Final answer:
In a period of rising prices, the Last-In, First-Out (LIFO) inventory costing method will typically yield the lowest annual income tax expense as it increases the cost of goods sold (COGS) by assuming the most recently acquired (and higher-cost) inventory are sold first, thus reducing taxable income.
Step-by-step explanation:
The student's question concerns the impact of different inventory costing methods on annual income tax expense when the price level is steadily rising. If inventory is valued at cost and there is a consistent increase in the price levels, the costing method that will typically yield the lowest annual income tax expense is the Last-In, First-Out (LIFO) method. Under LIFO, the cost of goods sold (COGS) assumes that the last items placed in inventory are the first to be sold, meaning that in a period of rising prices, the higher-cost goods (i.e., more recently acquired inventory) are sold first, leading to a higher COGS and a lower taxable income.
When comparing LIFO to the other two inventory valuation methods - First-In, First-Out (FIFO) and weighted-average cost - the FIFO method often results in a lower COGS and higher profits because it assumes the earliest bought (cheaper) goods are sold first. The weighted-average cost method smooths out price fluctuations by averaging the cost of all goods available for sale during the accounting period, leading to a COGS that lies somewhere between what LIFO and FIFO would yield. When optimizing for the lowest tax bill in a period of rising prices, businesses often prefer the LIFO method due to the resulting decrease in reported profits and, therefore, taxes.