Porter SM Ch. 08_2pp

Chapter 8: Operating Assets: Property, Plant and Equipment, Natural Resources, and Intangiles

8-30Financial accounting solutions manual

chapter 8 operating assets: property, plant, and equipment, natural resources, and intangibles8-31

CHAPTER 8

Operating Assets: Property, Plant, and Equipment, Natural Resources, and Intangibles

OVERVIEW OF EXERCISES, PROBLEMS, AND CASES

Estimated

Time in

Learning OutcomesExercisesMinutesLevel

1.Understand balance sheet disclosures for 11*30Mod

operating assets.

2.Determine the acquisition cost of an operating asset.110Easy

220Mod

320Mod

3.Explain how to calculate the acquisition cost of assets

purchased for a lump sum.

4.Describe the impact of capitalizing interest as part of the 12*5Easy

acquisition cost of an asset.

5.Compare depreciation methods and understand the factors415Mod

affecting the choice of method.12*5Easy

6.Understand the impact of a change in the estimate of the asset 515Mod

life or residual value.

7.Determine which expenditures should be capitalized as asset costs 11*30Mod

and which should be treated as expenses.

8.Analyze the effect of the disposal of an asset at a gain or loss.615Mod

715Mod

9.Understand the balance sheet presentation of intangible assets.13*10Mod

10.Describe the proper amortization of intangible assets.815Easy

13*10Mod

11.Explain the impact that long-term assets have on the statement 95Mod

of cash flows.105Mod

12.Understand how investors can analyze a companys

operating assets.

*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

ProblemsEstimated

andTime in

Learning OutcomesAlternatesMinutesLevel

1.Understand balance sheet disclosures for

operating assets.6*30Mod

2.Determine the acquisition cost of an operating asset.7*15Diff

3.Explain how to calculate the acquisition cost of assets 120Mod

purchased for a lump sum.6*30Mod

4.Describe the impact of capitalizing interest as part of the


5.Compare depreciation methods and understand the factors210Easy

affecting the choice of method.315Mod

6*30Mod

7*15Diff

8*20Mod

6.Understand the impact of a change in the estimate of the asset 9*10Mod


7.Determine which expenditures should be capitalized as asset costs 6*20Mod

and which should be treated as expenses.8*20Mod

8.Analyze the effect of the disposal of an asset at a gain or loss.6*30Mod

8*20Mod

10*35Mod

9.Understand the balance sheet presentation of intangible assets.6#30Mod

11*20Diff

10.Describe the proper amortization of intangible assets.6#30Mod

9*10Mod

11*20Mod


of cash flows.540Diff

10*35Mod

11*20Diff

12.Understand how investors can analyze a companys

operating assets.

*Exercise, problem, or case covers two or more learning outcomes

# Alternative problem only


Estimated

Time in

Learning OutcomesCasesMinutesLevel

1.Understand balance sheet disclosures for 1*20Mod

operating assets.3*20Mod

4*25Mod

2.Determine the acquisition cost of an operating asset.

3.Explain how to calculate the acquisition cost of assets 615Mod

purchased for a lump sum.

4.Describe the impact of capitalizing interest as part of the


5.Compare depreciation methods and understand the factors4*25Mod

affecting the choice of method.525Mod

710Mod

6.Understand the impact of a change in the estimate of the asset


7.Determine which expenditures should be capitalized as asset costs

and which should be treated as expenses.

8.Analyze the effect of the disposal of an asset at a gain or loss.

9.Understand the balance sheet presentation of intangible assets.1*20Mod

3* 20Mod

10.Describe the proper amortization of intangible assets.


of cash flows.

12.Understand how investors can analyze a companys 3*

operating assets.4**Exercise, problem, or case covers two or more learning outcomes


QUESTIONS

1.Operating assets include property, plant, and equipment and intangibles. Examples of assets considered operating assets are buildings, equipment, land, land improvements, patents, copyrights, and goodwill. Operating assets are important to the long-term future of the company because they are the assets used to produce a product or service sold to customers. The operating assets allow a company to produce a product efficiently and remain competitive with other firms.

2.The acquisition cost of an asset includes all the costs normally necessary to acquire the asset and prepare it for its intended use. Acquisition costs include the purchase price, freight costs, installation costs, taxes paid at the time of purchase, and repairs made to prepare the asset for use.

3.The acquisition cost of assets purchased as a group should be determined by allocating the purchase price on the basis of the proportions of the fair market values to the total fair market value.

4.It is important to separately account for the cost of land and building because the amount allocated to a building represents a depreciable amount, while the amount allocated to land does not.

5.Interest should be capitalized when an asset is constructed by the acquiring company over time, and the asset is not an item of inventory.

6.The decline in usefulness of an operating asset is related to physical deterioration factors, such as wear and tear. It is also related to obsolescence and technological factors and to the repair and maintenance of the asset. The depreciation method chosen should match the decline in usefulness of the asset to the periods benefited by the asset after all factors have been taken into account. However, the company is not required to use the same method for all depreciable assets.

7.The straight-line method is the most popular method of depreciation for several reasons, including its simplicity and ease of application. It is most appropriate for assets that experience a decline in usefulness related to the passage of time. It may also be used by companies that wish to report a stable income over time.

8.When the straight-line method is used, the residual value should be deducted from the acquisition cost to determine the depreciable amount to be allocated over the useful life of the asset. When the double-declining-balance method is used, the residual value is not deducted. However, the asset should not be depreciated to an amount that is lower than the residual value.

9.Companies may use one method of depreciation for financial reporting and another method for tax purposes because the objectives are different. The accountants purpose in recording depreciation for financial reporting purposes is to allocate the original cost of the asset to the periods benefited in a manner that matches the decline in usefulness of the asset. The accountants purpose in recording depreciation for tax purposes is to minimize the amount of income tax that must be paid.

10.If an estimate must be changed, the change in estimate should be recorded prospectively over the remaining life of the asset. Past amounts recorded for depreciation are not changed or altered. The remaining depreciable amount should be recorded over the remaining life of the asset, using the revised estimate or estimates of residual value and asset life.

