Problems - Ch



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 |$ 92,700 |$ 77,000 |

|Cost of goods sold |59,800 |52,000 |

|Gross profit |$ 32,900 |$ 25,000 |

|Selling and general expense |26,400 |21,500 |

|Pretax income |$ 6,500 |$ 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 |$ 92,700 |$ 77,000 |

|Cost of goods sold |61,300 |53,675 |

|Gross profit |$ 31,400 |$ 23,325 |

|Selling and general expense |26,400 |21,500 |

|Pretax income |$ 5,000 |$ 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 |$ 92,700 |$ 77,000 |

|Cost of goods sold |61,943 |53,675 |

|Gross profit |$ 30,757 |$ 23,325 |

|Selling and general expense |26,400 |21,500 |

|Pretax income |$ 4,357 |$ 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.

| | Zenab (LIFO) | Faybech (FIFO) |

|Year |19X5 19X6 |19X5 19X6 |

|Current ratio | 2.89 2.65 | 3.24 3.24 |

|Inventory turnover |2.45 |1.98 |

|Gross profit margin |.339 |.32 |

|Pretax income/sales |.054 |.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:

| | Zenab (FIFO) | Faybech (FIFO) |

|Year |19X5 19X6 |19X5 19X6 |

|Current ratio1 |3.20 3.04 |3.24 3.68 |

|Inventory turnover2 |2.03 |1.98 |

|Gross profit margin |.355 |.32 |

|Pretax income/sales |.070 |.045 |

1 19X5 = ($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:

| | Zenab (100% LIFO) | Faybech (LIFO) |

|Year |19X6 |19X6 |

|Gross profit margin | .332 | .303 |

|Pretax income/sales |.047 |.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 |$61,943 |$53,675 |

|FIFO average inventory |29,400 |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:

| | Zenab | Faybech |

|Year |19X5 19X6 |19X5 19X6 |

|FIFO current ratio | 3.20 3.04 | 3.24 3.68 |

|FIFO inventory turnover | 2.03 2.11 | 1.98 2.04 |

|Current cost turnover | | |

|LIFO gross profit margin | .332 | .303 |

|LIFO pretax income/sales |.047 |.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:

1991 1992 1993

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

Gross margin 954 832 1,104

GM percentage 16.3% 14.5% 17.0%

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

1991 1992 1993

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.

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