Professional Documents
Culture Documents
Fae3e SM ch06
Fae3e SM ch06
QUESTIONS
Q6.1 The Consistency Principle. The consistency principle is important to
shareholders and investment professionals because it facilitates inter-period
comparisons of data. When an accounting policy change (e.g., a LIFO to FIFO
switch) occurs, a firms reported performance and financial condition will, in
most cases, be altered as a consequence of the policy change, making inter-
period comparisons difficult. To help overcome this data comparability problem,
accounting policy changes are usually implemented for all periods of data
included in the annual report. Thus, if a company reports two years of balance
sheet data and three years of income statement data (as is customary in the
U.S.), all of the data will reflect the use of the new accounting policy. This
practice facilitates two-year balance sheet comparisons and three-year income
statement comparisons, but comparisons of longer duration are usually unwise.
Q6.3 Inventory Valuation Method Changes and Share Prices. There is a growing
body of literature, called Signaling Theory, which suggests that the
management of a company sends unintended signals to the capital markets
regarding a firms future financial performance by the actions and decisions that
the management team undertakes. Signaling Theory has been extended to
include voluntary accounting policy decisions and changes by B. Dharan and B.
Lev in The Valuation Consequences of Accounting Changes, Journal of
Accounting, Auditing and Finance (1993). What these researchers discovered
is that the capital market acts counter intuitively to accounting policy changes,
as follows:
For voluntary accounting policy changes that result in an increase in
accounting earnings (i.e., a LIFO-to-FIFO switch), the share price of a
firm tends to decline as the market anticipates that the method change is
being undertaken to hide future poor operating performance.
For voluntary accounting policy changes that result in a decrease in
accounting earnings (i.e., a FIFO-to-LIFO switch), the share price tends
to rise as the market hypothesizes that firm performance is exceeding
market expectations and management is attempting to bank the higher
anticipated future performance by creating an earnings reserve.
When would these policy changes not indicate the presence of earnings
management? In the case of a LIFO to FIFO switch, when inventory costs are
declining; and, in the case of a LIFO layer liquidation, when a restructuring or
downsizing of a business is undertaken to reflect a reduction in demand or
change in consumer tastes.
Since LIFO tends to cause a firm to report the lowest level of net income and to
understate the value of its ending inventory, these restatements enable
investment professionals and shareholders to obtain a less conservative
assessment of firm performance. In addition, the LIFO inventory reserve also
facilitates necessary financial statement restatements to enable an apples-to-
apples comparison of interfirm performance when other comparable firms are
using the FIFO method of inventory valuation.
Q6.7 LIFO and Earnings Management. Under the LIFO approach to inventory
valuation, the most recent inventory purchase prices are charged to cost of
goods sold when inventory is sold, while the oldest prices are taken to the
balance sheet as the value of ending inventory. Since most firms try to avoid
liquidating all of their inventory (i.e., they try to maintain some minimal level of
inventory on hand to meet customer demand), in a period of rising inventory
purchase prices, the first-in prices that are retained on the balance sheet under
LIFO as the value of ending inventory may become very outdated and
significantly undervalued relative to their replacement cost. The amount of this
undervaluation is captured by the LIFO inventory reserve, and in essence,
represents the hidden earnings reserve referred to by investment
professionals.
Management may access the LIFO earnings reserve by reducing the quantity
of its LIFO price layers that is, by undertaking a LIFO layer liquidation. When
analysts identify from a companys footnote information that a LIFO layer
liquidation has occurred, it is often interpreted as earnings management (i.e.,
an attempt by management to make the firms performance look better than it
really is).
Q6.9 LIFO Layer Liquidations. When a company using the LIFO method to value
its inventory reduces the quantity of inventory on hand, the result is that lower
costs (i.e., lower than current replacement cost) are transferred to cost of goods
sold when inventory is sold, thereby lowering the cost of sales. (This assumes
the presence of inflation or rising inventory replacement prices). In 2012 and
2011, the LIFO layer liquidation actually resulted in an increase in cost of sales
for Alleghany. A LIFO layer liquidation does not always indicate that a firm is
trying to manage its earnings. For instance, if consumer tastes change and
demand for a companys products declines, an appropriate managerial
response would be to lower the amount of inventory that is normally kept on
hand to service customers. Thus, this type of inventory downsizing is an
appropriate managerial response to a decline in demand but has the
unintended consequence of raising operating income as if the goal were to
manage the companys earnings.
