Accounting
Textbooks
Boundless Accounting
Controlling and Reporting of Inventories
Detail on Using LIFO
Accounting Textbooks Boundless Accounting Controlling and Reporting of Inventories Detail on Using LIFO
Accounting Textbooks Boundless Accounting Controlling and Reporting of Inventories
Accounting Textbooks Boundless Accounting
Accounting Textbooks
Accounting
Concept Version 9
Created by Boundless

Comparability

If a company uses LIFO, the recorded amount of inventory is not an accurate reflection of cost, reducing comparability to companies using FIFO.

Learning Objective

  • Explain why comparability is important for valuing a company


Key Points

    • The LIFO method results in lower ending (and beginning) inventory on a company's balance sheet because the oldest (and therefore usually less expensive due to inflation) items remain in the inventory.
    • If a company uses LIFO, recorded inventory is not an accurate reflection of cost of the current period. This low valuation affects the computation and evaluation of current assets and any financial ratios that include inventory, reducing comparability between companies using different methods.
    • The most common normalization adjustments fall into the following four categories: Comparability Adjustments, Non-operating Adjustments, Non-recurring Adjustments, and Discretionary Adjustments.

Terms

  • valuation

    The process of estimating the market value of a financial asset or liability.

  • adjustment

    a small change; a minor correction; a modification

  • comparability

    Comparison or equivalence.


Full Text

Why Comparability is Important

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to perfect a sale of a business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to:

  • estate and gift taxation,
  • divorce litigation,
  • allocating business purchase price among business assets,
  • establishing a formula for estimating the value of partners' ownership interest for buy-sell agreements,
  • and many other business and legal purposes.

Seasonal Inventory

Valuing inventory using the LIFO method.

Inventory Valuation with LIFO

The LIFO method results in lower ending (and beginning) inventory on a company's balance sheet because the oldest (and therefore usually less expensive due to inflation) items remain in the inventory. Based off of this information, one can assume that if a company uses LIFO, the recorded amount of inventory is not an accurate reflection of cost of the current period. This low valuation affects the computation and evaluation of current assets and any financial ratios that include inventory, resulting in reduced comparability between companies using LIFO and others using FIFO.

Normalization (adjustment) methods

Comparability Adjustments

The valuer may adjust the subject company's financial statements to facilitate a comparison between the subject company and other businesses in the same industry or geographic location. These adjustments are intended to eliminate differences between the way that published industry data is presented and the way that the subject company's data is presented in its financial statements.

Non-operating Adjustments

It is reasonable to assume that if a business were sold in a hypothetical sales transaction (which is the underlying premise of the fair market value standard), the seller would retain any assets which were not related to the production of earnings or price those non-operating assets separately. For this reason, non-operating assets (such as excess cash) are usually eliminated from the balance sheet.

Non-recurring Adjustments

The subject company's financial statements may be affected by events that are not expected to recur, such as the purchase or sale of assets, a lawsuit, or an unusually large revenue or expense. These non-recurring items are adjusted so that the financial statements will better reflect the management's expectations of future performance.

Discretionary Adjustments

The owners of private companies may be paid at variance from the market level of compensation that similar executives in the industry might command. In order to determine fair market value, the owner's compensation, benefits, perquisites and distributions must be adjusted to industry standards. Similarly, the rent paid by the subject business for the use of property owned by the company's owners individually may be scrutinized.

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