Question

Inventory Valuation and Earnings
Santiago, Inc., began operations as an importer of fine Chilean wine to the United States. Sales and purchase information is provided below.

	Year 1			Year 2			Year 3
	Units		$	Units		$	Units		$
Sales	250			140			300
Purchases	300	@	$10	200	@	$15	?	@	$20
Ending Inventory	50	@	$10	50	@	$10
				60	@	$15

Santiago, Inc., uses the LIFO method of inventory valuation. The purchase amount for Year 3 has been left blank because the company has not yet decided the total number of units to purchase during the year. (Assume that all sales occur on the last day of the year, after all purchases for the year have been made. The company’s year-end is December 31.)

Required

How many units should be purchased in Year 3 if the firm’s objective is to minimize income taxes for the year?

Answer

Compute the cost of goods sold for Year 3 assuming that the number of units computed in (1) is purchased.

$Answer

How many units should be purchased in Year 3 if the firm’s objective is to maximize reported income for the year?

Answer

Compute the cost of goods sold for Year 3 assuming that the number of units computed in (3) is purchased.

$Answer

Answer 1

• All working forms part of the answer
• LIFO concepts:

>Cost of goods sold is computed from latest purchases first.

>Higher the cost of goods sold, lower will be Net Income and hence lower income taxes.

>Lower the cost of goods sold, higher will be Net Income and hence higher income taxes.

• Requirement 1: Units to be purchased in Year 3 if OBJECTIVE is to minimise income taxes.

--If objective is to minimise the tax, the cost of goods sold needs to be higher.

--It is given that in Year 3, units are to be purchased at $20, which is higher than $ 10 and $15 rate of beginning inventory rate for Year 3.

---Hence, cost of goods sold need to be from $20 rate purchases.

--That is why, whole 300 units needs to be from units purchased at $ 20 rate.

Answer: No. of units that should be purchased in Year 3 if the firm’s objective is to minimize income taxes for the year = 300 units at $ 20

• Requirement 2

Cost of Goods Sold = 300 units x $ 20 (of latest purchases in Year 3) = $ 6,000

• Requirement 3: Units to be purchased in Year 3 if OBJECTIVE is to maximise reported Income.

---The cost of goods sold need to be lower.

---Beginning Inventory are at $ 10 and $ 15, which is lower than Year 3 $ 20 rate.

---Hence, of 300 units, 50 + 60 = 110 units must be from beginning inventory and rest need to be purchased at $ 20.

Answer: No. of units that should be purchased in Year 3 if the firm’s objective is to maximize reported income for the year = 190 units at $ 20 [300 – 50 – 60 = 190]

• Requirement 4

Cost of Goods Sold =

50 units x $ 10 = $ 500
60 units x $ 15 = $ 900
190 units x $ 20 = $ 3,800

Total 50 + 60 +190 = 300 units for $ 5,200

Cost of Goods Sold = $ 5,200