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5.^ a.
This problem tests the interrelationships among accounting methods and differentiates between the flow of units and the flow of costs. Keep in mindthat some factors are affected by the choice of accounting method but othersare not.
FIFO
Weighted^ Average
LIFO
Opening inventory Purchases Cost of goods sold Closing inventory Inventory turnover (reported) Inventory turnover (actual)
$ 500 12,500 11,500 1,500 11.5X 12.0X
$ 500 12,500 12,000 1,000 16.0X 12.0X
$ 500 12,500 12,500^500 25.0X 12.0X
Opening inventory (in this problem), purchases, and actual inventory turnoverare not a function of accounting method. Physical turnover is based on unitswhile reported turnover is based on dollars and is affected by the choice ofaccounting
method.
Thus
the accounting
method
can
only
approximate
the
physical turnover. Opening inventory is $500 for all methods. Since the firm replenishes inventoryevery month, its actual inventory turnover is 12. Thus, in units, its cost of goodssold is 12 times its inventory level. That is, 12 months of inventory were sold;one month remains.
b.^
Reported turnover under the FIFO method most closely approximates the^
actual
physical
turnover
whereas
LIFO
is^ farthest
away.
The
preferred
(current cost) turnover ratio (LIFO COGS/Average FIFO inventory) $12,500/1,000= 12.5 also approximates the physical turnover.
The solution begins with the weighted average method: Cost-of-goods sold = units sold x average cost = $12,
c.^
The choice of method affects reported income, income taxes paid, and (therefore) the change in cash. The LIFO method reports the lowest net incomebut highest cash flow from operations (because of lower tax payments). Neithercash for investment nor cash for financing are affected. Thus LIFO reports thehighest net cash flow. The FIFO method reports the lower cash from operationsand, therefore, the lowest net cash flow. The average cost method is halfwaybetween the other two methods.
As closing inventory = units in inventory x average cost, and, units sold are 12times units in inventory; then closing inventory equals $1,000. We can now solve for purchases: Opening Inventory + Purchases = COGS + Closing Inventory $500 +? = $12,000 + $1,000 Therefore, purchases equal $12,500. Reported turnover = COGS/Average Inventory = $12,000/$750 = 16. Under the LIFO method:
6.^ a.
The first step is to obtain FIFO cost-of-goods-sold:
Since inventory in units does not change:
Pretax income = sales - COGS - other expenses
Closing Inventory = Opening Inventory = $
$5,000 = $25,000 - COGS - $12,
Therefore, Cost of Goods Sold = Purchases = $12,
Solving: COGS = $8,
Reported turnover = COGS/Average Inventory = $12,500/$500 = 25.
Purchases are equal to COGS + Closing Inventory
Under the FIFO method:
First, note that under the weighted average method, closing inventory is greaterthan opening inventory. As cost changes were only in one direction, they musthave gone up during the year. Therefore, use of FIFO must result in higher netincome (lower COGS) and higher income taxes. Since the cash flow difference is$400 (all attributable to taxes), the income/COGS difference must be $1000.Therefore, COGS
is $11,500 and Closing Inventory is $1,500.FIFO
The key to this problem is to distinguish between the flow of units and the flowof costs. Purchases are independent of the accounting method used. Since half the units were sold, half remain in inventory. Under LIFO, therefore,the cost allocations to inventory and COGS are the reverse of those allocatedunder FIFO. That is, under LIFO, COGS = $10,000 and Closing Inventory =$8,000.
Reported turnover = COGS/Average Inventory = $11,500/$1,000 = 11.5.
Under the weighted average method, as total purchases equal $18,000, the
The completed table is:
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allocation between COGS and closing inventory will be equal: COGS = ClosingInventory = $9,000. Recalling that pretax CFO depends on purchases, not COGS, we can now fill inthe rest of the table.
