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LOS d: Interpret the effect of differences between international and U.S. GAAP accounting standards on the balance sheet, income statement, and the statement of changes in equity for some commonly used financial ratios.

United Corporation and Intrepid Company are similar firms operating in the same industry. United follows U.S. Generally Accepted Accounting Principles and Intrepid follows International Financial Reporting Standards. At the end of last year, Intrepid had a higher inventory turnover ratio than United. Are the following plausible explanations for the difference?

Explanation #1 – United accounts for its inventory using the first-in, first-out method and Intrepid uses the last-in, first-out method.

Explanation #2 – United recognized an upward valuation of inventory that had been previously written down. Intrepid does not revalue its inventory upward.

While the LIFO firm will typically report lower average inventory (higher inventory turnover), Intrepid cannot be a LIFO firm because LIFO is not permitted under IFRS. An upward revaluation of inventory would lower the inventory turnover ratio; however, United cannot revalue its inventory upward because it follows U.S. GAAP. U.S. GAAP prohibits upward inventory revaluations (except in very limited circumstances which are beyond the scope of the Level 1 exam).

What would be the impact on a firm’s return on assets ratio (ROA) of the following independent transactions, assuming ROA is less than one?

Transaction #1 – A firm owned investment securities that were classified as available-for-sale and there was a recent decrease in the fair value of these securities.

Transaction #2 – A firm owned investment securities that were classified as available-for-trading and there was recent increase in the fair value of the securities.

Available-for-sale securities are reported on the balance sheet at fair value and any unrealized gains and losses bypass the income statement and are reported as an adjustment to equity. Thus, a decrease in fair value will result in a higher ROA ratio (lower assets). Trading securities are also reported on the balance sheet at fair value; however, the unrealized gains and losses are recognized in the income statement. Therefore, an increase in fair value will result in higher ROA. In this case, both the numerator and denominator are higher; however, since the ratio is less than one, the percentage change of the numerator is greater than the percentage change of the denominator, so the ratio will increase.

Three years ago, Ranchero Corporation purchased a patent for a process used in production, for ?3 million. At the end of last year, Ranchero determined the fair value of the patent was greater than its book value. No impairment losses have been recognized on the patent. Assuming Ranchero follows International Financial Reporting Standards, what is the impact on its total asset turnover ratio and return on equity of reporting the value of the patent on the balance sheet at fair value?

Increasing the value of the patent on the balance sheet will increase assets and thus decrease the total asset turnover ratio (higher denominator). Increasing the value of the patent will also increase equity, otherwise, the balance sheet equation would not balance. Increasing equity will result in lower ROE (higher denominator). The increase in the value of the patent is not recognized in the income statement unless it is reversing a previously recognized write-down.

Patch Grove Nursery uses the LIFO inventory accounting method. Maria Huff, president, wants to determine the financial statement impact of changing to the FIFO accounting method. Selected company information follows:

Under FIFO, the nursery’s ending inventory and after-tax profit for the year would have been:

FIFO ending inventory = LIFO ending inventory + LIFO reserve = 22,000 + 4,000 = $26,000

FIFO after-tax profit = LIFO after-tax profit + (change in LIFO reserve)(1 ? t) = $2,000 + ($1,000)(1 ? 0.4) = $2,000 + $600 = $2,600