CFA Practice Question

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CFA Practice Question

A recent annual report included the following information:

Note 5: Assets placed in service before January 1, 2015, are depreciated using the accelerated method. Assets placed in service in 2015 will be depreciated using the straight-line method of depreciation. This change in accounting principle is being made to reflect improvements in the design and flexibility of manufacturing machinery and equipment and improvements in maintenance practices. These improvements have resulted in more uniform productive capacities and maintenance costs over the useful life of assets. Straight-line depreciation is preferable in these circumstances. The change is expected to improve 2015 after-tax results by $80 to $100 million. The change was not made for income tax reporting purposes.

Which of the following would generally be true as a result of this change?
A. Return on assets would increase.
B. Return on assets would decrease.
C. Cash flows would increase.
Explanation: Income will increase because less depreciation is being taken out of income. The assets will gradually decrease. Both effects together will increase the return on assets.

User Contributed Comments 6

User Comment
BZZNone Yes income will increase and asset will decrease. But asset will decrase at a slower pace compared to old accelerated depreciation. So both numerator and denominator are higer than before accounting change. It's difficult to tell what's ROA's direction.
gjwhite The percentage effect on net income tends to be greater than the percentage effect on net assets, therefore net income will generally increase more than net assets with the changing depreciation method, causing ROA to increase.
achu Think about BOTH numerator and denominator before choosing the answer!
soorajiyer For now you can always think like this (totally from cfa exam point of view, dont take it generally) - everywhere when a change is affecting a nr and dr in a ratio, we can safely assume that the effect by dr is offset by nr. So the movement of ratio is in the direction of movement of the nr. This is again strictly from level 2 perspective only!
bbadger I got it wrong, but on second thought it makes sense. Assets are generally much larger than income so a change in depreciation would be a much larger change in the numerator than in the denominator. ROA would increase.
rjdelong As a general rule, Wiley says the effect on income tends to dominate other accounts. "Follow the profit"
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