PTD6 Flashcards
The CEO of ABC, Inc. has asked for your advice about changing the company’s inventory method from FIFO to LIFO. As the controller, you believe that LIFO is the best methodology for the company. Write a memo to the CEO supporting your recommendations to change to LIFO for inventory costing purposes. In your memo, explain the advantages and disadvantages of each method and identify conditions under which LIFO might produce advantages over FIFO.
This memorandum explains the advantages and disadvantages of the FIFO and LIFO inventory methods, including the conditions under which LIFO might produce advantages over FIFO. In addition, this memorandum describes the reasons that I believe ABC, Inc. should change from the FIFO to the LIFO method of inventory
When the FIFO method of inventory is used, the cost of the earliest inventory acquired is the first inventory cost that is recognized as cost of goods sold each period. This method of recognizing inventory cost has the effect of matching the cost of the earliest acquired inventory with current revenue. During a period of rising prices, this would have the disadvantage of matching lower earlier cost of inventory with a higher current sales price, resulting in a higher gross profit than would occur under the LIFO method. And, if the FIFO method is used for taxes purposes, other things being equal, the higher gross profit would result in a higher taxable income and higher income tax expense. The primary advantage of using the FIFO method is that, because the earliest cost incurred is expensed, the remaining cost is the most recent cost, resulting in the inventory value shown on the balance sheet more closely approximating current cost than would occur under the LIFO method.
The LIFO method of inventory has the advantage of closely matching the most recent cost of inventory with the current revenue from the sale of inventory. As a consequence, in a period of rising prices, reported gross profit, taxable income and income tax expense will be lower than under the FIFO inventory method. Because the most recent inventory cost is expensed, the LIFO method has the disadvantage of reporting the remaining inventory asset at it earliest cost which, during a period of rising prices, would be less than the current cost of that inventory. In addition, it should be noted that, if the LIFO method is used for tax purposes, IRS regulations require that it also be used for financial reporting purposes.
Since ABC’s inventory tends to follow a last in, first out physical flow, and in view of the tax advantage associated with the LIFO inventory method, I believe that LIFO is the better of the methods for ABC, Inc. Therefore, I recommend we switch from using FIFO to using LIFO for inventory costing purposes. Such a change would result in our cost of goods sold being more closely aligned with the physical flow of our inventory. In addition, since prices tend to increase rather than decrease, the use of the LIFO inventory method likely will result in lower taxable income and lower tax expense for reporting purposes. Finally, the use of LIFO rather than FIFO will result in both a higher cash flow, resulting from a lower tax payment, and a higher inventory turnover ratio, resulting from both a higher cost of goods sold and a lower reported inventory value.
Please let me know if I can provide additional information about the two inventory costing methods and the basis for my recommendation that ABC, Inc. switch from using FIFO inventory to LIFO inventory.
ABC, Inc. Controller
3WAT, Inc. is discussing the data-storage possibilities for its highly mobile workforce. Currently, data is stored on laptop hard drives and is not centrally available. Management is concerned about data security, accessibility, and cost.
Prepare a memo to management discussing various options for data storage for a highly mobile workforce including advantages, disadvantages, and costs.
Currently, data stored on laptop hard drives limits accessibility to those with direct access to the laptop. Data stored on laptops increases the number of portals into data stores; hence, care must be taken to ensure that laptops do not afford access to hackers, crackers, and peepers. In such a system, all machines should include username and password system access, with potential additional access levels required to access sensitive data stores. In addition, while decentralized data storage costs are relatively low, inefficient accessibility as well as time-consuming and limited data sharing are important disadvantages to this configuration.
Centralizing data storage into a cloud-based system affords many important advantages. These include universal access (to anyone with an Internet connection), long-run lower costs due to the reduced need to maintain differing operating systems and configurations, scalability (i.e., the ability to grow with the organization), outsourcing and economies of scale, and, enterprise-wide integration into a centralized system. Disadvantages of a cloud-based storage system include start-up costs, concerns over having all of one’s data “eggs” in one “basket,” dependence on a single system (and potentially, a single vendor), server overload or disruption, and the ongoing maintenance costs of network administration. However, despite these disadvantages, many organizations are realizing improved access and lower costs by moving to cloud-based systems.
Sincerely,
[Your name]
Future CPA
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Many ratios and other metrics are used to evaluate the financial position of enterprises. For example, both working capital and the current ratio are often used to analyze liquidity. As a division manager you are asked to evaluate your division’s liquidity and compare it to other divisions of various sizes within the company. In doing so, a new clerk asks you to explain why you would want to include both working capital and the current ratio in your analysis. “Isn’t one liquidity indicator enough to provide an adequate evaluation?” He states. Please provide a brief response to the clerk
Thank you for asking about this. The use of both working capital and the current ratio are beneficial to a more complete analysis of liquidity than using one of those metrics alone. Working capital is defined as current assets minus current liabilities. This definition provides a result that is expressed in dollars. A clear dollar amount is useful in determining the adequacy of our ability as a division to meet our current obligations on a timely basis.
We have also been asked to compare our division’s liquidity with other divisions of various sizes in our company. Since a larger division has more obligations than a smaller division, it would not make sense to compare our working capital adequacy in dollars to a division of different size. For comparison purposes, we need to standardize the result for size differences. We can accomplish standardization by using the current ratio.
The current ratio is defined as current assets divided by current liabilities. This definition is similar to that of working capital but is divided rather than subtracted, thereby expressing the result as a ratio rather than a dollar amount. The standardized ratio result of one division can effectively be compared to other divisions of different size.
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