ETHICS CHALLENGE

EC $6-1$

Diversion Inc. is a retail sports store carrying primarily women's golf apparel and equipment. The store is at the end of its second year of operations and, as new businesses often do$,$ is struggling a bit to be profitable. The cost of inventory items has increased just in the short time the store has been in business.

In the first year of operations the store accounted for inventory costs using the moving weighted average method. A loan agreement the store has with Dollar Bank, its prime source of financing, requires that the store maintain a certain gross profit and current ratio.

$501$

CHAPTER $6$ Inventory Costing and Valuation

The store's owner, Cindy Foor, is looking over Diversion's annual financial statements after year$-$end inventory has been taken. The numbers are not very favourable and the only way the store can meet the required financial ratios agreed upon with the bank is to change from the moving weighted average to the FIFO method of inventory.

Cindy originally decided upon moving weighted average for inventory costing because she felt that moving weighted average yielded a better matching of costs to revenues. Cindy recalculates the ending inventory using FIFO and submits her income statement and balance sheet to the loan officer at the bank for the required bank review of the loan.

As Cindy mails the financial statements to the bank, she gratefully reflects on the latitude she has as manager in choosing an inventory costing method.

Required

Why does Diversion's use of FIFO improve the gross profit ratio and current ratio?

Is the action by Diversion's owner ethical?