Jean Honore, president of Fragonard Co., recently read an article that claimed that at least 100 of the country’s largest 500 companies were either adopting or considering adopting the last-in, first-out (LIFO) method for valuing inventories. The article stated that the firms were switching to LIFO to

(1) Neutralize the effect of inflation in their financial statements,

(2) Eliminate inventory profits, and

(3) Reduce income taxes. Ms. Honore wonders if the switch would benefit her company.

Fragonard currently uses the first-in, first-out (FIFO) method of inventory valuation in its periodic inventory system.

The company has a high inventory turnover rate, and inventories represent a significant proportion of the assets.

Ms. Honore has been told that the LIFO system is more costly to operate and will provide little benefit to companies with high turnover. She intends to use the inventory method that is best for the company in the long run rather than selecting a method just because it is the current fad.

Instructions

(a) Explain to Ms. Honore what “inventory profits” are and how the LIFO method of inventory valuation could reduce them.

(b) Explain to Ms. Honore the conditions that must exist for Fragonard Co. to receive tax benefits from a switch to the LIFO method.