Evaluating the UFO and FIFO Choice When Costs Are Rising and Falling (P7-5)
Income is to be evaluated under four different situations as follows:
- a. Prices are rising:
- (1) Situation A: FIFO is used.
- (2) Situation B: LIFO is used.
- b. Prices are falling:
- (1) Situation C: FIFO is used.
- (2) Situation D: UFO is used.
The basic data common to all four situations are: sales, 510 units for $13,260; beginning inventory, 340 units; purchases, 410 units; ending inventory, 240 units; and operating expenses, $5,000. The following tabulated income statements for each situation have been set up for analytical purposes:
PRICES RISING | PRICES FALLING | |||
Situation A | Situation B | Situation C | Situation I) | |
FIFO | LIFO | FIFO | LIFO | |
Sales revenue | $13,260 | $13,260 | $13,260 | $13,260 |
Cost of goods sold: Beginning inventory' | 3,060 | ? | ? | ? |
Purchases | 4,100 | ? | ? | ? |
Goods available for sale | 7,160 | ? | ? | ? |
Ending inventory | 2,400 | ? | ? | ? |
Cost of goods sold | 4,760 | ? | ? | ? |
Gross profit | 8,500 | ? | ? | ? |
Expenses | 5,000 | 5.000 | 5,000 | 5,000 |
Pretax income | 3,500 | ? | ? | ? |
Income tax expense (30%) | 1,050 | ? | ? | ? |
Net income | $ 2,450 |
Required:
- 1. Complete the preceding tabulation for each situation. In Situations A and B (prices rising), assume the following: beginning inventory, 340 units at $9 = $3,060; purchases, 410 units at $10 = $4,100. In Situations C and D (prices falling), assume the opposite; that is. beginning inventory, 340 units at $10 = $3,400; purchases, 410 units at $9 = $3,690. Use periodic inventory procedures.
- 2. Analyze the relative effects on pretax income and net income as demonstrated by requirement (1) when prices are rising and when prices are falling.
- 3. Analyze the relative effects on the cash position for each situation.
- 4. Would you recommend FIFO or LIFO? Explain.
1.
Complete the preceding tabulation for each situation.
Answer to Problem 7.3AP
Prices Rising | Prices Falling | |||
Particulars | A | B | C | D |
FIFO | LIFO | FIFO | LIFO | |
Sales revenue (a) (1) | $13,260 | $13,260 | $13,260 | $13,260 |
Beginning inventory | 3,060 | 3,060 | 3,400 | 3,400 |
Add: Purchases | 4,100 | 4,100 | 3,690 | 3,690 |
Goods available for sale Table (2) | 7,160 | 7,160 | 7,090 | 7,090 |
Less: Ending inventory | 2,400 Table (3) | 2,160 Table (4) | 2,160 Table (5) | 2,400 Table (6) |
Cost of goods sold (b) Table (7) | 4,760 | 5,000 | 4,930 | 4,690 |
Gross profit | 8,500 | 8,260 | 8,330 | 8,570 |
Less: Expenses | 5,000 | 5,000 | 5,000 | 5,000 |
Pretax income | 3,500 | 3,260 | 3,330 | 3,570 |
Less: Income tax expense | 1,050 | 978 (2) | 999 (3) | 1,071 (4) |
Net income | $2,450 | $2,282 | $2,331 | $2,499 |
Table (1)
Explanation of Solution
Periodic Inventory System:
Periodic inventory system is a system, in which the inventory is updated in the accounting records on a periodic basis such as at the end of each month, quarter or year. In other words, it is an accounting method which is used to determine the amount of inventory at the end of each accounting period.
First-in-First-Out:
In First-in-First-Out method, the costs of the initially purchased items are considered as cost of goods sold, for the items which are sold first. The value of the ending inventory consists of the recent purchased items.
Last-in-Last-Out:
In Last-in-First-Out method, the costs of last purchased items are considered as the cost of goods sold, for the items which are sold first. The value of the closing stock consists of the initial purchased items.
Cost of goods sold:
Cost of goods sold is the accumulate total of all direct cost incurred in manufacturing the goods or the products which has been sold during a period. Cost of goods sold involves direct material, direct labor, and manufacturing overheads.
