Clair Coolage is the chief accountant for a sales company called Far Eastern Imports. The company has been highly successful and is trying to increase its capital base by attracting new investors. The company operates in an inflationary environment and has been using the LIFO inventory cost flow method to minimize its net earnings and thereby reduce its income taxes. Katie Bailey, the vice president of finance, asked Coolage to estimate the change in net earnings that would occur if the company switched to FIFO. After reviewing the company’s books, Coolage estimated that pretax income would increase by $1,200,000 if the company adopted the FIFO cost flow method. However, the switch would result in approximately $400,000 of additional taxes. The overall effect would result in an increase of $800,000 in net earnings. Bailey told Coolage to avoid the additional taxes by preparing the tax return on a LIFO basis but to prepare a set of statements on a FIFO basis to be distributed to potential investors.

Required
a. Comment on the legal and ethical implications of Bailey’s decision.
b. How will the switch to FIFO affect Far Eastern’s balance sheet?
c. If Bailey reconsiders and makes a decision to switch to FIFO for tax purposes as well as financial reporting purposes, net income will increase by $800,000. Comment on the wisdom of paying $400,000 in income taxes to obtain an additional $800,000 of net income.