bapswarrior

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 32.1%.

C) increase to 30.0%.

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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.

bapswarrior

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	[td] [td] [/td]
Interest Expense	60,000
Income Tax Expense	75,000	[td] [td] [/td]
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%.

bapswarrior

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	[td] [td] [/td]
Interest Expense	60,000
Income Tax Expense	75,000	[td] [td] [/td]
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%.

bapswarrior

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

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

bapswarrior

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, lower cash flows, and lower inventory.

B) higher COGS, lower income, higher 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.

bapswarrior

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.

bapswarrior

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

A) Average Cost.

B) LIFO.

C) FIFO.

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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.

bapswarrior

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) FIFO LIFO

C) LIFO FIFO

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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.

bapswarrior

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

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

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

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

bapswarrior

During periods of rising prices:

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

B) LIFO Inventory Turnover < FIFO Inventory Turnover.

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

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