financial statement analysis
CHAPTER 7
INVESTING ACTIVITIES
Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases
7.1 Capitalization versus Expensing Decision.
a. The effect in the first year would be an equal decrease in both the numerator (adjusted net income) and the denominator (average total assets) of ROA. Because net income is substantially smaller than average total assets, the percentage decrease in the numerator would be greater, and ROA would be understated. However, in the next two years, net income would be overstated because it is not burdened by a depreciation charge, average total assets would remain understated, and ROA would be overstated.
b. This error does not affect cash flows, but it does affect classification within the statement of cash flows. Expensing results in an operating cash ouflow in year one. Capitalization results in an investing cash outflow.
7.2 Self-Constructed Assets. The company should capitalize the full costs of construction, including direct labor, direct materials, and an allocation of overhead (both variable and fixed). Also, if interest is incurred during the project, interest cost on accumulated average expenditures should be capitalized.
1. Natural Resources. All costs are capitalized except for exploration costs associated with dry wells, which may be capitalized if the firm chooses the full costing approach or expensed if the firm chooses the successful efforts approach. Capitalization is justified because most of the costs are necessary to yield probable future economic benefits. Proponents of expensing unsuccessful exploration efforts argue that no product was discovered and, thus, that the probable future economic benefits criterion is not met.
7.4 Research and Development Costs. Standard setters require R&D costs to be expensed because of the uncertainty in judging their future revenue-generating potential. Although it is debatable whether capitalization better serves investors,
INVESTING ACTIVITIES
Solutions to Questions, Exercises, and Problems, and Teaching Notes to Cases
7.1 Capitalization versus Expensing Decision.
a. The effect in the first year would be an equal decrease in both the numerator (adjusted net income) and the denominator (average total assets) of ROA. Because net income is substantially smaller than average total assets, the percentage decrease in the numerator would be greater, and ROA would be understated. However, in the next two years, net income would be overstated because it is not burdened by a depreciation charge, average total assets would remain understated, and ROA would be overstated.
b. This error does not affect cash flows, but it does affect classification within the statement of cash flows. Expensing results in an operating cash ouflow in year one. Capitalization results in an investing cash outflow.
7.2 Self-Constructed Assets. The company should capitalize the full costs of construction, including direct labor, direct materials, and an allocation of overhead (both variable and fixed). Also, if interest is incurred during the project, interest cost on accumulated average expenditures should be capitalized.
1. Natural Resources. All costs are capitalized except for exploration costs associated with dry wells, which may be capitalized if the firm chooses the full costing approach or expensed if the firm chooses the successful efforts approach. Capitalization is justified because most of the costs are necessary to yield probable future economic benefits. Proponents of expensing unsuccessful exploration efforts argue that no product was discovered and, thus, that the probable future economic benefits criterion is not met.
7.4 Research and Development Costs. Standard setters require R&D costs to be expensed because of the uncertainty in judging their future revenue-generating potential. Although it is debatable whether capitalization better serves investors,