Reading 35 p. 342 #5 a bit confused here… Equity (FIFO) = Equity (LIFO) + change in equity due to LIFO Effect (L) = Equity (LIFO) + (1-t)xL which t=35% as tax rate Equity (LIFO) can be easily calculated by known Return(LIFO)/ROE(LIFO). The key is how to get L? The data gives us 20x3 LIFO reserve $46,000 and 20x4 LIFO reserve $50,000. I thought LIFO Effect (L) would be $4,000. However, the answer key tells to go for Average LIFO Reserve which is $46,000/2 + $50,000/2 = $48,000. Then adjust this amount for taxes: (1 - 35%)x$48,000 = $31,200 Can you help to explain why in this case, the LIFO Effect is the summation of the two years’ average LIFO Reserve???
you have to add the extra income under the FIFO method to find the equity. ROE is calculated on avg equity so we have to add average of lifo reserve to find equity under fifo method. adding change in lifo reserve is for calculating cogs not equity,
Excellent. I appreciate your explanation, madanalyst.
The scary bit is I just finished this from Schweser and they don’t address equity under FIFO like this at all. There’s it’s just a Debt/Equity ratio recalc where the EOY LIFO reserve is added to Equity. "Equity (FIFO) = Equity (LIFO) + change in equity due to LIFO Effect (L) = Equity (LIFO) + (1-t)xL which t=35% as tax rate "…doesn’t exist!! To them… Cheers, Nash
Thanks for adding this post manavecplan… i’ll have to go back and re-study this chapter because… schweser is omitting certain key points. Posted by: madanalyst (IP Logged) [hide posts from this user] Date: September 22, 2008 08:17PM you have to add the extra income under the FIFO method to find the equity. ROE is calculated on avg equity so we have to add average of lifo reserve to find equity under fifo method. adding change in lifo reserve is for calculating cogs not equity, CAN SOMEONE EXPLAIN THIS A LITTLE MORE…
If you have trouble understanding this you might need to revise the basics again … income that is not paid to shareholders goes into retained earnings and become part of equity, as lifo method understates earnings by the amount of lifo reserve so we have to add the lifo reserve after tax into lifo equity to get fifo equity. roe is calculated as: ROE = income after paying preferred div/ avg equity if you want to do it step by step, you can calculate fifo equity for current and last year and then calculate avg fifo equity or in little direct fashion you can calculate avg lifo equity and add the avg lifo reserve after tax to get fifo avg equity. Divide income after preferred div by the calculated equity and multiply by 100 and booom you have calculated roe under fifo method …
I thought ROE = net income / avg shareholders equity I guess there are various ways of calculating this… and in order to calculate the ROE fifo you must have net income after tax. thanks