Your friend D. Vadar has become the Accounting Czar of the great country, Endor. His first problem

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Question:

Your friend D. Vadar has become the "Accounting Czar" of the great country, Endor. His first problem deals with the accounting of inventory. Endor, has used the direct costing method for inventory and has allowed LIFO, average cost or FIFO. Furthermore, Endor has never considered the idea of lower of cost or market. Vadar is considering inventory alternatives for financial reporting.

Under current tax policies in Endor, companies can use lifo for taxes, however; if they choose lifo for taxes they MUST use LIFO for external reporting. Jabba-the-Hut the Secretary of the Treasury has informed Vadar that the treasury will NOT change this policy, so that any change removing lifo from financial reporting will automatically remove it from the tax returns.

H. Solo, a highly respected entrepreneur has suggested to Vadar that Endor should switch its inventory accounting from direct to absorption. He noted that both IFRS and US GAAP require this method for external reporting. He believes that comparability of Endor's statements with those of these two governing bodies would only help attract foreign investors. He also argues that absorption forces companies to look at the long-run costs of production. Furthermore, H. Solo wants Endor to keep all 3 methods (especially LIFO) so that he pays less in taxes which gives him more to invest in his business. Han also wants to use all 3 methods for lower of cost or market which will most likely give him a smaller ending inventory number with a bigger write-off and thus pay less in taxes.

Ms. Leah, head of the major union in Endor strongly opposes the switch to absorption costing. She is concerned that companies will produce more than they sell in the early years of operations thus reporting higher income (or more likely smaller losses) and then when established produce less than sales which reduces income which reduces the profit sharing granted to the well deserving union employees. Furthermore, Ms. Leah also points out that direct costing does not allow income manipulation and by showing inventory at the cost of making the next one (variable cost) it encourages better decision making with respect to special orders. It would also make our inventory with a lower cost which should encourage foreign investment and with that more union jobs. Leah also wants Endor to require the use of FIFO for inventory costing. With rising prices, this method shows the lowest cost of goods sold along with the highest income and balance sheet. Having companies report higher income and strong balance sheets would only help her in her pursuit for increased wages for the employees. Leah recognizes that companies may have to write inventory down if prices decline, but she wants Endor to follow the IFRS approach of ONLY looking at net realizable value for this procedure.

Professor Obi-Won wants Endor to ONLY allow FIFO as the inventory method because of his high regard for ethics. Obi-Won recognizes that both average and LIFO inventory can be manipulated by management. FIFO cannot and thus it gives a more 'accurate' picture of the performance of the company. Furthermore, with his love of ethical behavior, Obi-Won wants companies to only use direct costing. Obi-Won doesn't like the fact the absorption costing allows income manipulation through the production process. With absorption costing, increasing production increases income with no change in sales. . Obi-Won opposes ANY write-down of inventory. Since profits are only shown when the merchandise is sold losses should also wait for the sale. In addition, Obi-Won is afraid that companies will vendor shop or use artificial selling prices to show the inventory at the value they want it shown at. If companies want to reduce this year's income (and thus increase next year's income) they simply put an item 'on sale' thus reducing its net realizable value and magically show an extra expense and lower income. Since this inventory now has a lower value, when it is sold next period income is inflated.

REQUIRED:

Write a memo to your friend d. Vadar giving your suggestions with respect to inventory. Your memo should discuss whether endor should allow direct and/or absorption costing; inventory costing methods (FIFO only or FIFO plus other methods: note, if you are removing LIFO discuss the tax implications) and whether (and how) lower of cost or market should be incorporated into the statements of endorian companies. Make sure your memo addresses the concerns of each of these distinguished citizens of endor.