Accounting: What the Numbers Mean 9th Edition by Wayne W McManus, Daniel F Viele, David H Marshall

Exercise 80

Capitalizing versus expensing—effect on ROI and operating income During the first month of its current fiscal year, Green Co. incurred repair costs of $20,000 on a machine that had five years of remaining depreciable life. The repair cost was inappropriately capitalized. Green Co. reported operating income of $160,000 for the current year

Required:

a. Assuming that Green Co. took a full year’s straight-line depreciation expense in the current year, calculate the operating income that should have been reported for the current year.

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b. Assume that Green Co.’s total assets at the end of the prior year and at the end of the current year were $940,000 and $1,020,000, respectively. Calculate ROI (based on operating income) for the current year using the originally reported data and then using corrected data.

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c. Explain the effect on ROI of subsequent years if the error is not corrected.

Step 1 of 8

Capitalizing versus Expensing-Effect-ROI & Operating income:

Capitalizing versus Expensing :

• When a company procures an asset that provides benefit for more than a financial year, it is capitalized as a fixed asset in the balance sheet of the company, instead of being written off immediately under the current year’s profit and loss.

• The fixed asset is next depreciated above a number of years to allocate the cost till the point it is useful for the company. The charge of depreciation affects the profit and loss as an expense.

ROI :

• Return on investment indicates the performance of the investment. It is very useful to compare different investments and select the best investment based on that comparison. The return on investment determines the benefit from the investment, that is, the income or return on the original cost of investment.

• It is a measure to evaluate the effectiveness or performance of an investment in terms of its returns or benefits.

Operating income :