Question

Jane Yoakam, president of Estefan Co., recently read an article that claimed that at least 100 of the country’s largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to

(1) neutralize the effect of inflation in their financial statements,

(2) eliminate inventory profits, and (3) reduce income taxes. Ms. Yoakam wonders if the switch would benefit her company.

Estefan currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system. The company has a high inventory turnover rate, and inventories represent a significant proportion of the assets.

Ms. Yoakam has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just because it is the current fad.

Instructions

(a) Explain to Ms. Yoakam what “inventory profits” are and how the LIFO method of inventory valuation could reduce them.

(b) Explain to Ms. Yoakam the conditions that must exist for Estefan Co. to receive tax benefits from a switch to the LIFO method.

Short answer

Inventory profits are the result of valuing costs at historical prices. The LIFO method must be adopted when there is less chance of manipulating the net income.

Step-by-step solution

Inventory profits and LIFO

Inventory profit is the change in net profit due to the change in the inventory valuation method. Under FIFO, the cost of goods sold is valued on the oldest cost for the oldest inventory. In the LIFO method, the COGS are valued on the recent cost for the current inventories. So the COGS under FIFO is always lower than the COGS under LIFO.

In the case of inflationary prices, the gap between the COGS based on FIFO and COGS based on LIFO would be wide. This gap is the inventory profits.

LIFO would reduce the inventory profits due to the inflationary pressure.