Question

Speed World Cycles sells high-performance motorcycles and Motocross racers.  One of Speed World’s most popular models is the Kazomma 900 dirt bike.  During the current year, Speed World purchased eight of these cycles at the following costs:

Purchase Date                                             Units Purchased      Unit Cost   Total Cost

July 1                                                                        2                    $4,950          $9,900

July 22 3                      5,000           15,000

August 3                                                                  3                        5,100           15,300

                                                                                ------                                  ------------

8                                            $40,200

On July 28, Speed World sold four Kazomma 900 dirt bikes to the Vince Wilson racing team. The remaining four bikes remained in inventory at September 30, the end of Speed World’s fiscal year.

Assume that Speed World uses a perpetual inventory system.

Compute the cost of goods sold relating to the sale on July 28 and the ending inventory of Kazomma 900 dirt bikes at September 30, using the following cost flow assumptions:

Average cost

FIFO

LIFO

Show the number of units and the unit costs of each layer comprising the cost of goods sold and ending inventory.

Using the cost figures computed in part a. answer the following questions:

a. Which of the three cost flow assumptions will result in Speed World Cycles reporting the highest net income for the current year?  Would this always be the case?  Explain.

b. Which of the three cost flow assumptions will minimize the income taxes owed by Speed World Cycles for the year? Would you expect this usually to be the case?  Explain.

c. May Speed World Cycles use the cost flow assumption that results in the highest net income for the current year in its financial statements, but use the cost flow assumption that minimizes taxable income for the current year in its income tax return?  Explain.

Answer 1

Average cost Method

Cost of Goods Sold = $19,920

Ending Inventory = $20,280

First in First Out (FIFO)

Cost of Goods Sold = $19,900

Ending Inventory = $20,300

Last in First Out (FIFO)

Cost of Goods Sold = $19,950

Ending Inventory = $20,250

a. Which of the three cost flow assumptions will result in Speed World Cycles reporting the highest net income for the current year?  Would this always be the case?  Explain.

Because Cost of Goods sold is lowest in FIFO, i.e., $19,900. Using FIFO method would report highest net income for the current year.

b. Which of the three cost flow assumptions will minimize the income taxes owed by Speed World Cycles for the year? Would you expect this usually to be the case?  Explain.

Because Cost of goods sold is highest in LIFO, i.e., $19,950. the net income is minimised under this method, hence the lowest tax is minimised.

c. May Speed World Cycles use the cost flow assumption that results in the highest net income for the current year in its financial statements, but use the cost flow assumption that minimizes taxable income for the current year in its income tax return?  Explain.

It is a common practice by many companies to use one method of cost flow assumption for tax reporting and another method for financial statements reporting. Speed World cycles, may use FIFO for net income reporting in financial statement, so that the profitability is maximised. And can use LIFO method for tax reporting, so that the COGS is highest in this case and hence minimise the tax.