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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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Financial Statement Analysis
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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Financial Statement Analysis
603
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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Financial Statement Analysis
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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Financial Statement Analysis
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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Financial Statement Analysis
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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Financial Statement Analysis
607
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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Financial Statement Analysis
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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Financial Statement Analysis
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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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Financial Statement Analysis
611
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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Financial Statement Analysis
612
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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Financial Statement Analysis
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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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Financial Statement Analysis
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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
620
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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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[(10,000 - 4,800) - $2,000] / 3 = $1,067
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Financial Statement Analysis
628
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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Financial Statement Analysis
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600,000 (1 0.4) = 360,000.
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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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Average age of fixed assets = accumulated depreciation / annualdepreciation
= $35,341,773 / $3,885,398 = 9.10.
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Financial Statement Analysis
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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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Financial Statement Analysis
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Average depreciable life is approximated by:
Ending gross investment / depreciation expense
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Financial Statement Analysis
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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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Financial Statement Analysis
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The average depreciable life = Gross PPE / Depreciation expense
$1,250,000 / $235,000 = 5.32
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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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The average age = accumulated depreciation / depreciation expense
$725,000 / $235,000 = 3.09
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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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
l l
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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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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Financial Statement Analysis
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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%.
Financial Statement Analysis
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Financial Statement Analysis
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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.
Financial Statement Analysis
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Financial Statement Analysis
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Although assets and equity will increase, the larger increase in netincome will cause an overall increase in ROA and ROE.
Financial Statement Analysis
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Financial Statement Analysis
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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.
Financial Statement Analysis
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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.
Financial Statement Analysis
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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.
Financial Statement Analysis
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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
Financial Statement Analysis
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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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