Question

A firm has used LIFO for several years during which costs have trended higher. If this firm achieves a substantial reduction in inventory quantities in 2014 by selling more merchandise than it purchases, the effect on 2014 net income of the inventory reduction, compared to having no change in inventory quantity from the beginning to the end of 2014, is?

1) net income for 2014 will be greater if the inventory quantity declines.
2) net income for 2014 will be less if the inventory quantity declines.
3) net income for 2014 will not be affected because of the inventory quantity decline.
4) can't tell from the information given.

Answer 1

The use of LIFO (Last In, First Out) accounting method implies that the last inventory items purchased are assumed to be the first ones sold.

The correct answer is 2) net income for 2014 will be less if the inventory quantity declines.

Step-by-step explanation:

In a scenario where inventory quantities decline, this often means that the older, lower-cost items are being sold, leading to a lower cost of goods sold (COGS) and higher reported net income. Since the firm has been using LIFO and costs have trended higher over the years, a reduction in inventory quantities in 2014 would result in recognizing a higher value of older, lower-cost inventory in the cost of goods sold calculation. This, in turn, would lead to a lower cost of goods sold and, consequently, higher net income compared to a situation with no change in inventory quantity.

In the given context, as the firm achieves a substantial reduction in inventory quantities by selling more merchandise than it purchases, the COGS on the income statement is calculated using older, lower-cost inventory. This lower COGS contributes to higher net income for the period. Therefore, the firm is likely to experience higher net income in 2014 if the inventory quantity declines compared to a scenario with no change in inventory quantity. This outcome aligns with option 2, indicating that net income for 2014 will be less if the inventory quantity declines.

Therefore, the correct option is 2.net income for 2014 will be less if the inventory quantity declines.