CFA Level 1 (2009) - 3

Study Sl:ssion 9

Cross-Reference to CFA Institute Assigned Rl:ading #35 - Inventories

8.In periods of falling prices, compared [() using LIFO, firms using FIFO will report: I

A.higher earnings.

B.lower earnings.

C.identical earnings.

9.If prices are rising and two firms arc identical except for inventory methods, the firm using FIFO will have:

A.higher net income.

B.lower inventory.

C.higher total cash flow.

10.In periods of rising prices and stable or increasing inventory levels, compared to

FIFO accoun ting for inven[()ries, LIFO accoun ti ng will give:

A.lower profitability ratios.

B.higher inventory values.

C.a higher current ratio.

11.All else equal, in periods of rising prices and inventory levels, which of the following statements is most accuratc~

A.FI FO firms have higher debt-to-equity ratios than otherwise iden tical LI FO firms.

B.LIFO firms have higher gross profit margins than otherwise idenricall~lFO firms.

C.FIFO firms will have greater stockholders' equity than otherwise idenrical LIFO firms.

12.A firm uses UFO for inventory accounting and reports the following:

•COGS $125,000

•Beginning inventory $25,000

•Ending inven[()ry $27,000

•Footnotes to the financial statements reveal a beginning UFO reserve of

$12,000 and an ending LIFO reserve of $15,000 COGS on a FIFO basis is:

A.$122,000.

B.$125,000.

C.$128,000.

13.A firm's financial statemenrs are prepared using LIFO. Ignoring income taxes, which of the following accounts should an analyst most lil?ely adjust before comparing this firm's financial statement ratios to those of a hrm that uses FIFO?

A.Stockholders' equiry.

B.Accounts receivable.

C.Long-term debt.

14.A UFO liquidation will most lil?cly result in an increase in:

A.gross profit margin.

B.inventory.

C.accounts payable.

Study St'ssion ')

Cross-Refercncc to CFA Institute Assigned Rcading #35 - Inventories

1'). Assuming no LIFO liquidation, a LIl~O 11rl11 rq)()["(s highcr ncr incomc (han an othcrwise identical FIFO 11rl11. Prices must be:

A.steady.

B.rISing.

c:.Ldling.

1.A f1rm wirh a beginning inventory of zero made rhe following purchases and sales:

should an analyst makc to rhe company's financial starcmcnrs ro:

A. adjusr cnd-of-period LIFO inventory to FIFO inventory?

B. calcuJarc rhc debr-ro-equiry ratio on a FiFO basis?

C. adjusr cnd-of.-pcriod accounrs payable from a UFO basis ro a FIFO basis?

D. adjust COGS from a LIFO basis ro a FIFO basis?

Study Session ')

Cross-Reference to CFA Institute Assigned Reading #35 - Inventories

S.B Falling prices liH a firm using FIFO Illean older, more <:xpensive goods arc going to

COGS, thus lowering net income compared to LIFO.

9, A Firms using FIFO will have lower COGS, which means they will have higher net income when compared to a firm using LIFO when prices arc rising.

10, A With rising prices, UFO will result in higher COGS. Higher COGS will result in lower profitability as compared to FIFO. Inventory values, and therefore the current ratio, are lower using LIFO than using FIFO.

I I. C All else equal, the FIFO firm has a higher level of assets due to higher inventory. Sincc liabilities arc assumed to be egual, the FIFO firm must have higher equity to finance those assets.

12. A FIFO COGS = LIFO COGS - (ending LIFO reserve - beginning LIFO reserve) ~ $125,000 - ($15,000 - $12,000) ~ $122,000.

13, A Restating LIFO inventory on a FIFO basis would increase inventory and therefore assets, which means eguity would need to increase to keep the accounting equation in balance.

14. A COGS per unit decline and pro/lt margins increase.

15, C If the LIFO firm is reporting highcr net income, priccs must be faJJing.

Sludy Session 9

Cross-Reference to CFA Institute Assigned Reading #35 -Inventories

1.A. 108 unils were sold (13 + 35 + 60), and 150 unilS were available for sale (beginning invelHory of 0 plus purchases of 40 + 20 + 90), so lhere are 150 - 108 = 42 unils in

ending invclllory.

Under FIFO, 42 unilS from rhe laSl purchase would remain in inventory:

42 x $50 = $2, 100.

Under LIfO, rhe firsr 42 unils purchased would remain in invenrory:

(40 x $30) + (2 x $40) = $1,280.

The average cos I ofinvenrory is [(40 x $30) c (20 x $40) + (90 x $50)] / (40 + 20 + 90)

= $43.33, Invenlory value under the weighred average COSI melhod is $43.33 x 42 unirs

=$1,820.

B.RcvCIlue = (1.3 x $.'\'))1 D'S x $4'S) I (60 x 5(0) = $'),630

Purchases = (40 x $30) 1 (20 x $40) + (90 x $50) = $6,500.

Under LIfO:

COGS = purchases + beginning invenlOry - ending invenrory

=6,500 + 0 - 1,280 = $'S,220.

