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Chapter 8: Q6CA. (page 437)

Jane Yoakam, president of Estefan Co., recently read an article that claimed that at least 100 of the country鈥檚 largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to

(1) neutralize the effect of inflation in their financial statements,

(2) eliminate inventory profits, and (3) reduce income taxes. Ms. Yoakam wonders if the switch would benefit her company.

Estefan currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system. The company has a high inventory turnover rate, and inventories represent a significant proportion of the assets.

Ms. Yoakam has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just because it is the current fad.

Instructions

(a) Explain to Ms. Yoakam what 鈥渋nventory profits鈥� are and how the LIFO method of inventory valuation could reduce them.

(b) Explain to Ms. Yoakam the conditions that must exist for Estefan Co. to receive tax benefits from a switch to the LIFO method.

Short Answer

Expert verified

Inventory profits are the result of valuing costs at historical prices. The LIFO method must be adopted when there is less chance of manipulating the net income.

Step by step solution

01

Inventory profits and LIFO

Inventory profit is the change in net profit due to the change in the inventory valuation method. Under FIFO, the cost of goods sold is valued on the oldest cost for the oldest inventory. In the LIFO method, the COGS are valued on the recent cost for the current inventories. So the COGS under FIFO is always lower than the COGS under LIFO.

In the case of inflationary prices, the gap between the COGS based on FIFO and COGS based on LIFO would be wide. This gap is the inventory profits.

LIFO would reduce the inventory profits due to the inflationary pressure.

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Most popular questions from this chapter

Ann M. Martin Company makes the following errors during the current year.

(Evaluate each case independently and assume ending inventory in the following year is correctly stated.)

1. Ending inventory is overstated, but purchases and related accounts payable are recorded correctly.

2. Both ending inventory and purchases and related accounts payable are understated. (Assume this purchase was recordedand paid for in the following year.)

3. Ending inventory is correct, but a purchase on account was not recorded. (Assume this purchase was recorded and paidfor in the following year.)

Instructions

Indicate the effect of each of these errors on working capital, current ratio (assume that the current ratio is greater than 1), retained earnings, and net income for the current year and the subsequent year.

Richardson Company cans a variety of vegetable-type soups. Recently, the company decided to value its inventories using dollar-value LIFO pools. The clerk who accounts for inventories does not understand how to valuethe inventory pools using this new method, so, as a private consultant, you have been asked to teach him how this new method works.

He has provided you with the following information about purchases made over a 6-year period.

Ending Inventory

Date (End-of-Year Prices) Price Index

Dec. 31, 2013 $ 80,000 100

Dec. 31, 2014 111,300 105

Dec. 31, 2015 108,000 120

Dec. 31, 2016 128,700 130

Dec. 31, 2017 147,000 140

Dec. 31, 2018 174,000 145

You have already explained to him how this inventory method is maintained, but he would feel better about it if you were to leavehim detailed instructions explaining how these calculations are done and why he needs to put all inventories at a base-year value.

Instructions

(a) Compute the ending inventory for Richardson Company for 2013 through 2018 using dollar-value LIFO.

(b) Using your computation schedules as your illustration, write a step-by-step set of instructions explaining how the calculationsare done. Begin your explanation by briefly explaining the theory behind this inventory method, includingthe purpose of putting all amounts into base-year price levels.

Question:Matlock Company uses a perpetual inventory system. Its beginning inventory consists of 50 units that cost \(34 each. During June, the company purchased 150 units at \)34 each, returned 6 units for credit, and sold 125 units at $50 each.

Journalize the June transactions.

Ehlo Company is a multiproduct firm. Presented below is information concerning one of its products, the Hawkeye.

Date Transaction Quantity Price/Cost

1/1 Beginning inventory 1,000 $12

2/4 Purchase 2,000 18

2/20 Sale 2,500 30

4/2 Purchase 3,000 23

11/4 Sale 2,200 33

Instructions

Compute cost of goods sold, assuming Ehlo uses:

(a) Periodic system, FIFO cost flow. (d) Perpetual system, LIFO cost flow.

(b) Perpetual system, FIFO cost flow. (e) Periodic system, weighted-average

cost flow.

(c) Periodic system, LIFO cost flow. (f) Perpetual system, moving-average

cost flow.

Arruza Co. is considering switching from the specific-goods LIFO approach to the dollar-value LIFO approach. Because the financial personnel at Arruza know very little about dollar-value LIFO, they ask youto answer the following questions.

(a) What is a LIFO pool?

(b) Is it possible to use a LIFO pool concept and not use dollar-value LIFO? Explain.

(c) What is a LIFO liquidation?

(d) How are price indexes used in the dollar-value LIFO method?

(e) What are the advantages of dollar-value LIFO over specific-goods LIFO?
See all solutions

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