long-lived assets(Reading 30)

Exercise Problems:

1. On January 1, Year 1, a firm purchases a machine for $68,000 that has an estimated useful life of five years, at which time it will have a salvage value of $10,000. Using the double-declining balance method, Year 3 depreciation expense is closest to:

A. $27,200

B.$16,320

C. $9,792

Ans: C

Double-declining balance method does not consider salvage value when calculating depreciation. So depreciation expense on:

Year 1= 2/5($68,000-0)= $27,200

Year 2= 2/5($68,000-27,200)=$16,320

Year 3= 2/5 ($68,000-27,200-16,320)=$9,792

A. $27,200 is Year 3 depreciation expense under double-declining balance method

B. $16,320 is Year 2 depreciation expense under double-declining balance method

2. A company records an asset retirement obligation (ARO) because of environmental damage. Which of the following will most likely result from the recording an ARO in any given year?

A. An increase in return on equity and an increase in depreciation expense

B. An decrease in return on equity and an increase in depreciation expense

C. An decrease in return on equity and an decrease in depreciation expense

Ans: B

Obligation associated with the retirement of tangible fixed assets are referred to as asset retirement obligations (AROs) and include costs for cleaning up the operating site and restoring it to pre-existing conditions, including rectifying any environmental damages.

ARO accounting requires companies to record an asset and a related liability for costs incurred to remedy environmental damage. The asset increase will result in an increase in depreciation expense that will reduce net income. Lower net income will reduce the company’s return on equity.

3. The effects on a firm’s financial statement in the initial year when cost of an asset is expensed rather than capitalized are:

A. Pre-tax cash flow is lower and the debt-to-equity ratio is higher.

B. Pre-tax cash flow remains the same and the debt-to-equity ratio is lower.

C. Pre-tax cash flow remains the same and the debt-to-equity ratio is higher.

Ans: C

Pre-tax cash flow stays the same because depreciation (or amortization) is a non-cash expense.

However, when the cost is expensed rather then capitalized, net income and retained earnings are lower, resulting in a lower equity. So the debt-to-equity ratio will be higher.

Effects of expensing versus capitalizing costs in the year of the capitalization:

4. Which of the following would most likely be lower in the early years of an asset’s life using accelerated depreciation methods rather than straight-line depreciation?

A. Investing cash flow

B. Shareholder’s equity

C. Cash flow from operations

Ans: B

The greater depreciation expense in the early years of an asset’s life using accelerated depreciation methods rather than straight-line depreciation would lead to lower net income and lower retained earnings in those years. Lower retained earnings would result in lower shareholders’ equity.

Effect of depreciation method on financial statements and key ratios:

5. An analyst has gathered the following information from the current year fixed asset disclosures of three competing companies:

Based on this information, which company is depreciating its building over the longest average period?

A. Company X.

B. Company Y.

C. Company Z.

Ans: B.

Based on the average depreciable lives of these buildings, Company Y’s buildings are being depreciated over the longest average period. The average depreciable lives can be calculated as follows:

Company X=

Company Y=

Company Z =

6. An analyst is comparing the financial statements of Company A and Company B. both companies have incurred expenses of approximately $250 million in the current year to expand their production facilities. Company A is highly leveraged. Company B does not have any outstanding debt and paid the $250 million from internal cash reserves. The most likely effect of the difference in the capital structures of the two companies will be:

A. Company A will report higher asset balances related to the facilities under construction.

B. The companies will report the same asset balances related to the facilities under construction.

C. Company A’s interest coverage ratio will be lower than it would have been if the company had expensed all interest.

Ans. A.

Since Company A is leveraged, it will be required to capitalize the interest related to the construction project even if there was no borrowing specially for the $250 million (an assumption is made that the money actually came from some kind of borrowing, even if there is no specific loan for the amount). Company B on the other hand, will not have any interest to capitalize. As a result, Company A’s balance sheet will reflect an amount in excess of the $250 million for the facilities under construction, while Company B will reflect only the $250 million.

B is incorrect. Company A will report an amount in excess of the $250 million in construction costs, which includes the capitalized interest related to the project. Company B, on the other hand, will not have any capitalized interest to report.

C is incorrect.

If interest is capitalized, EBIT is unchanged and interest expense falls. These changes will cause the interest coverage ratio to be higher, not lower.

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.

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.

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.

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:

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

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.

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:

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.

