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Doug Dalby, CFA and Luke Brown, CFA are consulting to the executive board of Housekeeping Enterprises (Housekeeping) concerning strategic changes to the company’s balance sheet.
Housekeeping is considering changing its inventory accounting method to FIFO from LIFO. Dalby briefs the board on the effect of falling/rising prices and stable or increasing inventory quantities, on cost of goods sold and cash flows, depending on inventory accounting method.
Housekeeping would like to capitalize various costs it had previously been expensed, but is worried about the change being refused by its auditors. The board asks Brown which costs are most likely to be capitalized under U.S. GAAP.If Housekeeping uses last in, first out (LIFO) reports an inventory balance of $44,000 and a LIFO reserve of $8,000 (assume a 40% effective tax rate), the estimated value for the inventory on a first in, first out (FIFO) basis would be closest to:

A) $48,800.

B) $36,000.

C) $52,000.

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FIFO INV = LIFO INV + LIFO Reserve
X = 44,000 + 8,000
X = 52,000The effective tax rate is not used in this calculation.
(Study Session 5, LOS 20.b)

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In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report cost of goods sold which is:

A) higher.

B) the same.

C) lower.

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In this situation, LIFO results in higher cost of goods sold because it uses the more recent and higher costs than FIFO. (Study Session 5, LOS 20.a)

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In periods of rising prices and stable or increasing inventory quantities, a company using LIFO rather than FIFO will report cash flows which are:

A) the same.

B) lower.

C) higher.

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LIFO results in higher cash flows because with lower reported income, income tax will be lower. (Study Session 5, LOS 20.a)

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If Housekeeping changed policy and capitalizes some costs instead of expensing them, the company will:

A) have a higher reported income initially, with lower income levels to follow invariably.

B) have a lower reported income initially, with higher income levels to follow invariably.

C) have a higher reported income as long as capitalized expenditures exceed depreciation on them.

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If management decides to capitalize costs instead of expensing them, it will report higher income as long as such capitalized expenses exceed the depreciation of such expenses in later periods. (Study Session 5, LOS 21.a)

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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. (Study Session 5, LOS 21.a)

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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 cost of an acquisition of a patent from an outside entity.

C) The costs associated with an internally created trademark.

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The cost of an acquisition of a patent from an outside entity is correct because this cost may be capitalized. When patents and copyrights are internally developed, only the legal fees incurred for registration can be capitalized. However, if the patents and copyrights are purchased from other entities, full acquisition cost can be capitalized. (Study Session 5, LOS 21.a)

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Management of the Beef, Etc. corporation has changed certain accounting assumptions in hopes of improving the public perception of the company’s prospects. These accounting assumptions relate primarily to the treatment of capitalized expenses and long-term leases. Lisa Kelps, CFA, wants to adjust the financial statements to make them more comparable across years and to similar firms in the same industry. When comparing a company that expenses with a company that capitalizes the same expense, analyst can adjust the cash flow statement of the company that capitalizes by:

A) increasing cash flow from investing activities and reducing cash flow from operations.

B) increasing cash flow from investing activities and increasing cash flow from operations.

C) reducing cash flow from investing activities and reducing cash flow from operations.

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When adjusting cash flow statement, we want to reverse capitalizing of expenses. For that we reduce cash flow from operations (due to lower net income as expenses are recognized), and reduce cash outflow from investing activities. Reducing cash outflow is the same as increasing cash flow.

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When comparing a company that expenses with a company that capitalizes the same expense, analyst can adjust the earnings before tax of the company that capitalizes by:

A) subtracting the capitalized expenses and adding back amortization of capitalized expenses.

B) adding the capitalized expenses and adding back amortization of capitalized expenses.

C) subtracting the capitalized expenses and subtracting amortization of capitalized expenses.

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When adjusting the earnings before tax, we want to reverse capitalizing of expenses.
For that we use:
Adj. EBT = EBT − Capitalized exp. + Amortization of Capitalized exp.

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When comparing a company that reports a lease as an operating lease with a company that reports that same lease as a financial lease, the company that reports a lease as an operating lease will most likely:

A) report higher profits, lower return measures and lower solvency in earlier years.

B) report lower profits, higher return measures and lower solvency in earlier years.

C) report higher profits, higher return measures and higher solvency in earlier years.

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Companies that report a lease as an operating lease instead of a finance lease will usually have higher profits in early years due to lower lease expense as compared to sum of depreciation and interest expense under a finance lease. Due to higher reported profits, return measures (Profit Margin, ROA, ROE etc. will be higher). Also, since operating lease does not recognize a liability, solvency measures are higher.

