Question

Assuming rising costs, the switch from LIFO to FIFO or average cost would most likely have what effect(s)?

a. Increase reported net income in the income statement

b. Decrease tax obligations to the Internal Revenue Service (IRS)

c. Increase reported net income and tax obligations

d. Decrease reported net income and tax obligations.

Answer 1

Answer-C

To convert the LIFO inventory to FIFO, you take LIFO Inv. + LIFO Reserve.
To convert COGS LIFO to COGS FIFO, you take COGS FIFO and subtract the increase in LIFO reserve.

This would imply that your new net income is higher in an inflationary environment, given that FIFO COGS is a lower expense.

The increase in net income would be calculated as (1 - taxrate)*increase in LIFO reserve.

That would also increase taxes on the income statement to tax rate * increase in LIFO reserve.

Now, because the firm under US GAAP paid taxes in the tax return under LIFO, a conversion to FIFO would mean that pretax income is now higher than what it was before the conversion, therefore you would trigger a increase in deferred tax liabilities.