Final answer:
To reduce tax liability during inflation, companies may choose the Last-In, First-Out (LIFO) inventory valuation method, which leads to a higher cost of goods sold, lower profits, and therefore less tax. In contrast, the First-In, First-Out (FIFO) method may increase tax liabilities underinflation due to lower costs of goods sold and higher profits.
Step-by-step explanation:
During periods of inflation, the choice of inventory valuation methods by companies is strategically significant. Typically, companies aim to adopt a method that minimizes tax liability. The Last-In, First-Out (LIFO) method allows companies to report higher costs of goods sold, which results in lower taxable income since the latest inventory purchased (usually at higher prices due to inflation) is considered sold first. Consequently, companies report reduced profits and often incur less tax liability.
In contrast, the First-In, First-Out (FIFO) method could result in higher tax liabilities during inflationary periods as it implies the sale of older inventory first, which was purchased at lower prices. Hence, the cost of goods sold will be lower, and reported profits could potentially be higher, leading to increased taxes.
It's imperative to note that while LIFO can be advantageous for tax purposes during inflation, not all countries permit its use for financial reporting purposes, and it may affect the comparability of financial statements among firms following different inventory methods. Additionally, the choice of inventory valuation method should be consistent with a company's overall business strategy and in compliance with the accounting principles and regulations that apply to the jurisdiction in which the company operates.