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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 time
Tangible assets: e.g., land, buildings, and
equipment
Intangible assets: e.g., copyrights, patents,
trademarks, franchises, and goodwill
Natural resources: oil fields, mines, timberland
Plant property and equipment recorded at purchase cost
including shipping and installation, or construction cost
including labor, materials, overhead, and interest
601

Depreciation and Depletion
LOS 41.c,e, pp. 146, 149
Tangible assets have decreased value over time:
depreciation is the allocation of the cost of tangible assets
over time; land is not depreciated
Natural resources are used up over time: depletion is the
allocation of the cost (per unit) of natural resources as they
are used
Balance sheet (book) values are:
Historical cost - accumulated depreciation or
Historical cost - accumulated depletion
unless asset values are impaired
602

Sale of Depreciable Assets: Example
LOS 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 (less
than) book value
Sale for $3,000, gain = 3,000 2,000 = $1,000
Gain is reported as other income, is taxable
603

Intangible Assets and Goodwill
LOS 41.f, p. 149-150
Intangible assets: (e.g., patents, licenses,
franchises, leaseholds, trademarks, non-compete
agreements) value is reduced over time by
amortization (like depreciation for tangible assets)
Goodwill is the excess of purchase price (of a
whole business) over the fair market value of
tangible and other intangible business assets
Not amortized under US GAAP
Can be impaired, like any other asset
604

LOS 43.a, p. 167
Depreciation Methods
We are looking at depreciation for financial
reporting, not for taxes
Straight line (SL) Depreciation
Equal depreciation each year
Results in an increasing return on assets
during assets life
original cost - salvage value
depreciation expense =
depreciable life
605

LOS 43.a, p. 168
Example (straight-line method):
Useful life = 5 years; cost = $10,000; salvage
value = $2,000
original cost - salvage value
depreciation expense =
depreciable life
10,000 - 2,000
= = $1,600 annual depreiciation
5
606

LOS 43.a, p. 168
There are two accelerated depreciation methods,
sum-of-years digits (SYD), and double-declining
balance (DDB), which recognize greater depreciation
expense in the early part of an assets life and less
expense in the latter portion of its life.
Accelerated depreciation methods are usually used
on tax return (when allowed) because greater
depreciation expense in the early portion of the
assets life results in less taxable income and a
smaller tax payment.
607

LOS 43.a, p. 169
1- Example (SYD method):
Useful life = 5 years; cost = $10,000; salvage
value = $2,000; what is the depreciation for
year 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

608

LOS 43.a, p. 169
Example (SYD method): Useful life = 5 years;
cost = $10,000; salvage value = $2,000; what is
the depreciation for year 1 and year 5?
(original cost - salvage value) = $8,000
5 - 1 +1 5 1
Year 1: = , (8,000) = $2,667
1+2+3+ 4+5 15 3
5 - 5 +1 1 1
Year 5 : = , (8,000) = $533
1+2+3+ 4+5 15 15
609

LOS 43.a, p. 169-170
2) Double declining balance (DDB) method
Do not use salvage value in calculation
Do not depreciate below salvage value
Uses new book value in each years
calculation
(
(

Book value at
Deprec. expense =
beginning of year x
2
number of years
610

LOS 43.a, p. 170
Example (DDB method): Useful life = 5 years;
cost = $10,000; salvage value = $2,000; what is
the depreciation for years 1 - 4?
| |
|
\ .
BV at beginning
2
Yr 1 depreciation =
of year x depreciable life
2
= (10,000) =$4,000
5
611

LOS 43.a, p. 170
Example (DDB method)continued:
BV at end of Yr 1 = 10,000 - 4,000 = $6,000
Yr 2 depreciation = 2/5 6,000 = $2,400
BV 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
612

Impact of Depreciation Method on
Financial 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 Lower
Return on equity Higher Lower
Turnover ratios Lower Higher
Cash flow Same Same
613

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 =
Relative age =
614

1-A company is switching from straight-line depreciation to an
accelerated method of depreciation. Assuming all other revenue
and expenses are at the same levels for the next period, switching
to 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.
615

The use of an accelerated depreciation method will increase
depreciation 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, because
the book value of the fixed assets will be lower.

616

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

A) Accelerated depreciation methods will decrease the amount of taxes
in early years.
B) Straight-line depreciation methods will have higher book values for
the assets on the balance sheet than companies that use accelerated
depreciation.
C) Accelerated depreciation methods will increase the total amount of
depreciation expense over the life of an asset.
D) Units-of-production and service hours methods to depreciate assets
will overstate income during periods of low production.

