Q3ISTQ - Intermediate Accounting (Kieso)

Question

Starfish Company (a company using GAAP and the LIFO inventory method) is considering changing to IFRS and the FIFO inventory method. How would a comparison of these methods affect Starfish’s financials? (a) During a period of inflation, working capital would decrease when IFRS and the FIFO inventory method are used as compared to GAAP and LIFO. (b) During a period of inflation, the taxes will decrease when IFRS and the FIFO inventory method are used as compared to GAAP and LIFO. During a period of inflation, net income would be greater if IFRS and the FIFO inventory method are used as compared to GAAP and LIFO. (d) During a period of inflation, the current ratio would decrease when IFRS and the FIFO inventory method are used as compared to GAAP and LIFO.

Step-by-Step Solution

Answer

The correct option is “c.”

Step1: Effect of FIFO method

(c) Under the FIFO method, inventories thatare purchased first or early are sold first as compared to the recent inventories purchased. In the event of a price increase in the market or in case of inflation, the cost of goods sold will include inventories purchased at a lower price. Hence, the cost of goods sold will be lower, increasing the net income. 

Step2: Explanation of incorrect options

(a) The working capital will increase, as current assets will include inventories purchased at a higher price. 

(b) The taxes will increase, as in this case cost of goods sold will decrease, and net income will increase, which will increase the overall tax liability. 

(d) Current ratio will increase, as current assets will include inventories purchased at a higher price. 

Thus, the correct option is the third.