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Financial Statement Analysis

600

Accounting for Long-Term Assets

LOS 41.a,b, p. 145-146

Long-term assets convey benefits over timeTangible assets : e.g., land, buildings, andequipment

Intangible assets : e.g., copyrights, patents,trademarks, franchises, and goodwill

Natural resources : oil fields, mines, timberland

Plant property and equipment recorded at purchase costincluding shipping and installation, or construction costincluding labor, materials, overhead, and interest


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602

Sale of Depreciable Assets: ExampleLOS 41.d, p. 148

Machine purchased 4 years ago for $10,000 Accumulated depreciation is $8,000

Book value is $10,000 - $8,000 = $2,000

When it is sold:

Gross PPE is reduced by $10,000

Accumulated depreciation reduced by $8,000

Gain (loss) recorded when sale price is greater (lessthan) book value

Sale for $3,000, gain = 3,000 2,000 = $1,000

Gain is reported as other income, is taxable


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Intangible Assets and GoodwillLOS 41.f, p. 149-150

Intangible assets : (e.g., patents, licenses,franchises, leaseholds, trademarks, non-competeagreements) value is reduced over time by

amortization (like depreciation for tangible assets)Goodwill is the excess of purchase price (of awhole business) over the fair market value oftangible and other intangible business assets

Not amortized under US GAAP

Can be impai red , like any other asset


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604

LOS 43.a, p. 167

Depreciation MethodsWe are looking at depreciation for financialreporting, not for taxes

Straight line (SL) Depreciation

Equal depreciation each year

Results in an increasing return on assets

during assets life original cost - salvage valuedepreciation expense =

depreciable life


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605

LOS 43.a, p. 168

Depreciation MethodsExample (straight-line method):

Useful life = 5 years; cost = $10,000; salvagevalue = $2,000

original cost - salvage valuedepreciation expense =depreciable life

10,000 - 2,000= = $1,600 annual depreiciation5


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606

LOS 43.a, p. 168

Depreciation MethodsThere are two accelerated depreciation methods,sum-of-years digits (SYD), and double-decliningbalance (DDB), which recognize greater depreciation

expense in the early part of an assets life and lessexpense in the latter portion of its life.

Accelerated depreciation methods are usually usedon tax return (when allowed) because greaterdepreciation expense in the early portion of theassets life results in less taxable income and asmaller tax payment .


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LOS 43.a, p. 169

Depreciation Methods1- Example (SYD method):

Useful life = 5 years; cost = $10,000; salvagevalue = $2,000; what is the depreciation foryear 1 and year 5?

SYD = n(n+1) / 2 or 5+4+3+2+1

Depreciation in year x

(Original cost salvage value) (n x + 1) / SYD


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608

LOS 43.a, p. 169

Depreciation MethodsExample (SYD method): Useful life = 5 years;cost = $10,000; salvage value = $2,000; what isthe depreciation for year 1 and year 5?

(original cost - salvage value) = $8,0005 - 1 +1 5 1Year 1: = , (8,000) = $2,667

1+ 2 + 3 + 4 + 5 15 35 - 5 +1 1 1Year 5 : = , (8,000) = $533

1+ 2 + 3 + 4 + 5 15 15


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LOS 43.a, p. 170

Depreciation Methods

Example (DDB method): Useful life = 5 years;cost = $10,000; salvage value = $2,000; what isthe depreciation for years 1 - 4?

BV at beginning2Yr 1 depreciation =

of year xdepreciable life

2 = (10,000) = $4,0005


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LOS 43.a, p. 170

Depreciation MethodsExample (DDB method )continued:

BV at end of Yr 1 = 10,000 - 4,000 = $6,000

Yr 2 depreciation = 2/5 6,000 = $2,400BV at end of Yr 2 = 6,000 - 2,400 = 3,600

Yr 3 depreciation = 2/5 3,600 = $1,440

BV end of Yr 3 = 3,600 - 1,440 = $2,160

Yr 4 depreciation = 2,160 - 2,000 = 160

Salvage value


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Impact of Depreciation Method onFinancial Statements

LOS 43.a, p. 172

Straight Line Accelerated (DDB & SYD)

