Question

An accounting intern for a local CPA firm was reviewing the financial statements of a client in the electronics industry. The intern noticed that the client used the FIFO method of determining ending inventory and cost of goods sold. When she asked a colleague why the firm used FIFO instead of LIFO, she was told that the client used FIFO to minimize its income tax liability. This response puzzled the intern because she thought that LIFO would minimize income tax liability. 

 

Required: 

What would you tell the intern to resolve the confusion?

Answer 1

When inventory prices are rising and the quantity of inventory is not decreasing then the LIFO method produces a higher cost of goods sold.

 

The higher cost of goods sold will decrease the accounting income

 

So the income tax liability will be minimized by using LIFO method of inventory.

 

When inventory prices are decreasing then the FIFO method of inventory will decrease the income tax liability.

When inventory prices are rising and the quantity of inventory is not decreasing then the LIFO method produces a higher cost of goods sold.