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# Financial Reporting and Analysis【 Reading 21】Sample

Selected information from Yorktown Corp.’s financial statements for the year ended December 31, 2004 was as follows (in \$ millions):
 Accounts Payable 8 Long-term Debt 9 Common Stock 17 Retained Earnings 23 Total Liabilities & Equity 57

In 2004, Yorktown paid \$10 million cash to purchase a franchise.  The franchise cost was fully expensed in 2004.  If the company had elected to amortize the franchise cost over 5 years instead of expensing it, Yorktown’s total debt ratio (total debt-to-total capital) would (ignore taxes):
 A) decrease from 0.298 to 0.262.
 B) increase from 0.474 to 0.551.
 C) decrease from 0.474 to 0.403.

Total capital equals total assets which must equal total liabilities and equity. Yorktown’s total debt ratio was ((\$8 + \$9) / \$57 =) 0.298. If the franchise cost were amortized, retained earnings would be increased \$8 million (\$10 cost less (\$10 / 5 =) \$2 million of amortization.) The total debt ratio would change to ((\$8 + \$9) / (\$57 + \$8) =) 0.262.

Which of the following statements regarding the capitalization of an expense is least accurate?
 A) Capitalizing an expense creates an asset.
 B) Capitalizing an expense lowers current period net income.
 C) Capitalized expenses increases equity.

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.
When comparing capitalizing versus expensing costs which of the following statements is most accurate?
 A) Capitalizing costs creates higher cash flows from operations and lower cash flows from investing.
 B) Expensing costs creates lower cash flows from operations and lower cash flows from investing.
 C) Capitalizing costs creates lower cash flows from operations and higher cash flows from investing.

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.
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) 35.6%.
 B) 38.9%.
 C) 31.1%.

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%.
Compared with firms that expense costs, firms that capitalize costs can be expected to report:
 A) higher asset levels and higher equity levels in the early years of the asset's life.
 B) higher asset levels and lower equity levels in the early years of the asset's life.
 C) lower asset levels and higher equity levels in the early years of the asset's life.

The capitalized cost is recorded as an asset, which is then expensed in the form of depreciation over future years. Spreading the depreciation out over future years causes net income to increase along with retained earnings and equity in the early years of the asset’s life.
Under U.S. generally accepted accounting principles (GAAP), which of the following costs associated with intangible assets is most likely to be capitalized?
 A) Research and development costs associated with software development.
 B) The costs associated with an internally created trademark.
 C) The cost of an acquisition of a patent from an outside entity.

The cost of an acquisition of a patent from an outside entity is correct because this cost may be capitalized.
Capitalizing interest costs related to a company’s construction of assets for its own use is required by:
 A) both IFRS and U.S. GAAP.
 B) IFRS only.
 C) U.S. GAAP only.

Both U.S. GAAP and IFRS require companies to capitalize the interest that accrues during a the construction of capital assets for their own use.
Capitalized interest costs are typically reported in the cash flow statement as an outflow from:
 A) operating.
 B) investing.
 C) financing.

Capitalized interest costs are reported as CFI on the statement of cash flows, as they are treated as part of the cost of the constructed capital asset.
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) have smoother reported income over time.
 B) report a smooth income pattern initially, but income variability will increase over time.
 C) have lower income variability as it grows, but the variability will increase as the firm matures.

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.
Compared to firms that expense costs, firms that capitalize expenses will have:
 A) higher leverage ratios.[size=+0]
 B) lower income variablity.
 C) lower cash flow from operations.

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.
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