Inventory Method Change, Damaged Stock and a Bank Covenant
A small manufacturing company uses a periodic inventory system and follows the accounting period 1 April to 31 March. It began the year with 400 units valued at ₹180 each. During the year it purchased 600 units at ₹200 and 500 units at ₹220. It sold 1,100 units. A physical count at year-end shows 400 units on hand; 20 of these are damaged and can be sold only as scrap for ₹50 each. The accountant has always used FIFO but proposes switching to the weighted-average method because 'it smooths profit'. The company's bank covenant requires a current ratio of at least 1.5, and the income-tax officer is expected to scrutinise any method change. The accountant asks whether the switch is permissible, what the effect on gross profit and tax will be, and how the damaged units should be treated.
1. Compute closing inventory and cost of goods sold under FIFO and weighted-average cost, showing the treatment of damaged units.
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Goods available: 400 + 600 + 500 = 1,500 units; cost = 72,000 + 120,000 + 110,000 = ₹302,000. Under FIFO, COGS for 1,100 units = 400 × 180 + 600 × 200 + 100 × 220 = 72,000 + 120,000 + 22,000 = ₹214,000. Closing stock before damage = 400 × 220 = ₹88,000. The 20 damaged units have cost 20 × 220 = ₹4,400 but NRV = 20 × 50 = ₹1,000, so write down ₹3,400. Good units: 380 × 220 = ₹83,600. Closing inventory net = 83,600 + 1,000 = ₹84,600; total COGS including write-down = ₹217,400. Under weighted average, cost per unit = 302,000/1,500 = ₹201.333. COGS = 1,100 × 201.333 = ₹221,466.67. Closing stock before damage = 400 × 201.333 = ₹80,533.33. Damaged units cost ₹4,026.67, NRV ₹1,000, write-down ₹3,026.67. Good units = 380 × 201.333 = ₹76,506.67. Closing inventory net = ₹77,506.67; total COGS = ₹224,493.33. FIFO therefore reports lower COGS and higher gross profit by about ₹7,093.
2. Advise whether the proposed change is permissible and how it affects comparability, tax and the bank covenant.
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Both FIFO and weighted average are acceptable cost formulas for inventories, so the method itself is not prohibited. The problem is the stated motive and the lack of a faithful-representation rationale. A change in accounting policy must be justified, applied consistently and disclosed with its effect; retrospective restatement is normally required if the change is material. 'Smoothing profit' is not a valid justification because it suggests an intention to manage reported earnings rather than to improve reliability. For tax, the position depends on the tax rules and on whether the same valuation basis is accepted; the accountant should not assume that a book change automatically reduces taxable income. For the bank covenant, weighted average gives lower closing inventory and therefore a lower current ratio, which could breach the 1.5 threshold. The accountant should compute the covenant effect before switching and discuss it with management and the lender.
3. What should the accountant do about the 20 damaged units and the 'smoothing profit' rationale?
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The damaged units must be measured at the lower of cost and net realisable value. Their carrying amount should be written down to ₹1,000, with the loss recognised in profit or loss, and the fact should be disclosed if material. The write-down should not be buried inside the normal cost formula. On the rationale, the accountant should reject profit smoothing as a basis for the change. The method should be selected because it gives a more faithful representation of the cost flow and because it can be applied consistently. The accountant should document the reasons, compute the effect on gross profit, tax and the covenant, and disclose the change. If the only reason for the switch is to improve a ratio or reduce tax, the change should not be made.