1 of 6

When compared to how the European firms account for inventory, Piezo's method is most likely to result in a
lower:
days of inventory on hand.
total liabilities to equity ratio.
cash flow from operations.

Jacob Smith is a hedge fund manager at Thames-Hill Advisers in New York City. He is currently reviewing the
financial statements of Piezo Materials, Inc. of Atlanta, Georgia, USA. Piezo specializes in the production of
materials that generate electricity when mechanical force is applied to them. The products are widely used in
vibration sensors, automotive airbags, and numerous medical devices.
Piezo prepares its financial statements using U.S. GAAP, and Smith wants to compare Piezo with several
similar firms operating in Europe that report under International Financial Reporting Standards (IFRS) and
account for their inventory on a first-in, first-out (FIFO) basis. As with Piezo, these firms face material costs
that are continuing to rise. The companys recent abbreviated financial statements are shown in Exhibit 1,
and selected notes to the financial statements are provided in Exhibit 2.
Exhibit 1
Piezo Materials, Inc. Balance Sheet Excerpts and Income Statement
Balance Sheet Excerpt (US$ thousands)
As of 31 December
2013
Cash and accounts receivable
$1,328
Inventories (Note 5)
1,406
Total current assets
2,734
Property, plant, and equipment, net (Note 11)
2,836
Total assets
$5,570
Total current liabilities
Long-term debt (Note 9)
Income Statement (US$ thousands)
Periods Ending 31 December
Net sales
Cost of goods sold
Selling & administrative expense (S&A)
Interest
Total costs and expenses
Earnings before tax
Taxes (Note 7)
Net income
Exhibit 2
Piezo Materials, Inc.
Selected Notes to Financial Statements
31 December 2013
(All figures in US$ thousands)
Note 5. Inventories

2012
$1,025
2,220
3,245
3,043
$6,288

$1,039
974

$1,697
1,237

2013
$11,159
9,898
872
122
$10,892
267
89
$178

2012
$8,895
7,901
717
158
$8,776
119
38
$81

Inventories are reported on a last-in, first-out (LIFO) basis. The LIFO Reserve was $867 and
$547 at the end 2013 and 2012, respectively. During 2013, the company liquidated certain
LIFO inventories that had been carried at lower costs in prior years, and the effect of the
liquidation was to decrease cost of goods sold by $263. There was no LIFO liquidation in
2012.
Note 7. Tax Rates
The companys tax rate in 2013 was 33.3% and 32% for all prior years.
Note 9. Debt and Debt Covenant
The debt covenant requires that an interest coverage ratio of 2.25 must be maintained; the
ratio is to be calculated excluding the effects of capitalized interest.
Note 11. Property and Equipment
Depreciation expense for 2013 and 2012 was $388 and $362, respectively. These amounts
include capitalized interest of $34 and $143, respectively.
Interest is allocated and capitalized to construction in progress by applying the firms cost of
borrowing rate to qualifying assets. Interest capitalized in 2013 and 2012 was $66 and $170,
respectively.
Smith is interested in several aspects of the financial statements as presented. He wants to

determine what impact the LIFO liquidation in 2013 had on the companys gross profit margin when

compared with 2012, and

ensure that the companys interest coverage ratio meets the requirements of the debt covenant.

In early January 2014, Smith saw a news release that Piezo would be forced to reduce production at its
highly specialized Peachtree City ceramics production plant because a new technology introduced by a
competitor eliminated a major product line. Exhibit 3 summarizes information and estimates that Smith has
been able to gather from various sources about the plant and its future prospects.
Exhibit 3
Piezo Materials Ltd. Selected Information Related to
Peachtree City Ceramics Production Plant
(US$ thousands)
Acquisition cost (start of 2010)
$2,800
Estimated useful life at acquisition
10 years
Depreciation method
Declining balance, 13% /year
Estimated residual value
$500
At the end of 2013
Expected future net cash flows
Fair value of plant
Revised estimate of useful life
Depreciation method
Revised estimate of residual value

$1,350
$1,225
4 years
Straight line
$200

________________________________________________________________________________
_________
Correct.

Days of inventory on hand

Inventory turnover ratio

= 365/Inventory turnover ratio

= COGS/Inventory
Piezo uses LIFO under U.S. GAAP, whereas the European firms use FIFO under IFRS. With
rising prices, under LIFO, cost of goods sold (COGS) will be higher and the inventory carrying
amount will be lower. The result is that the inventory turnover ratio will be higher under LIFO
than FIFO.The higher inventory turnover will lead to fewer days of inventory on hand under
LIFO.
2014 CFA Level II
Inventories: Implications for Financial Statements and Ratios, by Michael A. Broihahn Section 3
Question
2 of 6

On a comparable basis to the European firms in the industry, using Notes 5 and 7, Piezo's 2013 return on
assets ratio, based on end of year assets, is closest to:
7.7%.
6.4%.
6.2%.