Gross profil = $5,630 - $5,220 = $410.

Under FIFO:

COGS = purchases + beginning invenrory - ending invenlory

= 6,500 + 0 - 2,100 = $4,400.

Gross prahl = $5,630 - $4,400 = $1,230.

Under weigh red average cos!:

COGS = 43.33 x 108 = 4,680.

Gross profir =$5,630 - $4,680 = $950.

2.A. To adjusr end-of-period LIfO invenlOry ro FIFO invenlOry, rhe analysr should add rhe LIfO reserve of $60,000 ro LIfO invenlOry.

B. Retained earnings musr be increased by rhe LIFO reserve ner of rax, or $60,000 x

(l - 0.4) = $36,000.

C.No adjuslmenr is needed. Accounrs payable are nor affecred by inventory accounring merhods.

D.To adjusr COGS from a UFO basis 10 a FIFO basis, rhe analyst should decrease LIFO COCS by rhe $10,000 change in rhe LIFO reserve.

The following is a review of the Financial Reporting and Analysis principles dcsigncd to addrcss thc Icarning outcome statemcnts set forch by CFA Institute®. This topic is also covered in:

LONG-LIVED ASSETS

Study Session ')

EXAM Focus

LOS 36.3.: Explain the accounting standards related to the capitaliz<niol1 of ,:,;!),.'ndillli<.:'S as part of long-lived assets, including interest costs.

When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement for the period. As a general rule, an expenditure that is expected to provide a future economic benefit over nlllltiple accounting periods is capitalized, but if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed.

An expenditure that is capitalized is initially recorded at cost, presumably its fair value at acquisition. The capitalized cost is reported on the balance sheet as an asset and

is reported in the cash Row statement as an outRow from investing activities. Except for land and intangible assets with indefinite lives, the cost is then allocated to each subsequent income statement over the life of the asset, as depreciation expense (for tangible assets) or amortization expense (for intangible assets with finite Jives).

Sometimes assets are acquired in a nonmonetary exchange. In this case, COSt is based on the fair value of the asset exchanged, or on the fair value of the asset received if it can be determined more readily.

An expenditure that is expensed is reponed in the cash Row statement as an outRow from operating activities. Although total cash Row is not affected by the choice, the cash

Row classifications (CFI vs. CFO) arc affected by the decision to capitalize or expense.

Capitalized Interest

When a firm constructs an asset for its own usc or, in limited circumstances, for resale, the interest that accrues during the construction period is capitalized as a parr of the

Sllldy Session 9

Cross-Rtfercnce (0 CFA Institute Assigned Reading #36 - Long-Lived Assets

asset's cost. The objeerive of capitalizing interest is to accurately measure the cost of thc assct and ro helle!" match lhe cost with the revenues gcner~\led by th~ constrllered assct. This trcatll1ent is now rClJuired by both U.S. CAAP and IFRS.

The intcrcst rate used to capitali/.e interest is based on debt spccillcally rdatcd to the constructio!l of thc asset. If no construction dcbt is outstanding, thc illlLrcst ratc is

based on cxisting unrelatcd borrowings. Interest costs on gcneral corporate debt in excess or project constrllction costs are expcnsed.

Capitalized interest is not reponed ill the income statement as interest expense. Once consrrucrion interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for usc), or COGS (if' the assct is held for sale).

C;enerally, clpitalizecl interest is reponed in the cash How statemcl1l as an outHow from investing activities, while iIHerest expense is reponed as an out!1ow from opcrating actlvlllCS.

LOS Vl.b: Compute: and describe !he effects or capitalizing versus expensing on net income, shJreholders' equity, cash Hoy\, from operations, :lnd financial ratios including the effect on the interest coverage ratio of capitJlizing interest co,;! s.

Although it may make no operational difference, the choice between capitalizing ~Uld expensing will affect net income, shareholders' equity, total assets, cash How from operations, cash How from financing, and various financial ratios.

Net income. Capitalizing an expenditure delays the recognition of expense in the income statement. Thus, in the period that an expenditure is capitalized, the Ilrm will report higher net income compared to expensing. in subsequent periods, the firm will report lower net income compared to expensing, as the capitalized expenditure is

allocated to the income statement through depreciation expense. This allocation process reduces the variability of net income by spreading the expense over time.

Conversely, if a firm expenses the expenditure in the current period, net income is reduced by the total amount of the expenditure (assuming no tax effects). In subsequent periods, no allocation of cost is necessary; thus, net income in future periods is higher than if the asset was capitalized.

Over the life of an asset, total net income will be identical. Timing of the expense recognition is the only difference.

Shareholders' equity. Because capitalization results in higher net income in the period of the expenditure as compared to expensing, it also results in higher shareholders' equity (retained earnings). As the cost is allocated to the income statement in subsequent periods, net income will be reduced along with shareholders' equity (retained earnings). Total assets arc higher with capitalization and liabilities are unaffected, so that A - L = E holds.