11.A capital expenditure is an amount that must be capitalized or added to the value of the asset. A revenue expenditure is an outlay that should be recorded as an expense in the year incurred. An item should be treated as a capital expenditure if it increases the life or productivity of the asset. Otherwise, the amount should be treated as a revenue expenditure.

12.The gain or loss on the sale of an asset should be calculated as the difference between the selling price and the book value of the asset as of the date of sale. The account Gain on Sale of Asset should appear on the income statement in the other income/expense category.

13.Patents, copyrights, trademarks, and goodwill are examples of intangible assets. Some companies have a separate category on the balance sheet titled Intangibles for such assets. Other companies include intangibles in a category titled Long-Term Assets or in the Other Assets category of the balance sheet.

14.Goodwill represents the difference between the acquisition price paid to acquire a business and the total of the fair market values of the identifiable net assets acquired. Goodwill can be recorded as an asset only when one company acquires another. It cannot be recorded on the basis of internally generated factors that some may refer to as goodwill.

15.An argument in favor of expensing R&D is that it allows comparability among firms, since all firms must record the item as an expense. Also, it is argued that R&D should be expensed because it is very difficult to determine whether an asset exists and, if it does exist, what periods are benefited by the asset. On the other hand, many argue that R&D is an asset and should be recorded on the balance sheet. They believe that if R&D is not recorded, the balance sheet is seriously understated.

16.The current view of the FASB is that some intangible assets have a limited life and should be amortized over their legal life or useful life, whichever is shorter. However, some intangible assets are thought to have an indefinite life and should not be amortized. This treatment of intangibles has been debated extensively, and many disagree with the current view. Some would argue that the value of almost all intangible assets eventually becomes diminished and therefore amortization should be recognized.

17.Amortization should occur over the shorter of the legal life or useful life. For example, a patent has a legal life of 20 years. But if the invention under patent will be useful over only 10 years, then the patent should be amortized over the shorter 10-year period.

18.If an intangible becomes worthless, the asset should be written off as an expense in the period when the decline in value occurs. If the intangible continues to have value but will provide benefit over a period shorter than was originally estimated, the event should be treated as a change in estimate. The portion of the intangible that is unamortized should be amortized over the remaining life of the asset.

exercises

LO 2EXERCISE 8-1 ACQUISITION COST

The acquisition cost of the asset should be computed as follows:

List price$60,000

Less: Discount(1,200)

Freight1,000

Pollution device2,500

Architects fee

6,000

Total acquisition cost$68,300Note:Repair costs of $4,000 are not included because they are not normal or necessary to the acquisition.

Insurance cost of $8,000 should be treated as prepaid insurance.

Interest cost of $3,000 is not included unless an asset is constructed over time.

LO 2EXERCISE 8-2 LUMP-SUM PURCHASE

1.The total market value is

Land

$200,000

Building

150,000

Equipment

250,000

Total

$600,000

Amount allocated to each account should be

Land $200,000/$600,000 $520,000 = $173,333

Building $150,000/$600,000 $520,000 = $130,000

Equipment $250,000/$600,000 $520,000 = $216,667

The effect of the acquisition on the accounting equation is as follows:

Balance Sheet

income Statement

Assets=Liabilities+Stockholders Equity+ Revenues Expenses

Land 173,333

Building 130,000

Equipment 216,667

Cash (520,000)

2.The amount of depreciation expense that should be recorded for 2007 is as follows:

Land= $0

Building $130,000/20 years = $6,500

Equipment $216,667/20 years = $10,833

3.The assets would appear on the balance sheet as follows:

Long-term assets:

Land

$173,333

Building$130,000

Less: Accumulated depreciation

6,500123,500

Equipment$216,667


10,833

205,834

Total long-term assets

$502,667LO 2EXERCISE 8-3 STRAIGHT-LINE AND UNITS-OF-PRODUCTION METHODS

Depreciation, accumulated depreciation, and book value for the straight-line method should be as follows:

Accumulated

YearDepreciationDepreciationBook Value

2007$10,800*$10,800$49,200

200810,80021,60038,400

200910,80032,40027,600

201010,80043,20016,800

201110,80054,0006,000

*($60,000 $6,000)/5 years = $10,800 per year

The estimated total number of units to be produced is

10,000 + 20,000 + 30,000 + 40,000 + 50,000 = 150,000 units.

Depreciation expense per unit= ($60,000 $6,000)/150,000 units

= $0.36 per unit

Depreciation, accumulated depreciation, and book value for the units-of-production should be as follows:

Accumulated


200710,000 $0.36 =$ 3,600$3,600$56,400

200820,000 $0.36 =7,20010,80049,200

200930,000 $0.36 =10,80021,60038,400

201040,000 $0.36 =14,40036,00024,000

201150,000 $0.36 =18,00054,0006,000

Students may note that the units-of-production method results in a depreciation pattern in this exercise that is the opposite of accelerated depreciation. That is appropriate because of the pattern of usage of the asset.

LO 5EXERCISE 8-4 ACCELERATED DEPRECIATION

1.

Accumulated


200740%*$6,000 =$2,400$2,400$3,600

200840%3,600 =1,4403,8402,160

200940%2,160 =8644,7041,296

201040%1,296 =5185,222778

2011

178**5,400600

*Straight-line rate: 100%/5 years = 20%; double the straight-line rate = 40%.

**Since the asset should not be depreciated below residual value, the amount to be recorded is $6,000 $5,222 $600 = $178.

2.The effect of the depreciation for 2007 on the accounting equation is as follows:

Balance Sheet

income Statement


Accumulated

Depreciation

Depreciation (2,400)

Expense (2,400)

3.Koffman may believe that the double-declining-balance method best matches the decline in usefulness of the asset with the revenues produced by the asset. Koffman may also choose this method because it allows more depreciation to be taken in the early years of the assets life and thus delays taxes until the later years.

