Question

What are the effects on the income statement and balance sheet of each of the inventory cost flow assumptions—FIFO, LIFO, and average-cost? What are the tax effects of each method? Suggest when a company might choose to use each method.

Answer 1

The management shall use the system that will produce the highest gross profit to ensure they achieve highest net income. The only component of the income statement that will change based on the choice of inventory cost flow method is cost of goods sold (COGS). Because COGS is subtracted from sales to arrive at gross profit, the lower the COGS, the higher the gross profit. The higher the gross profit the higher the net income and the higher the bonus to the managers. In a period of continuously rising prices, the method that uses the older items to value COGS would produce the lowest value for COGS. Because the older items are used to calculate the COGS under FIFO, it would produce the lowest COGS. Similarly, in a period of continuously decreasing prices, LIFO is preferred.
However, if it is not easy to predict the direction of cost (rising or declining) the weighted average method is recommended as it will always produce a COGS and ending inventory valuation that is in between LIFO and FIFO.