To begin, read the following scenario: Company 1 and Company 2 are online retail

Question

To begin, read the following scenario: Company 1 and Company 2 are online retailers. Both companies are basically identical and follow the same accounting practices except that Company A uses LIFO and Company B uses FIFO to value their inventory. Because of rising inventory costs, both companies need additional capital to manage their operations. For your main discussion post, reflect on these questions: If Company A and Company B apply for a loan at their local bank and the bank bases its decision on net income, which company is more likely to obtain the loan? Explain. What if the bank based its decision on cash flows associated with the inventory costing valuation method the company uses? Which company might be better positioned to obtain the loan? Elaborate your responses and provide an example as needed to support your assessment.

Explanation / Answer

In the given scenario, Company B will show more profit hence Company B is likely to get loan if bank bases its decision on net income.

It is mentioned that cost of inventory is rising. In FIFO method, inventory which came first will be sold first. So left out inventory is the one which came in in a later stage of financial period. Since cost is in rising trend, value of inventory left out will be more than the one which is sold. HIgher value of inventory will reflect more profit in financial statements. Hence, Company B will show more profit.

Eg. Other things remaining same, both company bought inventory in three lots on three different dates.

First lot on 5th of month at $10 per unit.

Second lot on 10th of month at $12 per unit

Third lot on 15th of month at $15 per unit.

Now both company sold 2 lots out of 3 lots bought in a month and left out with 1 lot.

Now Company A uses LIFO method, it would have considered sales of 2 lots of inventory costing $15 per unit and $12 per unit. Inventory left out will be reflected at $ 10 per unit.

Whereas Company B uses FIFO method, it would have considered sales of first 2 lots and would have left out with inventory costing $15 per unit. Value of its inventory is $15 per unit whereas the same quantity of Company A will be reflected with Inventory value of $10 per unit. Hence, profit of Company B will be reflected more compared to Company A.

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