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Morgan Manufacturing*
Morgan Manufacturing is a straightforward case to illustrate how information on the LIFO Reserve can
be used to adjust the results of a company on LIFO to make them more comparable to those of a company
on FIFO. This case extends the learning developed in question 4 of Case 6-2, Lewis Corporation. Morgan
Manufacturing may not require a full class for discussion, and the instructor may want to assign it in
conjunction with Lewis Corporation.
Answers to questions:
1. Westwoods gross margin percentage = $900 divided by $2,000 = 45%; pretax return on sales = $300
divided by $2,000 = 15%; pretax return on assets = $300 divided by $2,240 = 13.4%.
2. Students will quickly recognize that both the inventory and the cost of goods sold accounts are
affected. You are likely, however, to have to guide them to recognize what other accounts and
financial items are also affected. For example, if inventory is affected, then some other balance sheet
account must be affected to keep the balance sheet balanced. Students will likely conclude it must be
retained earnings or owners equity. If cost of goods sold is affected, then clearly items such as gross
margin, pretax net income, tax expense and net income will also be affected. Typically, assuming the
norm of continuing inflation and growing inventory, LIFO produces higher cost of goods sold and
lower inventory, owners equity, gross margin, pretax net income, tax expense, and net income than
FIFO. It is possible, therefore, for two companies to have identical underlying economic
performance, but the financial measures of performance of the firm using the LIFO method will look
worse than the financial measures of the firm using the FIFO method (or the underlying economic
performance of the LIFO firm might be even better than that of the FIFO firm, and the LIFO firms
financial measures can still look worse!).
3. Adjustment to 2010 inventory: $100 LIFO inventory + $70 LIFO reserve = $170 FIFO inventory.
Adjustment to 2010 total assets: $2,170 + $70 = $2,240
Amount to adjust COGS:

$70
-10
$60

2006 LIFO reserve

2005 LIFO reserve
Difference between 2006 LIFO and FIFO COGS

Adjustment to 2010 COGS: $1,110 - $60 = $1,050

Adjustment to 2010 gross margin: $890 + $60 = $950
Adjustment to 2010 pretax net income: $290 + $60 = $350
Adjusted gross margin percentage = $950 divided by $2,000 = 47.5%
Adjusted pretax return on sales $350 divided by $2,000 = 17.5%
Adjusted pretax return on assets $350 divided by $2,240 = 15.6%
4. Once adjusted to FIFO, Morgans performance exceeds Westwoods on each of the three measures, as
shown in Exhibit 1. In addition, Morgan has paid less in taxes than Westwood.
Pedagogical Approach
You can begin with a general discussion of why we often want to compare the financial performance of
different companies and how our ability to compare companies is affected by the different accounting
choices that they make; this issue, of course, is much broader than simply the choice of LIFO or FIFO. In
*

This teaching note was prepared by Julie H. Hertenstein. Copyright Julie H. Hertenstein.

Chapter 5, students encountered different revenue recognition choices which produce different financial
results for the same underlying economic events. When firms choose different inventory accounting
methods, these affect financial measures, as well. When trying to compare one company on LIFO with
another on FIFO, one is trying to compare apples and oranges. For purposes of comparison, you would
like to get the companies on a common basis. The LIFO reserve, which is frequently available in the
inventory footnote or elsewhere in the annual report of a firm using LIFO, allows you to make
adjustments to achieve a common basis for comparison.
The three key measures for Morgan are given in the case. You can write them on the board, and put up
Westwoods for comparison when students answer question 1, as shown in the first two lines of Exhibit 1.
As indicated in the answer to question 2, you may need to draw students out on which accounts and
measures will be affected by the choice of inventory accounting method, and how this choice affects the
financial statement readers ability to compare the two companies.
Before proceeding to the calculations in question 3, you may wish to first discuss, conceptually, how you
can adjust results to make them more comparable. The first point regarding the adjustments is that you
have LIFO reserve information, (and since there is not an analogous FIFO reserve), you must adjust the
LIFO company to a FIFO basis. Since the LIFO reserve is the difference between the LIFO and FIFO
inventory, it can be used directly to adjust inventory, and similarly, it is also the adjustment to total assets;
a comparable adjustment can be made to owners equity to keep the balance sheet in balance. The LIFO
reserve represents not only the difference between LIFO and FIFO inventory, but also the cumulative
difference between LIFO and FIFO cost of goods sold. Thus, the LIFO reserve for two consecutive years
can be used to compute the difference between LIFO and FIFO cost of goods sold for the more recent of
the two years, which allows you to make adjustments to the income statement as well.

You may want to raise the issue of what to do if you want to compare after-tax results, instead of the
pretax measures that the case suggests. Some students may want to adjust the tax expense of the LIFO
firm, for example, using the same ratio of tax expense to pretax net income as shown on the LIFO income
statement. Others may argue that the tax expense should be unchanged, reflecting the fact that the LIFO
company paid lower taxes due to its choice of the LIFO inventory accounting method, a true economic
difference between the two firms.
Following the conceptual discussion, the actual calculations can be examined and the results posted on
the board, as shown in Exhibit 1. From these results, students will quickly observe that Morgans
performance was better on all three measures. They may also conclude that the productivity
improvements that Charles Crutchfield had implemented were, indeed, reflected in Morgans financial
performance measures.

Exhibit 1
Gross Margin %
Pretax Return on Sales Pretax Return on Assets
Morgan (LIFO)...................................................................................................................................................................
44.5%
14.5%
13.4%
Westwood (LIFO)..............................................................................................................................................................
45.0%
15.0%
13.4%
Morgan (Adjusted).............................................................................................................................................................
47.5%
17.5%
15.6%