LO 6EXERCISE 8-5 CHANGE IN ESTIMATE

1.Depreciation, accumulated depreciation, and book value for the straight-line method should be as follows:

Accumulated


2007$8,000*$8,000$72,000

20088,00016,00064,000

200915,500**31,50048,500

201015,50047,00033,000

201115,50062,50017,500

201215,50078,0002,000

*($80,000 $8,000)/9 years = $8,000.

**$64,000 $2,000 = $62,000.

$62,000/4 years = $15,500.

EXERCISE 8-5 (Concluded)

2.Depreciation for 2007 and 2008 was not wrong. The company used the best information available at that time to develop its estimate of depreciation. The information available in 2009 made it necessary to revise the estimate of depreciation. This illustrates the difference between a change in estimate and a correction of an error.

LO 8EXERCISE 8-6 ASSET DISPOSAL

1.The depreciation for 2007 is calculated as follows:

($60,000 $6,000)/6 years = $9,000 per year.

$9,000 6/12 = $4,500 for 2007.

The effect of the sale of the asset on the accounting equation is as follows:

Balance Sheet

income Statement


Cash

40,000

Gain on Sale

Accumulated

of Asset2,500**

Depreciation

Asset22,500*

Asset

(60,000)

*Accumulated depreciation at time of sale:

Depreciation for 2005 and 2006($9,000 2)$18,000

Depreciation for 2007

4,500

Total$22,500

**Gain on sale is calculated as follows:

Asset cost$60,000


22,500

Book value$37,500

Sale price

40,000

Gain on sale$2,500

2.The gain or loss should appear in the Other Income category of the income statement to indicate that it is not part of the normal operating activity of the company.

LO 8EXERCISE 8-7 ASSET DISPOSAL

1.The depreciation for 2007 is calculated as follows:

($60,000 $6,000)/6 years = $9,000 per year.

$9,000 6/12 = $4,500 for 2007.

The effect of the sale of the asset on the accounting equation is as follows:

Balance Sheet

income Statement


Cash

15,000

Loss on Sale

Notes Receivable 15,000

of Asset (7,500)*

Accumulated

Depreciation

Asset 22,500

Asset (60,000)

*The loss on sale is calculated as follows:

Asset cost$60,000


22,500

Book value$37,500

Sale price

30,000

Loss on sale$7,500

2.The gain or loss should appear in the Other Expense category of the income statement to indicate it is not part of the normal operating activity of the company.

LO 10EXERCISE 8-8 AMORTIZATION OF INTANGIBLES

Trademark is not amortized because it has an indefinite life.Amortization expense= $0

Accumulated amortization = $0

Patent amortization= $50,000/10 years= $ 5,000

Accumulated amortization= $5,000 6 years= $30,000

Copyright amortization= $80,000/20 years= $ 4,000

Accumulated amortization= $4,000 3 years= $12,000

LO 11EXERCISE 8-9 IMPACT OF TRANSACTIONS INVOLVING OPERATING ASSETS ON STATEMENT OF CASH FLOWS

Purchase of land: I

Proceeds from sale of land: I

Gain on sale of land: O

Purchase of equipment: I

Depreciation expense: O

Proceeds from sale of equipment: I

Loss on sale of equipment: O

LO 11EXERCISE 8-10 IMPACT OF TRANSACTIONS INVOLVING INTANGIBLE ASSETS ON STATEMENT OF CASH FLOWS

Cost incurred to acquire copyright: I

Proceeds from sale of patent: I

Gain on sale of patent: O

Research and development costs: N

(not separately reported as an operating activity)

Amortization of patent: O

MULTI-CONCEPT EXERCISES

LO 1,7EXERCISE 8-11 CAPITAL VERSUS REVENUE EXPENDITURES

1.The effect of the capitalized costs of the new conveyor system on the accounting equation is as follows:

Balance Sheet

income Statement


Building40,000

Cash

(40,000)

The effect of the capitalized costs of the hydraulic lift on the accounting equation is as follows:

Balance Sheet

income Statement


Delivery Truck5,000

Cash

(5,000)

EXERCISE 8-11 (Concluded)

Note: Some may choose to capitalize the engine overhaul costs of $4,000 and the window repair costs of $10,000. However, both costs appear to keep the asset in its normal operating condition and are more properly treated as expenses.

2.

The depreciation for 2007 should be calculated as follows:

BuildingTruck

Original cost$200,000$20,000

Less: Depreciation for 2005 and 2006

16,000

6,667

Book value$184,000$13,333

Plus: Capitalized costs

40,000

5,000

Depreciable amount$224,000$18,333

Depreciation per year on building =

$224,000/23 years =$9,739

Depreciation per year on truck =

$18,333/4 years =

$4,583

3.The assets should appear on the 2007 balance sheet as follows:

Building$240,000


25,739$214,261

Truck$25,000


11,250

13,750

Total property, plant, and equipment

$228,011LO 4,5EXERCISE 8-12 CAPITALIZATION OF INTEREST AND DEPRECIATION

1.$200,000 + $8,000 = $208,000.

2.The amount of depreciation expense for 2007 is zero because the asset was not completed and put into use until January 1, 2008. The amount of depreciation expense for 2008 is $200,000 + $8,000 $5,000 = $203,000/20 years = $10,150.

LO 9,10EXERCISE 8-13 RESEARCH AND DEVELOPMENT AND PATENTS

a.All research and development costs should be treated as an expense. The 2007 income statement should reflect an expense of $20,000.

b.Patent costs should be treated as an asset. The 2007 balance sheet should reflect a Patent account of $10,000 ($10,000/5 years) = $8,000.

c.The $8,000 cost of defending the patent should be added to the Patent account and reflected in the 2008 balance sheet.

2007 amortization= $10,000/5 years = $2,000

2008 amortization= $10,000 $2,000 + $8,000 =

$16,000

$16,000/4 years =$4,000problems

LO 3PROBLEM 8-1 LUMP-SUM PURCHASE OF ASSETS AND SUBSEQUENT EVENTS

1.Relative fair values:

Section 1$630,00050%

Section 2378,00030

Section 3

252,000

20

Total$1,260,000100%

Section

123

50%30%20%

(a)$1,260,000$630,000$378,000$252,000

(b)1,560,000780,000468,000312,000

(c)1,000,000500,000300,000200,000

2.The purchase of the land has no effect on total assets. Current assets (cash) declines and long-term assets (land) increases and therefore only the composition of assets on the balance sheet is changed.

