Question

The management of Svetlana Corp. is considering the effects of inventory-costing methods on its financial statements and its income tax expense. Assuming that the price the company pays for inventory is increasing, which method will:

a. Provide the highest net income, LIFO or FIFO?

b. Provide the highest ending inventory, LIFO or FIFO?

c. Result in the lowest income tax expense, LIFO or FIFO?

Answer 1

• Concept summarised:
  >Under FIFO, ending inventory belongs to latest purchases and hence value will be based on latest purchase price.
  >Under LIFO, ending inventory belongs to first or earliest purchases and hence gets valued at prices of earliest bought inventory.
  >Higher ending inventory = Lower Cost of Goods Sold = Higher net income.
• Requirements

[a]
Highest Net Income would be from FIFO during the price rising period, because ending inventory would be valued at latest purchase price that are rising.

[b]
Highest Ending Inventory would be from LIFO during the price of rising prices.

[c]
Lowest income tax expense will be from LIFO, because under period of rising prices, cost of goods sold will be higher (as it will be based on latest prices) and hence gross profits will be lower leading to lower income before income taxes. Hence, income tax expense would also be lower.