Assuming high inflation in the short run and lower levels of inflation in the long run, the current ratio of a company using last in, first out (LIFO) relative to a firm using first in, first out (FIFO), will be:
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The LIFO firm's current ratio will be lower and the difference between the two firms' current ratios will increase as inflation decreases. For example, assume purchases equal sales so the quantity of inventory is constant. Inventory value under LIFO will also remain constant as inflation decreases, whereas FIFO inventory value will increase even as the inflation rate decreases. As long as inflation remains positive, the FIFO inventory value and the difference between LIFO and FIFO inventory values will increase, as will the difference between the LIFO and FIFO firms' current ratios.
Units Unit Price Beginning Inventory 709 $2.00 Purchases 556 $6.00 Sales 959 $13.00 SGA Expenses $2,649 per annum
What are the earnings before taxes using the FIFO method and LIFO method?
FIFO | LIFO |
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FIFO COGS = (709 units)($2/unit) + (959 ? 709)($6/unit) = $1,418 + $1,500 = $2,918 Sales = (959 units)($13/unit) = $12,467 EBIT = Sales ? COGS ? Expenses LIFO COGS = (556 units)($6/unit) + (959 ? 556)($2/unit) = $3,336 + $806 = $4,142 Sales = (959 units)($13/unit) = $12,467 EBIT = Sales ? COGS ? Expenses = 12,467 ? 4,142 ? 2,649 = $5,676
In general, when analyzing profitability and costs, or when analyzing asset and equity ratios, which of the following should be used?
Profitability/Cost Ratios | Asset/Equity Ratios |
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In general, an analyst should use LIFO when examining profitability or cost ratios and FIFO when examining asset or equity ratios.
When analyzing profitability ratios, which inventory accounting method is preferred?
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Using LIFO cost of goods sold (COGS) gives a more accurate measure of future earnings because the LIFO COGS is more representative of the current cost of product sold as compared to using FIFO therefore net income will be more accurately represented.
The best way to compute an inventory turnover ratio is to use:
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Inventory turnover makes no sense at all for firms using LIFO due to the mismatching of costs (the numerator is current while the denominator is historical). FIFO based inventory is relatively unaffected by price changes and is a good approximation of actual turnover. In this way, current costs are matched in the numerator and denominator.
Selected information from Mendota, Inc.’s financial statements for the year ended December 31 includes the following (in $):
Sales |
7,000,000 |
Cost of Goods Sold |
5,000,000 |
LIFO Reserve on Jan. 1 |
600,000 |
LIFO Reserve on Dec. 31 |
850,000 |
Mendota uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is 40%. If Mendota changed from LIFO to first in, first out (FIFO), its gross profit margin would:
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Gross profit margin under LIFO ((sales – cost of goods sold) / sales) is (($7,000,000 ? $5,000,000) / $7,000,000) = 28.6%. Under FIFO, cost of goods sold is reduced by the increase in the LIFO reserve, and the resulting FIFO gross profit margin is (($7,000,000 – ($5,000,000 – ($850,000 - $600,000)) / $7,000,000) = 32.1%. Note that the tax rate only affects income totals after income tax expense is shown and does not affect the gross profit margin.
Selected information from Oldtown, Inc.’s financial statements for the year ended December 31, 2004 included the following (in $):
Cash |
1,320,000 |
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Accounts Payable |
1,620,000 |
Accounts Receivable |
2,430,000 |
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Deferred Tax Liability |
715,000 |
Inventory |
6,710,000 |
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Long-term Debt |
15,230,000 |
Property, Plant & Equip. |
12,470,000 |
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Common Stock |
1,000,000 |
Total Assets |
22,930,000 |
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Retained Earnings |
4,365,000 |
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Total Liabilities & Equity |
22,930,000 |
Sales |
15,000,000 |
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Net Income |
3,000,000 |
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LIFO Reserve at Jan. 1 |
1,620,000 |
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LIFO Reserve at Dec. 31 |
1,620,000 |
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Oldtown uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate was 40%. If Oldtown changed from LIFO to first in, first out (FIFO) for 2004, net profit margin would:
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Net profit margin under LIFO (net income / net sales) was ($3,000,000 / $15,000,000 =) 20.0%. Under FIFO, net income does not change in 2004 because there was no change in the LIFO reserve balance, and no adjustment of net income is made.
Selected information from Jenner, Inc.’s financial statements for the year ended December 31 included the following (in $):
Cash
$200,000
Accounts Payable
$300,000
Accounts Receivable
300,000
Deferred Tax Liability
600,000
Inventory
1,500,000
Long-term Debt
8,100,000
Property, Plant & Equip.
