CFA Level 1 - Financial Reporting and Analysis Session 9 - Reading 29

CFA Level 1 - Financial Reporting and Analysis Session 9 - Reading 29 (Notes, Practice Questions, Sample Questions) 1. Diabelli Inc. is a manufacturing company that is operating at normal capacity levels. Which of the following inventory costs is most likely to be recognized as an expense on Diabelli’s financial statements when the inventory is sold? A)Administrative overhead. B)Allocation of fixed production overhead. C)Selling cost. [Explanation]: B — Assuming normal capacity levels, allocation of fixed production overhead is a product cost that is capitalized as part of inventory. Thus, this cost will not be recognized as an expense until the inventory is sold (it becomes part of COGS for that period). Administrative overhead and selling costs are period costs that must be expensed in the period incurred. 2. Goldberg Inc. produces and sells electronic equipment. Which of the following inventory costs is most likely to be recognized as an expense on Goldberg’s financial statements in the period incurred? A)Conversion cost. B)Selling cost. C)Freight costs on inputs. [Explanation]: B — Selling costs are expensed in the period incurred since they result in no future benefit (i.e. the inventory has been sold). Conversion costs and freight costs add value in assisting in the future sale of the related inventory. Therefore, these costs are not recognized until the inventory is ultimately sold 3. In an environment of increasing prices, the last-in first-out (LIFO) inventory cost method results in: A)cost of sales near current cost and inventory below replacement cost. B)inventory near replacement cost and cost of sales below current cost. C)cost of sales below current cost and inventory above replacement cost. [Explanation]: A — LIFO assumes the most recently purchased items are the first items sold. In an increasing or decreasing price environment, LIFO results in cost of sales that are nearer to current costs compared to other inventory cost methods, and inventory values based on outdated prices (below replacement cost if prices are increasing, above replacement cost if prices are decreasing) 4. A U.S. company uses the LIFO method to value its inventory for their income tax return. For its financial statements prepared for shareholders, the company may: A)use any other inventory method under generally accepted accounting principles (GAAP). B)only use the LIFO method. C)use the FIFO method, but must disclose a LIFO reserve. [Explanation]: B — The LIFO conformity rule in the U.S. requires firms to use LIFO for their financial statements if they use LIFO for income tax purposes 5. JME purchased 400 units of inventory that cost $4.00 each. Later the firm purchased an additional 500 units that cost $5.00 each. JME sold 700 units of inventory for $7.00 each. If JME uses a first in, first out (FIFO) cost flow method, the amount of gross profit appearing on the income statement is: A)$2,400. B)$3,100. C)$1,800. [Explanation]: C — (units sold × sales price) – [(inventory cost × unit cost) + (inventory cost × unit cost)] = sales – COGS = gross profit (700 × 7.00) – [(400 × 4.00) + (300 × 5.00)] = 1,800 6. Given the following inventory data about a firm: ·Beginning inventory 20 units at $50/unit ·Purchased 10 units at $45/unit ·Purchased 35 units at $55/unit ·Purchased 20 units at $65/unit ·Sold 60 units at $80/unit What is the inventory value at the end of the period using first in, first out (FIFO)? A)$1,575. B)$3,475. C)$3,100. [Explanation]: A — Ending inventory equals 20 + 10 + 35 + 20 − 60 = 25 of last units purchased in inventory. (20 units)($65/unit) + (5 units)($55/unit) = $1,300 + $275 = $1,575 7. Which inventory method will provide the largest net income during periods of falling prices? A)Weighted average cost. B)FIFO. C)LIFO. [Explanation]: C — During periods of falling prices last in, first out (LIFO) provides a higher net income than first in, first out (FIFO) or the average cost methods because the items most recently purchased are the ones being sold first and these costs are continually falling increasing net income. Using FIFO during periods of falling prices would cause net income to be lower than LIFO or average cost methods because the first inventory purchased is the first sold but during periods of falling prices this is the most expensive inventory causing net income to be lower 8. Blocher Company is evaluating the following methods of accounting for depreciation of long-lived assets and inventory: Depreciation: straight-line; double-declining balance (DDB) Inventory: first in, first out (FIFO); last in, first out (LIFO) Assuming a deflationary environment (prices are falling), which of the following combinations will result in the highest net income in year 1? A)DDB; FIFO. B)Straight-line; FIFO. C)Straight-line; LIFO. [Explanation]: C — For year 1, straight-line depreciation will be lower than DDB. During deflationary periods, LIFO will result in lower cost of goods sold and hence higher income. 