Brian Jordan is interviewing for a junior equity analyst position at Orion Investment Advisors.

As part
of the interview process, Mary Benn, Orion’s Director of Research, provides Jordan with information
about two hypothetical companies, Alpha and Beta, and asks him to comment on the information on
their financial statements and ratios. Both companies prepare their financial statements in
accordance with International Financial Reporting Standards (IFRS) and are identical in all respects
except for their accounting choices.

Jordan is told that at the beginning of the current fiscal year, both companies purchased a major new
computer system and began building new manufacturing plants for their own use. Alpha capitalized
and Beta expensed the cost of the computer system; Alpha capitalized and Beta expensed the
interest costs associated with the construction of the manufacturing plants.

Benn asks Jordan, “What was the impact of these decisions on each company’s current fiscal year
financial statements and ratios?”

Jordan responds, “Alpha’s decision to capitalize the cost of its new computer system instead of
expensing it results in higher net income, higher total assets, and higher cash flow from operating
activities in the current fiscal year. Alpha’s decision to capitalize its interest costs instead of
expensing them results in a lower fixed asset turnover ratio and an unchanged interest coverage
ratio.”

Jordan is told that Alpha uses the straight-line depreciation method and Beta uses an accelerated
depreciation method; both companies estimate the same useful lives for long-lived assets. Many
companies in their industry use the units-of-production method.

Benn asks Jordan, “What are the financial statement implications of each depreciation method, and
how do you determine a company’s need to reinvest in its productive capacity?”

Jordan replies, “All other things being equal, the straight-line depreciation method results in the least
variability of net profit margin over time, while an accelerated depreciation method results in an
improving trend in net profit margin over time. The units-of-production can result in a net profit
margin trend that is quite variable. I use a three-step approach to estimate a company’s need to
reinvest in its productive capacity. First, I estimate the average age of the assets by dividing
accumulated depreciation by depreciation expense. Second, I estimate the average remaining useful
life of the assets by dividing net property, plant, and equipment by annual depreciation expense.
Third, I add the estimates of the average remaining useful life and the average age of the assets in
order to determine the total useful life.”

Jordan is told that at the end of the current fiscal year, Alpha revalued a manufacturing plant; this
increased its reported carrying amount by 15 percent. There was no previous downward revaluation
of the plant. Beta recorded an impairment loss on a manufacturing plant; this reduced its carrying by
10 percent.

Benn asks Jordan “What was the impact of these decisions on each company’s current fiscal year
financial ratios?”

Jordan responds, “Beta’s impairment loss increases its debt to total assets and fixed asset turnover
ratios, the impairment loss is a non-cash charge and will not affect cash flow from operating
activities. Alpha’s revaluation decreases its debt to capital and return on assets ratios, and reduces
its return on equity.”