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Chapter 6: Problem 23

Describe the circumstances under which a manager might want to change her firm's inventory method from FIFO to LIFO. Similarly, describe why a change from LIFO to FIFO might be desirable.

Short Answer

Expert verified
A change from FIFO to LIFO is often desirable during periods of inflation or rising prices as it leads to higher costs of goods sold, thereby reducing net income and tax liability. Conversely, a switch from LIFO to FIFO might be desired when prices for inventory items are decreasing or when inventory costs are stable, leading to lower costs of goods sold, higher net income, and subsequently, higher taxes.

Step by step solution

01

Understand FIFO and LIFO

First, understand what FIFO and LIFO mean and how they work. FIFO (First-In, First-Out) assumes that the inventory items that are bought first are sold first, hence the oldest inventory costs are recognized first. On the other hand, LIFO (Last-In, First-Out) assumes that the most recently purchased inventory items are sold first, meaning the latest inventory costs are recognized first.
02

Circumstances for switching from FIFO to LIFO

A manager might want to change the inventory method from FIFO to LIFO under circumstances involving inflation. During inflation, when prices are rising, the use of LIFO will lead to greater costs of goods sold, and thus lower net income and lower taxes. This is because the LIFO method recognizes the cost of the most recent purchases first, which are higher in an inflationary scenario. Therefore, LIFO can serve as a tax shield during periods of inflation.
03

Circumstances for switching from LIFO to FIFO

On the other hand, a change from LIFO to FIFO might be desirable when the prices for inventory items are decreasing. Using FIFO in this scenario will result in lower costs of goods sold, higher net income, and subsequently, higher taxes. FIFO might also be preferred when inventory costs are fairly stable over time, or in industries where products are prone to obsolescence and thus it's more logical to sell older inventory first.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

FIFO (First-In, First-Out)
FIFO, or First-In, First-Out, is a popular inventory accounting method employed by companies to manage and cost their inventory. In this method, it is assumed that the oldest inventory items鈥攖he ones purchased first鈥攁re sold first.
This is akin to items moving through a conveyor belt, where the first item placed is the first item removed.
  • One of the main benefits of using FIFO is its straightforward nature, making it simple to both implement and understand.
  • Additionally, under FIFO, the ending inventory on the balance sheet reflects the most recent purchase costs, which can provide a more current view of the inventory valuation.
This means that in times of rising prices, FIFO results in lower cost of goods sold (COGS) compared to LIFO, leading to higher gross profit.
However, businesses should be mindful that using FIFO could lead to higher taxable income in an inflationary period, as the reported taxable income would be larger.
LIFO (Last-In, First-Out)
LIFO, or Last-In, First-Out, is another common inventory accounting strategy where the most recent inventory purchases are the first to be counted as sold.
This is much like dealing from the top of a deck of cards, with the newest cards (or inventory) always being dealt first.
  • A key advantage of LIFO is its usefulness as a tax-deferring tool.
  • In periods of inflation, LIFO can reduce a company's tax burden since the higher recent costs of goods sold reduce taxable income.
While LIFO is beneficial in inflationary scenarios, it can also lead to older inventory being left unsold, which might not adequately reflect the current market conditions on the balance sheet.
It is worth noting that many companies outside the United States might not be able to use LIFO due to its exclusion under International Financial Reporting Standards (IFRS).
Inflation and Deflation Impacts
The impacts of inflation and deflation are significant in determining whether a company might switch between inventory accounting methods such as FIFO and LIFO.
When prices in the economy are generally rising (inflation), the choice of inventory method can affect financial reporting and tax liability in different ways.

**Inflation Impacts:**
  • In times of inflation, using LIFO can be beneficial because it matches higher current costs with current revenues, effectively reducing net income and thus income taxes.
  • On the flip side, the balance sheet may not accurately depict the worth of current inventory.
**Deflation Impacts:**
  • Conversely, during deflation, or when prices are generally falling, using FIFO can maximize inventory value on the balance sheet, showing higher net income since older, higher-cost inventory is being recorded as sold.
  • While this means higher taxes, it often results in a depiction of higher profitability.
Each method has its merits based on the prevailing economic conditions, making it essential for companies to consider inflation and deflation impacts when choosing or switching between FIFO and LIFO.

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Most popular questions from this chapter

Describe how LIFO provides better matching of revenues and expenses than FIFO.Why would such an attribute be desirable for income measurement?

Shard Crockery Co. recognized the following events related to customer accounts receivable during \(2000 .\) At the start of the year, the firm reported gross accounts receivable of 22,000,000 dollars and an allowance for uncollectible accounts of \(\$ 2,000,000 dollars .1. Sales on credit totaled 60,000,000 dollars for the year. 2\. The company factored 18,000,000 dollars of its receivables to a financial institution and paid a fee of 700,000 dollars . 3\. Uncollectible customer accounts totaling 3,200,000 dollars were written off during the year. 4\. Based on an aging of its remaining accounts receivable at year-end, the company estimates that \)10 \%$ of its remaining receivables will ultimately be uncollectible. a. Determine the balance of accounts receivable (net of allowance) to be reported in Shard Crockery's balance sheet at the end of 2000 . b. Determine the effects of each of the events described above on the company's accounts receivable (net), total assets, revenues, and expenses. c. How would the factoring of accounts receivable during the year affect your calculation or interpretation of the company's accounts receivable collection period (if at all)? Discuss.

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