Users of Financial statements rely on the information available to them to decid
ID: 2377628 • Letter: U
Question
Users of Financial statements rely on the information available to them to decide whether to invest in a company or lend it money. As an investor, you are comparing 3 companies in the same industry. The cost to purchase inventory is rising in the industry. Assume that all expenses incurred by the 3 companies are the same except for cost of goods sold. The companies use the following methods to value ending inventory:Company A- Weighted average cost
Company B- first-in, first-out (FIFO)
Company C- last-in, first-out (LIFO)
Required
1. Which of the 3 companies will report the highest net income? Explain your answer.
2. Which of the 3 companies will pay the least in income taxes? Explain your answer.
3. Which method of inventory costing do you believe is superior to the others in providing information to potential investors? Explain.
4. Explain how your answer to (1),(2), and (3) would change if the costs to purchase inventory had been falling instead of rising.
Explanation / Answer
1. Company B, using the FIFO method will report the highest net income. Since the cost to purchase inventory is increasing, the goods purchased initially will be the cheapest, and thus lead to the lowest cost of goods sold. Thus the net income will be the highest. 2. The company that will pay the least in income taxes is the one with the lowest income. Company C, using LIFO, will pay the least taxes because it has the lowest income. Look at 1. for explanation. 3. (I think that the LIFO would be superior because it would match with the most recent costs in the market, giving us a good current picture of the company. Note however, that to convince investors, FIFO might be a better method, as it would give the company the largest income, and thus possibly convince some investors). The answer to this one can be changed to what you think would be the better method. 4. If the cost had been falling, the answer to 1. would be LIFO, the answer to 2. would be FIFO, and the answer to 3. would be LIFO again. 1. would be LIFO because now the goods purchased last would be the cheapest, yielding the most income. 2. can be explained in a similar fashion. 3. would remain LIFO because it always estimates the current state of the company
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