BBMF3063 Financial Statement Analysis
Tutorial 4 – Analyzing Investing Activities
1. a. Identify the main concerns in analysis of accounts receivable.
One of the main concerns in analysis of account receivable is genuine, due and enforceable. The
other concern is the probability of collection is properly evaluated. Although the opinions of an
independent auditor can provide certain assurance for these issues, the financial analyst must
recognize the possibility of misjudgment and luck of complete independence.
b. Describe information, other than that usually available in financial statements, that we
should collect to assess the risk of non collectibility of receivables.
The description of the receivable usually does not have enough information to reliable determine
whether a receivable is genuine, due, and enforceable. Therefore, the knowledge of industry
practices and supplementary sources of information must be use for additional assurance. For
instance, there is substantial right to return goods for certain companies, so allowance must be
provided for this. Hence, the analysts must use their past experience, own judgement and
knowledge of the industry to assess the adequacy of provision for uncollectable accounts.
2. Compare and contrast the effects of LIFO and FIFO inventory costing methods on earnings in
an inflationary period. Provide Illustration.
Answer
Last-in, First-Out (LIFO) is one of the inventory costing methods whereby the cost of goods sold
is measures by the recent costs and the ending inventory will be the oldest costs.
First-In, First-Out (FIFO) is another inventory costing method that the costs of goods sold is
based on the oldest costs and the ending inventory will be the recent costs
Below is the illustration of coting methods,
Inventory on Jan 1, Y2
30 @ 200
RM6000
Inventory Purchased during the year
40 @ 300
RM12000
Cost of Goods available for sale
70 units
RM18000
Note: 20 units are sold in Year 2 for RM500 each = Total revenue – RM10000
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BBMF3063 Financial Statement Analysis
Tutorial 4 – Analyzing Investing Activities
Beginning Inventory +
Net Purchase =
Cost of goods Sold +
End. Inv
FIFO
RM6000
RM12000
RM4000
RM14000
LIFO
RM6000
Rm12000
RM6000
RM12000
Sales -
Cost of goods sold =
Gross Profit
FIFO
RM10000
RM4000
RM6000
LIFO
RM10000
RM6000
RM4000
From the diagram above we can see that using FIFO costing method has higher earning compare
to the LIFO costing method. This is because using FIFO will sell out the older inventories which
are lower cost. Thus, the gross profit will be higher.
3. Cost for inventory purposes should be determined by the inventory cost flow method best
reflecting periodic income.
Required:
a. Describe the inventory cost flow assumptions of (1) average-cost, (2) FIFO, and (3) LIFO.
1. FIFO assumes that the first item purchased is also the first one sold.
2. LIFO assumes that the last item purchased is also the first one sold.
3. The average-cost cost flow assumption tends to yield a mid-range cost, and therefore
also a mid-range profit.
b. Discuss management’s usual reasons for using LIFO in an inflationary economy.
Businesses that sell products that rise in price every year benefit from using LIFO. When
prices are rising, a business that uses LIFO can better match their revenues to their latest
costs. A business can also save on taxes that would have been accrued under other
forms of cost accounting, and they can undertake fewer inventory write-downs.
Virtually any industry that faces rising costs can benefit from using LIFO cost accounting.
For example, many supermarkets and pharmacies use LIFO cost accounting because
almost every good they stock experiences inflation. Many convenience stores, especially
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BBMF3063 Financial Statement Analysis
Tutorial 4 – Analyzing Investing Activities
those that carry fuel and tobacco, elect to use LIFO because the costs of these products
have risen substantially over time.
c. When there is evidence the value of inventory, through its disposal in the ordinary course
of business is less than cost, what is the accounting treatment? What concept justifies
this treatment?
The proper accounting treatment would be the LCM (lower of cost or market)
methodology. The concept under which this treatment is justified is conservatism.
Conservatism holds that when you are in doubt, it is best to choose the accounting
alternative that will be least likely to overstate assets or income. The usage of the LCM
accounting treatment demonstrates the concept of conservatism in that, when the cost
of inventory exceeds its expected benefit, a reduction of the inventory to its market value
is a better measure of its expected future benefit.
