Accounting Concepts and Depreciation

Questions and Answers

How can firms increase net income in the period of acquisition?

By expensing asset costs

By capitalizing asset costs (correct)

By reducing salvage values

By using shorter useful lives for assets

What is one effect of capitalizing an asset instead of expensing it?

Lower net income in the acquisition period

Lower assets and equity on the balance sheet

Higher cash flow from investing activities (correct)

Higher expenses in the initial acquisition period

Which statement is true about amortization methods for intangible assets?

They can be straight line, accelerated, or based on units of production (correct)

They vary greatly from those of tangible assets

They do not affect financial ratios

They are exclusively based on the declining balance method

What effect does increasing the estimate of an asset’s useful life have on financial metrics?

It reduces annual amortization expense Signup and view all the answers

How does capitalizing assets affect the debt-to-assets ratio?

It decreases the ratio Signup and view all the answers

Which is a potential downside of capitalizing assets concerning future financial periods?

Lower ROE and ROA in later periods Signup and view all the answers

What happens to the Return on Equity (ROE) in the years following the capitalization of an asset?

It decreases after an increase in net income Signup and view all the answers

Which factor contributes to the overall financial impact when choosing different amortization methods?

Variability in asset lifespan estimates Signup and view all the answers

Which of the following factors can lead to low-quality financial reporting?

Wide ranges of acceptable accounting treatments Signup and view all the answers

What can potentially indicate a company's future income and cash flows?

Forecast sales growth and estimates of profit margins Signup and view all the answers

Which indicators are essential in assessing a firm's creditworthiness?

Financial leverage and operational efficiency Signup and view all the answers

When comparing financial statements, why might an analyst need to adjust for different accounting methods?

To ensure comparability among firms Signup and view all the answers

Which of the following presents a challenge when screening for attractive equity investments?

Selecting and prioritizing financial ratios to use Signup and view all the answers

What is a key consideration when using ratio analysis?

Comparable ratios may be hard to find for diverse companies. Signup and view all the answers

What does horizontal common-size data present?

Each item as a percentage of its value in a base year. Signup and view all the answers

Which of the following is a characteristic of a business segment?

It should account for more than 10% of the firm’s sales. Signup and view all the answers

What is an important factor in assessing management's performance using ratios?

Utilize a variety of ratios including profitability and turnover. Signup and view all the answers

What do activity ratios measure?

How efficiently a firm utilizes its assets. Signup and view all the answers

What is the formula for the financial leverage ratio?

average total assets / average total equity Signup and view all the answers

Which of the following is NOT an advantage of leasing over purchasing an asset?

Higher financing costs Signup and view all the answers

Which of the following is included in other comprehensive income?

Gains and losses from foreign currency translation Signup and view all the answers

How is interest coverage calculated?

EBIT / interest payments Signup and view all the answers

What do lessees report on their balance sheet for short-term leases under IFRS?

Rent expense on the income statement with no balance sheet entries Signup and view all the answers

What distinguishes current assets from noncurrent assets on a balance sheet?

Current assets are those to be used within one year or the firm's operating cycle. Signup and view all the answers

In what manner are cash equivalents reported on the balance sheet?

At amortized cost or fair value, which are usually close. Signup and view all the answers

Under which classification does a lease fall if benefits and risks of ownership have substantially transferred to the lessee under U.S. GAAP?

Finance lease Signup and view all the answers

How are accounts receivable typically reported on the balance sheet?

At net realizable value by estimating bad debt expense. Signup and view all the answers

Which of the following is true about lessor classifications under U.S. GAAP?

Sales-type leases meet the criteria for transfer of ownership. Signup and view all the answers

Which of the following methods is NOT a way to measure inventory cost?

Historical cost only with no adjustments Signup and view all the answers

What is reported by the lessor for a finance lease?

A lease receivable asset and interest as income Signup and view all the answers

Which type of financial gain or loss is associated with cash flow hedging derivatives?

