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12-1
Analysis of Analysis of Investing Investing ActivitiesActivities
Analysis of Analysis of Investing Investing ActivitiesActivitiesElectronic Presentation by Douglas Cloud
Pepperdine University
Electronic Presentation by Douglas Cloud
Pepperdine University
Chapter Chapter F12F12
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1. Explain why investing decisions are important to a company and how they can affect its profits.
2. Explain how operating leverage affects a company’s risk and profits.
3. Use financial statements to evaluate investing activities for various companies.
ObjectivesObjectivesObjectivesObjectives
Once you have Once you have completed this chapter, completed this chapter, you should be able to:you should be able to:
Once you have Once you have completed this chapter, completed this chapter, you should be able to:you should be able to:
ContinuedContinuedContinuedContinued
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4. Explain how investing activities affect company value, and use accounting information to measure value-increasing activities.
5. Identify ways in which a company can use its assets to improve effectiveness and efficiency.
6. Explain why accounting information about long-term assets is useful for creditors.
ObjectivesObjectivesObjectivesObjectives
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11ObjectiveObjectiveObjectiveObjective
Explain why investing decisions are important to a company and how they can affect its profits.
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Exhibit 1Exhibit 1Exhibit 1Exhibit 1 The Production Process for Mom’s Cookie Company
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Obviously, we need equipment.
Obviously, we need equipment.
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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Can’t we just buy what we need?
Can’t we just buy what we need?
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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We have to decide how much of each type of equipment we need.
We can start small and add equipment as demand increases.
We have to decide how much of each type of equipment we need.
We can start small and add equipment as demand increases.
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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Perhaps the biggest decision we have to make is how much
automation we want in the production process.
Perhaps the biggest decision we have to make is how much
automation we want in the production process.
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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As an alternative, we can purchase more sophisticated equipment. Exhibit 2 shows
this alternative.
As an alternative, we can purchase more sophisticated equipment. Exhibit 2 shows
this alternative.
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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Exhibit 2Exhibit 2Exhibit 2Exhibit 2 An Alternative Production Process for Mom’s Cookie Company
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Thus, our basic choice is manual or automated equipment. If we select manual equipment, we
can start with less investment and add equipment as demand increase, but we will
have the capacity we expect to need.
Thus, our basic choice is manual or automated equipment. If we select manual equipment, we
can start with less investment and add equipment as demand increase, but we will
have the capacity we expect to need.
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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Also, we will be able to produce a higher quality product because the automated process is more reliable.
Also, we will be able to produce a higher quality product because the automated process is more reliable.
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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What effect do the choices have on our expected profits if we anticipate sales of $3,000,000?
What effect do the choices have on our expected profits if we anticipate sales of $3,000,000?
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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(in thousands) Manual Automated(in thousands) Manual Automated
Assets:Current assets $1,000 $1,000Plant assets 3,500 4,000
Total assets $4,500 $5,000Sales $3,000 $3,000Cost of ingredients (800) (800)Depreciation (250) (300)Wages and benefits (780) (700)Other operating expenses (1,000) (1,000)Operating income 170 200Interest expense (170) (170)Pretax income --- 30Income taxes --- (9)Net income $ --- $ 21
Sales of $3.0 Million
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In the second year of operations we anticipate sales of $3.6 million. What would be our projected net income if
our expectations are correct?
In the second year of operations we anticipate sales of $3.6 million. What would be our projected net income if
our expectations are correct?
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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If we select manual equipment, we will have to purchase an
additional $250,000 of equipment to meet the higher demand.
If we select manual equipment, we will have to purchase an
additional $250,000 of equipment to meet the higher demand.
