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21.Assume U.S. GAAP (generally accepted accounting principles) applies unless otherwise noted. A company has equipment with an original cost of $850,000, accumulated amortization of $300,000 and 5 years of estimated remaining useful life. Due to a change in market conditions the company now estimates that the equipment will only generate cash flows of $80,000 per year over its remaining useful life. The company’s incremental borrowing rate is 8 percent. Which of the following statements concerning impairment and future return on assets (ROA) is most accurate? The asset is: A. impaired and future ROA increases. B. impaired and future ROA decreases. C. not impaired and future ROA increases.

Ans: A. Under U.S.GAAP, an asset is tested for impairment only when events and circumstance indicate the firm may not be able to recover the carrying value through future use. 1. Recoverability test. An asset is considered impaired if the carrying value (original cost less accumulated depreciation) is greater than the asset’s future undiscounted cash flow stream. 2. Loss measurement. If impaired, the asset’s value is written down to fair value on the balance sheet and a loss, equal to the excess of carrying value over the fair value of the asset (or the discounted value of its future cash flows if the fair value is not known), is recognized in the income statement. The equipment is impaired. NBV = $550,000 which is greater than the sum of the undiscounted cash flows 5 yrs x $80,000 = $400,000. The company’s future ROA will increase. Once the asset is written down, there will be lower depreciation charges, which will increase net income, and a lower carrying value of assets, which decreases total assets. Both factors would increase any future ROA.

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22. A company acquires some new depreciable assets. Which of the following combinations of estimated salvage value and useful life will most likely produce the highest net profit margin? A. low salvage value estimates and long average lives. B. high salvage value estimates and long average lives. C. high salvage value estimates and short average lives.

Ans: B. A high salvage value estimate reduces the depreciable base and thus depreciation expense; long average lives reduce the annual depreciation expense for any givendepreciable base. The combination of the two would result in the lowest depreciation expense which leads to the highest net income and profit margins.

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23. A company acquires a manufacturing facility in which it will produce toxic chemicals. The cost of the facility (exclusive of the underlying land) is $25 million and it is expected to provide a 10-year useful life, after which time the company will demolish the building and restore the underlying land. The cost of this restoration and cleanup is estimated to be $3 million at that time. The facility will be amortized on a straight-line basis. The company’s discount rate associated with this obligation is 6.25 percent. The total expense that will be recorded in the first year associated with the asset retirement obligation on this property is closest to: A. $163,618. B. $224,945. C. $265,879.

Ans: C. The PV of the future cleanup costs = 1,636,183 (FV = 3,000,000; N = 10; I/Y = 6.25; PMT = 0; CPT PV). The firm will record asset retirement costs of $1,636,183 as part of the cost of the property and a corresponding ARO liability of $1,636,183. The asset retirement costs will be amortized at the same rate as the property (10 years, straight-line) and an accretion expense representing the change in the ARO liability will also arise. Depreciation Expense=1/10 x 1,636,183 = 163,618 Accretion Expense = 6.25% x 1,636,183 = 102,261 Total Expense                                              265,879

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24. A European based company follows IFRS (International Financial Reporting Standards) and capitalizes new product development costs. During 2008 they spent€25 million on new product development and reported an amortization expense related to a prior year’s new product development of €10 million. Other information related to 2008 is as follows: € millions Net income 225 Cash flow from operations 290 An analyst would like to compare the European company to a similar U.S. based company and has decided to adjust their financial statements to U.S. GAAP. Under U.S. GAAP, and ignoring tax effects, the cash flow from operations (€ millions) for the company would be closest to: A. 265. B. 275. C. 290.

Ans: A. If all development costs had been expensed then net income would be reduced by the amount spent, and increased by the amortization of the previously capitalized amounts: 225 – 25 + 10 = 210 million. CFO would be lower by the amount spent on development 290 – 25 = 265 million. Note: The amortization of previous development costs is a non-cash expense so does not affect cash flow.

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25. On 1 January, a company, which prepares its financial statements according to IFRS, arranged financing for the construction of a new plant. The company: · Borrowed NZ$5,000,000 at an interest rate of 8%. · Issued NZ$5,000,000 of preferred shares with a cumulative dividend rate of 6%, and · During the first year of construction of the company was able to temporarily invest NZ$2,000,000 of the loan proceeds for the first six months and earned 7% on that amount. The amount of financing costs to be capitalized (NZS) to the cost of the plant in the first years is closest to: A. 330,000. B. 400,000. C. 630,000.

