Why is the choice of inventory costing method (such as FIFO, LIFO, or weighted average) important for a company's financial statements?

• A. Because it changes the company's total assets without affecting expenses.
• B. Because it determines the company's cash flow from investing activities.
• C. Because it affects reported net income and the value of inventory on the balance sheet.
• D. Because it only impacts the physical flow of goods, not financial reporting.

Answer: (C)

Verified step by step guidance

1. Understand the concept of inventory costing methods: Inventory costing methods like FIFO (First-In, First-Out), LIFO (Last-In, First-Out), and Weighted Average are accounting techniques used to determine the cost of goods sold (COGS) and the value of inventory on the balance sheet.
2. Recognize the impact on financial statements: The choice of inventory costing method directly affects the reported net income and the value of inventory on the balance sheet. This is because the cost assigned to inventory sold (COGS) and the remaining inventory can vary depending on the method chosen.
3. Analyze the effect on net income: For example, under FIFO, older (and often cheaper) inventory costs are used for COGS, which can result in higher net income during periods of rising prices. Conversely, LIFO uses newer (and often more expensive) inventory costs, which can lower net income in the same scenario.
4. Consider the impact on the balance sheet: The inventory valuation on the balance sheet will differ based on the method. FIFO typically results in higher inventory values during inflationary periods, while LIFO may show lower inventory values.
5. Understand the broader implications: The choice of inventory costing method can influence tax liabilities, financial ratios, and investor perceptions. It is important for companies to select a method that aligns with their financial strategy and reporting objectives.