When analyzing the balance sheet, which of the following is an argument against using LIFO in times of rising prices?
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A. B. C. D.D
LIFO values ending inventory at the oldest prices, thus in times of rising prices, inventory will be understated. This results in reporting an unrealistic valuation of the company's inventory.
When analyzing the balance sheet, the use of the LIFO (Last-In, First-Out) inventory valuation method in times of rising prices has certain arguments against it. The correct answer to the question is:
D. Under LIFO, ending inventory is valued at the oldest prices, an unrealistic valuation.
Here's a detailed explanation of why this is the correct answer:
LIFO is an inventory valuation method that assumes the last items purchased or produced are the first ones sold. In times of rising prices, using LIFO can lead to several issues and distortions in the valuation of inventory on the balance sheet. Let's explore the arguments against using LIFO in such situations:
Inaccurate Valuation: LIFO can result in an unrealistic valuation of ending inventory. When prices are rising, the cost of replacing inventory (the most recent purchases) tends to be higher than the cost of older inventory. However, under LIFO, the older, lower-cost inventory is assumed to be sold first, leaving the ending inventory valued at the oldest (and likely lower) prices. This can result in an understatement of the value of inventory on the balance sheet.
Misrepresentation of Profitability: LIFO can distort the measurement of a company's profitability. Since older, lower-cost inventory is assumed to be sold first, the cost of goods sold (COGS) will reflect these lower costs. As a result, the company's reported gross profit will be higher compared to using other inventory valuation methods like FIFO (First-In, First-Out) or average cost. This can lead to an overstatement of profitability, which can mislead investors and stakeholders.
Inconsistency: LIFO creates inconsistencies in the valuation of inventory over time. As new purchases are made at higher prices, the older inventory's value remains on the balance sheet at outdated, lower prices. This inconsistency can make it challenging to compare financial statements across different periods or assess the company's financial performance accurately.
Tax Implications: LIFO can have tax implications. Since COGS is higher under LIFO due to the usage of older, lower-cost inventory, it can lead to lower taxable income and, consequently, lower tax payments. However, this tax advantage comes at the expense of an unrealistic valuation of inventory and potential misrepresentation of profitability.
To summarize, the argument against using LIFO in times of rising prices is that it values ending inventory at the oldest, lower prices, which can result in an unrealistic valuation, misrepresentation of profitability, inconsistency, and potential tax advantages. Therefore, option D is the correct answer.