Question

There are four basic inventory methods to account for items. They are: First In First Out FIFO, Last In First Out LIFO, Average Cost, and Specific Cost. However all firms must also take into consideration the Lower Cost or Market value for items in inventory. Please choose an item, industry, or product and then explain what method a company would use to account for this item, product or industry and why. Also, discuss the impact on the financial statements and tax consequences. (Example: FIFO increases Net Income & Taxes during periods of inflation and also increase the amount of inventory on the Balance Sheet.) For example: Home construction company. This type of business would use specific cost because the cost of each individual home would be different from the other houses built by this company. The cost would include all construction costs including land, labor, materials, overhead and upgrades. Upgrades could include adding a deck, better lighting fixtures and additional outlets, better grade carpeting, an additional bathroom or garage. However, if the cost of a house in this area or if the cost of housing was to drop drastically, then the company would have to consider the lower of cost or market. The company is probably more concerned with tracing costs directly to the individual construction projects, so it will not take into consideration tax consequences or the impact on the Balance Sheet or Income Statement

Answer 1

The inventory method I have chosen is LIFO (Last-In-First-Out) and the example I have chosen where LIFO is usually used is that of a bookstore company.

First of all let's understand what do we mean by LIFO method of inventory valuation : It is basically a method which assumes that the most recent purchases which are added to the company's inventory are sold first. This method may reduce the profit of a company but at the same time it can also mean reduced tax liability for the company.

This method is generally used in industries where rapid changes occur in the latest product/technology, where obsolesence occurs at a faster rate. Hence we have taken the example of a bookstore company. The example is as follows :

XYZ owns a bookstore in US named as XYZ digital and printed books. This store prides in always having the latest releases as in the books industry, latest releases are always more in demand. The customers generally assume latest novels and digital releases to be available at the store, hence it becomes much more likely that the current sales are from the most recent purchases that have been added to the inventory. Let's assume XYZ has the following inventory build-up as on 15th March, 2020 :

Purchase Date	No. of Books	Price per book	Total
15-Feb-20	30	1,500	45,000
18-Feb-20	50	2,000	1,00,000
28-Feb-20	10	1,000	10,000
10-Mar-20	20	2,000	40,000
		Total	1,95,000

XYZ sales as on 31st March, 2020 are 70 books.

Now, XYZ wants to calculate the cost of goods sold. Cost of goods sold will now be calculated as per LIFO method which is as follows :

Cost of Goods Sold :
Purchase Date	No. of Books	Price per Book	Total
10-Mar-20	20	2,000	40,000
28-Feb-20	10	1,000	10,000
18-Feb-20	40	2,000	80,000
		Total COGS :	1,30,000

Hence we can see from the above example that XYZ is here assuming that the sales have been made from the latest purchases, i.e., from 10th March, 28th Feb and 18th Feb and that the books purchased on 15th Feb must still be in the inventory which is consistent with the industry trend and customer expectations in the books industry.

Impact on the financial statements : Since LIFO assumes that the latest purchases are utilized first, that means that the cost of goods sold appearing in the income statement pertains to the latest purchases. And the latest purchases are always more costly due to the inflation and technological advancements/improvements. Hence LIFO method reduces the profit by increasing the amount of cost of goods sold which inturn also reduces the tax liability of the company.