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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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:

A) lower, and the difference between the two firms' current ratios will increase as inflation decreases.

B) lower, and the difference between the two firms' current ratios will decrease as inflation decreases.

C) higher, and the difference between the two firms' current ratios will decrease as inflation decreases.

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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.

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During periods of rising prices:

A) LIFO Gross Profit Margin > FIFO Gross Profit Margin.

B) LIFO Debt to Equity Ratio > FIFO Debt to Equity Ratio.

C) LIFO Inventory Turnover < FIFO Inventory Turnover.

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FIFO inventory, and therefore FIFO assets and equity, will be higher by the LIFO reserve.

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Which of the following statements concerning a period of rising prices is least accurate?

A) Inventory turnover is less using the last in, first out (LIFO) inventory valuation method than using the first in, first out (FIFO) method.

B) The debt-to-equity ratio is greater using the last in, first out (LIFO) inventory valuation method than using the first in, first out (FIFO) method.

C) Gross profit using the last in, first out (LIFO) inventory valuation method is less than the gross profit using the first in, first out (FIFO) method.

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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.

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Assume that Hunter Round Restaurant Supply currently uses the last in, first out (LIFO) method to account for inventory and that the business environment is one of rising prices and stable or growing inventory balances. In addition, Hunter Round has an effective tax rate of zero percent due to tax loss carrybacks. All else equal, which of the following statements is least likely valid? By using LIFO instead of first in, first out (FIFO), Hunter Round has:

A) higher cash flows.

B) lower net income.

C) lower working capital.

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In the absence of taxes, there is no difference in cash flow between LIFO and FIFO. The other statements are true. For the examination, memorize the financial impact of rising and falling prices for the two inventory methods.

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Which of the following statements regarding inventory accounting methods is most accurate? In periods of:

A) declining prices FIFO results in higher net income than LIFO.

B) rising prices and stable unit purchases, using the FIFO method results in higher inventory turnover than the LIFO method.

C) rising prices and stable unit purchases, using the LIFO method results in a lower current ratio than the FIFO method.

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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.

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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.

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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

A) FIFO FIFO

B) LIFO FIFO

C) FIFO LIFO

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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.

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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.