Reading 21:Inventories: Implications for Financial Statement 2011, statements, different, companies, including

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Session 5: Financial Reporting and Analysis: Inventories and Long-lived Assets
Reading 21: Inventories: Implications for Financial Statements and Ratios

LOS e: Analyze and compare the financial statements and ratios of companies, including those that use different inventory valuation methods.

 

 

During periods of rising prices, which of the following is most likely to occur?

A) LIFO COGS > FIFO COGS, therefore LIFO net income < FIFO net income.

B) LIFO COGS > FIFO COGS, therefore LIFO net income > FIFO net income.

C) LIFO COGS < FIFO COGS, therefore LIFO net income < FIFO net income.

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Under the assumptions of this question and using LIFO, the most expensive units go to COGS, resulting in lower net income.

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During a period of rising prices, the financial statements of a firm using first in, first out (FIFO) reporting, instead of last in, first out (LIFO) reporting would show:

A) higher total assets and higher net income.

B) lower total assets and higher net income.

C) lower total assets and lower net income.

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When the FIFO method is used when prices are rising, the cheaper goods in beginning inventory, reflecting earlier purchases, are assigned to COGS (hence, higher income) and the more expensive units (last purchases) are assigned to ending inventory (greater current assets). When the LIFO method is used during a period when prices are rising, the more expensive last purchases are assigned to COGS (hence, lower income) and the cheaper units in beginning inventory and earlier purchases are assigned to ending inventory.

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When analyzing profitability ratios, which inventory accounting method is preferred?

A) Weighted average.

B) Last in, first out (LIFO).

C) First in, first out (FIFO).

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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.

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The best way to compute an inventory turnover ratio is to use:

A) last in, first out (LIFO) for cost of goods sold (COGS) and first in, first out (FIFO) for average inventory.

B) last in, first out (LIFO) for both cost of goods sold (COGS) and average inventory.

C) first in, first out (FIFO) for both cost of goods sold (COGS) and average inventory.

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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.

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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:

A) increase to 40.1%.

B) increase to 30.0%.

C) increase to 32.1%.

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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.

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Selected information from Newcomb, Inc.’s financial statements for the year ended December 31, 20X4 included the following (in $):

Cash	70,000		Accounts Payable	90,000
Accounts Receivable	140,000		Deferred Tax Liability	100,000
Inventory	460,000		Long-term Debt	520,000
Property, Plant & Equip.	1,200,000		Common Stock	600,000
Total Assets	1,870,000		Retained Earnings	360,000
			Total Liabilities & Equity	1,870,000
Earnings Before Interest and Taxes	280,000
Interest Expense	60,000
Income Tax Expense	75,000
Net Income	145,000
LIFO Reserve at Jan. 1	185,000
LIFO Reserve at Dec. 31	250,000

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:

A) decrease from 16.5 to 12.6%.

B) increase from 16.5 to 20.3%.

C) remain unchanged at 16.5%.

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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%.

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If all else holds constant in periods of rising prices and inventory levels:

A) FIFO firms have higher debt to equity ratios than LIFO firms do.

B) FIFO firms will have greater stockholder's equity than LIFO firms do.

C) LIFO firms have higher gross profit margins than FIFO firms do.

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The FIFO method of inventory accounting assigns the cost of the earliest units acquired to goods transferred out and the cost of most recent acquisitions to ending inventory. When prices are rising, the cheaper goods in beginning inventory reflecting earlier purchases are assigned to COGS (hence, higher income and higher shareholder's equity through retained earnings.)

Explanations for other choices:

In periods of rising prices and inventory levels (all else constant):

• FIFO firms have lower debt to equity ratios than LIFO firms do because stockholder's equity is higher and debt is constant.
• LIFO firms have lower gross profit margins ((Sales-COGS)/Sales) because the more expensive last purchases are assigned to COGS, lowering the numerator.

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In periods of rising prices and stable or increasing inventory quantities, using the LIFO method for inventory accounting compared to FIFO will have:

A) higher COGS, lower income, higher cash flows, and lower inventory.

B) higher COGS, lower income, lower cash flows, and lower inventory.

C) lower COGS, higher income, identical cash flows, and lower inventory.

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In periods of rising prices and stable or increasing inventory quantities, the LIFO method – as compared with FIFO – will result in higher COGS, lower taxes, lower net income, lower inventory balances, lower working capital, and higher cash flows.

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In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report cost of goods sold and cash flows which are, respectively:

COGS

Cash Flows

A) Lower Lower

B) Higher Lower

C) Higher Higher

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In this situation, LIFO results in higher cost of goods sold because it uses the more recent and higher costs than FIFO. LIFO results in higher cash flows because with lower reported income, income tax will be lower.

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During periods of declining prices, which inventory method would result in the highest net income?

A) Average Cost.

B) FIFO.

C) LIFO.

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When prices are declining and LIFO is used the COGS is smaller than if FIFO is used leading to a larger net income.