Q6.10 Inventory Value Write-Down. Delphis decision to write down the value of its
inventory reflects the lower-of-cost-or-market (LCM) method, which is founded
on the conservatism concept. When Delphi executes the write-down, it will
reduce the value of its inventory on hand by $100 million and report a loss on
inventory write-down on its income statement. If the $100 million write-down is
immaterial in amount, it may be reported as an increase in Delphis cost of
goods sold instead. The write-down will increase the companys inventory
turnover ratio and lower its inventory-on-hand period. The write-down lowers
the cost basis of the inventory on hand, and thus, assuming retail prices do not
materially decline, increases the profit margin on those goods when they are
ultimately sold in a future period. In short, an inventory write-down has the
effect of transferring a portion of the expected profit from the sale of inventory
from the current period to a future period (i.e., recognizing a loss now in
exchange for higher profits in a later period). As a consequence, some
companies have used an inventory write-down as a way to manage the amount
and timing of their earnings.
It can be argued that it should not make any difference if the professional (e.g
an accountant working for an organization rather than directly for the public)
should also be subject to an ethical code of conduct. Ethical dilemmas are not
limited to dealing with the public, rather they appear in many situations. A code
of ethics, detailing proper conduct in such situations, could greatly benefit the
professional. Just because a professional does not deal directly with the public
does not mean that the public does not rely on their work, at least indirectly.
For example, internal auditors provide assurance that controls are in place and
functioning properly so that an organizations financial reporting can be relied
upon. This work, in turn, serves to provide assurance to a firms external
auditors whose work is directly relied upon by the public.
Purchases: 10 @ $14
0
Sales: 80 @ $10 800
50 @ $14 700
Ending Inventory 50 @ $14 = $700 Cost of Goods Sold $2,700
2012
Purchases 10 @ $16
0
Sales: 50 @ $14 $700
30 @ $16 480
Purchases: 10 @ $18
0
Sales: 70 @ $16 1,120
30 @ $18 540
Ending inventory: 70 @ $18 = $1,260 Cost of goods sold $2,840
Summary:
Periodic Perpetual
2011:
Cost of goods sold $2,700 $2,700
Ending inventory 700 700
2012:
Cost of goods sold $2,840 $2,840
Ending inventory 1,260 1,260
a. Periodic
2011
Purchases: 20 @ $10
0
10 @ $14
0
Sales: 100 @ $14 = $1,400
30 @ $10 = 300
120 @ $10 = 1,200
Ending inventory 50 @ $10 = $500 Cost of goods sold $2,900
2012
Purchases: 10 @ $16
0
10 @ $18
0
Sales: 100 @ $18 = $1,800
80 @ $16 = 1,280
Ending inventory 20 @ $16 = $320 Cost of goods sold = $3,080
50 @ $10 = 500
$820
b. Perpetual
2011
Purchases: 200 @ $10
Sales: 120 @ $10 = $1,200
Purchases: 100 @ $14
Sales 100 @ $14 = 1,400
30 @ $10 300
Ending inventory 50 @ $10 = $500 Cost of goods sold $2,900
2012
Purchases: 100 @ $16
Sales 80 @ $16 = 1,280
Purchases 100 @ $18
Sales 100 @ $18 = 1,800
Cost of goods sold $3,080
Ending inventory 50 @ $10 = $500
20 @ $16 = 320
$820
Summary
Periodic Perpetual
2011:
Cost of goods sold $2,900 $2,900
Ending inventory 500 500
2012:
Cost of goods sold $3,080 $3,080
Cambridge Business Publishers, 2014
Solutions Manual, Chapter 6 6-9
Ending inventory 820 820
2012
Beginning Inventory 50 @ $11.33 = $566.50
Purchases 100 @ $16.00 = 1,600.00
100 @ $18.00 = 1,800.00
250 $3,966.50
Weighted-Average cost per unit = $15.87
b. Perpetual
2011
Purchases: 20 @ $10.00
0
Sales: 120 @ $10.00 = $1,200.00
Purchases: 10 @ $14.00
0
Weighted-Average cost per unit = $12.22
Sales 130 @ $12.22 = $1,588.60
Ending inventory* 50 @ $12.22 = $611
Cost of goods sold $2,788.60
2012
Purchases: 10 @ $16.00
0
Weighted-Average cost per unit = $14.74
Sales: 80 @ $14.74 = $1,179.20
Purchases: 10 @ $18.00
0
Weighted-Average cost per unit = $16.66
Sales 100 @ $16.66 = $1,666.00
Cost of goods sold $2,845.20
Ending inventory* 70 @ $16.66 = $1,16
6
*minor rounding difference
Summary
