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Chapter 11 Depreciation, Impairments, and Depletion
Chapter 11 Depreciation, Impairments, and Depletion
1. Distinguish among depreciation, depletion, and amortization.
2. Identify the factors that are relevant in determining the annual depreciation charge, and explain whether these factors are determined objectively or whether they are based on judgment.
3. Some believe that accounting depreciation measures the decline in the value of fixed assets. Do you agree? Explain.
4. Explain how estimation of service lives can result in unrealistically high carrying values for fixed assets.
5. The plant manager of a manufacturing firm suggested in a conference of the company’s executives that accountants should speed up depreciation on the machinery in the finishing department because improvements were rapidly making those machines obsolete, and a depreciation fund big enough to cover their replacement is needed. Discuss the accounting concept of depreciation and the effect on a business concern of the depreciation recorded for plant assets, paying particular attention to the issues raised by the plant manager.6. For that reasons are plant assets retired? Define inadequacy, supersession, and obsolescence.
7. What basic questions must be answered before the amount of the depreciation charge can be computed?
8. Workman Company purchased a machine on January 2, 2012, for $800,000. The machine has an estimated useful life of 5 years and a salvage value of $100,000. Depreciation was computed by the 150% declining-balance method. What is the amount of accumulated depreciation at the end of December 31, 2013?
9. Silverman Company purchased machinery for $162,000 on January 1, 2012. It is estimated that the machinery will have a useful life of 20 years, salvage value of $15,000, production of 84,000 units, and working hours of 42,000. During 2012, the company uses the machinery for 14,300 hours, and the machinery produces 20,000 units. Compute depreciation under the straight-line, units-of-output, working hours, sum-of-the-years’-digits, and doubledeclining- balance methods.
10. What are the major factors considered in determining what depreciation method to use?
11. Under what conditions is it appropriate for a business to use the composite method of depreciation for its plant assets? What are the advantages and disadvantages of this method?
12. If Remmers, Inc. uses the composite method and its composite rate is 7.5% per year, what entry should it make when plant assets that originally cost $50,000 and have been used for 10 years are sold for $14,000?
13. A building that was purchased December 31, 1988, for $2,500,000 was originally estimated to have a life of 50 years with no salvage value at the end of that time. Depreciation has been recorded through 2012. During 2013, an examination of the building by an engineering firm discloses that its estimated useful life is 15 years after 2012. What should be the amount of depreciation for 2013?
14. Charlie Parker, president of Spinners Company, has recently noted that depreciation increases cash provided by operations and therefore depreciation is a good source of funds. Do you agree? Discuss.
15. Andrea Torbert purchased a computer for $8,000 on July 1, 2012. She intends to depreciate it over 4 years using the double-declining-balance method. Salvage value is $1,000. Compute depreciation for 2013.
16. Walkin Inc. is considering the write-down of its long-term plant because of a lack of profitability. Explain to the management of Walkin how to determine whether a write-down is permitted.
17. Last year, Wyeth Company recorded an impairment on an asset held for use. Recent appraisals indicate that the asset has increased in value. Should Wyeth record this recovery in value?
18. Toro Co. has equipment with a carrying amount of $700,000. The expected future net cash flows from the equipment are $705,000, and its fair value is $590,000. The equipment is expected to be used in operations in the future. What amount (if any) should Toro report as an impairment to its equipment?
19. Explain how gains or losses on impaired assets should be reported in income.
20. It has been suggested that plant and equipment could be replaced more quickly if depreciation rates for income tax and accounting purposes were substantially increased. As a result, business operations would receive the benefit of more modern and more efficient plant facilities. Discuss the merits of this proposition.
21. Neither depreciation on replacement cost nor depreciation adjusted for changes in the purchasing power of the dollar has been recognized as generally accepted accounting principles for inclusion in the primary financial statements. Briefly present the accounting treatment that might be used to assist in the maintenance of the ability of a company to replace its productive capacity.
22. List (a) the similarities and (b) the differences in the accounting treatments of depreciation and cost depletion.
23. Describe cost depletion and percentage depletion. Why is the percentage depletion method permitted?
24. In what way may the use of percentage depletion violate sound accounting theory?
25. In the extractive industries, businesses may pay dividends in excess of net income. What is the maximum permissible? How can this practice be justified?
26. The following statement appeared in a financial magazine: “RRA—or Rah-Rah, as it’s sometimes dubbed—has kicked up quite a storm. Oil companies, for example, are convinced that the approach is misleading. Major accounting firms agree.” What is RRA? Why might oil companies believe that this approach is misleading?
27. Shumway Oil uses successful-efforts accounting and also provides full-cost results as well. Under full-cost, Shumway Oil would have reported retained earnings of $42 million and net income of $4 million. Under successfulefforts, retained earnings were $29 million, and net income was $3 million. Explain the difference between full-costing and successful-efforts accounting.
28. Target Corporation in 2010 reported net income of $2.5 billion, net sales of $63.4 billion, and average total assets of $44.3 billion. What is Target’s asset turnover ratio? What is Target’s rate of return on assets?
*2 9. What is a modified accelerated cost recovery system (MACRS)? Speculate as to why this system is now required for tax purposes.
E F EXERCI S E S
BE11-1 Fernandez Corporation purchased a truck at the beginning of 2012 for $50,000. The truck is estimated to have a salvage value of $2,000 and a useful life of 160,000 miles. It was driven 23,000 miles in 2012 and 31,000 miles in 2013. Compute depreciation expense for 2012 and 2013.
BE11-2 Lockard Company purchased machinery on January 1, 2012, for $80,000. The machinery is estimated to have a salvage value of $8,000 after a useful life of 8 years. (a) Compute 2012 depreciation expense using the straight-line method. (b) Compute 2012 depreciation expense using the straight-line method assuming the machinery was purchased on September 1, 2012.
BE11-3 Use the information for Lockard Company given in
BE11-2. (a) Compute 2012 depreciation expense using the sum-of-the-years’-digits method. (b) Compute 2012 depreciation expense using the sum-of-the-years’-digits method assuming the machinery was purchased on April 1, 2012.
BE11-4 Use the information for Lockard Company given in
BE11-2. (a) Compute 2012 depreciation expense using the double-declining-balance method. (b) Compute 2012 depreciation expense using the double-declining-balance method assuming the machinery was purchased on October 1, 2012.
BE11-5 Cominsky Company purchased a machine on July 1, 2013, for $28,000. Cominsky paid $200 in title fees and county property tax of $125 on the machine. In addition, Cominsky paid $500 shipping charges for delivery, and $475 was paid to a local contractor to build and wire a platform for the machine on the plant floor. The machine has an estimated useful life of 6 years with a salvage value of $3,000. Determine the depreciation base of Cominsky’s new machine. Cominsky uses straight-line depreciation.
BE11-6 Dickinson Inc. owns the following assets. Asset Cost Salvage Estimated Useful Life A $70,000 $7,000 10 years B 50,000 5,000 5 years C 82,000 4,000 12 years Compute the composite depreciation rate and the composite life of Dickinson’s assets.
BE11-7 Holt Company purchased a computer for $8,000 on January 1, 2011. Straight-line depreciation is used, based on a 5-year life and a $1,000 salvage value. In 2013, the estimates are revised. Holt now feels the computer will be used until December 31, 2014, when it can be sold for $500. Compute the 2013 depreciation.
BE11-8 Jurassic Company owns machinery that cost $900,000 and has accumulated depreciation of $380,000. The expected future net cash flows from the use of the asset are expected to be $500,000. The fair value of the equipment is $400,000. Prepare the journal entry, if any, to record the impairment loss.
