Inventory Valuation Improving Net Profit Margin & Ratio
The use of the FIFO method for inventory valuation improves the net profit margin and current ratio because of the following features of the FIFO method:
- Under the FIFO method, the prices at which units were most recently purchased are assigned to ending inventory. As a result, ending inventory valued under FIFO most closely approximates the current cost.
- In a period of rising prices, the FIFO method will result in the highest value for ending inventory. On the other hand, the use of the LIFO method of inventory valuation will result in the lowest value for ending inventory.
- In periods of rising prices, this method will also result in the lowest amount of cost of sales and thus results in the highest amounts for gross profits and net income. Whereas the LIFO method results in the highest amount of cost of sales and the lowest amount of gross profit and net income.
Change in accounting principle is not unethical, provided the disclosure of such change in the income, and net assets are properly disclosed in the notes to the financial statements. From this point of view, the owner of Golf Away Corporation did the right thing to change the method of valuation of inventory from LIFO to FIFO, presumably under inflationary periods. Secondly, there was no agreement with a bank whereby Golf Away was barred from changing the inventory valuation method. The use of FIFO by Golf Away to improve net profit margins and current ratio is certainly not unethical.