Financial Reporting and Analysis Session 5 - Reading 20

CFA Level 2 - Financial Reporting and Analysis Session 5 - Reading 20 (Practice Questions, Sample Questions) 1. A firm’s financial statements reflect the following information: Beginning inventory $3,200,000 Purchase during the year $1,700,000 Ending inventory $2,100,000 Sales $4,800,000 Gross profit margin ? What was the firm’s gross profit margin? A) 0.58 B) 0.42 C) 2.29 Explanation: (First we can determine the COGS by: COGS = beginning inventory + purchases – ending inventory = $2,800,000. Then, gross profit margin = (sales – COGS) / sales = 0.42) 2. An analyst notes the following about a company: Beginning inventory was reported as $5,000. Costs of goods sold were reported as $8,000. Ending inventory is $7,000 (the analyst has physically verified this amount). Which of the following statements is most accurate? A) If the analyst discovered that beginning inventory was overstated by $1,000, then cost of goods sold must have been understated by $1,000. B) Purchases must have been $6,000. C) If the analyst discovered that beginning inventory was understated by $2,000, then earnings before taxes must have been overstated by $2,000. Explanation: (If inventory is overstated then COGS must also be overstated or purchases were understated, since you are told that ending inventory is ok.) 3. While attending a local university, CFA candidate Anjolie Webster accepts a temporary position with a small manufacturing firm. Currently, the firm uses LIFO to account for inventory, but the owner is “just curious” about how the financial results would look if the company used FIFO. The owner hands Webster a photocopy of the inventory data for the current period (summarized below). -Beginning inventory of 1,000 units at $30 cost. -Ending inventory of 800 units. -Sales of 1,100 units. -Three inventory purchases (listed from earliest purchase to latest purchase): 400 units at $27 each, 300 units at $25 each, and an unreadable number of units at $22 each. (Unfortunately, when the owner copied the original document, he left a yellow sticky note covering some of the inventory information.) -Current assets (less inventory) of $75,000. -Current liabilities of $65,000. Using the information provided, determine which of the following statements is least accurate? All else equal, compared to LIFO, using FIFO would result in: A) a lower ending inventory balance. B) a current ratio of approximately 1.60. C) a lower gross margin. Explanation: (To calculate the current ratio (which includes the ending inventory balance) using FIFO, we first need to determine how many units were purchased in the third illegible purchase order. Ending inventory = beginning inventory + units purchased – units sold, so units purchased = units sold + ending inventory – beginning inventory = 1,100 + 800 – 1,000 = 900 Third purchase units = 900 – 400 – 300 = 200 -FIFO ending inventory = [(300 × 27) + (300 × 25) + (200 × 22)] = $20,000 -FIFO current ratio (all else equal) = (75,000 + 20,000) / 65,000 = approximately 1.46 The other choices are correct. Since prices are decreasing, FIFO cost of goods sold is higher (and gross margin is lower) than LIFO. And, FIFO ending inventory is lower than LIFO ending inventory. No LIFO) 4. A firm’s financial statements reflect the following information: Beginning inventory $2,900,000 Purchase during the year $1,600,000 Ending inventory ? Sales $3,900,000 Gross Margin 0.41 What was the firm’s ending inventory for this period? A) $2,199,000. B) $2,799,000. C) $1,699,000. Explanation: (First we can determine the cost of goods sold (COGS) by: COGS = sales (1 − gross margin) = $2,301,000. Then, the ending inventory = beginning inventory + purchases − COGS = $2,199,000.) 5. A firm uses the last in, first out (LIFO) accounting method and posts $100,000 as ending inventory. Last year's financial statements show inventory at $110,000. This period's income statement shows costs of goods sold at $90,000 with a LIFO reserve of $30,000. How much inventory was purchased this period, and what would the ending inventory balance be under first in, first out (FIFO)? Inventory purchases Ending inventory (FIFO) A) $80,000 $130,000 B) $90,000 $130,000 C) $80,000 $70,000 Explanation: (EI = BI + P - COGS 100 = 110 + P - 90 P = $80,000 In order to convert ending inventory under FIFO to LIFO you have to add the LIFO reserve to the ending inventory