Accounting Principles - Capitalization and Depreciation

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Questions and Answers

What is the primary purpose of activity ratios in analysis?

To assess management performance

To compare a firm with its industry competitors

To evaluate a firm's cash flow to total debt

To indicate how well a firm uses its assets (correct)

What does horizontal common-size data represent?

Each item as a percentage of sales

Each item as a percentage of its value in a base year (correct)

Each item in relation to the firm’s competitors

Each item as a percentage of total assets

Which ratio is primarily emphasized in credit analysis?

Turnover ratios

Profitability ratios

Interest coverage ratios (correct)

Activity ratios

What is a requirement for reporting business or geographic segments?

The segment must be a distinguishable portion of the firm Signup and view all the answers

What is a significant limitation of ratio analysis?

Different accounting treatments may affect ratio comparability Signup and view all the answers

What does other comprehensive income include?

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

What type of presentation is commonly used in the banking industry for assets and liabilities?

Liquidity-based presentation Signup and view all the answers

Which of the following is true regarding current assets?

Expected to be used up or converted to cash in less than one year Signup and view all the answers

How are accounts receivable typically reported?

At net realizable value Signup and view all the answers

Which method is NOT allowed under U.S. GAAP for reporting property, plant, and equipment (PP&E)?

Revaluation model Signup and view all the answers

Which of the following describes cash equivalents?

Short-term, highly liquid financial assets Signup and view all the answers

In which scenario would a company recognize unrealized gains or losses?

In available-for-sale securities Signup and view all the answers

What is a potential effect of different cost flow assumptions on inventory values?

Variations in reported income Signup and view all the answers

What is the primary impact of using longer useful lives for asset depreciation?

Lower depreciation expense and higher net income Signup and view all the answers

What financial metric is affected by the method of amortization chosen for intangible assets?

Expenses, assets, equity, and financial ratios Signup and view all the answers

How does capitalization of assets influence cash flow from operations (CFO)?

It increases CFO because capitalized assets do not affect operating cash flows Signup and view all the answers

What effect does an increase in the estimate of an asset’s useful life have on financial statements?

It lowers annual amortization expense and increases net income Signup and view all the answers

What is the effect of using higher useful lives or salvage values on a firm's financial ratios in the initial years?

Higher ROE and ROA Signup and view all the answers

What is a potential consequence of capitalizing an asset instead of expensing it immediately?

Lower expenses and higher net income in the period of acquisition Signup and view all the answers

How does the choice of capitalization method affect a firm's balance sheet?

It can increase total assets and equity Signup and view all the answers

What happens to the debt-to-assets ratio when a firm capitalizes assets?

It decreases due to higher asset values and equity Signup and view all the answers

What does the cash flow statement report for proceeds from a premium bond?

Inflows from financing activities Signup and view all the answers

How is a premium bond reported on the balance sheet at issuance?

At a value greater than its face value Signup and view all the answers

What happens to the book value of a discount bond as the discount is amortized?

It increases until it reaches its face value Signup and view all the answers

What is included in the interest expense for bonds?

Amortization of any discount or premium Signup and view all the answers

In using the effective interest rate method, what represents the interest expense?

Book value of the bond liability at the beginning of the period multiplied by the yield at issuance Signup and view all the answers

What occurs to the bond liability for a premium bond when calculating interest expense?

It decreases by the difference between interest expense and coupon payment Signup and view all the answers

When comparing interest expense to coupon payment for a discount bond, how are they related?

Interest expense is greater than the coupon payment Signup and view all the answers

What happens to the book value of a premium bond as the premium is amortized?

It decreases until it reaches its face value Signup and view all the answers

What might an increase in raw materials and goods in process suggest about future demand?

Increasing future demand and higher earnings Signup and view all the answers

Which scenario indicates a potential for decreasing demand or inventory obsolescence?

Increases in finished goods greater than increases in sales Signup and view all the answers

How can inventory turnover indicate the quality of a firm's inventory management?

Low turnover may indicate obsolete inventory Signup and view all the answers

What does a high inventory turnover coupled with low sales growth imply?

Inadequate inventory levels leading to lost sales Signup and view all the answers

Which of the following is NOT a reporting standard for inventory under U.S. GAAP?

Reversals of inventory write-downs Signup and view all the answers

What could carrying value of inventories pledged as collateral indicate?

Potential for future inventory write-downs Signup and view all the answers

What formula is used to calculate depreciation expense under the double-declining balance method?

DDB depreciation = 2 × (Original cost / depreciable life) Signup and view all the answers

What is the effect of an asset cost being expensed in the current period?

Reduces taxable income for that period Signup and view all the answers

Study Notes

Depreciation and Amortization

Firms can improve net income by extending asset useful lives and using higher salvage values.
Capitalization places the asset value on the balance sheet, expensing costs over the asset's life instead of upfront.
Capitalization results in lower initial expense and higher net income at acquisition compared to direct expensing.
Amortization for intangible assets follows the same methods as depreciation: straight-line, accelerated, or units of production.

Financial Ratios and Cash Flow

Depreciation method choice impacts financial ratios, affecting expenses, assets, equity, and overall financial health.
Increasing useful life or residual value decreases amortization expense, enhancing net income, assets, and key ratios like ROE and ROA.
Capitalized assets lead to lower Cash Flow from Investing (CFI) but higher Cash Flow from Operations (CFO).
Higher assets and equity improve debt-to-assets and debt-to-equity ratios.

Other Comprehensive Income

Other comprehensive income includes:
- Gains/losses from foreign currency translation.
- Pension obligation adjustments.
- Unrealized gains/losses from cash flow hedges.
- Unrealized gains/losses on available-for-sale securities.

Classified Balance Sheets

Classified balance sheets distinguish current and noncurrent assets and liabilities, focusing on liquidity or operating cycle.
Current assets are expected to be converted to cash or consumed within a year or operating cycle.
Cash equivalents are highly liquid assets, often valued similarly using amortized cost or fair value.

Inventory Valuation

Accounts receivable reported at net realizable value accounts for bad debt estimates.
Inventory reported at the lower of cost or net realizable value (IFRS) or cost or market (U.S. GAAP).
Different inventory cost flow assumptions can significantly affect valuation.

Activity Ratios

Activity ratios assess asset utilization efficiency, aiding performance analysis.
Key inventory disclosures indicate demand trends, such as finished goods growth compared to raw materials.
Inventory turnover, days on hand, and gross profit margin evaluate inventory management quality.
Low inventory turnover may signal slow movement or obsolescence; high turnover with low sales may indicate inadequate stock.

Bond Valuation

A premium bond sells above face value; as amortization occurs, its book value decreases to face value at maturity.
A discount bond sells below face value; amortization increases its book value to face value over time.
Interest expense includes any discount or premium amortization calculated using the effective interest rate method.
For premium bonds, interest expense is less than coupon payment; for discount bonds, it is greater, affecting bond liability on the balance sheet.

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Description

This quiz examines the accounting principles related to capitalization, depreciation, and how they impact net income. Understand how longer useful lives and higher salvage values influence financial statements. Test your knowledge on these crucial concepts in accounting.