Question

(FIFO and LIFO) Harrisburg Company is considering changing its inventory valuation method from FIFO to LIFO because of the potential tax savings. However, management wishes to consider all of the effects on the company, including its reported performance, before making the final decision.

The inventory account, currently valued on the FIFO basis, consists of 1,000,000 units at \(8 per unit on January 1, 2017. There are 1,000,000 shares of common stock outstanding as of January 1, 2017, and the cash balance is \)400,000.

The company has made the following forecasts for the period 2017–2019.

	2017	2018	2019
Unit sales (in millions of units)	1.1	1.0	1.3
Sales price per unit	\(10	\)12	\(12
Unit purchases (in millions of units)	1.0	1.1	1.2
Purchase price per unit	\)8	\(9	\)10
Annual depreciation (in thousands of dollars)	\(300	\)300	\(300
Cash dividends per share	\)0.15	\(0.15	\)0.15
Cash payments for additions to and replacement of plant and equipment (in thousands of dollars)	\(350	\)350	$350
Income tax rate	40%	40%	40%
Operating expenses (exclusive of depreciation) as a percent of sales	15%	15%	15%
Common shares outstanding (in millions)	1	1	1

Instructions

a. Prepare a schedule that illustrates and compares the following data for Harrisburg Company under the FIFO and the LIFO inventory method for 2017–2019. Assume the company would begin LIFO at the beginning of 2017.

1. Year-end inventory balances.
2. Annual net income after taxes.
3. Earnings per share.
4. Cash balance.

Assume all sales are collected in the year of sale and all purchases, operating expenses, and taxes are paid during the year incurred.

b. Using the data above, your answer to (a), and any additional issues you believe need to be considered, prepare a report that recommends whether or not Harrisburg Company should change to the LIFO inventory method. Support your conclusions with appropriate arguments.

Short answer

S.no.	Data	2017	2018	2019
(a1)	Year-end inventory balances	(7,200)	(9,000) and (8,100)	(9,000) and (7,200)
(a2)	Annual net income after taxes	$150	$1,080 and $540	$576 and $36
(a3)	Earnings per share	$0.15	$1.08 and $0.54	$0.58 and $0.04
(a4)	Cash balance	$1,150	$230 and $590	$606 and $1,326
(b)By converting to the LIFO approach, Harrisburg Company may meet its aim of income tax savings, as calculated in (a).

Step-by-step solution

Meaning of LIFO

LIFO is an inventory valuation method in which the last item is sold first. LIFO is not adopted by every business enterprise because at the end of the year items become old and lose value over time

(a1) Calculating Year-end inventory balances

Computing data under the FIFO method

	2017	2018	2019
Sales revenue	$11,000	$12,000	$15,600
Cost of goods sold
Beginning inventory	8,000	7,200	9,000
Purchases	8,000	9,900	12,000
Cost of goods available for sale	16,000	17,100	21,000
Ending inventory	(7,200)	(9,000)	(9,000)
Cost of goods sold	8,800	8,100	12,000

Working notes:

Calculation of value of ending inventory

Date	Calculation	Amount
2017		$7,200
2018		$9,000
2019		$9,000

Computing data under the LIFO method

	2017	2018	2019
Sales revenue	$11,000	$12,000	$15,600
Cost of goods sold
Beginning inventory	8,000	7,200	8,100
Purchases	8,000	9,900	12,000
Cost of goods available for sale	16,000	17,100	20,100
Ending inventory	(7,200)	(8,100)	(7,200)
Cost of goods sold	8,800	9,000	12,900

Working notes:

Calculation of value of ending inventory

Date	Calculation	Amount
2017		$7,200
2018		$8,100
2019		$7,200

(a2) Calculating Annual net income after taxes

Computing data under the FIFO method

	2017	2018	2019
Sales revenue	$11,000	$12,000	$15,600
Cost of goods sold
Beginning inventory	8,000	7,200	9,000
Purchases	8,000	9,900	12,000
Cost of goods available for sale	16,000	17,100	21,000
Ending inventory	(7,200)	(9,000)	(9,000)
Cost of goods sold	8,800	8,100	12,000
Gross profit	2,200	3,900	3,600
Operating expense	1,650	1,800	2,340
Depreciation expense	300	300	300
Income before taxes	250	1,800	960
Income tax expense (40%)	100	720	384
Net Income	$150	$1,080	$576