under LIFO. EIFIFO = $100,000 + $30,000 = $130,000) 6. A company's beginning inventory was overstated by $3,000, now ending inventory is understated by $2,000. If purchases were properly reported, then earnings before taxes will be: A) overstated by $1,000. B) overstated by $5,000. C) understated by $5,000. Explanation: (The key relationship being tested is beginning inventory + purchases – COGS = ending inventory. So, beginning inventory + purchases – ending inventory = COGS. You could solve the equation as +3000 +0 - -2000 = +5000. However, it is probably easier to conceptualize by making up numbers that meet the requirements. Actual (I made these numbers up): 20,000 + 5,000 – 15,000 = 10,000 Reported: (20,000 + 3,000) + 5,000 – (15,000-2,000) = 15,000 COGS will be overstated by 5,000 so earnings before taxes (EBT) will be understated by 5,000.) 7. During a period of rising prices, the financial statements of a firm using first in, first out (FIFO) reporting, instead of last in, first out (LIFO) reporting would show: A) lower total assets and higher net income. B) higher total assets and higher net income. C) lower total assets and lower net income. Explanation: (When the FIFO method is used when prices are rising, the cheaper goods in beginning inventory, reflecting earlier purchases, are assigned to COGS (hence, higher income) and the more expensive units (last purchases) are assigned to ending inventory (greater current assets). When the LIFO method is used during a period when prices are rising, the more expensive last purchases are assigned to COGS (hence, lower income) and the cheaper units in beginning inventory and earlier purchases are assigned to ending inventory.) 8. When analyzing profitability ratios, which inventory accounting method is preferred? A) Weighted average. B) Last in, first out (LIFO). C) First in, first out (FIFO). Explanation: (Using LIFO cost of goods sold (COGS) gives a more accurate measure of future earnings because the LIFO COGS is more representative of the current cost of product sold as compared to using FIFO therefore net income will be more accurately represented) 9. The best way to compute an inventory turnover ratio is to use: A) last in, first out (LIFO) for cost of goods sold (COGS) and first in, first out (FIFO) for average inventory. B) last in, first out (LIFO) for both cost of goods sold (COGS) and average inventory. C) first in, first out (FIFO) for both cost of goods sold (COGS) and average inventory. Explanation: (Inventory turnover makes no sense at all for firms using LIFO due to the mismatching of costs (the numerator is current while the denominator is historical). FIFO based inventory is relatively unaffected by price changes and is a good approximation of actual turnover. In this way, current costs are matched in the numerator and denominator.) 10. Selected information from Mendota, Inc.’s financial statements for the year ended December 31 includes the following (in $):Sales 7,000,000 Cost of Goods Sold 5,000,000 LIFO Reserve on Jan. 1 600,000 LIFO Reserve on Dec. 31 850,000 Mendota uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is 40%. If Mendota changed from LIFO to first in, first out (FIFO), its gross profit margin would: A) increase to 40.1%. B) increase to 32.1%. C) increase to 30.0%. Explanation: (Gross profit margin under LIFO ((sales – cost of goods sold) / sales) is (($7,000,000 − $5,000,000) / $7,000,000) = 28.6%. Under FIFO, cost of goods sold is reduced by the increase in the LIFO reserve, and the resulting FIFO gross profit margin is (($7,000,000 – ($5,000,000 – ($850,000 $600,000)) / $7,000,000) = 32.1%. Note that the tax rate only affects income totals after income tax expense is shown and does not affect the gross profit margin.) 11. Selected information from Newcomb, Inc.’s financial statements for the year ended December 31, 20X4 included the following (in $): [tr][td] [tr][td] Cash 70,000 Accounts Payable 90,000 Accounts Receivable 140,000 Deferred Tax Liability 100,000 Inventory 460,000 Long-term Debt 520,000 Property, Plant & Equip. 