Chapter 7, Problem 7.5P

Evaluating the LIFO and FIFO Choice When Costs Are Rising and Falling (AP7-3)

Income is to be evaluated under four different situations as follows:

a. Prices are rising:

1. (1) Situation A: FIFO is used.
2. (2) Situation B: LIFO is used.

b. Prices are falling:

1. (1) Situation C: FIFO is used.
2. (2) Situation D: LIFO is used.

The basic data common to all four situations are: sales, 500 units for $15,000; beginning inventory, 300 units; purchases, 400 units: ending inventory, 200 units: and operating expenses, $4,000. The following tabulated income statements for each situation have been set up for analytical purposes:

	PRICES RISING		PRICES FALLING
	Situation A FIFO	Situation B LIFO	Situation C FIFO	Situation D LIFO
Sales revenue	$15,000	$15,000	$15,000	$15,000
Cost of goods sold:
Beginning inventory	3,300	?	?	?
Purchases	4,800	?	?	?
Goods available for sale	8,100	?	?	?
Ending inventory	2,400	?	?	?
Cost of goods sold	5,700	?	?	?
Gross profit	9,300	?	?	?
Expenses	4,000	4,000	4,000	4,000
Pretax income	5,300	?	?	?
Income tax expense (30%)	1,590	?	?	?
Net income	$ 3,710

Required:

1. 1. Complete the preceding tabulation for each situation. In Situations A and B (prices rising), assume the following: beginning inventory, 300 units at $11 = $3,300: purchases, 400 units at $12 = $4,800. In Situations C and D (prices falling), assume the opposite; that is. beginning inventory, 300 units at $12 = $3,600; purchases. 400 units at $11 = $4,400. Use periodic inventory procedures.
2. 2. Analyze the relative effects on pretax income and net income as demonstrated by requirement (1) when prices are rising and when prices are falling.
3. 3. Analyze the relative effects on the cash position for each situation.
4. 4. Would you recommend FIFO or LIFO? Explain.

To determine

Complete the preceding tabulation for each situation.

Answer to Problem 7.5P

	Prices Rising		Prices Falling
Particulars	A	B	C	D
	FIFO	LIFO	FIFO	LIFO
Sales revenue (a) (1)	$15,000	$15,000	$15,000	$15,000
Beginning inventory	3,300	3,300	3,600	3,600
Add: Purchases	4,800	4,800	4,400	4,400
Goods available for sale Table (2)	8,100	8,100	8,000	8,000
Less: Ending inventory	2,400  Table (3)	2,200  Table (4)	2,200  Table (5)	2,400  Table (6)
Cost of goods sold (b) Table (7)	5,700	5,900	5,800	5,600
Gross profit $\left(\text{a}-\text{b}\right)$	9,300	9,100	9,200	9,400
Less: Expenses	4,000	4,000	4,000	4,000
Pretax income	5,300	5,100	5,200	5,400
Less: Income tax expense	1,590	1,530 (2)	1,560 (3)	1,620 (4)
Net income	$3,710	$3,570	$3,640	$3,780

Table (1)

Explanation of Solution

Periodic Inventory System:

Periodic inventory system is a system, in which the inventory is updated in the accounting records on a periodic basis such as at the end of each month, quarter or year. In other words, it is an accounting method which is used to determine the amount of inventory at the end of each accounting period.

First-in-First-Out:

In First-in-First-Out method, the costs of the initially purchased items are considered as cost of goods sold, for the items which are sold first. The value of the ending inventory consists of the recent purchased items.

Last-in-Last-Out:

In Last-in-First-Out method, the costs of last purchased items are considered as the cost of goods sold, for the items which are sold first. The value of the closing stock consists of the initial purchased items.

Cost of goods sold:

Cost of goods sold is the accumulate total of all direct cost incurred in manufacturing the goods or the products which has been sold during a period. Cost of goods sold involves direct material, direct labor, and manufacturing overheads.

