Financial Statement Investigation WA04-05-2017

FSI Revised 04-16-2020

HARIS ALI
ha2657
ASSIGNMENT #8

Analysis of Depreciation Policies

Two companies, Lululemon and American Eagle Outfitters, in the same industry, use different
depreciation policies. Lululemon uses the declining balance method (an accelerated method) for
book purposes and American Eagle Outfitters uses the straight-line method for book purposes.
Each company’s property, plant & equipment and depreciation expense is provided below:

Feb-01- Jan-31- Jan-30- Jan-28- Feb-03-

Lululemon Athletica Inc. 2014 2015 2016 2017 2018

Gross Property, Plant & Equipment 374.6 453.9 553.4 701.8 817.4

Accumulated Depreciation (119.0) (157.9) (203.8) (278.3) (343.7)

Net Property, Plant & Equipment 255.6 296.0 349.6 423.5 473.6

Depreciation Expense 48.2 57.5 72.6 87.0 108.0

Feb-01- Jan-31- Jan-30- Jan-28- Feb-03-

American Eagle Outfitters 2014 2015 2016 2017 2018

Gross Property, Plant & Equipment 1,594.4 1,690.2 1,792.4 1,884.3 2,023.9

Accumulated Depreciation (961.4) (991.9) (1,088.8) (1,176.5) (1,299.6)

Net Property, Plant & Equipment 633.0 698.2 703.6 707.8 724.2

Depreciation Expense 116.8 132.5 140.6 152.6 159.0

1. Which company’s assets are “younger”? On what do you base your answer?
Lululemon's assets are younger than American Eagle Outfitters' assets.
We can compare the average age of assets by calculating the ratio of Accumulated Depreciation to Gross Property, Plant &
Equipment for each company:
Lululemon Athletica Inc.:
2014: 119 / 374.6 = 0.3177
2015: 157.9 / 453.9 = 0.3477
2016: 203.8 / 553.4 = 0.3681
2017: 278.3 / 701.8 = 0.3965
2018: 343.7 / 817.4 = 0.4203

American Eagle Outfitters:

2014: 961.4 / 1594.4 = 0.6029
2015: 991.9 / 1690.2 = 0.5867
2016: 1088.8 / 1792.4 = 0.6076
2017: 1176.5 / 1884.3 = 0.6244
2018: 1299.6 / 2023.9 = 0.6422

Therefore, based on the calculated ratios, Lululemon's assets are younger than American Eagle Outfitters' assets, as the ratios are
lower for Lululemon in each year.
Norman J. Bartczak, Columbia University, prepared this assignment as a basis for class discussion. It is not intended to illustrate
either effective of ineffective handling of an administrative situation. Copyright © 2017 Norman J. Bartczak.
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WA04-05-2017 Assignment #8 – Analysis of Depreciation & Inventory Valuation Policies
Revised 04-16-2020

2. At what percentage rate is each company depreciating its assets over the five-year period?
Are the rates you calculated consistent with Lululemon using accelerated depreciation and
American Eagle Outfitters using straight-line depreciation? Why or why not?

Feb-01- Jan-31- Jan-30- Jan-28- Feb-03-

Lululemon Athletica Inc. 2014 2015 2016 2017 2018

Depreciation Rate (%) 12.86% 12.67% 13.12% 12.39% 13.21%

Feb-01- Jan-31- Jan-30- Jan-28- Feb-03-

American Eagle Outfitters 2014 2015 2016 2017 2018

Depreciation Rate (%) 7.32% 7.83% 7.84% 8.10% 7.86%

To calculate the percentage rate of depreciation for each company, we can divide the Depreciation
Expense by the Gross Property, Plant & Equipment. The depreciation rates calculated for Lululemon
are higher than those for American Eagle Outfitters, which is consistent with Lululemon using an
accelerated depreciation method (declining balance) and American Eagle Outfitters using a straight-
line depreciation method.

