Question

The inventory method used by a company will affect profitability by affecting the amount of income taxes a company owes. True False

Answer 1

True, the inventory method used by the company will affect the profit of a company and it will impact the taxable income. so if the company adopt a wrong method to valuate the inventory and resulted in a higher amount of inventory, it will resultin paying more amount of tax. same way, if the company undervalue the inventory using a wrong method of valuation, it will end up paying less tax than required.

The most precise method for tracking the cost of inventory is the specific identification method, under which a cost is assigned to each individual unit of stock. This approach is usually only possible if each unit can be uniquely identified, which is not possible for goods sold in bulk. In this latter case, the Internal Revenue Service has expressed a preference for costing using either the FIFO or LIFO methods.

The FIFO (first in, first out) method assumes that the first unit to enter stock is the first one sold, which means that the earliest costs assigned to inventory are the first ones to be charged to expense when items are sold. If prices are rising (which is usually the case), this means that the remaining inventory will have a relatively high price, which means that the cost of inventory charged to expense is low, which creates more taxable income.

The LIFO (last in, first out) method assumes that the last unit to enter stock is the first one sold, which means that the latest costs assigned to inventory are the first ones to be charged to expense when items are sold. If prices are rising, this means that the remaining inventory will have a relatively low price, which means that the cost of inventory charged to expense is high, which creates the smallest amount of taxable income.

There is other methods also to value the inventory like Retail method, Direct costing method, Lower of Cost or market etc. the company need to consider it's environment and choose the valuation method which is suitable for it.