Working notes:

Determine the amount of sales revenue:

$\begin{array}{c}\text{Sales}\text{revenue}=\text{Units}\text{sold}\times \text{Sales}\text{per}\text{unit}\\ \$13,260=\text{510Units}\times \text{Sales}\text{per}\text{unit}\\ \frac{\$13,260}{\text{510Units}}=\text{Sales}\text{per}\text{unit}\\ \text{Sales}\text{per}\text{unit}=\text{\$26}\end{array}$ (1)

Determine the goods available for sale for FIFO:

Date	Particulars	Units ($)	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
January 1	Beginning inventory	300	11	3,300
January 12	Purchased	400	12	4,800
	Total	700		8,100
	Less: Goods sold	500
	Ending inventory	200

Table (2)

Determine the amount of ending inventory for situation A using FIFO method:

Date	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
	Purchased	200	12	2,400
	Ending inventory	200		2,400

Table (3)

Determine the amount of ending inventory for situation B using LIFO method:

Date	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
	Purchased	200	11	2,200
	Ending inventory	200		2,200

Table (4)

Determine the amount of ending inventory for situation C using FIFO method:

Date	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
	Purchased	200	11	2,200
	Ending inventory	200		2,200

Table (5)

Determine the amount of ending inventory for situation D using LIFO method:

Date	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
	Purchased	200	12	2,400
	Ending inventory	200		2,400

Table (6)

Determine the amount of cost of goods sold for each method:

Situation	Particulars	Units	Unit cost ($)	Total cost ($)
		(a)	(b)	(c = a × b)
a. FIFO	Beginning	300	11	3,300
	Purchased	200	12	2,400
		500		5,700
b. LIFO	Beginning	100	11	1,100
	Purchased	400	12	4,800
		500		5,900
c. FIFO	Beginning	300	12	3,600
	Purchased	200	11	2,200
		500		5,800
d. LIFO	Beginning	100	12	1,200
	Purchased	400	11	4,400
		500		5,600

Table (7)

Determine the amount of income tax expense for Situation B:

$\begin{array}{c}\text{Income tax expenses}=\text{30\% of Preatx income}\\ =\text{30\% }\times \$5,100\\ =\$1,530\end{array}$ (2)

Determine the amount of income tax expense for Situation C:

$\begin{array}{c}\text{Income tax expenses}=\text{30\% of Preatx income}\\ =\text{30\% }\times \$5,200\\ =\$1,560\end{array}$ (3)

Determine the amount of income tax expense for Situation D:

$\begin{array}{c}\text{Income tax expenses}=\text{30\% of Preatx income}\\ =\text{30\% }\times \$5,400\\ =\$1,620\end{array}$ (4)

To determine

Analyze the relative effects on pretax income and net income, when there is a rise and fall in prices.

Answer to Problem 7.5P

The amounts of pretax income when there is rise and fall in prices are compared as below:

Particulars	Situation A FIFO ($)	Situation B LIFO ($)	Difference ($) $\left(\text{A}-\text{B}\right)$
Pretax income when prices are rising	5,300	5,100	200
	Situation C FIFO ($)	Situation D LIFO ($)	Difference ($) $\left(\text{D}-\text{C}\right)$
Pretax income when prices are falling	5,200	5,400	200

Table (8)

Explanation of Solution

• From the above calculation, it is clear that the difference between the pretax tax income between FIFO and LIFO is same. Thus, a difference in inventory has a dollar-for-dollar effect on pretax income.
• When price rises, the FIFO method gives a higher net income than the LIFO method. On the other hand, when there is a fall in price, the LIFO method gives a higher net income than the FIFO method.

To determine

Analyze the relative effects on the cash position for each situation.

Explanation of Solution

• The LIFO method gives most favorable cash position than the FIFO method, when prices are rising. On the other hand, the FIFO method gives most favorable cash position than the LIFO method, when prices are falling. Thus, these cash positions are equal to the difference in income tax.

To determine

Explain the method that is recommended.

Explanation of Solution

• Both the LIFO method and FIFO method are equally reasonable in their aspects. For example, when there is a rise in price, the FIFO method produces most favorable results than LIFO by focusing on current income and EPS.
• On the other hand, when there is a rise in price, the LIFO method also produces most favorable results than FIFO by focusing on income tax expenses and cash position.  Still, these results will reverse when there is a fall in prices.
• On the income statement, FIFO does not match current expense with current revenues. However it provides a better valuation on the balance sheet. On the other hand, LIFO matches expenses with revenues. However, it provides a less related inventory valuation on the balance sheet.