FIFO
Weighted^ Average
LIFO
Sales Cost of goods sold Other expenses Pretax income Tax expense Net income Retained earnings Cash from operations1 Cash balance2 Closing inventory Purchases
$25,000^ 8,000^ 12,000^ 5,000^ 2,000^ 3,000^ 3,000^ (7,000)^ 3,000^ 10,000^ 18,
$25,000^ 9,000^ 12,000^ 4,000^ 1,600^ 2,400^ 2,400^ (6,600)^ 3,400^ 9,000^ 18,
$25,000^ 10,000^ 12,000^ 3,000^ 1,200^ 1,800^ 1,800^ (6,200)^ 3,800^ 8,000^ 18,
1 Cash from operations = Sales - Other expenses - Purchases - Tax expense. 2 Cash balance = $10,000 + Cash from operations b.^
M & J Company Balance Sheet, December 31, 20X
FIFO
Weighted^ Average
LIFO
Cash Inventory Total assets
$ 3,000^ 10,000 $ 13,
$ 3,400^ 9,000 $ 12,
$ 3,800^ 8,000 $ 11,
Common stock Retained earnings
$ 10,000^ 3,
$ 10,000^ 2,
$ 10,000^ 1,
Total equities
c.^
The advantages of LIFO are that it results in the highest cash flow (by reducing income taxes) and it best measures net income by matching the cost ofsales with most recent costs to replace inventory sold. The disadvantage of LIFOis that inventory on the balance sheet is understated. The advantage of FIFO is that inventory is measured at most recent costs. Itsdisadvantages are the reduced cash flow and overstatement of reported income. Average
cost
has
the disadvantage
of^
misreporting
both
the balance
sheet
inventory and net income. Income taxes are higher than under the LIFO method(but lower than under FIFO). The "advantage" of average cost is that it is "lesswrong" than LIFO on the balance sheet and "less wrong" than FIFO on theincome statement. 7.^ a.
The number of units in inventory at December 31, 20X2 = 475 (100 + 500 - 125). Beginning inventory plus fourth quarter purchases equal $25,000($4,400 + $8,600 + $12,000). How that amount is allocated between endinginventory (EI) and cost-of-goods-sold (COGS) depends on the inventory method. (i)^
FIFO EI equals:
175 units @ $
300 units @ $
Total EI
475 units
(ii)^
LIFO EI equals:
100 units @ $
200 units @ $
175 units @ $
Total EI
475 units
b.^
Cost of^
goods
sold
equals
beginning
inventory
plus
purchases
less
ending inventory:
FIFO: $25,000 - $19,525 = $5,475 LIFO: $25,000 - $20,000 = $5,
Therefore, FIFO pretax income is $475 lower and income taxes are lower by$190 (40% of $475). c.^
As the market price is now $40, the lower of cost or market (LOCOM) rule applies, and inventory with a cost exceeding $19,000 ($40 x 475) must bewritten down to that amount. (i)^
FIFO:
Inventory
must
be^
written
down
by^
increasing
COGS,
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The gross profit margin percentages calculated in part a more accurately reflectsSunoco’s real profitability as by using LIFO (i.e. current cost) for cost of sales,inventory-holding gains (losses) are removed from gross profit.
LIFO reserve
FIFO Basis COGS (FIFO)1 Inventory (FIFO)2 Average inventory Inventory turnover Number of days
$ 27,478^ 5,495^ 5,626^ 4.88 X
$ 27,296^ 5,664^ 5,580^ 4.89 X
Current Cost Basis COGS (LIFO) Inventory (FIFO)2 Average inventory Inventory turnover Number of days
$ 27,444^ 5,495^ 5,626^ 4.88 X
$ 27,212^ 5,664^ 5,580^ 4.88 X
d.^
Sunoco’s gross profit decreased in 1999-2000 as prices increased. This indicates that Sunoco is not able to “pass on” price increases immediately or infull^ to^ customers.
Gross
profit
was
highest
when
price
levels
fell,
consistent with prices not being decreased as quickly as costs fell. e.
LIFO
FIFO
Current cost
Cost of sales average inventory = turnover
$10,819^ $351^ = 30.
