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Financial Reporting, Financial Statement Analysis and Valuation 9th Edition

Financial Reporting, Financial Statement Analysis and Valuation (9th Edition)

Book Edition9th Edition
Author(s)Wahlen
ISBN9781337614689
PublisherCengage
SubjectFinance
Chapter 8, End of Chapter, Questions and Exercises, Exercise 8.1
Page 555

Capitalization versus Expensing Decision.  

 

When a firm incurs costs on an item to be used in operations, management must decide whether to treat the cost as an asset or an expense. Assume that a company used cash to acquire machinery expected to contribute to the generation of revenues over a three-year period and the company erroneously expensed the cost to acquire the machine.

 

a. Describe the effects on ROA of the error over the three-year period.

Capitalization versus Expensing Decision.  

 

When a firm incurs costs on an item to be used in operations, management must decide whether to treat the cost as an asset or an expense. Assume that a company used cash to acquire machinery expected to contribute to the generation of revenues over a three-year period and the company erroneously expensed the cost to acquire the machine.

 

b. Explain how the error would affect the statement of cash flows.

Verified Answer

If the acquisition of machinery is expensed in the income statement, then, in the first year, the net income will fall and the total assets would increase. While computing the return on assets (ROA), the figure obtained by dividing the reduced net income by the increased total assets would be underrated.

 

For the next two years, because the acquisition is not treated as an asset, there is no depreciation charged. This would over rate the net income but the total assets would remain the same. This results in an overrated ROA. 

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