You have just been hired as a consultant to Tangier Industries, a newly formed c

Question

You have just been hired as a consultant to Tangier Industries, a newly formed company. 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.
Required:
Prepare a report for the president describing the factors that should be considered by Tangier in choosing between LIFO and FIFO.

Explanation / Answer

                                 Choosing between FIFO and LIFO- Factors to Consider

The system of inventory accounting method used could have profound effects on a company’s reported costs of goods sold, the value of the inventory, income and subsequent tax liability working on the premise that prices rise over time. LIFO assumes that the goods purchased last are sold first, implying that the more expensive goods are sold first. Subsequently, the cost of goods sold is higher while the value of the inventory will is lower since the inventory is composed of goods purchased earlier when prices were low. On the other hand, FIFO method assumes that the goods purchased first are also the first to be sold. If prices are rising, FIFO method results in low cost of goods sold, since the goods sold may have been purchased at significantly low prices compared to the current prices. The value of the inventory is higher since it is composed of the latest goods purchased at higher prices. Therefore, assuming prices will rise, which is the common phenomenon, a couple of factors should be considered in choosing between LIFO and FIFO.

Need to Reduce Tax Burden

            Since, as mentioned, LIFO results to a higher measure of the cost of goods sold, assuming prices are rising, the reported income is reduced. Subsequently, the tax liability also reduces. FIFO method results to a lower cost of goods sold but higher reported profit. Consequently, the tax liability is higher. Therefore, for goods whose prices are rising, LIFO would be the best since it would lead to lower tax burden.

Need to Impress Investors and Creditors

If prices are rising, FIFO will result in lower cost of goods sold and higher reported earnings. Therefore, for companies that need to impress investors and creditors with high book profits, FIFO would be an ideal. Similarly, if a company wants a strong balance sheet to satisfy investors and creditors, FIFO would be the appropriate method since it results in high valued inventory.

Legal and Standards Restrictions

            Apparently, LIFO   can reduce a firm's tax burden. However, there are tough restrictions on the use of the method in the United States. Once a company uses LIFO in a particular year, it cannot use any other method for that year to value inventory, determine income and profit or loss in any financial report provided to shareholders or creditors. Additionally, International Financial Reporting Standards(IFRS) prohibits the use of LIFO. Since the US operates under GAAP as opposed to IFRS, US-based firms are required to translate their statements to FIFO method in footnotes of their financial reports. Due to the limitations on the use of LIFO, most companies in the US and internationally have switched to FIFO.

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