Computing data under the LIFO method

	2017	2018	2019
Sales revenue	$11,000	$12,000	$15,600
Cost of goods sold
Beginning inventory	8,000	7,200	8,100
Purchases	8,000	9,900	12,000
Cost of goods available for sale	16,000	17,100	20,100
Ending inventory	(7,200)	(8,100)	(7,200)
Cost of goods sold	8,800	9,000	12,900
Gross profit	2,200	3,000	2,700
Operating expense	1,650	1,800	2,340
Depreciation expense	300	300	300
Income before taxes	250	900	60
Income tax expense	100	360	24
Net Income	$150	$540	$36

(a3) Calculating Earnings per share

Computing data under the FIFO method

	2017	2018	2019
Sales revenue	$11,000	$12,000	$15,600
Cost of goods sold
Beginning inventory	8,000	7,200	9,000
Purchases	8,000	9,900	12,000
Cost of goods available for sale	16,000	17,100	21,000
Ending inventory	(7,200)	(9,000)	(9,000)
Cost of goods sold	8,800	8,100	12,000
Gross profit	2,200	3,900	3,600
Operating expense	1,650	1,800	2,340
Depreciation expense	300	300	300
Income before taxes	250	1,800	960
Income tax expense (40%)	100	720	384
Net Income	$150	$1,080	$576
Earnings per share	$0.15	$ 1.08	$0.58

Notes:

For calculating earnings per share following formula should be used

Computing data under the LIFO method

	2017	2018	2019
Sales revenue	$11,000	$12,000	$15,600
Cost of goods sold
Beginning inventory	8,000	7,200	8,100
Purchases	8,000	9,900	12,000
Cost of goods available for sale	16,000	17,100	20,100
Ending inventory	(7,200)	(8,100)	(7,200)
Cost of goods sold	8,800	9,000	12,900
Gross profit	2,200	3,000	2,700
Operating expense	1,650	1,800	2,340
Depreciation expense	300	300	300
Income before taxes	250	900	60
Income tax expense	100	360	24
Net Income	$150	$540	$36
Earnings per share	$0.15	$0.54	$0.04

(a4) Calculating Cash balance

Computing data under the FIFO method

	2017	2018	2019
Cash balance
Beginning balance	$ 400	$ 1,150	$ 230
Sales proceeds	11,000	12,000	15,600
Purchases	(8,000)	(9,000)	(12,000)
Operating expenses	(1,650)	(1,800)	(2,340)
Property, plant, and equipment	(350)	(350)	(350)
Income taxes	(100)	(720)	(384)
Dividends	(150)	(150)	(150)
Ending balance	$ 1,150	$ 230	$ 606

Computing data under the LIFO method

	2017	2018	2019
Cash balance
Beginning balance	$ 400	$ 1,150	$ 590
Sales proceeds	11,000	12,000	15,600
Purchases	(8,000)	(9,900)	(12,000)
Operating expenses	(1,650)	(1,800)	(2,340)
Property, plant, and equipment	(350)	(350)	(350)
Income taxes	(100)	(360)	(24)
Dividends	(150)	(150)	(150)
Ending balance	$ 1,150	$ 590	$ 1,326

(b) Explaining the additional issues and the report

Switching to the LIFO approach, according to the computation in (a), will allow Harrisburg Company to meet its aim of saving money on taxes. According to the schedules, Harrisburg will have lower net income and hence fewer income taxes in 2018 and 2019 under the LIFO approach (tax savings of $360,000 each year). As a consequence, Harrisburg's financial position will be stronger at the end of 2018 and especially in 2019 (the year-end cash balance will be higher by $360,000 in 2018 and $720,000 in 2019).

Due to growing purchase costs, the LIFO approach will result in considerably reduced net income and profits per share in 2018 and 2019. Before opting to switch to the LIFO technique, management may need to assess the possible impact on the firm of decreased net income and profits per share.