Question

Sirotka Retail Company began doing business in 20X1. The following information pertains to its first three years of operation: Use the following links to the present value tables to calculate answers. (PV of 1, PVAD of 1, and PVOA of 1) (Use the appropriate factor(s) from the tables provided.)

				Purchases					Sales
Year	Operating Expenses			Units			Unit Cost			Units			Unit Price
20X1	$	60,000			15,000		$	20.00			12,000		$	35
20X2		90,000			20,000			25.00			18,000			40
20X3		65,000			5,000			30.00			10,000			40

Assume the following:

• The income tax rate is 21%.
• Purchase and sale prices change only at the beginning of the year.
• Sirotka uses the LIFO cost flow assumption.
• Operating expenses are primarily selling and administrative expenses.

Required:

1. Compute cost of goods sold and the cost of ending inventory for each of the three years.
2. Prepare income statements for each of the three years.
3. Compute the LIFO reserve at the end of 20X1, 20X2, and 20X3.
4. Compute the effect of LIFO liquidation on the net income of the company for the years 20X2 and 20X3.
5. Compute the inventory turnover ratio for the years 20X2 and 20X3. Do not make adjustments for any potential biases in LIFO accounting.
6. How can the physical turnover of inventory (that is, true inventory turnover) best be approximated using all of the information available in a LIFO financial statement? Illustrate your approach by recomputing Sirotka’s inventory turnover ratios for 20X2 and 20X3.
7. Compute the gross margin percentages for the years 20X2 and 20X3.
8. Provide an estimate of the FIFO cost of goods sold for the years 20X1, 20X2, and 20X3 using the information available in the financial statements.
9. Based on your answers to requirements 1 and 8, estimate Sirotka’s tax savings for 20X1, 20X2, and 20X3.
10. Assuming a discount rate of 10%, compute the January 1, 20X1, present value of the tax savings over the period 20X1–20X3 (that is, discount the 20X1 tax savings one period, and so on).

Answer 1

Computation of cost of Goods sold and cost of ending inventory for each of the three years:

Particulars	Year 1	Year 2	Year 3
Sales	4,20,000 [12,000×35]	7,20,000 [18,000×40]	4,00,000 [10,000×40]
Beginning Inventory	-	60,000	1,10,000
Purchases	3,00,000 [15,000×20]	5,00,000 [20,000×25]	1,50,000 [5,000×30]
Ending inventory	60,000 [15,000 - 12,000]×20	1,10,000 [(20,000 - 18,000)×25 + ( 3,000×20)]	-
Cost of goods sold (Beginning Inventory +Purchase - Ending Inventory)	2,40,000 [0+3,00,000-60,000]	4,50,000 [60,000+5,00,000-1,10,000]	2,60,000 [1,10,000+1,50,000-0]

Preparation of Income Statement for each of the three years:

Particulars	Year 1	Year 2	Year 3
Sales	4,20,000	7,20,000	4,00,000
Less: Cost of Goods sold	(2,40,000)	(4,50,000)	(2,60,000)
Net Revenue	1,80,000	2,70,000	1,40,000
Less: Operating Expense	(60,000)	(90,000)	(65,000)
EBT	1,20,000	1,80,000	75,000
Less: Tax@21%	(25,200)	(37,800)	(15,750)
EAT	94,800	1,42,200	59,250

Computation of LIFO Reserve at the end of 20X1, 20X2 and 20X3:

LIFO Reserve = FIFO Inventory - LIFO Inventory

For 20X1	FIFO Inventory	LIFO Inventory
Sales	4,20,000	4,20,000
Beginning Inventory	-	-
Purchases	3,00,000	3,00,000
Ending inventory	60,000	60,000

LIFO Reserve for 20X1 = FIFO Inventory - LIFO Inventory

= 60,000 - 60,000 = 0

For 20X2	FIFO Inventory	LIFO Inventory
Sales	7,20,000	7,20,000
Beginning Inventory	60,000	60,000
Purchases	5,00,000	5,00,000
Ending Inventory	1,25,000 [5,000×25]	1,10,000

LIFO Reserve for 20X2 = 1,25,000 - 1,10,000 = $15,000

Total LIFO Reserve upto 20X2 = $15,000

For 20X3	FIFO Inventory	LIFO Inventory
Sales	4,00,000	4,00,000
Beginning Inventory	1,25,000	1,10,000
Purchases	1,50,000	1,50,000
Ending Inventory	-	-

LIFO Reserve for 20X3 = 0

Total LIFO Reserve upto 20X3 = 15,000

Effect of LIFO Liquidation on Net Income of the company for years 20X2 and 20X3:

For 20X2	FIFO	LIFO
Sales	7,20,000	7,20,000
Less: Cost of Goods sold	(2,35,000) [60,000+3,00,000-1,25,000]	(4,50,000)
Net Revenue	4,85,000	2,70,000
Less: Operating Expense	(90,000)	(90,000)
EBIT	3,95,000	1,80,000
Less: Tax@21%	(82,950)	(37,800)
EAT	3,12,050	1,42,200

For the Year 20X2, Net income from FIFO to LIFO has been reduced by $1,69,850 from 3,12,050 to 1,42,200

For 20X3	FIFO	LIFO
Sales	4,00,000	4,00,000
Less: Cost of Goods sold	(2,75,000) [1,25,000+1,50,000-0]	(2,60,000)
Net Revenue	1,25,000	1,40,000
Less: Operating Expense	(65,000)	(65,000)
EBIT	60,000	75,000
Less: Tax@21%	(12,600)	(15,750)
EAT	47,400	59,250

For Year 20X3, Net income from FIFO to LIFO has been increased by $11,850 from 47,400 to 59,250