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.

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.

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.

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.

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.

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.

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.

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

20. An analyst gathers the following information ($ millions) about three companies operating in the same industry:

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.

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.

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.

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

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:

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.

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.

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:

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:

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.

27. The following are excerpts from Bao, Inc. financial statements related to its fixed assets activity for the fiscal year ended June 30, 2004 ($million):

Assuming the firm uses straight line depreciation, the average age and the average depreciable life of Bao’s fixed assets are closest to:

A. 7 years for average age and 20 years for average depreciable life.

B. 6 years for average age and 14 years for average depreciable life.

C. 6 years for average age and 20 years for average depreciable life.

Ans: C.

Accumulated depreciation=gross PP&E – net PP&E

                                           = $390 – 275

                                           = $115

Average age = accumulated depreciation / depreciation expense

                     = $115/ 20 =5.8 years

Depreciable life = gross PP&E / depreciation expense

                           = $390/20 = 19.5 years

28. Based on recently complied projections, management expects that the book value of Asset X will not be recovered. The following information for Asset X is available:

In accordance with IFRS, the amount of the write-down is closest to:

A. $24,346.

B. $24,465.

C. $47,428.

Ans: B.

Under IFRS, an impairment loss exists when the carrying amount (net book value) of the assets exceeds its recoverable amount. The recoverable amount is defined as the greater of the assets net realizable value (fair value costs to sell) and its value in use:

In 2010 and 2011, there is no impairment because the carrying amount of the asset is less than the recoverable amount. In 2012, the carrying amount exceeds the recoverable amount, so an impairment loss equal to $24,465 ($390,200-365,735) must be recognized.

29. The capitalization of interest (versus expensing) will have which of the following effects on a company’s financial ratios?

A. Lower interest coverage ratio.

B. Lower debt-to-equity ratio.

C. Higher asset turnover ratio.

Ans: B.

The capitalization of interest will increase shareholders’ equity, resulting in a lower debt-to-equity ratio.

A is incorrect. Since interest expense (denominator) will be lower when interest is capitalized, the interest coverage ratio will be higher, not lower.

C is incorrect. The capitalization of interest will result in a larger asset base and a lower asset turnover ratio (sales/ average assets).

30. A company, which prepares its financial statements according to IFRS, owns several investment properties on which it earns rental income. It values the properties using the fair value model based on prevailing rental markets. A summary of the properties’ valuations is as follows:

Which of the following best describe the impact of the revaluation on the 2011 financial statements?

A.    €6.5million charge to net income.

B.     €6.5million charge to revaluation surplus.

C.     €4.5million charge to revaluation surplus and €2.0 million charge to net income.

Ans: A.

For investment properties, when using the fair value model of revaluing assets, all increases and decreases affect the net income. Here, it is 54.5 – 48.0 = 6.5.

31. A company purchased equipment in 2011 for ￡25,000; the year-end values for accounting purposes and tax purposes are as follows:

Which of the following statements best describes the effect of the change in the tax rate on the company’s 2012 financial statements? The deferred tax liability:

A. Increased by ￡250.

B. Decreased by ￡200.

C. Decreased by ￡800.

Ans: B.

Deferred tax liability = taxable temporary difference x tax rate.

In 2010 if the rates had not changed, the deferred tax liability would be:

0.30x4,000=￡1,200

1,200But with the lower tax rate, the deferred tax liability will be:

0.25 × 4,000 =￡1,000

Effect of the change in rate therefore is a decrease in the liability: 1,200-1,000=200

Alternative calculation = change in rate × taxable difference:–5% × 4,000=￡ (200)

32. An analyst has gathered the following information about a company’s capital assets:

As at the end of 2012, the expected remaining life of the assets, in years, is closest to:

A. 6.

B. 17.

C. 20.

Ans: B.

The expected remaining useful life of a company’s overall asset base = net PPE ÷ depreciation expense.

Depreciation expense equals the change in accumulated depreciation *

375 – 250 = 125

The expected remaining useful life

2,125 ÷ 125 = 17 years

*When there are no asset dispositions or acquisitions, as appears to be the case here, because the gross PPE does not change.

33. During 2011, the following events occurred at a company. The company:

Based on these events, the amortization expense that the company should report in 2012 is closest to:

A. $25,000.

B. $45,000.

C. $125,000.

Ans: A.

