Ankita Aggarwal PGP2011517 SECTION B

Merrimack Tractors and Mowers, Inc.: LIFO or FIFO?

Ricardo Rick Martino, the President and Chief Operating Officer of Merrimack Tractors and Mowers, Inc., was faced with a situation where he had to make up his minds whether to change the current inventory accounting system. Originally Mowers were manufactured and assembled in workshop and factory in Nashua. However, by 2008 company was buying all of its tractors and machines; manufactured to its specifications, from a contract manufacturer in China, and was operating almost exclusively as a machine-and-parts designer and distributor. About 25% of the shares of the company were held by the members of the Martino family. However, there were a number of factors due to which the projected net income of 2008 was less than that of 2007 and earlier years. Its strategy of outsourcing to China due to the following reasons: a) Beijing Olympic Games increased the labour costs in the Chinese Market b) Chinese currency has appreciated against the U.S. Dollar c) A rise in oil prices had also increased the costs of shipping finished mowers to the United States Rick Martino was facing tremendous pressure from outside directors to keep earnings growing or face the possibility of being replaced by professional manager who was not a Martino family member. Company management dismissed the idea of re-establishing manufacturing operations in Nashua, as there is no way of doing so before the end of 2008 or even 2009 if the companys profit trends and growth were to be maintained. Changing the Method of Accounting: The company controller, James Colburn, gave the idea of that inventory accounting be changed to FIFO assumption This could report a higher income figure in 2008 than it had reported for 2007 However increase in income will come with increase in taxes payable

Ankita Aggarwal PGP2011517 SECTION B

QUESTION OF DISCUSSION How does the change in accounting methods for inventory have an effect on reported income?

The company has been following LIFO method for the last 27 years, i.e. since its incorporation. Because of the selection of LIFO there was under valuation of stock and hence over valuation of Cost of Goods sold. This resulted in a cumulative undervaluation of $ 5 million over the years. This will lead to cumulative increase in the value of closing inventory.

The company decided to change its inventory accounting method due to the following reasons: 1. Increase the profit by reduction in valuation of Cost of Goods Sold.

2. Inventory valuation will increase and hence the cost of goods sold will decrease. This will lead to a higher projection of profit of $ 5.5 million. The only drawback of this method is that they will have to pay an extra tax of $ 2 million. The effect of changes in inventory of the past period has to reflect in the current year-2008. That is why there is a drastic increase in the revenue of the current year.

According to the 2007 data, the Closing inventory valuation by FIFO method is 19000 Therefore current year Opening inventory value = 19000

If FIFO method is followed in 2008 also, then Cost of goods sold[Amount in $000] Beginning inventory Purchases, Quarter 1 Purchases, Quarter 2 Purchases, Quarter 3 Purchases, Quarter 4 Total 56000 15000 units @ 1266.67 =19000 10000 units @ 1400 =14000 10000 units @ 1500 =15000 5000 units @ 1600 =8000 5000 units @ 1600 =8000 10000 units @ 1700 =17000 25000 Closing Inventory[Amount in $000]

Ankita Aggarwal PGP2011517 SECTION B If LIFO method is followed in 2008

Cost of goods sold[Amount in $000] Beginning inventory Purchases, Quarter 1 Purchases, Quarter 2 Purchases, Quarter 3 Purchases, Quarter 4 Total 10000 units @ 1400 =14000 10000 units @1500 =15000 10000 units @ 1600 = 16000 10000 units @ 1700 = 17000 62000

Closing Inventory[Amount in $000] 15000 units @ 900 = 13500 13500

Change in profit due to change in inventory valuation = Difference in the cost of goods sold, i.e. (Or) Difference in the closing inventory, i.e. Here 5500 is the last years LIFO adjustment 62000- 56000 = 6000 25000-13500-5500=6000

Increase in profit due to change in accounting method from LIFO to FIFO for reel mowers = $6,000,000