I need small explanations for calculations Decision Cases Case 1. (Learning Obje
ID: 2599666 • Letter: I
Question
I need small explanations for calculations
Decision Cases Case 1. (Learning Objectives 2, 3: Measuring profitability based on different inventory and depreciation methods) Suppose you are considering investing in two businesses, La Petite France Bakery and Burgers Ahoy!. The two companies are virtually identical, and both began operations at the beginning of the current year. During the year, each company purchased inventory as follows: 10,000 units at $4 - 40,000 5,000 units at $5 25,000 7,000 units at $6 42,000 10,000 units at $7- 70,000 $177,000 an Apr 6 Aug 9 Nov 27 Totals 32,000 During the first year, both companies sold 25,000 units of inventory In early January, both companies purchased equipment costing $150,000 that had a 10-year estimated useful life and a $20,000 residual value. La Petite France uses the inventory and depreciation methods that maximize reported income. By contrast, Burgers uses the inventory and depreciation methods that minimize income tax companies' trial balances at December 31 included the following payments. Assume that both Sales revenue Operating expenses $350,000 50,000 The income tax rate is 40% I Requirements 1. Prepare both companies' income statements. 2. Write an investment newsletter to address the following questions: Which company appears to be more profitable? Which company has more cash to invest in promising projects? If prices continue rising over the long term, which company would you prefer to invest in? Why? (Challenge)Explanation / Answer
Question (1).
Note:
As per information of the question, it is given that La Petite France Bakery uses the inventory and depreciation methods that maximize reported income. Hence we will use FIFO method of inventory will result into low amount of cost of goods sold and straight line method of depreciation because this method of depreciation will also result into low amount of depreciation thus as a result reported income will be maximized.
Income Statement
La Petite France Bakery
Sales revenue
$350000
Less: Cost of goods sold
($128000)
Gross margin
$222000
Less: Operting expenses
($50000)
Less: Depreciation
($13000)
Net income
$159000
Less: Income tax @ 40%
($63600)
Net profit after tax
$95400
Working Note;
1. Calculation of cost of goods sold;
As per FIFO method first purchased units will be sold first. Thus cost of goods sold will be as follow;
(10000 units * $4) + (5000 units * $5) + (7000 units * $6) + (3000 units * $7)
= ($40000 + $25000 + $42000 + $21000) = $128000
2. Calculation of Depreciation expense;
As per straight line method depreciation expense will be calculated as follow;
($150000 – $20000) / 10 years
= $130000 / 10 = $13000
Note:
As per information of the question, it is given that Burgers uses the inventory and depreciation methods that minimize income tax payment. Hence we will use LIFO method of inventory that will result into high amount of cost of goods sold and double decline method of depreciation because this method of depreciation will also result into high amount of depreciation thus as a result reported income will be lower and as a result income tax payment will be minimized.
Income Statement
Burgers
Sales revenue
$350000
Less: Cost of goods sold
($149000)
Gross margin
$201000
Less: Operting expenses
($50000)
Less: Depreciation
($30000)
Net income before tax
$121000
Less: Income tax @40%
$48400
Net income after tax
$72600
Working Note;
1. Calculation of cost of goods sold;
As per LIFO method last purchased units will be sold first. Thus cost of goods sold will be as follow;
(10000 units * $7) + (7000 units * $6) + (5000 units * $5) + (3000 units * $4)
= ($70000 + $42000 + $25000 + $12000) = $149000
2. Calculation of Depreciation expense;
As per double decline line method depreciation expense will be calculated as follow;
$150000 / 10 years = $15000
Thus rate of depreciation will be $15000 / $150000 = 10%
As it is double decline method thus rate will be (10% * 2) = 20%
So depreciation expense for the year will be ($150000 * 20%) = $30000
Question (2).
La Petite France Bakery is looking more profitable because its’ net income is $95400 in compare to net income of Burgers that is $72600. Although this gap is due to different method of inventory valuation & depreciation but as per question we need to find out more profitable company only.
Burgers company has more cash to invest in promising project because it has less cash outflow due to less amount of tax payment. And as we know that depreciation is a non-cash expense that is why more amount of depreciation charged will not affect cash position of Burgers company.
In case of rising prices I will prefer to make investment in La Petite France Bakery because it uses FIFO methods that is why it will lead to lower amount of cost of goods sold thus as a result EPS will be more. Thus i will prefer La Petite France Bakery company. Although many other factors need to consider for making investment in this company.
Income Statement
La Petite France Bakery
Sales revenue
$350000
Less: Cost of goods sold
($128000)
Gross margin
$222000
Less: Operting expenses
($50000)
Less: Depreciation
($13000)
Net income
$159000
Less: Income tax @ 40%
($63600)
Net profit after tax
$95400