Final Answer:
When replacement cost falls below FIFO, LIFO, or average cost, it can lead to higher reported costs and lower net income, especially in FIFO. In LIFO, the impact may affect tax liabilities. Average cost may result in a mismatch between reported and market values, impacting financial statements.
Step-by-step explanation:
When the replacement cost of inventory drops below the cost determined using FIFO (First-In, First-Out), LIFO (Last-In, First-Out), or average cost, it can have an impact on financial reporting and inventory valuation. Let's explore how each method is affected:
FIFO (First-In, First-Out):
In FIFO, the cost of goods sold (COGS) is based on the cost of the oldest inventory first. When replacement cost drops below the FIFO cost, the company continues to use the older, higher-cost inventory in its cost calculations.
This can result in a lower reported net income because the cost of goods sold is higher. It may also lead to a higher reported inventory value on the balance sheet.
LIFO (Last-In, First-Out):
LIFO assumes that the newest inventory is used first, and the cost of goods sold is based on the most recent purchases. If the replacement cost drops below the LIFO cost, the company may still value its inventory at the higher historical LIFO cost.
This can have tax implications, as using LIFO may result in lower taxable income in periods of rising prices. However, it can lead to an understatement of the current value of inventory on the balance sheet.
Average Cost:
Average cost is calculated by taking the weighted average of the costs of all units in inventory. If replacement cost drops below the average cost, it may result in a situation where the reported average cost is higher than the replacement cost.
This could lead to a mismatch between the reported inventory value and the current market value. The company may be carrying inventory at a higher cost than it could replace it, affecting both income statement and balance sheet figures.