3.Carter would be concerned with the value assigned to each section if it intended to sell one or two sections and keep others. Carter would want the section it intended to sell to be assigned the highest value in order to defer a gain. The value assigned to buildings would be depreciated; therefore, Carter would want more value assigned to the buildings in order to depreciate them and take advantage of the tax shield.

LO 5PROBLEM 8-2 DEPRECIATION AS A TAX SHIELD

If the asset is not purchased, the company must pay income tax of $50,000 35% = $17,500.

If the asset is purchased, the company should record depreciation of $20,000 per year. The amount of income tax the company must pay is $50,000 $20,000 = $30,000 35% = $10,500.

The amount of the depreciation tax shield is the amount of income tax saved by purchase of the asset, or $17,500 $10,500 = $7,000. The depreciation tax shield can also be expressed as the amount of depreciation each year times the tax rate, or $20,000 35% = $7,000.

LO 5PROBLEM 8-3 BOOK VERSUS TAX DEPREICATION

1.YearStraight-LineMACRS=Difference

1$5,600*$6,720$(1,120)

25,60010,750(5,150)

35,6006,450(850)

45,6003,8701,730

55,6003,8701,730

6

5,600

1,940

3,660

$33,600$33,600$0

*$33,600/6 years = $5,600 per year

2.The president is correct that a total of $33,600 will be deducted as depreciation under either method over the six-year life. However, the memo should stress that all other things being equal, Griffith should prefer MACRS for taxes, since it results in the payment of less income tax during the early years in the life of the truck. Money received earlier is preferable to money received later.

The memo should also stress that it is important to analyze the tax position of Griffith carefully. A variety of other factors may be important in the choice of a depreciation method for tax purposes.

The memo should also stress to the president that not only is it legal, but also it is not a violation of GAAP, to use one method of depreciation for the books and a different one for tax purposes. Using straight-line depreciation for the books will tend to even out the income over the life of the asset and will report higher income in the earlier years than would be reported if an accelerated method, such as MACRS, is used.

LO 11PROBLEM 8-4 DEPRECIATION AND CASH FLOW

1.

OHARE COMPANY

INCOME STATEMENT

FOR THE YEAR ENDED DECEMBER 31, 2007

Service revenue$100,000

Depreciation expense

15,000

Net income$85,000

2.The amount of the net cash inflow for 2007 is $100,000.

3.The amount of the net income ($85,000) does not equal the amount of the net cash inflow ($100,000) because of depreciation expense. Depreciation is an expense on the income statement but does not involve a cash outlay. For that reason, depreciation must be added back to net income to determine the amount of the net cash inflow.

4.If Ohare develops a cash flow statement using the indirect method, the operating category should appear as follows:

Cash Flow from Operating Activities:

Net income$85,000

Plus: Depreciation

15,000

Net cash from operations$100,000LO 11PROBLEM 8-5 RECONSTRUCT NET BOOK VALUES USING STATEMENT OF CASH FLOWS

1.Book value of equipment at time of sale:

Book value$X

Sales proceeds

315,000

Loss (gain) on sale$35,000

X $315,000 =$35,000

X = $350,000

Book value of copyright at time of sale:

Book value$X

Sales proceeds

75,000

Loss (gain) on sale $(55,000)

X $75,000 = $(55,000)

X = $20,000PROBLEM 8-5 (Concluded)

2.Net book value of property, plant, and equipment at December 31, 2006:

Net book value at 12/31/06$X

Plus purchases during 2007292,000

Less book value of equipment sold during 2007(350,000)

Less 2007 depreciation

(672,000)

Net book value at 12/31/06$4,459,000

X + $292,000 $350,000 $672,000 = $4,459,000

X = $5,189,000

3.Net book value of intangibles at December 31, 2006:


Plus payment of legal fees during 200715,000

Less book value of copyright sold during 2007(20,000)

Less 2007 amortization

(33,000)

Net book value at 12/31/06$673,000

X + $15,000 $20,000 $33,000 =$673,000

X = $711,000MULTI-CONCEPT PROBLEMS

LO 1,3,5,7,8PROBLEM 8-6 COST OF ASSETS, SUBSEQUENT BOOK VALUES, AND BALANCE SHEET PRESENTATION

1.Values assigned to each asset:

a.Value at time of purchase: $14,000 + $4,800 = $18,800

b.Allocation of purchase price:

Supplies expense $200/$3,200 $2,400 = $150

Office furniture $600/$3,200 $2,400 =$450

Equipment $2,400/$3,200 $2,400 = $1,800

c.Value of this prepaid license expense: $1,500

d.Cost of truck$12,000

Less: Accumulated depreciation at time

of sale [($12,000 $800) 5/8]

7,000

Book value$5,000

PROBLEM 8-6 (Concluded)

2.Depreciation or other expense recorded for each asset during 2007:

a.($18,800 $800)/4 years = $4,500

b.Supplies expense$150

Depreciation of office furniture $450/9 years = $50

Depreciation of equipment $1,800/4 years = $450

c.$1,500/3 years = $500 11/12 = $458

d.Depreciation $11,200/8 years = $1,400 8/12 = $933

Book value at the time of sale$5,000

Sale price

4,800

Loss on sale of truck$(200)

3.Balance Sheet Presentation:

Current assets:

Prepaid license expense ($1,500 $458)

$1,042

Property, plant, and equipment:

Truck$18,800

Office furniture450

Equipment

1,800

$21,050


($4,500 + $50 + $450)

(5,000)

Property, plant, and equipment, net

$16,050LO 2,5PROBLEM 8-7 COST OF ASSETS AND THE EFFECT ON DEPRECIATION

1.$165,000/10 years = $16,500 depreciation. The correct amount of depreciation is $19,700 [($150,000 + $15,000 + $4,000 + $25,000 + $3,000)/10 years].