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For firms that expense rather than capitalize costs, which of the following statements is least accurate?

A) Lower ROA and ROE will occur because of higher asset and equity levels in the early years.

B) Net cash flows are the same regardless of which method is used.

C) Higher debt/equity and debt/assets will occur because of lower asset and equity levels.

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Firms that expense costs rather than capitalize costs will have lower ROE and lower ROA in early years. This occurs because of lower profits and not because of higher assets and equity levels. Actually, the assets and equity are lower due to expensing the costs.

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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) higher cash flows from operations and lower cash flow from investing.

C) lower profitability (ROA & ROE) in early years and higher in later years.

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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.

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Which of the following statements about depreciation is least accurate?

A) For a firm with increasing capital expenditures, accelerated depreciation methods tend to increase both net income and stockholders' equity when compared to straight-line depreciation.

B) Return on assets is initially higher using straight-line depreciation than it is using accelerated depreciation.

C) If an asset produces a constant stream of net income over its useful life and is depreciated using the straight-line method, the rate of return on the asset increases over its life.

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For a firm with increasing capital expenditures, accelerated depreciation methods tend to decrease both net income and stockholders' equity when compared to straight-line depreciation. Assuming the firm continues to invest in new assets, the following relationships hold. These relationships will eventually reverse if the firm's capital expenditures decline.

	Straight Line	Accelerated (DDB & SDY)
Depreciation Expense	Lower	Higher
Net Income	Higher	Lower
Assets	Higher	Lower
Equity	Higher	Lower
Return on Assets	Higher	Lower
Return on Equity	Higher	Lower

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Roger Margotta, the CFO of Brainchild, Inc., is considering several alternative methods of depreciation for long-term assets. With respect to double-declining method of depreciation, which of the following statements is the most accurate?

A) Current ratio will increase over the life of the asset.

B) Asset turnover ratio will decrease over the life of the asset.

C) Return on Investment will increase over the life of the asset.

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With the use of any accelerated method of depreciation, the deductions in assets and net income are greatest in the early years. For DDB, the greatest impact is year 1. After year 1, net income will increase, increasing ROI.

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Which of the following statements comparing straight-line depreciation methods to alternative depreciation methods is least accurate? Companies that use:

A) accelerated depreciation methods will decrease the amount of taxes in early years.

B) the units-of-production method to depreciate assets will overstate income during periods of low production.

C) accelerated depreciation methods will increase the total amount of depreciation expense over the life of an asset.

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Accelerated depreciation methods will not change the total amount of depreciation expense over the life of an asset. Accelerated depreciation methods will increase the amount of depreciation expense in the early years of the asset’s life, but the depreciation expense will be less in the latter years of the asset’s life.

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A company is switching from straight-line depreciation to an accelerated method of depreciation. Assuming all other revenue and expenses are at the same levels for the next period, switching to an accelerated method will most likely increase the company’s:

A) total assets on the balance sheet.

B) net income/sales ratio.

C) fixed asset turnover ratio.

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The use of an accelerated depreciation method will increase depreciation expenses early in the asset’s life. The book value of the asset will be lower. Fixed asset turnover ratio (sales/fixed assets) will increase, because the book value of the fixed assets will be lower.

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Lakeside Co. recently determined that one of its processing machines has become obsolete three years early and, unexpectedly, has no salvage value. Which of the following statements is most consistent with this discovery?

A) Historically, economic depreciation was understated.

B) Historically, economic depreciation was overstated.

C) Lakeside Co. will owe back taxes.

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Historically, economic depreciation was understated. If an asset becomes obsolete and its useful life is less than expected, accounting methods for depreciation have understated the economic depreciation. In addition, if there is no salvage value when positive salvage value was expected, the understatement problem is compounded.

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As part of a major restructuring of business units, General Security (an industrial conglomerate operating solely in the U.S. and subject to U.S. GAAP) recognizes significant impairment losses. The Investor Relations group is preparing an informational packet for shareholders, employees, and the media. Which of the following statements is least accurate?

A) The write-downs are reported as a component of income from continuing operations.

B) Write-downs taken on asset values can be reversed in later years if market conditions improve.

C) During the year of the write-downs, retained earnings and deferred taxes will decrease.

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Impairments cannot be restored under U.S. GAAP. Both remaining statements are correct.