BE11-9 Everly Corporation acquires a coal mine at a cost of $400,000. Intangible development costs total $100,000. After extraction has occurred, Everly must restore the property (estimated fair value of the obligation is $80,000), after which it can be sold for $160,000. Everly estimates that 4,000 tons of coal can be extracted. If 700 tons are extracted the first year, prepare the journal entry to record depletion.
BE11-10 In its 2009 annual report, Campbell Soup Company reports beginning-of-the-year total assets of $6,474 million, end-of-the-year total assets of $6,056 million, total sales of $7,586 million, and net income of $736 million. (a) Compute Campbell’s asset turnover ratio. (b) Compute Campbell’s profit margin on sales. (c) Compute Campbell’s rate of return on assets (1) using asset turnover and profit margin and (2) using net income.
*BE11-11 Francis Corporation purchased an asset at a cost of $50,000 on March 1, 2012. The asset has a useful life of 8 years and a salvage value of $4,000. For tax purposes, the MACRS class life is 5 years. Compute tax depreciation for each year 2012–2017. EXERCI S E S
E11-1 (Depreciation Computations—SL, SYD, DDB) Lansbury Company purchases equipment on January 1, Year 1, at a cost of $518,000. The asset is expected to have a service life of 12 years and a salvage value of $50,000.
Instructions (a) Compute the amount of depreciation for each of Years 1 through 3 using the straight-line depreciation method. 2 3 2 3 2 3 2 3 4 4 5 6 7 8 2 3 2 3 (b) Compute the amount of depreciation for each of Years 1 through 3 using the sum-of-the-years’-digits method. (c) Compute the amount of depreciation for each of Years 1 through 3 using the double-decliningbalance method. (In performing your calculations, round constant percentage to the nearest onehundredth of a point and round answers to the nearest dollar.)
E11-2 (Depreciation—Conceptual Understanding) Hasselback Company acquired a plant asset at the beginning of Year 1. The asset has an estimated service life of 5 years. An employee has prepared depreciation schedules for this asset using three different methods to compare the results of using one method with the results of using other methods. You are to assume that the following schedules have been correctly prepared for this asset using (1) the straight-line method, (2) the sum-of-the-years’-digits method, and (3) the double-declining-balance method. Sum-of-the- Double-Declining- Year Straight-Line Years’-Digits Balance 1 $ 9,000 $15,000 $20,000 2 9,000 12,000 12,000 3 9,000 9,000 7,200 4 9,000 6,000 4,320 5 9,000 3,000 1,480 Total $45,000 $45,000 $45,000
Instructions Answer the following questions. (a) What is the cost of the asset being depreciated? (b) What amount, if any, was used in the depreciation calculations for the salvage value for this asset? (c) Which method will produce the highest charge to income in Year 1? (d) Which method will produce the highest charge to income in Year 4? (e) Which method will produce the highest book value for the asset at the end of Year 3? (f) If the asset is sold at the end of Year 3, which method would yield the highest gain (or lowest loss) on disposal of the asset?
E11-3 (Depreciation Computations—SYD, DDB—Partial Periods) Cosby Company purchased a new plant asset on April 1, 2012, at a cost of $774,000. It was estimated to have a service life of 20 years and a salvage value of $60,000. Cosby’s accounting period is the calendar year.
Instructions (a) Compute the depreciation for this asset for 2012 and 2013 using the sum-of-the-years’-digits method. (b) Compute the depreciation for this asset for 2012 and 2013 using the double-declining-balance method.
E11-4 (Depreciation Computations—Five Methods) Wenner Furnace Corp. purchased machinery for $279,000 on May 1, 2012. It is estimated that it will have a useful life of 10 years, salvage value of $15,000, production of 240,000 units, and working hours of 25,000. During 2013, Wenner Corp. uses the machinery for 2,650 hours, and the machinery produces 25,500 units.
Instructions From the information given, compute the depreciation charge for 2013 under each of the following methods. (Round to the nearest dollar.) (a) Straight-line. (b) Units-of-output. (c) Working hours. (d) Sum-of-the-years’-digits. (e) Double-declining-balance.
E11-5 (Depreciation Computations—Four Methods) Maserati Corporation purchased a new machine for its assembly process on August 1, 2012. The cost of this machine was $150,000. The company estimated that the machine would have a salvage value of $24,000 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 21,000 hours. Year-end is December 31.
Instructions Compute the depreciation expense under the following methods. Each of the following should be considered unrelated. (a) Straight-line depreciation for 2012. (b) Activity method for 2012, assuming that machine usage was 800 hours. (c) Sum-of-the-years’-digits for 2013. (d) Double-declining-balance for 2013. 2 3
E11-6 (Depreciation Computations—Five Methods, Partial Periods) Agazzi Company purchased equipment for $304,000 on October 1, 2012. It is estimated that the equipment will have a useful life of 8 years and a salvage value of $16,000. Estimated production is 40,000 units and estimated working hours are 20,000. During 2012, Agazzi uses the equipment for 525 hours and the equipment produces 1,000 units.
Instructions Compute depreciation expense under each of the following methods. Agazzi is on a calendar-year basis ending December 31. (a) Straight-line method for 2012. (b) Activity method (units of output) for 2012. (c) Activity method (working hours) for 2012. (d) Sum-of-the-years’-digits method for 2014. (e) Double-declining-balance method for 2013.
E11-7 (Different Methods of Depreciation) Jeeter Industries presents you with the following information. Accumulated Date Salvage Life in Depreciation Depreciation to Depreciation Description Purchased Cost Value Years Method 12/31/12 for 2013 Machine A 2/12/11 $159,000 $16,000 10 (a) $37,700 (b) Machine B 8/15/10 (c) 21,000 5 SL 29,000 (d) Machine C 7/21/09 88,000 28,500 8 DDB (e) (f) Machine D 10/12/(g) 219,000 69,000 5 SYD 70,000 (h)
Instructions Complete the table for the year ended December 31, 2013. The company depreciates all assets using the half-year convention.
E11-8 (Depreciation Computation—Replacement, Nonmonetary Exchange) Goldman Corporation bought a machine on June 1, 2010, for $31,800, f.o.b. the place of manufacture. Freight to the point where it was set up was $200, and $500 was expended to install it. The machine’s useful life was estimated at 10 years, with a salvage value of $2,500. On June 1, 2011, an essential part of the machine is replaced, at a cost of $2,700, with one designed to reduce the cost of operating the machine. The cost of the old part and related depreciation cannot be determined with any accuracy. On June 1, 2014, the company buys a new machine of greater capacity for $35,000, delivered, trading in the old machine which has a fair value and trade-in allowance of $20,000. To prepare the old machine for removal from the plant cost $75, and expenditures to install the new one were $1,500. It is estimated that the new machine has a useful life of 10 years, with a salvage value of $4,000 at the end of that time. The exchange has commercial substance.
Instructions Assuming that depreciation is to be computed on the straight-line basis, compute the annual depreciation on the new equipment that should be provided for the fiscal year beginning June 1, 2014.
E11-9 (Composite Depreciation) Presented below is information related to Morrow Manufacturing Corporation. Machine Cost Estimated Salvage Value Estimated Life (in years) A $40,500 $5,500 10 B 33,600 4,800 9 C 36,000 3,600 8 D 19,000 1,500 7 E 23,500 2,500 6
Instructions (a) Compute the rate of depreciation per year to be applied to the machines under the composite method. (b) Prepare the adjusting entry necessary at the end of the year to record depreciation for the year. (c) Prepare the entry to record the sale of Machine D for cash of $5,000. It was used for 6 years, and depreciation was entered under the composite method.