Investing Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and ProfitInvesting Decisions and Profit
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(in thousands) Manual Automated(in thousands) Manual AutomatedAssets:
Current assets $1,200 $1,440Plant assets 3,750 4,000
Total assets $4,950 $5,440Sales $3,600 $3,600Cost of ingredients (960) (960)Depreciation (275) (300)Wages and benefits (936) (700)Other operating expenses (1,000) (1,000)Operating income 429 640Interest expense (170) (170)Pretax income 259 470Income taxes (78) (141)Net income $ 181 $ 329
Sales of $3.6 Million
Depreciation for Depreciation for manual increases manual increases due to additional due to additional
equipment required equipment required costing $250,000costing $250,000
Depreciation for Depreciation for manual increases manual increases due to additional due to additional
equipment required equipment required costing $250,000costing $250,000
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22Explain how operating leverage affects a company’s risk and profits.
ObjectiveObjectiveObjectiveObjective
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What would happen to net income if sales are only
$2.8 the first year?
What would happen to net income if sales are only
$2.8 the first year?
Investment Decisions and RiskInvestment Decisions and RiskInvestment Decisions and RiskInvestment Decisions and Risk
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(in thousands) Manual Automated(in thousands) Manual AutomatedAssets:
Current assets $ 900 $ 900Plant assets 3,400 4,000
Total assets $4,300 $4,900Sales $2,800 $2,800Cost of ingredients (747) (747)Depreciation (233) (300)Wages and benefits (728) (700)Other operating expenses (1,000) (1,000)Operating income 92 53Interest expense (170) (170)Pretax income (78) (117)Income taxes 23 35Net income $ (55) $ (82)
Sales of $2.8 Million
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Exhibit 6Exhibit 6Exhibit 6Exhibit 6 A Comparison of the Effects of Investment Decisions on Profits of Mom’s Cookie Company
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Fixed costs are costs that do not increase in proportion to
increases in sales.
Fixed costs are costs that do not increase in proportion to
increases in sales.
Investing Decisions and RiskInvesting Decisions and RiskInvesting Decisions and RiskInvesting Decisions and Risk
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Variable costs are costs that do increase in proportion to
increases in sales.
Variable costs are costs that do increase in proportion to
increases in sales.
Investing Decisions and RiskInvesting Decisions and RiskInvesting Decisions and RiskInvesting Decisions and Risk
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The use of fixed costs to increase net income as sales increase is known as operating leverage.
The use of fixed costs to increase net income as sales increase is known as operating leverage.
Investing Decisions and RiskInvesting Decisions and RiskInvesting Decisions and RiskInvesting Decisions and Risk
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33Use financial statements to evaluate investing activities for various companies.
ObjectiveObjectiveObjectiveObjective
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Identifying Investing ActivitiesIdentifying Investing ActivitiesIdentifying Investing ActivitiesIdentifying Investing Activities
As a first step in our analysis, we want to identify the companies’ long-term assets and the changes in these assets
resulting from investing activities.
As a first step in our analysis, we want to identify the companies’ long-term assets and the changes in these assets
resulting from investing activities.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Plant and equipment accounts for most of
the long-term assets of both companies.
Plant and equipment accounts for most of
the long-term assets of both companies.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s total assets grew by 63%.
Krispy Kreme’s total assets grew by 63%.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Starbucks’ total assets grew by 24%.
Starbucks’ total assets grew by 24%.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s plant and equipment grew by 29%.
Krispy Kreme’s plant and equipment grew by 29%.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Starbucks’ plant and equipment grew by 22%.
Starbucks’ plant and equipment grew by 22%.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s revenue grew by 37%.
Krispy Kreme’s revenue grew by 37%.
Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s revenue grew by 37%.
Krispy Kreme’s revenue grew by 37%.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s revenue grew by 37%.
Krispy Kreme’s revenue grew by 37%.
Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Starbucks’ revenue grew by 22%.
Starbucks’ revenue grew by 22%.
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44Explain how investing activities affect company value, and use accounting information to measure value-increasing activities.
ObjectiveObjectiveObjectiveObjective
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The Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset Growth
Growth in assets is important to the value of a company and the
wealth of its stockholders.
Growth in assets is important to the value of a company and the
wealth of its stockholders.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s revenue grew by 37%.
Krispy Kreme’s revenue grew by 37%.
Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s net income increased 147%.
