The company president, John Meeks, is seeking your advice as to the appropriate inventory method Tangier should use to value its inventory and cost of goods sold. Mr. Meeks has narrowed the choice to LIFO and FIFO. He has heard that LIFO might be better for tax purposes, but FIFO has certain advantages for financial reporting to investors and creditors. You have been told that the company will be profitable in its first year and for the foreseeable future.
Prepare a report for the president describing the factors that should be considered by Tangier in choosing between LIFO and FIFO.
There are different types of inventory accounting systems can be used by the companies; each of the system have different effects on company’s reported COGS (cost of goods sold), the valuation on the company’s inventory items and lastly taxation issues.
“The first-in, first-out (FIFO) method assumes that units sold are the first units acquired. Beginning inventory is sold first, followed by purchases during the period in the chronological
order of their acquisition.”1
“The first-in, first-out (FIFO) method assumes that items sold are those that were acquired first. Ending inventory-applying FIFO consists of the most recently acquired items.”2 “The last-in, first-out (LIFO) method assumes that the units sold are the most recent units purchased. The last-in, first-out (LIFO) method assumes that items sold are those that were most recently acquired. Ending inventory-applying LIFO consists of the items acquired first.”3
In the LIFO system, the company will sales the latest goods firsts, we can imply that the more expensive goods sales first. From this perspective; the costs of goods sold number is higher; in mean time, the inventory value will lower because the company already sold the higher valued goods on the first place. In the FIFO system, if prices rising, the costs of goods sold resulted in low amounts; the goods sold in the first place ordered in a lower price than the latest goods. The value of the inventory will be higher than the LIFO system. In the assumption of the increasing
prices the FIFO system is more beneficial to the company.
1 http://connect.mheducation.com/connect/hmEBook.do?setTab=sectionTabs access date 2/25/2016
2 http://connect.mheducation.com/connect/hmEBook.do?setTab=sectionTabs access date 2/25/2016
3 http://connect.mheducation.com/connect/hmEBook.do?setTab=sectionTabs access date 2/25/2016
Reducing the tax burden: “Many companies choose LIFO in order to reduce income taxes in periods when prices are rising. If a company uses LIFO to measure its taxable income, IRS regulations require that LIFO also be used to measure income reported to investors and creditors (the LIFO conformity rule).” 4
Affecting the investor and/or creditor decisions: In the assumption of the increase on the prices, FIFO system has the resulted with lower cost of goods sold and higher reported earnings. This conclusion shows how profitable the company is, resulting higher level of earnings the company can affect the investors decision to invest on the company’s stock or shares. This situation also gives the same idea to the company’s creditors.
We should consider using both of inventory accounting system (FIFO and LIFO). In recent years, companies prefer to use LIFO for external reporting and income tax purposes but in meantime keeping their internal records using FIFO or average cost. Their logic based on several reasons such as, (1) recordkeeping costs high in LIFO system, (2) in the bonus or profit sharing agreements, calculation based on a method other than LIFO, and (3) pricing decisions is better with the FIFO. “If prices change during a period, then LIFO generally will provide a better match of revenues and expenses. Sales reflect the most recent selling prices, and cost of goods sold includes the costs of the most recent purchases. Proponents of LIFO argue that it results in a better match of revenues and expenses.”5