Highest Net Income in Rising Prices

A

FIFO assigns the lowest dollar value amounts to COGS when purchase prices are rising, thus resulting in higher net income.

In periods of rising prices, the inventory costing method that typically results in the highest net income is the FIFO (First-In, First-Out) method.

FIFO assumes that the inventory items that were purchased or produced first are sold or used first. Under this method, the cost of goods sold (COGS) is calculated by valuing the inventory based on the most recent purchases or production costs. This means that the COGS reflects the lower, older costs of inventory items. As a result, when prices are rising, the FIFO method tends to report lower COGS and higher net income.

To understand why FIFO results in higher net income during rising prices, let's consider an example. Imagine a company that sells a product and experiences increasing purchase costs over time. Under FIFO, the company assumes that the earliest units acquired (at lower costs) are the first ones sold. As prices rise, the cost of goods sold is calculated using the lower cost of those earlier units, which leaves higher-cost inventory on hand. This leads to a higher valuation of the remaining inventory and, consequently, higher net income.

On the other hand, the LIFO (Last-In, First-Out) method assumes that the most recently acquired inventory items are sold first. In periods of rising prices, LIFO results in higher COGS because it attributes the most recent, higher costs to the goods sold. This generally leads to lower net income compared to FIFO.

The average cost method calculates COGS by taking the average cost of all units in inventory. This method smooths out the effects of rising prices but typically falls between FIFO and LIFO in terms of the resulting COGS and net income. Therefore, average cost is not likely to yield the highest net income during periods of rising prices.

The perpetual inventory system is not directly related to the calculation of COGS or net income. It refers to a system where inventory balances are continuously updated in real-time, typically using computerized systems, rather than periodic physical counts. The perpetual inventory system can be used with any of the inventory costing methods, including FIFO, LIFO, and average cost.

In summary, during periods of rising prices, the FIFO method tends to result in the highest net income among the given options (A, B, C, and D) because it assigns the lower, older costs to the goods sold, leading to a higher valuation of the remaining inventory.