Question

Explain how the choice of one of the following accounting methods over the other raises or lowers a company’s net income during a period of continuing inflation.

a. Use of FIFO instead of LIFO for inventory costing.

b. Use of a 6-year life for machinery instead of a 9-year life.

c. Use of straight-line depreciation instead of declining-balance depreciation.

Answer 1

• Part ‘a’
  Company uses FIFO instead of LIFO for inventory Costing.

In the period of inflation, the prices of latest purchases would be higher than earlier purchases.
Under FIFO, the ending inventory gets valued at LATEST purchases. This means that cost of ending inventory would includes inflationary prices.
Hence, cost of ending inventory would be higher.
Higher Ending Inventory = Higher Gross Profits = Net Income.
However, if LIFO had been used, the results would be reversed.

• Part ‘b’
  Company uses a 6 year life instead of 9 year.
  A machinery depreciated over 6 year life instead of 9 years would have larger depreciation expense for all those 6 years than it would have been had the asset been depreciated over 9 years.
  Higher Depreciation expense = Higher expenses = Lower Net Income
• Part ‘c’
  Company uses Straight Line depreciation instead of declining balance

Under Straight Line method, depreciation expense remains same each year, while under Declining balance, the depreciation expenses are higher in initial years and then gradually decrease over the next years.
Hence, if Straight line depreciation is used:-
--For initial years, depreciation expense would be lower = Lower expense = Higher Net Income,
--For later years, depreciation expense would be higher = Higher expense = Lower Net Income