Professional Documents
Culture Documents
CH 22 SM
CH 22 SM
DISCUSSION QUESTIONS
Q22-1. Effective planning and control of capital Q22-4. The economic life of a project is the period
expenditures are important because: during which it produces earnings. It need
(a) financial risk is increased by long-term not, and probably will not, be equal to the
commitments; physical life of the related asset(s). Its length
(b) the magnitude of capital expenditures is depends primarily upon the obsolescence of
substantial and the penalties for unwise the product or manufacturing process
decisions are usually severe; involved or the nature of the product itself.
(c) decisions made in this area provide the Managers usually find it quite difficult to esti-
supporting structure for operating activi- mate economic life because it depends upon
ties of the firm. future events over which they may have little
Q22-2. Examples of opportunities and temptations or no control.
for unethical behavior in the capital budgeting Q22-5. Cash outflows that might be expected for a
area include: capital expenditure include:
(a) pressure applied to the cost/managerial (a) purchase price of one or more assets (or
accountant by superiors or associates to a down payment if property is purchased
circumvent the capital expenditure on installment);
approval process, in order to get a pet (b) construction period interest and taxes if
project approved; the property is being constructed;
(b) pressure to write off or devalue assets (c) machinery and equipment setup cost,
below their true value in order to justify particularly if machinery being evaluated
replacement; utilizes a more advanced technology than
(c) exaggerating the expected economic bene- that currently in use;
fits of a pet project in order to increase the (d) computer software development cost if a
likelihood of getting it approved computer aided design, computer aided
Q22-3. The cost/managerial accountant has an obli- manufacturing, or fully computer inte-
gation to the company to make sure that the grated manufacturing system is being
company’s legitimate policies and procedures purchased;
are not circumvented and to make sure that (e) increased annual maintenance and/or
the data used in the evaluation of capital power costs resulting from more compli-
expenditure proposals are as reliable and cated or technologically advanced machin-
realistic as possible. If an ethical violation ery or equipment;
occurs, the cost/managerial accountant (f) lease payments, if some or all of the
should first discuss the perceived problem assets being acquired in the project are
with his or her immediate supervisor (in order leased;
to clarify the significance of the problem and (g) working capital requirements (inventory,
identify possible courses of action) and then cash on hand, receivables, payables,
with the individual or individuals involved. If etc.) may increase as a result of
the individual involved is the accountant’s increased business generated by the
immediate supervisor, the cost/managerial capital project.
accountant should consult the next higher Q22-6. Cash inflows that might be expected from a
level of management. If the problem cannot capital expenditure include:
be resolved through discussion, the (a) revenues from additional business gener-
cost/managerial accountant is obligated to ated by the project;
provide a full disclosure of all the details to the (b) cost savings created by the capital expen-
executives responsible for evaluating and diture that result in a reduction of cash
approving capital expenditures. outflows (e.g., maintenance savings,
22-1
22-2 Chapter 22
labor savings, reduced inventory require- of tax liability that is a cash outflow. The timing
ments resulting from reduced setup of cash flows is affected by the tax depreciation
times, etc.); method and the recovery period used.
(c) retention of market share that might have Q22-11. Financial accounting data are not entirely
been lost if the capital expenditure were suitable for use in evaluating capital expendi-
not made (particularly in the case of ture proposals because:
advanced technologies that improve (a) Financial accounting uses the accrual
product quality, reduce costs, provide basis. Capital expenditure decisions gen-
manufacturing flexibility, etc. that can pro- erally rely on estimates of cash flows,
vide a competitive advantage to the firm rather than revenues and expenses
with the technology); determined on the accrual basis.