The customer list is the only identifiable intangible asset and it should be amortized on a straight-line basis over its expected future life: $100,000/4=$25,000 per year. Goodwill is an generated intangible that is not recorded on the balance sheet and is therefore not amortized.

34. For which type of long-lived asset is it most appropriate to test for impairment at least annually:

A. Property, plant and equipment.

B. Intangible assets with finite live.

C. Intangible assets with indefinite lives.

Ans: C.

Intangible assets with indefinite lives need to be tested for impairment at least annually.

A and C are incorrect. PP&E and intangible with finite lives are tested only if there has been a significant change or other indication of impairment.

35. A company that prepares its financial statements in accordance with IFRS standards is in the process of developing a more efficient production process for one of its primary products. The most appropriate accounting treatment for the costs incurred in the project is to:

A. expense all cost as incurred.

B. capitalize costs directly related to the development.

C. expense costs until technical feasibility has been established.

Ans: C.

Under IFRS research and development costs are expensed until certain criteria are met, including that technical feasibility has been established and the company intends to use it.

(Under U.S.GAAP, both research and development costs are generally expensed as incurred. One exception is software development.)

36. On January 1, 2009, Bao limited bought a piece of manufacturing equipment for $250,000. At that time they estimated its useful life to be 10 years and its salvage value to be $10,000. During 2011, it became apparent that the equipment was wearing our more quickly than they had originally estimated. It now appeared that its useful life would only be 6 years in total. If Bao Limited uses the straight-line method for depreciation and  has a policy of only taking one-half year’s depreciation in the year of acquisition, the depreciation expense on this piece of equipment for 2011 will be closest to:

A. $48,000.

B. $51,000.

C. $53,125.

Ans: B.

Original depreciation (250,000-10,000)/10=24,000 per year. They have taken 1.5year worth (0.5 for 2009 and full year for 2010)=36,000. The new estimate is for 6 years in total and 2 years have passed, so there are 4 years remaining. Revised depreciation (250,000-36,000-10,000)/4=$51,000.

37. Bao Incorporated recently paid more than the net book value to acquire Cleanway Corporation. Cleanway operates an active research and development program into environmentally friendly cleaning products. Bao is very interested in this research program as well as the good management team in place at Cleanway. The excess price paid over the net book value of the assets should be accounted for on Bao’s financial statements as:

A. goodwill.

B. a trademark.

D. an intangible asset, research and development.

Ans: A.

The excess price paid over the net book value during an acquisition that cannot be assigned to other identifiable assets is assumed to be for goodwill. Goodwill is said to be an unidentifiable asset that cannot be separated from the business itself.

38. Two companies are identical except for their accounting treatment of research and development costs. On e company expenses all such costs immediately, while the other company capitalizes a portion of the costs. Compared to the company that capitalizes costs, the company that expenses immediately will most likely:

A. earn a lower ROA.

B. have a lower financial leverage.

C. report lower cash flow from operations in the statement of cash flows.

Ans: C.

Companies that capitalize research and development costs report those expenditures in the investing activities section of the statement of cash flows; companies that expense research and development costs report those expenditures in cash flow from operations.

A is incorrect.

ROA=. The company expensing all research and development costs has both lower NI and lower total assets, while the company capitalizing all the research and development costs has both higher NI and higher total assets. So whose ROE is lower cannot be determined.

B is incorrect.

Financial leverage =

The company expensing all research and development costs has both lower total assets and lower total equity, while the company capitalizing all the research and development costs has both higher total assets and higher total equity. So whose ROE is lower cannot be determined.

39. A firm that rents DVDs to customers capitalizes the cost of newly released DVDs that it purchases and depreciates them over years to a value of zero. Based on the underlying economics of the DVD rental business, the most appropriate method of depreciation for the firm to use on its financial statements is:

A. straight-line.

B. declining balance.

C. units-of-production.

Ans: B.

Since the value of newly released DVDs will typically fall most rapidly in the first year after their release, some form of accelerated depreciation is appropriate. The declining balance method is the only accelerate depreciation method among the answer choices.

A is incorrect. Straight-line depreciation is appropriate when the decrease in value is uniform over an asset’s life.

C is incorrect. Units-of-production depreciation assumes that there is a given amount of service that an asset will provide.

40. In the period when a firm makes an expenditure, capitalizing the expenditure instead of recognizing it as an expense will result in higher:

A. debt-to-equity and debt-to-assets ratios.

B. net income and have no effect on total cash flows.

C. cash flow from investing and lower cash flow from operations.

Ans: B.

