Accounting Principles - Capitalization and Depreciation

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.

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.