Question

Very Briefly describe the following concepts and for each one explain using an example how each concept may cause a distortion in doing Financial Analysis within a single company or across different companies. There is no single right answer or example of how a distortion may occur. Rather there are many. Think through the concept and pick an example. 1. One company uses LIFO and the other uses FIFO 2. Accelerated Depreciation methods 3. An operating lease VS a Capital lease relative to the balance sheet

Answer 1

One company uses LIFO and the other uses FIFO

LIFO & FIFO = LIFO (Last in First Out) and FIFO (First in First out) are methods to determine the value of COGS (Cost of goods sold) and closing inventory. LIFO method assumes goods last added to the inventory are assumed to be first removed from inventory for sale. While, FIFO method assumes goods first added to the inventory are assumed to be first removed from inventory for sale.

Distortion on Finacial Analysis - In case of inflation, LIFO method will show higher value of Inventory and lower the income of the company and taxes paid on it. Whereas, FIFO method will show the lower value of inventory and higher income

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Accelarated Depreciation Method - As per this method asset loses book value at accelarated (faster) rate in the earlier years of an asset. It could be 200% declining or 150% declining where asset will be depreciated 200%/150% of straight line method. There's another method which is called sum of the year digits method.e.g. If assets's useful life is 3 years then it would be depreciated 50% (3/6) in first year, 33.33% (2/6) in 2nd year and 16.67% (1/6) in 3rd year.

Distortion on Finacial Analysis - Higher depreciation will make lower income and lower taxes in initial years.

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Operating Lease vs. Capital Lease -

Operating Lease	Capital Lease
Risk & Rewards are not transferred to Lessee with the transfer of the assets	Risk & Rewards are transferred to Lessee with the transfer of the assets
It's treated like renting	it's treated like loan

Distortion on Finacial Analysis -

Impact on	Operating Lease	Financial Lease
Balance Sheet	Asset or liability will not be recorded	Lessee will record equipment as asset and PV of minimum lease payments as Liability
Income Statement	Operating lease will be trated as operating expense	Interest expense will be included in income statement but principal payment will not be included in income statement but depreciation expenses will be included