Summit Distributors was in danger of violating loan covenants because of slow economic activity and forecasted losses and was faced with a choice. Changing the inventory valuation method from LIFO to FIFO would avoid default but would require higher future income taxes. Not changing could mean default on covenants, renegotiating loan terms at less favorable interest rates, or possible bankruptcy. Therefor even if we assumed no cash- flow consequences associated with the change, the answer would still be the same. The switch would prevent an unnecessary default on the bank loan if Prime Trust bank refuses to rework the loan covenants. The loan covenant of interest is tangible net worth, which the bank has set at a minimum of $12 million. Without the switch, the LIFO method would report a tangible net worth of $9,828,000, which would violate this loan covenant. Under the FIFO method, the tangible net worth would increase by $4,215,000, and would yield a total of $14,043,000.
The decision to change to FIFO would impact three main groups: Prime Trust Bank, shareholders, and auditors. The primary impact on Prime Trust Bank would be that Summit would not default on the loan in 1992. According to Ms. Hutton’s strong future economic predictions, Summit would have a chance to recover and continue to make all payments to Prime Trust. Furthermore, the inventory revaluation impacts Prime Trust because the value of inventory would increase by $4,802,000. Based on the loan covenant, the loan outstanding balance would increase to the point of 80% of accounts receivable and 50% of inventory. These statistics mean that Summit can borrow an additional $2,401,000 from Prime Trust in the coming year. This inventory valuation change would have both positive and negative impacts exist for shareholders. Positive impacts would include an increase in retained earnings ($4,215,000) and avoidance of bankruptcy (assuming Prime Trust Bank would not rework the loan covenants), which...
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