- CFA Exams
- CFA Level I Exam
- Topic 4. Financial Statement Analysis
- Learning Module 6. Analysis of Inventories
- Subject 2. The Effects of Inflation and Deflation on Inventories, COGS and Gross Margin
CFA Practice Question
Which of the following statements is true in an inflationary environment?
B. Under LIFO, working capital may be distorted.
C. Under FIFO, cash flows will be increased.
D. The use of FIFO will cause debt-to-equity ratios to be overstated.
A. Under FIFO, income will tend to be understated.
B. Under LIFO, working capital may be distorted.
C. Under FIFO, cash flows will be increased.
D. The use of FIFO will cause debt-to-equity ratios to be overstated.
Correct Answer: B
When LIFO is used, inventory shown under current assets will be very low, as it will be using older, lower costs. While cash flows will be higher under LIFO, the increase in cash flows is usually not enough to counteract the effect of the low inventory, and thus working capital will tend to be lower under LIFO.
User Contributed Comments 6
| User | Comment |
|---|---|
| stranger | a. in FIFO income is overstated since COGS is understated b. IN LIFO COGS IS OVERSTATED AND INVENTORY UNDERSTATED, THE INCOME TAX SAVINGS CAUSING BETTER CASH FLOW DO NOT GIVE SUFFICIENT CONTER EFFECT AND HENCE WORKING CAPITAL IS STATED LOWER c. in FIFO cash flows decreas because of higher income and hence higher taxes d. this is a possible answer since higher income becomes part of equity in FIFO and causes higher debt-to-equity ratio |
| melissatt | This question and question 8 is basically the same. So, why is it that in question 8, the answer is D-to-E ratio is overstated, but in THIS question, the answer is B? I mean, shouldn't (D) be the correct answer as well? |
| hkcfa | melissatt: in Q 8 the answer is D-to-E ratio is understated, not overstated. |
| mordja | FIFO -> increase Equity -> understatement of D/E ratio as denominator increases. Therefore can not be D. |
| past1sttime | distorted can mean up or down |
| ashish100 | typing in all caps has the opposite effect. i totally skipped that dudes comment. no need to yell guys. |