CFA Practice Question

CFA Practice Question

The current economic environment is one of steady inflation. A firm uses historical cost accounting. Which of the following is (are) true?

I. The firm's book value is overstated.
II. The firm's depreciation expense is understated.
III. The firm's tax expense is overstated.
IV. The firm's net income is understated.
A. II & III.
B. II & IV.
C. I & II.
Explanation: Since the assets are carried at historical values which are lower than the current asset values due to inflation, the depreciation expense is understated. Therefore, income is overstated, leading to an overstatement of taxes. Historical cost accounting in inflationary environment implies that the asset values are understated.

User Contributed Comments 8

User Comment
ENDER but...when income is overstated, book value is overstated too. Am I right?
ohmms No, book value refers to the book value of the asset not equity, which is lower than should be due to the lack of inflation consideration in depreciation.
dimos When depreciation expense is understated, income (before taxes) is overstated. Due to higher taxes, net income (after taxes) is understated. Why not IV?
steved333 It CAN be understated. It depends on the degree to which the under/overstatement occurs. Since it can be, but isn't necessarily so, you can't say that IV is correct. Good point, though.
bleublau IV can NOT be correct!
INFERENCE: 1.depreciation US
3. NET (after-tax) effect: NI OS (to the degree of delta Dep. * (1-T)

It does NOT depend on degree to which US/OS occurs!
birdperson I'm with Dimos. if DEP is understated, than EBIT is overstated, and tax is overstated, and NI is understated.... i guess there is a balancing act in there as DEP is also lower which leads to NI.

could use a better explanation from analystnotes.
farhan92 dep. is understaded so less NI is killed off therefore NI is higher and taxes would be higher than they should be.

I have made far too many stupid mistakes for this mock!
GBolt93 Think of it this way. If everything is correct NI is 0.
However if DE is understated by 1 NI increases by 1, but you also pay .35 (assuming 35% tax) in additional taxes. Therefore total effect on NI is =1(1-.35)=+0.65 So overall NI is still overstated. Much easier to just plug in simple numbers for these kind of questions.
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