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 i ...