Subject 5. Financial statement analysis issues

Financial statement disclosures provide information regarding the accounting policies adopted in measuring inventories, the principal uncertainties regarding the use of estimates related to inventories, and details of the inventory carrying amounts and costs. This information can greatly assist analysts in their evaluation of a company's inventory management.

Companies are required to disclose the carrying amounts within inventory classifications such as raw materials, work-in-progress, and finished goods. Changes in these amounts, along with the growth rates of sales and finished goods inventories, may provide signals about a company's future sales, profits, cash positions and working capitals.

Relevant information with respect to inventory management and future sales may be found in the Management Discussion and Analysis or similar items within the annual or quarterly reports, industry news and publications, and industry economic data.

Inventory management may have a substantial impact on a company's activity, profitability, liquidity, and solvency ratios. For example, a possible inventory write-down can have a negative impact on profitability, solvency and liquidity ratios but a positive impact on activity ratios. It is critical for the analyst to be aware of industry trends and management's intentions.

Practice Question 1

Which of the following statements is false?

A. The use of FIFO will lead to a meaningful inventory turnover.
B. The use of FIFO will understate the debt-to-equity ratio and overstate income.
C. Cash flows are improved under LIFO.
Correct Answer: A

Inventory turnover will be distorted under both LIFO and FIFO. Because FIFO uses earlier, lower costs for cost of goods sold, the inventory turnover will likely be too low. Under LIFO, the inventory value is too low, which can lead to an inventory turnover that is too high.

Practice Question 2

Assume the correct current ratio is bigger than 1. If purchase (on account) is overstated by $3,000 and the ending inventory is overstated by $3,000, the current ratio is ______ and the working capital is ______.

A. understated, not affected.
B. not affected, overstated.
C. overstated, not affected.
Correct Answer: A

EI = BI + purchase - COGS.

If both purchase on account and ending inventory are overstated by the same amount, the current ratio will be understated (current ratio = current assets / current liabilities, in which both numerator and the denominator are overstated, but the ratio will be lowered since it is bigger than 1). However, the working capital which equals current assets - current liability should be unaffected.

Practice Question 3

In 2010, Patriot Corporation found that they overstated their inventory by $5,000 in 2008. How would this affect the company's net income in 2010 (Assume the tax rate of 40%)?

A. it is overstated by $5,000.
B. it is understated by $5,000.
C. it is not affected.
Correct Answer: C

The effect of the error in 2008 on net income will be counterbalanced in 2009, leaving the net income of 2010 unaffected.

Practice Question 4

Inventory at the end of the current period was erroneously understated. Which of the following is true as a result of the understatement not being corrected? Assume FIFO is used.

A. The cost of goods sold for the current year is understated.
B. Net income at the end of the following year will be overstated.
C. Net income for the current year is overstated.
Correct Answer: B

Net income is understated, and capital (retained earnings) is understated. For the following year, the cost of goods sold will be understated and net income overstated.

Practice Question 5

Consider the following conditions of ending inventory and the stated results:

Ending Cost of
Inventory Goods Sold Net Income
A. Overstated Overstated Overstated
B. Overstated Understated Understated
C. Understated Overstated Understated

Which condition is true with regard to the ending inventory?

A. Condition A.
B. Condition B.
C. Condition C.
Correct Answer: C

When ending inventory is understated, inventory costs assigned to the cost of goods sold will be overstated and consequently the net income will be understated.

Practice Question 6

Consider the following conditions of beginning inventory and the stated results:

Beginning Cost of
Inventory Goods Sold Net Income
A. Overstated Overstated Overstated
B. Understated Understated Understated
C. Overstated Overstated Understated

Which condition is true with regard to the beginning inventory, assuming FIFO is used?

A. Condition A.
B. Condition B.
C. Condition C.
Correct Answer: C

When beginning inventory is overstated, inventory costs assigned to the cost of goods sold will be overstated and consequently the net income will be understated.

Practice Question 7

Ending inventory is overstated in Period A. Which of the following occurred as a result of this error?

A. Retained Earnings at the end of Period A is understated.
B. Retained Earnings at the end of Period B is overstated.
C. Retained Earnings at the end of Period B is correct.
Correct Answer: C

The Retained Earnings balance of Period B will be correct. The Period A error caused the net income of Period A to be overstated, therefore, the income of Period B to be understated by that same amount. The Retained Earnings balance will be correct at the end of period B.

Practice Question 8

A firm using the LIFO inventory valuation method in an inflationary environment will have ______ profit margins and ______ inventory turnover compared to a firm using FIFO.

A. Higher, lower.
B. Lower, higher.
C. Lower, lower.
Correct Answer: B