Working notes:
Determine the amount of sales revenue:
Determine the goods available for sale for FIFO:
Date | Particulars | Units ($) | Unit cost ($) | Total cost ($) |
(a) | (b) | (c = a × b) | ||
January 1 | Beginning inventory | 340 | 9 | 3,060 |
January 12 | Purchased | 410 | 10 | 4,100 |
Total | 750 | 7,160 | ||
Less: Goods sold | 510 | |||
Ending inventory | 240 |
Table (2)
Determine the amount of ending inventory for situation A using FIFO method:
Date | Particulars | Units | Unit cost ($) | Total cost ($) |
(a) | (b) | (c = a × b) | ||
Purchased | 240 | 10 | 2,400 | |
Ending inventory | 240 | 2,400 |
Table (3)
Determine the amount of ending inventory for situation B using LIFO method:
Date | Particulars | Units | Unit cost ($) | Total cost ($) |
(a) | (b) | (c = a × b) | ||
Purchased | 240 | 9 | 2,160 | |
Ending inventory | 240 | 2,160 |
Table (4)
Determine the amount of ending inventory for situation C using FIFO method:
Date | Particulars | Units | Unit cost ($) | Total cost ($) |
(a) | (b) | (c = a × b) | ||
Purchased | 240 | 9 | 2,160 | |
Ending inventory | 240 | 2,400 |
Table (5)
Determine the amount of ending inventory for situation D using LIFO method:
Date | Particulars | Units | Unit cost ($) | Total cost ($) |
(a) | (b) | (c = a × b) | ||
Purchased | 240 | 10 | 2,400 | |
Ending inventory | 240 | 2,400 |
Table (6)
Determine the amount of cost of goods sold for each method:
Situation | Particulars | Units | Unit cost ($) | Total cost ($) |
(a) | (b) | (c = a × b) | ||
a. FIFO | Beginning | 340 | 9 | 3,060 |
Purchased | 170 | 10 | 1,700 | |
510 | 4,760 | |||
b. LIFO | Beginning | 410 | 10 | 4,100 |
Purchased | 100 | 9 | 900 | |
510 | 5,000 | |||
c. FIFO | Beginning | 340 | 10 | 3,400 |
Purchased | 170 | 9 | 1,530 | |
510 | 4,930 | |||
d. LIFO | Beginning | 410 | 9 | 3,690 |
Purchased | 100 | 10 | 1,000 | |
510 | 4,690 |
Table (7)
Determine the amount of income tax expense for Situation B:
Determine the amount of income tax expense for Situation C:
Determine the amount of income tax expense for Situation D:
2.
Analyze the relative effects on pretax income and net income, when there is a rise and fall in prices.
Answer to Problem 7.3AP
The amounts of pretax income when there is rise and fall in prices are compared as below:
Particulars |
Situation A FIFO ($) |
Situation B LIFO ($) |
Difference ($) |
Pretax income when prices are rising | 3,500 | 3,260 | 240 |
Situation C FIFO ($) |
Situation D LIFO ($) |
Difference ($) | |
Pretax income when prices are falling | 3,330 | 3,570 | 240 |
Table (8)
Explanation of Solution
- From the above calculation, it is clear that the difference between the pretax tax income between FIFO and LIFO is same. Thus, a difference in inventory has a dollar-for-dollar effect on pretax income.
- When price rises, the FIFO method gives a higher net income than the LIFO method. On the other hand, when there is a fall in price, the LIFO method gives a higher net income than the FIFO method.
3.
Analyze the relative effects on the cash position for each situation.
Explanation of Solution
- The LIFO method gives most favorable cash position than the FIFO method, when prices are rising. On the other hand, the FIFO method gives most favorable cash position than the LIFO method, when prices are falling. Thus, these cash positions are equal to the difference in income tax.
4.
Explain the method that is recommended.
Explanation of Solution
- Both the LIFO method and FIFO method are equally reasonable in their aspects. For example, when there is a rise in price, the FIFO method produces most favorable results than LIFO by focusing on current income and EPS.
- On the other hand, when there is a rise in price, the LIFO method also produces most favorable results than FIFO by focusing on income tax expenses and cash position. Still, these results will reverse when there is a fall in prices.
- On the income statement, FIFO does not match current expense with current revenues. However it provides a better valuation on the balance sheet. On the other hand, LIFO matches expenses with revenues. However, it provides a less related inventory valuation on the balance sheet.
Want to see more full solutions like this?