11,000,000
Common Stock
2,200,000
Total Assets
13,000,000
Retained Earnings
1,800,000
LIFO Reserve at Jan. 1
400,000
Total Liabilities & Equity
$13,000,000
LIFO Reserve at Dec. 31
600,000
Net Income
(after 40% tax rate)
800,000
Jenner uses the last in, first out (LIFO) inventory cost flow assumption. If Jenner changed from LIFO to first in, first out (FIFO) in 2001, return on total equity would:
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Return on total equity (net income / total equity) was ($800,000 / ($2,200,000 + $1,800,000) =) 20%. Under FIFO, net income increases by the increase in the LIFO reserve multiplied by (1 – tax rate). FIFO net income for 2001 was ($800,000 + ($600,000 – $400,000) (1 – 0.40) = ) $920,000. Total equity increases by the amount of accumulated FIFO profits that are added to retained earnings which is calculated by multiplying the amount of the ending LIFO reserve by (1 – tax rate) for an increase of (($600,000) * (1 – 0.40) =) $360,000. Total equity is ($2,200,000 + $1,800,000 + $360,000 =) $4,360,000. FIFO return on total equity is ($920,000 / $4,360,000 =) 21.1%.
Given the following information and assuming beginning inventory was zero what is the gross profit at the end of the period using the FIFO, LIFO, and average cost methods?
Purchases
Sales 20 units at $50 15 units at $60 35 units at $40 35 units at $45 85 units at $30 85 units at $35
FIFO | LIFO | Cost Average |
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FIFO: $5,450 ? 4,800 = $650 LIFO: $5,450 ? $4,700 = $750 Cost Average: $5,450 ? $4,773.21 = $676.79
During periods of decreasing prices, a firm will report higher net income if its inventory cost assumption is:
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In periods of falling prices, LIFO results in lower COGS, and therefore higher net income than FIFO, because LIFO assumes the most recently purchased (lower cost) goods are sold first.
Which of the following statements regarding inventory accounting methods is most accurate? In periods of:
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In periods of rising prices LIFO results in lower current assets because the ending inventory is based on inventory items that were purchased first at a lower price.
During periods of rising prices:
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FIFO inventory, and therefore FIFO assets and equity, will be higher by the LIFO reserve.
Which of the following statements concerning a period of rising prices is least accurate?
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LIFO results in lower inventory and higher cost of goods sold (COGS) during a period of rising prices, hence a higher inventory turnover.
Selected information from Newcomb, Inc.’s financial statements for the year ended December 31, 20X4 included the following (in $):
Cash |
70,000 |
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Accounts Payable |
90,000 |
Accounts Receivable |
140,000 |
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Deferred Tax Liability |
100,000 |
Inventory |
460,000 |
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Long-term Debt |
520,000 |
Property, Plant & Equip. |
1,200,000 |
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Common Stock |
600,000 |
Total Assets |
1,870,000 |
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Retained Earnings |
360,000 |
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Total Liabilities & Equity |
1,870,000 |
Earnings Before Interest and Taxes |
280,000 |
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Interest Expense |
60,000 |
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Income Tax Expense |
75,000 |
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Net Income |
145,000 |
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LIFO Reserve at Jan. 1 |
185,000 |
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LIFO Reserve at Dec. 31 |
250,000 |
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If Newcomb had used first in, first out (FIFO) for 20X4 and we assume that average total capital was $1,700,000 for both the LIFO and FIFO computations, the return on total capital would:
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The return on total capital under LIFO (EBIT / average total capital) was $280,000 / $1,700,000 = 16.5%. Under FIFO, EBIT is increased by the increase in the LIFO reserve during the year. FIFO return on total capital is ($280,000 + ($250,000 ? $185,000)) / $1,700,000 = 20.3%.
Selected financial data from Krandall, Inc.’s balance sheet for the year ended December 31 was as follows (in $):
Cash
$1,100,000
Accounts Payable
$400,000
Accounts Receivable
300,000
Deferred Tax Liability
700,000
Inventory
2,400,000
Long-term Debt
8,200,000
Property, Plant & Eq.
8,000,000
Common Stock
1,000,000
Total Assets
11,800,000
Retained Earnings
1,500,000
LIFO Reserve at Jan. 1
600,000
Total Liabilities & Equity
11,800,000
LIFO Reserve at Dec. 31
900,000
Krandall uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is 40%. If Krandall used first in, first out (FIFO) instead of LIFO and paid any additional tax due, its assets-to-equity ratio would be closest to:
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With FIFO instead of LIFO:
So assets under FIFO would be $11,800,000 + $900,000 - $360,000 = $12,340,000 and equity would be $1,000,000 + $1,500,000 + $540,000 = $3,040,000. The assets-to-equity ratio would be $12,340,000 / $3,040,000 = 4.06.
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