Page 298 - Accounting Principles (A Business Perspective)

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goods in the next period. Under LIFO, these higher costs are charged to cost of goods sold in the current period,
resulting in a substantial decline in reported net income. To obtain higher income, management could delay
making the normal amount of purchases until the next period and thus include some of the older, lower costs in

cost of goods sold.
Tax benefit of LIFO The LIFO method results in the lowest taxable income, and thus the lowest income taxes,
when prices are rising. The Internal Revenue Service allows companies to use LIFO for tax purposes only if they use
LIFO for financial reporting purposes. Companies may also report an alternative inventory amount in the notes to
their financial statements for comparison purposes. Because of high inflation during the 1970s, many companies
switched from FIFO to LIFO for tax advantages.
Advantages and disadvantages of weighted-average When a company uses the weighted-average

method and prices are rising, its cost of goods sold is less than that obtained under LIFO, but more than that
obtained under FIFO. Inventory is not as badly understated as under LIFO, but it is not as up-to-date as under
FIFO. Weighted-average costing takes a middle-of-the-road approach. A company can manipulate income under
the weighted-average costing method by buying or failing to buy goods near year-end. However, the averaging
process reduces the effects of buying or not buying.
The four inventory costing methods, specific identification, FIFO, LIFO, and weighted-average, involve
assumptions about how costs flow through a business. In some instances, assumed cost flows may correspond with
the actual physical flow of goods. For example, fresh meats and dairy products must flow in a FIFO manner to avoid
spoilage losses. In contrast, firms use coal stacked in a pile in a LIFO manner because the newest units purchased

are unloaded on top of the pile and sold first. Gasoline held in a tank is a good example of an inventory that has an
average physical flow. As the tank is refilled, the new gasoline mixes with the old. Thus, any amount used is a blend
of the old gas with the new.
Although physical flows are sometimes cited as support for an inventory method, accountants now recognize
that an inventory method's assumed cost flows need not necessarily correspond with the actual physical flow of the
goods. In fact, good reasons exist for simply ignoring physical flows and choosing an inventory method based on
other criteria.

In Exhibit 60 and Exhibit 61, we use data from Exhibit 49 to show the cost of goods sold, inventory cost, and
gross margin for each of the four basic costing methods using perpetual and periodic inventory procedures. The
differences for the four methods occur because the company paid different prices for goods purchased. No
differences would occur if purchase prices were constant. Since a company's purchase prices are seldom constant,
inventory costing method affects cost of goods sold, inventory cost, gross margin, and net income. Therefore,
companies must disclose on their financial statements which inventory costing methods were used.
Which is the correct method? All four methods of inventory costing are acceptable; no single method is the
only correct method. Different methods are attractive under different conditions.
If a company wants to match sales revenue with current cost of goods sold, it would use LIFO. If a company

seeks to reduce its income taxes in a period of rising prices, it would also use LIFO. On the other hand, LIFO often
charges against revenues the cost of goods not actually sold. Also, LIFO may allow the company to manipulate net
income by changing the timing of additional purchases.
The FIFO and specific identification methods result in a more precise matching of historical cost with revenue.
However, FIFO can give rise to paper profits, while specific identification can give rise to income manipulation. The

Accounting Principles: A Business Perspective 299 A Global Text