Net income is higher with capitalization because it does not decrease by the full amount spent, as it would with expensing. Capitalizing expenditure changes its cash flow classification from an operating cash outflow to an investing cash outflow. As a result, CFO is higher and CFI is lower than they would be if the expenditure had been immediately expensed. Total cash flow, however, is unaffected (assuming the tax treatment of the expenditure is independent of the financial reporting treatment). Equity is higher in the period of the expenditure with capital capitalization. Assets are higher because they include the capitalized asset. Debt is unaffected by the decision to capitalize or expense. Thus, the debt-to-equity and debt-to-assets ratios are lower with capitalization.

References: question 3.

41. Which of the following statement about expenses and intangible assets is least accurate?

A. advertising fees are generally expensed as incurred.

B. In most countries, research and development costs are capitalized.

C. Intangible assets are initially entered on the balance sheet at their purchase prices when they are acquired from an outside entity.

Ans: B.

U.S.GAAP requires R&D costs to be expensed. IFRS requires research costs to be expensed, but development costs are capitalized.

42. In the early years of an asset’s life, a firm that chooses an accelerated depreciation method instead of using straight-line depreciation will tend to have:

A. lower net income and lower equity.

B. higher return on equity and higher return on assets.

C. lower depreciation expense and lower turnover ratios.

Ans: A.

These relationships are reversed in the later years of the asset’s life if the firm’s capital expenditures decline.

42. A manufacturing firm shuts down production at one of its plants and offers the facility for rent. Based on the market for similar properties, the firm determines that the fair value of the plant is €500,000 more than its original cost. If this firm uses the cost model for plant and equipment and the fair value model for investment property, should it recognize a gain on its income statement under IFRS?

A. Yes, because the plant will be reclassified as investment property.

B. No, because the increase in value does not reverse a previously recognized loss.

C. No, because the firm must continue to use the cost model for valuation of this asset.

Ans: B.

According to IFRS, property held for the purpose of earning rental income is classified as investment property. However, when a property is transferred from owner-occupied to investment property, a firm using the fair value model must treat any increase in the property’s value as a revaluation. That is, the firm may only recognize a gain on the income statement to the extent that it reverses a previously recognized loss.

43. Under U.S.GAAP, an asset is considered impaired if its book value is:

A. less than its market value.

B. greater than the present value of its expected future cash flows.

C. greater than the sum of its undiscounted expected cash flows.

Ans: C.

Under U.S.GAAP, an asset is considered impaired when its book values is greater than the sum of the estimated undiscounted future cash flows from its use and disposal.

44. Bao Inc. owns a machine with a carrying value of $3.0 million and a salvage value of $2.0 million. The present value of the machine’s future cash flows is $1.7 million. The asset is permanently impaired. Bao should (under IFRS):

A. immediately write down the machine to its salvage value.

B. immediately write down the machine to its recoverable amount.

C. write down the machine to its recoverable amount as soon as it is depreciated down to salvage value.

Ans: B.

Under IFRS, when an asset is permanently impaired, it must be written down to its recoverable amount (greater of value in use or fair value less selling costs) in the period in which the impairment is recognized.

45. Bao Company has revalued an intangible asset with an indefinite life upward by €25 million. In its financial statements, Bao will most likely:

A. disclose how it determined the fair value of the intangible asset.

B. report lower net income in subsequent periods because of increased amortization expense on the asset.

C. report higher assets, net income, and shareholders’ equity in the most recent period than it would have reported under the cost model.

Ans: A.

For firms that revalue assets upward, IFRS requires disclosure of the date the asset was revalued, how management determined its fair value, the asset’s carrying value using the historical cast model, and (for intangible assets) whether the asset’s useful life is finite or indefinite. Although assets and shareholders’ equity will increase as a result of the revaluation, net income will not increase. The increase in the value of the asset is reported as a revaluation surplus in shareholders’ equity. Amortization expense will not increase because indefinite-lived intangible assets are not amortized.

46. As a result of a recent acquisition, Bao Inc. has placed the following items on their balance sheet as of the beginning of their fiscal year:

If Bao amortizes intangible assets using the straight line method, the amortization expense on these assets for the fiscal year will be:

A. $1 million.

B. $2 million.

C. $3 million.

Ans: A.

