Question 1. Suppose Sonics Inc. just started business this period. The firm purchased 400 units during the period at various prices as follows:

The firm sold 250 units at $30 each on the following dates:

Required (assume the firm faces a marginal tax rate of 35%):

a. Calculate taxable income and taxes payable assuming the firm uses FIFO (first-in, first-out) for inventory costing purposes.

b. Calculate taxable income and taxes payable assuming the firm uses LIFO (last-in, first-out) for inventory costing purposes.

Discuss your results, including any nontax costs that might be associated with either inventory costing system.

An additional assumption needs to be made. Is LIFO being applied at each sale (so only the latest cost figures at the sale date can be used, known as the continuous method) or applied at the end of the year (so the latest cost figures for the year are used regardless of when the sale occurred within the year, known as the periodic method)? We will assume the latter as this minimizes taxable income and hence taxes.

Now compare the difference and discuss. also are there financial accounting (reporting) issues using LIFO vs FIFO?

Question 2. Assume Sonics Inc., from the prior exercise, uses LIFO with the periodic inventory system. Thus the LIFO cost of ending inventory at year 1 of 150 units is $1,600 (100 @ $10 + 50 @ $12). Suppose in year 2, Sonics reports the following purchases and sales:

Required:

a. Calculate taxable income and taxes payable (again assuming Sonics faces a marginal tax rate of 35%) for year 2.

-How many more units did Sonics sell than purchase?
-What is the difference in the unit cost and latest purchase price for each of these units?

b. Instead of purchasing 100 units in June, Sonics purchased 110 units. Recalculate taxable income and taxes payable.

c. Instead of purchasing 100 units in June, Sonics purchased 90 units. Recalculate taxable income and taxes payable.

d. How many units should Sonics have purchased to avoid dipping into earlier layers of inventory?

e. Do you notice any opportunities for Sonics Inc. to smooth reported net income (by varying the amount purchased relative to sales)? Are there any costs associated with this strategy? Does FIFO offer the same opportunities?

f. Suppose the top managers of Sonics are compensated, in part, by a bonus linked to reported net income. What inventory costing method might you expect the managers to favor? What costs to the firm arise from this choice?

By varying the number of units purchased at year-end, managers can increase or decrease taxable income AND reported earnings. illustrate this statement both mathematically and in writing below.

Increasing purchases at year-end (even if units purchased is greater than units sold) allows the latest unit prices to be used in calculating cost of goods sold and taxable income thus lowering taxable income and taxes. Note disadvantages of this practice below.

Why doesn't FIFO offer the same opportunity as LIFO. Consider rising prices due to inflation in your response below.

g. Suppose the top managers of Sonics are compensated, in part, by a bonus linked to reported net income. What inventory costing method might you expect the managers to favor? What costs to the firm arise from this choice?

Managers face a trade-off. Discuss this tradeoff below. Consider which inventory method would report higher earnings when prices were increasing.

Question 3. Suppose a firm is equally likely to earn $2 million this year or lose $3 million. The firm faces a tax rate of 40% on each dollar of taxable income, and the firm pays no taxes on losses. In this simple one-period scenario, ignore the carryback and carryforward rules. The firm's expected taxable income is thus a loss of $500,000 calculated as .50(-$3) + .50($2). What is the firm's expected marginal tax rate?

Suppose a second firm is equally likely to earn $3 million this year or lose $2 million. This firm also faces a tax rate of 40% on each dollar of taxable income (and the firm pays no taxes on losses). Again in this simple one-period scenario, ignore the carryback and carryforward rules. The firm's expected taxable income is thus a profit of $500,000 calculated as .50($3) + .50(-$2).

What is the firm's expected marginal tax rate?

Explain and discuss your results.

Question 4. Find the annual report for some publicly listed high-technology company that has losses. Refer to the tax footnote in the report to extract the NOL carryforward. Assume an after-tax discount rate of 10%.

Calculate the firm's marginal explicit tax rate using the Manzon (1994) market-value approach. Discuss and explain your result.

Attachment:- Exercises.xlsx