Your firm uses return on assets (ROA) to evaluate investment centers and is considering changing the valuation basis of assets from historical cost to current value. When the historical cost of the asset is updated, a price index is used to approximate replacement value. For example, a metal fabrication press, which bends and shapes metal, was bought seven years ago for $522,000. The company will add 19 percent to this cost, representing the change in the wholesale price index over the seven years. This new, higher cost figure is depreciated using the straight-line method over the same 12-year assumed life (no salvage value).

a.) Calculate depreciation expense and book value of the metal press under both the historical cost and the price-level-adjusted historical cost.

b.) In general, what is the effect on ROA of changing the valuation bases from historical costs to current values?

c.) The manager of the investment center with the metal press is considering replacing it because it is becoming obsolete. Will the manager's incentives to replace the metal press change if the firm shifts from historical cost valuation to the proposed price-level-adjusted historical cost valuation?

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asked by Jamal
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  2. We examine whether and why companies prefer fair value to historical cost when they
    can choose between the two valuation methods. With the exception of investment property
    owned by real estate companies, historical cost by far dominates fair value in practice. Indeed,
    fair value accounting is not used for plant, equipment, and intangible assets. We find that
    companies using fair value accounting rely more on debt financing than companies that use
    historical cost. This evidence is consistent with companies using fair value to signal asset
    liquidation values to their creditors, and is not consistent with equity investors demanding fair
    value accounting for non-financial assets. Our evidence broadly speaks to the importance of
    accounting for contracting.
    Keywords: Fair value accounting, IFRS, international accounting.
    JEL Classification: M4, M42, M48

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