2.Reported income in Year 1 is $51,500 ($100,000 $16,500 $25,000 $4,000 $3,000). Reported income should be $80,300 ($100,000 $19,700).

3.A cost is the amount incurred to acquire an asset or pay an expense, and an expense is the amount of an expired asset or a cost that is incurred to generate revenue.

LO 5,7,8PROBLEM 8-8 CAPITAL EXPENDITURES, DEPREICATION, AND DISPOSAL

1.The depreciation for 2006 should be calculated as follows:

($364,000 $14,000)/25 years = $14,000 for 2006.

The depreciation for 2007 should be calculated as follows:

Original cost$364,000

Less: 2006 depreciation(14,000)

Less: Residual value(14,000)

Plus 2007 capitalized costs

42,000

Depreciable amount$378,000

Remaining asset life

30 years

Depreciation $378,000/30 years =$12,600

2.The pollution-control equipment extended the life of the asset and should be capitalized rather than expensed. It is difficult to determine whether Merton would rather expense or capitalize the equipment. If the company can expense the equipment for tax purposes, it would normally desire to do so.

3.Original cost of building$364,000

Pollution device capitalized42,000

Less:2006 depreciation(14,000)

2007 depreciation

(12,600)

Book value 1/1/2008$379,400

Less:2008 depreciation ($12,600 3/12)

3,150

Book value at sale$376,250

Sale proceeds

392,000

Gain on sale$15,750

If the pollution equipment had been expensed (and original life of 25 years was used for depreciation purposes):


Less: Accumulated depreciation ($14,000 2 1/4 years)

31,500

Book value at 4/1/2008$332,500

Sale proceeds

392,000

Gain on sale$59,500LO 6,10PROBLEM 8-9 AMORTIZATION OF INTANGIBLE, REVISION OF RATE

1.The $85,000 should be recorded as an expense. The $11,900 should be capitalized in a patent account.

2.Reynosa should record $595 of amortization expense each fiscal year: a total of $2,975 ($595 per year 5 years) = $2,975.

$11,900/20 years = $595

3.Reynosa should record a loss of $8,925 for the year ended September 30, 2008.

Original cost of patent$11,900

Less: Depreciation for 5 years

2,975

Book value, 10/1/07$8,925LO 8,11PROBLEM 8-10 PURCHASE AND DISPOSAL OF OPERATING ASSET AND EFFECTS ON STATEMENT OF CASH FLOWS

1.Partial statements of cash flows for 2007:

Cash flows from operating activities:

Net income$XX,XXX

Plus depreciation expense12,000

Cash flows from investing activities:

Purchase of machinery(104,000)

Partial statements of cash flows for 2008:


Net income$XX,XXX

Plus:Depreciation expense12,000

Loss on sale of machinery5,000


Purchase of machinery(205,000)

Proceeds from sale of machinery (see below)75,000

Book value at time of sale ($104,000 $12,000 $12,000)$80,000

Sale price

X

Loss on sale of machinery$5,000

$80,000 X = $5,000

X =

$75,000

2.Castlewood would replace machinery if the replacement would result in additional net income in the future. Any additional revenues generated as a result of a possible increase in production capacity (that is, the ability to make and thus sell more product) and any costs that could be saved by automating the production process (for example, lower wages) would increase net income. On the other hand, this increase would be offset by the costs of acquiring and operating the new machinery.

LO 9,10,11PROBLEM 8-11 AMORTIZATION OF INTANGIBLES AND EFFECTS ON STATEMENT OF CASH FLOWS

1.2007 amortization expense:

Accumulated amortization at 12/31/06$102,000

Plus 2007 amortization expense

X


$102,000 + X = $119,000

X = $17,000

2.Acquisition cost:

Cost of patent$X

Less accumulated amortization at 12/31/07

(119,000)

Carrying value at 12/31/07$170,000

X $119,000 = $170,000

X = $289,000

Year acquired:


Divided by annual amortization

17,000

Years owned7 years

It was acquired in 2001

Estimated useful life:

Cost of patent$289,000

Divided by estimated useful life

X years

Annual amortization$17,000

$289,000/X = $17,000

X =

17 years

The acquisition cost of $289,000 would have been reported as an outflow in the Investing Activities section of the 2001 statement of cash flows.

3.Assuming the indirect method is used, the amortization expense relating to the patent would be added back to net income in the Cash Flows from Operating Activities section of the statement of cash flows.

4.The proceeds from the sale of $200,000 would be reported as an inflow in the Cash Flows from Investing Activities section of the statement of cash flows. In addition, the gain on the sale of $30,000 ($200,000 $170,000) would be subtracted from net income in the Cash Flows from Operating Activities section of the statement of cash flows.

alternate problems

LO 3PROBLEM 8-1A LUMP-SUM PURCHASE OF ASSETS AND SUBSEQUENT EVENTS

1.Relative fair values:

Piece 1

$200,000

23.8%

Piece 2200,000

23.8

Piece 3

440,000

52.4

Total

$840,000

100.0%

Piece

123

23.8%23.8%52.4%

(a)$480,000$114,240$114,240$251,520

(b)680,000161,840161,840356,320

(c)800,000190,400190,400419,200

2.The purchase does not affect total assets; it affects only the composition of the assets. Cash is a current asset; equipment is a long-term asset.

LO 5PROBLEM 8-2A DEPRECIATION AS A TAX SHIELD

If asset is not purchased:

Annual income tax is $62,000 30% = $18,600

If asset is purchased:

Income Before TaxDepreciationIncomeTax

and DepreciationExpenseBefore Tax30%

2007$62,000$24,000*$38,000$11,400

200862,00014,40047,60014,280

200962,0008,64053,36016,008

201062,0005,18456,81617,045

201162,0007,776**54,224

16,267

Total$75,000

*Straight-line rate = 1/5 or 20%; double-declining-balance rate = 2 20% = 40%, 2007 depreciation = 40% $60,000 = $24,000.

