Users of financial statements rely on the information available to them to decid

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 three companies in the same industry. The cost to purchase inventory is rising in the industry. Assume that all expenses incurred by the three companies are the same except for cost of goods sold. The companies use the following methods to value ending inventory:

                               Company A

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 three companies in the same industry. The cost to purchase inventory is rising in the industry. Assume that all expenses incurred by the three 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) Which of the three companies will report the highest net income? Explain your answer. Which of the three companies will pay the least in income taxes? Explain your answer. Which method of inventory costing do you believe is superior to the others in providing information to potential investors? Explain. Explain how your answers to parts (1), (2), and (3) would change if the costs to purchase inventory had been falling instead of rising.

Explanation / Answer

Rising-cost scenario
1. The company that reports the lowest cost of goods sold will have the highest net income. The method that reports lowest cost of goods sold in a time of rising prices for goods is FIFO.

2. The company that reports the highest cost of goods sold will hence have the lowest net income, and pay less in income taxes. The method that reports the highest cost of goods sold in a time of rising prices is LIFO.

3. No method is superior. In the long run (over several accounting periods), all three methods 'even out', i.e. give the same result.

4. Falling-cost scenario.
. . . 1) LIFO
. . . .2) FIFO
. . . .3) Same answer as above

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