Accounting - Decision Case 5-10

Decision Case 5-10
a). The CEO is mainly concerned with reporting the highest amount of income possible. Thus the CEO will be pleased if the company uses the FIFO method. This method recognizes as cost of goods sold the oldest costs, and because prices are rising, the costs charged to cost of goods sold will be less than if LIFO is used.

b). It would be difficult to state absolutely which method is truly in the best interest of the stockholders, as FIFO results in lower COGS on the income report; it also results in higher earnings. But when earnings are higher so the taxes are also higher. And when taxes are higher, after-tax earnings become lower. On the other hand, LIFO results in lower pre-tax earnings since COGS are higher and therefore lower taxes and therefore higher after-tax earnings. The interplay between pre-tax earnings, taxes and after-tax earnings is a complicated one and proper analysis must be used to choose the best accounting method for any given company in interest of stockholders. The LIFO method minimizes the amount of income taxes paid since this method would report the highest costs of goods sold and thus the lowest income before taxes. From a cash flow perspective, LIFO is the most advantageous method in a period of rising prices and also in favor of stockholder’s.

c). Memo to the CEO:
As we end our first year of operations, I am aware of the need to present a favorable impression to our stockholders. In this regard, I would like to address the selection of an inventory valuation method.
I can appreciate your interest in maximizing income whenever possible. However, a method of inventory valuation that addresses this objective will not necessarily satisfy our other concerns. Certainly one of our primary concerns should be to minimize the payment of taxes whenever possible.
FIFO will result in the lowest amount reported as cost of goods sold and thus an income number which is higher than if LIFO were used. For this reason, however, the use of FIFO will result in a higher amount of taxes payable than if LIFO were used. It is my opinion that we should attempt to conserve cash whenever possible, and thus I believe that we should adopt the LIFO method of inventory valuation.

Thank you for the opportunity to present my views on this important matter.