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16.  Which of the following is the least likely reason as to why a firm’s management would increase the value of a capital asset that had been previously written down? A. Management wants to increase ROE in future periods. B. The company is approaching the leverage limits of its borrowing agreement. C. Management is concerned that income for the current year will fall below levels expected by analysts.

Ans: A. The increase in an asset’s value would increase depreciation expense and therefore decrease ROE in future periods, not increase it. An asset revaluation that reverses a previous downward revaluation is reported in net income in the period it is revalued. Hence management can use upward revaluations to increase net income (and hence meet the analysts’ expectations). This one-time increase in net income would increase ROE for the current year only.

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15.  A company, which prepares its financial statements in accordance with IFRS uses the revaluation model to value land. At the end of the current year the land value of the land has increased and will be adjusted on the balance sheet. Which of the following statements is most accurate? In the current period the revaluation of the land will: A. increase return on sales. B. increase return on assets. C. decrease the debt to equity ratio.

Ans: C. The increase in the value of the land bypasses the income statement and goes directly to a revaluation surplus account in equity. Equity increases thereby decreasing the debt to equity ratio. A is incorrect. Return on sales= The increase in the value of the land bypasses the income statement and goes directly to a revaluation surplus account in equity. It doesn’t affect net income or sales. So the return on sales stays the same. B is incorrect. Return on asset= The increase in the value of the land increases asset, while the net income stays the same. So it decreases the return on asset.

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14. A Mexican corporation is computing the depreciation expense of a piece of manufacturing equipment for the fiscal year ended December 31, 2010 using the information below. The company takes a full year’s depreciation in the year of acquisition. Date of purchase January 1, 2010 Cost of equipment MXN 2,000,000 Estimated residual value MXN 200,000 Expected useful life 10 years Total productive capacity 5,000,000 units Production in 2010 800,000 units The depreciation expense (in MXN) will most likely be: A. 180,000 lower using the straight-line method compared with the double-declining balance method. B. 140,000 higher using the units-of-production method compared with the straight-line method. C. 112,000 higher using the double-declining method compared with the units-of-production method.

Ans: C.          The difference between the double declining balance and units-of-production is: 400,000 – 288,000 = 112,000. Straight-line Units of Production Declining balance Rate 1/10 5,000,000 units 1/10 x 2 = 20% Annual expense 2,000,000 – 200,000 10 (2,000,000 – 200,000) x (800,000/5,000,000) 0.20 x 2,000,000 = 180,000 = 288,000 = 400,000 Difference between the declining balance and units of production is: = 400,000 – 288,000 = 112,000

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13. At the start of the year, a company acquired new equipment at a cost of €50,000, estimated to have a 3 year life and a residual value of €5,000. If the company depreciates the asset using the double declining balance method, the depreciation expense that the company will report for the third year is closest to: A. €555. B. €3,328. C. €3,705.

Ans: A. Under double declining balance method, the depreciation rate would be 2 x the straight line rate of 33.3%, i.e., 66.6%, or 2/3 depreciation rate per year. However, the asset should not be depreciated below its assumed residual value in any year. Double Declining Method of Depreciation Year Net BV at Start of Year Depreciation Net BV at End of Year 1 50,000 33,333 16,667 2 16,667 11,111 5,555 3 5,555 * 555 ** 5,000 * Alternative calculation for start of Year 3 Net Book Value: 50,000 x (1-0.667) x (1-0.667) = 5,555 ** Depreciation cannot be 2/3 x 5,555 = 3,705 since that would reduce book value to below the estimated 5,000

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12. A company recently purchased a warehouse property and related equipment (shelving, forklifts, etc.) for €50 million, which were valued by an appraiser as follows: Land €10 million, building €35 million, and equipment €5 million. The company incurred the following additional costs in getting the warehouse ready to use: ? €2.0 million for repairs to the building’s roof and windows ? €0.5 million to modify the interior layout to meet their needs (moving walls and doors, inserting and removing partitions, etc.) ? €0.1 million on an orientation and training session for employees to familiarize them with the facility The cost to be capitalized to the building account (in millions) for accounting purposes is closest to: A. €37.0. B. €37.5. C. €38.5.

