Table of Contents
Advanced Topics in Financial Statements
Between 1955 and 1972, consumer prices increased by less than one percent a year. The first-in, first-out (FIFO) inventory pricing method was, by a wide margin, the most popular choice. This method assigns the cost of the earliest purchased items as the cost of goods sold and assigns the cost of the most recent purchases to the value of the unsold goods, shown as inventory on the balance sheet. This method of determining cost flow matches the actual physical flow of inventory (selling the oldest items first, keeping the physical goods fresh).
From about 1972 to about 1985, inflation occurred in the United States. In some years, prices increased by more than twelve percent. In some industries, the price increase was much higher than twelve percent. A method of computing the cost flow of inventory called the last-in, first-out (LIFO) method quickly became the most popular choice, again by a wide margin. This method assigns the cost of the earliest (cheapest) purchases to inventory and assigns the cost of the latest (most expensive) purchases as the cost of goods sold. Note that the use of LIFO for cost-flow determination has no effect on the physical flow of inventory, which will continue to sell the oldest items first and maintain a fresh inventory.
For this week’s discussion, prepare 4–5 paragraphs discussing inventory valuations. Consider the following to include in your discussion:
- If prices were steady—no inflation and no deflation—would net income be different depending on whether a company used FIFO or LIFO? Explain.
- If you were the owner of a company, and thus responsible for the payment of income taxes, which inventory method would you prefer if you were operating in an inflationary environment? Explain, using an example.
- If you were the manager of a division of a company, operating in an inflationary environment, and your bonus depended on net income, which inventory method would you prefer? In answering this question, assume that you are concerned only about receiving a high bonus; you are not concerned about the well-being of the company. Explain, using an example.
- The use of LIFO has been described as sacrificing the balance sheet in order to achieve an income statement in which gross profit is determined by matching the current costs of replacing inventory against the current selling prices of the inventory. What is meant by that description?
- How can you find out what inventory cost flow method is being used by a company?
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