Introduction to financial accounting 9e Problem 7-63 (Inventory accounting Effects of LIFO and FIFO)

a. Profit under LIFO & FIFO for each year is calculated below. Total profit for LIFP & FIFO for 5 Yrs is $11,700 b. If prices are rising, each of the accounting methods produce the following results: * FIFO gives us a better indication of the value of ending inventory (on the balance sheet), but it also increases net income because inventory that might be several years old is used to value the cost of goods sold. Increasing net income sounds good, but remember that it also has the potential to increase the amount of taxes that a company must pay. * LIFO isn't a good indicator of ending inventory value because the leftover inventory might be extremely old and, perhaps, obsolete. This results in a valuation that is much lower than today's prices. LIFO results in lower net income because cost of goods sold is higher.

Over the 5-year period, net income and tax expense are the same under FIFO and LIFO. However, since the price of inventory is increasing, net income under LIFO in every pre-20X5year is less than that of under FIFO. Also, because of higher cost of goods sold under LIFO, tax expenses under LIFO in these 4 years before 20X5 are less than those of under FIFO. If the company wants to make the income statement look good, we should choose FIFO because net income under FIFO is higher than that of LIFO in every year except 20X5; the income statement under FIFO gives us a better impression about the company's business operation. On the other hand, if we want to minimise the present value of tax liability, we should choose LIFO for tax purpose because it defers the tax liability till 20X5. In other words, tax expense under LIFO in every year before 20X5 is smaller than that of under FIFO, even though the total nominal tax liabilities over the 5-year period under both method are the same; this means we are putting off the tax liability till 20X5 under LIFO and therefore minimising the present value of the tax liability.