GAAP vs. IFRS Part Two
After speaking a bit about the differences between IFRS and GAAP in a previous article, I wanted to take the time and actually show how a company could be valued differently just by using some of the specifics that are allowed / disallowed as a result of filing under one of the two systems.
One of the greatest differences between GAAP and IFRS is that IFRS forces companies to use the first in first out (FIFO) form of accounting for their inventory. On the other hand, GAAP will allow a company to choose whether or not they want to use FIFO or the last in first out (LIFO) method. (Again, FIFO is allowed under GAAP methods, however, this article is also good for an understanding the difference between two US companies, one using LIFO and the other using FIFO). There are associated benefits and also risks by choosing one of the two methods, but it is important to actually see how the same company can be made to look otherwise better or worse just by which methods they use.
Let us run through a few quick scenarios to see what could potentially happen:
As you can see, the company has 10,000 units of a good in their inventory that is valued at a cost of $1.00 per unit. In either the GAAP or IFRS accounting standards, this is the baseline.
Now, let us assume that the company anticipates a high level of upcoming sales, so it decides to acquire additional inventory rather than face a shortage for when the time comes to sell.
As you can see, the company has added inventory to their reserves in anticipation of the upcoming increase in sales, however the cost to acquire this final inventory has gone up to $1.25 per unit. So, the company still has 10,000 units in inventory valued at $1.00, and now 5,000 units at $1.25. This is standard to both methods of accounting and nothing major has happened yet.
Where the difference emerges is where the company made a sale. Below are three quick scenarios that are sure to occur in any sort of business practice and see how the situation is handled by both standards of accounting.
1. Average Sale.
If we assume that the units can be sold across all scenarios at $2.00 per unit, then you will see what happens under the different scenarios below. Assume that the GAAP company is using LIFO to try and capture the advantages for argument’s sake, and the IFRS company is using FIFO.
When the company sells off 4,000 units at the $2.00 the above results occur. As you can see, by using LIFO, the GAAP method would sell the last items into inventory before they sold the items valued earlier. This would lead to the same exact sales in both cases, but by being able to include a higher than average cost of goods sold (COGS), the GAAP company will be able to carry a lower overall income and therefor profit to their bottom line. This might seem like a bad thing, but they are actually reducing their tax liability by doing this. It should be noted that the IFRS had sold off all 4,000 units but had to account for the sales by their earliest evaluated cost.
Second – Large Sale
In this scenario, we assume that 6,000 units are sold. This isn’t a problem for either company, but it starts to go against the strategy of the company when they are using the GAAP standards because the sales are actually “cutting into” the LIFO layers. It doesn’t harm the company now, because even though the company had to cut into the LIFO layers they still have created a higher COGS and will continue to reduce their tax liability. The problem may come down the line for the company if they are using the GAAP method of evaluation, because they are eating into the very inventory stock that they had set up for the entire purpose of lowering their tax liability. It doesn’t hurt them as much as it is counterproductive to their plans.
Third – Largest Sale
This example is just like the last one where the entire plan for the company when using the GAAP method of accounting starts to crumble. Yes they have been able to capitalize on reducing their cost of goods sold, but at the same time they have completely eaten away at their LIFO layer and will not be able to replicate what they did here much longer. Meanwhile, the IFRS method would allow the company to do business as usual and not think twice about their inventory method.
As you can see this would severely affect the actual valuations of the company just in one simple time period, and yet the exact same sales and valuations took place. The only thing that differed was the actual method of accounting (LIFO vs. FIFO), and yet some investors would inevitably value the company higher if they looked at the IFRS statements versus the GAAP statements.
This can not only lead us to suggest that individuals would need to dig deeper into the actual methodology of how any given company is valuated in order to get a strong benchmark, it would also suggest that for international (or cross national) valuations due diligence must exist. If you evaluate two similar companies that follow the different methods and get different answers, or if you were to evaluate two similar companies and get numbers that are relatively the same, what does it actually tell you? For this reason you must look deeper into the company/companies and understand the differences between not just FIFO/LIFO, but the GAAP and IFRS statements altogether.