Anna Norton, Chief Financial Officer of Specter Systems, Inc., was faced with two difficult analyses that needed her attention prior to her upcoming meeting with the company’s executive committee. First, the company’s president had asked her to examine the wisdom of switching from FIFO to LIFO for inventory accounting. The president had just returned from a four-week executive training seminar where he had been told that LIFO, while reducing profits, improved cash flows. He was curious about the effect a LIFO method would have on Specter’s finances.
The second decision concerned the lease of a new PBX (switchboard) and telecommunications system for the company. Specter could have either an operating lease or a capital lease, and Ms. Norton was to present the executive committee with her analysis of the options, including a recommended course of action.
Specter Systems, Inc. (Specter) manufactured heating and cooling systems for small office buildings and apartment complexes. The company had grown rapidly over the past 12 years, and, while not a leader in the field, enjoyed a comfortable share of the local market.
Specter both assembled and installed heating and cooling systems. It purchased component parts in large quantities several times a year from manufacturers within a 500 mile radius of its plant, and assembled the parts into systems that it then installed in buildings. Most of its work was with new construction, although it occasionally became involved with renovations.
Specter prided itself on its flexibility to meet a general contractor’s schedule demands. Many contractors experienced scheduling and delivery problems due to delays of various sorts, making flexibility one of Specter prime selling points. It frequently allowed Specter to win a contract despite a higher price than its competitors.
At any given time, Specter had a sizable raw material inventory, consisting of motors, housings, and sheet metal. It maintained a large raw materials inventory for two reasons. First, buying in large quantities allowed it to negotiate very favorable prices from its suppliers. Second, having its raw materials on hand meant that the company could assemble them quickly, if necessary, and get them to a job site much faster than any of its competitors. Indeed, it was this capability for rapid response that allowed Specter to compete on the basis of flexibility.
Despite the company’s volume purchases, the prices of most of its raw materials had been increasing rapidly during the past few months due to some shortages of components in the . . .
- Calculate the raw materials portion of Specter’s cost of goods sold for 2001 and 2002 if (a) they had continued to use FIFO to value their inventory and (b) if they had switched to LIFO.
- For the two years taken as a whole, which method would have resulted in reporting the larger net income? The larger cash balance?
- What would be the impact on the income statement, the balance sheet, and the cash account if Specter treated the lease as (a) an operating lease or (b) a capital lease?
- What should Ms. Norton recommend to the executive committee at the next meeting?