3. If Lululemon used American Eagle Outfitters depreciation rate for fiscal year 2018, what
would be the impact on its income statement, balance sheet and cash flows for fiscal year
2018?

Income Statement Balance Sheet

Operating income/Profit before Tax would Accumulated Depreciation would
increase by 43.75, as the depreciation decrease by 43.75, and Net Property,
expense would decrease by 43.75. Plant & Equipment would increase by
43.75.
Tax expense would increase by (43.75 x 35%)
15.31. Assuming tax rate to be 35%. DTL would increase by 15.31 due to
increase in tax expense.
Net Income would increase by (43.75 - 15.31)
28.44. Retained earnings would increase by
28.44 due to increase in Net Income.

If Lululemon used American Eagle Outfitters'

depreciation rate for fiscal year 2018 (7.86%):
Depreciation Expense: 817.4 * 0.0786 = 64.25
Difference in Depreciation Expense:
108 - 64.25 = 43.75

Cash Flow
There would be no impact on the cash flows statement, as depreciation is a non-
cash expense.
However, the increase in operating income would cause the operating cash flow to
appear higher, even though the actual cash flow remains unchanged.

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Assignment #8 – Analysis of Depreciation & Inventory Valuation Policies WA04-05-2017
Revised 04-16-2020

Analysis of Inventory Valuation Policies

1. Computations involving different cost-flow assumptions.

Sun Health Food’s purchases of vitamins during 2016, its first year of operations , were as
follows:
--------------------------------------------------------------------------
Quantity Cost per Unit Total Cost
--------------------------------------------------------------------------

January 5 Purchase 870 $4.10 $ 3,567

April 16 Purchase 500 4.16 2,080
August 26 Purchase 670 4.20 2,814
November 13 Purchase 460 4.30 1,978
Totals 2,500 $10,439

During 2016, the Company sold 2,080 units for $10,400 leaving 420 units in inventory on
December 31, 2016. Assume that Sun Health’s only expenses are the cost of the units sold
and income taxes. Also, assume an income tax rate of 40%. Finally, recall what we discussed
in class regarding “book” and tax accounting with respect to inventory valuation policies:

a. What is the cost of the inventory at December 31 using:

(1) FIFO

Cost of the inventory = 420 units x $4.30 = $1806

(2) LIFO

Cost of the inventory = 420 units x $4.10 = $1722

b. What is the cost of goods sold for the year ended 2016 using:

(1) FIFO
Cost of Goods Sold = (870 x 4.10) + (500 x 4.16) + (670 x 4.20) + (40 x 4.30) = $8633

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WA04-05-2017 Assignment #8 – Analysis of Depreciation & Inventory Valuation Policies
Revised 04-16-2020

(2) LIFO

Cost of Goods Sold = (460 x 4.30) + (500 x 4.16) + (670 x 4.20) + (450 x 4.10) = $8717

c. Calculate net income for the year ended 2016 using:

(1) FIFO

Revenue 10400
Cost of Goods Sold (8633)
Gross Profit 1767
Tax @ 40% (706.8)
Net Income 1060.2

(2) LIFO

Revenue 10400
Cost of Goods Sold (8717)
Gross Profit 1683
Tax @ 40% (673.2)
Net Income 1009.8

d. As the chief financial officer, based on the trend in unit purchase costs, what inventory
valuation method would you recommend for Sun Health? Why?

As the CFO of Sun Health, based on the trend in unit purchase costs, I would recommend using the
LIFO method for inventory valuation assuming that the company is motivated to reduce tax expense.
Using the LIFO method, would result in lower net income, higher cost of goods sold, and lower ending
inventory, as compared to the FIFO method. This is because the LIFO method assumes that the last
units purchased are the first units sold. Lower operating income means lower taxes for Sun Health.