(d) salvage from the sale of the property at (b) Financial accounting is designed to
the end of the economic life of the capital measure periodic earnings. Capital
project. expenditure evaluation is concerned with
Q22-7. Some nonquantifiable benefits from investing the life of a given project, which seldom
in advanced manufacturing technologies, corresponds to usual accounting periods.
such as CIM, FMS, and robotics, include: (c) Financial accounting measures the
(a) improved product quality (ability to meet results of operations of a company or a
closer production tolerances and at the segment of a company. Although this
same time reduce the variability in pro- entity sometimes corresponds with a cap-
duction output); ital expenditure project, it is usually com-
(b) decreased machine setup and shorter posed of many intermingled capital
manufacturing cycle times (which provide expenditure projects.
the company with the ability to adjust out- (d) Financial accounting capitalizes expendi-
put quantity and variety quickly to meet tures if the expenditure is deemed to have
rapidly changing customer demands). a future value or benefit to the company.
Q22-8. Tax depreciation is quite likely to differ from Capitalization is an attempt to match
book depreciation because the cost recovery expenditures with revenues generated by
period used for tax purposes is usually those expenditures. When future value or
shorter than the economic life of the asset benefit cannot be reliably measured,
used for financial accounting purposes. Also, financial accounting treats the expendi-
an accelerated method of depreciation is typ- ture as a period expense rather than as
ically used for tax purposes, whereas the an asset acquisition.
straight-line method is more often used for Q22-12. Benefits of following up project results include:
book purposes. (a) comparison of actual with projected
Q22-9. Book depreciation should not be considered results to ensure that a project is meeting
in estimating the future cash flows from a proj- expected performance, or taking correc-
ect because book depreciation has no effect tive action or terminating a project that is
on the amount or timing of cash flows. not achieving expected performance;
Q22-10. Tax depreciation should be considered in esti- (b) evaluation of accuracy of projections from
mating the future cash flows from a project different departments;
because tax depreciation reduces taxable (c) improvement of future capital estimates;
income and, therefore, tax liability. Tax depreci- (d) motivation of personnel arising from
ation results in a tax savings, i.e., a reduction knowledge that follow-up will occur.
Chapter 22 22-3
EXERCISES
E22-1
E22-2
E22-3
E22-4
**
MACRS 5-year Depreciable Tax
Year Recovery Rate Basis Depreciation
1 .200 $600,000 $120,000
2 .320 600,000 192,000
3 .192 600,000 115,200
4 .115 600,000 69,000
5 .115 600,000 69,000
6 .058 600,000 34,800
1.000 $600,000
22-5
22-6 Chapter 22
E22-6
E22-7
Problems
P22-1
(1) (2) (3)
Inflation-
Adjusted
Estimated
Periodic Cash
Cash Inflows
Year Inflows 8% Price-Level Adjustment (1) × (2)
1 $19,000 (1 + .08) = 1.080 $ 20,520
2 22,000 (1 + .08)2 = 1.166 25,652
3 24,000 (1 + .08)3 = 1.260 30,240
4 18,000 (1 + .08)4 = 1.360 24,480
5 15,000 (1 + .08)5 = 1.469 22,035
6 10,000 (1 + .08)6 = 1.587 15,870
$109,000 $138,797
P22-2
P22-3
P22-3 (Concluded)
(2) Total after-tax cash inflows from making product (from part (1) above) .......................... $3,868,000
Initial cash outlay to purchase tools..................................................................................... 2,500,000
Excess of total net after-tax cash inflows over initial cost of capital project .................. $1,368,000
22-13
P22-4 22-14
(1)
P22-5 (Continued)
P22-5 (Concluded)
**The cash inflow from the salvage sale at the end of the project would be fully taxable because the tax
basis of the machine would be zero (i.e., the machine was fully depreciated). Thus, the tax on the cash
inflow from salvage would be $4,678 ($11,694 × 40%).
