In a period of rising prices, how would the following ratios be affected by the accounting decision to select LIFO, rather than FIFO, for inventory valuation?

Answer 1

The impact of the selection of LIFO rather than FIFO for inventory valuation will appear in Inventory and Cost of Goods Sold. Under LIFO, the most recent and most expensive (during inflationary periods) items in inventory will be the first used for accounting purposes. Relative to a firm using FIFO, the LIFO firm will report a lower value for inventory because its ending inventory contains the oldest and least expensive items. As a result of using its higher priced inventory first, the LIFO firm has a higher cost of goods sold.
Gross marginislower for the LIFO firm. The LIFO firm has higher cost of goods sold expenses which makes its gross margin appear lower than the FIFO firm.
Current ratiofalls. The current ratio equals current assets divided by current liabilities. Current assets are lower under LIFO because inventories are lower. Hence, the value of current assets divided by current liabilities drops under LIFO.
Asset turnover increases. Asset turnover equals sales divided by assets. Sales remains the same but assets are lower under LIFO, so asset turnover declines.
Debt-to-equity ratioincreases using the book value of equity. The debt-to-equity ratio equals (short-term debt + long-term debt) divided by book value of shareholders' equity. The LIFO decision does not affect either the short-term or long-term debt levels, but LIFO has a negative net impact on the book value of shareholders' equity. Under LIFO, the higher cost of goods sold leads to lower net income, which in turn leads to a decrease in book shareholders' equity.
This decrease may be mitigated if the firm has a lower tax bill due to lower taxable income. Overall, however, the decline in net income is likely to be greater than the decrease in tax payments, yielding a decline in shareholders' equity and increasing the debt-to-equity ratio.
Average tax rateremains the same. The LIFO firm reports higher expenses which lowers income before tax. Because the firm reports smaller income before tax, it has less taxable income and, hence, has a smaller tax liability. However, the average tax rate is likely to remain the same.