Question

Susan Smith, president of Miami Co., recently read an article that claimed that at least 100 of the country's largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to (1) neutralize the effect of inflation in their financial statements, (2) eliminate inventory profits, and (3) reduce income taxes. Ms. Smith wonders if the change would benefit her company. Miami Co. currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system. The company has a high inventory turnover rate, and inventories represent a significant proportion of the assets. Ms. Smith has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just becuase it is the current fad. Your assignment: Explain to Ms. Smith what "inventory profits" are and how the LIFO method of inventory valuation could reduce them. Also explain to her the conditions that must exist for Miami Co. to receive tax benefits from a switch to the LIFO method

Answer 1

INVENTORY PROFITS:

Inventory valuation is the increase in the value of an asset that has been held as inventory for a certain period of time. The following are the two main reasons of inventory profits:

1. APPRECIATION: In case of inventories, the market value of these may increase over a period. This is most common when commodities are held in stock.Through speculatuion, a company could generate profits, in the hope that the market value of inventory held may rise.

2. INFLATION: When the value of currency in whcih inventory is recorded declines so that the amount of the currency required, if inventory is to be purchased, increases then it is known as inflation. The common cause of inventory profits is inflation. For instance, the items in stock are charged to the cost of goods sold when unitsare consumed in case of first-in-first-out inventory costing. FIFO costing method leads to inventory profit as the oldest items in stock should have the lowest cost.

If the inventory is well managed, there will be less chances of inventory profits as there will be less time for it to accrue. On the other hand, inventory with low turnover has greater opprtunity to generate profit, since there is more time before it is consumed.

The LIFO method of inventory valuation could reduce inventory profits as the LIFO method provides for a better measurement of current earnings by matching most recent costs against current revenues.

The non-LIFO methods (such as FIFO method) match old costs against current revenues. When old costs matches with the current revenues, the inventory profit is created. Inventory profit occurs when replacement cost of inventory is more than the inventory cost matched against revenues.

LIFO method helps in reducing the inventory profits by matching the most recent costs against revenues. It results in reduction of understatement of cost of goods sold (COGS) and overstatement of profit. Therefore LIFO method improves the quality and reliability of earnings.

The conditions that must exist for Miami Co. to receive tax benefits from a switch to the LIFO method are that when the company switches from FIFO to LIFO, LIFO method will be based on the fact that prices have risen almost constantly and the newest costs charged to cost of goods sold are also teh highest costs, larger cost of goods sold means smaller net income. So the LIFO method results in the lowest taxable income and thus the lowest income taxes, when prices are rising.thsi provides a tax advantage to companies following LIFO method.