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Reading 22: Long-lived Assets: Implications for Financial Sta

Session 5: Financial Reporting and Analysis: Inventories and Long-lived Assets
Reading 22: Long-lived Assets: Implications for Financial Statements and Ratios

LOS b: Discuss the implications for financial statements and ratios of the different depreciation methods for property, plant, and equipment.

 

 

For firms that expense rather than capitalize costs, which of the following statements is least accurate?

A)
Net cash flows are the same regardless of which method is used.
B)
Higher debt/equity and debt/assets will occur because of lower asset and equity levels.
C)
Lower ROA and ROE will occur because of higher asset and equity levels in the early years.


 

Firms that expense costs versus capitalize costs, they will have a lower ROE and ROA in early years because of lower profits and not due to higher assets and equity levels (actually the assets and equity are lower due to expensing the costs).

Meyer Investment Advisory and Smith Brothers Investments are operationally identical except that Meyer capitalizes some costs that Smith expenses. Compared to Smith, Meyer is likely to have:

A)
higher debt/equity ratio and higher debt/assets ratio.
B)
lower profitability (ROA & ROE) in early years and higher in later years.
C)
higher cash flows from operations and lower cash flow from investing.


The net cash flow remains the same regardless of which accounting method is used. But components of cash flows change and cash flows from operations (CFO) will be higher when costs are capitalized and lower when expensed. On the other hand, cash flows from investing (CFI) will be lower when costs are capitalized and higher when expensed. Compared to firms expensing costs, firms that capitalize costs will have smaller debt to equity ratios and higher initial ROAs, but lower ROAs in the future.

TOP

Which of the following statements about depreciation is least accurate?

A)
Return on assets is initially higher using straight-line depreciation than it is using accelerated depreciation.
B)
For a firm with increasing capital expenditures, accelerated depreciation methods tend to increase both net income and stockholders' equity when compared to straight-line depreciation.
C)
If an asset produces a constant stream of net income over its useful life and is depreciated using the straight-line method, the rate of return on the asset increases over its life.


For a firm with increasing capital expenditures, accelerated depreciation methods tend to decrease both net income and stockholders' equity when compared to straight-line depreciation.

Assuming the firm continues to invest in new assets, the following relationships hold. These relationships will eventually reverse if the firm's capital expenditures decline.

Straight Line Accelerated (DDB & SDY)
Depreciation Expense Lower Higher
Net Income Higher Lower
Assets Higher Lower
Equity Higher Lower
Return on Assets Higher Lower
Return on Equity Higher Lower

TOP

Roger Margotta, the CFO of Brainchild, Inc., is considering several alternative methods of depreciation for long-term assets. With respect to double-declining method of depreciation, which of the following statements is the most accurate?

A)
Return on Investment will increase over the life of the asset.
B)
Current ratio will increase over the life of the asset.
C)
Asset turnover ratio will decrease over the life of the asset.


With the use of any accelerated method of depreciation, the deductions in assets and net income are greatest in the early years. For DDB, the greatest impact is year 1. After year 1, net income will increase, increasing ROI.

TOP

Which of the following statements comparing straight-line depreciation methods to alternative depreciation methods is least accurate? Companies that use:

A)
accelerated depreciation methods will decrease the amount of taxes in early years.
B)
the units-of-production method to depreciate assets will overstate income during periods of low production.
C)
accelerated depreciation methods will increase the total amount of depreciation expense over the life of an asset.


Accelerated depreciation methods will not change the total amount of depreciation expense over the life of an asset. Accelerated depreciation methods will increase the amount of depreciation expense in the early years of the asset’s life, but the depreciation expense will be less in the latter years of the asset’s life.

TOP

A company is switching from straight-line depreciation to an accelerated method of depreciation. Assuming all other revenue and expenses are at the same levels for the next period, switching to an accelerated method will most likely increase the company’s:

A)
total assets on the balance sheet.
B)
net income/sales ratio.
C)
fixed asset turnover ratio.


The use of an accelerated depreciation method will increase depreciation expenses early in the asset’s life. The book value of the asset will be lower. Fixed asset turnover ratio (sales/fixed assets) will increase, because the book value of the fixed assets will be lower.

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