cost of goods
sold,
and income.
Adjustment for inventory balances: Add the LIFO reserve to LIFO inventory. This
transforms LIFO inventory to FIFO. Now, since you changed inventory on the left side of the
balance sheet to current cost, the left side of the balance sheet doesn’t balance with the right
side. So, you must then: increase retained earnings by the LIFO reserve times (1 – t).
Retained earnings increases, because accumulated FIFO profits would be greater than LIFO
profits. Increase deferred tax liability by the LIFO reserve times the tax rate, t. This deferred
tax liability would exist if LIFO were used for taxes and FIFO for the financial statements.
Adjustment of cost of goods sold The next step is to adjust the LIFO income statement to
an approximation of a FIFO income statement. The COGS adjustment uses the difference in
the beginning and ending LIFO reserves. The change in the LIFO reserve between two years
represents the impact of using LIFO during that year. During periods of rising prices, LIFO
COGS will be greater than FIFO COGS. So, to convert LIFO COGS to FIFO COGS you must
reduce the LIFO COGS by the current year’s increase in the LIFO reserve. This will, in turn,
cause after tax income to increase by the change in the LIFO Reserve times 1 - the tax rate.
Note, if the LIFO reserve should fall, then the analysis above would be reversed. Change in
LIFO Reserve = LIFO Reserve
ENDING
– LIFO Reserve
BEGINNING.
e: Compute and describe the effects of the choice of inventory method on
profitability, liquidity, activity, and solvency ratios.
Let beginning inventory be one unit at $10. One more unit was purchased for cash during the
year at $20. One of the two units available for sale was sold for $30. At year end the
replacement cost of inventory is $30. Ending current assets other than inventory is $40,
current liabilities is $25, and long-term liabilities is $50. Cash expenses other than cost of
goods sold is $5 and the income tax rate is 40%. Beginning stockholder’s equity is $100 and
no dividends were paid. The statement above summarizes the financials given the three
inventory accounting methods. The statement below summarizes financial results:
FIFO
LIFO
Cost of goods sold
10
20
Net income
9
3
Ending inventory
20
10
Beginning inventory
10
10
Average inventory
15
10
Ending Stockholders' Equity
109
103
Beginning Stockholders' Equity
100
100
Average Stockholders' Equity
104.5
101.5
Total Current Assets
20+40 =60
10+40 =50
Current Ratio
60/25 =2.4
50/25 =2.0
Debt to Equity Ratio
75/109 =0.688
75/103 =0.728
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