Question

Shepard Company sold 4,000 units of its product at \(100 per unit in year 2017 and incurred operating expenses of \)15 per unit in selling the units. It began the year with 840 units in inventory and made successive purchases of its product as follows.

Jan 1	Beginning Inventory	840 units @ \(58 per unit
April 2	Purchases	600 units @ \)59 per unit
June 14	Purchases	1,205 units @ \(61 per unit
Aug 29	Purchases	700 units @ \)64 per unit
Nov 18	Purchases	1,655 units @ $65 per unit
Total		5,000 units

Required

1. Prepare comparative income statements similar to Exhibit 5.8 for the three inventory costing methods of FIFO, LIFO, and weighted average. (Round all amounts to cents.) Include a detailed cost of goods sold section as part of each statement. The company uses a periodic inventory system, and its income tax rate is 40%.
2. How would the financial results from using the three alternative inventory costing methods change if the company had been experiencing decreasing prices in its purchases of inventory?
3. What advantages and disadvantages are offered by using (a) LIFO and (b) FIFO? Assume the continuing trend of increasing costs.

Short answer

1. Net income under different inventory costing methods:

FIFO	$57,000
LIFO	$52,896
Weighted Average	$55,200

2. Due to decreasing prices, the net income reported under the LIFO method will be higher than other methods.

3. Advantages and disadvantages of LIFO and FIFO

Method	Advantage	Disadvantage
LIFO	Reduction in tax liability	Lower EPS and Understatement of inventory.
FIFO	Higher Net income and EPS, the market value of inventory.	Higher tax liability

Step-by-step solution

Definition of Comparative Income Statement

A comparative income statement can be defined as the schedule calculating the net income of the different periods in separate columns. It is done for making comparisons and arriving at a decision.

Comparative Income Statement

Calculation of Comparative Income

Particular	FIFO	LIFO	Weighted Average
Sales $\left(4,000\times \$100\right)$	$400,000	$400,000	$400,000
Less: Cost of goods sold	($245,000)	($251,840)	($248,000)
Gross Profit	$155,000	$148,160	$152,000
Less: $\left(4,000\times \$15\right)$	($60,000)	($60,000)	($60,000)
Operating profit	$95,000	$88,160	$92,000
Less: Tax expenses @ 40%	(38,000)	(35,264)	(36,800)
Net income	$57,000	$52,896	$55,200

Working Note:

Calculation of total cost of goods available for sale:

Particular	Units	X	Per unit cost	=	Total cost
Jan 1	840	X	$58	=	$48,720
April 2	600	X	$59	=	$35,400
June 14	1,205	X	$61	=	$73,505
Aug 29	700	X	$64	=	$44,800
Nov 18	1,655	X	$65	=	$107,575
Total	5,000				$310,000

Calculation of Ending Inventory:

(a) FIFO

Particular	Units	X	Per unit cost	=	Total cost
Nov 18	1,000	X	$65	=	$65,000
					$65,000

(b) LIFO

Particular	Units	X	Per unit cost	=	Total cost
Jan 1	840	X	$58	=	$48,720
April 2	160	X	$59	=	$9,440
					$58,160

(c) Weighted Average

$\begin{array}{rcl}Endinginventory& =& \frac{Totalcostofgoodsavailableforsale}{Totalunitsavailableforsale}\times unitsinendinginventory\\ & =& \frac{\$310,000}{5,000}\times 1,000\\ & =& \$62,000\end{array}$

Calculation of cost of goods sold:

Particular	FIFO	LIFO	Weighted Average
Cost of goods available for sale	$310,000	$310,000	$310,000
Less: Ending Inventory	(65,000)	(58,160)	(62,000)
Cost of goods sold	$245,000	$251,840	$248,000

Change in Financial Results When the prices are decreasing

When the prices are decreasing, the cost of goods sold reported under LIFO will be lower than other methods because the recent goods with lower cost will be sold out first. Due to the lower cost of goods sold, the net income reported under this method will be higher than other methods.

Advantages and Disadvantages of LIFO When the Prices are Increasing

Advantages: Under rising prices, LIFO will report a higher cost of goods sold and lower net income, reducing tax liability.

Disadvantages: Under rising prices, if the LIFO is used, it will generate lower net income and earnings per share. The inventory of the balance sheet will be understated.

Advantages and Disadvantages FIFO When the Prices are Increasing

Advantages: Adopting the FIFO method under rising prices will raise net income and EPS, and the inventory will be reported at its market value.

Disadvantages: A business entity will report higher tax liability using the FIFO method for inventory valuation under rising prices.