Unrealized gains and losses Signup and view all the answers

Under IFRS, how are lease payments characterized in an operating lease?

Reported as lease expense on the income statement Signup and view all the answers

Which reporting model is permitted under U.S. GAAP for property, plant, and equipment (PP&E)?

Cost model only Signup and view all the answers

What does 'lower of cost or market' refer to in inventory reporting?

Reporting inventory at either its purchase cost or current market value, whichever is lower. Signup and view all the answers

Study Notes

Depreciation and Amortization

Firms can enhance net income by extending asset useful lives, which reduces depreciation expense.
Capitalization involves treating asset costs as balance sheet assets, expensing them through depreciation or amortization rather than immediate expensing.
Capitalization leads to lower initial expenses and greater net income during acquisition, with higher subsequent expenses and lower net income as the asset depreciates.
Capitalized assets result in higher reported assets and equity, impacting cash flow metrics.
Amortization methods for intangible assets mirror tangible asset depreciation methods: straight-line, accelerated, or units of production.
Increasing useful life or residual value estimates can lower annual amortization, enhancing net income and financial ratios.

Other Comprehensive Income

Other comprehensive income encompasses equity-affecting transactions not included in net income.
Examples include gains/losses from foreign currency translation, pension obligation adjustments, and unrealized gains/losses from hedging derivatives and available-for-sale securities.

Balance Sheet Classifications

Classified balance sheets distinguish between current and noncurrent assets/liabilities, impacting analysis of liquidity.
Current assets are designed to be used or converted within one year or the operating cycle; noncurrent is the opposite.
Cash equivalents are highly liquid assets close to cash value, impacting overall liquidity assessments.

Financial Reporting and Inventory

Accounts receivable are reported at net realizable value, adjusted for estimated bad debts.
Inventories valuated at lower of cost or net realizable value (IFRS) or lower of cost or market (U.S. GAAP) can differ based on cost flow assumptions.
Property, plant, and equipment can be accounted under cost or revaluation models (IFRS), while U.S. GAAP mandates cost model only.

Ratio Analysis

Ratio analysis offers insights into a firm's performance but must be contextualized, as isolated ratios can mislead.
Variations in accounting practices require adjustments for accurate comparisons.
Activity ratios assess asset utilization efficiency.

Leasing Considerations

Advantages of leasing compared to purchasing may include lower financing costs, fewer restrictions, and reduced obsolescence risk.
Under IFRS, leases (except short-term) implicate both asset and liability reporting based on present value of lease payments; lease payments impact expenses differently across lease types.
U.S. GAAP classifies leases as finance or operating based on risk and benefits transfer.

Financial Leverage and Coverage Ratios

Financial leverage ratio signifies company proportion of asset funding through equity, impacting risk assessment.
Coverage ratios, including interest and fixed charge coverage, evaluate a firm's ability to meet financial obligations, essential in credit analysis.

Business Segment Reporting

Significant business/geographic segments must be reported separately; performance metrics like profitability and leverage by segment can enhance analytical insights.

Forecasting and Credit Analysis

Analyzing trends in financial ratios alongside competitive benchmarks can elucidate a firm's strategic positioning.
Future income projections integrate sales growth forecasts with estimates for margins and capital needs, critical for financial planning.
Indicators of creditworthiness include operational efficiency, scale, margin stability, and leverage; thorough credit analysis requires these assessments.

Investment Screening and Accounting Adjustments

Identifying potentially attractive equity investments involves screening stocks based on ratios, which poses challenges regarding selecting appropriate metrics.
When accounting methods differ, analysts need to adjust reported figures for comparative accuracy, particularly with LIFO and FIFO adjustments.

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Description

This quiz explores key accounting concepts related to depreciation, capitalization, and the impact on net income. Understand how altering asset useful lives and salvage values can influence financial reporting. Test your knowledge on the effects of these practices in accounting principles.