The FIFO (First-In, First-Out) method values inventory based on the assumption that older, lower-cost inventory is sold first, leaving newer, higher-cost inventory in stock. During periods of rising prices, FIFO results in lower cost of goods sold (COGS) and higher net income, making it susceptible to manipulation by management.
(A) Correct – First-in, first-out method (FIFO).
FIFO lowers COGS when older, cheaper inventory is sold first, inflating net income.
Management can manipulate earnings by selectively selling older, lower-cost inventory.
(B) Incorrect – Last-in, first-out method (LIFO).
LIFO assumes newer, higher-cost inventory is sold first, resulting in higher COGS and lower net income.
LIFO is typically used to reduce taxable income, not to inflate net income.
(C) Incorrect – Specific identification method.
This method tracks the exact cost of each unit, eliminating the ability to manipulate costs easily.
(D) Incorrect – Average-cost method.
The average-cost method smooths out fluctuations in inventory costs, preventing significant income manipulation.
IIA’s Global Internal Audit Standards – Financial Reporting and Inventory Valuation Risks
Discusses inventory accounting methods and their impact on financial statements.
IFRS and GAAP Accounting Standards – Inventory Valuation
Defines how FIFO can be used to influence financial performance.
COSO’s ERM Framework – Financial Manipulation Risks
Identifies inventory valuation as an area where earnings management can occur.
Analysis of Answer Choices:IIA References and Internal Auditing Standards:
