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? Assume costs have been steadily rising over time.
(Response does not need to be super in depth, just a brief explanation)

Answer 1

1. Last-in, First-out method = LIFO method

2. First-in, First-out method = FIFO method

3. Weighted average inventory method

In the given case the cost are steadily rising, it shows us the cost of purchasing inventory is less today, high tomorrow and very high on day after tomorrow.

LIFO method :-

In LIFO method the inventory which was last bought will be taken first for the purpose of production. It means the inventory used for production is costly than inventory remained in the closing inventory. It means by following the LIFO method the value of inventory using for production is high it leads to decrease in net income in income statement. The effect on balancesheet for usage of LIFO method is reduced value of closing inventory which leads to reduce in assets of the company.

FIFO method :-

In FIFO method the inventory which was first bought will be taken first for the production, in the environment of steadily rising prices the inventory which was bought for less price will be taken first for production. Effect on income statement bis as the less cost inventory was first taken per production, the high cost inventory remains in closing inventory in that situation it leads to increase in closing inventory which causes increase in income in income statement and effect on balance sheet is having hugh value of closing stock which leads to overall increase in assets in balancesheet.

The LIFO and FIFO method are quite opposite to each other and it shows quite opposite effects on income statement and balancesheet.

Weighted average inventory systems :-

In this system the cost of inventory will be calculated by using averages of prices of inventory, in the environment which has steadily increase in the cost, the weighted average cost system also increases the value of inventory in very low pace, the newly bought inventory is at high cost compared with previously bought inventory then automatically average price of inventory gets increased. The effect on income statement is high value of inventory used for production, same value inventory will be in closing inventory. This system does not show considerable effect on income statement and balancesheet.

As per above given explanation, a firm is concerned about reducing their tax burden the that firm should adopt LIFO method becasue the high value inventory is used for production, which leads to increase in cost of goods sold which reduces the profit, reduction in profit leads to reduction in tax burden.

These are all the information required to solve the above given question.

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