Krispy Kreme’s net income increased 147%.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Krispy Kreme’s revenue grew by 37%.
Krispy Kreme’s revenue grew by 37%.
Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Selected Financial Statement Information for Krispy Kreme and Starbucks
Starbucks’ net income increased 92%.
Starbucks’ net income increased 92%.
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The Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset GrowthThe Importance of Asset Growth
Starbucks opened 1,208 new stores during 2001 and Krispy Kreme
opened 26 new stores during 2001.
Starbucks opened 1,208 new stores during 2001 and Krispy Kreme
opened 26 new stores during 2001.
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Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth
A common measure of outcome of a company’s investment decisions
is return on assets (ROA).
A common measure of outcome of a company’s investment decisions
is return on assets (ROA).
Return on Assets =Net IncomeTotal Assets
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Return on Assets =Net Income
Total Assets
Krispy Kreme =$14,725
$171,493 = 8.6%
Starbucks =$181,210
$1,851,039= 9.8%
20012001
Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth
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Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth
Asset turnover is the ratio of revenues to total assets. It is a
measure of the ability of a company to use its assets to
sell its products.
Asset turnover is the ratio of revenues to total assets. It is a
measure of the ability of a company to use its assets to
sell its products.
Revenues
Total AssetsAsset
Turnover =
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Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth
A company with a high asset turnover is more effective in
using its assets than one with a low asset turnover.
A company with a high asset turnover is more effective in
using its assets than one with a low asset turnover.
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Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth
Profit margin (or return on sales) is the ratio of net income to sales. It is a
measure of the ability of a company to produce profits
from it sales.
Profit margin (or return on sales) is the ratio of net income to sales. It is a
measure of the ability of a company to produce profits
from it sales.
Net Income
Revenues
Profit Margin =
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Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth
A company with a high profit margin is more efficient in
controlling costs than one with a low profit margin.
A company with a high profit margin is more efficient in
controlling costs than one with a low profit margin.
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Measuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of GrowthMeasuring the Effects of Growth
Once profit margin and asset turnover have been calculated,
return on assets can be determined by finding the
product of the two.
Once profit margin and asset turnover have been calculated,
return on assets can be determined by finding the
product of the two.
ROA = Asset Turnover x Profit Margin
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
Exhibit 8Exhibit 8Exhibit 8Exhibit 8
Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
StarbucksStarbucksKrispy KremeKrispy Kreme 2001 2000 2001 20002001 2000 2001 2000
Asset Turnover 1.754 2.098 1.431 1.460Profit Margin 4.90% 2.70% 6.84% 4.34%Return on Assets 8.59% 5.67% 9.79% 6.34%
Krispy Kreme was able to generate
$1.75 of sales for every $1 invested
in assets.
Krispy Kreme was able to generate
$1.75 of sales for every $1 invested
in assets.
Starbucks was able to generate $1.43 of sales for every $1 invested in assets.
Starbucks was able to generate $1.43 of sales for every $1 invested in assets.
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
Exhibit 8Exhibit 8Exhibit 8Exhibit 8
Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
StarbucksStarbucksKrispy KremeKrispy Kreme 2001 2000 2001 20002001 2000 2001 2000
Asset Turnover 1.754 2.098 1.431 1.460Profit Margin 4.90% 2.70% 6.84% 4.34%Return on Assets 8.59% 5.67% 9.79% 6.34%
Krispy Kreme was able to generate $0.049 of net
income for every $1 of sales.
Krispy Kreme was able to generate $0.049 of net
income for every $1 of sales.
Starbucks was able to generate over $0.068 of net
income for every $1 of sales.
Starbucks was able to generate over $0.068 of net
income for every $1 of sales.
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55Identify ways in which a company can use its assets to improve effectiveness and efficiency.
ObjectiveObjectiveObjectiveObjective
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The Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and EfficiencyThe Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and Efficiency
Effectiveness increases when the dollar amount of
sales increases more rapidly than the dollar amount of
additional investment.
Effectiveness increases when the dollar amount of
sales increases more rapidly than the dollar amount of
additional investment.
