Kathy Hutton, chief executive officer of Summit Distributors, was concerned with the poor economic outlook for the coming year. Continued deterioration of the economy could

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Kathy  Hutton,  chief  executive  officer  of  Summit  Distributors,  was  concerned  with  the  poor  economic  outlook  for  the  coming  year.    Continued  deterioration  of  the  economy  could  place  the  future viability of Summit Distributors in jeopardy.  After a decade of steady growth in earnings per share (EPS), the company had experienced a 32% decline in EPS for 1990 and a 40% decline for 1991 (see Exhibit  1).    Furthermore,  the  1992  operating  budget  forecasted  the  company's  first  loss  in  over  two decades.   Because  of  the  deterioration  of  general  economic  conditions  in  the  United  States  and  elsewhere,  Summit  began  a  program  of  selling,  liquidating,  or  otherwise  disposing  of  unprofitable  domestic  and  foreign  operations.    In  the  fiscal  year  1992,  a  provision  for  losses  of  $3.7  million  was  expected  for  disposal  and  restructuring  of  domestic  operations,  and  a  provision  for  losses  of  $2.4  million was expected for disposal of foreign operations.  The forecasted losses would cause retained earnings to decline from $11.6 million in 1991 to $5.6 million by the end of 1992. Summit  Distributors  was  in  danger  of  default  on  financial  covenants  in  its  loan  agreement  with  Prime  Trust  Bank.    Financial  covenants  included  in  the  lending  agreement  specified  limits  on  certain financial ratios, and if these limits were violated, the required payments could be accelerated or the capital stock of Summit's subsidiaries could be seized.  Kathy was in the process of evaluating several  possible  courses  of  action,  including  accounting  changes  proposed  by  Dave  Flanders,  the  company's  new  chief  financial  officer.    The  proposed  accounting  changes  would  strengthen  the  company's  balance  sheet  and  could  postpone  default  for  at  least  another  year.    The  most  significant  accounting  change  proposed  was  a  shift  in  inventory  valuation  methods  from  Last-In-First-Out  (LIFO) to First-In-First-Out (FIFO). Industry Outlook Summit  Distributors  sold  and  distributed  industrial  supplies  to  fabricators,  manufacturers,  and  distributors  throughout  the  United  States.    The  company  sold  approximately  30,000  different  industrial-supply  products.    Major  markets  for  the  company's  products  included  construction,  energy,  metal  fabrication,  general  manufacturing,  and  utilities.    Industrial-supply  products  were  consumed  in  fabrication  and  manufacturing  processes  and  in  maintenance  activities.    Customers  typically ordered $200 to $800 worth of supplies to meet their immediate needs.

 The  industrial-supply  industry  was  highly  fragmented,  and  most  products  were  available  from  multiple  suppliers.    Since  purchase  amounts  were  relatively  small,  price  differences  were  generally  not  the  dominant  competitive  factor.    Competition  was  based  mainly  on  service,  such  as  reliability  in  meeting  delivery  requirements  of  customers,  the  variety  and  quality  of  products  distributed,  and  the  accessibility  of  sales  personnel.    To  compete  successfully,  Summit  had  to  maintain significant inventories at many strategically located warehouses. With  customers  ordering  industrial  supplies  only  for  their  immediate  use,  performance  of  Summit Distributors and its competitors was closely tied to the fortunes of the industries they served.  When  specific  sectors  of  the  economy  experienced  a  downturn,  distributors,  who  were  essentially  just-in-time suppliers, felt the squeeze almost immediately.  Along with the downturn in demand for industrial products, a decline in demand for industrial supplies was expected for fiscal 1992.  Financial Covenants with Bank Kathy  Hutton  was  very  concerned  with  how  Prime  Trust  Bank  would  respond  if  the  company  violated  its  financial  covenants.    The  company  had  a  strong  relationship  with  Sandy  Petronka,  Summit's  lending  officer  at  Prime  Trust.    Whenever  there  had  been  a  need  for  additional  working  capital  for  growth,  Sandy  had  been  willing  to  increase  the  limit  on  Summit's  line  of  credit.    However,  the  decline  in  Summit's  performance  had  put  strains  on  the  company's  future  financial  flexibility.   Under  Summit  Distributors'  loan  covenants,  the  company  was  required  to:    (a)  maintain  a  minimum  consolidated  tangible  net  worth  of  $12  million;  (b)  maintain  minimum  consolidated  working capital of $16 million and a current ratio exceeding 1.5 to 1; and (c) maintain an outstanding loan balance not to exceed the sum of 80% of accounts receivables and 50% of inventory.  (Exhibit 1includes  selected  notes  to  the  company's  financial  statements.    Note  6    contains  details  on  the  loan  covenants.)             

