Business Scenario - Inventory Valuation and Credit

To begin, read the following scenario:

Company 1 and Company 2 are online retailers. Both companies are basically identical and follow the same accounting practices except that Company A uses LIFO and Company B uses FIFO to value their inventory. Because of rising inventory costs, both companies need additional capital to manage their operations.

For your main discussion post, reflect on these questions: If Company A and Company B apply for a loan at their local bank and the bank bases its decision on net income, which company is more likely to obtain the loan? Explain. What if the bank based its decision on cash flows associated with the inventory costing valuation method the company uses? Which company might be better positioned to obtain the loan? Elaborate your responses and provide an example as needed to support your assessment.

For your responses, focus on the following questions: Do you agree with your classmates’ responses as far as which company might obtain the loan if the bank bases its decision on net income and/or cash flows? Why or why not? How has the discussion impacted your understanding of the effects of FIFO and LIFO inventory methods on net income and cash flows? Support your responses to classmates with additional research and/or examples of your understanding of these inventory valuation methods.

Be sure to post at least 2 references in support of your explanations and conclusions.

Answer and explanation:

If company A & B apply for a loan from the bank and the bank bases its decision on net income.

A uses LIFO and B uses FIFO.

We have to assume that the cost of purchase generally rises. If the cost of purchase of goods are constant, it will not make any difference to whether you are using FIFO or LIFO.

In FIFO method, the charge to the cost of goods account is based on the earliest available inventory. Hence under rising prices, charge to the costs of goods sold will be lower under FIFO.  

Under LIFO method, the charge to the cost of goods account is based on the latest available inventory. Hence under rising prices, charge to the costs of goods sold will be higher under LIFO.  

If cost of goods is higher, net income will be lower.  

Hence , if everything is identical, LIFO method will show lower net income in the income statements than the FIFO method.  

This will be clear with following example:

Assume beginning of month inventory =100 pieces at $ 10 per piece  

Purchase 100 pieces at $ 12 per piece.  

Sales 80 pieces at sales price =$20 per price

INCOME STATEMENT

                                         FIFO                LIFO

Sales(80*20)                    $1,600              $1,600

Cost of goods sold         $800                $960 FIFO=80*10LIFO=80*12

Gross Margin                  $800                 $640

Operating expenses      $0                     $0

Income before taxes      $800                $640

Income Tax expense(40%)$320.0        $256.0

Net Income                     $480.0            $384.0

Closing inventory value under FIFO=20*10+100*12=$1,400

Closing inventory value under LIFO=100*10+20*12=$1,240  

If the bank bases its decision on net income, Company B which uses FIFO is more likely to obtain the loan.  

The cash inflow from Sales or cash outflow for purchase does not change with the inventory method. But the reported income changes and it is higher in FIFO.  

Since the reported income is higher in FIFO method, the tax expense will also be higher.  

Cash outflow due to tax expense will be higher in FIFO.  

Hence, net cash flow will be lower in FIFO compared to LIFO.  

As shown in the example above, tax expense is $ 320 under FIFO and $256 under LIFO.  

If the bank bases its decision on cash flow, company A which uses LIFO is likely to obtain loan.  

Closing inventory will be higher in FIFO than LIFO. Reduction in inventory will show higher cash flow in LIFO.  

It should be kept in mind that above effects will occur in condition of increasing prices. In situation of decreasing prices, opposite will happen. And at constant prices, there will be no difference in LIFO and FIFO