Depreciation expense Lower Higher

Net Income Higher Lower Assets Higher Lower

Equity Higher Lower

Return on assets Higher LowerReturn on equity Higher LowerTurnover ratios Lower Higher

Cash flow Same Same


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LOS 43.c, p. 174

Using Balance Sheet Disclosures to

Analyze Fixed Assets

accumulated depreciation Average age (in years) =depreciation expense

ending gross fixed assets Average depreciable life =depreciation expense

accumulated depreciationRelative age =ending gross fixed assets


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614

1- A company is switching from straight-line depreciation to anaccelerated method of depreciation. Assuming all other revenue

and expenses are at the same levels for the next period, switchingto an accelerated method will most likely increase the companys:

A) Total assets on the balance sheet.B) Taxes.

C) Net income/sales ratio.D) Fixed asset turnover ratio.
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The use of an accelerated depreciation method will increasedepreciation expenses early in the assets life.

The book value of the asset will be lower.

Net income and taxes will also be lower due to the increase in

depreciation expense.

Fixed asset turnover ratio (sales/fixed assets) will increase, becausethe book value of the fixed assets will be lower.


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

A) Accelerated depreciation methods will decrease the amount of taxesin early years.

B) Straight-line depreciation methods will have higher book values forthe assets on the balance sheet than companies that use accelerated

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

D) Units-of-production and service hours methods to depreciate assetswill overstate income during periods of low production.
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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 ofdepreciation expense in the early years of the assets life, but thedepreciation expense will be less in the latter years of the assets life.


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3- A carpet cleaning company uses service hours to depreciate thecompanys assets. The company had very little business over thepast year due to a poor economy. Which of the following is mostaccurate ?

A) Depreciation expense will be higher due to the decrease in demandfor carpet cleaning equipment.

B) Income will be overstated on the income statement.C) The economic value of the carpet cleaning equipment will increase

due to lower depreciation expense.D) Assets will be understated on the balance sheet.


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Using service hours to estimate depreciation expense will overstate

income during periods of low sales.

When the revenues are low, it is likely that the company has suffereda decline in the economic value of the assets. However, depreciation

expense will be low based on the low level of asset use .


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4- Slovac Company purchased a machine that has an estimateduseful life of eight years for $7,500. Its salvage value is estimated at

$500.

What is the depreciation expense for the second year, assumingSlovac uses the double-declining balance method of depreciation?

A) $1,438.B) $1,406.C) $1,875.D) $3,750.


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Double-declining balance depreciation rate = 2 1/8 = or 25%

First year depreciation will be $7,500 0.25 = $1,875

Second year depreciation will be ($7,500 $1,875) 0.25 = $1,406


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5-What is the depreciation expense for the third year, assuming Slovacuses the sum-of-years digits method of depreciation?

A) $292.B) $518.C) $1,167.

D) $583.


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Sum-of-years digits = n(n + 1) / 2 = (8 9) / 2 = 36

Third year depreciation = (6 / 36) ($7,500 $500) = $1,167


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6-This information pertains to equipment owned by Brigade Company.

Cost of equipment $10,000Estimated residual value $2,000Estimated useful life 5 yearsDepreciation method Straight-line

The accumulated depreciation at the end of year 3 is:

A) $1,600.B) $4,800.C) $3,200.D) $5,200.
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7-After three years, Brigade expects that it will use the equipment fora total of six years (i.e., 3 more years). Brigade estimates no

change in the residual value. What is the depreciation expense foryear 4?

A) $1,067.B) $1,600.C) $1,733.D) $800.


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[(10,000 - 4,800) - $2,000] / 3 = $1,067


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8- On January 1, 2005, JME Corporation changed from the straightline method to an accelerated method of depreciation. Under theaccelerated method, the accumulated depreciation throughDecember 31, 2004, was $600,000 higher than if the straight linemethod had been used. JMEs income tax rate is 40%. What is thecumulative effect of this change in accounting principle?

A) $360,000.B) $240,000.C) $600,000.D) $0.


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600,000 (1 0.4) = 360,000.


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630

9-JME acquired an asset on January 1, 2004, for $60,000 cash. At thattime JME estimated the asset would last 10 years and have nosalvage. During 2006 JME estimated the remaining life of the assetto be only three more years with a salvage value of $3,000. If JMEuses straight line depreciation, what is the depreciation expense for2006?