Correct.
To be comparable with the European firms, it is necessary to adjust the net income and total asset from LIFO
to FIFO. Under FIFO, total assets increase by the LIFO reserve but decrease by the cash paid for the
cumulative amount of additional income taxes that would arise. Net income will be higher under FIFO
because of lower COGS (i.e., the increase in the LIFO reserve, but it will be reduced by the taxes paid on the
increase in operating profit).
(US$ thousands)
Net Income (LIFO)
+ Reduction in COGS
Tax on increased operating profit
Net Income (FIFO)
Total assets (LIFO)
+Increase in inventory (FIFO)
Tax paid on higher cumulative profits
Total assets (FIFO)

$178
+ 320
106.6
$391.4
$5,570
+ 867
281.6
$6,155.4

Increase in LIFO reserve: 867 547

33.3% 320 (use 2013 tax rate)

Add LIFO reserve: 867

33.3% 320 + 32% 547a

Cumulative tax savings: 2013 tax rate for the increase in LIFO reserve; 32% on remainder

2014 CFA Level II

Inventories: Implications for Financial Statements and Ratios, by Michael A. Broihahn
Section 3.1
Question
3 of 6

After adjusting for the LIFO liquidation in 2013, the change in gross profit margin compared to 2012 is most
likely:
higher by 2.5%.
lower by 2.3%.
higher by 3.0%.

Correct.

Gross profit under LIFO in 2013 = 11,159 9,898 = $1,261

But this arose in part because of the LIFO liquidation, which decreased cost of goods sold by 263 (Exhibit 2, Note 5)
Adjusted gross profit = $1,261 263 = $998
Adjusted gross profit margin in 2013 = 998 / 1,159 x 100 = 8.9%
Gross profit margin in 2012 = (8,895 7,901)/8,895 x 100 = 11.2%
After adjusting for the LIFO liquidation, gross profit margin is lower by 2.30% (8.9% - 11.2%)
2014 CFA Level II
Inventories: Implications for Financial Statements and Ratios, by Michael A. Broihahn
Sections 3.1 and 3.2
Question
4 of 6

The most appropriate conclusion that Smith can make about the debt covenant restriction, using Notes 9 and
11, is that the firm has:
just satisfied it.
failed to meet it by at least 5%.
exceeded it by at least 5%.
Incorrect.
The interest coverage ratio is calculated excluding the effects of capitalized interest. Capitalized interest
affects interest expense and depreciation expense.
(US$ thousands)

$389

EBITa
Add back capitalized interest included in depreciation expense (Note 11)
Adjusted EBIT

34
$423

Interest expense from income statement

Capitalized interest (Note 11)
Total interest

$122
66
$188

The interest coverage ratio requirement has been exactly achieved.

a

EBIT = Sales COGS S&A expenses = 11,159 9,898 872 = $389

2014 CFA Level II

Long-Lived Assets: Implications for Financial Statements and Ratios, by Elaine Henry and Elizabeth A.
Gordon
Section 2.1
Question
5 of 6

Ignoring the effects of income taxes, the expensing of previously capitalized interest, Note 11, most
likely causes Piezo's cash flow from operations to be:
higher.
unchanged.
lower.
Incorrect.
The expensing of the previously capitalised interest is a non-cash amount (the cash outflow was in a previous
period when the expense was incurred) and therefore does not affect operating cash flow. Net income is
lower as a result of the previously capitalized amount being expensed, but as it is a non-cash expense it is
added back to determine cash from operations. (Lower net income but higher add back = no change in CFO).
2014 CFA Level II
"Long-Lived Assets: Implications for Financial Statements and Ratios," by Elaine Henry and Elizabeth A.
Gordon
Section 2.1
Question
6 of 6

Assuming Smith's information and estimates concerning Peachtree City ceramics plant in Exhibit 3 prove
accurate, the depreciation expense (in $1,000s) that should be reported for 2014 related to the plant
is closest to:
306.
256.

279.

Correct.
At the end of 2013, a test of impairment is required because events or changes in circumstances indicate
that its carrying amount may not be recoverable.
Carrying amount of asset at 31 December 2013: 2,800 (1 0.13)4 = 1,604
U.S. GAAP Impairment Test
Step 1: Assess recoverability: Compare carrying amount with undiscounted future net cash flows.
Carrying amount 1,604 > 1,350 Expected future cash flows
The recoverability test is not satisfied, so an impairment loss is required.
Step 2: Write the asset down to its fair value.
New carrying value: $1,225 (Exhibit 3)
Estimated depreciation in 2014

2014 CFA Level II

Long-Lived Assets: Implications for Financial Statements and Ratios, by Elaine Henry and Elizabeth A.
Gordon
Sections 3 and 4