|Posted: 27 Jul 2008 at 11:08 | IP Logged
Need help on the answer to the below question - I do not understand the sentence highlighted/bolded in blue. Why would stockholder's equity be larger? Is this because of OCI? I don't quite understand....please help.
Lynn Manufacturing Co. prepares income statements using both standard absorption and standard variable costing methods. For 1994, unit standard costs were unchanged from 1993. In 1994, the only beginning and ending inventories were finished goods of 5,000 units. How would Lynn's ratios using absorption costing compare with those using variable costing?
1) Return on Current Ratio, 2) stockholders' equity
And here is the answer:
Choice "d" is correct. Under variable (direct) costing, fixed manufacturing overhead is treated as a period cost and expensed, while under absorption costing this expense is treated as a product cost and is inventoried. The two different methods will therefore result in different year-end inventory amounts, with inventory under the absorption method being higher. Since the current ratio includes inventory in current assets, the current ratio under absorption costing will be higher.
Since inventory balances did not change, both methods will result in the same net income for the current year. However, this would not have been the case in every prior year. The first year that had an ending inventory would have resulted in a difference in income between the two methods, with absorption costing generating a higher income than variable costing. Since the previous year had an amount in ending inventory, this timing difference has not entirely reversed, and therefore stockholders' equity will be larger under absorption costing than under variable costing. A higher stockholders' equity with a constant net income results in a lower value for return on equity.
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