9. Arlington, Inc. uses the first in, first out (FIFO) inventory cost flow assumption. Beginning inventory and purchases of refrigerated containers for Arlington were as follows: Beginning Inventory Purchases, April Purchases, July Purchases, October Units 20 10 10 20 Unit Cost $10,000 12,000 12,500 15,000 Total Cost $200,000 120,000 125,000 300,000 In November, Arlington sold 35 refrigerated containers to Johnson Company. What is the cost of goods sold assigned to the 35 sold containers? A) $485,000 B) $434,583 C) $382,500 [Explanation]: C — Under FIFO, cost of goods sold is the value of the first units purchased. The 35 units sold consist of the 20 units in beginning inventory, the 10 units purchased in April, and 5 of the units purchased in July. COGS = $200,000 + $120,000 + (5 × $12,500) = $382,500 10. In a decreasing price environment, the first-in first-out (FIFO) inventory cost method results in: A)lower gross profit compared to last-in first-out. B)higher inventory compared to last-in first-out. C)lower cost of goods sold compared to last-in first-out. [Explanation]: A — If prices are decreasing, FIFO assumes the higher-cost earliest purchases are the first items sold. This results in higher COGS, lower inventory, and lower gross profit compared to LIFO 11. If prices are increasing, the weighted average cost method most likely results in inventory values that are higher than the inventory values using: A)first-in first-out (FIFO). B)last-in first-out (LIFO). C)specific identification. [Explanation]: B — In a increasing price environment, inventory values reported under LIFO are lower than the values reported under FIFO, and the values that result from weighted average cost are between the LIFO and FIFO values. Thus, the value of inventory using weighted average cost is higher than inventory using LIFO. The value of inventory using specific identification depends on which particular items from inventory are sold, and thus can be higher or lower than the inventory values that result from the other methods 12. Lincoln Corporation and Continental Incorporated are identical companies except that Lincoln complies with U.S. Generally Accepted Accounting Principles and Continental complies with International Financial Reporting Standards. Assuming an inflationary environment and stable inventory quantities, which permissible cost flow assumption will minimize each firm’s pre-tax financial income? Lincoln Corporation Continental Incorporated A) Last-in, first-out Last-in, first-out B) Last-in, first-out Average cost C) First-in, first-out Last-in, first-out [Explanation]: B — LIFO will result in the lowest pre-tax financial income and FIFO will result in the highest pre-tax income. Average cost pre-tax financial income will fall in the middle. LIFO is allowed under U.S. GAAP but is not allowed under IFRS. Thus, Lincoln should choose LIFO and Continental should choose average cost in order to minimize pre-tax financial income 13. A company that uses the LIFO inventory cost method records the following purchases and sales for an accounting period: Beginning inventory, July 1: $5,000, 10 units July 8: Purchase of $2,600 (5 units) July 12: Sale of $2,200 (4 units) July 15: Purchase of $2,800 (5 units) July 21: Sale of $1,680 (3 units) The company’s cost of goods sold using a perpetual inventory system is: A)$3,780. B)$3,760. C)$3,500. [Explanation]: B — With a perpetual inventory system, units purchased and sold are recorded in inventory in the order that the purchases and sales occur. Cost of goods sold for the July 12 sale uses 4 of the units purchased on July 8: 4 × ($2,600 / 5) = $2,080. Cost of goods sold for the July 21 sale uses 3 of the units purchased on July 15: 3 × ($2,800 / 5) = $1,680. COGS = $2,080 + $1,680 = $3,760 14. Inventory, cost of sales, and gross profit can be different under periodic and perpetual inventory systems if a firm uses which inventory cost method? A)FIFO or weighted average cost, but not LIFO. B)LIFO or weighted average cost, but not FIFO. C)LIFO or FIFO, but not weighted average cost. [Explanation]: B — The LIFO and weighted average cost methods can provide different values for inventory, cost of sales, and gross profit depending on whether the firm uses a periodic or perpetual inventory system. FIFO produces the same values from either a periodic or perpetual inventory system 15. During periods of rising prices, which of the following is most likely to occur? A)LIFO COGS > FIFO COGS, therefore LIFO net income < FIFO net income. B)LIFO COGS > FIFO COGS, therefore LIFO net income > FIFO net income. C)LIFO COGS < FIFO COGS, therefore LIFO net income < FIFO net income. [Explanation]: A — Under the assumptions of this question and using LIFO, the most expensive units go to COGS, resulting in lower net income 16. Which accounting methods are preferable for income statements and balance sheets? A)Last in, first out (LIFO) for the balance sheet and first in, first out (FIFO) for the income statement. B)First in, first out (FIFO) for both income statements and balance sheets. C)Last in, first out (LIFO) for income statements and first in, first out (FIFO) for the balance sheet [Explanation]: C — LIFO allocates the most recent prices to the cost of goods sold and provides a better measure of current income. For balance sheet purposes, inventories based on FIFO are preferable since these values most closely resemble current cost and economic value 17. For balance sheet purposes, inventories based on: A)LIFO are preferable to those based on