(2) Total after-tax cash inflows from the capital expenditure .................................................. $63,984
Less original investment cash outflow................................................................................. 40,000
Excess of total after-tax cash inflows over initial investment............................................ $23,984
Chapter 22
Chapter 22 22-19
P22-6
P22-6 (Concluded)
(1)
Chapter 22
(2)
(1) (2) (3) (4) (5) (6) (7) (8)
Inflation- Inflation- Tax Periodic
Adjusted Adjusted Net Depre- Net
Periodic Lost Periodic Periodic ciation Taxable Tax After-tax
Savings Contribution Savings and Income Effective Liability Cash
with CIM Margin Saved with CIM Amor- (Loss) Tax (Refund) Inflows
Year from Part (1) with CIM** (1) + (2) tization* (3) – (4) Rate (5) × (6) (3) – (7)
1 $ 53,000 $212,000 $265,000 $240,000 $ 25,000 40% $ 10,000 $ 255,000
2 78,680 224,800 303,480 360,000 (56,520) 40% (22,608) 326,088
3 107,190 238,200 345,390 232,000 113,390 40% 45,356 300,034
4 113,580 252,400 365,980 155,000 210,980 40% 84,392 281,588
5 120,420 267,600 388,020 155,000 233,020 40% 93,208 294,812
6 127,710 283,800 411,510 58,000 353,510 40% 141,404 270,106
Total annual after-tax savings from investment in CIM...................................................................... $1,727,628
Less initial investment for equipment and software (from above) ................................................... 1,200,000
Excess of after-tax savings over cost of CIM system with new information................................... $ 527,628
Chapter 22
Chapter 22 22-23
P22-7 (Concluded)
CASES
C22-1
Some of the factors that affect the decision of whether or not to delay the invest-
ment in new cleaning equipment are given below. Each factor can have two sides
(i.e., delay versus no delay) depending upon the circumstances involved.
(a) Unemployment, inflation rate, and business conditions in general.
Business outlook improving—do not delay.
Business outlook deteriorating—delay.
All of these factors affect the climate for business and should be consid-
ered.
(b) Difficulty associated with acquisition and installation of equipment and
training of operators.
Great difficulty—do not delay.
Little difficulty—delay.
The greater the lead time involved, the sooner the equipment should be
acquired so that it is ready when needed.
(c) Extent of operating efficiency improvements.
Great—do not delay.
Little—delay.
The greater the efficiency, the less it should be delayed because costs will
be saved even though volume does not increase.
(d) Inflation rate in cost of equipment.
Cost of equipment not expected to increase drastically—delay.
Cost of equipment expected to increase drastically—do not delay.
Company wants to minimize its initial cost outlay.
(e) Dependability of present equipment and likelihood of breakdowns.
Dependability is good—delay.
Dependability is not good—do not delay.
Company could defer, or have to go ahead with investment due to condition
of present equipment.
(f) Chance for technological advances in equipment.
Good—delay.
No chance—do not delay.
If there is a chance that technological advances will develop in the design of
the equipment, the company might want to take advantage of the new
design.
(g) Ability to obtain market advantage by providing better quality service at
same or lower price.
Good—do not delay.
Poor/neutral—delay.
Better service means more customers or justifies higher rates.
Chapter 22 22-25
C22-1 (Concluded)
(h) Competitors’ plans for obtaining similar equipment and achieving market
advantage.
High probability—do not delay.
Low probability—delay.
Company wants to maintain competitive advantage or meet competition.
(i) Ability to predict timing and increased volume of demand from new or exist-
ing customers.
Good—better quality of decision; could defer switch longer.
Low—less reliable criteria for decision.
The better a company is able to predict new business, the more certain It can
be of its decision and, possibly, the longer it can wait to make a change.
C22-2
Knight is probably correct in her assessment that the proposed capital invest-
ment framework grants too much freedom to the divisions. Neoglobe’s long-run
performance depends on its capital investments. While divisions must have
some responsibility for capital investments for the proposed organization struc-
ture to be effective, corporate management must maintain adequate control to
direct the future course of the firm. Under the proposed framework, division
management controls a substantial portion of the capital budget, and in some
years, few funds would be available for investment by corporate management.
The present proposal would reduce corporate management’s ability to diminish
a product line, and it also would impair management’s ability to have adequate
funds available for investment in new businesses.
