Adjusting Financial Statements for Comparability | CFA Level I FSA

PREREQUISITE LESSON

This lesson is a prerequisite for the course. While you won’t be directly tested on its content in the exam, it’s assumed you’ve gained this knowledge or skill during your university studies. We strongly recommend reviewing this lesson, as its content may be essential for understanding subsequent parts of the curriculum.

Today, we’ll discuss the common adjustments analysts often make to increase the accuracy and comparability of a company’s financials.

Comparing Financials: A Reality Check

When comparing a company’s statements and ratios against its peers, we assume they use the same accounting standards and methods. However, this is often not the case. Companies can have different accounting methods, even under the same standard, and local accounting standards can differ across nations.

It’s an analyst’s duty to adjust the financial statements of the firm under evaluation to make comparisons fair. Let’s look at some common adjustments.

Adjusting for Investment Securities Classifications

Take this example of three firms (A, B, and C) with different classifications of investment securities:

• Firm A: held-to-maturity
• Firm B: available-for-sale
• Firm C: trading security

Even though all 3 firms bought security XYZ for $10,000, their financial statements and ratios look different due to their classifications when the value of XYZ increased to $15,000. An analyst should adjust for these differences to ensure a fair comparison.

Adjusting for Differences between IFRS and US GAAP

Unrealized gains and losses from exchange rate fluctuations on available-for-sale debt securities are recorded on the income statement under IFRS but not US GAAP. Analysts should adjust such items from the income statement when comparing firms that report under different standards.

Adjusting for LIFO and FIFO

Remember that a firm using the LIFO cost flow method will report higher cost of goods sold, lower inventory, and lower income in an inflationary environment compared to a firm using FIFO.

To adjust LIFO-based statements to FIFO-based statements, analysts should follow these steps:

1. Add the LIFO reserve to LIFO inventory on the balance sheet.
2. Remove the LIFO reserve multiplied by the tax rate from the cash balance.
3. Increase retained earnings by the LIFO reserve times (1 minus the tax rate).
4. Subtract the change in the LIFO reserve for the period from the LIFO cost of goods sold.

Adjusting for Depreciation

Adjusting for depreciation is not straightforward due to often insufficient disclosures related to depreciation. However, if an analyst believes that aggressive accounting is practiced, they can adjust net income and fixed asset carrying values to make the figures and ratios more comparable.

Adjusting for Intangible Assets

Intangible assets, such as goodwill, can cause significant differences in asset values on the balance sheet. To improve comparability, analysts should subtract goodwill from assets when calculating financial ratios and reverse any expense from impairment of goodwill on the income statement, thus increasing reported net income.

When calculating book value per share, some analysts choose to remove goodwill from the calculation or exclude all intangible assets, resulting in a more comparable tangible book value per share ratio.

And that’s it! Pay attention to the methods outlined for forecasting income and cash flows, as well as the various analyst adjustments to financial statements.