1,200,000 Common Stock 600,000 Total Assets 1,870,000 Retained Earnings 360,000 Total Liabilities & Equity 1,870,000 Earnings Before Interest and Taxes 280,000 Interest Expense 60,000 Income Tax Expense 75,000 Net Income 145,000 LIFO Reserve at Jan. 1 185,000 LIFO Reserve at Dec. 31 250,000 If Newcomb had used first in, first out (FIFO) for 20X4 and we assume that average total capital was $1,700,000 for both the LIFO and FIFO computations, the return on total capital would: A) decrease from 16.5 to 12.6%. B) increase from 16.5 to 20.3%. C) remain unchanged at 16.5%. Explanation: (The return on total capital under LIFO (EBIT / average total capital) was $280,000 / $1,700,000 = 16.5%. Under FIFO, EBIT is increased by the increase in the LIFO reserve during the year. FIFO return on total capital is ($280,000 + ($250,000 − $185,000)) / $1,700,000 = 20.3%.) 12. If all else holds constant in periods of rising prices and inventory levels: A) FIFO firms have higher debt to equity ratios than LIFO firms do. B) LIFO firms have higher gross profit margins than FIFO firms do. C) FIFO firms will have greater stockholder's equity than LIFO firms do. Explanation: (The FIFO method of inventory accounting assigns the cost of the earliest units acquired to goods transferred out and the cost of most recent acquisitions to ending inventory. When prices are rising, the cheaper goods in beginning inventory reflecting earlier purchases are assigned to COGS (hence, higher income and higher shareholder's equity through retained earnings.) Explanations for other choices: In periods of rising prices and inventory levels (all else constant): -FIFO firms have lower debt to equity ratios than LIFO firms do because stockholder's equity is higher and debt is constant. -LIFO firms have lower gross profit margins ((Sales-COGS)/Sales) because the more expensive last purchases are assigned to COGS, lowering the numerator.) 13. In periods of rising prices and stable or increasing inventory quantities, using the LIFO method for inventory accounting compared to FIFO will have: A) higher COGS, lower income, lower cash flows, and lower inventory. B) higher COGS, lower income, higher cash flows, and lower inventory. C) lower COGS, higher income, identical cash flows, and lower inventory. Explanation: (In periods of rising prices and stable or increasing inventory quantities, the LIFO method – as compared with FIFO – will result in higher COGS, lower taxes, lower net income, lower inventory balances, lower working capital, and higher cash flows.) 14. In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report cost of goods sold and cash flows which are, respectively: COGS Cash Flows A) Lower Lower B) Higher Lower C) Higher Higher Explanation: (In this situation, LIFO results in higher cost of goods sold because it uses the more recent and higher costs than FIFO. LIFO results in higher cash flows because with lower reported income, income tax will be lower.) 15. During periods of declining prices, which inventory method would result in the highest net income? A) Average Cost. B) LIFO. C) FIFO. Explanation: (When prices are declining and LIFO is used the COGS is smaller than if FIFO is used leading to a larger net income.) 16. In general, when analyzing profitability and costs, or when analyzing asset and equity ratios, which of the following should be used? Profitability/Cost Ratios Asset/Equity Ratios A) FIFO FIFO B) FIFO LIFO C) LIFO FIFO Explanation: (In general, an analyst should use LIFO when examining profitability or cost ratios and FIFO when examining asset or equity ratios.) 17. Which of the following statements regarding inventory accounting methods is most accurate? In periods of: A) rising prices and stable unit purchases, using the LIFO method results in a lower current ratio than the FIFO method. B) declining prices FIFO results in higher net income than LIFO. C) rising prices and stable unit purchases, using the FIFO method results in higher inventory turnover than the LIFO method. Explanation: (In periods of rising prices LIFO results in lower current assets because the ending inventory is based on inventory items that were purchased first at a lower price.) 18. During periods of rising prices: A) LIFO Gross Profit Margin > FIFO Gross Profit Margin. B) LIFO Inventory Turnover < FIFO Inventory Turnover. C) LIFO Debt to Equity Ratio > FIFO Debt to Equity Ratio. Explanation: (FIFO inventory, and therefore FIFO assets and equity, will be higher by the LIFO reserve.) 