If  Summit  Distributors  violated  one  of  these  loan  covenants,  Prime  Trust  would  have  the  right to accelerate maturity of the debt or seize collateralized assets.  If this happened, the company's only hope would be to reorganize under Chapter 11 of the Bankruptcy Reform Act of 1978.  Prior to an  actual  default,  Kathy  could  approach  Sandy  Petronka  and  attempt  to  renegotiate  the  financial  covenants.  Kathy anticipated that Sandy and Prime Trust's credit-watch committee would request at least a 50-basis-point increase in the interest rate on the outstanding loan (50 basis point is equivalent to  0.5%).    However,  as  Dave  Flanders  had  pointed  out,  the  cost  of  default  could  be  considerably  higher.  Other lenders had been known to require increased collateralization of assets, restrict future borrowing,  require  additional  covenants,  force  the  sale  of  assets  to  pay  down  the  debt,  or  even  demand  warrants  or  common  stock  of  the  company  be  issued  to  them.    Kathy  was  not  sure  what  actions Sandy Petronka and the credit-watch committee might take, how she should react, and what costs the company might incur as a result.   Situation Facing Kathy Hutton As of August 31, 1991, the company reported tangible net worth of $16.7 million (Exhibit 1).  If nothing were done to improve the balance sheet, the current forecast for 1992 would place Summit in default of the minimum tangible net worth covenant by year's end (see Exhibit 2 for status of loan covenants).    Kathy  Hutton  expected  the  economy  to  turn  around  in  1993,  and  she  believed  Summit  was  well  positioned  to  return  to  profitability  with  the  economic  upswing.    Kathy  had  to  admit,  however, the immediate future looked bleak. Dave  Flanders  had  suggested  a  number  of  accounting  changes  permitted  under  generally  accepted  accounting  practices.    These  accounting  changes  would  improve  the  company's  balance  sheet  and  help  Summit  avoid  default  during  the  coming  year.    The  largest  proposed  accounting  change  would  require  a  return  to  the  FIFO-inventory-valuation  method.    Since  1988,  Summit  Distributors  had  employed  the  LIFO-inventory-valuation  method  for  financial  and  tax  reporting.    With  the  trends  of  rising  prices  for  industrial  supplies,  LIFO  had  resulted  in  income  being  reported  lower  than  it  would  have  been  reported  if  FIFO  or  the  average-cost  method  of  inventory  valuation  had  been  used.    To  demonstrate  his  point  that  by  merely  changing  the  inventory-valuation  method  default on the loan covenant could be postponed for at least one year, Dave had quickly jotted down the balance-sheet effects of switching to FIFO (see Exhibit 3). Dave  briefly  explained  his  calculations  to  Kathy.    For  1992,  the  projected  LIFO  reserve  was  $4,802,000,  and  therefore  a  switch  to  FIFO  would  increase  the  reported  inventory  amounts  and  taxable income by $4,802,000.  Retained earnings and net worth would increase by $4,215,000, enough to  delay  or  avoid  default.    As  Kathy  glanced  at  Dave's  back-of-the-envelope  calculations,  she  was  initially pleased by the apparent ability to avoid default.  However, as she examined the calculations more closely, she noticed that refundable taxes declined by $825,000 and deferred taxes increased by only  $238,000,  as  a  result  of  the  switch  to  FIFO.    Dave  explained  that  under  either  method  Summit  would report a loss for 1992.  The good news was that the loss would allow Summit to claim a refund of  taxes  paid  in  earlier  years.    However,  since  the  switch  to  FIFO  in  financial  reports  would  require  the same switch in the company's income tax returns (including amendments to tax returns in earlier years) and would result in less of a loss than LIFO, the current refund would be $825,000 less under FIFO than it was forecasted to be under LIFO. Kathy  sat  back  in  her  chair  and  began  listing  the  pros  and  cons  of  adopting  the  FIFO-inventory  method.    She  had  received  some  input  from  her  chief  financial  officer  but  wondered  how  other  parties  that  could  be  affected  by  her  decision  viewed  the  current  crisis,  and  how  they  would  view  a  return  to  the  FIFO-inventory  method.    Kathy  especially  wondered  how  Prime  Trust  Bank  viewed Summit's current circumstances. Questions 

1.If you were Kathy Hutton, what would you do?   

2.If  you  were  Dave  Flanders,  would  you  recommend  staying  with  the  LIFO-  inventory-valuation  method  or  switching  to  FIFO?    Why?    What  are  the  cash-  flow ramifications of the accounting change? 

3.If there were no cash-flow consequences associated with the accounting change, would you change your answers to questions 1 or 2?

4.How  does  the  decision  facing  Kathy  Hutton  impact  Summit  Distributors'  other  constituencies,   such   as   Prime   Trust   Bank,   shareholders,   auditors,   and   the   company's internal financial reporting group? 

5.Dave  Flanders  had  not  been  employed  by  the  company  four  years  earlier.    However,  he  was  aware  that  at  that  time  the  company  had  switched  inventory-valuation methods for most inventory from FIFO to LIFO.  The company's 1988 annual report justified the change as follows: The  Company  believes  the  LIFO  method  of  accounting  will  result  in  a  more  representative presentation of the Company's financial position and results of operations. Does the fact that Summit Distributors switched methods four years ago change your answers to questions 1 or 2? 

6.When   companies   change   accounting   methods,   managers   and   auditors   are   required  to  justify  the  change.    Their  justification  must  explain  why  the  new  method  is  preferable  to  the  old  method.    What  are  the  potential  justifications  for  Summit's managers changing to FIFO from LIFO?