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Assignment #8 – Analysis of Depreciation & Inventory Valuation Policies WA04-05-2017
Revised 04-16-2020

2. The next page contains a condensed balance sheet for Kroger Co. as of its fiscal year end
January 28, 2017. It is as reported by the Company in its 10-K filed with the SEC. Note
that Kroger includes the adjustment for the LIFO reserve directly in its balance sheet in-
stead footnote disclosure. This is an acceptable alternative to footnote disclosure since it
results in the same inventory value on the balance sheet. The net inventory value on
Kroger’s balance sheet is:
January 28, January 30,
(In millions, except par values) 2017 2016
FIFO inventory 7,852 7,440
LIFO reserve (1,291) (1,272)
LIFO inventory 6,561 6,168

a. What are the approximate current values of Kroger’s inventories at January 28, 2017
and January 30, 2016?
Approximate current values of Kroger’s inventories at January 28, 2017 is 7,852 and
January 30, 2016 is 7440.

b. How much did Kroger save in income taxes (assume a tax rate of 35%) for the 12
months ended January 28, 2017 by being on LIFO? The Takeaway for Inventory Val-
uation should help you answer this question. Was the savings very significant for the
12 months ended January 28, 2017? Why or why not?
Change in LIFO Reserve = 1291 - 1272 = 19

Tax Savings = Change in LIFO Reserve x Tax Rate

= 19 x 35%
= 6.65 million

For the 12 months ended January 28, 2017, the savings were not very significant because
they were less than 1% of Net Income for the year.

c. Assume Kroger pays a tax rate of 35% (the U.S. federal statutory rate as of 2017). As
of January 28, 2017, how much has Kroger cumulatively (over its lifetime) saved on
income taxes by being on LIFO? The Takeaway for Inventory Valuation should help
you answer this question. Is the cumulative savings very significant? Why or why not?

Savings in Income Taxes = LIFO Reserve x Tax Rate

= 1291 x 35%
= 451.85 million

The cumulative savings were significant as they were approximately 2.91% of the retained
earnings as of 2017.

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WA04-05-2017 Assignment #8 – Analysis of Depreciation & Inventory Valuation Policies
Revised 04-16-2020

d. As of January 28, 2017, cumulatively (over its lifetime) how much has Kroger’s re-
tained earnings been affected by using LIFO instead of FIFO?

Cumulative effect on Retained Earnings = LIFO Reserve x (1 - Tax Rate)

= 1291 x ( 1 - 35% )
= 839.15 million

THE KROGER CO.

CONSOLIDATED BALANCE SHEETS

January 28, January 30,

(In millions, except par values) 2017 2016
ASSETS
Current assets
Cash and temporary cash investments $ 322 $ 277
Store deposits in-transit 910 923
Receivables 1,649 1,734
FIFO inventory 7,852 7,440
LIFO reserve (1,291) (1,272)
Prepaid and other current assets 898 790
Total current assets 10,340 9,892

Total Assets $ 36,505 $ 33,897

LIABILITIES
Current liabilities
Total current liabilities 12,860 12,971

Total Liabilities 29,795 27,099

SHAREHOLDERS’ EQUITY
Common shares, $1 par per share, 2,000 shares authorized; 1,918 shares issued in
2016 and 2015 1,918 1,918
Additional paid-in capital 3,070 2,980
Accumulated other comprehensive loss (715) (680)
Retained earnings 15,543 14,011
Common shares in treasury, at cost, 994 shares in 2016 and 951 shares in 2015 (13,106) (11,387)
Total Equity 6,710 6,798

Total Liabilities and Equity $ 36,505 $ 33,897

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1. ACCOUNTING POLICIES

Inventories

Inventories are stated at the lower of cost (principally on a last-in, first-out “LIFO” basis) or
market. In total, approximately 89% of inventories in 2016 (ended January 31, 2017) and 95% of
inventories in 2015 (ended January 31, 2016) were valued using the LIFO method. Replacement cost
was higher than the carrying amount by $1,291 at January 28, 2017 and $1,272 at January 30, 2016.