**To bring accumulated depreciation to $60,000.

PROBLEM 8-2A (Concluded)

Total tax if not purchased:

$18,600 5 years =$93,000

Total tax if purchased =

75,000

Depreciation tax shield$18,000

The tax shield if Rummy uses the straight-line method is $60,000 30%, or $18,000. Rummy would choose accelerated depreciation because the company would save tax earlier.

LO 5PROBLEM 8-3A BOOK VERSUS TAX DEPRECIATION

1.YearStraight-LineMACRS=Difference

1$4,700*$5,650$(950)

24,7009,025(4,325)

34,7005,400(700)

44,7003,2501,450

54,7003,2501,450

6

4,700

1,625

3,075

$28,200$28,200$0

*$28,200/6 years = $4,700 per year

2.The president is correct that a total of $28,200 will be deducted as depreciation under either method over the six-year life. However, the memo should note that all other things being equal, Payton should prefer MACRS for taxes, since it results in lower taxes during the early years in the life of the truck. Money received earlier is preferable to money received later.

LO 11PROBLEM 8-4A AMORTIZATION AND CASH FLOW

1.2007 income = $500,000 $62,500 $50,000 = $387,500.

2.Cash on hand, December 31, 2007 = $500,000 $62,500 = $437,500.

3.Cash increased from revenue and decreased by cash expenses. The amount is different than income for 2007 because amortization, like depreciation, is an expense but not a cash outflow. The cost of long-term assets like a copyright is a cash outflow when it is purchased.

LO 11PROBLEM 8-5A RECONSTRUCT NET BOOK VALUES USING STATEMENT OF CASH FLOWS

1.Book value of land at time of sale:

Book value$X

Sales proceeds

187,000

Loss (gain) on sale$17,000

X $187,000 =$17,000

X = $204,000

Book value of trademark at time of sale:

Book value$X

Sales proceeds

121,000

Loss (gain) on sale $(7,000)

X $121,000 = $(7,000)

X = $114,000

2.Net book value of property, plant, and equipment at December 31, 2006:


Plus purchases during 2007277,000

Less book value of land sold during 2007(204,000)

Less 2007 depreciation

(205,000)

Net book value at 12/31/07$1,555,000

X + $277,000 $204,000 $205,000 = $1,555,000

X = $1,687,000

3.Net book value of intangibles at December 31, 2006:


Plus payment of legal fees during 2007

6,000

Less book value of trademark sold during 2007

(114,000)

Less 2007 amortization

(3,000)

Net book value at 12/31/07$34,000

X + $6,000 $114,000 $3,000 =$34,000

X = $145,000ALTERNATE MULTI-CONCEPT PROBLEMS

LO 1,5,8,9,10PROBLEM 8-6A COST OF ASSETS, SUBSEQUENT BOOK VALUES, AND BALANCE SHEET PRESENTATION

Depreciation or amortization and book values

a.Depreciation should be calculated as follows:


Add: Cab/oven

10,900

Total cost$26,900

Less:Residual value

300

Depreciable amount$26,600

Depreciation expense $26,600/5 years$5,320

Book value:

Total cost$26,900

Accumulated depreciation

5,320

Book value$21,580

b.Depreciation:

$2,700 66 2/3%* = $1,800

*Straight-line rate = 100%/3 = 33 1/3%, double-declining-balance rate = 66 2/3%.

Book value:

$2,700 $1,800 = $900

c.Depreciation:

($8,000 $1,000)/8 3/12 = $219

Book value at time of sale:

Accumulated depreciation = ($8,000 $1,000) 5/8 = $4,375

Book value = $8,000 $4,375 =$3,625

Book value$3,625

Sale price

1,500

Loss on sale$2,125

d.Amortization:

$14,000/4 years = $3,500

$3,500 6/12 = $1,750

Book value:

$14,000 $1,750 = $12,250LO 2,5PROBLEM 8-7A COST OF ASSETS AND THE EFFECT ON DEPRECIATION

1.The proper cost to record for the acquisition is $190,000 ($168,000 + $16,500 + $4,400 + $1,100). All costs, except the operating costs for the first year, should be capitalized as part of the cost of the equipment. The operating costs of $26,400 should be expensed.

2.Depreciation reported in Year 1 is $21,640 ($216,400/10). Depreciation that should have been reported is $19,000 [($168,000 + $16,500 + $4,400 + $1,100)/10]. Operating costs are not included in the cost of the asset.

3.Key reported income of $55,000 $21,640, or $33,360. The correct amount of income should be as follows:

Income before equipment cost$55,000

Depreciation

(19,000)

Operating expenses

(26,400)

Net income$9,600

4.Key should not include operating costs in the value of the asset recorded on the balance sheet. The effect of this error is to overstate assets on the balance sheet.

LO 7,8PROBLEM 8-8A CAPITAL EXPENDITURES, DEPRECIATION, AND DISPOSAL

1.2006 Depreciation = [($612,000 $12,000)/25 years] = $24,000

2007 Depreciation = [($612,000 + $87,600 $30,000 $24,000)/24] = $26,900

2.The cost of the fire equipment increased the value of an asset that will last for more than one year. The cost would have been expensed if it was maintenance. Wagner would prefer to expense the cost of the fire equipment for taxes in order to take advantage of the tax shield immediately. However, Wagner would prefer to capitalize the cost for accounting purposes in order to better match revenue with the costs incurred to generate that revenue.

3.Loss at sale = $612,000 + $87,600 $24,000 $26,900 $360,000 = $288,700

Loss on sale if fire equipment is expensed = $612,000 $24,000 $24,000 $360,000 = $204,000LO 6,10PROBLEM 8-9A AMORTIZATION OF INTANGIBLE, REVISION OF RATE

1.The $350,000 of cost that represents research and development should be treated as an expense in the year of acquisition, 2002. The $23,800 of cost that represents the patent should be treated as an intangible asset and amortized over the 20-year time period.

2.Maciel should record amortization expense of $23,800/20 years, or $1,190 per year.

3.The book value of the patent after five years of amortization is:

$23,800 (5 $1,190) = $17,850. Since the patent is worthless, the amount of $17,850 should be recorded as a loss.