FIFO, as they more closely reflect the current costs. B)LIFO are preferable to those based on average cost, as they more closely reflect the current costs. C)FIFO are preferable to those based on LIFO, as they more closely reflect current costs. [Explanation]: C — The inventories based on FIFO are preferable to those presented under LIFO or average cost for balance sheet purposes. Under FIFO, the older inventories are taken out first, and the ending inventory balance consists of the recent purchases and thus most closely reflect the current (economic) value 18. During periods of rising prices and stable or growing inventories, the most informative inventory accounting method for income statement purposes is: A)weighted average because it allocates average prices to cost of good sold (COGS) and provides a better measure of current income. B)LIFO because it allocates current prices to cost of good sold (COGS) and provides a better measure of current income. C)FIFO because it allocates historical prices to cost of good sold (COGS) and provides a better measure of current income. [Explanation]: B — LIFO is the most informative inventory accounting method for income statement purposes in periods of rising prices and stable or growing inventories. It allocates the most recent purchase prices to COGS, and thus provides a better measure of current income and future profitability 19. Assuming inventory levels remain constant during the year and prices have been stable over time, COGS would be: A)higher under LIFO than FIFO or average cost. B)higher under the average cost than LIFO or FIFO. C)the same for both LIFO and FIFO. [Explanation]: C — During stable prices inventory levels are the same for both LIFO and FIFO 20. During periods of declining prices, which inventory method would result in the highest net income? A)Average Cost. B)FIFO. C)LIFO. [Explanation]: C — When prices are declining and LIFO is used the COGS is smaller than if FIFO is used leading to a larger net income 21. During periods of decreasing prices, a firm using a periodic inventory system will report higher gross profit if its inventory cost assumption is: A)FIFO because during periods of decreasing prices, COGS will be higher, resulting in a higher gross profit. B)FIFO because during periods of decreasing prices, COGS will be lower, resulting in a higher gross profit. C)LIFO because during periods of decreasing prices, COGS will be lower, resulting in a higher gross profit. [Explanation]: C — In periods of falling prices, LIFO results in lower COGS, and therefore higher gross profit than FIFO, because LIFO assumes the most recently purchased (lower cost) goods are sold first. 22. If prices and inventory quantities are increasing, the last-in first-out (LIFO) inventory cost method results in: A)higher inventory compared to first-in first-out. B)lower gross profit compared to first-in first-out. C)lower cost of goods sold compared to first-in first-out. [Explanation]: B — In an environment of increasing prices, LIFO results in higher COGS, lower inventory value, and lower gross profit compared to FIFO 23. If prices are decreasing, the best estimates of inventory and cost of goods sold from an analyst’s point of view are provided by: A)LIFO inventory and FIFO cost of goods sold. B)FIFO inventory and LIFO cost of goods sold. C)FIFO inventory and FIFO cost of goods sold. [Explanation]: B — Whether prices are increasing or decreasing, LIFO cost of goods sold and FIFO inventory are preferred because they are the closest estimates of current costs 24. Barber Inc. sells DVD recorders. On October 14, it purchased a large number of recorders at a cost of $90 each. Due to an oversupply of recorders remaining in the marketplace due to lower than anticipated demand during the Christmas season, the selling price at December 31 is $80 and the replacement cost is $73. The normal profit margin is 5 percent of the selling price and the selling costs are $2 per recorder. Under U.S. GAAP, what is the value of the recorders on December 31? A)$74. B)$73. C)$78. [Explanation]: A — Under U.S. GAAP, market is equal to the replacement cost subject to replacement cost being within a specific range. The upper bound is net realizable value (NRV), which is equal to selling price ($80) less selling costs ($2) for an NRV of $78. The lower bound is NRV ($78) less normal profit (5% of selling price = $4) for a net amount of $74. Since replacement cost ($73) is less than NRV minus normal profit ($74), then market equals NRV minus normal profit ($74). As well, we have to use the lower of cost ($90) or market ($74) principle so the recorders should be recorded at the lower amount of $74 25. Using the lower of cost or market principle under U.S. GAAP, if the market value of inventory falls below its historical cost, the minimum value at which the inventory can be reported in the financial statements is the: A)net realizable value. B)net realizable value minus selling costs. C)market price minus selling costs minus normal profit margin. [Explanation]: C — When inventory is written down to market, the replacement cost of the inventory is its market value, but the “market value” must fall between net realizable value (NRV) and NRV less normal profit margin. NRV is the market price of the inventory less selling costs. Therefore the minimum value is the market price minus selling costs minus normal profit margin. 