Case Analysis for Summit Distribution

Q1. If you were Kathy Hutton, what would you do? Articulate the specific pros and cons of switching to FIFO that could underpin your decision to support your answer.

If I were Kathy Hutton, I would agree to switch to FIFO from a CEO’s perspective, because of three main benefits: First, giving the deterioration of macro economy and rising prices of inventories, a FIFO method will restore a stronger balance sheet position and higher earnings, and thus satisfies creditors covenants and avoid credit default and bankruptcy. The switch form LIFO to FIFO will lead to an increase of inventory value of $4,802,000 and an increase of earnings of 4.215,000, which will help improve financial ratios and meet Prime Trust Bank’s loan covenants. Second, Under FIFO, the cost of inventory will be more updated and accurate given an inflationary market situation or rising inventory prices scenario. The ending balance in inventory will be stated terms of an approximate current market value since the inventory which remains on the balance sheet will be the units that have been purchased most recently. Third, the switch to FIFO could secure Kathy Hutton (CEO)’s job and compensation, which motivates her to choose switching to FIFO if she behaviors for her own interests.

There are also some downsides of switching to FIFO. First, during inflationary times or periods of rising inventory prices, FIFO usually results in a higher income tax because of lower cost of goods sold. This is why LIFO is used during inflationary times to defer income tax payments. Therefore, switching to FIFO means the company has to give up potential tax benefits arising from using LIFO method. Second, FIFO requires an accurate booking and tracing system for the old inventories. It is sometimes costing and time consuming. Third, the switching to FIFO may raise inventors and analysts’ suspicion, and may cause drop of stock price. The company needs to fully disclose and carefully explain the reasons behind of the change.

Q2. If you were Dave Flanders, would you recommend staying with the LIFO-inventory-valuation method or switching to FIFO? Why? What are the cash-flow ramifications of the accounting change?

If I were Dave Flanders, I would also recommend switching to FIFO. First, a FIFO method will strengthen the balance sheet and increase earnings, and thus avoid credit default or possible bankruptcy. Second, under FIFO, the inventories can be measured approximately as market value (or replacement value). Third, from CFO’s perspective, avoiding default and having a good relationship with banks are CFO’s main responsibilities. Choosing FIFO can protect shareholders interests (thought it is temporary strategy), and the company will have more time to improve financial performance.

In terms of cash flow impact, the change to FIFO will affect cash flow from taxes only. During inflationary time, under FIFO, the cost of goods