Chapter: Chapter 21: Alternative Ways to Measure Return on Capital
Multiple Choice
1. According to U.S. Generally Accepted Accounting Principles (GAAP), which of the following
must be expensed?
I. A patent developed by the firm.
II. A building.
III. Equipment.
IV. A distribution network.
a) I and II only.
b) I and IV only.
c) II and III only.
d) III and IV only.
2. Concerning the impact on ROIC of capitalizing R&D, will increasing the asset life and/or the
percentage of revenues spent on R&D increase ROIC?
a) Increasing either the asset life or the percentage of revenues spent on R&D will increase
ROIC.
b) Neither increasing the asset life nor increasing the percentage of revenues spent on R&D will
increase ROIC.
c) Increasing the asset life will increase ROIC, but increasing the percentage of revenues spent
on R&D will not.
d) Increasing the asset life will not increase ROIC, but increasing the percentage of revenues
spent on R&D will.
3. Will either measures of performance or valuation be affected by changing the accounting
treatment of R&D?
a) Both measures of performance and valuation will be affected.
b) Neither measures of performance nor valuation will be affected.
c) Measures of performance will be affected, but valuation will not be affected.
d) Measures of performance will not be affected, but valuation will be affected.
4. If managers were given freedom to choose which expenses to classify as investments, which
of the following is most accurate?
a) Managers will have an incentive to classify all expenses as investments.
b) Managers will have an incentive to classify no expenses as investments.
c) Managers will not have an incentive either way with respect to classifying expenses as
investments.
d) Managers would most likely follow the rules established by GAAP, because they were
formulated to be optimal for managers to follow.
5. What is the recommendation concerning expensing or capitalizing R&D to measure a
company’s performance? Explain the reason for the choice.
McKinsey/Valuation
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Response: [It is recommended that R&D be capitalized. By expensing items with long-term
benefits, the accounting statements will understate the company’s historical investment. This
understatement of capital can artificially boost ROIC in later years, making a business appear
more attractive than it really is.]
True/False
6. If growth of a company is falling, expensing R&D will lead to an overestimation of the
resulting drop in true performance.
7. A firm that capitalizes R&D has more opportunity to manipulate short-term earnings
compared to a firm that expenses R&D.
8. In early years, for a given company with a positive profit, ROIC with capitalized R&D will be
higher than that with expensed R&D.
9. One benefit of capitalizing R&D is that reductions in current R&D will not affect current
operating profits.
10. Expensing items with long-term benefits will usually mean that the accounting statements
will overstate the company’s historical investment, which can artificially lower ROIC in later
years, making a business appear less attractive than it really is.