Conservative Corp. has reduced the estimated salvage value on all machinery and equipment balances to zero. The company uses straight-line depreciation for both reporting and tax purposes. All else being equal, which of the following statements is least accurate with respect to the effect of this change on subsequent financial statements? a. Reported net income will be lower. b. Current ratio will remain constant. c. Balance sheet assets will decrease. d. Operating cash flow will remain constant. Just checking your understanding. Dreary
B is an ambush answer here since you might think that assets decrease(which is true) BUT CURRENT ASSETS remain constant so current ratio will remain constant… By elimination, I’d say D as well…but i’m not too sure how exactely Operating cash flow changes here (it’s been a few weeks that i read that material). Help anyone? thanks…
My first intuition is B. I think I have forgotten the tax issue. D should be inaccurate, too. But if cash position changes then current asset would have to change as well?
If it is D, in what direction is the change, and explain how.
I’ll give it a try. Would operating cash flow be higher due to higher inflation?
Since you increased the life… your dep exp would increase… This make A True No effect on the Current Ratio - B True Due to higher dep exp (acc. dep) fixed assets will decrease -C True With higher dep exp, Net Income will be lower which will have a negitive effect on CFO… Operating CF will not stay constant due to difference in Tax Expense
chadtap Wrote: ------------------------------------------------------- > Since you increased the life… your dep exp would > increase… > > This make A True > > No effect on the Current Ratio - B True > > Due to higher dep exp (acc. dep) fixed assets will > decrease -C True > > With higher dep exp, Net Income will be lower > which will have a negitive effect on CFO… > > Operating CF will not stay constant due to > difference in Tax Expense good that you edited your post to add that last sentence in there, I was going to say that depreciation is a non-cash expense, and as we all know it doesn’t impact CFO.
Ok Chadtap but you came short of saying whether cash flow would increase or decrease.
Here is my take assuming same tax and reporting treatment. Assume depreciation increase by D. Income before depreciation is I. Tax rate t. Income after tax is (I - D) * (1-t) CFO will be: (I-D) * (1 - t) + D = I * (1-t) + t * D; So CFO increased by t * D due to paying less tax. But if less cash is paid for tax, current asset should change as well. So B may be inaccurate, too. But probably the least accurate is D.
OCF will increase, no ? Reason: you’re adding back a bigger Depreciation amt.
Correct, operating cash flow will increase because we are adding a lrger depreciation amount to NI. But disptra raises an interesting question! If we pay more taxes cash should be less, thus current ratio should be lower! Dreary
Kevin, I believe CFO will stay the same based on that reasoning because if depreciation increases, Net Income will be reduced by a similar amount, which would simply be added back to get CFO. All things being equal, if NI was $50 and Depreciation was $10, CFO would be $60. If you increase depreciation to $15, NI becomes $45 and then you add back depreciation so that CFO is $60, which is the same as it was before. But this is assuming a zero tax rate. If you consider a 20% tax rate, pretax NI in the first case is $50/0.8 = $62.5. If you add an additional $5 in depreciation expense, $62.5 - $5 = $57.5 * 0.8 = $46, which is NI with $5 in additional depreciation on a 20% tax rate. Using the same calculation, CFO is $46 + $5 = $51. So my guess is that the answer is D, provided that you are a tax-paying entity. If this is not correct, someone please let me know!! Thanks
Yes, finance03, pretax cash flows are not affected, and the question assumes operating cash flow after tax. That’s teh definition of CFO: NI + depreciation, and of course NI is after tax. But yes, in the unusual event that the comapny pays no tax, your reasoning is correct.
Dreary, IMO the current ratio answer (B) is a second derivative effect, if we are paying less taxes (not more as you said) then you can also justify that C (Balance Sheet assets will decrease) is incorrect as you will have the same amount/more cash on hand. That seems like a slippery slope to me.
Actually, the question explicitly said subsequent financial statements!! So, only D is good.