Ch21 Test Bank Alternative Ways To Measure Return On Capital

Chapter: Chapter 21: Alternative Ways to Measure Return on Capital

Multiple Choice

1. According to U.S. Generally Accepted Accounting Principles (GAAP), which of the following must be expensed?

I. A patent developed by the firm.

II. A building.

III. Equipment.

IV. A distribution network.

a) I and II only.

b) I and IV only.

c) II and III only.

d) III and IV only.

Response: [When a company builds a plant or purchases equipment, the asset is capitalized on the balance sheet and depreciated over time. Conversely, when a company creates an intangible asset, such as a brand name, distribution network, or patent, accounting rules dictate that the entire outlay must be expensed immediately.]

2. Concerning the impact on ROIC of capitalizing R&D, will increasing the asset life and/or the percentage of revenues spent on R&D increase ROIC?

a) Increasing either the asset life or the percentage of revenues spent on R&D will increase ROIC.

b) Neither increasing the asset life nor increasing the percentage of revenues spent on R&D will increase ROIC.

c) Increasing the asset life will increase ROIC, but increasing the percentage of revenues spent on R&D will not.

d) Increasing the asset life will not increase ROIC, but increasing the percentage of revenues spent on R&D will.

Response: [There is an inverse relationship between ROIC and both the length of life of the R&D capitalization and the percentage of revenues spent on R&D.]

3. Will either measures of performance or valuation be affected by changing the accounting treatment of R&D?

a) Both measures of performance and valuation will be affected.

b) Neither measures of performance nor valuation will be affected.

c) Measures of performance will be affected, but valuation will not be affected.

d) Measures of performance will not be affected, but valuation will be affected.

Response: []

4. If managers were given freedom to choose which expenses to classify as investments, which of the following is most accurate?

a) Managers will have an incentive to classify all expenses as investments.

b) Managers will have an incentive to classify no expenses as investments.

c) Managers will not have an incentive either way with respect to classifying expenses as investments.

d) Managers would most likely follow the rules established by GAAP, because they were formulated to be optimal for managers to follow.

Response: [Left unchecked, managers will have an incentive to classify all expenses as investments, even those with no long-term benefits, because this will maximize reported short-term performance.]

Short Answer

5. What is the recommendation concerning expensing or capitalizing R&D to measure a company’s performance? Explain the reason for the choice.

Response: [It is recommended that R&D be capitalized. By expensing items with long-term benefits, the accounting statements will understate the company’s historical investment. This understatement of capital can artificially boost ROIC in later years, making a business appear more attractive than it really is.]

True/False

6. If growth of a company is falling, expensing R&D will lead to an overestimation of the resulting drop in true performance.

Response: [If growth is falling, expensing R&D masks the resulting drop in true performance.]

7. A firm that capitalizes R&D has more opportunity to manipulate short-term earnings compared to a firm that expenses R&D.

Response: [Under traditional accounting, a manager looking to meet short-term earnings targets can simply reduce R&D spending.]

8. In early years, for a given company with a positive profit, ROIC with capitalized R&D will be higher than that with expensed R&D.

Response: [To capitalize R&D, R&D expense is replaced with amortization of historical R&D. Since R&D expense is greater than amortization in the company’s formative years, this keeps early margins and ROICs high.]

9. One benefit of capitalizing R&D is that reductions in current R&D will not affect current operating profits.

Response: []

10. Expensing items with long-term benefits will usually mean that the accounting statements will overstate the company’s historical investment, which can artificially lower ROIC in later years, making a business appear less attractive than it really is.

Response: [By expensing items with long-term benefits, the accounting statements will understate the company’s historical investment. This understatement of capital can artificially boost ROIC in later years, making a business appear more attractive than it really is.]