Problems - Ch. 6
10.{L}A.
Adjusting Zenab 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). Pretax income is $1,500
higher at $6,500.
A comparison of both companies on a FIFO basis is
presented below:
Zenab
Sales
Cost of goods sold
Gross profit
Selling and general expense
Pretax income
B.
$ 92,700
59,800
$ 32,900
26,400
$ 6,500
Faybech
$ 77,000
52,000
$ 25,000
21,500
$ 3,500
Adjusting Faybech to LIFO/Current Cost is more
complicated. The first step is to calculate an implied
inflation rate using Zenab's statements. On a FIFO
basis, Zenab'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, Faybech'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:
Zenab
Sales
Cost of goods sold
Gross profit
Selling and general expense
Pretax income
$ 92,700
61,300
$ 31,400
26,400
$ 5,000
Faybech
$ 77,000
53,675
$ 23,325
21,500
$ 1,825
Note that this solution is incomplete as Faybech is
100% on LIFO while Zenab is only 70% on LIFO. To
Solutions Chapter 6 - P. 1
complete the solution, convert the remaining 30% of
Zenab's inventories to LIFO using the same inflation
rate:
Thirty percent (30%) of Zenab 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:
Sales
Cost of goods sold
Gross profit
Selling and general expense
Pretax income
C.
Zenab
Faybech
$ 92,700
61,943
$ 30,757
26,400
$ 4,357
$ 77,000
53,675
$ 23,325
21,500
$ 1,825
It depends on the purpose of the comparison. There are
three possibilities:
(1)
(2)
(3)
Comparison of firms' operations.
Comparison of firms' operations and tax policy.
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
11.{L}A.
Year
Zenab (LIFO)
19X5
19X6
Current ratio
Inventory turnover
Gross profit margin
Pretax income/sales
2.89
2.65
2.45
.339
.054
Faybech (FIFO)
19X5
19X6
3.24
3.68
1.98
.32
.045
B.
Faybech's liquidity (as measured by the current ratio)
appears to be better. Its inventory turnover is lower,
however, implying lower efficiency. Faybech appears to
be slightly less profitable as well.
C.
(i)
Using the FIFO income statements from problem 10,
we compute the following ratios:
Year
Current ratio1
Inventory turnover2
Gross profit margin
Pretax income/sales
1
2
Zenab
(FIFO)
19X5
19X6
Faybech
(FIFO)
19X5
19X6
3.20
3.24
3.04
2.03
.355
.070
3.68
1.98
.32
.045
19X5 = ($33,500 + $3,600)/$11,600
19X6 = ($33,600 + $5,100)/$12,700
$59,800
($25,200 + $5,100 + $24,900 + $3,600)/2
(ii) Using the LIFO income statements from problem 10
(using the Zenab statement after conversion to
100%
LIFO),
we
compute
the
following
profitability ratios:
Zenab (100% LIFO)
Year
Gross profit margin
Pretax income/sales
Faybech (LIFO)
19X6
19X6
.332
.047
.303
.024
Balance sheet adjustments are not possible for
Faybech and the 30% of Zenab inventories on FIFO.
Solutions Chapter 6 - P. 3
Thus adjusted current and
ratios cannot be computed.
inventory
turnover
(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:
Zenab
LIFO cost of goods sold
FIFO average inventory
Inventory turnover ratio
D.
Faybech
$61,943
29,400
$53,675
26,300
2.11X
2.04X
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:
Year
FIFO current ratio
Zenab
19X5
19X6
Faybech
19X5
19X6
3.20
3.24
3.04
3.68
FIFO inventory turnover
Current cost turnover
2.03
2.11
1.98
2.04
LIFO gross profit margin
LIFO pretax income/sales
.332
.047
.303
.024
Notice that, based on these ratios, Zenab is clearly
more profitable than Faybech. The inventory turnover
ratios are, however, virtually identical. While
Faybech 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
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:
Sales
Gross margin
GM percentage
B.
1991
$5,848
954
1992
$5,723
832
1993
$6,479
1,104
16.3%
14.5%
17.0%
Excluding the LIFO liquidation increases COGS
decreases gross margin by the same amounts:
Reported COGS
LIFO liquidation
Adjusted COGS
Adjusted gross margin
Adjusted GM percentage
1991
$4,894
128
$5,022
$826
1992
$4,891
65
$4,956
$767
14.1%
13.4%
and
1993
$5,375
51
$5,426
$1,053
16.3%
Excluding the LIFO liquidation, the GM percentage
still declines in 1992, and increases in 1993.
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