CFA Level 1 - Financial Reporting and Analysis Session 9 - Reading 30

CFA Level 1 - Financial Reporting and Analysis Session 9 - Reading 30 (Notes, Practice Questions, Sample Questions) 1. When comparing capitalizing versus expensing costs which of the following statements is most accurate? A)Expensing costs creates lower cash flows from operations andlower cash flows from investing. B)Capitalizing costs creates higher cash flows from operationsand lower cash flows from investing. (Explanation: Although net cash flows are not affected by the choice of capitalizationor expensing, the components of cash flow are affected.Because, a firm that capitalizes classifies the expenditure asinvesting (not operations), cash flow from operations will behigher for firms that capitalize and investing cash flows willbe lower than that of an expensing firm ) C)Capitalizing costs creates lower cash flows from operations andhigher cash flows from investing. 2. Which of the following statements regarding capitalizing versus expensing costs is least accurate? A)Capitalization results in higher profitability initially. B)Total cash flow is higher with capitalization than expensing.(Explanation: Total cash flow is higher with capitalization than expensing is least accurate because total cash flow wouldbe the same under both methods, not considering taximplications ) C)Cash flow from investing is higher with expensing than withcapitalization.

3. Which of the following statements regarding the capitalization of an expense is least accurate? A)Capitalizing an expense creates an asset. B)Capitalizing an expense lowers current period net income.(Explanation: Capitalizing expenses reduces current period expenses by the amount capitalized. The amount capitalized isadded to assets which increases equity by increasing netincome and retained earnings in the current period ) C)Capitalized expenses increases equity. 4. Capitalizing interest costs related to a company’s construction of assets for its own use is required by: A)IFRS only. B)both IFRS and U.S. GAAP. (Explanation: Both U.S. GAAP and IFRS require companies to capitalize the interest that accruesduring a the construction of capital assets for their own use ) C)U.S. GAAP only. 5. Capitalized interest costs are typically reported in the cash flow statement as an outflow from: A)investing. (Explanation: Capitalized interest costs are reported as CFI on the statement of cash flows, as they aretreated as part of the cost of the constructed capital asset ) B)operating.C)financing. 6. Dobkin Company decides to expense costs that it would have otherwise capitalized. Compared to capitalizing, expensing thesecosts will result in:

A)lower asset levels and lower equity levels. (Explanation: Expensing instead of capitalizing results in lower assets. Sincethe entire expense is recognized in the current period (whereasonly a portion of the expenditure is amortized whencapitalizing), net income (and therefore equity, via retainedearnings) is lower with expensing than with capitalizing.Liabilities are unaffected ) B)lower asset levels and higher equity levels.C)lower asset levels and lower liability levels. 7. A firm that capitalizes rather than expensing costs will have: A)lower cash flows from investing. (Explanation: A firm that capitalizes costs classifies them as an investing cash flowrather than an operating cash flow. Investing cash flows willbe lower and cash flow from operations will be higher whencosts are capitalized ) B)lower cash flows from operations.C)lower profitability in the earlier years. 8. Which of the following items is least likely an example of an intangible asset with an indefinite life? A)Goodwill. B)Acquired patents. (Explanation: Acquired patents are most likely purchased with the intent to use over a specific period oftime and therefore would be an example of an intangible assetwith a finite life. Goodwill, by definition, is an intangible assetwith an indefinite life. Trademarks that can be renewed atminimal cost are also considered to be intangible assets withinfinite lives ) C)Trademarks that can be renewed at minimal cost.

9. During 2007, Big 4 Company’s warehouse was totally destroyed by a tornado. Tornados are very rare in the region where Big 4 islocated. The book value of the warehouse at the time of the tornadowas € 10 million and Big 4 is self-insured. In addition, on June 30, 2007, Big 4 acquired one of its major suppliers. The fair value of thenet assets acquired by Big 4 was greater than the purchase price.According to International Financial Reporting Standards, shouldBig 4 recognize an extraordinary item for tornado damage andshould Big 4 recognize negative goodwill on its balance sheet due tothe acquisition? Extraordinary loss Negative goodwill A) No No B) Yes No C) No Yes Explanation: IFRS does not permit income statement items to be recognized as “extraordinary” in the income statement.Negative goodwill is not reported on the balance sheet; rather,the excess of fair value over the price paid in an acquisition isrecognized as a gain in the income statement 10. Which of the following statements comparing straight-line depreciation methods to alternative depreciation methods is leastaccurate? Companies that use: A)accelerated depreciation methods will decrease the amount oftaxes in early years.B)the units-of-production method to depreciate assets will overstateincome during periods of low production. C)accelerated depreciation methods will increase the totalamount of depreciation expense over the life of an asset(Explanation: Accelerated depreciation methods will not change the total amount of depreciation expense over the life