$10,709^ $1,169^ = 9.
$10,819^ $1,169^ = 9.
See text P. 209
20.^
8.^
See text P. 209
14.^
8.^
1 COGS (LIFO) less change in LIFO reserve.
Turnover on a LIFO basis is clearly overstated and continues to climb as pricelevels increase. The FIFO and current cost based turnover calculations are bettermeasures and paint a similar picture – turnover increased in 2000 from 1998-1999 levels – number of days inventory is now (just under) 40 days
2 Inventory (LIFO) plus LIFO reserve The FIFO-based measure(s) of turnover are better as they more closely measurethe actual physical turnover. The LIFO-based measure overstates turnover, asthere is a mismatch of costs with current costs in the numerator and historicalcosts in the denominator. Thus, the LIFO-based turnover measure is upwardlybiased due to price increases.
a. LIFO Basis
COGS Inventory Average inventory Inventory turnover Number of days
$ 27,444^ 4,816^ 4,930^ 5.57 X
$ 27,212^ 5,069^ 4,943^ 5.51 X
The LIFO adjustment is the change in the LIFO reserve which, when added toFIFO COGS, yields LIFO COGS. (Like most companies, Sears keeps track of itsinventories on a day-to-day basis using FIFO. At year-end they adjust the FIFOamounts to arrive at the LIFO amounts reported in their financial statements). Based on the balance sheet data, the adjustments are 1998: = ($679 - $713) = ($ 34) and 1999: = ($595 - $679) = ($ 84) The $34 credit reported by Sears in 1998 is identical to that calculated above.For 1999, there is a discrepancy of $11 million as Sears reported a $73 millioncredit and our calculations yield an $84 million credit. The discrepancy could bedue^
to^ a divestiture
-^ Sears
may
have
sold
a^ subsidiary
or^
division,
thus
removing its inventory and LIFO reserve from its books.
In adjusting inventories to a FIFO basis one can calculate turnover on a FIFO basis by adjusting COGS to FIFO as well, or Current cost basis by leaving COGS on a LIFO basis. The differences are often minimal (see below)
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13. a.
Inventory turnover = Cost of sales/Average inventory = $2,512 = 8.63 .5 x (249 +333) Gross profit margin = ($3,663-$2,512)/$3,663 = 31.4% ROE = Net income / Average equity
.5 x (2,171 + 2,333) b.^
FIFO Cost of sales = $2,512 – change in LIFO reserve = $2,512 – [($469 – $333)– ($368 - $249)]) = $2,495 Inventory turnover = Cost of sales/Average inventory = $2,495 = 5.96 .5 x (368 +469)^ Gross profit margin = ($3,663 - $2,495)/$3,663 = 31.8% The effect on net income for the year would be $17 x (1 - tax rate) = $17 (0.65) = $11, therefore FIFO net income would be $255 + $11 = $266 The adjusted equity equals the reported equity plus the LIFO reserve x (1 – taxrate) 1999 adjustment: $119 x 65% = $77, therefore Equity = $2,171 + $77 = $2,248 2000 adjustment: $136 x 65% = $88 Equity = $2,333 + $88 = $2,421 ROE = Net income / Average equity = $266 = 11.4% .5 x ($2,248 + $2,421) c.^
LIFO artificially inflates the inventory turnover ratio as the denominator is depressed. The gross margin is slightly lower using LIFO as COGS is higher.ROE is little changed as both the numerator and denominator are lower usingLIFO. d.^
The FIFO measure (part b) is a more useful measure of the turnover ratio as it removes the inflation effect. On the other hand LIFO COGS (part a) isa more useful measure than FIFO COGS as it reflects current costs. For ROE, theideal would be to have LIFO income in the numerator and FIFO equity in the
denominator,
as^
both would
measure
current
costs;
the analyst
should
use
neither the “pure” FIFO nor the LIFO ROE measure. 14.
