Question

Information: Tangy Industries, a newly formed company, has hired you as a consultant. The company president, John Mills, is seeking your advice as to the appropriate inventory method the company should use to value its ending inventory and cost of goods sold. Mr. Mills is only aware of the LIFO and FIFO inventory valuations. He believes that LIFO might be better for tax purposes, but speculates that FIFO has certain advantages for financial reporting to investors and creditors. Mr. Mills advises you that the company will be profitable in its first year and for the foreseeable future.

Question: What factors should you consider when choosing an inventory method? What are the different effects on ending inventory and COGS when using LIFO and FIFO?

Answer 1

Factors should be consider when choosing an inventory method:

1. Theoretical soundness -

The inventory valuation method should be theoretically sound, based on firm economic theory. The methodology used needs to be statistically/econometrically accurate, robust and logical.

2. Practical applicability -

A inventory valuation method should be suitable to the type of property and there should be sufficient relevant and reliable data to compute the value estimate.

3. Change in raw material inventory value -

A suitable inventory valuation method is based on overall economic conditions. Wheather raw material value is increasing, decresing or stable during the acconting period should consider to adopt suitalbe inventory valuation method.

4. Impacts on the financial statements -

Invetory valuation should be based on whather it will benefit most from having higher net income? Does its balance sheet need to report higher assets for financing purposes?

5. Cash Flow implecation -

While selecting suitable inventory valuation method it needs to identify the cash flow implications and evaluate what cash flow will look like in the next three to five years.

Different effects on ending inventory and COGS when using LIFO and FIFO

1. With the FIFO method, the oldest items of inventory are sold first. This inventory method is most beneficial for a small business during inflationary periods. This is because the costs assigned to the oldest inventory are the lowest there fore the FIFO method is most advantageous when attempting to maximize net income.

2. With the LIFO inventory method, the last inventory items bought are the first ones to be sold. When selecting the LIFO method in an inflationary period, the COGS will be more and income will be lower because inventory of highest value is included in COGS.

3. Advantage of the FIFO method is it conceptually avoids obsolescence. Because older inventory items are sold first, inventory listings have a lower chance of reporting items too old to sold.

4. Advantage of the LIFO method is the accuracy of the timing of expense recognition. Expenses are actually reported in the period they occur.

5. FIFO method gives inventory valuation more realistic as inventory value is more near to market value becauous it will include the inventory purchase in near period.

6. Under LIFO method if most recent purchase inventory are always used as cost of goods sold, it will create older inventory which can never be sold hence it is quite unrealistic.