In a period of rising prices, the inventory method that produces the lowest ending inventory is the:

Your company has three inventory costing methods from which to choose. The choice is important because it influences your cost of goods sold, net income and income tax payable. Whichever method you choose, accounting rules call for you to stick with it; the Internal Revenue Service might not allow you to flip-flop your accounting method just to take advantage of the latest price trend.

About Costing Methods

Last-in, first-out, or LIFO, uses the most recent costs first. When prices are rising, you prefer LIFO because it gives you the highest cost of goods sold and the lowest taxable income. First-in, first-out, or FIFO, applies the earliest costs first. In rising markets, FIFO yields the lowest cost of goods sold and the highest taxable income. If you sell one-of-a-kind items like custom jewelry, you might prefer the specific identification method. You record the cost of each item, so the cost of goods sold doesn’t require as much fancy math.

Periodic Inventory Under LIFO

When you use the periodic, or book, inventory system, you value your inventory at specific intervals and lump together the results. For example, suppose you purchase 10 items at $100 each on the first of the month. On the 14th, you sell six items and on the 16th buy another 10 for $120 each. You sell eight items on the 19th and buy another 10 on the 23rd for $130 each. On the last day of the month, you sell nine items. Under periodic inventory LIFO, your cost of goods sold is the sum of 10 items times $130, 10 items times $120 and three items times $100. This adds up to $2,800, and you value your remaining inventory at $700.

Perpetual Inventory Under LIFO

In the perpetual inventory system, you figure the cost at the time of each sale instead of at specific intervals. Your cost of goods sold on the 14th is six items times $100, or $600. The sale on the 19th costs $120 times eight units, or $960. The last sale costs $130 times nine items, or $1,170. Notice that each sale uses the latest item cost, which simplifies the math. The total cost is $2,730, or $70 less than the cost under the periodic inventory method. Your remaining inventory tallies in at $770. Your taxable income is $70 less using the periodic inventory system. If you are in the 25 percent bracket, this translates into a tax savings of $17.50.

Things to Consider

Since prices always seem to increase over time, LIFO is a good bet for consistently maximizing your cost of goods sold. The example deals with a retail situation but also applies to product manufacturers. However, if you manufacture products using raw materials that fluctuate in price, such as petroleum, you may not always benefit from the LIFO method. The IRS lets you initially choose your inventory accounting method but wants you to use it consistently year to year. If you choose LIFO, you must file IRS Form 970 in the first year you use this method. If you want to change methods, you might need to ask for IRS approval by filing Form 3115.

Robert Reas
Sinclair Community College

The two systems of inventory are: (1) perpetual inventory and (2) periodic inventory. Each system has certain advantages and disadvantages. The perpetual inventory system provides up-to-date inventory information but requires more time and record keeping to use it. The periodic inventory system is simpler to use but does not provide us with the number of units on hand unless we physically count the inventory. A business has a choice between the two systems. A perpetual inventory system is the best if a business can afford the cost of maintaining it.

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Under the perpetual inventory system, all merchandise increases and decreases are recorded. When a sale is made, we not only record the sale, we also record the decrease in the inventory account. The merchandise inventory account at any point in time reflects the merchandise on hand at that date. When the periodic inventory system is used, only revenue is recorded each time a sale is made. No entry is made at the time of the sale to decrease the inventory account. A physical count is taken at the end of the accounting period to determine the cost of merchandise sold and the cost of inventory on hand.

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The three most common methods to assign costs to inventory are: (1) first-in, first-out (FIFO), (2) last-in, first-out (LIFO), and (3) average cost.

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There are three common cost flow assumptions: (1) the flow of the costs are the same as the flow of the physical goods (first-in, first-out), (2) cost flows are in reverse order to the flow of the physical goods (last-in, first-out), and (3) cost flows are an average of the unit costs (average cost method). The fifo method of costing inventory assumes that costs should be charged against revenue in the order in which they were incurred. The units left in ending inventory are assumed to be the most recently purchased and therefore represent the most recent costs. The fifo method of costing is usually consistent with the physical movement of the merchandise. The lifo method assumes that the most recent costs incurred should be charged against revenue. The units left in ending inventory are assumed to be the first units purchased and therefore the earliest costs. Under lifo, the flow of the costs is not the same as the flow of the physical goods. The average cost method assumes that the average cost of all units sold should be charged against revenue.

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Companies have a choice of inventory valuation methods. They can choose the method that provides the results they want to achieve in the financial statements. Each method assumes a different order of cost flows. If the cost of units stays the same during any given accounting period, all three methods yield the same ending inventory values and net income figures. When prices change, however, each method yields different results in the short run (and sometimes long run as well). In periods of rising prices, the fifo method yields the highest amount for ending inventory, the lowest cost of merchandise sold, and the highest net income. In periods of rising prices, the lifo method yields the lowest ending inventory , the highest cost of merchandise sold, and the lowest net income.

In periods of declining prices the effects stated in the above two sentences would all be the opposite. The average cost method yields results that are in between those of fifo and lifo. During periods of rising prices, many companies like lifo because it results in paying less income taxes. But if prices later decline, the company would be reporting higher net incomes, thus paying higher taxes. Companies must use a method consistently. Both generally accepted accounting principles and federal tax law prohibit companies from switching back and forth between methods.

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Accuracy in counting and assigning costs to the units is extremely important to ensure meaningful financial statements. For every dollar that we are off in the ending inventory valuation, our net income will be off the same number of dollars and the same direction.

• If the ending inventory is understated, the cost of merchandise sold would be overstated, gross profit understated, and net income understated.
• If the ending inventory is overstated, the cost of merchandise sold would be understated, gross profit overstated, and net income overstated.

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What produces the lowest ending inventory?

When prices are rising which method of inventory if any will result in the lowest?

When inventory prices are rising which inventory method will result in the lowest net income?

What happens to LIFO when prices are rising?