of an asset. Accelerated depreciation methods will increase theamount of depreciation expense in the early years of theasset’s life, but the depreciation expense will be less in thelatter years of the asset’s life ) 11. A company is switching from straight-line depreciation to an accelerated method of depreciation. Assuming all other revenueand expenses are at the same levels for the next period, switchingto an accelerated method will most likely increase the company’s: A)total assets on the balance sheet. B)fixed asset turnover ratio. (Explanation: The use of an accelerated depreciation method will increase depreciationexpenses early in the asset’s life. The book value of the assetwill be lower. Fixed asset turnover ratio (sales/fixed assets)will increase, because the book value of the fixed assets will belower. ) C)net income/sales ratio. 12. Lakeside Co. recently determined that one of its processing machines has become obsolete three years early and, unexpectedly,has no salvage value. Which of the following statements is mostconsistent with this discovery? A)Historically, economic depreciation was overstated.B)Lakeside Co. will owe back taxes. C)Historically, economic depreciation was understated.(Explanation: Historically, economic depreciation was understated. If an asset becomes obsolete and its useful life isless than expected, accounting methods for depreciation haveunderstated the economic depreciation. In addition, if there isno salvage value when positive salvage value was expected, theunderstatement problem is compounded )

13. Novak, Inc. owns equipment with a historical cost of $20,000, a useful life of 5 years, and an estimated salvage value of $5,000.Using the double declining balance method, depreciation expensein Year 3 for this equipment is: A)$2,200. (Explanation: DDB depreciation in each year is 2/5 of the carrying value at the beginning of the year, until thecarrying value reaches the estimated salvage value.Year 1 DDBdepreciation = $20,000 × 2/5 = $8,000Carrying value = $20,000 – $8,000 = $12,000 Year 2 DDBdepreciation = $12,000 × 2/5 = $4,800Carrying value = $12,000 – $4,800 = $7,200 Year 3 DDBdepreciation = $7,200 × 2/5 = $2,880Because $7,200 – $2,880 = $4,320 would depreciate theequipment below its salvage value, depreciation in Year 3 islimited to $7,200 – $5,000 = $2,200 ) B)$2,880.C)$3,000. 14. Component depreciation is required under: A)IFRS, but not U.S. GAAP. (Explanation: IFRS requires firms to use component depreciation, which refers to depreciating theidentifiable components of an asset separately. U.S. GAAPpermits component depreciation but does not require it ) B)both IFRS and U.S. GAAP.C)U.S. GAAP, but not IFRS. 15. This information pertains to equipment owned by Brigade Company. ·Cost of equipment: $10,000. ·Estimated residual value: $2,000.

·Estimated useful life: 5 years. ·Depreciation method: straight-line. The accumulated depreciation at the end of year 3 is: A)$1,600. B)$4,800. (Explanation: Accumulated depreciation at the end of year 3 = [($10,000 − $2,000) / 5] × 3 = $4,800 ) C)$5,200. 16. JME acquired an asset on January 1, 2004, for $60,000 cash. At that time 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)$6,000. B)$15,000. (Explanation: first two years = (60,000 − 0) / 10 = 6,000 per yearyr. 2006 = (60,000 − 12,000 − 3,000) / 3 = 15,000 ) C)$12,000. 17. Walsh Furniture has purchased a machine with a 7-year useful life for $250,000. At the end of its life it will have an estimatedsalvage value of $15,000. Using the double-declining balance (DDB)method, depreciation expense in year 2 is closest to: A) $58,750.B) $71,430. C) $51,020. Explanation:

