Selected financial data from Krandall, Inc.’s balance sheet for the year ended December 31 was as follows (in $): Cash $1,100,000 Accounts Payable $400,000 Accounts Receivable 300,000 Deferred Tax Liability 700,000 Inventory 2,400,000 Long-term Debt 8,200,000 Property, Plant & Eq. 8,000,000 Common Stock 1,000,000 Total Assets 11,800,000 Retained Earnings 1,500,000 LIFO Reserve at Jan. 1, 600,000 Total Liabilities & Equity 11,800,000 LIFO Reserve at Dec. 31 900,000 Krandall uses the last in, first out (LIFO) inventory cost flow assumption. The tax rate is 40 percent. If Krandall used first in, first out (FIFO) instead of LIFO and paid any additional tax due, its assets-to-equity ratio would be closest to: A) 3.63 B) 4.06 C) 3.73 D) 4.18
Assets: 11800+900=12700 Inv increase due to FIFO ==> Add Ending LIFO Reserve. Equity: L+E=11800 (Before) L=700+400+8200=9300 E=2500 (Before) New E = 2500 + End LIFO Reserve * (1-T) = 2500 + 900 * .6 = 3040 A/E = 12700/3040 = 4.18 Choice D CP
Thats what I got CPK. But answer is B. They have added LIFO*(1-t) to assets. Here is the schweser solution: With FIFO instead of LIFO: Inventory would be higher by $900,000, the amount of the ending LIFO reserve. Cumulative pretax income would also be higher by $900,000, so taxes paid would be higher by 0.40($900,000) = $360,000. Therefore cash would be lower by $360,000. Cumulative retained earnings would be higher by (1 - 0.40)($900,000) = $540,000. So assets under FIFO would be $11,800,000 + $900,000 - $360,000 = $12,340,000 and equity would be $1,000,000 + $1,500,000 + $540,000 = $3,040,000. The assets-to-equity ratio would be $12,340,000/$3,040,000 = 4.06. ***This makes sense to, but shouldn’t we be taking (LIFOend-LIFOstart)*t as extra cash flow towards taxes p150 FSA schweser notes: “when calculating FIFO equity, add the entire LIFO reserve without tax adjustment for taxes” … Then does some cautioning about when to add LIFO vs. LIFO*(1-t). Can you please help clarifying this too. Thanks as always !!
CP LIFO Reserve should not be adjusted for taxes unless a liquidation of LIFO layers is assumed. Equity should be adjusted by the same amount as assets, thus, the answer should be C (12700/3400=3.735). Check the curriculum (V3:326). Regards
analiticar - Here is another question of same league posted some while ago. Also in your solution above what about the extra tax (cash outflow and decrease of assets) due to change to FIFO ? http://www.analystforum.com/phorums/read.php?11,552622,552622#msg-552622
thunderanalyst You stated that pretax income would be higher by 900,000, but that figure represents ending LIFO reserve. Let’s remind ourselves: COGS(FIFO) = COGS(LIFO) - (LIFO Reserve(E) - LIFO Reserve(B)) So, because of the lower COGS(FIFO), the pretax income (FIFO) should be higher by 300,000 (900,000-600,000). The tax is 300,000*0.4=120,000, and the rest (180,000) goes to retained earnings. So we adjust inventories for LIFO Reserve (+900,000) and cash for taxes (-120,000). Restated assets are 11,800+900-120=12,580. Restated equity is 1000+1,500+900+180=3,580. Thus, the A/E leverage ratio is 3.51. Though this seems logical to me, there is no such a choice, so I must be wrong. Come on people, let’s sort this out.
> > ***This makes sense to, but shouldn’t we be taking > (LIFOend-LIFOstart)*t as extra cash flow towards > taxes > > This is my first post and I’m taking Level 1 this summer too. To me, the book answer makes the most sense. The income statement adjustments already accounts for the changes, so the cash flow is irrelevant. If you have the balance statement and income stmnt, you can derive a cash flow stmnt. So, if you properly adjustment the income statement and balance sheet, then cash flow stmnt will reflect that.
Analiticar I totally agree with you and thats what I stated "***This makes sense to, but shouldn’t we be taking (LIFOend-LIFOstart)*t as extra cash flow towards taxes " I got it wrong too. I you see page 150 schweser FSA, it says something about when to apply tax and when to exclude it but I don’t understand that completely. Also on the same page there is a worked out example which excludes any taxes. We need experts to jump in. Thanks
There is a nice example in V3:339, Problem 3. See the solution (A-14), but disregard dividend payments and restate retained earnings and closing cash balance. The example shows that FIFO pretax income is higher than LIFO by the amount of COGS difference, of which one portion represents tax and decreases FIFO CFO and cash, and remaining amount increases FIFO retained earnings and equity (however, LIFO reserve is not included). If you apply solution for this example on our problem, you get the following result: Assets (FIFO): 11,800+900-120= 12,580 Equity (FIFO): 1,000+1,500+180= 2,680 A/E= 4.69
Analticar - What about integrity of A=L+E equation ? If you increase equity by certain amount, which is LIFOend*(1-t) in this case, you should be increasing the same amount on assets too (no matter how you calculate A=L+E should be balanced).
Thunderanalyst, It seems that the treatment of FIFO/LIFO conversions is inconsistent both in Schweser and CFAI. In solution to the 5th question (practice problems for reading 35), FIFO equity is calculated by adding tax adjusted average LIFO reserve. They did not even consider the effect on retained earnings, as in problem 3. However, both Schweser and CFAI state that tax adjusting is to be done only in case of LIFO liquidation.