FRA

Periodic versus Perpetual Inventory Systems

Specific identification & FIFO produce same ending inventory values and COGS under both systems Weighted average cost and LIFO - different value for ending inventory and COGS

Inventory Valuation: permissable methods under IFRS

Specific identification. First-in, first-out. Weighted average cost.

Periodic Inventory Valuation: permissable methods under US GAAP

Specific identification. First-in, first-out. Weighted average cost. Last-in, First-out - has income tax advantages so popular - tax savings result in lower reported earning associated with higher cash flow from operations

Under U.S. GAAP, the actual coupon payment on a bond is reported on the statement of cash flow as: A) an operating cash outflow. Achieved B) an investing cash outflow. Failed C) a financing cash outflow.

The coupon payment is recorded on the statement of cash flows as an operating cash outflow under U.S. GAAP.

In periods of rising prices and stable inventory quantities, which of the following best describes the effect on gross profit of using LIFO as compared to using FIFO? A) Lower. B) Higher. C) The same.

A. Compared to FIFO, COGS calculated under LIFO will be higher because the most recent, higher cost units are assumed to be the first units sold. Higher COGS under LIFO will result in lower gross profit (revenue - COGS).

LIFO reserve

For a company using LIFO, the difference between inventory reported using LIFO and inventory using FIFO. The LIFO reserve will increase when prices are rising and inventory quantities are stable or increasing. If a firm is liquidating its inventory, or if prices are falling, the LIFO reserve will decline.

Component depreciation is required under:

IFRS, but not U.S. GAAP.

If timing differences that give rise to a deferred tax liability are not expected to reverse then the deferred tax: A) should be considered an increase in equity. Achieved B) should be considered an asset or liability. Failed C) must be reduced by a valuation allowance.

If deferred tax liabilities are expected to reverse in the future, then they should be classified as liabilities. If, however, they are not expected to reverse in the future, then they should be classified as equity.

A U.S. GAAP firm writes down inventory to net realizable value. In the period of the writedown, what is the most likely effect on cost of goods sold? A) Increase. Achieved B) Decrease. Failed C) No effect. Failed

A write-down of inventory to net realizable value is typically recognized under U.S. GAAP as an increase in cost of goods sold in the period of the write-down. Consider the inventory equation: ending inventory = beginning inventory + purchases - cost of goods sold A write-down to NRV decreases ending inventory, with no effect on beginning inventory or purchases. For the inventory equation to hold, cost of goods sold must increase.

Solvency Ratios

Adjusting to FIFO results in higher total assets because inventory is higher. Higher total assets under FIFO result in higher stockholders' equity (assets − liabilities). Because total assets and stockholders' equity are higher under FIFO, the debt ratio and the debt-to-equity ratio are lower under FIFO compared to LIFO.

last-in, first-out (LIFO) method

in an inflationary environment, LIFO ending inventory is less than current cost.

Diabelli Inc. is a manufacturing company that is operating at normal capacity levels. Which of the following inventory costs is most likely to be recognized as an expense on Diabelli's financial statements when the inventory is sold? Administrative overhead. Allocation of fixed production overhead. Selling cost.

Assuming normal capacity levels, allocation of fixed production overhead is a product cost that is capitalized as part of inventory. Thus, this cost will not be recognized as an expense until the inventory is sold (it becomes part of COGS for that period). Administrative overhead and selling costs are period costs that must be expensed in the period incurred. By capitalizing inventory cost as an asset, expense recognition is delayed until the inventory is sold and revenue is recognized.

Under IFRS, inventory is reported on the balance sheet at

the lower of cost or net realizable value

Mammoth, Inc. reports under U.S. GAAP. Mammoth has begun a long-term project to develop inventory control software for external sale. On its financial statements, Mammoth should: A) expense all costs of this project until technological feasibility has been established. Achieved B) capitalize all costs of this project. Failed C) expense all costs of this project in the periods incurred.

Under IFRS and U.S. GAAP, costs of developing software are expensed until technological feasibility is established, and capitalized after technological feasibility has been established.

how an inventory write-down or write-up affects a firm's ratios

a write-down may significantly affect inventory turnover in current and future periods. Thus, comparability of ratios across periods may be an issue.

Under U.S. GAAP, inventory is reported on the balance sheet at

companies that use inventory cost methods other than LIFO or the retail method - report inventories at the lower of cost or NRV. For companies using LIFO or the retail method - inventory is reported on the balance sheet at the lower of cost or market Market is usually equal to replacement cost, but cannot be greater than NRV or less than NRV minus a normal profit margin. If replacement cost exceeds NRV, then market is NRV. If replacement cost is less than NRV minus a normal profit margin, then market is NRV minus a normal profit margin. Think of lower of cost or market, where "market" cannot be outside a range of values. The range is from net realizable value minus a normal profit margin, to net realizable value. So the size of the range is the normal profit margin. "Net" means sales price less selling and completion costs.

Net Realizable Value (NRV)

equal to the expected sales price less the estimated selling costs and completion costs.

Activity Ratios - Inventory turnover

measure how effectively management is turning over inventory (COGS / average inventory) Higher under LIFO Lower under FIFO also low days of inventory on hand under lifo - (365 / inventory turnover).

FIFO LIFO Cost of sales Lower Higher Ending inventory Higher Lower Gross profit Higher Lower Note: Assumes increasing prices and stable or increasing inventory levels.

FIFO provides the most useful measure of ending inventory and a better approximation of current cost, and thus a better approximation of economic value. Because LIFO COGS is based on the most recent purchases,LIFO produces a better approximation of current cost in the income statement.

