Professional Documents
Culture Documents
QUESTIONS
Q7.1 Brand Names. Intangible assets, like brand names, are capitalized to the
balance sheet when they are purchased that is, when there is a transaction
with an independent party. Williams-Sonoma (WS) did not acquire its brand
name in a purchase transaction; it built the brand name with advertising, quality
service and products, and by word-of-mouth. If WS is subsequently acquired by
another company, the brand would be reported on the acquiring companys
balance sheet because the brand name would have been part of the acquisition
transaction. Brand names are thus a form of unreported asset (i.e., an off-
balance-sheet asset).
One solution for companies like AOL is to follow a successful efforts approach
to advertising, namely initially capitalizing the cost of advertising until the rate of
new subscribers can be ascertained and then expensing the portion of the cost
that was unsuccessful. This strategy would not be possible for Johnson and
Johnson, however, since consumers are notoriously fickle and there is no
guarantee of their brand loyalty.
U.K. GAAP allows companies to annually revalue their appreciated assets like
land, by increasing the asset account to its fair market value and also
increasing a shareholders equity account called the asset revaluation
reserve. In short, the U.K. system treats the appreciation of land as an
increase in overall firm wealth, not to be realized or reported on the income
statement until the asset is sold.
Under U.S. GAAP, revaluation of investments that are available for sale is
permitted (i.e. see Chapter 8) and is basically handled the same way as U.K.
GAAP accounts for land appreciation. Thus, precedents do exist to permit the
revaluation of assets in both the U.K. and the U.S. The reason that land
revaluation has not been permitted in the U.S. is the absence of an efficiently
functioning marketplace for real estate similar to that which exists for stocks
and bonds.
Q7.6 Changing Depreciation Methods. A change from the straight-line (SL) method
of depreciation to the declining-balance (DB) method will normally result in a
reduction in current earnings as the depreciation charges under DB are often
larger than those under SL. This financial outcome would be expected in every
circumstance except where a firms assets are relatively old in age; and, under
these circumstances, it is possible that earnings would increase following a
change from SL depreciation to DB depreciation. In the specific case of
Tomoegawa Paper, earnings declined.
Q7.8 Exploration and Development Costs in the Natural Resource Industry. The
process of exploration and development (E&P) in the natural resource industry
is very similar to the process of research and development (R&D) in the biotech
industry. Thus, it does appear inconsistent to treat E&P as a capitalizable asset
under the full cost and successful efforts methods, while treating R&D only as
an expense. The treatment of E&P as an asset rather than as an expense,
appears to have some historical context, namely that early in the 20 th century,
the U.S. government made a strategic decision to prioritize the development of
U.S. natural resources. For example, by examining the IRS Code for the
allowable percentage depletion allowance, we can see that the oil and gas
industry received the highest (15 percent) percentage depletion allowance, thus
reflecting the priority for development of this resource. No doubt this same kind
of thinking was involved in the deliberations around acceptable U.S. GAAP.
Clearly, allowing natural resource companies to capitalize some or all of their
E&P avoids the managerial disincentive associated with expensing R&D.
Further, allowing natural resource firms to capitalize some or all E&P facilitates
capital development (i.e., it is easier to raise capital if earnings are higher, as
they would be if E&P were capitalized).
Q7.9 Asset Impairments. The process followed by most firms to evaluate whether
an asset impairment has occurred is usually based on the concept of
discounted cash flow. For example, Bristol-Myers Squibb (BMS) reports in its
annual report:
Q7.12 R & D Failure and Share Prices. Since research and development costs are
expensed when incurred, the termination of the Torcetrapib clinical trials would
have no immediate impact on Pfizers financial statements (i.e. there were no
capitalized R&D costs to expense following the news announcement). The
decline in Pfizers share price reflected the reduction in future revenues,
earnings, and cash flow that the capital market had already impounded into
Pfizers share price in anticipation of the successful completion of the
Torcetrapib clinical trials. The price decline reflects the futuristic approach
utilized by the capital market to value shares (i.e., a companys share price
today is a function of its future expected earnings and cash flow).
The cost of an asset includes its acquisition cost ($1,200,000) and any costs
incurred to bring the asset to a revenue-producing state ($75,000).
