Question

To begin, read the following scenario: Company 1 and Company 2 are online retailers. Both companies are basically identical and follow the same accounting practices except that Company A uses LIFO and Company B uses FIFO to value their inventory. Because of rising inventory costs, both companies need additional capital to manage their operations. For your main discussion post, reflect on these questions: If Company A and Company B apply for a loan at their local bank and the bank bases its decision on net income, which company is more likely to obtain the loan? Explain. What if the bank based its decision on cash flows associated with the inventory costing valuation method the company uses? Which company might be better positioned to obtain the loan? Elaborate your responses and provide an example as needed to support your assessment.

Answer 1

The choice of inventory costing method has an effect on the net income of the firm. During period of rising inventory costs, FIFO method produces a higher net income because the lower unit costs of the first units purchased are matched against revenue and LIFO method produces lowest net income. During the period of falling inventory costs, the results from LIFO and FIFO are reversed: FIFO will produce the lowest net income and LIFO the highest.

Therefore if the bank bases its decision on net income, then company B is more likely to get the loan.

A tax rule often referred to as LIFO conformity rule requires that companies use LIFO method for tax purposes. They must also report it for financial purposes and will also have to report lower net income in its financial statement. Thus if the bank bases its decision on the cash flows associated with the inventory costing valuation method the company uses, then company A is most likely to get the loan.