Periodic Perpetual
2011:
Cost of goods sold $2,832.50 $2,788.60
Ending inventory 566.50 611.00
Cambridge Business Publishers, 2014
Solutions Manual, Chapter 6 6-11
2012:
Cost of goods sold $2,856.60 $2,845.20
Ending inventory 1,110.90 1,166.00
Company X Company Z
(FIFO) (LIFO)
Company X has a higher return on sales and a higher current ratio, suggesting
that its profitability and liquidity are better than Company Z. Company Z, on the
other hand, has a higher inventory turnover, and consequently, a lower
inventory-on-hand period, suggesting superior asset management. Of course,
the firms cash flows are identical as any differences that are observed in the
ratios are merely a manifestation of the cost allocation assumption inherent in
LIFO and FIFO. Thus, the two companies would represent equivalent
investment opportunities if evaluated on the basis of their cash flow.
Year 1 Year 2
Inventory turnover 5.52x 5.05x
Inventory-on-hand period 66.1 days 72.3 days
Gross profit percentage 57.7% 59.4%
Yes; Intels inventory management ratios would have looked somewhat better if
the company had used LIFO instead of FIFO to value its inventory. This
outcome results because LIFO assigns a lower cost to ending inventory than
does FIFO.
After the policy change, Riverwood Internationals results will appear as follows:
Thus, the companys income from operations will increase by 0.124 percent,
which is clearly immaterial.
Weighted
FIFO LIFO Average
Coca-Cola Enterprises (CCE) reduced its days payable period from 91.8 days
to 86.1 days, a reduction of 5.7 days (or 6.2%). This decline indicates that CCE
is paying its current trade obligations more quickly, a positive sign that the
companys credit risk is decreasing (i.e., probably due to increased liquidity in
the form of excess cash on the balance sheet and/or increased cash flow from
operations).
E6.22 LIFO Layer Liquidations and Net Income. The Claremont Corporation:
Year 2 Year 1
The LIFO layer liquidation profit constituted 7.8 percent and 30 percent of the
companys operating income in Year 2 and Year 1, respectively. This profit is
often referred to as phantom profit because there is no parallel increase in the
cash flow from operations. The profit results from the lowering of the cost of
sales, not from an increase in sales revenue. Thus, profits are increased, but
cash flow is not. And, since the incremental (or phantom) profit is subject to
taxation, the level of operating cash flow is actually reduced by a LIFO
P6.23 Calculating the Value of Ending Inventory and Cost of Goods Sold:
Periodic Method.
1. Cost of steel produced and
sold.
a. FIFO 500 tons @ $40 = $20,000
700 tons @ $35 = 24,500
200 tons @ $33 = 6,600
300 tons @ $30 = 9,000
1,700 $60,100
c. Weighted average
$79,300 2,200 = $36.05
2. Ending Inventory
Replacement cost: 500 tons @ $39 = $19,500
January February
Cost of Ending Cost of Ending
Goods Sold Inventory Goods Sold Inventory
a. FIFO $789,830 $154,560 $910,080 $264,420
b. LIFO 797,190 147,200 958,120 209,020
c. Wt. Average 792,446 151,944 937,888 233,996
a. FIFO
Beginning inventory, January 1 $120,000
Add: Purchases
January 5 207,200
January 20 617,190
Total available (January) 944,390
Less: Cost of goods sold
60,000 @ 2.00 = 120,000
103,600 @ 2.00 = 207,200
220,300 @ 2.10 = 462,630
(789,830)
Ending inventory (January) 154,560
(73,600 @ 2.10)
Add: Purchases
282,200 @ 2.20 620,840
153,500 @ 2.60 399,100
Total available (February) 1,174,500
Less: Cost of goods sold
73,600 @ 2.10 = 154,560
282,200 @ 2.20 = 620,840
51,800 @ 2.60 = 134,680
(910,080)
Ending inventory (February) $264,420
c. Weighted average
Total available (January) $944,390
Less: Cost of goods sold
$944,390 457,500 = 2.0642
383,900 @ 2.0642 (792,446)
Ending inventory (January) 151,944
Add: Purchases 1,019,940
Total available (February) 1,171,884
73,600 @ 2.064 = 151,925*
282,200 @ 2.20 = 620,840
153,500 @ 2.60 = 399,100
509,300 1,171,865
407,600 @ 2.301 = (937,888)
Ending inventory (February) 233,996
* Rounded
P6.25 Calculating the Value of Ending Inventory and Cost of Goods Sold:
Lower-of-Cost-or-Market Method.