a.^ First, calculate the change in the LIFO reserve: Total inventories
Change
Current cost
Carrying value
LIFO reserve
The rate of price change equals the year 2000 change in the LIFO reservecompared with current cost LIFO inventories at the end of 1999: LIFO inventories
Carrying value
LIFO reserve
Current cost
The year 2000 rate of price change equals $17/$276 = 6.2% Opening FIFO Inventory = Total inventories – LIFO inventories = $249 - $157 =$92 million Adjustment to COGS = $92 x 6.2% = $6 million Adjusted COGS = $2,512 + $6 = $2,518 Adjusted gross profit= $3,663 – $2,
Adjusted net income= $255 - $6(.65)
It provides a current cost measure of income for all of the company’s sales The assumption is reasonable if the FIFO inventories are similar to those carriedon LIFO but are located in jurisdictions where LIFO is not permitted or there areother reasons for not using LIFO. On the other hand, the reason the companycarries these inventories on a FIFO basis may be that they face a lower inflationrate. 5
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Change in LIFO reserve
The preferred calculations are:
Cost of goods sold at LIFO
Average inventories at FtIFO
Turnover ratio
5.^
b.^
COGSFIFO = COGSLIFO – change in LIFO reserve For 1998: $372,033 – $ 381 = $371,652 For 1999: 385,892 – 1,391 = 384,501 c.^
Income
would
decline
if^ prices
in^ previous
years
were
higher
than
current prices and the higher priced layer was liquidated. d.^
(i) 1998: COGS = $372,033 – $150 = $371,883 1999: COGS = 385,892 + 47 = 385,
Under any measure, GE’s turnover ratio remained relatively stable over the 1999-2000 period. Management’s chosen method shows a higher turnover ratio thanthe^
preferred
method.
Comparisons
with
other
firms
are
misleading
when
turnover ratios are computed differently.
(ii)^
For FIFO, COGS is the same as in part b – “liquidations” do not affect FIFO COGS e.^
The most appropriate measure is the calculation computed in part d(i): LIFO COGS after eliminating effects of liquidation. That measure of COGS isclosest to replacement cost.
The point of this problem is that ratios reported by management cannot be usedblindly (especially for comparisons with other firms). The analyst must determinehow management calculates its ratios and ensure that those calculations accordwith calculations made by other firms and, most important, by the analyst.
f.^
By adding the LIFO reserve to equity; i.e. add $32,876,000 to 1998 equity and $34,267,000 to 1999 equity. Depending on the purpose of analysis, itmay be appropriate to tax-adjust these values i.e. add [$32,876,000 x (1-taxrate)] to 1998 equity and [$34,267,000 x (1–tax rate)] to 1999 equity.
17. a.
January 1, 20X3 inventory = $2,700,000 ($2,000,000 + $700,000).
19. a.
The company wrote down the carrying values of the inventories to market
value.
The
write-downs
of^
$^
and^
$^
million
in^
and
respectively were charged to income.
b.^
To maintain its inventory balance at $2,700,000, Jofen would have had to increase its purchases by $1,000,000 ($700,000 + $300,000); $300,000 is thedifference between the LIFO and FIFO inventory cost. The choice of inventorymethod does not affect purchases, which reflect actual prices paid.
b.^
There may have been market value adjustments (write-downs) prior to 1997 that were reversed in 1999 in addition to those of 1997-1998.
c.^
Ignoring taxes and any change in accounts payable, reported cash flow from operations increased by $1,000,000 due to lower purchases.
c.^
Income
would
decline
if^ prices
in^ previous
years
were
higher
than
current prices and the higher priced layer was liquidated.
d.^
COGS should be increased by $300,000 to exclude the effect of the LIFO liquidation.
d.^
The market value and liquidation adjustments do not relate to current year COGS and therefore should be excluded:
e.^
The^
LIFO
liquidation
is^ likely
not a^ recurring
event.
Excluding
that
income makes net income more useful for evaluating operating performance (netincome and cash from operations) and forecasting future performance.
