Problems - Ch. 6 Adjusting Zenab to FIFO:

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1 10.{L}A. Problems - Ch. 6 Adjusting to FIFO: Since the LIFO reserve increased by $1,500, the LIFO effect is $1,500. Under FIFO, COGS is $1,500 lower at $59,800 ($61,300 - $1,500). is $1,500 higher at $6,500. A comparison of both companies on a FIFO basis is presented below: 59,800 $ 32,900 $ 6,500 52,000 $ 25,000 $ 3,500 B. Adjusting to LIFO/Current Cost is more complicated. The first step is to calculate an implied inflation rate using 's statements. On a FIFO basis, 's inventories are $24,900 + $3,600 = $28,500 at the beginning of the year. Of that inventory, 70% or $19,950 (.70 x $28,850) are carried on LIFO. The increase in the LIFO reserve implies a specific inflation rate of $1,500/$19,950 = 7.52%. Therefore, 's COGS (pretax income) on an LIFO/current cost basis increases (decreases) by.0752 x $22,300 = $1,675. This decrease in pretax income is close to 50%. A comparison of both companies on a LIFO basis is presented below: 61,300 $ 31,400 $ 5,000 53,675 $ 23,325 $ 1,825 Note that this solution is incomplete as is 100% on LIFO while is only 70% on LIFO. To Solutions Chapter 6 - P. 1

2 complete the solution, convert the remaining 30% of 's inventories to LIFO using the same inflation rate: Thirty percent (30%) of inventory is FIFO (.30 x $28,500) or $8,550. Applying the same inflation rate of 7.52% increases COGS (reduces pretax income) by $643. The comparison now becomes: 61,943 $ 30,757 $ 4,357 53,675 $ 23,325 $ 1,825 C. It depends on the purpose of the comparison. There are three possibilities: (1) Comparison of firms' operations. (2) Comparison of firms' operations and tax policy. (3) Analysis of firm's "economic" status. If the purpose is a comparison of a firm's operations with another firm's, then the adjustment should be "as if" and a tax adjustment should be made. If the purpose is to compare operations and tax policy, then no tax adjustment should be made. Finally, for evaluation of the economic status no tax adjustment should be made unless liquidation is considered to be imminent. Solutions Chapter 6 - P. 2

3 11.{L}A. Current ratio Inventory turnover (LIFO) 19X (FIFO) 19X B. 's liquidity (as measured by the current ratio) appears to be better. Its inventory turnover is lower, however, implying lower efficiency. appears to be slightly less profitable as well. C. (i) Using the FIFO income statements from problem 10, we compute the following ratios: Current ratio 1 Inventory turnover 2 (FIFO) 19X (FIFO) 19X X5 = ($33,500 + $3,600)/$11,600 = ($33,600 + $5,100)/$12,700 2 $59,800 ($25,200 + $5,100 + $24,900 + $3,600)/2 (ii) Using the LIFO income statements from problem 10 (using the statement after conversion to 100% LIFO), we compute the following profitability ratios: (100% LIFO) (LIFO) Solutions Chapter 6 - P. 3

4 Balance sheet adjustments are not possible for and the 30% of inventories on FIFO. Thus adjusted current and inventory turnover ratios cannot be computed. (iii)the current cost method of computing the inventory turnover ratio uses the FIFO measure of inventory and the LIFO measure of COGS. The ratios are: LIFO cost of goods sold FIFO average inventory $61,943 29,400 $53,675 26,300 Inventory turnover ratio 2.11X 2.04X D. Balance sheet values are most meaningful when FIFO is used. For the income statement, however, LIFO should be used. Therefore for the current ratio, we use the FIFO amounts. For the gross profit margin, and pretax/sales we use the 100% LIFO amounts. For the inventory turnover ratio, the current cost approach is preferred. However that ratio and the FIFO based ratio are similar in this case: 19X5 19X5 FIFO current ratio FIFO inventory turnover Current cost turnover LIFO gross profit margin LIFO pretax income/sales Notice that, based on these ratios, is clearly more profitable than. The inventory turnover ratios are, however, virtually identical. While still has a higher current ratio, the difference is smaller than it appears based on the reported balance sheet data. Solutions Chapter 6 - P. 4

5 13.[S]A. January 1, 19X3 inventory = $2,700,000 ($2,000,000 + $700,000). 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 the difference between the LIFO and FIFO inventory cost. The choice of inventory method does not affect purchases which reflect actual prices paid. C. Ignoring taxes and any change in accounts payable, reported cash flow from operations increased by $1,000,000 due to lower purchases. D. COGS should be increased by $300,000 to exclude the effect of the LIFO liquidation. 21.{S} A. Deere s gross margin percentage, using reported data: $5,848 $5,723 $6,479 Gross margin ,104 GM percentage 16.3% 14.5% 17.0% B. Excluding the LIFO liquidation increases COGS and decreases gross margin by the same amounts: Reported COGS $4,894 $4,891 $5,375 LIFO liquidation Adjusted COGS $5,022 $4,956 $5,426 Adjusted gross margin $826 $767 $1,053 Adjusted GM percentage 14.1% 13.4% 16.3% Excluding the LIFO liquidation, the GM percentage still declines in 1992, and increases in However, the 1993 level using adjusted data exceeds that of 1991 by a much larger amount. E. The LIFO liquidation is not an operating activity. Excluding that income makes net income more useful for evaluating operating performance (net income and cash from operations) and forecasting future performance. Solutions Chapter 6 - P. 5