Reading 25 lesson 2

Given stable inventory quantities and falling prices, use of FIFO will most likely understate or overstate profits:

Replacement costs will be overstated in COGS and profits will be understated.

Since COGSFIFO is lower than COGSLIFO during periods of rising prices, FIFO gross profits and net income before taxes are greater than their values under LIFO by an amount equal to the change in -. However, net income after tax under FIFO will be greater than LIFO net income after tax by

LIFO reserve Change in LIFO reserve×(1−Tax rate)

if a uniform tax rate were applicable during the entire period, we could have calculated the cumulative amount of tax savings from using LIFO as of the end of 2012 as

LIFO reserve current year × (Tax rate)

When converting from LIFO to FIFO assuming rising prices: Equity (retained earnings) increases by:

LIFO reserve×(1−Tax rate)

When converting from LIFO to FIFO assuming rising prices: Liabilities (deferred taxes) increase by:

LIFO reserve×(Tax rate)

FIFO retained earnings =

LIFO retained earnings + [LIFO reserve × (1 - Tax rate)]

The cumulative amount of tax savings that WNF has generated by using LIFO instead of FIFO equals

calculated as the sum of cumulative tax savings as of 2011 (computed using a tax rate of 30%) and the incremental savings for 2012 (computed using a tax rate of 20%).

a change from LIFO to FIFO would result in decrease or increase in cash and what type of additional liability

decrease tax liab

If it is found that LIFO liquidation has occurred, analysts must

exclude the increase in earnings due to LIFO liquidation from their analysis. COGS must be adjusted upward for the decline in LIFO reserve, and net income must be lowered.

U.S. GAAP requires firms that use the LIFO inventory cost flow assumption to disclose the beginning and ending balances for the LIFO reserve (LR) in the

footnotes to the financial statements

Changes in the inventory cost flow assumption result in a change in the allocation of inventory costs across COGS and EI, but the only cash flow-related consequence of the change is the change in

income taxes.

Under IFRS, a change in policy is acceptable only if the change results in the provision of more reliable and relevant information in the financial statements.: -Changes in inventory accounting policy are applied --. -Information for all periods presented in the financial report is --. -Adjustments for periods prior to the earliest year presented in the financial report are reflected in the --for the earliest year presented in the report.

retrospectively restated beginning balance of retained earnings

The amount that would be added to WNF's retained earnings would be the cumulative increase in operating profit due to

the decrease in COGS for each year

LIFO reserve equals the difference between

the value of inventory under LIFO, and its value under FIFO (EI FIFO- EI LIFO)

When a company includes older, cheaper units of stock in its COGS, it severely understates or overstate COGS, and LIFO COGS no longer reflects recent, current prices. Consequently, a firm with LIFO liquidation understate or overstates net income.

understates overstates

Given stable inventory quantities and falling prices, use of LIFO will will or will not overstate net income. why?

will not overstate net income. Current replacement costs will be reflected in COGS, which would result in an accurate value for net income.

if LIFO DOH is less than FIFO DOH analyst must take into account what type of inventory method is being used bc could erroneously conclude that a company manages its inventory more

efficiently

In periods of rising prices and stable inventory levels, LIFO EI is higher or lower than FIFO EI.

lower

If the LIFO method is followed when prices are falling, the cost of goods sold will be lower or higher and the inventory value will be high. Therefore, the inventory turnover ratio will be low or high.

lower high

In a period of rising prices and stable inventory quantities, use of FIFO results in lower/higher activity ratios, lower/higher solvency ratios, and lower/higher profitability ratios.

lower activity ratios, lower solvency ratios, and higher profitability ratios.

COGS FIFO =

COGS LIFO - (LRending - LRbeginning)

The gross profit margin is lower under LIFO because

COGS is higher

The net profit margin is lower under LIFO because

COGS is higher

COGS () is lower than COGS() during periods of rising prices

FIFO LIFO

LIFO liquidation can result from

strikes, recessions, or a decline in demand for the firm's product.

LIFO is used primarily for the

tax benefits it provides in an inflationary environment

which method is inventory turnover higher? LIFO or FIFO and why?

The ratio is higher under LIFO because, given stable inventory levels and rising inventory costs, COGS would be higher and inventory carrying amounts will be lower under LIFO

LIFO liquidation occurs when

a firm that uses LIFO sells more units during a given period than it purchases over the period. This causes year-end inventory levels to be lower than the beginning-of-year inventory levels.

To postpone the taxes on holding gains on old units of inventory, a LIFO firm must

always purchase as many if not more units than it sells.

