Question

Explain how LIFO, FIFO, and Weighted average inventory systems will have different affects on a firm’s income statement and balance sheet. If a firm was concerned about reducing their tax burden, which inventory system would best benefit them? Describe a type of business that would use each of the basis of accounting for inventory; LIFO/FIFO/Weighted Average. What is the benefit to each firm?

Answer 1

1. There is a general assumption that prices of Inventory tend to rise. Assuming this,

	Impact on Income Statement	Income on Balance sheet
FIFO	Cost of Goods Sold will be lesser and hence net income will be higher.	Closing Inventory will be higher.
LIFO	Cost of Goods Sold will be higher and hence Net income will be lower	Closing Inventory will be lesser.
Weighted Average	The advantage of lower cost is offset by higher volume. Similarly disadvantage of higher cost is offset by advantage by lower volume. Thus depicts reliable picture of income	weighted inventory will show an healthy Inventory that's not high as in FIFO or less like LIFO.

2.

As explained above, the best way to reduce income is by adopting LIFO method. It records the cost of goods sold at prices at the end of the accounting period that are generally higher than that at the beginning of the year.

3. Examples with advantages:

• FIFO: Stationary, seasonal products, perishable items.
  • The advantage is that goods have limited life and disposed off as first come first go basis to ensure there is no losses caused by obsolescence.
• LIFO: Pharmacy, Automobile, Mining
  • Since these products need to perform/deliver well, latest items are demanded and disposed off first then the items preceeding will follow.
• Weighted average: Fuel, Gold
  • Where products are subject to no obsolescence and prices have gradual variations, this method is advantageous.