LO 8,11PROBLEM 8-10A PURCHASE AND DISPOSAL OF OPERATING ASSET AND EFFECTS ON STATEMENT OF CASH FLOWS

1.Partial statements of cash flows for 2007:


Net income$XX,XXX

Plus depreciation expense8,000


Purchase of delivery truck(45,000)

Partial statements of cash flows for 2008:


Net income$XX,XXX

Plus:Depreciation expense8,000

Loss on sale of delivery truck12,000


Purchase of delivery truck(80,000)

Proceeds from sale of machinery (see below)17,000

Book value at time of sale ($45,000 $8,000 $8,000)$29,000

Sale price

X

Loss on sale of machinery$12,000

$29,000 X = $12,000

X =

$17,000

2.Mansfield would replace the medium-sized delivery truck with a larger truck if the replacement would result in additional net income in the future. Any additional revenues generated as a result of Mansfields ability to deliver and sell more product would increase net income. On the other hand, this increase would be offset by the costs of acquiring and operating the new delivery truck.

LO 9,10,11PROBLEM 8-11A AMORTIZATION OF INTANGIBLES AND EFFECTS ON STATEMENT OF CASH FLOWS

1.2007 amortization expense:

Accumulated amortization at 12/31/06$1,510,000

Plus 2007 amortization expense

X


$1,510,000 + X = $1,661,000

X = $151,000

2.Acquisition cost:

Cost of patent$X

Less accumulated amortization at 12/31/07

(1,661,000)

Carrying value at 12/31/07$1,357,000

X $1,661,000 = $1,357,000

X = $3,018,000

Year acquired:


Divided by annual amortization

151,000

Years owned11 years

It was acquired in 1997

Estimated useful life:

Cost of patent$3,018,000

Divided by estimated useful life

X years

Annual amortization$151,000

$3,018,000/X = $151,000

X =

20 years

The acquisition cost of $3,018,000 would have been reported as an outflow in the Investing Activities section of the 1997 statement of cash flows.

3.Assuming that the indirect method is used, the amortization expense relating to the patent would be added back to net income in the Cash Flows from Operating Activities section of the statement of cash flows.

4.The proceeds from the sale of $1,700,000 would be reported as an inflow in the Cash Flows from Investing Activities section of the statement of cash flows. In addition, the gain on the sale of $343,000 ($1,700,000 $1,357,000) would be deducted from net income in the Cash Flows from Operating Activities section of the statement of cash flows.

DECISIoN CASES

READING AND INTERPRETING FINANCIAL STATEMENTS

LO 1,9DECISION CASE 8-1 FOOT LOCKER

1.A note to the statements indicates the company has land, buildings, furniture and fixtures, and improvements to leased and owned buildings.

2.The company uses the straight-line method of depreciation.

3.Owned property and equipment is depreciated on a straight-line basis over the estimated useful lives of the assets: maximum of 50 years for buildings and 310 years for furniture, fixtures, and equipment. Property and equipment under capital leases and improvements to leased premises are generally amortized on a straight-line basis over the shorter of the estimated useful life of the asset or the remaining lease term.

4.The property and equipment has accumulated depreciation of $800 million and a book value of $336 million. Additionally, an amount of $339 million is listed net of depreciation for alterations of leased and owned buildings.

5.The statement of cash flows indicates purchases of $155 million and cash received from property and equipment of $1 million.

LO 11DECISION CASE 8-2 FOOT LOCKERS STATEMENT OF CASH FLOWS

1.The statement of cash flows indicates purchases of property and equipment of $155 million.

2.The statement of cash flows does not indicate sales of property and equipment during the year but does indicate a positive amount of $1 million related to acquisitions.

3.Depreciation and amortization is indicated in the cash flows statement as $171 million. Depreciation is not a cash flow. It is listed in the Operating Activities category of the cash flows statement when using the indirect method because it is necessary to eliminate the items that did not involve cash.

MAKING FINANCIAL DECISIONSLO 1,9, 12DECISION CASE 8-3 COMPARING TWO COMPANIES IN THE SAME INDUSTRY: FOOT LOCKER AND FINISH LINE

1.Foot Locker lists the following items in property, plant, and equipment: land, buildings, furniture, fixtures and equipment, and alterations to leased and owned buildings. Finish Line lists similar items on the balance sheet: land, buildings, leasehold improvements, furniture, fixtures and equipment, and construction in progress. While the account titles used by the two companies are slightly different, the information provided is very similar.

2.Both companies use the straight-line method of depreciation. In most cases, the straight-line method is chosen because of its simplicity and because it results in an even pattern of expense over the life of the assets.

3.Foot Locker indicates the property and equipment has accumulated depreciation of $800 million and a book value of $336 million. Additionally, an amount of $339 million is listed net of depreciation for alterations of leased and owned buildings. Finish Line has a total book value for property and equipment of $221 million and accumulated depreciation of $161 million.

4.Foot Locker indicates the maximum life of buildings as 50 years and furniture, fixtures, and equipment is 310 years. Finish Line indicates an estimated useful life of buildings at 30 years and furniture, fixtures, and equipment at 310 years.

5.Foot Locker purchased property, plant, and equipment of $155 million. The statement does not indicate sales of property, plant, and equipment but does indicate a positive amount of $1 million related to acquisitions. Finish Line had purchases of property and equipment of $70,126,000 and sales of property and equipment of $137,000. For both companies, information about whether a gain or loss occurred from the sale of assets is provided in the Operating Activities section of the statement of cash flows.

6.For both companies, investment in property, plant, and equipment is vital to the long-term outlook of the company. The companies must invest heavily in property, plant, and equipment to constantly update to modern, more efficient assets. While the operating assets are adding value to both companies, even more value could probably be created if the companies could afford to invest more in long-term assets.LO 1,5, 12DECISION CASE 8-4 COMPARING COMPANIES

ACCELERATED COMPANY

INCOME STATEMENT


Sales

$720,000

Cost of goods sold

360,000Gross profit

$360,000

Administrative costs$96,000

Depreciation expense

144,000Operating expenses

240,000Income before tax

$120,000

Tax expense (40%)

48,000

Net income

$72,000Since the balance of the Accumulated Depreciation account for Straight Company is $240,000 and the depreciation expense is $120,000 per year, the assets must be two years old. The amount of depreciation expense for Accelerated Company on the double-declining-balance method is as follows:

2006: $600,000 40% = $240,000.

