CFA Practice Question

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CFA Practice Question

Which of the following statements is true in a period of rising prices?

A. The use of FIFO will lead to a useful inventory turnover.
B. The use of FIFO will tend to understate income.
C. The use of FIFO will tend to understate the debt-to-equity ratio.
D. The use of FIFO will improve cash flows.
Correct Answer: C

The use of FIFO will generate a lower cost of goods sold, because the earlier, lower costs will be included in cost of goods sold. The lower cost of goods sold will result in a higher income. The higher income will be included in stockholders' equity, which will cause the debt-to-equity ratio to be lower.

User Contributed Comments 17

User Comment
stranger a. possible answer but since profits are reported higher and cogs lower it is not correct b. FIFO overstates income because the costs accounted are from the first in c. FIFO REDUCES DEBT TO EQUITY RATIO AS EQUITY IS OVERSTATED d. FIFO accounts lower costs for cogs hence higher for inventory which improves working capital but improved income accounts for higher taxes and decreases cash flow
kalps Lower COGS -----> Higher Turnover & retained earnings ------> Higher equity ------> therefore d/e falls
gjwhite Generally, fifo numbers should be used for balance sheet ratios and lifo nubers should be used for income statement ratios. a)inventory turnover ratio to be most acurate should be (lifo cogs)/(fifo inventory), however using fifo numbers would tend to be more acurate than all lifo numbers. Choices B,C and D are completely incorrect. Judging by some of the comments one tends to see, some of us have not made the distinction bewteen a figure being naturaly higher or lower, but, more acurate, and something being overstated or understated.
Gina C is correct
Gina NOTE that question refers to "best measures/most useful ratio" and not to "what will be higher/lower under inventory cost flow method X"
lukesun In my sense, in a period of rising prices the higher is the better. But in a period of decreasing prices, the answer is not corrcet. So we should remember that FIFO should be used for balance sheet items, and the LIFO should be used for Income Statement items.
danlan A is unclear, gjwhite is correct that best is lifo cogs/fifo inventory
Lucho actually it is c , cuase fifo it will inderstate margins instead of income...
gth763s C is wrong. Assets are understated because current value of inventory exceeds book value, while liabilities are unchanged, so equity is understated. Therefore, debt/equity ratio is overstated.
o123 gth- youre right, but the question isnt asking your 'analyst' opinion in this case (where you would be right to revalue the LIFO Cogs). Its asking for the stright up accounting affect of using FIFO cogs on the statements.
o123 on second thought...the current value of inventory isnt over overstated at all, FIFO is the most accurate measure of inventory value, as the inventory is based on current replacement costs. It is the extra Cash aspect (resulting from FIFO having an inaccurate COGS value) that causes the problem. COGS are understated --> NI is overstated --> Therefore, higher equity & Lower D/E.
This is why you would rather use LIFO figures for Net Income (I/S).
Tomcat82 What's wrong with A?
kutta2102 Tomcat, I had the same question as you. Inventory turnover under FIFO would be more useful since the inventory would closely approximate today's replacement cost. Since Sales would be the same under both methods, turnover ratio would be more useful under FIFO
joywind Inventory Turnover will be affected primarily through COGS instead of average inventory . Therefore, the ratio under LIFO is more useful because COGS is more close to the recent replacement costs.
johntan1979 C is right. FIFO ==> Higher NI ==> Higher equity ==> Understate Debt/Equity ratio

A is partially right. FIFO as the denominator for inventory turnover is best while the numerator should be from LIFO.
quanttrader remember that inventory T.0 = sales / inventory, but also equals COGS / average inventory. Since FIFO implies a non-current COGS it is not a a good estimate for inv t.o
daverco What if higher inventory levels on the balance sheet under FIFO are financed with debt? Wouldn't that increase the debt-to-equity ratio?
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