Final answer:
During periods of rising costs, FIFO leads to lower COGS and higher profits, resulting in higher tax liabilities. In contrast, LIFO results in higher COGS and lower profits, which may lower tax expenses but can lead to outdated inventory valuation. The choice affects tax liabilities, profits, and cash flows.
Step-by-step explanation:
When discussing inventory accounting during periods of rising costs, two widely recognized methods come into focus: First-In, First-Out (FIFO) and Last-In, First-Out (LIFO). Understanding the effects of FIFO and LIFO is crucial for businesses as they impact the reported amount of income and inventory valuation.
Under FIFO, it is assumed that the first items purchased (the oldest inventory) are sold first. Consequently, during a time of rising costs, the cost of goods sold (COGS) reflects the cost of older, likely cheaper inventory. This results in a lower COGS, higher remaining inventory valuation, and thus higher profits. Conversely, LIFO assumes the last items purchased (the newest inventory) are sold first. In times of rising costs, this means the COGS reflects the price of newer, more expensive inventory, leading to a higher COGS, lower profit, and lower remaining inventory valuation.
The choice between these two methods impacts not only reported profit but also tax liabilities and cash flow. Companies choosing FIFO might pay higher taxes due to higher profits during inflationary periods, whereas those using LIFO may benefit from lower tax payments. Nevertheless, while LIFO can provide tax benefits, it may result in outdated inventory valuation if prices continue to rise, which may not be truly reflective of current market values.
It's important to note that the use of LIFO is prohibited or restricted in some countries under International Financial Reporting Standards (IFRS). In the United States, however, both FIFO and LIFO are acceptable under Generally Accepted Accounting Principles (GAAP).