E11-10 (Depreciation Computations, SYD) Bosh Company purchased a piece of equipment at the beginning of 2009. The equipment cost $502,000. It has an estimated service life of 8 years and an expected salvage value of $70,000. The sum-of-the-years’-digits method of depreciation is being used. Someone has already correctly prepared a depreciation schedule for this asset. This schedule shows that $60,000 will be depreciated for a particular calendar year. 2 3 2 3 2 3 4 2 3
Instructions Show calculations to determine for what particular year the depreciation amount for this asset will be $60,000.
E11-11 (Depreciation—Change in Estimate) Machinery purchased for $52,000 by Carver Co. in 2008 was originally estimated to have a life of 8 years with a salvage value of $4,000 at the end of that time. Depreciation has been entered for 5 years on this basis. In 2013, it is determined that the total estimated life should be 10 years with a salvage value of $4,500 at the end of that time. Assume straight-line depreciation.
Instructions (a) Prepare the entry to correct the prior years’ depreciation, if necessary. (b) Prepare the entry to record depreciation for 2013.
E11-12 (Depreciation Computation—Addition, Change in Estimate) In 1985, Abraham Company completed the construction of a building at a cost of $1,900,000 and first occupied it in January 1986. It was estimated that the building will have a useful life of 40 years and a salvage value of $60,000 at the end of that time. Early in 1996, an addition to the building was constructed at a cost of $470,000. At that time, it was estimated that the remaining life of the building would be, as originally estimated, an additional 30 years, and that the addition would have a life of 30 years and a salvage value of $20,000. In 2014, it is determined that the probable life of the building and addition will extend to the end of 2045 or 20 years beyond the original estimate.
Instructions (a) Using the straight-line method, compute the annual depreciation that would have been charged from 1986 through 1995. (b) Compute the annual depreciation that would have been charged from 1996 through 2013. (c) Prepare the entry, if necessary, to adjust the account balances because of the revision of the estimated life in 2014. (d) Compute the annual depreciation to be charged beginning with 2014.
E11-13 (Depreciation—Replacement, Change in Estimate) Peloton Company constructed a building at a cost of $2,400,000 and occupied it beginning in January 1993. It was estimated at that time that its life would be 40 years, with no salvage value. In January 2013, a new roof was installed at a cost of $300,000, and it was estimated then that the building would have a useful life of 25 years from that date. The cost of the old roof was $180,000.
Instructions (a) What amount of depreciation should have been charged annually from the years 1993 to 2012? (Assume straight-line depreciation.) (b) What entry should be made in 2013 to record the replacement of the roof? (c) Prepare the entry in January 2013, to record the revision in the estimated life of the building, if necessary. (d) What amount of depreciation should be charged for the year 2013?
E11-14 (Error Analysis and Depreciation, SL and SYD) Kawasaki Company shows the following entries in its Equipment account for 2013. All amounts are based on historical cost. Equipment 2013 2013 Jan. 1 Balance 133,000 June 30 Cost of equipment sold Aug. 10 Purchases 32,000 (purchased prior 12 Freight on equipment to 2013) 23,000 purchased 700 25 Installation costs 2,500 Nov. 10 Repairs 500
Instructions (a) Prepare any correcting entries necessary. (b) Assuming that depreciation is to be charged for a full year on the ending balance in the asset account, compute the proper depreciation charge for 2013 under each of the methods listed below. Assume an estimated life of 10 years, with no salvage value. The machinery included in the January 1, 2013, balance was purchased in 2011. (1) Straight-line. (2) Sum-of-the-years’-digits. 2 3 2 3
E11-15 (Depreciation for Fractional Periods) On March 10, 2014, No Doubt Company sells equipment that it purchased for $240,000 on August 20, 2007. It was originally estimated that the equipment would have a life of 12 years and a salvage value of $21,000 at the end of that time, and depreciation has been computed on that basis. The company uses the straight-line method of depreciation.
Instructions (a) Compute the depreciation charge on this equipment for 2007, for 2014, and the total charge for the period from 2008 to 2013, inclusive, under each of the six following assumptions with respect to partial periods. (1) Depreciation is computed for the exact period of time during which the asset is owned. (Use 365 days for the base.) (2) Depreciation is computed for the full year on the January 1 balance in the asset account. (3) Depreciation is computed for the full year on the December 31 balance in the asset account. (4) Depreciation for one-half year is charged on plant assets acquired or disposed of during the year. (5) Depreciation is computed on additions from the beginning of the month following acquisition and on disposals to the beginning of the month following disposal. (6) Depreciation is computed for a full period on all assets in use for over one-half year, and no depreciation is charged on assets in use for less than one-half year. (b) Briefly evaluate the methods above, considering them from the point of view of basic accounting theory as well as simplicity of application.
E11-16 (Impairment) Presented below is information related to equipment owned by Pujols Company at December 31, 2012. Cost $9,000,000 Accumulated depreciation to date 1,000,000 Expected future net cash fl ows 7,000,000 Fair value 4,400,000 Assume that Pujols will continue to use this asset in the future. As of December 31, 2012, the equipment has a remaining useful life of 4 years.
Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2012. (b) Prepare the journal entry to record depreciation expense for 2013. (c) The fair value of the equipment at December 31, 2013, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value.
E11-17 (Impairment) Assume the same information as
E11-16, except that Pujols intends to dispose of the equipment in the coming year. It is expected that the cost of disposal will be $20,000.
Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2012. (b) Prepare the journal entry (if any) to record depreciation expense for 2013. (c) The asset was not sold by December 31, 2013. The fair value of the equipment on that date is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value. It is expected that the cost of disposal is still $20,000.
E11-18 (Impairment) The management of Sprague Inc. was discussing whether certain equipment should be written off as a charge to current operations because of obsolescence. This equipment has a cost of $900,000 with depreciation to date of $400,000 as of December 31, 2012. On December 31, 2012, management projected its future net cash flows from this equipment to be $300,000 and its fair value to be $280,000. The company intends to use this equipment in the future.
Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2012. (b) Where should the gain or loss (if any) on the write-down be reported in the income statement? (c) At December 31, 2013, the equipment’s fair value increased to $300,000. Prepare the journal entry (if any) to record this increase in fair value. (d) What accounting issues did management face in accounting for this impairment?
E11-19 (Depletion Computations—Timber) Hernandez Timber Company owns 9,000 acres of timberland purchased in 2001 at a cost of $1,400 per acre. At the time of purchase, the land without the timber was valued at $400 per acre. In 2002, Hernandez built fire lanes and roads, with a life of 30 years, at a cost of $87,000. Every year, Hernandez sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2003, Hernandez selectively logged and sold 700,000 board feet 2 3 5 5 5 6 of timber, of the estimated 3,000,000 board feet. In 2004, Hernandez planted new seedlings to replace the trees cut at a cost of $100,000.
Instructions (a) Determine the depreciation expense and the cost of timber sold related to depletion for 2003. (b) Hernandez has not logged since 2003. If Hernandez logged and sold 900,000 board feet of timber in 2014, when the timber cruise (appraiser) estimated 5,000,000 board feet, determine the cost of timber sold related to depletion for 2014.
E11-20 (Depletion Computations—Oil) Federer Drilling Company has leased property on which oil has been discovered. Wells on this property produced 18,000 barrels of oil during the past year that sold at an average sales price of $65 per barrel. Total oil resources of this property are estimated to be 250,000 barrels. The lease provided for an outright payment of $600,000 to the lessor (owner) before drilling could be commenced and an annual rental of $31,500. A premium of 5% of the sales price of every barrel of oil removed is to be paid annually to the lessor. In addition, Federer (lessee) is to clean up all the waste and debris from drilling and to bear the costs of reconditioning the land for farming when the wells are abandoned. The estimated fair value, at the time of the lease, of this clean-up and reconditioning is $30,000.