2007: $600,000 $240,000 = $360,000 40% = $144,000.

The analyst should consider the difference in the cash flows of the two companies. Accelerated Company has a lower net income but actually has a higher cash inflow. This occurs because the depreciation expense results in a tax savings. It is not entirely accurate to say that depreciation is a noncash expense because it results in a real cash savings in the form of lower income tax.

LO 5DECISION CASE 8-5 DEPRECIATION ALTERNATIVES

For accounting purposes, the company should use straight-line depreciation because it will better match the cost using the asset with the equal production levels. For taxes, the company should also use the straight-line method because the increasing tax rates will yield a higher cash savings from the tax shield. Depreciation is not a cash outflow, but the tax savings results in a cash inflow because of reduced tax liability.

ETHICAL DECISION MAKING

LO 3DECISION CASE 8-6 VALUING ASSETS

Students should be asked to determine the impact of using the first appraisal versus the second appraisal. Both appraisals result in a total increase in assets of $20,000 ($220,000 $200,000), but they differ in the amount allocated to the Land account. Students should see that a second opinion may have been necessary to accurately appraise the property, but, on the other hand, the appraisal may have been requested to maximize the amount allocated to the depreciable asset, the building.

Students should be asked about the nature of the appraisal process. Is it possible for two appraisers to have different estimates of the fair market value? Should the accountant always accept the first appraisal? When is it acceptable to seek another opinion? Are Terry and Tammy unethical simply because they sought a separate opinion? The instructor may wish to draw a parallel to opinion-shopping on the part of clients who seek an opinion of auditors or public accountants.

It appears that the concept of neutrality has been violated in this case. It is not wrong for Terry and Tammy to seek a second appraisal if their motive was to develop an accurate, unbiased measure of the land and building. However, if their motive was to minimize the amount allocated to the Land account, their actions must be questioned.

LO 5DECISION CASE 8-7 DEPRECIATION ESTIMATES

Both methods will result in the total cost of the asset being recorded on the income statement over the life of the asset. However, depreciating the asset is much more preferable because it matches the cost evenly over the assets life. You should try to convince the manager that it is not correct to depreciate the asset over a longer life and then record a large loss in the third year. If the manager is not convinced, you may have to consider whether the matter should be discussed with his superior and/or the companys auditors.

REAL WORLD PRACTICE 8.1

Depreciation and amortization is indicated in the statement of cash flows as $171 million. The notes indicate the company uses the straight-line method.

REAL WORLD PRACTICE 8.2

Purchases of property and equipment were $70,126,000 in 2005. Depreciation and amortization were $34,633,000.

SOLUTION TO INTEGRATIVE PROBLEM

Part 2

1.

PEK COMPANY

INCOME STATEMENT


Sales revenue

$1,250,000

Cost of goods sold

636,500

Gross profit

$

613,500

Depreciation on plant equipment$85,400*

Depreciation on buildings12,000

Interest expense55,400**

Other expenses

83,800

236,600

Income before taxes

$

376,900

Income tax expense (30% rate)

113,070

Net income

$

263,830

*$58,400 + ($270,000/10 years).

**$33,800 + ($270,000 8%).

PEK COMPANY

STATEMENT OF CASH FLOWS



Net income

$263,830

Adjustments to reconcile net income to net

cash provided by operating activities

(includes depreciation expense)

110,200*

Net cash provided by operating activities

$374,030

Cash flows from financing activities:

Dividends

(35,000)

Net increase in cash

$339,030

*$83,200 + $27,000 additional depreciation.

Supplemental Schedule of Noncash Investing and Financing Activities:

Acquisition of equipment in exchange for a note of $270,000.

INTEGRATIVE PROBLEM (Continued)

2.

PEK COMPANY

INCOME STATEMENT


Sales revenue

$1,250,000

Cost of goods sold

636,500

Gross profit

$

613,500

Depreciation on plant equipment$107,491*

Depreciation on buildings12,000

Interest expense55,400

Other expenses

83,800

258,691

Income before taxes

$

354,809

Income tax expense (30% rate)

106,443

Net income

$

248,366

*$58,400 + $49,091.

PEK COMPANY

STATEMENT OF CASH FLOWS



Net income$248,366

Adjustments to reconcile net income to net

cash provided by operating activities

(includes depreciation expense)

132,291*

Net cash provided by operating activities$380,657

Cash flows from financing activities:

Dividends

(35,000)

Net increase in cash$345,657

*$83,200 + $49,091 additional depreciation.

Supplemental Schedule of Noncash Investing and Financing Activities:

Acquisition of equipment in exchange for a note of $270,000.

INTEGRATIVE PROBLEM (Concluded)

3.a.LIFO cost of goods sold:

40,000($3.25) =$130,000

60,000($3.10) =186,000

75,000($3.00) =225,000

40,000($2.50) =100,000

30,000($2.20) =66,000

5,000($2.10) =

10,500

Total LIFO cost of goods sold

$717,500

Total FIFO cost of goods sold

636,500

Increase in cost of goods sold

$81,000

b.Additional cost of goods sold

$81,000

Times the tax rate

30%

Decrease in income tax expense

$24,300

c.Additional cost of goods sold

$81,000

Decrease in income taxes

24,300

Decrease in net income

$56,700

4.a.Sales on account

$800,000

Times estimated uncollectibles

3%

Increase in other expenses

$24,000

b.Increase in other expenses

$24,000

Times the tax rate

30%

Decrease in income tax expense

$7,200

c.Increase in other expenses

$24,000

Decrease in income taxes

7,200

Decrease in net income

$16,800

8-1

Documents

Porter SM Ch. 08_2pp