# 3 we are assuming that houston electronics is a

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3 We are assuming that Houston Electronics is a corporation, and corporations are required to pay income taxes. PDF Watermark Remover DEMO : Purchase from to remove the watermark

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In periods of changing prices, the cost flow assumption can have a significant impact on income and on evaluations based on income. In most instances, prices are rising (inflation). In a period of inflation, FIFO produces a higher net income because the lower unit costs of the first units purchased are matched against rev- enues. In a period of rising prices (as is the case in the Houston example), FIFO reports the highest net income (\$2,310) and LIFO the lowest (\$1,750); average cost falls in the middle (\$2,030). If prices are falling, the results from the use of FIFO and LIFO are reversed: FIFO will report the lowest net income and LIFO the highest. To management, higher net income is an advantage: It causes external users to view the company more favorably. In addition, management bonuses, if based on net income, will be higher. Therefore, when prices are rising (which is usually the case), companies tend to prefer FIFO because it results in higher net income. Some argue that the use of LIFO in a period of inflation enables the company to avoid reporting paper (or phantom ) profit as economic gain. To illustrate, as- sume that Kralik Company buys 200 units of a product at \$20 per unit on January 10 and 200 more on December 31 at \$24 each. During the year, Kralik sells 200 units at \$30 each. Illustration 6-13 shows the results under FIFO and LIFO. Inventory Costing 261 FIFO LIFO Sales (200 H11003 \$30) \$6,000 \$6,000 Cost of goods sold 4,000 (200 H11547 \$20) 4,800 (200 H11547 \$24) Gross profit \$2,000 \$1,200 Illustration 6-13 Income statement effects compared Under LIFO, Kralik Company has recovered the current replacement cost (\$4,800) of the units sold.Thus, the gross profit in economic terms is real. However, under FIFO, the company has recovered only the January 10 cost (\$4,000). To re- place the units sold, it must reinvest \$800 (200 H11003 \$4) of the gross profit.Thus, \$800 of the gross profit is said to be phantom or illusory.As a result, reported net income is also overstated in real terms. BALANCE SHEET EFFECTS A major advantage of the FIFO method is that in a period of inflation, the costs al- located to ending inventory will approximate their current cost. For example, for Houston Electronics, 400 of the 450 units in the ending inventory are costed under FIFO at the higher November 27 unit cost of \$13. Conversely, a major shortcoming of the LIFO method is that in a period of in- flation, the costs allocated to ending inventory may be significantly understated in terms of current cost.The understatement becomes greater over prolonged periods of inflation if the inventory includes goods purchased in one or more prior ac- counting periods. For example, Caterpillar has used LIFO for 50 years. Its balance sheet shows ending inventory of \$4,675 million. But the inventory’s actual current cost if FIFO had been used is \$6,799 million.
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