Instructions From the provisions of the lease agreement, compute the cost per barrel for the past year, exclusive of operating costs, to Federer Drilling Company.
E11-21 (Depletion Computations—Timber) Jonas Lumber Company owns a 7,000-acre tract of timber purchased in 2005 at a cost of $1,300 per acre. At the time of purchase, the land was estimated to have a value of $300 per acre without the timber. Jonas Lumber Company has not logged this tract since it was purchased. In 2012, Jonas had the timber cruised. The cruise (appraiser) estimated that each acre contained 8,000 board feet of timber. In 2012, Jonas built 10 miles of roads at a cost of $8,400 per mile. After the roads were completed, Jonas logged and sold 3,500 trees containing 880,000 board feet.
Instructions (a) Determine the cost of timber sold related to depletion for 2012. (b) If Jonas depreciates the logging roads on the basis of timber cut, determine the depreciation expense for 2012. (c) If Jonas plants five seedlings at a cost of $4 per seedling for each tree cut, how should Jonas treat the reforestation?
E11-22 (Depletion Computations—Mining) Henrik Mining Company purchased land on February 1, 2012, at a cost of $1,250,000. It estimated that a total of 60,000 tons of mineral was available for mining. After it has removed all the natural resources, the company will be required to restore the property to its previous state because of strict environmental protection laws. It estimates the fair value of this restoration obligation at $90,000. It believes it will be able to sell the property afterwards for $100,000. It incurred developmental costs of $200,000 before it was able to do any mining. In 2012, resources removed totaled 30,000 tons. The company sold 24,000 tons.
Instructions Compute the following information for 2012. (a) Per unit mineral cost. (b) Total material cost of December 31, 2012, inventory. (c) Total materials cost in cost of goods sold at December 31, 2012.
E11-23 (Depletion Computations—Minerals) At the beginning of 2012, Callaway Company acquired a mine for $850,000. Of this amount, $100,000 was ascribed to the land value and the remaining portion to the minerals in the mine. Surveys conducted by geologists have indicated that approximately 12,000,000 units of the ore appear to be in the mine. Callaway incurred $170,000 of development costs associated with this mine prior to any extraction of minerals. It also determined that the fair value of its obligation to prepare the land for an alternative use when all of the mineral has been removed was $40,000. During 2012, 2,500,000 units of ore were extracted and 2,200,000 of these units were sold.
Instructions Compute the following. (a) The total amount of depletion for 2012. (b) The amount that is charged as an expense for 2012 for the cost of the minerals sold during 2012. 6
E11-24 (Ratio Analysis) The 2009 Annual Report of McDonald’s Corporation contains the following information. (in billions) December 31, 2009 December 31, 2008 Total assets $30,225 $28,462 Net sales 22,745 Net income 4,551
Instructions Compute the following ratios for McDonald’s for 2009. (a) Asset turnover ratio. (b) Rate of return on assets. (c) Profit margin on sales. (d) How can the asset turnover ratio be used to compute the rate of return on assets? *E 11-25 (Book vs. Tax (MACRS) Depreciation) Annunzio Enterprises purchased a delivery truck on January 1, 2012, at a cost of $41,000. The truck has a useful life of 7 years with an estimated salvage value of $6,000. The straight-line method is used for book purposes. For tax purposes the truck, having an MACRS class life of 7 years, is classified as 5-year property; the MACRS tax rate tables are used to compute depreciation. In addition, assume that for 2012 and 2013 the company has revenues of $200,000 and operating expenses (excluding depreciation) of $130,000.
Instructions (a) Prepare income statements for 2012 and 2013. (The final amount reported on the income statement should be income before income taxes.) (b) Compute taxable income for 2012 and 2013. (c) Determine the total depreciation to be taken over the useful life of the delivery truck for both book and tax purposes. (d) Explain why depreciation for book and tax purposes will generally be different over the useful life of a depreciable asset. *
E11-26 (Book vs. Tax (MACRS) Depreciation) Elwood Inc. purchased computer equipment on March 1, 2012, for $36,000. The computer equipment has a useful life of 10 years and a salvage value of $3,000. For tax purposes, the MACRS class life is 5 years.
Instructions (a) Assuming that the company uses the straight-line method for book and tax purposes, what is the depreciation expense reported in (1) the financial statements for 2012 and (2) the tax return for 2012? (b) Assuming that the company uses the double-declining-balance method for both book and tax purposes, what is the depreciation expense reported in (1) the financial statements for 2012 and (2) the tax return for 2012? (c) Why is depreciation for tax purposes different from depreciation for book purposes even if the company uses the same depreciation method to compute them both? See the book’s companion website, www.wiley.com/college/kieso, for a set of B Exercises. 7 8 8 PROBLEMS
P11-1 (Depreciation for Partial Period—SL, SYD, and DDB) Alladin Company purchased Machine #201 on May 1, 2012. The following information relating to Machine #201 was gathered at the end of May. Price $85,000 Credit terms 2/10, n/30 Freight-in costs $ 800 Preparation and installation costs $ 3,800 Labor costs during regular production operations $10,500 It was expected that the machine could be used for 10 years, after which the salvage value would be zero. Alladin intends to use the machine for only 8 years, however, after which it expects to be able to sell it for $1,500. The invoice for Machine #201 was paid May 5, 2012. Alladin uses the calendar year as the basis for the preparation of financial statements. 2 3
Instructions (a) Compute the depreciation expense for the years indicated using the following methods. (Round to the nearest dollar.) (1) Straight-line method for 2012. (2) Sum-of-the-years’-digits method for 2013. (3) Double-declining-balance method for 2012. (b) Suppose Kate Crow, the president of Alladin, tells you that because the company is a new organization, she expects it will be several years before production and sales reach optimum levels. She asks you to recommend a depreciation method that will allocate less of the company’s depreciation expense to the early years and more to later years of the assets’ lives. What method would you recommend?
P11-2 (Depreciation for Partial Periods—SL, Act., SYD, and DDB) The cost of equipment purchased by Charleston, Inc., on June 1, 2012, is $89,000. It is estimated that the machine will have a $5,000 salvage value at the end of its service life. Its service life is estimated at 7 years; its total working hours are estimated at 42,000; and its total production is estimated at 525,000 units. During 2012, the machine was operated 6,000 hours and produced 55,000 units. During 2013, the machine was operated 5,500 hours and produced 48,000 units.
Instructions Compute depreciation expense on the machine for the year ending December 31, 2012, and the year ending December 31, 2013, using the following methods. (a) Straight-line. (b) Units-of-output. (c) Working hours. (d) Sum-of-the-years’-digits. (e) Declining-balance (twice the straight-line rate).