When prices are rising or falling,

FIFO provides the most useful measure of ending inventory. Recall that FIFO inventory is made up of the most recent purchases. These purchase costs can be viewed as a better approximation of current cost, and thus a better approximation of economic value.

A U.S. company uses the LIFO method to value its inventory for their income tax return. For its financial statements prepared for shareholders, the company may:

The LIFO conformity rule in the U.S. requires firms to use LIFO for their financial statements if they use LIFO for income tax purposes.

For example, consider a firm with a LIFO reserve of $150 that faces a tax rate of 40%.

To convert the balance sheet to FIFO, 1. increase inventory by $150, 2. decrease cash by $60 ($150 × 40%), 3. and increase stockholders' equity (retained earnings) by $90 [$150 × (1 - 40%)]. This will bring the accounting equation back into balance. The net effect of the adjustments is an increase in assets and shareholders' equity of $90, which is equal to the LIFO reserve net of tax.

Inventory Valuation Methods

-FIFO: inventory reflects cost of most recent purchases, COGS reflects cost of oldest purchases -LIFO: COGS reflects cost of most recent purchases, inventory reflects cost of oldest purchases - weighted average cost: unit cost equals cost of goods available for sale divided by total units available and is used for both COGS and inventory -specific identification: each item in inventory is identified and its historical cost is used for calculating COGS when the item is sold

In periods of rising prices and stable inventory quantities, which of the following best describes the effect on gross profit of using FIFO as compared to using LIFO? A) Lower. B) Higher. C) The same.

B. Higher Conversely, FIFO COGS is based on the earliest purchase costs. In an inflationary environment, COGS will be understated compared to current cost. As a result, earnings will be overstated.

A firm revalues its long-lived assets upward. All other things equal, which of the following financial impacts is least likely to occur? A) Higher profitability in the periods after revaluation. Achieved B) Lower solvency ratios. Failed C) Higher earnings in the revaluation period.

Because the asset has now been increased to a higher depreciable base, there will now be higher depreciation expense and therefore, lower profitability in the periods after revaluation. There could be higher earnings in the revaluation period because there may be impairment losses that can be reversed on the income statement. Otherwise, there will be an adjustment to earnings through other comprehensive income. Solvency ratios (i.e. debt to equity) will decrease since the increase in assets will be balanced by an increase in equity. Higher denominators and unchanged numerators will result in lower solvency ratios.

Which of the following statements about deferred taxes is most accurate? Deferred tax liabilities: A) arise primarily due to differences between financial and tax accounting. Achieved B) should be treated as debt when calculating financial statement ratios. Failed C) can relate to either permanent or temporary differences.

Deferred tax liabilities result from temporary differences between financial accounting and tax accounting that cause income tax expense for a period to be larger than taxes due. Permanent differences do not result in deferred tax items. Whether to treat deferred tax liabilities as debt or equity depends on whether they are expected to reverse in the foreseeable future.

As part of a major restructuring of business units, General Security (an industrial conglomerate operating solely in the U.S. and subject to U.S. GAAP) recognizes significant impairment losses. The Investor Relations group is preparing an informational packet for shareholders, employees, and the media. Which of the following statements is least accurate? The write-downs are reported as a component of income from continuing operations. Failed B) During the year of the write-downs, retained earnings and deferred taxes will decrease. Failed C) Write-downs taken on asset values can be reversed in later years if market conditions improve.

Impairments cannot be restored under U.S. GAAP. Both remaining statements are correct.

In an inflationary environment, a LIFO liquidation will most likely result in an increase in: A) inventory. B) accounts payable. C) operating profit margin.

In a LIFO liquidation, older and lower costs are included in cost of sales. Thus, cost of sales per unit decreases and profit margins increase.

First-in, first-out (FIFO) method

In an inflationary environment, COGS will be understated compared to current cost. As a result, earnings will be overstated.

These four relations hold when prices have been rising over the relevant period:

LIFO inventory < FIFO inventory. LIFO COGS > FIFO COGS. LIFO net income < FIFO net income. LIFO tax < FIFO tax.

Liquidity Ratios

Lower under LIFO Higher under FIFO so is current ratio, and working capital

Profitability Ratios

Lower under LIFO Higher under FIFO assuming increasing prices

Convert from LIFO to FIFO

To make financial statements prepared under LIFO comparable to those of FIFO firms, an analyst must: 1. add the LIFO reserve to LIFO inventory on the balance sheet. 2. increase the retained earnings component of shareholders' equity by the LIFO reserve. LIFO net income < FIFO net income. When prices are increasing, a LIFO firm will pay less in taxes than it would pay under FIFO. For this reason, analysts often decrease a LIFO firm's cash by the tax rate times the LIFO reserve and increase its retained earnings by the LIFO reserve times (1 - tax rate) instead of the full LIFO reserve. it is also necessary to convert the LIFO firm's COGS to FIFO COGS. The difference between LIFO COGS and FIFO COGS is equal to the change in the LIFO reserve for the period. (LIFO COGS > FIFO COGS when inflationary period) To convert COGS from LIFO to FIFO, simply subtract the change in the LIFO reserve: FIFO COGS = LIFO COGS − (ending LIFO reserve − beginning LIFO reserve) IF Ending LIFO reserve - beginning LIFO reserve = $35,000 - $ 40,000 = -$5,000 With FIFO COGS $5,000 greater than LIFO COGS, gross profit under FIFO would be $5,000 lower than under LIFO.

Compared to reporting under FIFO for both tax and financial statements, a firm that chooses to report under LIFO during a period of falling prices would be most likely to report a lower:

When prices are falling, LIFO would result in lower COGS (higher gross profit) and higher ending inventory than FIFO. Higher gross profit with LIFO would result in higher taxes payable which would reduce cash balances (as long they pay their taxes).