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    Choosing LIFO or FIFO for inventory

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    I would like someone to check my math and methodologies related to the following problem and identify any errors in my methodology and thought process. Here is the data:

    Purchased $600,000 in 2000.
    Purchased $3,000,000 during 2001. Operating expenses (excluding management bonuses) are $400,000, and sales are $6,000,000.

    The management compensation agreement provides for incentive bonuses totaling 1% of after-tax income (before bonuses). Taxes are 25%, and accounting a taxable income will be the same.

    The company is undecided about the selection of the LIFO or FIFO inventory methods. For the year ended 2001, ending inventory would be $700,000 and $1,000,000 respectively under LIFO and FIFO.

    1. Evaluate management's incentives to choose FIFO.
    Management will receive a larger bonus using the FIFO methodology. They
    will also show a larger net income that raises their earnings per share.
    2. Evaluate management's incentives to choose LIFO.
    Their taxes will be lower.

    I have attached my calculations, however, I believe there is something wrong with them as it was my understanding from reading my textbook that LIFO creates a lower book income, but cash flows are higher, therefore the reaction in the security market is an increase in the stock price. But according to what I calculated cash flow is not higher. Thanks.

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    Solution Preview

    What you have done is correct. Purchases in 2000 are $600,000 which you have taken as opening inventory for 2001. That is an assumption to be mentioned and in the absence of ...

    Solution Summary

    The solution explains the impact of LIFO or FIFO method on net income