Capital investment procedures should involve both division and corporate
managements in such a way that division management still should be able to
influence the future direction of the firm. Such procedures might include classi-
fication of capital projects into groups, some of which could be approved by divi-
sion management without corporate management study.
An alternative to the Neoglobe capital investment program might have the fol-
lowing features:
(a) All proposed investment projects would be classified according to their
nature—replacement, cost savings, expansion.
(b) Replacement and cost savings projects could be adopted by division man-
agement alone, without approval of corporate management, provided an
individual project did not exceed a specified dollar limit and the total of such
projects did not exceed another specified dollar limit. The dollar limits would
reflect the nature and size of each division’s operations.
(c) All expansion projects, or other projects that exceed the dollar limit, would
be submitted to corporate management for evaluation and approval.
22-26 Chapter 22
C22-3
C22-4
(1) Arnett’s revision of the first proposal described in the case can certainly be con-
sidered a violation of the Standards of Ethical Conduct. Arnett discarded the rea-
sonable projections and estimates after being questioned and pressured by
Earle, and used figures that have only a remote chance of occurring. By doing
this, Arnett violated the standard of objectivity (which requires that the manage-
ment accountant communicate information fairly and objectively and disclose
fully relevant information that could reasonably be expected to influence an
Chapter 22 22-27
C22-5
(1) Referring to the specific standards in the IMA’s Standards of Ethical Conduct for
Practitioners of Management Accounting and Financial Management, the con-
duct of H. Dodge and G. Watson is unethical as discussed below:
(a) H. Dodge’s first revision of the proposal for the warehouse conversion was
unethical because Dodge’s actions violate the following standards:
Integrity. Watson has the responsibility to advise all parties of any potential
conflict of interest. Watson should refuse any favor (the warehouse reducing
his commuting time) that would appear to influence his actions. Watson
should communicate unfavorable as well as favorable information and pro-
fessional judgments and opinions.
Objectivity. Watson has the responsibility to disclose fully all relevant infor-
mation that can influence an intended user’s understanding of the analysis.
Chapter 22 22-29
C22-5 (Concluded)
C22-6
(1) By referring to the IMA’s Standards of Ethical Conduct and taking into consider-
ation the specific standards of competence, confidentiality, integrity, and objec-
tivity, L. Forrest should evaluate B. Rolland’s directives as follows:
Integrity. Rolland is engaging in activities that could prejudice him from carrying
out his duties ethically. In evaluating Rolland’s directive as it affects Forrest,
Forrest has an obligation to communicate unfavorable as well as favorable infor-
mation and professional judgments or opinions.
22-30 Chapter 22
(2) By referring to the Standards of Ethical Conduct, L. Forrest should take the fol-
lowing steps to resolve this situation:
(a) Forrest should first investigate and see if IDI has an established policy for
resolution of ethical conflicts and, if so, follow those procedures.
(b) If this policy does not resolve the ethical conflict, the next step would be for
Forrest to discuss the situation with his supervisor, Rolland, and see if he
can obtain resolution. One possible solution may be to present a “base
case” and sensitivity analysis of the investment. Forrest should make it clear
to Rolland that he has a problem and is seeking guidance.
(c) If Forrest cannot obtain a satisfactory resolution with Rolland, Forrest could
take the situation up to the next layer of management, and inform Rolland
that is being done. If this is not satisfactory, Forrest should progress to the
next level, and eventually to all higher levels of management until the issue
is resolved (i.e., the president, audit committee, or board of directors).
(d) Since Rolland has instructed him not to discuss the situation with anyone
else at IDI, Forrest may want to have a confidential discussion with an objec-
tive advisor to clarify relevant concepts and obtain an understanding of pos-
sible courses of action. Forrest may want to talk to a close professional
friend or the IMA “Ethics Hotline” for this purpose.
(e) If Forrest cannot satisfactorily resolve the situation within the organization,
he may resign from the company and submit an informative memo to an
appropriate person in IDI (i.e., the president, audit committee, or board of
directors).
(f) Forrest may consult with personal legal counsel.