1.
Periodic Perpetual
Ending Ending
Inventor Cost of Inventor Cost of
Method y Goods Sold y Goods Sold
a. FIFO $42,000 $310,000 $42,000 $310,000
Replacement cost:
30,000 @ 1.40 = $42,000
b. LIFO
Periodic:
Total available for sale $370,000
Less: Cost of goods sold:
60,000 @ 2.00 = 120,000
60,000 @ 1.50 = 90,000
130,000 @ 1.00 = 130,000
(340,000)
Cost of ending inventory $30,000
Perpetual:
Total available for sale $370,000
Less: Cost of goods sold:
Feb. 3: 120,000 @1.00 = 120,000
June 30: 30,000 @1.50 = 45,000
Oct. 5: 60,000 @ 2.00 = 120,000
30,000 @ 1.50 = 45,000
10,000 @ 1.00 = 10,000
(340,000)
Cost of ending inventory $30,000
Perpetual:
Total available for sale $370,000
Cost of goods sold:
Feb. 3 120,000 @ $1.00 = 120,000
Jun. 30 30,000 @ $1.30 = 39,000
Oct. 5 100,000 @ = 162,310
$1.6231
(321,310)
Under both the periodic and perpetual methods, LIFO yields the highest
cost of goods sold (i.e., $340,000), and hence the lowest taxable net
income; thus, LIFO would be preferred for tax purposes.
4. Deflationary periodFIFO would have the highest COGS and the lowest
net income
The total estimated tax savings (in millions) experienced by the company as
a consequence of using LIFO rather than FIFO are $710.2 as of Year 2.
2. The cost of using FIFO instead of LIFO is DM156 million, which is the
additional income taxes that BASF would have paid.
Using just the ratios, and ignoring the question of income taxes, FIFO Company
appears to have the best liquidity, profitability, and solvency. But, if FIFO
Company uses FIFO for income tax purposes and LIFO Company uses LIFO
for income tax purposes, the LIFO Company will have a higher cash flow from
operations due to the income tax savings, making the LIFO Company the better
investment, acquisition, and lending opportunity.
2. The LIFO reserve increased by $21 ($108-$87); hence NIBT under FIFO
would be higher by $21. NIBT under FIFO in 2012 would have been $2,788
(i.e., $2,767+$21)
The increase in cumulative tax payments would have been $7.58 (i.e., $21 x
36.1%).
Cambridge Business Publishers, 2014
Solutions Manual, Chapter 6 6-25
CORPORATE ANALYSIS
P&Gs inventory represents 4.9 percent and 5.9 percent of total assets in
2007 and 2008, respectively. Given these large percentages, it is somewhat
surprising that P&G is using FIFO to principally value its inventory, foregoing
the tax benefit of using LIFO.
Conclusions:
Inventory turnover improved from 2011 to 20128, reducing the
inventory-on-hand period by 9.7 days from 67.6 days to 57.9 days,
thus reversing a costly prior years trend at P&G.
Payable turnover increased from 2011 to 2012, indicating that the
company paid its payables off more quickly (i.e., by 0.4 days).
The combination of these two trends is positive for P&G. The company
is holding its inventory for a shorter period of time, which recognizes
the time value of money as well as potential storage/warehousing
cost savings. It is taking a shorter time (5.4 days) to pay it accounts
payable, and it may also be taking advantage of any quick pay
incentives.
b. When LVMH takes a write-down for inventory obsolescence (eg. at the end of
the fashion season), the transaction involves writing down its inventory to its
expected recovery value and recognizing an equivalent loss (ie. the provision
for inventory impairment) in the Other operating income and expenses
section as a reduction from Profit from recurring operations on LVMHs
income statement.