A) $15,000.B) $6,000.C) $12,000.D) $16,000.


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First two years = (60,000 0) / 10 = 6,000 per year

Yr. 2006 = (60,000 12,000 3,000) / 3 = 15,000


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10- On January 1, 2004, JME purchased a truck that cost $24,000.The truck had an estimated useful life of 5 years and $4,000

salvage value. The amount of depreciation expense recognized in2006 assuming that JME uses the double declining balancemethod is:

A) $4,000.B) $5,760.C) $8,000.D) $3,456.


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Yr. 2004 = 24,000 2/5 = 9,600

Yr. 2005 = (24,000 9,600) 2/5 = 5,760

Yr. 2006 = (24,000 9,600 5,760) 2/5 = 3,456


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634

11- Determine the average age as a percent of depreciable life and theaverage age of the plant and equipment given the followinginformation:

Depreciation expense is $15,000.Plant and equipment is $250,000.

Accumulated depreciation is $60,000.

Average Age (%) Average Age (Years)

A) 25% 4B) 24% 6C) 25% 6D) 24% 4


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accumulated depreciation Average age (in years) =depreciation expense

ending gross fixed assets Average depreciable life =depreciation expense

accumulated depreciationRelative age =ending gross fixed assets


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Average age as a percent of depreciable life = (60,000 / 250,000) 100 = 24%

Average age of plant and equipment = $60,000 / $15,000 = 4 years


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637

12- A firm using straight-line depreciation reports the following financialinformation:

Gross investment in fixed assets of $89,167,205. Accumulated depreciation of $35,341,773. Annual depreciation expense of $3,885,398.

The approximate age of the fixed assets is:

A) 2.52 years.B) 13.85 years.

C) 9.10 years.D) 22.95 years.


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Average age of fixed assets = accumulated depreciation / annualdepreciation

= $35,341,773 / $3,885,398 = 9.10.


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13- Ending gross investment/depreciation expense is used to estimatethe average:

A) Depreciable life.B) Age.C) Age as a percent of depreciable life.

D) Depreciation.


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Average depreciable life is approximated by:

Ending gross investment / depreciation expense


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14 -Gross plant and equipment $1,250,000Depreciation expense $235,000

Accumulated depreciation $725,000

The average depreciable life of plant and equipment is:

A) 3.09 years.B) 2.23 years.C) 5.32 years.D) 8.40 years.


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The average depreciable life = Gross PPE / Depreciation expense

$1,250,000 / $235,000 = 5.32


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15 -Average remaining useful life of the plant and equipment is:

A) 2.23 years.B) 3.09 years.C) 4.32 years.

D) 5.32 years.


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Remaining useful life = (gross investment accumulateddepreciation) / depreciation expense

($1,250,000 $725,000) / $235,000 = 2.23


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16 -The average age of plant and equipment is:

A) 1.40 years.B) 2.23 years.C) 5.32 years.D) 3.09 years.


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The average age = accumulated depreciation / depreciation expense

$725,000 / $235,000 = 3.09


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Average age of depreciable assets is useful for two reasons:

To assess how competitive the corporation will be going forward(older assets are less efficient).

To estimate financing required for major capital expenditures in the

near-term to replace depreciated assets.


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18- An asset is impaired when:

A) Accumulated depreciation exceeds acquisition costs.B) Accumulated depreciation plus salvage value exceeds acquisition

costs.C) The present value of future cash flows exceeds the carrying amount

of the asset.

D) The firm can no longer fully recover the carrying amount of theasset.


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Example: Asset impairment

Information related to equipment owned by GrownfieldCompany follows:

Original Cost $ 900 000 Accumulated depreciation to date $ 100 000Expected future cash flows $ 700 000Fair value $ 580 000

Assuming Bownfield will continue to use the equipment in thefuture, test the asset for impairment and discuss the results

I

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Answer

The carrying value of the equipment is $ 800 000 ( $ 900 000original cost - $ 100 000 accumulated depreciation ).

Since the carrying value exceeds the expected future cash

flow ( $ 800 000 carrying value > $ 700 000 expectedfuture cash flow ), the equipment is impaired.

