Adjustments to a Company’s Financial Statements to Facilitate Comparison

Analysts frequently make adjustments to a company’s reported financial statements when comparing those statements to those of another company that uses different accounting methods, estimates, or assumptions. Adjustments include those related to investments, inventory, property, plant, and equipment; goodwill; and off-balance-sheet financing.

Analyst Adjustments to Financial Statements

Analyst Adjustments Related to Investments

If two comparable companies have significant differences in the classification of investments, analyst adjustments may be useful in the facilitation of meaningful comparison.

Management’s intention will determine how investments in other companies’ debt and equity securities are accounted for. When securities are classified as “financial assets measured at fair value through profit or loss,” unrealized gains and losses will be reported in the income statement. However, when securities are classified as “financial assets measured at fair value through other comprehensive income,” unrealized gains and losses are not reported in the income statement. Instead, they are recognized in equity.

Analyst Adjustments Related to Inventory

The inventory method a company opts to use affects the value of inventory reflected on its balance sheet and the value of the cost of goods sold.

Companies that use the LIFO (last-in, first-out) method of inventory must also disclose the value of their inventory under the FIFO (first-in, first-out) method. To recast the inventory values for a company that uses the LIFO method on a FIFO basis, an analyst must add the ending balance of the LIFO reserve to the ending value of inventory under the LIFO method. Also, to adjust the cost of goods sold on a FIFO basis, an analyst must subtract the change in the LIFO reserve from the reported cost of goods sold under LIFO accounting.

Analyst Adjustments Related to Property, Plant, and Equipment

The amount of reported depreciation expense depends on the choice of accounting method and the estimates used in the calculations. Companies can either use the straight-line method, accelerated method, or usage method to depreciate fixed assets other than land. In addition to selecting a depreciation method, companies must estimate the asset’s salvage value and useful life to compute depreciation expense.

Depreciation is related to the following accounts:

• the balance sheet accounts for gross property, plant, and equipment (PPE), and accumulated depreciation;
• the income statement amount for depreciation expense; and
• the statement of cash flows disclosure of capital expenditure (CAPEX) and asset disposals.

PPE includes a mix of assets that have different depreciable lives and salvage values. Analysts look at the following relationships between these pools of assets:

• accumulated depreciation divided by gross PPE: this suggests how much of the useful life of the overall asset base has passed;
• accumulated depreciation divided by depreciation expense: this suggests how many years’ worth of depreciation expense have already been recognized;
• net PPE divided by depreciation expense: this gives an approximation of the number of years of useful life which remain for the overall asset base;
• gross PPE divided by depreciation expense: this suggests the average life of the company’s assets at installation;
• capex divided by the sum of gross PPE plus CAPEX: this suggests what percentage of the company’s asset base is renewed through capital investment; and
• capex concerning asset disposal: this provides information on the growth of the company’s asset base.

Analyst Adjustments Related to Goodwill

Goodwill comes from the company buying another at a price that is higher than the fair value of the net identifiable assets of the acquired company. Net identifiable assets, for that matter, include fixed assets, current assets, and specific intangible assets that need a valuation in the context based on the combination of a business, such as brand and technology. Goodwill, which is the difference between the purchase price and the fair value of the acquired entity, is usually recorded as an asset. The goodwill is tested annually for impairment. If it is impaired, the acquiring company should reduce the amount of the asset and report a write-off resulting from the impairment.

One challenge concerning goodwill is the comparative financial statement analysis. Ratios such as profitability ratios will generally differ among the companies due to differences in the accounting of the assets and income from intangible assets and goodwill.

Question 1

In relation to analyst adjustments related to inventory, which of the following statements is the least accurate?

1. In recasting inventory values for a company using LIFO reporting on a FIFO basis, the ending balance of the LIFO reserve must be added to the ending value of inventory under the LIFO method.
2. In recasting inventory values for a company using LIFO reporting on a FIFO basis, the ending balance of the LIFO reserve must be subtracted from the ending value of inventory under the LIFO method.
3. In adjusting the cost of goods sold on a FIFO basis, an analyst must subtract the change in the LIFO reserve from the reported cost of goods sold under LIFO accounting.

Solution

The correct answer is B.

In recasting inventory values for a company using LIFO reporting on a FIFO basis, the ending balance of the LIFO reserve must be added to, not subtracted from, the ending value of inventory under the LIFO method.

Options A and C are accurate statements.

Question 2

To compare two companies, the financial statements of these companies should most likely be:

1. Used as reported without adjustments.
2. Adjusted after completing a ratio analysis.
3. Adjusted for differences in accounting standards such as IFRS and US GAAP before making the comparison.

Solution

The correct answer is C.

If the financial reports were not adjusted before making the comparison, the comparison results would be wrong.