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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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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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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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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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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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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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20. An analyst gathers the following information ($ millions) about three companies operating in the same industry: Company Annual Depreciation Expense Accumulated Depreciation 1 10.8 58.9 2 27.8 80.3 3 33.6 128.8 Although the companies have different levels of sales and assets, they are all experiencing sales growth at about the same rate and use the same type of equipment in the manufacturing process. All three companies also use the same depreciation method. Which company is least likely to require major capital expenditures in the near future? Company: A. 1. B. 2. C. 3.

Ans: B. Average age of assets = accumulated depreciation/annual depreciation expense Company 1: 58.9/10.8 = 5.5 years Company 2: 80.3/27.8 = 2.9 years Company 3: 128.8/33.6 = 3.8years Because Company 2 has the lowest average age of assets, it is least likely to need major capital expenditures.

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19. A company prepares its financial statements in accordance with U.S. GAAP (generally accepted accounting principles). It expected to be the sole supplier for a state-wide school milk program and had production facilities valued at $28.4 million. Recently several other companies were also granted milk-supply contracts throughout the state and the company now estimates that it will only be able to generate cash flows of $3 million per year for the next 7 years with its facilities. The firm has a cost of capital of 10%. The impairment loss (in $-millions) on the production facilities will most likely be reported in the company’s financial statements as a: A. 13.8 reduction in operating cash flows. . B. 13.8 impairment loss in the income statement C. 7.4 reduction in the balance sheet carrying amount.

Ans: B. The company will report an impairment loss in the income statement: The facilities fail the recoverability test, the net book value cannot be recovered from undiscounted cash flows: 7 yrs x $3 = $21 < $28.4. Therefore, the asset is impaired. The asset should be written down to its fair value. Fair Value: PV of future benefits: (N=7; i=10; PMT=3): PV = 14.6 Impairment Loss: Carrying Value – Fair Value: 28.4 - 14.6 = 13.8 to be reported on the income statement

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18. Two software companies that report their financial statements under U.S. GAAP (generally accepted accounting principles) are identical except as to how soon they judge a project to be technologically feasible. One firm does so very early in the development cycle while the other usually waits until just before the project is released to manufacturing. Compared to the company that judges technological feasibility early, the one that waits until closer to manufacturing will most likely report lower: A. financial leverage. B. total asset turnover. C. cash flow from operations.

Ans: C. U.S. GAAP requires that a company expense costs related to software development until product feasibility is established and capitalize any costs thereafter. The company that capitalizes these software development costs reports the expenditures in the investing activities section of the statement of cash flows; the company that expenses software development costs reports the expenditures in the cash flow from operations.

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17. A Canadian printing company which prepares its financial statements according to IFRS has experienced a decline in the demand for its products. The following information relates to the company’s printing equipment as of 31 December 2010. C$ Carrying value of equipment (net book value) 500,000 Undiscounted expected future cash flows 550,000 Present value of expected future cash flows 450,000 Fair Value 480,000 Costs to sell 50,000 Value in use 440,000 The impairment loss (in C$) is closest to: A. 0. B. 60,000. C. 70,000.

Abs: B. Under IFRS, an asset is considered to be impaired when its carrying amount exceeds its recoverable amount (the higher of fair value less cost to sell or value in use). Fair value less costs to sell: 480,000 – 50,000 = 430,000 Value in use = 440,000 Recoverable amount (higher value) = 440,000 Impairment loss under IFRS = Carrying value – recoverable amount = 500,000 – 440,000 = 60,000 Note: impairment of long-lived tangible assets held for use An impairment loss is recognized when the carrying (book) value of the tangible of the asset exceeds its fair value and the carrying value is not recoverable. Impairment losses are recognized on the income statement. Under IFRS, an impairment loss exists when the carrying value of an asset exceeds the recoverable amount. The recoverable amount is the greater of its fair value less any selling costs and its value in use. The value in use is the present value of its future cash flow. 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. 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. 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.