Which is least likely to get affected? a) Quick Ratio b) Debt-to-Equity Ratio I’ve omitted the other two options because they were “likely to be affected.” The answer is A, but what i wanted to know was how the Debt-to-Equity ratio would be affected?
net income is part of retained earnings, which is part of equity bro net income is affected by the change
When going from LIFO to FIFO: COGS go down -> NI goes up NI goes up -> Retained Earnings go up Retained earnings go up -> Equity goes up Equity goes up -> D/E goes down
Cheers for the explanation guys. Isn’t FSA a bitch?
Is this assuming rising prices? If so then yeah as CFA_2010 said. Otherwise it would be the reverse (not that I have seen a question wth falling prices)
CFA_2010 Wrote: ------------------------------------------------------- > When going from LIFO to FIFO: > > COGS go down -> NI goes up > NI goes up -> Retained Earnings go up > Retained earnings go up -> Equity goes up > Equity goes up -> D/E goes down you guys are right, but you’re missing out on one point that is somewhat important: Equity = Assets - Liabilities switching inventory methods also changes the value of assets [not just NI, or equivalently, the change in equity (assuming no dividends or OCI)]. While you’re final answer is correct, I haven’t seen an explanation on this thread take that into account. COGS goes down -> NI goes up YES - BUT you also have to keep in mind that you have a higher inventory balance on the balance sheet. SO, the difference in the assets balance is that you end up having less cash (due to higher taxes from the lower COGS). In this instance it didn’t matter, but if there were a CF option, it may have (wouldn’t have changed your answer, just would have likely confused some of you).
JensensalphaMale Wrote: ------------------------------------------------------- > CFA_2010 Wrote: > -------------------------------------------------- > ----- > > When going from LIFO to FIFO: > > > > COGS go down -> NI goes up > > NI goes up -> Retained Earnings go up > > Retained earnings go up -> Equity goes up > > Equity goes up -> D/E goes down > > > you guys are right, but you’re missing out on one > point that is somewhat important: > > Equity = Assets - Liabilities > > switching inventory methods also changes the value > of assets . While you’re final answer is correct, > I haven’t seen an explanation on this thread take > that into account. > > COGS goes down -> NI goes up > YES - BUT you also have to keep in mind that you > have a higher inventory balance on the balance > sheet. SO, the difference in the assets balance > is that you end up having less cash (due to higher > taxes from the lower COGS). > > In this instance it didn’t matter, but if there > were a CF option, it may have (wouldn’t have > changed your answer, just would have likely > confused some of you). Sorry, I was wrong about the answer (not the reason for the answer). Quick ratio is effected as well because of the change in cash (quick ratio will decrease). Neither A or B is correct. What were the two that you “omitted”?
I think this is a straightforward question. The least likely has to be (a), which doesn’t mean it’s “not” affected but it’s affected less than any of the other options, where the effect is more direct.
I’m gonna dispute the cash affects here, although I’m really not certain, I don’t think the cash asset is affected at all. The increase in inventory on the asset side is balanced purely by the increase in tax expense. When the tax is paid it is charged against the tax expense account not cash, as per the rule a decrease in a liability is a cash outlay. I think we’re mixing up the cash flows with the cash account. thoughts??
Straight from my old CFA L1 Book: “In periods of rising prices and stable or increasing inventory quantities, the use of LIFO results in higher COGS expense and lower reported income. In the absense of income taxes, there would be no difference in cash flows. Cash flow would equal payments made for inventory purchases and be independent of the accounting method used.” One thing to keep in mind, the US Tax code requires the same method of inventory accounting to be used in both GAAP and tax accounting. In periods of rising prices and stable or increasing inventories, the use of FIFO results in: - Lower COGS, Higher Taxes, Higher NI, Higher Inventory Balances, Higher Working Capital and lower cash flows (more taxes paid out). “When the tax is paid it is charged against the tax expense account not cash, as per the rule a decrease in a liability is a cash outlay.” I’m not really certain what you are saying here. Are you indicating that taxes are expensed against a deferred tax liability (or something of that nature), and do not reflect an actual cash outlay?
Totally agree with all the effects you list above. I guess my point (question) comes from when you say: “…and lower cash flows (more taxes paid out)” This means we get lower retained earnings not a decrease in the cash asset account, so the cash account doesn’t change and thus answer A) is justified.
“This means we get lower retained earnings not a decrease in the cash asset account, so the cash account doesn’t change and thus answer A) is justified.” Wrong. CF is not the same as income. Remember, we are paying higher taxes because we have higher Earnings Before Taxes due to the lower COGS. The higher EBT will in essence turn into higher NI (which will be higher retained earnings if they aren’t distributed as dividends). While you have lower cash, you have higher inventory on the balance sheet. The inventory value increase is greater than the cash loss. Think about the accounting equation for a moment: A = L + E You have an increase in A (with inventory) a decrease in A (cash, which is not as large as the increase in inventory due to the fact that the tax rate is not 100%). In order for the accounting equation to remain true, equity will have to be larger. This effect is seen when you actually work through a problem and see that you have positive earnings (net income) from the effect. Now, change in Retained Earnings = NI - Dividends Paid out +/- Other Comprehensive Income. Retained Earnings is an accounting figure that does not necessarily imply cash being taken in or leaving (that’s what the SCF is for…not the income statement). There is a change in equity (assuming that the positive earnings wouldn’t be distributed as dividends), which makes B an incorrect answer. However, the quick ratio changes as well, due to the change in cash. This makes A also incorrect as well as the quick ratio is: (Cash + Mkt Securities + Receivables) / Current Liabilities Now, remember, liabilities remain unaffected. The cash, however, was changed due to the change in accounting method.