Question

2.3 Trade-Offs among Acceptable Accounting Alternatives. Firms value inventory under a variety of assumptions, including two common methods: last-in first- out (LIFO) and first-in first-out (FIFO). Ignore taxes, assume that prices increase over time, and assume that a firm’s inventory balance is stable or grows over time. Which inventory method provides a balance sheet that better reflects the underlying economics, and why? Which method provides an income statement that better reflects the underlying economics, and why?

Answer 1

The FIFO method will provide a higher value to the inventory. This is because this method assumes that stock which is purchased first goes out first. Hence the inventory which is purchased later is left as closing stock. This will have a higher value due to increasing prices and hence this will improve the balance sheet by placing a higher value on the assets.

The FIFO method will provide a better income statement. This is because it will consider the lower cost for calculating the cost of goods sold which will depict a better profitability in the income statement.