The difference ($600,000) between the capitalized cost of the two methods is
the amount of expenses that will be immediately written off. Thus, for tax
purposes, the successful efforts method provides immediate tax-sheltering of
income in the amount of $600,000. Assuming a tax rate of 30%, that could
mean a current tax saving of $180,000 ($600,000 x 30%). Under full cost, these
costs are capitalized, to be depleted over time, and hence, full cost provides the
highest level of current income. So, if earnings maximization is the goal, the full
cost method achieves that goal best.
a. Sum-of-the-years digits
n(n + 1) 12(13)
= = 78
Sum-of-the-years = 2 2
For this set of facts, it appears that for the five-year period, the sum-of-the-
years digits method yields the largest total depreciation deduction, and thus,
would be preferred to the double-declining method for income tax purposes.
For financial reporting purposes, it appears to be a toss-up.
a. Units-of-production depreciation
($400,000 - $40,000)
Depreciation Charge per Mile $0.72 per mile
500,000
Mileage Depreciation
Year Driven Rate Expense
b. Straight-line depreciation:
($400,000 - $40,000)
Depreciation Expense = = $45,000 per year
8
The trend of the intangible asset turnover ratio for Pfizer suggests that the
companys ability to generate revenue from its investment in intangibles is
declining. One possible explanation for this is that during Year 2, Pfizer made a
large acquisition involving a significant investment in new intangibles that have
yet to attain the expected level of revenue generation.
The trend of the fixed asset turnover ratio is negative, suggesting that the
company is generating a decreasing amount of revenue from its investment in
property, plant, and equipment.
The accumulated depreciation divided by gross fixed assets ratio indicates the
relative age of Pfizers fixed assets. Not surprisingly, the approximate age of the
companys fixed assets decreased by four percent. Pfizers fixed assets are
relatively young in that they have over 60 percent of their remaining useful
lives.
Year 9:
Remaining book value = ($750,000 - $576,000) = $174,000
Straight-line depreciation = ($174,000 - $30,000) 6 years = $24,000 per year
The choice of depreciation method does not impact a firms cash flow from
operations because under the indirect method, the amount of depreciation
subtracted from accrual net income is added back to net income, creating a
wash. The choice of method also does not affect a companys income taxes
because all U.S. firms are required to use the MACRS system; in short, there is
no method choice for income tax purposes.
3. Under U.S. Department of Treasury Publication 535, oil and gas companies
must use the higher of cost depletion or statutory percentage depletion. Cost depletion
is demonstrated in Questions 1 and 2 of this exercise. Under statutory percentage
depletion, an oil and gas company may deduct depletion expense equal to 15 percent of
annual gross revenue.
*Exploration costs = $40 x 20/50 = $16; (20/50 = ratio of unsuccessful to total wells).
**Depletion schedule:
Liabilities &
Shareholders Equity
Bank loan $ 40.0 $ 30.0 $ 20.0 $ 10.0 $-0-
Retained earnings 2.6 32.5 69.4 143.9 264.0
Total $ 42.6 $ 62.5 $ 89.4 $ 153.9 $ 264.0
Liabilities &
Shareholders Equity
Bank loan $ 40.0 $ 30.0 $ 20.0 $ 10.0 $-0-
Retained earnings 17.0 44.5 79.0 149.5 264.0
Total $ 57.0 $ 74.5 $ 99.0 $ 159.5 $ 264.0
Statement of Cash Flow: A $2.1 billion add-back to net income under the
operating activities section.
3. The amounts would be the same. Under either scenario the cash has been
expended, but it is how and when those payments become expenses on the
income statement that will differ.
4. 594 million = 630+111-147. If the amounts had always been expensed, then
there would be no need for the amortization (thus the add-back). However,
the cash expended would be expensed during the year, thus the subtraction
of $147.
Note: A full reconciliation of the balance sheet account with the statement
of cash flow data reveals the following:
The turnover ratios for both fixed assets and intangible assets improved
from 2011 to 2012. In short, P&G used its noncurrent assets more
effectively in terms of generating incremental sales in 2012.
P&Gs fixed assets are nearly 50 percent used up, with approximately 50
percent of their expected life still remaining.
d. Impairment Charges:
a. Purchased brand names are capitalized and amortized over their useful
lives. Internally-developed developed brand names are not capitalized and
instead are expensed. This policy is essentially consistent with U.S. GAAP.