be reversed if clearance sales go better than expected; under IFRS it could be.

Recommendation

The company should stay on FIFO. The tax deferral from LIFO, about $104,000 in the first year, is real but modest, and it comes at the cost of lower reported income, a thinner covenant margin, added complexity and a conflict with the likely acquirer's reporting. If the acquisition does not proceed and price increases continue for several years, the question is worth revisiting, perhaps with dollar-value LIFO applied to raw materials only. In the meantime, the company should record the $17,100 write-down on discontinued tubs and review slow-moving models each quarter, so that inventory on the balance sheet stays at amounts the company can actually recover.

Two smaller steps would also help. First, the notes to the statements should disclose the cost flow method, the amount of the write-down and the reason for it, so that the bank can see that the gross margin includes a one-time clearance loss. Second, the controller should begin tracking an internal LIFO reserve for raw materials even while reporting FIFO. That figure costs little to maintain, shows the owners each year how much tax LIFO would have deferred and makes a future switch easier to evaluate if the acquisition falls through.

Conclusion

Rising costs make LIFO tempting: on shells alone it would raise cost of goods sold by $48,000, and across all inventory it could defer about $104,000 of tax. But the conformity rule, covenant headroom, layer liquidation risk and a possible IFRS parent outweigh that benefit for now. FIFO should remain, with a $17,100 write-down of discontinued tubs to net realizable value.

References

Financial Accounting Standards Board. (2015). Inventory (Topic 330): Simplifying the measurement of inventory (Accounting Standards Update No. 2015-11). Author.

Guenther, D. A., & Trombley, M. A. (1994). The "LIFO reserve" and the value of the firm: Theory and empirical evidence. Contemporary Accounting Research, 10(2), 433-452. https://doi.org/10.1111/j.1911-3846.1994.tb00401.x

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate accounting (17th ed.). Wiley.