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Unformatted text preview: 9 a. The problem with using current costs is trying to determine what the current cost is. That is, how does one determine the current cost of a specialized piece of manufacturing equipment or the current cost of an office building in a slow­moving real estate market? This difficulty in determining current costs gives managers leeway to manipulate the amounts reported in the financial statements. If managers are given the opportunity to manipulate the financial statements through subjective current costs, then financial statement users will be wary of placing any reliance on the financial statements. Thus, current costs could potentially lead to the demise of financial statements. b. Historical costs are sunk costs in that they represent the cost of an asset at the time the asset was acquired; historical costs do not indicate the magnitude of cash or net assets that an asset will generate in the future. Since sunk costs are irrelevant for decision­making purposes, historical costs are not relevant for decision­making purposes. Alternatively, current costs provide a measure of the value of an asset today. For example, the amount reported for Cost of Goods Sold and Depreciation Expense under current cost represents the current values of the inventory sold during the period and of the fixed assets "consumed" during the accounting period, respectively. These values essentially represent what it would cost the company to replace the inventory it sold and the fixed assets it "consumed." In addition, the amounts reported on the balance sheet for inventory and fixed assets essentially represent what it would cost the company to replace its inventory and fixed assets, which is essentially the same value as what the company would realize if it sold the inventory and fixed assets. Thus, current cost information would be very relevant for decision­making purposes because it provides information about cash inflows the company could generate and about cash outflows the company is likely to make. In short, current cost information is very relevant for decision­making purposes. c. The argument comes down to reliability versus relevancy. Current cost information is more relevant than historical cost information, but it is considerably more difficult to objectively determine current costs than it is to determine historical costs. If individual financial statement users were able to dictate the valuation basis to be used in preparing financial statements, each individual would be able to determine his or her personal decision on the tradeoff between reliability and relevancy. However, financial statements are intended for general use, which means that the same financial statements will be used by a variety of people. Historically, reliability has been given more importance than relevancy because (1) relevant information is not very useful if you are not sure you can rely on the information and (2) managers and auditors are legally liable to financial statement users. That is, they are uneasy about providing information that might be subjective because it could greatly increase their legal exposure. ID9–10 a. 41 Asset write­downs allow Kellogg to manage earnings by reducing depreciation expenses in future periods. If Kellogg has a good quarter and decides to write down an asset this lowers the book value of the asset and thereby reduces the amount of depreciation expense that will be incurred in future periods. b. The accounting profession in general tends to prefer conservative accounting practices. By carrying the value of assets at a lower value, the auditors reduce their risk that if something goes wrong with the company that they will be sued. So if management makes estimates that reduce the value of assets, the auditors will be less likely to object. c. The FASB has come out against this policy of “taking a bath” by companies when they have had a really bad quarter to begin with. Some companies will then go ahead and write down assets so that in future periods the amount of depreciation will be reduced thereby improving reported net income. While the write down of assets may be conservative, this approach violates the matching principle. The appropriate costs are not being matched with the related revenues in future periods. ID9–11 a. The write­off of an outdated technology system would reduce assets and equity; equity is reduced because of the write­off expense, which reduces Retained Earnings through lower profits. b. The most likely factor in determining that a system is overvalued is the introduction of new technology products in the market that better meet the company’s needs. The old system, still carried on the balance sheet, is no longer as valuable because of the technological updates of the new systems. c. Management could decide to take the write­off expense in a year where earnings are otherwise very healthy, eliminating the need to take the expense in future years when earnings are less robust. A management team could lower current earnings (and thus future earnings expectations) by taking the write­off chargein the current period. ID9–12 According to U.S. GAAP, long­lived assets are recorded at original cost less accumulated depreciation. If the market value of the asset permanently falls below the balance sheet carrying value, an impairment charge must be recorded, and cannot be reversed in later periods, even if the value of the asset recovers. Under IFRS, companies can either follow the U.S. GAAP method, or they can periodically revalue their long­lived assets to fair market value, recognizing not only impairments but also recoveries of previously impaired assets and increases in asset values. Effectively, U.S. GAAP follows the more conservative “lower­of­cost­or market” principle, where asset values may be marked down but may never be marked up. IFRS, on the other hand, gives companies the option to value assets according to ever­changing market values, where both market value increases and decreases are recorded. Under U.S. GAAP, development costs must be expensed, while IFRS gives companies the ability, in certain circumstances, to capitalized development costs and amortize those costs over future accounting periods. U.S. GAAP requires immediate expensing, while IFRS can allow costs to be allocated to future periods. ID9–13 42 a. Property, plant and equipment make up 14.8% ($1,957.7/$13,249.6) of total assets. Other long­lived assets make up 11.8% ($1,557.9/$13,249.6) of total assets. b. According to Note 3, Machinery and Equipment is the largest category within property, plant and equipment. c. Depreciation expense (from the Statement of Cash Flow) is 1.7% ($335.0/$19,176.1) of Net Revenue. Because depreciation is a non­cash expense, it is added back in the Statement of Cash Flow in the calculation of cash from operating activities. d. According to Note 1, Nike depreciates its assets using the straight­line method. The company uses 2 to 40 years for buildings and leasehold improvements, 2 to 15 years for machinery and equipment, and 3 to 10 years for computer software. e. The company’s largest intangible asset is Trademarks. f. According to Note 1, Nike evaluates assets for impairment whenever business circumstances or events indicate the carrying value of assets might not be recoverable. If the evaluation determines impairment, the asset is written down to its estimated fair value. g. The acquisition of Umbro and the subsequent determination that the carrying value of the acquisition was greater than the fair value of the acquired company led to the large impairment charge. Impairment expenses appear on both the income statement and the statement of cash flow because they are non­cash expenses (and therefore are added back to earnings in the calculation of cash from operating activities). h. Nike spent $455.7 milliion for capital expenditures. The same year the company received $32 million in cash from the disposal of property, plant and equipment. 43...
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