P11-3 (Depreciation—SYD, Act., SL, and DDB) The following data relate to the Machinery account of Eshkol, Inc. at December 31, 2012. Machinery A B C D Original cost $46,000 $51,000 $80,000 $80,000 Year purchased 2007 2008 2009 2011 Useful life 10 years 15,000 hours 15 years 10 years Salvage value $ 3,100 $ 3,000 $ 5,000 $ 5,000 Depreciation Sum-of-the- Double-decliningmethod years’-digits Activity Straight-line balance Accum. depr. through 2012* $31,200 $35,200 $15,000 $16,000 *In the year an asset is purchased, Eshkol, Inc. does not record any depreciation expense on the asset. In the year an asset is retired or traded in, Eshkol, Inc. takes a full year’s depreciation on the asset. The following transactions occurred during 2013. (a) On May 5, Machine A was sold for $13,000 cash. The company’s bookkeeper recorded this retirement in the following manner in the cash receipts journal. Cash 13,000 Machinery (Machine A) 13,000 (b) On December 31, it was determined that Machine B had been used 2,100 hours during 2013. (c) On December 31, before computing depreciation expense on Machine C, the management of Eshkol, Inc. decided the useful life remaining from January 1, 2013, was 10 years. (d) On December 31, it was discovered that a machine purchased in 2012 had been expensed completely in that year. This machine cost $28,000 and has a useful life of 10 years and no salvage value. Management has decided to use the double-declining-balance method for this machine, which can be referred to as “Machine E.”
Instructions Prepare the necessary correcting entries for the year 2013. Record the appropriate depreciation expense on the above-mentioned machines.
P11-4 (Depreciation and Error Analysis) A depreciation schedule for semi-trucks of Ichiro Manufacturing Company was requested by your auditor soon after December 31, 2013, showing the additions, retirements, 2 3 depreciation, and other data affecting the income of the company in the 4-year period 2010 to 2013, inclusive. The following data were ascertained. Balance of Trucks account, Jan. 1, 2010 Truck No. 1 purchased Jan. 1, 2007, cost $18,000 Truck No. 2 purchased July 1, 2007, cost 22,000 Truck No. 3 purchased Jan. 1, 2009, cost 30,000 Truck No. 4 purchased July 1, 2009, cost 24,000 Balance, Jan. 1, 2010 $94,000 The Accumulated Depreciation—Trucks account previously adjusted to January 1, 2010, and entered in the ledger, had a balance on that date of $30,200 (depreciation on the four trucks from the respective dates of purchase, based on a 5-year life, no salvage value). No charges had been made against the account before January 1, 2010. Transactions between January 1, 2010, and December 31, 2013, which were recorded in the ledger, are as follows. July 1, 2010 Truck No. 3 was traded for a larger one (No. 5), the agreed purchase price of which was $40,000. Ichiro Mfg. Co. paid the automobile dealer $22,000 cash on the transaction. The entry was a debit to Trucks and a credit to Cash, $22,000. The transaction has commercial substance. Jan. 1, 2011 Truck No. 1 was sold for $3,500 cash; entry debited Cash and credited Trucks, $3,500. July 1, 2012 A new truck (No. 6) was acquired for $42,000 cash and was charged at that amount to the Trucks account. (Assume truck No. 2 was not retired.) July 1, 2012 Truck No. 4 was damaged in a wreck to such an extent that it was sold as junk for $700 cash. Ichiro Mfg. Co. received $2,500 from the insurance company. The entry made by the bookkeeper was a debit to Cash, $3,200, and credits to Miscellaneous Income, $700, and Trucks, $2,500. Entries for depreciation had been made at the close of each year as follows: 2010, $21,000; 2011, $22,500; 2012, $25,050; 2013, $30,400.
Instructions (a) For each of the 4 years, compute separately the increase or decrease in net income arising from the company’s errors in determining or entering depreciation or in recording transactions affecting trucks, ignoring income tax considerations. (b) Prepare one compound journal entry as of December 31, 2013, for adjustment of the Trucks account to reflect the correct balances as revealed by your schedule, assuming that the books have not been closed for 2013.
P11-5 (Depletion and Depreciation—Mining) Khamsah Mining Company has purchased a tract of mineral land for $900,000. It is estimated that this tract will yield 120,000 tons of ore with sufficient mineral content to make mining and processing profitable. It is further estimated that 6,000 tons of ore will be mined the first and last year and 12,000 tons every year in between. (Assume 11 years of mining operations.) The land will have a residual value of $30,000. The company builds necessary structures and sheds on the site at a cost of $36,000. It is estimated that these structures can serve 15 years but, because they must be dismantled if they are to be moved, they have no salvage value. The company does not intend to use the buildings elsewhere. Mining machinery installed at the mine was purchased secondhand at a cost of $60,000. This machinery cost the former owner $150,000 and was 50% depreciated when purchased. Khamsah Mining estimates that about half of this machinery will still be useful when the present mineral resources have been exhausted but that dismantling and removal costs will just about offset its value at that time. The company does not intend to use the machinery elsewhere. The remaining machinery will last until about one-half the present estimated mineral ore has been removed and will then be worthless. Cost is to be allocated equally between these two classes of machinery.
Instructions (a) As chief accountant for the company, you are to prepare a schedule showing estimated depletion and depreciation costs for each year of the expected life of the mine. (b) Also compute the depreciation and depletion for the first year assuming actual production of 5,000 tons. Nothing occurred during the year to cause the company engineers to change their estimates of either the mineral resources or the life of the structures and equipment.
P11-6 (Depletion, Timber, and Extraordinary Loss) Conan O’Brien Logging and Lumber Company owns 3,000 acres of timberland on the north side of Mount Leno, which was purchased in 2000 at a cost of $550 per acre. In 2012, O’Brien began selectively logging this timber tract. In May of 2012, Mount Leno erupted, burying the timberland of O’Brien under a foot of ash. All of the timber on the O’Brien tract was downed. In addition, the logging roads, built at a cost of $150,000, were destroyed, as well as the logging equipment, with a net book value of $300,000. 3 6 6 At the time of the eruption, O’Brien had logged 20% of the estimated 500,000 board feet of timber. Prior to the eruption, O’Brien estimated the land to have a value of $200 per acre after the timber was harvested. O’Brien includes the logging roads in the depletion base. O’Brien estimates it will take 3 years to salvage the downed timber at a cost of $700,000. The timber can be sold for pulp wood at an estimated price of $3 per board foot. The value of the land is unknown, but must be considered nominal due to future uncertainties.
Instructions (a) Determine the depletion cost per board foot for the timber harvested prior to the eruption of Mount Leno. (b) Prepare the journal entry to record the depletion prior to the eruption. (c) If this tract represents approximately half of the timber holdings of O’Brien, determine the amount of the extraordinary loss due to the eruption of Mount Leno for the year ended December 31, 2012.
P11-7 (Natural Resources—Timber) Bronson Paper Products purchased 10,000 acres of forested timberland in March 2012. The company paid $1,700 per acre for this land, which was above the $800 per acre most farmers were paying for cleared land. During April, May, June, and July 2012, Bronson cut enough timber to build roads using moveable equipment purchased on April 1, 2012. The cost of the roads was $250,000, and the cost of the equipment was $225,000; this equipment was expected to have a $9,000 salvage value and would be used for the next 15 years. Bronson selected the straight-line method of depreciation for the moveable equipment. Bronson began actively harvesting timber in August and by December had harvested and sold 540,000 board feet of timber of the estimated 6,750,000 board feet available for cutting. In March 2013, Bronson planted new seedlings in the area harvested during the winter. Cost of planting these seedlings was $120,000. In addition, Bronson spent $8,000 in road maintenance and $6,000 for pest spraying during calendar-year 2013. The road maintenance and spraying are annual costs. During 2013, Bronson harvested and sold 774,000 board feet of timber of the estimated 6,450,000 board feet available for cutting. In March 2014, Bronson again planted new seedlings at a cost of $150,000, and also spent $15,000 on road maintenance and pest spraying. During 2014, the company harvested and sold 650,000 board feet of timber of the estimated 6,500,000 board feet available for cutting.
