The question is talking about two companies which are the same except for: A uses LIFO, B FIFO B has take-or-pay contracts outstanding and A uses notes payable A emplyes the completed contract and B POC. Which one is least likely true: The answer is: Company A earning should be considered to be of lower quality relative to B. The explanation given: The use of LIFO and the completed contract method will both serve to depress net income (and hence, change in retained earnings) in the current period. (Fine get that) ---------->Since the change in retained earnings is lower, equity will be lower for A and debt will be higher due to the use of debt financing for inventory. (Don’t understand that)
A is using LIFO, so if prices are rising its COGS will be higher and its net income will be lower. Retained earnings in one period is equal to retained earnings in the last period plus net income, minus dividends. No information regarding dividends is provided. Thus, A’s retained earnings will be lower by the amount that its net income is lower. Its debt will also be higher because A is using straight-forward notes payable that show up on the balance sheet, rather than the off-balance sheet devices being used by B.