The impairment loss is equal to $ 220 000 ( $800 000

carrying value - $ 580 000 fair value). Thus, the carryingvalue of the equipment on the balance sheet is reduced to$ 580 000 and a $ 220 000 impairment loss is recognizedin the income statement.

i i l S A l i


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19- Changes in asset lives and salvage value are changes inaccounting:

A) Estimates and no specific disclosures are required.B) Estimates and specific disclosures are required.C) Principle and specific disclosures are required.

D) Principle and no specific disclosures are required .

Fi i l S A l i


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Changes in asset lives and salvage value are changes in accountingestimates and are not considered changes in accounting principle, sono specific disclosures are required.

Fi i l S A l i


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20- The following information has been gathered regarding WilliamsInvesting, which uses the straight-line method for depreciation.

Depreciable life of 8 years on its assets. Net book value of assets is $40 million. Accumulated depreciation is $28 million. Salvage value is $12 million.

It recently revised the estimates for the remaining useful life of itsissets from 4 years to 6 years. Net income before the change is $13 million. The effective tax rate

for the firm is 40 percent.

Depreciation expense for Williams Investing will decrease by:

A) $3.6 million.B) $1.4 million.C) $6.5 million.D) $2.3 million.

Fi i l St t t A l i


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To find the change in depreciation we have to find the annualdepreciation with the original assumptions and the annual

depreciation going forward with the new assumptions.

First find the original cost of the assets

= $40 book value + $28 accumulated depreciation = $68.

Original depreciation per year =($68 original cost - $12 salvage value)/8 years = $56/8 years

= $7 depreciation per year.

New depreciation = ($40 book value $12 salvage) / 6 years =$4.7

The change in depreciation = $7 - $4.7 = $2.3 less, or a decreaseof $2.3

Fi i l St t t A l i


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21 -Net income for Williams Investing will increase by:

A) 13.85%.B) 15.39%.C) 10.62%.D) 9.23%.

Fi i l St t t A l i


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Net income will increase by 2.3(1-.4)=$1.38 million

or on a percentage basis = 1.38/13 = 10.62%.



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22- When the depreciation method is changed from an accelerated methodto the straight-line method, which of the following statements about the

impact on financial statements is least accurate ?A) ROE and ROA will increase due to the increase in net income.B) ROE and ROA will decrease due to the increase in equity and assets.C) No cumulative effect exists if the change is applied only to newly

acquired assets.D) Depreciation expense will decrease and net income will increase.



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Although assets and equity will increase, the larger increase in netincome will cause an overall increase in ROA and ROE.



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23- ABC Investments has purchased a new computer system for $1.4million and decided to depreciate it over a 4-year period on a sum-of-years digits (SYD) method. ABC estimates that the salvagevalue will be $200,000 at the end of the four years. What will be thedepreciation expense for the third year?

A) $300,000.B) $240,000.C) $275,000.D) $186,000.



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Sum of years n(n + 1)/2 = 10

The SYD method depreciation = ($1,400,000 $200,000) (number of years remaining / sum of years).

For third year, = $1,200,000 (2 / 10) = $240,000.



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24- Rasmus Company purchased equipment for $96,000. The estimateduseful life is three years, and it is expected to have a salvage value of$24,000 at the end of its useful life. The depreciation in the third yearwas $12,000. What method of depreciation did Rasmus most likelyuse?

A) Sum-of-years digits.B) Straight Line.

C) Double-declining balance.D) Units of Production method.



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$96,000 24,000 = $72,000.

Sum-of-years digits = 3+2+1 = 6.The third year depreciation will be $72,000 (1/6) = $12,000.

SL depreciation would be ( 96,000 24,000 ) / 3 = $24,000/year.

DDB would beYear 1 (96000 X 2/3 ) = 64 000Year 2 8 000

Year 3 0



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25- In its first year of business, Digmore Corporations balance sheetshows gross fixed assets at $90 million and accumulateddepreciation of $10 million. If the estimated salvage value of theseassets is $10 million, and the original estimated useful life is 8 years,what method of depreciation did Digmore most likely use?

A) Sum-of-years digits.

B) Double-declining balance.C) Units of production.D) Straight Line.


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