19. Which of the following statements concerning a period of rising prices is least accurate? A) Inventory turnover is less using the last in, first out (LIFO) inventory valuation method than using the first in, first out (FIFO) method. B) The debt-to-equity ratio is greater using the last in, first out (LIFO) inventory valuation method than using the first in, first out (FIFO) method. C) Gross profit using the last in, first out (LIFO) inventory valuation method is less than the gross profit using the first in, first out (FIFO) method. Explanation: (LIFO results in lower inventory and higher cost of goods sold (COGS) during a period of rising prices, hence a higher inventory turnover) 20. Assume that Hunter Round Restaurant Supply currently uses the last in, first out (LIFO) method to account for inventory and that the business environment is one of rising prices and stable or growing inventory balances. In addition, Hunter Round has an effective tax rate of zero percent due to tax loss carrybacks. All else equal, which of the following statements is least likely valid? By using LIFO instead of first in, first out (FIFO), Hunter Round has: A) lower net income. B) higher cash flows. C) lower working capital. Explanation: (In the absence of taxes, there is no difference in cash flow between LIFO and FIFO. The other statements are true. For the examination, memorize the financial impact of rising and falling prices for the two inventory methods.) 21. Assuming high inflation in the short run and lower levels of inflation in the long run, the current ratio of a company using last in, first out (LIFO) relative to a firm using first in, first out (FIFO), will be: A) lower, and the difference between the two firms' current ratios will decrease as inflation decreases. B) lower, and the difference between the two firms' current ratios will increase as inflation decreases. C) higher, and the difference between the two firms' current ratios will decrease as inflation decreases. Explanation: (The LIFO firm's current ratio will be lower and the difference between the two firms' current ratios will increase as inflation decreases. For example, assume purchases equal sales so the quantity of inventory is constant. Inventory value under LIFO will also remain constant as inflation decreases, whereas FIFO inventory value will increase even as the inflation rate decreases. As long as inflation remains positive, the FIFO inventory value and the difference between LIFO and FIFO inventory values will increase, as will the difference between the LIFO and FIFO firms' current ratios.) 22. Tim Rogers is senior equity analyst with White Capital LLP. While analyzing the financial statements of Drako Toys Inc., a toy manufacturer based in Cleveland, Ohio, Tim concludes that Drako is expected to see above-average sales growth over the next three years. Which of the following conditions most likely support Tim’s conclusion? A) Finished goods inventory growing faster than sales in the last two years. B) Increase in raw-materials and work-in-progress inventory and corresponding decline in finished goods inventory over the last two years. C) Increase in finished goods inventory and corresponding decline in raw-materials and work-in-progress inventory over the last two years. Explanation: (An increase in raw materials and/or work-in-process inventory is probably an indication of an expected increase in demand. Conversely, an increase in finished goods inventory, while raw materials and work-in-process are decreasing, may be an indication of decreasing demand. Finished goods inventory that is growing faster than sales may be an indication of declining demand.) 23. Jim Banaji, credit analysts for HEQ, a fixed income fund, is evaluating three bonds. One of the bonds, issue by Prime Inc, a large printing and packaging company, has six years remaining to maturity and has limited liquidity in the market. While evaluating the financial statements of Prime, Banaji notices the following: Excerpts (Financial statements for years 20X9 and 20X8) ($'000) 20X9 20X8 Sales 11300 10800 ROE 12% 11.6% R&D expense 288 381 Finished goods 492 368 Raw Materials 329 324 Dividends 144 132 Inventory: Based on the information gathered, which of the following conclusions are most likely? A) Sales are expected to decrease in the future or grow at a slower pace. B) Sales are expected to grow at a more rapid pace in the future. C) Profits are expected to grow at a more rapid pace. Explanation: (Sales are expected to grow at a slower pace (or decrease). This is evidenced by growth in finished goods inventory accompanied with a stable raw materials inventory (as a proportion of sales).)