Year 2 / Depreciable Life × Book Value at Beginning ofthe Year = Depreciation 1 0.2857 250,000 71,429 2 0.2857 178,571 51,020 18. Slovac Company purchased a machine that has an estimated useful life of eight years for $7,500. Its salvage value is estimated at$500.What is the depreciation expense for the second year,assuming Slovac uses the double-declining balance method ofdepreciation? A)$1,406. (Explanation: double-declining balance depreciation rate = 2 × 1/8 = ¼ or 25%first year deprecation will be $7,500 × 0.25 = $1,875second year deprecation will be ($7,500 − $1,875) × 0.25 = $1,406 ) B)$1,438.C)$1,875. 19. 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 salvagevalue. The amount of depreciation expense recognized in 2006assuming that JME uses the double declining balance method is: A)$3,456. (Explanation: 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 ) B)$5,760.C)$4,000. 20. Allocating an intangible asset’s cost to the income statement over time is known as: A)depreciation.B)depletion.

C)amortization. (Explanation: Allocating an intangible asset’s cost to the income statement over time is known asamortization. The same process is known as depreciation fortangible assets. For natural resources, allocation of cost to theincome statement over time is commonly referred to asdepletion. ) 21. Intangible assets with finite useful lives are: A)amortized over their actual lives.B)not amortized, but are tested for impairment at least annually. C)amortized over their expected useful lives. (Explanation: Intangible assets with finite lives are amortized over theirexpected useful lives, which is an estimate. Actual lives ofintangible assets are often not known in advance. Intangibleassets with infinite lives are not amortized, but are tested forimpairment at least annually ) 22. Under normal circumstances, intangible assets with indefinite lives are: A)not amortized but subject to impairment. (Explanation: Intangible assets with indefinite lives are not amortized butare subject to impairment charges. Under such situations,there may be in impairment in the asset value where eventsand circumstances indicate that the firm may not be able torecover the carrying value through future use. Examplesinclude significant declines in market value of the asset orsignificant deterioration in the asset’s physical condition ) B)amortized over a reasonable period but not subject toimpairment.C)amortized over a reasonable period and subject to impairment.

23. Schubert, Inc. acquires 100% of another firm. As a result of the acquisition, Schubert reports on its balance sheet 1) a patent withfive years remaining and a carrying value of $2 million and 2)goodwill with a carrying value of $4 million. Using the straight-linemethod, total amortization expense in the first year for these twointangible assets is: A)$800,000.B)$1,200,000. C)$400,000. (Explanation: Amortization expense for the patent is $2 million / 5 = $400,000. Goodwill is an intangible asset withan indefinite life and is not amortized ) 24. Davis Inc. is a large manufacturing company operating in several European countries. Davis has long-lived assets currently inuse that are valued on the balance sheet at $600 million. Thisincludes previously recognized impairment losses of $80 million.The original cost of the assets was $750 million. The fair value ofthe assets was determined by in independent appraisal to be $690million. Which of the following entries may Davis record underIFRS? A)$90 million gain on income statement. B)$80 million gain on income statement and a $10 millionrevaluation surplus. (Explanation: Under IFRS, firms may choose to report long-lived assets at fair value. Upwardrevaluations are permitted and will result in a gainrecognized on the income statement to the extent it reverses apreviously recognized loss. Any excess is reported as arevaluation surplus, a direct adjustment to equity. In this case,the carrying value of the assets is $600 million ($750 millionoriginal cost less $70 million accumulated depreciation andless $80 million impairment loss). The fair value is $690million. Of the $90 million excess of fair value over carryingvalue, $80 million is recognized as a gain on the incomestatement to reverse the $80 million impairment loss that was

previously recognized. The remaining $10 million is recordedas a revaluation surplus in shareholders' equity ) C)$90 million revaluation surplus. 25. A firm revalues its long-lived assets upward. All other things equal, which of the following financial impacts is least likely tooccur? A)Higher profitability in the periods after revaluation.(Explanation: Because the asset has now been increased to a higher depreciable base, there will now be higher depreciationexpense and therefore, lower profitability in the periods afterrevaluation. There could be higher earnings in the revaluationperiod because there may be impairment losses that can bereversed on the income statement. Otherwise, there will be anadjustment to earnings through other comprehensive income.Leverage ratios (i.e. debt to equity) will decrease since theincrease in assets will be balanced by an increase in equity.Higher denominators and unchanged numerators will resultin lower leverage ratios ) B)Higher earnings in the revaluation period.C)Lower leverage ratios.

