Ending
inventory = 3 @ $3.80 = $11.40
b: Explain the usefulness of inventory and cost-of-goods-sold data provided by
the LIFO, FIFO, and average cost methods when prices are 1) stable, or 2)
rising.
Balance sheet: Inventories based on FIFO are preferable since these values most closely
resemble current cost and hence current economic value. GAAP requires that firms use the
lower of cost or market when valuing inventory. Applying the lower-of-cost-or-market to the
inventory calculated under any cost flow assumption would decrease income and inventory
on the balance sheet if market is lower than cost. If assigned costs to ending inventory using
one of the cost flow assumptions (LIFO, FIFO, or average cost) is greater than the
replacement market cost of that inventory, then that ending inventory must be written-down
to market. This rule is applied individually to each major classification of inventory. Inventory
is not changed if market price is greater than cost. This potentially increases cost of goods
sold and decreases net income and current assets.
Income statement: LIFO allocates the most recent prices to the cost of goods sold. For
income statement purposes, LIFO is the most informative accounting method and
provides a better measure of current income. The quandary, FIFO provides the best balance
sheet measure and LIFO the best income statement measure. From an analyst's perspective
there is often information available to permit restatement of one method to another to provide
a better analysis. The discussion above assumes the value for purchases is known but this
too may be affected by management choice.
c: Discuss the impact of LIFO and FIFO (in periods of rising prices and stable or
increasing inventory quantities) on a company's cost of goods sold, income, cash
flow, and working capital.
In periods of rising prices and stable or increasing inventory quantities:
LIFO
results
in:
FIFO results in:
higher COGS
lower COGS
lower taxes
higher taxes
lower net income (EBT & EAT)
higher net income (EBT & EAT)
lower inventory balances
higher inventory balances
lower working capital
higher working capital
higher cash flows (less taxes paid out)
lower cash flows (more taxes paid out)
d: Describe the effects of adjustment from LIFO to FIFO on inventory balances,
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