Ans: B. The capitalized cost of the building would include the other costs that are directly attributable to the building and are involved in extending its life or getting it ready to use: Initial cost €35.00 Repairs to roof and windows 2.00 Modifications to interiors 0.50 Total cost €37.5 million

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11.  A company has announced that it is going to distribute a group of long-lived assets to its owners in a spin-off. The most appropriate way to account for the assets until the distribution occurs is to classify them as: A. held for sale with no depreciation taken. B. held for use until disposal with no deprecation taken. C. held for use until disposal with depreciation continuing to be taken.

Ans. C. Long-lived assets that will be disposed of other than by sale, such as a spin-off, an exchange for other assets, or abandonment, are classified as held for use until disposal and continue to be depreciated until that time.

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10. Hadinoto Enterprises Inc. (HEI) purchased equipment for $400,00 on January 1, 20x5. The equipment has a 4 year life and no salvage value. HEI estimates that the equipment will be used to produce the following units of inventory: Year Unites 20x5 100,000 20x6 200,000 20x7 400,000 20x8 300,000 To maximize profit margin for 20x5, the depreciation method HEI will use is : A. Straight-line B. Units of production. C. Double-declining balance.

Ans: B. The unit-of-production method will result in the lowest depreciation expense and therefore the highest profit margin in 20x5. 20x5 depreciation is calculated as follows using the three methods: Straight-line = $400,000/4years=$100,000 Double-declining balance = $400,000*(1/4)*2=$200,000 Units of production: Depreciation rate = $400,000/1,000,000 units = $0.40 / unit 20x9 depreciation = $0.40/ unit * 100,000 units = $40,000

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9. During the early years of an asset’s life, a company using an accelerated depreciation method, rather than straight-line, could expect a lower value for: A. Asset turnover. B. Shareholders’ equity. C. Asset turnover and shareholders’ equity.

Ans: B. Shareholders’ equity would be less during the early years of the asset’s expected life because depreciation expense is higher, net income is lower, and retained earnings is lower. Asset turnover (sales/assets) is greater during the early years because accelerated depreciation increase accumulated depreciation at a faster rate than doer straight-line, thus reducing assets and increasing asset turnover.

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8. A company purchases a piece of equipment costing $7,000,000 that it expects will have a useful life of 5 years and a salvage value of $600,000. Assuming that the company uses double-declining-balance depreciation method rather than straight-line depreciation methods, the third-year depreciation expense difference and EBIT will be: A. $272,000 and the EBIT is higher using DDB. B. $400,000 and the EBIT is lower using DDB. C. $675,200 and the EBIT is higher using DDB.

Ans: A. Straight-line depreciation =(cost- salvage value) / useful life                                           = ($7,000,000 - $600,00)/5                                           = $1,280,000 DDB depreciation expense =(original cost- accumulation depreciation) * original cost- accumulation depreciation=net book value Year 1 = $7,000,000 *0.4=$2,800,000 Year 2 beginning net book value = $7,000,000-$2,800,000                                                      =$4,200,000 Year 2 = $4,200,000 * 0.4 = $1,680,000 Year 3 beginning net book value = $4,200,000 - $1,680,000                                                       =$2,520,000 Year 3 = $2,520,00 * 0.4 = $1,008,000 Depreciation expense in the third year will be $272,000 less using DDB, so EBIT (operating income) will be $272,000 higher. Note that year 3 is the crossover year in which depreciation expense from both methods was nearly equal. In the years after the crossover year, DDB will provide less tax shelter from depreciation and thus a higher EBIT.

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7. Which of the following would be expensed rather than capitalized as property, plant and equipment if incurred during construction of a new facility? A. Interest costs during construction. B. Expenses associated with classified advertising to recruit new employees. C. Shipping costs for an assembly required for customizing new equipment.

Ans. B. All administrative costs associated with hiring plant employees would be expensed in the period incurred. U.S.GAAP requires capitalizing interest costs on any project financed using debt, freight expenses incurred as part of making equipment ready for production, and labor costs incurred prior to the start of plant operations. B. Under both IFRS and U.S.GAAP, the interest costs incurred during the construction of a long-lived asset, such as a new manufacturing or distribution facility, are required to be capitalized. C. Shipping costs for an assembly required for customizing new equipment should be capitalized.