The correct option for the question is A. First-In, First-Out (FIFO). Detailed Explanation

1. Understanding Inventory Valuation Methods:
2. FIFO (First-In, First-Out): This method assumes that the oldest inventory items are sold first. In periods of rising prices, the cost of goods sold (COGS) will reflect the lower costs of older inventory, leading to higher net income.
3. LIFO (Last-In, First-Out): This method assumes that the most recently purchased items are sold first. In times of rising prices, this means that the COGS will be higher because it reflects the higher costs of the latest inventory, resulting in lower net income.
4. Weighted Average Cost: This method averages the cost of all inventory items available for sale during the period. It smooths out price fluctuations but does not typically lead to the highest net income in rising price environments.
5. Specific Identification: This method tracks the actual cost of each specific item sold. It can lead to varying results depending on the specific items sold, but it does not inherently favor higher or lower net income in a general sense.
6. Why FIFO Results in Higher Net Income:
7. In a period of rising prices, the older inventory (which is cheaper) is sold first under FIFO. This means that the COGS is lower compared to LIFO, where the more expensive, recently purchased inventory is sold first.
8. Lower COGS under FIFO leads to a higher gross profit, which, when combined with operating expenses, results in a higher net income.
9. Analysis of Other Options:
10. B. Last-In, First-Out (LIFO): This method would result in the highest COGS during periods of rising prices, leading to lower net income. Therefore, it is not the correct answer.
11. C. Weighted Average Cost: While this method can provide a middle ground, it does not typically yield the highest net income in a rising price environment because it averages costs rather than reflecting the lower costs of older inventory.
12. D. Specific Identification: This method can vary widely based on the specific items sold. It does not consistently lead to higher net income and is not a method that is typically used for large quantities of similar items.

Example Calculation To illustrate the impact of these methods, consider a company that has the following inventory purchases:

• 100 units at $10 each (oldest)
• 100 units at $12 each (newer)
• 100 units at $15 each (most recent)

If the company sells 150 units:

• FIFO: COGS = (100 units x $10) + (50 units x $12) = $1,000 + $600 = $1,600
• LIFO: COGS = (100 units x $15) + (50 units x $12) = $1,500 + $600 = $2,100
• Weighted Average Cost: Average cost = [(100 x $10) + (100 x $12) + (100 x $15)] / 300 = $12.33. COGS = 150 x $12.33 = $1,849.50

In this scenario, FIFO results in the lowest COGS and thus the highest net income. Common Pitfalls

• Students often confuse the effects of FIFO and LIFO, especially in terms of how they impact net income during inflationary periods.
• It’s important to remember that while FIFO may lead to higher net income, it can also result in higher taxes due to increased taxable income.

Revision Summary

• FIFO results in the highest reported net income during rising prices due to lower COGS.
• LIFO leads to higher COGS and lower net income in inflationary periods.
• Weighted Average Cost provides a middle ground but does not maximize net income.
• Specific Identification varies widely and is not typically used for large inventories of similar items.