Unformatted text preview: less than book value) and 2) the lowering of carrying value of fixed
assets to a new (impaired) market value. These amounts would also appear on the income statement.
The losses are added to net income in the calculation of cash from operations because the effect, if any,
on cash is an investment activity (long term assets) and should therefore be shown in a different section of
the statement of cash flows. ID14–3
a. The capitalization and matching process is not very useful for assessing the cash available to a company
because disbursing cash and consuming an item are two very different concepts. In order to measure
performance, it is necessary to match the costs that were incurred to generate benefits against the benefits. Under accrual accounting, costs should be capitalized if they are expected to provide benefits in
the future. Thus, when a company disburses cash to acquire an item expected to provide a future benefit,
the company should capitalize the cost of the item as an asset. As the company uses the item over time
to help generate revenue, the item will be expensed and matched against the revenue it helped generate.
Thus, through the process of capitalizing costs and then expensing them when the cost helps generate
revenue, revenues and expenses are closely matched. In this manner, the capitalization and matching
process make it difficult to assess a company’s cash performance.
b. Solvency refers to a company’s ability to pay its obligations as they come due, and earning power refers
to a company’s ability to generate net assets through operating activities. The two concepts are closely
related in that a company will not remain solvent if it is unable to generate net assets through operations.
That is, a company cannot stay in business indefinitely if its operations fail to generate sufficient net
assets to allow the company to pay back debt or pay dividends. Similarly, a company will not have very
good earning power if it is not solvent. If a company is having solvency problems, it will have to divert cash
away from operations and toward paying creditors.
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