4. Droog Co. is a retailer dealing in a single product. Beginning inventory at January 1 of this
year is zero and operating expenses for this same year are $5,000. The following purchases
are made this year:
Ending inventory at December 31 is 800 units. End-of-year assets, excluding inventories, amount
to $75,000, of which $50,000 of the $75,000 are current. Current liabilities amount to $25,000,
and long-term liabilities equal $10,000.
Required:
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BBMF3063 Financial Statement Analysis
Tutorial 4 – Analyzing Investing Activities
a. Determine net income for this year under each of the following inventory methods. Assume a
sales price of $25 per unit and ignore income taxes.
(1) FIFO
(2) LIFO
(3) Average cost
Answer
Ending inventory = 800 units, total inventory = 1000 units, sold = 1000 units, sales price =$25
per unit
FIFO
Sales
(100 x 25) = 2500
(300 x 25) = 7500
(600 x 25) = 15000
Cost of Goods Sold
(100 x10) = 1000
(300 x 11) = 3300
(600 x 12) = 7200
Gross Profit
1500
4200
7800
13500
Sales
(500 x 25) = 12500
(300 x 25) = 7500
(200 x 25) = 5000
Cost of Goods Sold
(500 x 15) = 7500
(300 x 14) = 4200
(200 x 12) = 2400
Gross Profit
5000
3300
2600
10900
Cost of Goods Sold
128900
Gross Profit
12110
Total
LIFO
Total
Average cost
Sales
25000
23200/18000 = 12.89 x 1000 = 12890
b. Compute the following ratios under each of the inventory methods of FIFO, LIFO, and average
cost.
(1) Current ratio
(2) Inventory turnover
(3) Gross margin as a percent of sales
(4) Net profit as a percent of sales
(5) Debt to equity ratio
(1) Current Ratio = Current Asset/Current Liabilities
FIFO
= 50000 + (300 x 14) + (500 x 15)/ 25000
= 61700/25000
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BBMF3063 Financial Statement Analysis
Tutorial 4 – Analyzing Investing Activities
2.468
LIFO
=5000 + (400 x 12) + (300 x 11) + (100 x 10) / 25000
=59100/25000
= 2.364
Average Cost
= 5000 + (800 x 12.89)/ 25000
= 2.4125
(2) Inventory turnover = Cost of Sales/ Average inventory
FIFO
= 11500/ (800/2)
= 28.75
LIFO
= 14100/ (800/2)
= 35.25
Average cost
= 12890/ (800/2)
= 32.225
(3) Gross margin as a percent of sales = [(Sales – COGS)/ Sales] x100
FIFO
= [(25000-11500)/ 25000] x 100
= 54%
LIFO
= [(25000-14100)/ 25000] x 100
= 43.6%
Average cost
= [(25000 – 12890)/ 25000] x 100
= 48.44%
(4) Net profit as a percent of sales = (Net income/ Sales) x 100
FIFO
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BBMF3063 Financial Statement Analysis
Tutorial 4 – Analyzing Investing Activities
= [(25000- 11500 – 5000)/ 25000] x 100
= 34%
LIFO
= [(25000- 14100 – 5000)/ 25000] x 100
= 23.66%
Average cost
= [(25000 – 12800 – 5000)/ 25000] x 100
= 28.44%
(5) Debt to equity ratio = Total Liability/ Shareholder equity
FIFO
= (10000 + 25000)/ 51700
= 0.677
LIFO
= (10000 + 25000)/ 49100
= 0.7128
Average cost
= (10000 + 25000)/ 50312
= 0.6957
c. Discuss the effects of inventory accounting methods for financial statement analysis given the
results from parts a. and b.
Based on the result from part a and b, we found out that the FIFO method may generate higher
profit since the gross profit from part a and the gross margin and net margin are higher than
LIFO method and average cost. Thus, FIFO may ranking the first, Average cost second and LIFO
third.
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