honeycfa

Selected information from the financial statements of Salvo Company for the years ended December 31, 2003 and 2004 is as follows (in $ millions):

	2003	2004
Sales	$21	$23
Cost of Goods Sold	(8)	(9)
Gross Profit	13	14
Cost of Franchise	(6)	0
Other Expenses	(6)	(6)
Net Income	$1	$8
Cash	$4	$5
Accounts Receivable	6	5
Inventory	9	7
Property, Plant & Equip. (net)	12	15
Total Assets	$31	$32
Accounts Payable	$7	$5
Long-term Debt	10	5
Common Stock	8	8
Retained Earnings	6	14
Total Liabilities and Equity	$31	$32

Salvo’s return on average total equity for 2004 was ($8 / (($8 + $6) + ($8 + $14)) / 2 =) 44.4%.

If Salvo had amortized the cost of the franchise acquired in 2003 over six years instead of expensing it, Salvo’s return on average total equity for 2004 would have decreased from 44.4% to:

A) 31.1%.

B) 35.6%.

C) 38.9%.

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If the franchise cost had been amortized over six years beginning in 2003, net income in 2003 would have been $6 million instead of $1 million due to the cost of franchise expense of $6 million being eliminated and replaced by franchise amortization of $1 million. Net income in 2004 would have been reduced by the franchise amortization to $7 million instead of $8 million. On the equity side, retained earnings at the end of 2003 would have been $11 million ($5 million higher), and total equity for 2003 would have been ($8 + $11 =) $19 million. Retained earnings for 2004 would be the 2003 retained earnings of $11 million increased by 2004 net income of $7 million for a total of $18 million, and total equity for 2004 would be ($8 + $18 =) $26 million. If the franchise cost were amortized, return on total equity for 2004 would be ($7 / ((19 + 26) / 2 =) 31.1%.

honeycfa

Compared to firms that expense costs, firms that capitalize expenses will have:

A) higher leverage ratios.

B) lower cash flow from operations.

C) lower income variablity.

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Firms that capitalize expenses have less variability of net income because the capitalized expense becomes an asset that is depreciated over years instead of all at once which happens when costs are expensed. Capitalizing expenses will result in higher cash flows from operations because capitalizing an expense becomes an investing cash flow instead of an operating cash flow which occurs when expenditures are expensed. Firms that capitalize expenses have lower leverage ratios because assets and equity are increased so any leverage ratio that have assets and equity in the denominator will decrease.

honeycfa

Which of the following statements regarding the capitalization of an expense is least accurate?

A) Capitalizing an expense creates an asset.

B) Capitalized expenses increases equity.

C) Capitalizing an expense lowers current period net income.

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Capitalizing expenses reduces current period expenses by the amount capitalized. The amount capitalized is added to assets which increases equity by increasing net income and retained earnings in the current period.

honeycfa

Dobkin Company decides to expense costs that it would have otherwise capitalized. Compared to capitalizing, expensing these costs will result in:

A) lower asset levels and lower equity levels.

B) lower asset levels and higher equity levels.

C) lower asset levels and lower liability levels.

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Expensing instead of capitalizing results in lower assets. Since the entire expense is recognized in the current period (whereas only a portion of the expenditure is amortized when capitalizing), net income (and therefore equity, via retained earnings) is lower with expensing than with capitalizing. Liabilities are unaffected.

honeycfa

The management of Berger Investments has changed their policy and will capitalize some costs instead of expensing them. Due to the new policy, Berger will:

A) report a smooth income pattern initially, but income variability will increase over time.

B) have lower income variability as it grows, but the variability will increase as the firm matures.

C) have smoother reported income over time.

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If management decides to capitalize costs instead of expensing them, it will report smoother reported income over time. If the firm decided to expense costs as incurred, it will have greater variability in reported income. This variability declines as the firm matures and is lower for larger firms.

honeycfa

When comparing capitalizing versus expensing costs which of the following statements is most accurate?

A) Expensing costs creates lower cash flows from operations and lower cash flows from investing.

B) Capitalizing costs creates lower cash flows from operations and higher cash flows from investing.

C) Capitalizing costs creates higher cash flows from operations and lower cash flows from investing.

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Although net cash flows are not affected by the choice of capitalization or expensing, the components of cash flow are affected. Because, a firm that capitalizes classifies the expenditure as investing (not operations), cash flow from operations will be higher for firms that capitalize and investing cash flows will be lower than that of an expensing firm.

honeycfa

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.

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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.