Goodwill has an indefinite life and is not amortized. A trademark or other intangible asset that has an expiration date but is renewable at minimal cost, is treated as having an indefinite life, and is not amortized. The patent has a finite life and its cost will be amortized at the rate of $1 million each year over ten years under the straight-line method.

47. Which of the following statements about the role of depreciable lives and salvage values in the computation of depreciation expenses for financial reporting is least accurate?

A. Estimates of the useful life of the same depreciable asset can differ between companies.

B. Companies are required to disclose data about estimated salvage values in the footnotes to the financial statements.

C. Depreciable lives and salvage values are chosen by management and allow for the possibility of income manipulation.

Ans: B.

Companies typically do not disclose data about estimated salvage values, except when estimates are changed.

48. Bao Corp. purchased a new stamping machine for $100,000, paid $100,000 for shipping, and paid $5,000 to have it installed in their plant. Based on an estimated salvage value of $25,000 and an economic life of six years, the difference between straight-line depreciation and double-declining balance depreciation in the second year of the asset’s life is closest to:

A. $7,220.

B. $10,556.

C. $16,666.

Ans: B.

Straight line depreciation is:

(100,000+10,000+5,000-25,000)/6=15,000each year.

Double-declining balance depreciation is the second year is:

115,000(2/3)(1/3)=25,556.

The difference is $10,556. Remember that salvage value is not part of the declining balance calculation.

49. A reconciliation of beginning and ending carrying values for long-lived tangible assets is required for firms reporting under:

A. IFRS.

B. U.S.GAAP.

C. both U.S.GAAP and IFRS.

Ans: A.

The required disclosures for long-lived assets under IFRS are more extensive than they are under U.S.GAAP. IFRS requires a reconciliation of beginning and ending carrying values for classes of long-lived tangible assets, while U.S.GAAP does not.

50. Two growing firms are identical except that A Company capitalizes costs for some long-lived assets that C Company expenses. For these two firms, which of the following financial statements effects is most likely? A Company will show higher:

A. net income than C Company.

B. working capital than C Company.

C. investing cash flow than C Company.

Ans: A.

For growing firms, capitalizing results in higher net income compared to expensing. A capitalizing company classifies the costs of the capitalized assets as CFI outflows, while a company that expenses these costs classifies them as CFO outflows. Thus, A Company’s CFO will be higher and CFI than C Company’s working capital is unaffected by the decision to capitalize or expense because the decision does not affect current assets or current liabilities.

51. A company takes a $10 million impairment charge on a depreciable asset in 2011. The most likely effect will be to:

A. increase reported net income in 2012.

B. decrease net income and taxes payable in 2011.

C. increase return on equity and operating cash flow in 2012.

Ans: A.

The impairment write-down in 2011 will reduce depreciation expense in 2012, which will increase 2012 EBIT and net income. Operating cash flow and taxes payable are not affected because an impairment cannot be deducted from income for tax reporting purposes until the asset is sold or otherwise disposed of.

52. East Company incurs $110,000 of costs to establish technological feasibility of a new software application it hopes to sell and $90,000 of costs to develop the application. West Company incurs $110,000 of research costs related to a new product and $90,000 of development costs for the product. If East reports under U.S.GAAP and West reports under IFRS, these projects will:

A. increase East’s total assets more the West’s total assets.

B. increase West’s total assets more the West’s total assets.

C. have the same effects on East’s and West’s total assets.

Ans: C.

Under U.S.GAAP, costs incurred to establish technological feasibility has been established must be capitalized. Under IFRS, research costs are expensed as incurred and development costs are capitalized. Thus, both East and West will capitalize $90,000 of development costs.

53. A company that capitalizes costs instead of expensing them will have:

A. higher income variability and higher cash flows from operations.

B. lower cash flows from investing and lower income variability.

C. lower cash flows from operations and higher profitability in early years.

Ans: B.

Capitalizing costs tends to smooth earnings and reduces investment cash flows. It will also increase cash flows from operating and increase profitability in the early years.

54. Harding Corp. has a permanently impaired asset. The difference between its carrying value and the present value of its expected cash flow should be written down immediately and:

A. reported as an operating loss.

B. charged directly against retained earnings.

C. reported as non-operating loss in other comprehensive income.

Ans: A.

Impairment writedowns are reported losses “above the line” and are included in income from continuing operations.