CFA Practice Question

CFA Practice Question

When prices are falling, which of the following is (are) true?

I. FIFO results in higher current assets.
II. LIFO results in higher taxes.
III. LIFO results in higher income.
IV. FIFO allows earnings manipulation through purchasing behavior.
A. I and IV
B. II, III and IV
C. II and III
Explanation: When prices are falling, units purchased later have a lower purchase price. Therefore, under the FIFO cost-flow assumption, the higher-cost goods will be assumed to have been sold first. This will raise COGS, lower the ending inventory value (and therefore lower current assets), and lead to lower income and hence lower income taxes compared to LIFO. However, earnings manipulation is not possible under FIFO.

User Contributed Comments 15

User Comment
lwang014 The last sentence is quite important :"earnings manipulation is not possible under FIFO"
dimos can we conclude that when prices are rising earning manipulation is not possible under LIFO? or this sentence refers only to FIFO?
help?
mtcfa I thnk if priced are rising, then earnings manipulation is possible under FIFO. In the example given, I think earnings manipulation is possible under LIFO.
sarath Earning manipulation is not possible in FIFO in case of decreasing prices...coz we will be reporting the highest cost of goods sold...which is what is required...
nike that's right, sarath. When prices are falling, if you use FIFO, purchasing additional inventories won't help in manipulating earnings as the cost is based on previously purchased inventories. For LIFO it's a different story.
egghead I thought manipulation is possible in the form similar to LIFO reserves liquidation for LIFO inventory accountig policy. Could you pls comment on it?
itconcepts always have to think about it, so this is my time saver. Just remember LIA & FAI. (Lifo, Icome, Assets)& (Fifo, Assets, Income)write it at an angle depicting the slope of prices goin up or down eg. under Lifi if prices are going up, the A(Assets) is higher, the I(income) is lower(than the A anyway) - works for me.
itconcepts CORRECTION TO THE ABOVE - use F.A.I.L. in the same way F=Fifo, L=Lifo. thus if prices go down Assets & Income will be lower with F, Read from the other side Assets and Income will be higher with Lifo, and the opposite when you write it upwards, denoting increasing prices.
MattM If you're selling FIFO as the old expensive stuff, and you stop purchasing, and start cutting down into the new cheaper stuff, that's earnings manipulation.
tom1980 conclusion: under fifo, impossible to manipulate earnings; under lifo,possible to manipulate earnings. regardless rising or falling prices
NNikolaiss Really, what does they mean here by pricep manipulation?!
tommyguard3 Nice tip itconcepts, except not thrilled with the idea of writing fail on my paper.
bidisha Lol
langerhans What's wrong with MattM's explanation? FIFO and deflation you could just stop purchasing, invest/hold the cash, burn through reserve, and then resume purchasing at last exact moment (i.e. current ratio and quick ratio are closer). You just risked running out of inventory, like a reverse LIFO liquidation? Maybe I'm missing something?
forry9er Answer I - FIFO results in higher current assets.

I thought this was tricky. The newest inventory is cheaper than the older inventory, then current assets are higher. THE POINT - Just because prices fall, doesn't mean the value of the most recent purchases is lower than the oldest purchases.
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