(3a) A Merchandiser’s greatest expense is cost of goods sold. Cost of goods sold
ID: 2493767 • Letter: #
Question
(3a) A Merchandiser’s greatest expense is cost of goods sold. Cost of goods sold is calculated based on the different inventory costing method that is used by the company: FIFO, LIFO, Specific identification method, or weighted average cost method. Consider the following scenario:
During the last month of the fiscal year, a company experienced extraordinarily good sales, and severely depleted its base stock of merchandise. Since the company accounts for inventory using LIFO, the controller realized that cost of goods sold will be reduced by an extraordinary amount, inflating net income. This effect will be increased by the fact that the purchasing department negotiated some very good prices on merchandise during the year. The controller decided that a last-minute inventory purchase, at current higher prices, was the answer to the problem, and asked the purchasing department to check the inventory files and stock up on as many items as possible to be sure that the company did not have to “liquidate the LIFO layers.”
Is this ethical? Explain your answer.
Explanation / Answer
LIFO Inventory
The last in, first out method of inventory costing treats the costs of sold items as if you sold the most recently purchased or produced items first. This is simply an assumption about costs and does not relate to the actual sequence in which you sell inventory. For LIFO bookkeeping, you must keep track of the costs of each new lot of an inventory item, by date. This creates cost layers of inventory. In normal economic times, costs rise over time, so the oldest cost layers are also the lowest-cost layers.
No, this is not ethical as the company has already been using LIFO method and now the sudden last-minute inventory purchase, at current higher prices would inflate the price of the inventory by really heavy costs.
If a company, using LIFO inventory valuation method, sells (or issues) the old stock of merchandise (or raw materials) inventory. In other words, it occurs when a company using LIFO method sells (or issues) more than it purchases.
LIFO liquidation causes distortion in net operating income and may become a reason of higher tax bill in current period. When LIFO inventory is liquidated, the old costs are matched with the current revenues and as a result, financial statements show higher income. The LIFO liquidation, therefore, causes a higher tax liability in periods of high inflation.
In most of the cases, companies do not liquidate their LIFO inventory voluntarily. A company may have to liquidate its LIFO inventory due to one or more of the following reasons:
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