617

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 of
depreciation expense in the early years of the assets life, but the
depreciation expense will be less in the latter years of the assets life.

618

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

A) Depreciation expense will be higher due to the decrease in demand
for 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.
619

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 suffered
a decline in the economic value of the assets. However, depreciation
expense will be low based on the low level of asset use.

620

4- 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 of depreciation?

A) $1,438.
B) $1,406.
C) $1,875.
D) $3,750.
621

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

622

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

A) $292.
B) $518.
C) $1,167.
D) $583.
623

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

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

624

6-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.
C) $3,200.
D) $5,200.
625

Accumulated depreciation at the end of year 3

[($10,000 - $2,000) / 5] = 1600

1600 x 3 = $4,800

626

7-After three years, Brigade expects that it will use the equipment for
a total of six years (i.e., 3 more years). Brigade estimates no
change in the residual value. What is the depreciation expense for
year 4?

A) $1,067.
B) $1,600.
C) $1,733.
D) $800.
627

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

628

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

A) $360,000.
B) $240,000.
C) $600,000.
D) $0.
629

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

630

9-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 no
salvage. During 2006 JME estimated the remaining life of the asset
to be only three more years with a salvage value of $3,000. If JME
uses straight line depreciation, what is the depreciation expense for
2006?

A) $15,000.
B) $6,000.
C) $12,000.
D) $16,000.
631

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

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

632

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 in
2006 assuming that JME uses the double declining balance
method is:

A) $4,000.
B) $5,760.
C) $8,000.
D) $3,456.
633

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

634

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

Depreciation expense is $15,000.
Plant and equipment is $250,000.
Accumulated depreciation is $60,000.

Average Age (%) Average Age (Years)

A) 25% 4
B) 24% 6
C) 25% 6
D) 24% 4
635

Average age (in years) =
Average depreciable life =
Relative age =
636

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

637

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

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.
638

Average age of fixed assets = accumulated depreciation / annual
depreciation

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

639

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

A) Depreciable life.
B) Age.
C) Age as a percent of depreciable life.
D) Depreciation.
640

Average depreciable life is approximated by:

Ending gross investment / depreciation expense

641

14-Gross plant and equipment $1,250,000
Depreciation 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.
642

The average depreciable life = Gross PPE / Depreciation expense

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

643

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.
644

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

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

645

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.
646

The average age = accumulated depreciation / depreciation expense

$725,000 / $235,000 = 3.09

647

17-An analyst will most likely use the average age of depreciable
assets to estimate the companys:

A) Future dividend payments.
B) Cash flows.
C) Near-term financing requirements.
D) Earnings potential.
648

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.

649

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 the
asset.
650

D-An asset is impaired when the firm can no longer fully
recover the carrying amount of the asset.

651

Example: Asset impairment

Information related to equipment owned by Grownfield
Company follows:

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

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

652

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

Since the carrying value exceeds the expected future cash
flow ( $ 800 000 carrying value > $ 700 000 expected
future cash flow ), the equipment is impaired.

The impairment loss is equal to $ 220 000 ( $800 000
carrying value - $ 580 000 fair value). Thus, the carrying
value of the equipment on the balance sheet is reduced to
$ 580 000 and a $ 220 000 impairment loss is recognized
in the income statement.
653

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

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.

654

Changes in asset lives and salvage value are changes in accounting
estimates and are not considered changes in accounting principle, so
no specific disclosures are required.

655

20-The following information has been gathered regarding Williams
Investing, 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 its
issets 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.
656

To find the change in depreciation we have to find the annual
depreciation 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 decrease
of $2.3

657

21-Net income for Williams Investing will increase by:

A) 13.85%.
B) 15.39%.
C) 10.62%.
D) 9.23%.
658

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

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

659

22-When the depreciation method is changed from an accelerated method
to 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.
660

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

661

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

A) $300,000.
B) $240,000.
C) $275,000.
D) $186,000.
662

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.

663

24-Rasmus Company purchased equipment for $96,000. The estimated
useful 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 year
was $12,000. What method of depreciation did Rasmus most likely
use?

A) Sum-of-years digits.
B) Straight Line.
C) Double-declining balance.
D) Units of Production method.
664

$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 be
Year 1 (96000 X 2/3 ) = 64 000
Year 2 8 000
Year 3 0
665

25-In its first year of business, Digmore Corporations balance sheet
shows gross fixed assets at $90 million and accumulated
depreciation of $10 million. If the estimated salvage value of these
assets 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.
666

$90 $10 million = $80 million; $80 million / 8 = $10 million
depreciation per year under SL depreciation.

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Financial Statement Analysis

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