A Comparison of Both Companies on a FIFO Basis Is Presented Below

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 / Faybech
Sales
Cost of goods sold
Gross profit
Selling and general expense
Pretax income / $ 92,700
59,800
$ 32,900
26,400
$ 6,500 / $ 77,000
52,000
$ 25,000
21,500
$ 3,500

B.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 / Faybech
Sales
Cost of goods sold
Gross profit
Selling and general expense
Pretax income / $ 92,700
61,300
$ 31,400
26,400
$ 5,000 / $ 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 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:

Zenab / Faybech
Sales
Cost of goods sold
Gross profit
Selling and general expense
Pretax income / $ 92,700
61,943
$ 30,757
26,400
$ 4,357 / $ 77,000
53,675
$ 23,325
21,500
$ 1,825

C.It depends on the purpose of the comparison. There are three possibilities:

(1)Comparison of firms' operations.

(2)Comparison of firms' operations and tax policy.

(3)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.

11.{L}A.

Year / Zenab (LIFO)
19X5 19X6 / Faybech (FIFO)
19X5 19X6
Current ratio
Inventory turnover
Gross profit margin
Pretax income/sales / 2.89 2.65
2.45
.339
.054 / 3.24 3.24
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 / Zenab (FIFO)
19X5 19X6 / Faybech (FIFO)
19X5 19X6
Current ratio1
Inventory turnover2
Gross profit margin
Pretax income/sales / 3.20 3.04
2.03
.355
.070 / 3.24 3.68
1.98
.32
.045

119X5 = ($33,500 + $3,600)/$11,600

19X6 = ($33,600 + $5,100)/$12,700

2 $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:

Year / Zenab (100% LIFO)
19X6 / Faybech (LIFO)
19X6
Gross profit margin
Pretax income/sales / .332
.047 / .303
.024

Balance sheet adjustments are not possible for Faybech and the 30% of Zenab inventories on FIFO. Thus adjusted current and inventory turnover ratios cannot be computed.

(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 / Faybech
LIFO cost of goods sold
FIFO average inventory / $61,943
29,400 / $53,675
26,300
Inventory turnover ratio / 2.11X / 2.04X

D.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 / Zenab
19X5 19X6 / Faybech
19X5 19X6
FIFO current ratio / 3.20 3.04 / 3.24 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.

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:

199119921993

Sales$5,848$5,723$6,479

Gross margin9548321,104

GM percentage16.3%14.5%17.0%

B.Excluding the LIFO liquidation increases COGS and decreases gross margin by the same amounts:

199119921993

Reported COGS $4,894 $4,891 $5,375

LIFO liquidation 128 65 51

Adjusted COGS $5,022 $4,956 $5,426

Adjusted gross margin $826 $767 $1,053

Adjusted GM percentage 14.1% 13.4% 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. 1