2. The management of ABC Company is considering the effects of various 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?
b) provide the highest ending inventory?
c) result in the lowest income tax expense?
d) result in the most stable earnings over a number of years?
a) The inventory costing method that will provide the highest net income when the price of inventory is increasing is the LIFO (Last-In-First-Out) method. This is because under the LIFO method, the most recently purchased inventory is assumed to be sold first, resulting in higher cost of goods sold and lower reported net income.
b) The inventory costing method that will provide the highest ending inventory when the price of inventory is increasing is the FIFO (First-In-First-Out) method. Under the FIFO method, the oldest inventory is assumed to be sold first, resulting in the most recent (and higher priced) inventory remaining in the ending inventory balance.
c) The inventory costing method that will result in the lowest income tax expense when the price of inventory is increasing is the LIFO (Last-In-First-Out) method. This is because the LIFO method usually results in higher cost of goods sold, which in turn reduces reported net income and subsequently lowers the taxable income, leading to lower income tax expense.
d) The inventory costing method that will result in the most stable earnings over a number of years when the price of inventory is increasing is the Weighted Average Cost method. Under this method, the cost of inventory is calculated by averaging the costs of all units available for sale during the period. This helps smooth out the effects of fluctuating inventory prices and results in more stable earnings over time.
To determine the effects of various inventory-costing methods on financial statements and income tax expense, let's discuss the different costing methods commonly used in accounting:
1. First-in, First-out (FIFO): This method assumes that the first items purchased or produced are the first ones sold or used. The cost assigned to the ending inventory is based on the most recent purchases.
2. Last-in, First-out (LIFO): This method assumes that the most recently purchased or produced items are the first ones sold or used. The cost assigned to the ending inventory is based on the earliest purchases.
3. Weighted Average Cost: This method calculates the average cost per unit by dividing the cost of goods available for sale by the number of units available for sale. The average cost is then applied to the ending inventory.
Now, let's analyze the effects of these methods on the specific outcomes you are interested in:
a) To find which method provides the highest net income, we need to consider that as the price of inventory increases, the first units purchased (under FIFO) or the most recent units purchased (under LIFO) will have the lowest cost assigned to them. Consequently, LIFO will typically result in the lowest ending inventory and higher cost of goods sold, thus reducing net income. Therefore, FIFO is assumed to provide the highest net income in a rising price environment.
b) To determine which method provides the highest ending inventory, FIFO is typically the preferred method. Since the earliest purchased units (with lower costs) are assigned to cost of goods sold, the most recently purchased units (with higher costs) are included in the ending inventory, resulting in a higher valuation of the inventory.
c) To find which method results in the lowest income tax expense, LIFO is usually advantageous. As LIFO assumes that the most recent and higher-priced units are sold, the cost of goods sold is higher, thus reducing taxable income and income tax expense.
d) For stability in earnings over time, the weighted average cost method can be used. This method takes into account the average cost of inventory and mitigates the impacts of price fluctuations, resulting in more consistent earnings compared to FIFO or LIFO.
It's important to note that the actual choice of inventory-costing method depends on other factors such as industry norms, regulatory requirements, and management preferences. Consulting with a qualified accountant or tax advisor would provide more specific guidance in making the appropriate choice for your company.