Ans: A. The interest costs can be capitalized. Under IFRS any amount earned by temporarily investing the period in which they are incurred. Capitalized costs Interest costs 0.08x5,000,000=400,000 Less interest income 0.07x2,000,000x0.5=(70,000) Total capitalized costs 330,000

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26. Lazlo Ltd, a European-based telecommunications providers, follows IASB GAAP and capitalizes new product development costs. During 2012 they spent €25 million on new product development and reported an amortization expense related to a prior year’s new product development of €10 million. Other information related to 2012 is as follows: In €millions Net income 225 Average assets 1,875 CFO 290 An analyst would like to compare Lazlo to a US-based telecommunications provider and has decided to adjust their financial statements to U.S.GAAP. under U.S.GAAP, and ignoring tax effects, the return on asset (ROA) and cash flow from operations (CFO) for Lazlo would be closest to: ROA CFO millions A 10.7% €265 B 10.7% €275 C 11.2% €265

Ans: C. If all development costs had been expensed then net income would be reduced by the amount spent, and increased by the amortization of the previously capitalized amounts: 225-25+10=210 million. ROA=210/1,875=11.2%. CFO would be lower by the amount spent on development 290-25=265 million. Note: the amortization of previous development costs is a non-cash expense so does not affect cash flow.

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27. The following are excerpts from Bao, Inc. financial statements related to its fixed assets activity for the fiscal year ended June 30, 2004 ($million): Capital expenditures $30.0 Depreciation expense $20.0 Gross PP&E $390.0 Net PP&E $275.0 Assuming the firm uses straight line depreciation, the average age and the average depreciable life of Bao’s fixed assets are closest to: A. 7 years for average age and 20 years for average depreciable life. B. 6 years for average age and 14 years for average depreciable life. C. 6 years for average age and 20 years for average depreciable life.

Ans: C. Accumulated depreciation=gross PP&E – net PP&E                                            = $390 – 275                                            = $115 Average age = accumulated depreciation / depreciation expense                      = $115/ 20 =5.8 years Depreciable life = gross PP&E / depreciation expense                            = $390/20 = 19.5 years

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28. Based on recently complied projections, management expects that the book value of Asset X will not be recovered. The following information for Asset X is available: 2010 2011 2012 Net book value $610,500 $520,700 $390,200 Net realizable value 645,171 545,046 342,772 Value in use 615,350 523,220 365,735 In accordance with IFRS, the amount of the write-down is closest to: A. $24,346. B. $24,465. C. $47,428.

Ans: B. Under IFRS, an impairment loss exists when the carrying amount (net book value) of the assets exceeds its recoverable amount. The recoverable amount is defined as the greater of the assets net realizable value (fair value costs to sell) and its value in use: 2010 2011 2012 Net book value $610,500 $520,700 $390,200 Net realizable value 645,171 545,046 342,772 Value in use 615,350 523,220 365,735 Recoverable amount 645,171 545,046 365,735 In 2010 and 2011, there is no impairment because the carrying amount of the asset is less than the recoverable amount. In 2012, the carrying amount exceeds the recoverable amount, so an impairment loss equal to $24,465 ($390,200-365,735) must be recognized.

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29. The capitalization of interest (versus expensing) will have which of the following effects on a company’s financial ratios? A. Lower interest coverage ratio. B. Lower debt-to-equity ratio. C. Higher asset turnover ratio.

Ans: B. The capitalization of interest will increase shareholders’ equity, resulting in a lower debt-to-equity ratio. A is incorrect. Since interest expense (denominator) will be lower when interest is capitalized, the interest coverage ratio will be higher, not lower. C is incorrect. The capitalization of interest will result in a larger asset base and a lower asset turnover ratio (sales/ average assets).

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30. A company, which prepares its financial statements according to IFRS, owns several investment properties on which it earns rental income. It values the properties using the fair value model based on prevailing rental markets. A summary of the properties’ valuations is as follows: Original cost (acquired in 2009) €50million Fair value valuation as at 31 December 2009 €50.5million Fair value valuation as at 31 December 2010 €54.5million Fair value valuation as at 31 December 2011 €48.0million Which of the following best describe the impact of the revaluation on the 2011 financial statements? A. €6.5million charge to net income. B. €6.5million charge to revaluation surplus. C. €4.5million charge to revaluation surplus and €2.0 million charge to net income.

Ans: A. For investment properties, when using the fair value model of revaluing assets, all increases and decreases affect the net income. Here, it is 54.5 – 48.0 = 6.5.