Week 3 DQs: LIFO Vs. FIFO The Controller Of Sagehen Enterpri

Week 3 Dqs LIFO vs. FIFO The controller of Sagehen Enterprises believes

The controller of Sagehen Enterprises believes that the company should switch from the LIFO (Last-In, First-Out) method to the FIFO (First-In, First-Out) method of inventory valuation. The motivation behind this suggestion is that the switch would likely increase the company's net income, which is relevant given that the controller's bonus is based on the next income. Understanding the differences between LIFO and FIFO is essential to evaluate this proposal.

Differences Between LIFO and FIFO Methods

The primary difference between LIFO and FIFO inventory valuation methods lies in the assumption about the flow of inventory costs and the impact on financial statements. FIFO assumes that the first items purchased (the oldest inventory) are sold first, so the ending inventory consists of the most recent purchases. Conversely, LIFO assumes that the most recent purchases are sold first, resulting in the ending inventory consisting of older costs.

Under FIFO, during periods of rising prices, the cost of goods sold (COGS) is lower because it reflects older, cheaper inventory; consequently, gross profit and net income tend to be higher. The ending inventory, which comprises the most recent (and higher) costs, is also higher. As such, FIFO often results in higher assets and equity on the balance sheet during inflationary periods.

On the other hand, LIFO typically results in higher COGS and lower net income during inflation because it matches the most recent higher costs against revenue. It also reduces taxable income and tax liabilities, which may be attractive to companies aiming to minimize current tax payments. However, LIFO can lead to older inventory valuations on the balance sheet, which may underestimate inventory value during periods of rising prices.

It is important to note that IFRS (International Financial Reporting Standards) does not permit the use of LIFO; only FIFO or weighted-average methods are allowed internationally, whereas U.S. GAAP permits both FIFO and LIFO.

The choice between these methods can significantly influence a company's reported profitability, tax liabilities, and asset valuation. Management may prefer LIFO for tax advantages, whereas investors may favor FIFO because it reflects more current inventory costs and typically shows higher asset values.

Implications of Switching Inventory Methods

If Sagehen Enterprises switches from LIFO to FIFO, its reported net income is likely to increase during periods of rising prices, aligning with the controller's belief. However, this change could also impact tax liabilities because higher net income can result in a higher tax expense. Additionally, switching methods might influence shareholders' perception of profitability and financial health.

It is crucial to consider the accounting standards and the consistency principle, which generally discourage frequent changes in accounting methods unless there is a valid justification. A change must be disclosed in the financial statements, accompanied by the rationale and the effect on financial results.

Ultimately, the decision to switch should involve a comprehensive analysis of the company's financial strategy, tax implications, and the perceptions of stakeholders.

References

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• FASB. (2020). Accounting Standards Codification Topic 330: Inventory. Financial Accounting Standards Board.
• International Accounting Standards Board (IASB). (2019). IAS 2 - Inventories. IASB.
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