Chapter 7 Solutions
CONNECT FINANCIAL ACCOUNTING >I<
- The line that begins at the origin on a CVP graph represents total expenses. total fixed expenses. total sales revenues. both the total expenses and the total sales revenues. Which of the following best describes the concept of a "constraint?" Expected future costs that differ among alternatives. None of the items in this list of answers. A benefit foregone by choosing one alternative course over another. The distribution of all products to be sold.arrow_forwardIf a company has three lots of products for sale, purchase 1 (earliest) for $17, purchase 2 (middle) for $15, purchase 3 (latest) for $12, which of the following statements is true? A.This is a deflationary cost pattern. B.The next purchase will cost less than $12. C.This is an inflationary cost pattern. D.None of these statements can be verified.arrow_forwardQuincy Corporation is trying to determine what type of cost they are observing. As sales increased the total amount this cost increased also. It looks as if it stays fixed in percentage terms at 20% of sales even as sales vary. Based on this relationship, would you say this cost is a fixed cost, variable cost, mixed cost, or a stepped cost? View keyboard shortcutsarrow_forward
- Which of the following statements about CVP analysis is true? O a. Unit selling price, unit variable costs, and total fixed costs are known and remain constant . b. All of the given answers are false. O . Operating income calculations in CVP analysis are based on gross margin. O d The CVP analysis assumes that total variable costs remain the same over a relevant range .arrow_forwardFollowing information is related to Product X of Zempa Company: Current replacement cost $230 Cost to distribute $42 Historical cost Normal profit margin Selling price $215 $36 $245 If lower-of-cost-or-market rule (LCM Rule) is applied, then the value of Product X that would be reported in the balance sheet is: a.arrow_forwardIf a company has three lots of products for sale, purchase 1 (earliest) for $17, purchase 2 (middle)for $15, purchase 3 (latest) for $12, which of the following statements is true?A. This is an inflationary cost pattern.B. This is a deflationary cost pattern.C. The next purchase will cost less than $12.D. None of these statements can be verifiedarrow_forward
- Which of the following is NOT true regarding an income statement organized according to thecontribution margin approach? Question 6 options: The contribution margin income statement is organized by cost behavior. Operating income will always be the same as operating income in a traditional income statement regardless of changes in inventory levels. All fixed costs, including fixed MOH, are expensed below the contribution margin line. The contribution margin is equal to sales revenue minus variable expenses.arrow_forwardThe price of a product is expressed as ?, PHP = 10 – 28? where ? is the demand. Which of the following correctlyexpresses the total revenue? 10 − 28?2 28? = 10 10? − 28? 10? − 28?2arrow_forwardChoose the best answer for each of the following multiple-choice questions.1. Cost-volume-profit analysis includes some simplifying assumptions. Which of thefollowing is not one of these assumptions?a. Cost and revenues are predictable.b. Cost and revenues are linear over the relevant range.c. Changes in beginning and ending inventory levels are insignificant in amount.d. Sales mix changes are irrelevant. 2. The term relevant range, as used in cost accounting, means the rangea. over which costs may fluctuateb. over which cost relationships are validc. of probable productiond. over which production has occurred in the past 10 years3. How would the following be used in calculating the number of units that must besold to earn a targeted operating income? Price per unit Targeted operating income Denominator Numerator Numerator Numerator Not used Denominator Numerator Denominator 4. Information concerning Korian Corporation’s product is as follows: Sales $300,000 Variable…arrow_forward
- As compared with the FIFO method of costing inventories,does the LIFO method result in a larger or smallernet income in a period of rising prices? What is the comparativeeffect on net income in a period of falling prices?arrow_forwardWhich of the following statements is true when making decisions using cost-volume-profit (CVP) analysis? Select one: a. As long as the contribution margin is a positive number, net income will be positive b. As long as variable costs are more than fixed costs, net income will be negative c. As long as the contribution margin is greater than fixed costs, net income will be positive d. As long as the sales price per unit is greater than fixed costs per unit, net income will be positivearrow_forwardAdams Inc. has the following data, rRF = 5%, RPm = 6% and Beta = 1.05. What is the firms cost of common from reinvested earning using CAPM? (11.30%, 12.72%, 11.64%, 11.99%, and 12.35%)arrow_forward
- Financial Reporting, Financial Statement Analysis...FinanceISBN:9781285190907Author:James M. Wahlen, Stephen P. Baginski, Mark BradshawPublisher:Cengage LearningPrinciples of Accounting Volume 1AccountingISBN:9781947172685Author:OpenStaxPublisher:OpenStax CollegeIntermediate Accounting: Reporting And AnalysisAccountingISBN:9781337788281Author:James M. Wahlen, Jefferson P. Jones, Donald PagachPublisher:Cengage Learning