U.S. GAAP has a similar requirement for changes in inventory accounting policies to IFRS and company must also

-a company must thoroughly explain how the newly adopted inventory accounting method is superior and preferable to the old one. -The company may be required to seek permission from the Internal Revenue Service (IRS) before making any changes. If inventory-related accounting policies are modified, the changes to the financial statements must be made retrospectively, unless the LIFO method is being adopted (which is applied prospectively).

the choice of LIFO, FIFO, or AVCO affects only how inventory costs are allocated between - and -. It does not affect -

EI /COGS purchases (P)

EI(FIFO)=

EI(LIFO)+LR ending

In which of the following inventory valuation methods will cost of sales and ending inventory be the same, irrespective of whether the perpetual or periodic inventory accounting system is used?

In FIFO, cost of sales and ending inventory will be the same under the perpetual as well as the periodic inventory valuation method.

COGS () is greater than COGS() in an inflationary environment

LIFO FIFO

which reflects most accurate current replacement cost in COGS and which represents most accurate measure of inventory value

LIFO FIFO

There can be two reasons for a decline in LIFO reserve:

LIFO liquidation. Declining prices.

FIFO net income =

LIFO net income + Increase in LIFO reserve × (1 - Tax rate)

Recall the following adjustment to inventory on the balance sheet, which would also make the balance sheet balance: Current assets (inventory) increase by:

LIFO reserve

What amount would be added to WNF's retained earnings as of December 31, 2012, if it had used FIFO instead of LIFO? LR's: 2012: 1,330 with tax rate 20% 2011: 1080 with tax rate 30% cumulative amount of income tax savings 374m

The amount that would be added to WNF's retained earnings would be the cumulative increase in operating profit due to the decrease in COGS for each year. On a cumulative basis, COGS would be lower under FIFO by $1,330 million (LIFO reserve as of the end of 2012). However, cumulative taxes paid would be higher under FIFO by $374 million (calculated in Solution 5). Therefore, the increase in retained earnings if FIFO were used instead of LIFO would be $956 million (= 1,330 - 374)

LIFO reserve: 2012: 1,330 with tax rate 20% 2011: 1080 with tax rate 30% What is the cumulative amount of income tax savings that WNF has generated as of the end of 2012 by using LIFO instead of FIFO?

The cumulative amount of tax savings that WNF has generated by using LIFO instead of FIFO equals $374 million. This amount is calculated as the sum of cumulative tax savings as of 2011 (computed using a tax rate of 30%) and the incremental savings for 2012 (computed using a tax rate of 20%). Cumulative tax savings as of 2011 = $1,080 × 30% = $324 million Addition tax savings for 2012 = Taxes on the increased operating profit are calculated as 250 × 20% = $50m Note that if a uniform tax rate were applicable during the entire period, we could have calculated the cumulative amount of tax savings from using LIFO as of the end of 2012 as LIFO reserve 2012 × (Tax rate) Total =$374m

Orange Corporation purchases and sells lumber. For the previous year, it reported a net profit of $58 million. The company is supposed to prepare its financial statements as per IFRS. It provides the following notes to its financial statements: The company uses the direct write-off method to recognize credit losses on customer receivables. The company values its plant and equipment using the revaluation model. Mr. Patrick is analyzing the financial statements of Orange Corporation. He finds that the LIFO method has been used for valuing inventory and cost of goods sold. Based on the information provided, which of the following is the most likely conclusion? Assume the economy is a deflationary environment.

Under the matching principle, when the revenue is recognized on a sale, a company is required to record an estimate of how much of the revenue will ultimately be uncollectible. The company records its estimate of uncollectible amounts as an expense on the income statement. The direct write-off method is not consistent with the matching principle. The direct write-off method overstates profits in the short term. Also, the company is using the LIFO cost formula for inventory valuation. The LIFO method leads to overstating profits when prices are falling. Orange Corporation is using the LIFO method in violation of IFRS requirements.

when can you see a decline in LIFO reserve

When prices of the firm's products fall over a given period,

Analysts should be aware that management can inflate their company's reported gross profits and net income by intentionally reducing inventory quantities and liquidating older or newer ( units of stock. Therefore, it is important to analyze the LIFO reserve footnote disclosures to determine if LIFO liquidation has occurred.

older (cheaper)

According to IFRS, inventories are recorded at the lower of the - Reversals of inventory write-downs are allowable to the extent of the previous write-down. Reversals of write-downs are not allowable under U.S. GAAP.

original cost or the net realizable value.