LIFO
Response to the following problem:
The 1970s were a period of historically high inflation. The 1976 financial statements of the Ford Motor Company included the following note:
Note 1 (in part): Inventory valuation. Inventories are stated at the lower of cost or market. In 1976 the company changed its method of accounting from first-in, first-out (FIFO) to lastin, first-out (LIFO) for most of its U.S. inventories.
The change to LIFO reduced net income in 1976 by $81 million or $0.86 a share. There is no effect on prior years' earnings resulting from the change to LIFO in 1976 and, accordingly, prior years' earnings have not been restated. If the FIFO method of inventory accounting had been used by the company, inventories on December 31, 1976 would have been $166 million higher than reported.
Required
1. Explain the arguments that must have been used in favor of LIFO for the management of Ford to accept a reduction in net income of $81 million.
2. Explain the disadvantages that are likely to result from the adoption of LIFO.
3. Explain why the effect on earnings is $81 million when the effect on the inventory valuation is $166 million.
4. Explain whether your answers to Requirements 1 and 2 would change if you were discussing a change to LIFO for a Ford dealer.