26. Which of the following statements about accounting treatments under IFRS and U.S. GAAP are most accurate regarding the periodic valuation of identifiable intangible assets and marketablesecurities classified as available for sale, respectively? Identifiable intangible assets Available-for-sale securities A) U.S. GAAP permits upward revaluation Carried at market value B) U.S. GAAP permits upward revaluation Carried at amortized cost C) IFRS permits upward revaluation Carried at market value Explanation: Under IFRS and U.S. GAAP, identifiable intangible assets are reported on the balance sheet at their cost lessaccumulated amortization. However, a significant differenceis that U.S. GAAP does not permit upward revaluations ofintangible assets.The accounting treatment for available-for-sale securities isthe same under IFRS and U.S. GAAP. These securities arecarried on the balance sheet at their fair market values.Unrealized gains and losses are not recognized on the incomestatement, but are included in other comprehensive income 27. On January 1, 2004, Cayman Corporation bought manufacturing equipment for $30 million. On December 31, 2006, Caymandetermined the equipment was impaired and recognized a $5million impairment loss in its income statement. As of December31, 2007, the fair value of the equipment exceeded the book valueby $7 million. What amount of the recovery in value can Caymanrecognize in its 2007 income statement under U.S. GenerallyAccepted Accounting Principles (U.S. GAAP) and underInternational Financial Reporting Standards (IFRS)?

U.S. GAAP IFRS A) $0 $7 million B) $0 $5 million C) $5 million $7 million Explanation: U.S. GAAP does not permit upward valuations of plant and equipment. Under IFRS, the recovery is reported inthe income statement to the extent that the previousdownward adjustment (loss) was reported in net income.Otherwise, the increase in value is reported as an adjustmentto equity. Thus, under IFRS, $5 million will be reported in 2007net income and $2 million will be directly added to to equity(as an adjustment to equity) . 28. Three years ago, Ranchero Corporation purchased a patent for a process used in production, for ₤ 3 million. At the end of last year, Ranchero determined the fair value of the patent was greater thanits book value. No impairment losses have been recognized on thepatent. Assuming Ranchero follows International FinancialReporting Standards, what is the impact on its total asset turnoverratio and return on equity of reporting the value of the patent onthe balance sheet at fair value? A)Only one will increase. B)Both will decrease. (Explanation: Increasing the value of the patent on the balance sheet will increase assets and thusdecrease the total asset turnover ratio (higher denominator).Increasing the value of the patent will also increase equity,otherwise, the balance sheet equation would not balance.Increasing equity will result in lower ROE (higherdenominator). The increase in the value of the patent is notrecognized in the income statement unless it is reversing apreviously recognized write-down ) C)Both will increase.

29. As part of a major restructuring of business units, General Security (an industrial conglomerate operating solely in the U.S.and subject to U.S. GAAP) recognizes significant impairment losses.The Investor Relations group is preparing an informational packetfor shareholders, employees, and the media. Which of thefollowing statements is least accurate? A)The write-downs are reported as a component of income fromcontinuing operations. B)Write-downs taken on asset values can be reversed in lateryears if market conditions improve. (Explanation: Impairments cannot be restored under U.S. GAAP. Bothremaining statements are correct ) C)During the year of the write-downs, retained earnings anddeferred taxes will decrease. 30. Marcel Inc. is a large manufacturing company based in the U.S. but also operating in several European countries. Marcel haslong-lived assets currently in use that are valued on the balancesheet at $600 million. This includes previously recognizedimpairment losses of $80 million. The original cost of the assets was$750 million. The fair value of the assets was determined in aprofessional appraisal to be $690 million. Assuming that Marcelreports under U.S. GAAP, the new appraisal of the assets’ valuemost likely results in: A)no change to Marcel’s financial statements. (Explanation: Under U.S. GAAP, long-lived assets are reported on the balancesheet at depreciated cost less any impairment losses ($750million original cost less $70 million accumulated depreciationand less $80 million impairment loss, for a net amount of $600million). Increases are generally prohibited with the exceptionof assets held for sale. Since these assets are currently in use,