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The Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and EfficiencyThe Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and Efficiency
Efficiency increases when a company is able to earn
greater profit for each additional dollar of
product it sells.
Efficiency increases when a company is able to earn
greater profit for each additional dollar of
product it sells.
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The Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and EfficiencyThe Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and Efficiency
Mom’s Cookie Company invests $5 million in assets. It pays employees $700,000. Utilities and
other costs amount to $300,000 per year.
Mom’s Cookie Company invests $5 million in assets. It pays employees $700,000. Utilities and
other costs amount to $300,000 per year.
Sales $3,000,000 Cost of goods sold (60%) (1,800,000)Other operating expenses (1,000,000)Pretax income 200,000Income tax (60,000) Net income $ 140,000
Average cost of goods sold for its product is 60% of sales, and income taxes are 30% of pretax income.
In 2004, the store sold $3.0 million of goods.
Average cost of goods sold for its product is 60% of sales, and income taxes are 30% of pretax income.
In 2004, the store sold $3.0 million of goods.
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The Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and EfficiencyThe Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and Efficiency
By changing some of its product line, the company can increase sales to $3.3 million without any
additional asset investment or increasing expenses.
By changing some of its product line, the company can increase sales to $3.3 million without any
additional asset investment or increasing expenses.
Sales $3,300,000 Cost of goods sold (60%) (1,980,000)Other operating expenses (1,000,000)Pretax income 320,000Income tax (96,000) Net income $ 224,000
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Exhibit 7Exhibit 7Exhibit 7Exhibit 7 The Effect of a Sales Increase on Return on Assets
Exhibit 9Exhibit 9Exhibit 9Exhibit 9
Asset Turnover and Profit Margin for Krispy Kreme and Starbucks
AfterAfterBeforeBefore
Sales Revenues (in millions) $3.0 $3.3Asset Turnover 0.600 0.660Profit Margin 4.67% 6.79%Return on Assets 2.80% 4.48%
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The Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and EfficiencyThe Effect of Investment on The Effect of Investment on Effectiveness and EfficiencyEffectiveness and Efficiency
If sales decrease for any length of time, a company
must find ways to reduce its investment so that it can
eliminate unnecessary costs.
If sales decrease for any length of time, a company
must find ways to reduce its investment so that it can
eliminate unnecessary costs.
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66Explain why accounting information about long-term assets is useful for creditors.
ObjectiveObjectiveObjectiveObjective
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Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
Companies often borrow money to acquire long-term assets.
Accordingly, the ability of a company to repay creditors and…
Companies often borrow money to acquire long-term assets.
Accordingly, the ability of a company to repay creditors and…
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Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
…to pay interest usually is connected to its ability to use it long-term assets to
generate profits and cash flows.
…to pay interest usually is connected to its ability to use it long-term assets to
generate profits and cash flows.
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Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
Accounting measurement rules require companies to write
down their assets if the market values of the assets decrease
below their book value.
Accounting measurement rules require companies to write
down their assets if the market values of the assets decrease
below their book value.
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Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
A company owns a building that it purchased for $1 million. Accumulated depreciation on the building at the end of 2004 was $600,000 (book value = $400,000). At that time, the
company determined that the market value of the building was $250,000. The company recognizes a loss by writing down the asset
by $150,000 ($400,000 – $250,000).
A company owns a building that it purchased for $1 million. Accumulated depreciation on the building at the end of 2004 was $600,000 (book value = $400,000). At that time, the
company determined that the market value of the building was $250,000. The company recognizes a loss by writing down the asset
by $150,000 ($400,000 – $250,000).
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Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
Investing Activities and Investing Activities and Creditor DecisionsCreditor Decisions
This measurement rule is known as lower of cost or market and is intended to
protect investors, particularly creditors, by ensuring that assets are not overstated.
This measurement rule is known as lower of cost or market and is intended to
protect investors, particularly creditors, by ensuring that assets are not overstated.
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THE ENDTHE END
CCHAPTERHAPTER F12 F12
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