How do different accounting method choices affect ratio comparisons between companies?

Cross-company comparability is a core analytical skill at Level II. Different accounting choices can make similar companies look very different on paper.

Key Accounting Choices That Affect Ratios:

FIFO-LIFO Adjustment (Most Common):

To convert a LIFO company to FIFO for comparison:

• Inventory: Add LIFO reserve to inventory
• COGS: Subtract the increase in LIFO reserve from COGS
• Equity: Add LIFO reserve x (1 - tax rate) to equity
• Tax liability: Add LIFO reserve x tax rate

Example -- Comparing Steelmont (LIFO) to Ironclad (FIFO):

Steelmont reports: Inventory $400M, LIFO reserve $60M, COGS $800M (LIFO reserve increased by $10M during the year), Tax rate 25%.

Adjusted for FIFO:

• Inventory = $400M + $60M = $460M
• COGS = $800M - $10M = $790M
• Equity increase = $60M x (1 - 0.25) = $45M

Lease Capitalization Adjustment:

To capitalize an operating lease for comparison:

1. Calculate PV of future lease payments (use disclosure in footnotes)
2. Add PV as both an asset and a liability
3. Replace rent expense with depreciation + interest
4. Reclassify part of cash payment from CFO to CFF

General Framework for Adjustments:

1. Identify the accounting differences from footnotes
2. Calculate the adjustments needed to make methods comparable
3. Restate the financial statements on a common basis
4. Recalculate ratios using adjusted figures
5. Note that adjustments are estimates and may not be perfect

Exam Tip: Level II item sets often present two companies with different accounting methods and ask you to adjust one to match the other, then compare ratios.

Practice accounting method adjustments in our CFA Level II question bank.