Literature

Q. Under what set of financial reporting standards were the BP financial statements prepared and who issues these standards Describe the cost flow assumptions for inventory and COGS that are available to BP under these standards. Which cost flow assumption did BP select for 2006
The BP financial statements were presented under the International Accounting Standards, which are being supplemented by the International Financial Reporting Standards. These are issued by the International Accounting Standards Board. Under these standards, BP can choose to represent its inventory using the specific identification method, the weighted average cost or through FIFO. The first two methods dont present much variation but in FIFO, the inventory is made up of goods that were purchased earlier on and thus have had less value associated with them compared to the newer goods which would be higher in value in an economy with inflation. Consequently, cost of goods sold will be higher for BP with FIFO as the newer, higher cost goods will be included in it. BP selected the FIFO assumption for the year 2006.

Q. Why did BP file financial statements with the US SEC
BP files financial statements with the SEC as it is a requirement for the company if it wants to be listed in the US stock exchanges and thus be able to access capital through equity in the country. This is required as investors and other financial experts as well as analysts will then be able to access the financial statements of BP to make decisions about whether to invest in the stock. Basic fundamental analysis takes place primarily by utilizing the information contained within these financial statements. However, foreign private issuers are required by the SEC to submit these statements with reconciliation to the US GAAP. This is useful as GAAP dictate the method of accounting to be utilized by the companies in the United States and its analysts and investors will also need to transform the IAS dictated BP statements to GAAP to be able to make meaningful comparisons with other companies in an investment decision.

Q. What cost flow assumption is Exxon using Is Exxon providing enough information to calculate ending inventory for 2006 and COGS for 2006 using an alternative method
Exxon is presenting its financial statements using the LIFO assumption. This means that the inventory at the end of the year is recorded on the balance sheet at the last prices for the goods which are higher, thus resulting in a relatively higher amount of inventory appearing on the balance sheet. Consequently, the COGS are recorded using lower costing goods which reduce the ultimate figure appearing on the income statement. To convert LIFO to FIFO requires the LIFO reserve to be mentioned. While this may not be explicitly stated, aggregate replacement costs for inventories are mentioned which basically reflect price difference between the FIFO inventory and the same inventory being bought in todays prices, which is effectively the LIFO reserve. The four figures mentioned in the footnote when added to the LIFO figures represented in the Exxon balance sheet return FIFO inventory figures equal to 26.6 billion for 2006, 24.7 billion for 2005 and 19.28 billion for 2004. Thus we can see that Exxon is providing enough information to provide for conversion of the LIFO inventory to FIFO via the LIFO reserve figures being represented in the footnotes to the financial statements. FIFO COGS can also be calculated using the COGS represented in LIFO and subtracting change in LIFO reserve from it. This requires the use of the same LIFO reserve figures mentioned above and their differences calculated. The LIFO inventory figure for 2003 is also given in the notes for this purpose as it allows the difference to be calculated with respect to the previous year in 2004 to get the FIFO COGS figure at the end of that period.

Q. Based on information in the case, are you able to compare inventory balances, COGS, inventory turnover and net profit margin for Exxon and BP in 2006
The inventory balances for BP and Exxon can be compared. Even though the former represents its inventory using FIFO and the latter with LIFO, the LIFO reserve figures that are mentioned in the notes to the financial statements by Exxon allow the LIFO inventory to be expressed in FIFO, thus allowing comparisons to be carried out between the two companies in this regard.

COGS present that same problem that both are calculated using different cost flow assumptions. However, the LIFO reserves for four years allow differences between them to be calculated which enables the FIFO COGS to be calculated for Exxon. After that, the figures of Exxon can be compared with those of BP to determine which has higher costs of goods sold.

Inventory turnover is a ratio that is basically calculated by dividing the COGS for a company with the average inventory at the years end. The denominator in this case is determined by adding the inventory figures at the start and end of the year and dividing them by 2. We have already shown that the cost flow assumption used by Exxon and the reconciliation tools provided allow it to be converted to LIFO inventory and COGS. Thus calculating the inventory turnover for both allows comparison to be made with regards to how long inventory is being kept by either company.

Net profit margin is calculated by dividing net income figure by the sales figure and deriving the percentage. The denominator is easy to acquire as the sales for both companies will be according to the prices they charge for their products and the number of products sold adjusted for discounts and returns, represented in US dollars. This will be independent of accounting standards. Net income however will be obtained after subtracting expenditures determined via different accounting standards. However, BP presents its financial statements by showing a reconciliation of its profit figure in IAS with US GAAP. This will allow similar net profit margins to be obtained and comparisons made between BP and Exxon.

Q. Which company do you think is using the better method to account for inventories Discuss in the context of an investor interested in investing in these companies. Explain clearly why you prefer one over the other

BP is using the better method to account for inventories and COGS when considering from the stand point of investors looking to make an investment decision. This has to be seen through the viewpoint of the implications for use of either assumption. For Exxon, the LIFO usage is beneficial to the extent that it results in higher COGS appearing on the income statement which leads to a lower EBIT figure and hence lower taxes. This means that cash outflow for tax expenditures would be less as compared to using FIFO which is what BP is doing. However, there are certain advantages that BP does get from this. Investors will be better able to trust BPs financial statements as representing economic reality as their accounting is done in a more conservative manner and do not look to inflate or deflate COGS. This means that for similar changes in fortunes of both companies, the BP stock may experience a better price appreciation compared to Exxon as its statements will be viewed as more fair. Since the investors do not possess private information about the firm like the management does and the managements actions are used as useful indicators of what the true fortunes of a company may be like, BPs continued use of FIFO may reflect that management views scope for the company as favorable as they are foregoing potentially favorable cash flow and tax savings by sticking to FIFO when LIFO is available if statements are filed using GAAP in the United States. This confidence is what the investor would prefer in the case of BP as the management is providing a hint for a good future for the company as opposed to Exxon which is sticking to tax savings and cash flow improvements through use of accounting tricks rather than better performance.