26. Judah Inc. prepares its financial statements under IFRS. On December 31, 20X8, Judah has inventory of manufactured goods with a cost of $720,000. The estimated selling cost of that inventory is $50,000 and its market value is $740,000. By January 31, 20X9, none of the inventory has been sold but its market value has increased to $810,000. Selling costs remain the same. Which of the following entries is most likely permissible under IFRS? A)Write down inventory by $30,000 on December 31, 20X8 and write up inventory by $30,000 on January 31, 20X9. B)Write down inventory by $30,000 on December 31, 20X8 and write up inventory by $70,000 on January 31, 20X9. C)Make no adjustments to the valuation of inventory on either date. [Explanation]: A — IFRS rules require inventory to be valued at the lower of cost or net realizable value (NRV). NRV is calculated as estimated sales price less estimated selling costs. At December 31, 20X8, NRV = $740,000 − $50,000 = $690,000. Since cost is $720,000, then the lower of cost or NRV is $690,000 and a $30,000 writedown is required. At January 31, 20X9, NRV = $810,000 − $50,000 = $760,000. Under IFRS, when inventory recovers in value after being written down, it may be “written up” and a gain recognized in the income statement. The amount of such gain, however, is limited to the amount previously recognized as a loss. Under IFRS it is not permissible to report inventory on the balance sheet at an amount that exceeds original cost, except in the case of some agricultural and mineral products. Since cost is $720,000, the lower of cost of NRV is $720,000 27. Which of the following statements about inventory presentation and disclosures is most accurate? A)IFRS permits reversals of inventory writedowns but the firm must disclose the circumstances of the reversal in its financial statements. B)An analyst must determine which inventory cost method was used by examining the firm’s current and historical inventory values. C)Changing from FIFO to LIFO is a change in accounting principle that must be applied retrospectively. [Explanation]: A — IFRS requires a firm that reverses an inventory writedown to discuss the circumstances that led to the reversal. Both IFRS and U.S. GAAP require firms to disclose the inventory cost flow method they use. While a change to LIFO from another inventory cost method is a change in accounting principle, under U.S. GAAP this change is not applied retrospectively. The carrying value of inventory is considered to be the first LIFO layer 28. Which of the following ratio levels would suggest that a company is holding obsolete inventory? A)Low inventory value compared to cost of goods sold. B)Low inventory turnover ratio. C)Low number of days in inventory. [Explanation]: B — Low inventory turnover (high number of days in inventory) may be a sign of slow-moving or obsolete inventory, especially when coupled with low or declining revenue growth compared to the industry. Low inventory value compared to cost of goods sold, however, implies a high inventory turnover ratio. This suggests much less risk of obsolescence 29. The inventory turnover ratio and the number of days in inventory are least likely used to evaluate the: A)effectiveness of a firm’s inventory management. B)age of a firm’s inventory. C)stability of a firm’s inventory levels [Explanation]: C — Neither metric is directly relevant in evaluating the stability of a firm’s inventory levels. Determining stability would presumably require other information such as purchase and sales levels, for example. The inventory turnover ratio and the number of days in inventory can be used to evaluate the relative age of a firm’s inventory as well as the effectiveness of a firm’s inventory management 30. When analyzing profitability ratios, which inventory accounting method is preferred? A)Weighted average. B)First in, first out (FIFO). C)Last in, first out (LIFO). [Explanation]: C — 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 31. United Corporation and Intrepid Company are similar firms operating in the same industry. United follows U.S. Generally Accepted Accounting Principles and Intrepid follows International Financial Reporting Standards. At the end of last year, Intrepid had a higher inventory turnover ratio than United. Are the following plausible explanations for the difference? Explanation #1 – United accounts for its inventory using the first-in, first-out method and Intrepid uses the last-in, first-out method. Explanation #2 – United recognized an upward valuation of inventory that had been previously written down. Intrepid does not revalue its inventory upward. Explanation #1 Explanation #2 A) No Yes B) No No C) Yes No [Explanation]: B — While the LIFO firm will typically report lower average inventory (higher inventory turnover), Intrepid cannot be a LIFO firm because LIFO is not permitted under IFRS. An upward revaluation of inventory would lower the inventory turnover ratio; however, United cannot revalue its inventory upward because it follows U.S. GAAP. U.S. GAAP prohibits upward inventory revaluations (except in very limited circumstances which are beyond the scope of the Level I exam)