Growth rate
Market value
Liquidation
(4)^
Total effect
Reported net income
Less: total effect
18. a.
The LIFO adjustment refers to the change in the LIFO reserve (or as Noland calls it ‘Reduction to LIFO’) 1997
LIFO Reserve
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22.^
The^
last^
sentence
in^ the^
statement
is^ patently
absurd.
The
accounting
method
for^
inventory
should
have
nothing
to^
do^ with
a^ company's
pricing
strategy. Pricing should be based on current market conditions. Companies thatignore the cost of replacing inventory when setting prices will suffer from poorcash flows and, in some cases, will fail.
Adjusted net income
Before adjustment the growth rate of net income is overstated at 102%. Afteradjustment, the actual growth rate is 29%, respectable but considerably belowthe reported growth rate.
- a.
For service companies, inventory is an insignificant component of assets and^
COGS
an^
insignificant
cost.
The
main
inputs
of^
service
companies
are
capacity and people. Thus inventory turnover is not a useful measure for suchcompanies.
20. a.
The cost of inventory may have declined due to deflation.
b.^
Capacity utilization is an important measure of operating efficiency for firms with fixed capacity. The fixed cost of such capacity means that utilization isan important determinant of profitability. An airline seat, rental car, or hospitalbed that goes unused generates no revenue; the variable cost saved may bevery low. This phenomenon explains why airlines sell discount tickets; such salesare profitable as long as the marginal revenue exceeds the variable cost.
b.^
(1)They might believe that the price decrease is temporary and in the future prices will increase again. (2)^
Since the LIFO reserve is large, a switch to FIFO would require a large tax expense (equal to tax rate times the LIFO reserve) immediately. Thus, evenif they felt that prices would continue to decrease in the future, they are stillbetter off paying the higher taxes slowly over time (as the LIFO reserve declines)rather than paying the full amount immediately.
It is also important to measure costs in relation to either capacity or utilization.As revenues are subject to competitive and regulatory constraints, lower costsare important to profitability. Thus an airline's costs relative to available seat-miles (or to passenger revenue miles) measures the efficiency of its operations.For a car rental company, cost per available car would be a similar measure. Fora hospital the analogous metric would be cost per available bed.
a.^ Sales
Gross margin
Gross margin %
b.^ LIFO liquidation
none
Pretax liquidation*
Adjusted Gross margin
Gross margin %
24.^
Contracts
can
provide
strong
incentives
that
affect
the
choice
of
inventory
method.
However
different
contracts
may
provide
incentives
for
different choices. The following discussion assumes rising prices. The management compensation plan provides a mixed incentive. Use of LIFOreduces income but increases cash from operations. Assuming a tax rate t, and aLIFO
effect
L,^
net^ income
decreases
by^
(1-t)L
while
cash
from
operations
increases by tL. The net effect (2t-1)L is positive only at tax rates above 50%.Thus management contracts argue against use of LIFO. Bond covenants also argue against LIFO. Working capital is reduced by the LIFOreserve less taxes saved. The annual amount is (t-1)L which is always negative.Retained earnings are also lower under LIFO. Union employee profit sharing payments are lower under LIFO, assuming thatprofits would exceed the minimum level. This would seem to argue for LIFO, toreduce compensation paid.
- Equals LIFO liquidation (net of tax)/.
However, there are also second and third order effects that must be considered.Lower profit sharing payments, for example, increase net income (and cash fromoperations), increasing management compensation and easing the effect of bondcovenants.
These
effects
require
complex
calculations
and
are
highly
firm-
specific.
c.^
The adjusted gross margin percentage is more indicative of the longer- term trend of the company. By removing the effects of the LIFO liquidation(s),COGS and subsequently gross margin are more reflective of current cost income.Removing
the effect
of^
the^
liquidation
shows
that
gross
margins
improved
significantly from 1997-1998 to 1999.
Some effects are non-quantitative. Lower profit sharing payments may result in 8
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