In periods of rising prices, LIFO will produce:
(a) higher net income than FIFO.
(b) the same net income as FIFO.
(c) lower net income than FIFO.
(d) higher net income than average-cost.
The Correct Answer and Explanation is :
The correct answer is:
(c) lower net income than FIFO.
Explanation:
LIFO (Last-In, First-Out) and FIFO (First-In, First-Out) are inventory valuation methods that impact financial statements differently, especially during periods of rising prices (inflation).
- How LIFO Works:
Under LIFO, the most recent inventory purchases (which are at higher prices during inflation) are recorded as the cost of goods sold (COGS), while older, lower-cost inventory remains on the balance sheet. This results in higher COGS and lower gross profit and net income compared to FIFO. - How FIFO Works:
FIFO assumes that the oldest inventory (which was purchased at lower costs) is sold first, leaving the more expensive, recently purchased inventory in stock. This leads to lower COGS and higher net income than LIFO during inflationary periods. - Comparison During Rising Prices:
- Since LIFO records the newest, higher-cost inventory as COGS, expenses increase, reducing net income.
- FIFO, on the other hand, uses older, lower-cost inventory in COGS, resulting in lower expenses and higher net income.
- Therefore, LIFO produces lower net income than FIFO during inflation.
- Tax Implications:
Companies may prefer LIFO during inflation because higher COGS leads to lower taxable income, reducing their tax burden. However, it also results in lower reported earnings, which might not be favorable for investors.
Conclusion:
During periods of rising prices, LIFO leads to higher COGS, lower gross profit, and lower net income than FIFO, making option (c) the correct answer.
Now, I will generate an image to illustrate the LIFO vs. FIFO effect.
Here is an infographic comparing LIFO and FIFO inventory valuation methods during inflation. Let me know if you need any modifications or further explanations!