Which of the following statements about how inflation affects the measurement of economic depreciation is least likely correct? In an inflationary period: A. reported ROAs and ROEs will be too low. B. reported income will be too high. C. depreciation based on historical costs will not be sufficient to replace the asset. D. depreciation based on the current cost of the asset (rather than historical costs) will create superior future net income estimates.
(A) is least likely correct because assets as reported are lower than what they should be, so ROA will be higher than should be. As for return on equity, since less depreciation is taken off sales, net income will be higher than if assets were priced correctly and depreciation higher. Thus ROE will also be higher. (B) yes net income will be too high because we are not taking off enough depreciation. © obvious (D) not sure it makes sense.
I think both A and D are incorrect, hence likely answers. D. depreciation based on the current cost of the asset (rather than historical costs) will create superior future net income estimates. In inflationary environment, replacement cost of the asset will be higher than the current costs. So the current depr. is actually understated. That means current net income is overstated. In future the net income will come down as depr is increased to reflect inflation. Any thoughts? Thanks in advance.
CPK, Super I, maratikus and other gurus, what are your thoughts on this question? Thanks for your help.
A is the answer. Since economic depreciation is higher than accounting depreciation, assets, equity and net income should be adjusted down. net income will be impacted higher in relative terms (i can explain that if necessary) -> ROE and ROA will be lower. Therefore, ROE and ROA are overstated during inflationary period because accounting depreciation is inadequate.
Thanks maratikus. A is the correct answer as per schweser too, but I was wondering why D is accurate? My reasoning as I stated before is: In inflationary environment, replacement cost of the asset will be higher than the current costs. So the current depr. is actually understated. That means current net income is overstated. In future the net income will come down as depr is increased to reflect inflation.
current cost is higher than historical cost -> depreciation based on current cost is closer to economic depreciation -> net income more indicative of economic income
It will create superior future net income estimates? What the heck does that mean?
superior -greater in quality it means the income with best quality to reflect the latest economic depreciation cost or current replacement cost in market.
estimates?