SruJy Session 9

Cross-Rcference to CFA Institute Assigned Reading #36 - Long-Lived Asscts

Ie the expenditure is eXllel1Sed, shareholders' elJllity (rnained earnings) will refleer the enrire reduuion in nel incollle in the period of (he expendilllre. I

Cash flow from operations. 1\ capitali'/.ed expenditUre is usually reported in the cash now SLllel1lelll as an outflow from investing aerivities. If expensed, the expenJilllre is reponed as ;In outflow from operating activities. Thus, capitalizing:ln expenditure will result in lower invesring cash How :lnd higher operating cash ([ow as compared to eXI>cnsing. Assuming no tax effeus, tliltt! cash now will be exactly the sallle. The classiflcation of the cash {~ow is the only difference.

Recall that when :In expenditUre is capitalized, depreciation expense is recognized in sllhsequenr periods. Depreciation is a non-cash expense am!, aside from any tax eflects, docs not affect operating c:lsh Row.

Financial ratios. CJpitali/.ing ~1l1 expenditure Inuits in higher :lssers and higher equity compared to expellSing. Thus. both the debt-lO-~ISSl'(Sratio and the debt-ro-equity ratio ;lle lower (tllL'y ILIVL' Llrgcr llcnominators) with clllitali/~l\ion,

Capir:llizing an expendilllre will illititt!!y result in higher return on asscrs (ROA) and higher return on equity (ROE). This is the result of higher net income in the first year. In subsequent years, ROA and ROE will be lower for the capit:llizing firm as net income is reduced hy the depreciation expense.

Since the expensing (lrm recognizes the entire eXlwnse in the first year, ROA and ROE, will be lower in the hrst year :lnd higher in the subsequent years, After the first ye:lr, ncr income (numerator) is higher, :lnd assets :lnd equit), (denominarors) :Ire lower, th:ll1 they would be if rh e firm had capitalized the expenditure,

Interest coverage ratio. The interest coverage ratio (EBIT / illlerest expense) measures a

I1rm's ability to make required interest paymellls on its ddll.

Rec:lII th:lt construction inrerest is capitalized as ,111 asset :1[1(1 then allocated to the income statcmcnt as the asset is depreciated over time, Thus, in the year of the expenditure, capit:llizing results in lower illlerest expense ;1lIc! higher net income compared to expensing. The result is :I higher i11lerest coverage ratio (smaller denominator) when interest is c:lpitalized.

111 su bsequem periods, the capi talized interest is :llloca ted to the income statemen t as depreciation expense, not interest expense. Higher depreciation expense results in lower

EBIT. Thus, in subsequent periods, the capitalized interest results in a lower interest coverage ratio (sm:llier numerator).

for flrms in all expansion ph:lse, capit-alizing interest may result in earnings that arc higher over many periods compared to an expensing hrm because the amount of depreciation from previously capit:llized interest is less than the amount of :ldditional interest that is being newly capitalized.

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #.:',6 - Long-Lived Assets

Implications for Analysis

I

An analyst may wam [0 reverse rhe effect of capitalized imerest and restate rhe fi.nancial StareIllems and related ratios. Many analysrs consider interest coverage ratios based

on total interest expense (including capitalized interest) to be a better measure of thc solvency of rhe firm, since the imerest is a required paymClH. Bond rating hrms oftcn make rhis adjustment. When there are debt covenants (provisions of the borrowing agreement) that specify a minimum interest coverage ratio, analysts should be aware of how the ratio is calculated for determining wherher the covenant has been violated (which can mean immediate repaymem is required). If the requirement is that the interest coverage ratio be calculated with capitalized inrerest included in imerest

expense, the analyst must adjust the ratio accordingly to determine how close the firm is to violating the debt covenant.

For analytical purposes, the effects of capitalizing illterest costs can be reversed by making the following adjusrmenrs:

Intcrest that was capitalized during the year shOldd be added to illlerest expense.

The amount of interest capitalized is disclosed in the flnancial sratemcllt footnotes.

•Thc allocation of imerest capitalized in previous years should be removed from depreciation expense.

•Interest that was capitalized during the year is classified as a cash outflow from investing activities. For analysis, it should be added back to cash flow from investing

activities and subtracted from cash flow from operating activities.

•Ratios such as imerest coverage and profitability ratios should be recalculated with the restated figures. The interest coverage ratio and net profit margin will likely be lower without capitalization.

The financial effects of Glpital i7-ing versus expensing are summarized in Figure 1.

Figure 1: Financial Statement Effects of Capitalizing vs. Expensing

Let's work through an cxtcnded cxample of the financial statement effects of capitalizing in terest.

Srudy Session 9

Cross-Reference to CFA Institute Assigned Reading #36 - Long-Lived Assets

Example: Effect of Capitalizing Interest

Soprano Company Balance Sheet

20X6 20X5

Assets

During 20X6, the company capitalized $20 of construction interest. The capitalized interest increased depreciation expense $5 for the year. For analytical purposes, yOll have decided to treat the capitalized interest as an immediate expense.

Complete the following table, ignoring any income tax effectS:

Soprano Company Answer Template