Instructions Compute the amount of depreciation and depletion expense for each of the 3 years (2012, 2013, 2014). Assume that the roads are usable only for logging and therefore are included in the depletion base.
P11-8 (Comprehensive Fixed-Asset Problem) Darby Sporting Goods Inc. has been experiencing growth in the demand for its products over the last several years. The last two Olympic Games greatly increased the popularity of basketball around the world. As a result, a European sports retailing consortium entered into an agreement with Darby’s Roundball Division to purchase basketballs and other accessories on an increasing basis over the next 5 years. To be able to meet the quantity commitments of this agreement, Darby had to obtain additional manufacturing capacity. A real estate firm located an available factory in close proximity to Darby’s Roundball manufacturing facility, and Darby agreed to purchase the factory and used machinery from Encino Athletic Equipment Company on October 1, 2011. Renovations were necessary to convert the factory for Darby’s manufacturing use. The terms of the agreement required Darby to pay Encino $50,000 when renovations started on January 1, 2012, with the balance to be paid as renovations were completed. The overall purchase price for the factory and machinery was $400,000. The building renovations were contracted to Malone Construction at $100,000. The payments made, as renovations progressed during 2012, are shown below. The factory was placed in service on January 1, 2013. 1/1 4/1 10/1 12/31 Encino $50,000 $90,000 $110,000 $150,000 Malone 30,000 30,000 40,000 On January 1, 2012, Darby secured a $500,000 line-of-credit with a 12% interest rate to finance the purchase cost of the factory and machinery, and the renovation costs. Darby drew down on the line-of-credit to meet the payment schedule shown above; this was Darby’s only outstanding loan during 2012. Bob Sprague, Darby’s controller, will capitalize the maximum allowable interest costs for this project. Darby’s policy regarding purchases of this nature is to use the appraisal value of the land for book purposes and prorate the balance of the purchase price over the remaining items. The building had originally cost Encino $300,000 and had a net book value of $50,000, while the machinery originally cost $125,000 and had a net book value of $40,000 on the date of sale. The land was recorded on Encino’s books at $40,000. An appraisal, conducted by independent appraisers at the time of acquisition, valued the land at $290,000, the building at $105,000, and the machinery at $45,000. 6 Angie Justice, chief engineer, estimated that the renovated plant would be used for 15 years, with an estimated salvage value of $30,000. Justice estimated that the productive machinery would have a remaining useful life of 5 years and a salvage value of $3,000. Darby’s depreciation policy specifies the 200% declining-balance method for machinery and the 150% declining-balance method for the plant. One-half year’s depreciation is taken in the year the plant is placed in service and one-half year is allowed when the property is disposed of or retired. Darby uses a 360-day year for calculating interest costs.
Instructions (a) Determine the amounts to be recorded on the books of Darby Sporting Goods Inc. as of December 31, 2012, for each of the following properties acquired from Encino Athletic Equipment Company. (1) Land. (2) Buildings. (3) Machinery. (b) Calculate Darby Sporting Goods Inc.’s 2013 depreciation expense, for book purposes, for each of the properties acquired from Encino Athletic Equipment Company. (c) Discuss the arguments for and against the capitalization of interest costs. (CMA adapted)
P11-9 (Impairment) Roland Company uses special strapping equipment in its packaging business. The equipment was purchased in January 2011 for $10,000,000 and had an estimated useful life of 8 years with no salvage value. At December 31, 2012, new technology was introduced that would accelerate the obsolescence of Roland’s equipment. Roland’s controller estimates that expected future net cash flows on the equipment will be $6,300,000 and that the fair value of the equipment is $5,600,000. Roland intends to continue using the equipment, but it is estimated that the remaining useful life is 4 years. Roland uses straightline depreciation.
Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2012. (b) Prepare any journal entries for the equipment at December 31, 2013. The fair value of the equipment at December 31, 2013, is estimated to be $5,900,000. (c) Repeat the requirements for (a) and (b), assuming that Roland intends to dispose of the equipment and that it has not been disposed of as of December 31, 2013.
P11-10 (Comprehensive Depreciation Computations) Kohlbeck Corporation, a manufacturer of steel products, began operations on October 1, 2011. The accounting department of Kohlbeck has started the fixed-asset and depreciation schedule presented on page 647. You have been asked to assist in completing this schedule. In addition to ascertaining that the data already on the schedule are correct, you have obtained the following information from the company’s records and personnel. 1. Depreciation is computed from the first of the month of acquisition to the first of the month of disposition. 2. Land A and Building A were acquired from a predecessor corporation. Kohlbeck paid $800,000 for the land and building together. At the time of acquisition, the land had an appraised value of $90,000, and the building had an appraised value of $810,000. 3. Land B was acquired on October 2, 2011, in exchange for 2,500 newly issued shares of Kohlbeck’s common stock. At the date of acquisition, the stock had a par value of $5 per share and a fair value of $30 per share. During October 2011, Kohlbeck paid $16,000 to demolish an existing building on this land so it could construct a new building. 4. Construction of Building B on the newly acquired land began on October 1, 2012. By September 30, 2013, Kohlbeck had paid $320,000 of the estimated total construction costs of $450,000. It is estimated that the building will be completed and occupied by July 2014. 5. Certain equipment was donated to the corporation by a local university. An independent appraisal of the equipment when donated placed the fair value at $40,000 and the salvage value at $3,000. 6. Machinery A’s total cost of $182,900 includes installation expense of $600 and normal repairs and maintenance of $14,900. Salvage value is estimated at $6,000. Machinery A was sold on February 1, 2013. 7. On October 1, 2012, Machinery B was acquired with a down payment of $5,740 and the remaining payments to be made in 11 annual installments of $6,000 each beginning October 1, 2012. The prevailing interest rate was 8%. The following data were abstracted from present value tables (rounded). Present value of $1.00 at 8% Present value of an ordinary annuity of $1.00 at 8% 10 years .463 10 years 6.710 11 years .429 11 years 7.139 15 years .315 15 years 8.559 2 3 5 KOHLBECK CORPORATION Fixed-Asset and Depreciation Schedule For Fiscal Years Ended September 30, 2012, and September 30, 2013 Depreciation Expense Year Ended Estimated Acquisition Depreciation Life in September 30 Assets Date Cost Salvage Method Years 2012 2013 Land A October 1, 2011 $ (1) N/A N/A N/A N/A N/A Building A October 1, 2011 (2) $40,000 Straight-line (3) $13,600 (4) Land B October 2, 2011 (5) N/A N/A N/A N/A N/A Building B Under $320,000 — Straight-line 30 — (6) Construction to date Donated Equipment October 2, 2011 (7) 3,000 150% declining- 10 (8) (9) balance Machinery A October 2, 2011 (10) 6,000 Sum-of-the- 8 (11) (12) years’-digits Machinery B October 1, 2012 (13) — Straight-line 20 — (14) N/A—Not applicable
Instructions For each numbered item on the schedule above, supply the correct amount. Round each answer to the nearest dollar.
P11-11 (Depreciation for Partial Periods—SL, Act., SYD, and DDB) On January 1, 2010, a machine was purchased for $90,000. The machine has an estimated salvage value of $6,000 and an estimated useful life of 5 years. The machine can operate for 100,000 hours before it needs to be replaced. The company closed its books on December 31 and operates the machine as follows: 2010, 20,000 hrs; 2011, 25,000 hrs; 2012, 15,000 hrs; 2013, 30,000 hrs; 2014, 10,000 hrs.
