Inventory Costing Methods and Income Tax Expense in Rising Prices

The LIFO (Last In, First Out) Method

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In periods of rising prices, which inventory costing method results in the smallest income tax expense?

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D

LIFO assigns the largest dollar value amounts to COGS when purchase prices are rising, thus resulting in lower net income and lower income taxes.

In periods of rising prices, the inventory costing method that results in the smallest income tax expense is the Last-In, First-Out (LIFO) method.

The LIFO method assumes that the most recent inventory purchases are the first ones sold. As a result, when prices are rising, the LIFO method values the cost of goods sold (COGS) using the higher-priced inventory items, which leads to a higher COGS and lower reported income. This lower reported income results in a smaller income tax expense since taxes are typically calculated based on taxable income, which is reduced by the lower reported income.

To understand this concept further, let's compare the LIFO method with the other options provided:

  1. Average Cost: The average cost method calculates the COGS by taking the average cost of all inventory items available for sale. It smooths out the impact of price fluctuations by using the average cost per unit. In periods of rising prices, the average cost method would result in COGS that falls between the LIFO and FIFO methods, depending on the specific cost fluctuations.

  2. Perpetual: Perpetual inventory systems continuously track inventory levels and costs, allowing for real-time updates of COGS. However, the perpetual system itself does not dictate the specific costing method used. It can be used with any of the costing methods, including LIFO, FIFO, or average cost.

  3. FIFO: The First-In, First-Out (FIFO) method assumes that the oldest inventory purchases are the first ones sold. In periods of rising prices, FIFO results in lower COGS since the lower-priced inventory items are considered sold first. As a result, FIFO generally leads to higher reported income compared to LIFO, and subsequently, higher income tax expense.

Therefore, among the options provided, the LIFO method results in the smallest income tax expense in periods of rising prices.

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