Under an inflationary environment with a constant inventory quantity, the LIFO Reserve tends to ________.
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A. B. C. D.A
As prices increase and LIFO layers are maintained, the inventory value at FIFO keeps increasing while that at LIFO remains constant. Hence, the reserve keeps increasing.
Under an inflationary environment with a constant inventory quantity, the LIFO Reserve tends to decrease over time.
To understand why, let's start by defining the LIFO Reserve. The LIFO Reserve is the difference between the cost of inventory reported under the LIFO (Last-In, First-Out) method and the cost of inventory that would be reported if the FIFO (First-In, First-Out) method were used. It represents the cumulative effect of using the LIFO method for inventory valuation instead of the FIFO method.
In an inflationary environment, prices of goods tend to increase over time. When a company uses the LIFO method, it assumes that the most recently purchased or produced items are sold first. As prices rise, the cost of the most recent purchases increases, leading to a higher cost of goods sold (COGS) under LIFO compared to FIFO. This is because the most recent purchases are valued at higher prices.
As COGS increases under LIFO, the LIFO Reserve also increases. The LIFO Reserve represents the cumulative difference between the cost of inventory under LIFO and FIFO. Therefore, as prices rise, the LIFO Reserve tends to increase over time.
However, the question states that the inventory quantity remains constant. In this case, the LIFO Reserve will tend to decrease over time. Here's why:
When prices are increasing, the LIFO Reserve increases due to the higher COGS under LIFO. But if the inventory quantity remains constant, the LIFO Reserve cannot continue to increase indefinitely. Eventually, the LIFO Reserve will reach a maximum value equal to the original difference in costs between LIFO and FIFO when the inventory quantity was first established.
Once the LIFO Reserve reaches this maximum value, it will stop increasing because there is no further difference between LIFO and FIFO to account for. From that point on, as prices continue to rise, the COGS under LIFO will increase, but the LIFO Reserve will remain constant because it has already captured the initial difference in costs.
Therefore, under an inflationary environment with a constant inventory quantity, the LIFO Reserve tends to decrease over time, as it reaches its maximum value and then remains constant. The correct answer is B. decrease over time.