Instructions (a) Compute the annual depreciation charges over the machine’s life assuming a December 31 year-end for each of the following depreciation methods. (1) Straight-line method. (2) Activity method. (3) Sum-of-the-years’-digits method. (4) Double-declining-balance method. (b) Assume a fiscal year-end of September 30. Compute the annual depreciation charges over the asset’s life applying each of the following methods. (1) Straight-line method. (2) Sum-of-the-years’-digits method. (3) Double-declining-balance method. *P 11-12 (Depreciation—SL, DDB, SYD, Act., and MACRS) On January 1, 2011, Locke Company, a small machine-tool manufacturer, acquired for $1,260,000 a piece of new industrial equipment. The new equipment had a useful life of 5 years, and the salvage value was estimated to be $60,000. Locke estimates that the new equipment can produce 12,000 machine tools in its first year. It estimates that production will decline by 1,000 units per year over the remaining useful life of the equipment. The following depreciation methods may be used: (1) straight-line; (2) double-declining-balance; (3) sum-of-the-years’-digits; and (4) units-of-output. For tax purposes, the class life is 7 years. Use the MACRS tables for computing depreciation.
Instructions (a) Which depreciation method would maximize net income for financial statement reporting for the 3-year period ending December 31, 2013? Prepare a schedule showing the amount of accumulated depreciation at December 31, 2013, under the method selected. Ignore present value, income tax, and deferred income tax considerations. (b) Which depreciation method (MACRS or optional straight-line) would minimize net income for income tax reporting for the 3-year period ending December 31, 2013? Determine the amount of accumulated depreciation at December 31, 2013. Ignore present value considerations. (AICPA adapted) 2 3
CA11-1 (Depreciation Basic Concepts) Burnitz Manufacturing Company was organized January 1, 2012. During 2012, it has used in its reports to management the straight-line method of depreciating its plant assets. On November 8, you are having a conference with Burnitz’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. James Bryant, president of Burnitz, has suggested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Following is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a salvage value of approximately $8,000. Accumulated Years of Depreciation Book Value Life Fraction Depreciation at End at End Year Used Rate Expense of Year of Year 1 1 1/15 $16,000 $ 16,000 $232,000 2 2 2/15 32,000 48,000 200,000 3 3 3/15 48,000 96,000 152,000 4 4 4/15 64,000 160,000 88,000 5 5 5/15 80,000 240,000 8,000 The president favors the new method because he has heard that: 1. It will increase the funds recovered during the years near the end of the assets’ useful lives when maintenance and replacement disbursements are high. 2. It will result in increased write-offs in later years and thereby will reduce taxes.
Instructions (a) What is the purpose of accounting for depreciation? (b) Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable. (c) The president wants your advice on the following issues. (1) Do depreciation charges recover or create funds? Explain. (2) Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations?
CA11-2 (Unit, Group, and Composite Depreciation) The certified public accountant is frequently called upon by management for advice regarding methods of computing depreciation. Of comparable importance, although it arises less frequently, is the question of whether the depreciation method should be based on consideration of the assets as units, as a group, or as having a composite life.
Instructions (a) Briefly describe the depreciation methods based on treating assets as (1) units and (2) a group or as having a composite life. (b) Present the arguments for and against the use of each of the two methods. (c) Describe how retirements are recorded under each of the two methods. (AICPA adapted)
CA11-3 (Depreciation—Strike, Units-of-Production, Obsolescence) Presented below and on page 649 are three different and unrelated situations involving depreciation accounting. Answer the question(s) at the end of each situation. Situation I Recently, Broderick Company experienced a strike that affected a number of its operating plants. The controller of this company indicated that it was not appropriate to report depreciation expense during this period because the equipment did not depreciate and an improper matching of costs and revenues would result. She based her position on the following points. 1. It is inappropriate to charge the period with costs for which there are no related revenues arising from production. 2. The basic factor of depreciation in this instance is wear and tear, and because equipment was idle, no wear and tear occurred.
Instructions Comment on the appropriateness of the controller’s comments. Situation II Etheridge Company manufactures electrical appliances, most of which are used in homes. Company engineers have designed a new type of blender which, through the use of a few attachments, will perform more functions than any blender currently on the market. Demand for the new blender can be projected with reasonable probability. In order to make the blenders, Etheridge needs a specialized machine that is not available from outside sources. It has been decided to make such a machine in Etheridge’s own plant.
Instructions (a) Discuss the effect of projected demand in units for the new blenders (which may be steady, decreasing, or increasing) on the determination of a depreciation method for the machine. (b) What other matters should be considered in determining the depreciation method? Ignore income tax considerations. Situation III Haley Paper Company operates a 300-ton-per-day kraft pulp mill and four sawmills in Wisconsin. The company is in the process of expanding its pulp mill facilities to a capacity of 1,000 tons per day and plans to replace three of its older, less efficient sawmills with an expanded facility. One of the mills to be replaced did not operate for most of 2012 (current year), and there are no plans to reopen it before the new sawmill facility becomes operational. In reviewing the depreciation rates and in discussing the residual values of the sawmills that were to be replaced, it was noted that if present depreciation rates were not adjusted, substantial amounts of plant costs on these three mills would not be depreciated by the time the new mill came on stream.
Instructions What is the proper accounting for the four sawmills at the end of 2012?
CA11-4 (Depreciation Concepts) As a cost accountant for San Francisco Cannery, you have been approached by Phil Perriman, canning room supervisor, about the 2012 costs charged to his department. In particular, he is concerned about the line item “depreciation.” Perriman is very proud of the excellent condition of his canning room equipment. He has always been vigilant about keeping all equipment serviced and well oiled. He is sure that the huge charge to depreciation is a mistake; it does not at all reflect the cost of minimal wear and tear that the machines have experienced over the last year. He believes that the charge should be considerably lower. The machines being depreciated are six automatic canning machines. All were put into use on January 1, 2012. Each cost $625,000, having a salvage value of $55,000 and a useful life of 12 years. San Francisco depreciates this and similar assets using double-declining-balance depreciation. Perriman has also pointed out that if you used straight-line depreciation the charge to his department would not be so great.
Instructions Write a memo to Phil Perriman to clear up his misunderstanding of the term “depreciation.” Also, calculate year-1 depreciation on all machines using both methods. Explain the theoretical justification for doubledeclining- balance and why, in the long run, the aggregate charge to depreciation will be the same under both methods.
CA11-5 (Depreciation Choice—Ethics) Jerry Prior, Beeler Corporation’s controller, is concerned that net income may be lower this year. He is afraid upper-level management might recommend cost reductions by laying off accounting staff, including him. Prior knows that depreciation is a major expense for Beeler. The company currently uses the doubledeclining- balance method for both financial reporting and tax purposes, and he’s thinking of selling equipment that, given its age, is primarily used when there are periodic spikes in demand. The equipment has a carrying value of $2,000,000 and a fair value of $2,180,000. The gain on the sale would be reported in the income statement. He doesn’t want to highlight this method of increasing income. He thinks, “Why don’t I increase the estimated useful lives and the salvage values? That will decrease depreciation expense and require less extensive disclosure, since the changes are accounted for prospectively. I may be able to save my job and those of my staff.”
Instructions Answer the following questions. (a) Who are the stakeholders in this situation? (b) What are the ethical issues involved? (c) What should Prior do?
FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B or can be accessed at the book’s companion website, www.wiley.com/college/kieso.
Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What descriptions are used by P&G in its balance sheet to classify its property, plant, and equipment? (b) What method or methods of depreciation does P&G use to depreciate its property, plant, and equipment? (c) Over what estimated useful lives does P&G depreciate its property, plant, and equipment? (d) What amounts for depreciation and amortization expense did P&G charge to its income statement in 2009, 2008, and 2007? (e) What were the capital expenditures for property, plant, and equipment made by P&G in 2009, 2008, and 2007?