this exception does not apply. Therefore, Marcel may notrevalue the assets upward ) B)a $90 million gain in other comprehensive income.C)an $80 million gain on income statement and $10 million gain inother comprehensive income. 31. Under U.S. GAAP, an asset is impaired when: A)the firm can no longer fully recover the carrying amount ofthe asset. (Explanation: An asset is impaired if its future cash flows (undiscounted) are less than its carrying value ) B)accumulated depreciation plus salvage value exceeds acquisitioncosts.C)the present value of future cash flows exceeds the carryingamount of the asset 32. An impairment write-down is least likely to decrease a company's: A)debt-to-equity ratio. (Explanation: An impairment write-down reduces equity and has no effect on debt. Thedebt-to- equity ratio would therefore increase ) B)assets.C)future depreciation expense. 33. An analyst determined the following information concerning Franklin, Inc.’s stamping machine:·Acquired seven years ago for $22 million·Straight line method used for depreciation·Useful life estimated to be 12 years·Salvage value originally estimated to be $4 million

The stamping machine is expected to generate $1,500,000 per yearfor five more years and will then be sold for $1,000,000. Under U.S.GAAP, the stamping machine is: A)not impaired. B)impaired because its carrying value exceeds expected futurecash flows. (Explanation: The carrying value of the stamping machine is its cost less accumulated depreciation.Depreciation taken through 7 years was ($22,000,000 -$4,000,000) / 12 × 7 = $10,500,000, so carrying value is $22,000,000- $10,500,000 = $11,500,000. Because the $11,500,000 carryingvalue is more than expected future cash flows of (5 ×$1,500,000) + $1,000,000 = $8,500,000, the stamping machine isimpaired ) C)impaired because expected salvage value has declined. 34. Spenser Inc. owns a piece of specialized machinery with a current fair value of $400,000. The original cost of the machinerywas $500,000 and to date has generated accumulated depreciationof $140,000. Which of the following must Spenser record on theincome statement if it decides to abandon the asset? A)Gain of $40,000.B)Loss of $100,000. C)Loss of $360,000. (Explanation: With an abandonment of an asset, the carrying value of the machinery is removed from thebalance sheet and a loss of that amount is recognized in theincome statement. The carrying value is $360,000, which equalsthe original cost ($500,000) less the accumulated depreciation($140,000) ) 35. Felker Inc. owns a piece of specialized machinery. The original cost of the machinery was $500,000 and to date there is anaccumulated depreciation balance of $140,000. Which of the

following will Felker recognize on its income statement if it sellsthe machinery for $400,000? A)Gain of $40,000. (Explanation: With a sale of an asset to a third party, the difference between the proceeds and carryingvalue is reported as a gain or loss on the income statement.The carrying value is $360,000, which equals the original cost($500,000) less the accumulated depreciation ($140,000).Therefore, the gain is equal to $40,000 ($400,000 proceeds less$360,000 carrying value) ) B)Loss of $100,000.C)Loss of $360,000. 36. Which set of accounting standards requires firms to disclose estimated amortization expense for the next five years onintangible assets? A)IFRS.B)Both IFRS and U.S. GAAP. C)U.S. GAAP. (Explanation: Estimated amortization expense for the next five years is required by U.S. GAAP but is not requiredby IFRS ) 37. Lucille Edgewater, CFA, is analyzing Pfaff Company, which reports its long-lived assets using the revaluation model. Edgewaterneeds to determine 1) what Pfaff’s carrying value of property, plantand equipment would be under the historical cost model, and 2)which of Pfaff’s intangible assets have finite useful lives. Will theseitems be disclosed in Pfaff’s financial statements? A)Both of these items are required to be disclosed.(Explanation: Under IFRS, firms that use the revaluation model for PP&E must disclose its carrying value under thehistorical cost model. Firms must also disclose whether theuseful lives of intangible assets are finite or indefinite )

B)Neither of these items is required to be disclosed.C)Only one of these items is required to be disclosed. 38. A building owned by a firm is most likely to be classified as investment property if: A)space in the building is rented to other firms. (Explanation: Under IFRS, investment property is an asset that is owned forthe purpose of earning income from rentals, capitalappreciation, or both ) B)the firm uses the building for its corporate headquarters.C)the building is a manufacturing plant or distribution center.