In a case study, a company reports higher profits using FIFO. What could be a potential risk of this method?
Practice Questions
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Q1
In a case study, a company reports higher profits using FIFO. What could be a potential risk of this method?
Overstated inventory.
Understated expenses.
Higher tax liabilities.
All of the above.
Using FIFO can lead to overstated inventory, understated expenses, and higher tax liabilities.
Questions & Step-by-step Solutions
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Q
Q: In a case study, a company reports higher profits using FIFO. What could be a potential risk of this method?
Solution: Using FIFO can lead to overstated inventory, understated expenses, and higher tax liabilities.
Steps: 5
Step 1: Understand FIFO - FIFO stands for 'First In, First Out'. This means that the oldest inventory items are sold first.
Step 2: Recognize profit reporting - When a company uses FIFO, it may show higher profits because the cost of older inventory is usually lower than newer inventory.
Step 3: Identify overstated inventory - Since FIFO sells older, cheaper items first, the remaining inventory on the balance sheet may be valued at higher prices, making it look more valuable than it actually is.
Step 4: Understand understated expenses - Because the older, cheaper costs are used for the cost of goods sold, the expenses reported are lower, which can inflate profits.
Step 5: Consider tax implications - Higher reported profits can lead to higher tax liabilities, meaning the company may have to pay more taxes than if they used a different method.