Comparative Analysis Case The Coca-Cola Company and PepsiCo., Inc.
Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What amount is reported in the balance sheets as property, plant, and equipment (net) of Coca-Cola at December 31, 2009, and of PepsiCo at December 26, 2009? What percentage of total assets is invested in property, plant, and equipment by each company? (b) What depreciation methods are used by Coca-Cola and PepsiCo for property, plant, and equipment? How much depreciation was reported by Coca-Cola and PepsiCo in 2009, 2008, and 2007? (c) Compute and compare the following ratios for Coca-Cola and PepsiCo for 2009. (1) Asset turnover. (2) Profit margin on sales. (3) Rate of return on assets. (d) What amount was spent in 2009 for capital expenditures by Coca-Cola and PepsiCo? What amount of interest was capitalized in 2009?
Financial Statement Analysis Case McDonald’s Corporation McDonald’s is the largest and best-known global food service retailer, with more than 32,000 restaurants in 118 countries. On any day, McDonald’s serves approximately 1 percent of the world’s population. Presented on the next page is information related to McDonald’s property and equipment. USING YOUR JUDGMENT
McDonald’s Corporation Summary of Significant Accounting Policies Section Property and Equipment. Property and equipment are stated at cost, with depreciation and amortization provided using the straight-line method over the following estimated useful lives: buildings—up to 40 years; leasehold improvements—lesser of useful lives of assets or lease terms including option periods; and equipment—3 to 12 years. [In the notes to the fi nancial statements:] Property and Equipment Net property and equipment consisted of: December 31 (In millions) 2009 2008 Land $ 5,048.3 $ 4,689.6 Buildings and improvements on owned land 12,119.0 10,952.3 Buildings and improvements on leased land 11,347.9 10,788.6 Equipment, signs and seating 4,422.9 4,205.1 Other 502.4 516.8 33,440.5 31,152.4 Accumulated depreciation and amortization (11,909.0) (10,897.9) Net property and equipment $ 21,531.5 $ 20,254.5 Depreciation and amortization expense related to continuing operations was (in millions): 2009—$1,160.8; 2008—$1,161.6; 2007—$1,145.0. [In its 6-year summary, McDonald’s provides the following information.] Cash Provided by Operations (dollars in millions) 2009 2008 2007 Cash provided by operations $5,751 $5,917 $4,876 Capital expenditures $1,952 $2,136 $1,947 Cash provided by operations as a percent of capital expenditures 295% 277% 250%
Instructions (a) What method of depreciation does McDonald’s use? (b) Does depreciation and amortization expense cause cash fl ow from operations to increase? Explain. (c) What does the schedule of cash fl ow measures indicate? Accounting, Analysis, and Principles Electroboy Enterprises, Inc. operates several stores throughout the western United States. As part of an operational and financial reporting review in a response to a downturn in its markets, the company’s management has decided to perform an impairment test on five stores (combined). The five stores’ sales have declined due to aging facilities and competition from a rival that opened new stores in the same markets. Management has developed the following information concerning the five stores as of the end of fiscal 2011. Original cost $36 million Accumulated depreciation $10 million Estimated remaining useful life 4 years Estimated expected future annual cash fl ows (not discounted) $4.0 million per year Appropriate discount rate 5 percent BRIDGE TO THE PROFESSION
Professional Research: FASB Codifi cation Matt Holmes recently joined Klax Company as a staff accountant in the controller’s office. Klax Company provides warehousing services for companies in several midwestern cities. The location in Dubuque, Iowa, has not been performing well due to increased competition and the loss of several customers that have recently gone out of business. Matt’s department manager suspects that the plant and equipment may be impaired and wonders whether those assets should be written down. Given the company’s prior success, this issue has never arisen in the past, and Matt has been asked to conduct some research on this issue.
Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) What is the authoritative guidance for asset impairments? Briefl y discuss the scope of the standard (i.e., explain the types of transactions to which the standard applies). (b) Give several examples of events that would cause an asset to be tested for impairment. Does it appear that Klax should perform an impairment test? Explain. (c) What is the best evidence of fair value? Describe alternate methods of estimating fair value. Accounting (a) Determine the amount of impairment loss, if any, that Electroboy should report for fiscal 2011 and the book value at which Electroboy should report the five stores on its fiscal year-end 2011 balance sheet. Assume that the cash flows occur at the end of each year. (b) Repeat part (a), but instead, assume that (1) the estimated remaining useful life is 10 years, (2) the estimated annual cash flows are $2,720,000 per year, and (3) the appropriate discount rate is 6 percent. Analysis Assume that you are a financial analyst and you participate in a conference call with Electroboy management in early 2012 (before Electroboy closes the books on fiscal 2011). During the conference call, you learn that management is considering selling the five stores, but the sale won’t likely be completed until the second quarter of fiscal 2012. Briefly discuss what implications this would have for Electroboy’s 2011 financial statements. Assume the same facts as in part (b) above. Principles Electroboy management would like to know the accounting for the impaired asset in periods subsequent to the impairment. Can the assets be written back up? Briefly discuss the conceptual arguments for this accounting.
Professional Simulation In this simulation, you are asked to address questions regarding the accounting for property, plant, and equipment. Prepare responses to all parts. Whitley Corporation purchased machinery on January 1, 2012, at a cost of $100,000. The estimated useful life of the machinery is 4 years, with an estimated salvage value of $10,000 at the end of that period. The company is considering different depreciation methods that could be used for financial reporting purposes. (a) What is the purpose of depreciation? (b) Identify the factors that are relevant in determining annual depreciation, and explain whether those factors are determined objectively or whether they are based on judgment. (a) Which depreciation method would result in the highest reported 2012 income? Explain. (b) Which method would result in the highest total reported earnings over the 4-year period? Explain. (c) Which method would result in the highest 2012 cash flow? Explain. Directions Situation Explanation Measurement Journal Entry Resources Directions Situation Explanation Measurement Journal Entry Resources Directions Situation Explanation Measurement Journal Entry Resources Directions Situation Explanation Measurement Journal Entry Resources Assume that the company sold the machinery on January 1, 2014, for $84,000 and that the company used the straight-line method. Prepare the journal entry to record the transaction. 1 2 3 45 A B C + KWW_Professional_Simulation Property, Plant, and Equipment Time Remaining 1 hour 40 minutes Unsplit Split Horiz Split Vertical Spreadsheet Calculator Exit GAAP adheres to many of the same principles of IFRS in the accounting for property, plant, and equipment. Major differences relate to use of component depreciation, impairments, and revaluations.
RELEVANT FACTS • The defi nition of property, plant, and equipment is essentially the same under GAAP and IFRS. • Under both GAAP and IFRS, changes in depreciation method and changes in useful life are treated in the current and future periods. Prior periods are not affected. GAAP recently conformed to IFRS in this area. • The accounting for plant asset disposals is the same under GAAP and IFRS. • The accounting for the initial costs to acquire natural resources is similar under GAAP and IFRS. • Under both GAAP and IFRS, interest costs incurred during construction must be capitalized. Recently, IFRS converged to GAAP. IFRS Insights • The accounting for exchanges of nonmonetary assets has recently converged between IFRS and GAAP. GAAP now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS. • GAAP also views depreciation as allocation of cost over an asset’s life. GAAP permits the same depreciation methods (straight-line, diminishing-balance, units-of-production) as IFRS. • IFRS requires component depreciation. Under GAAP, component depreciation is permitted but is rarely used. • Under IFRS, companies can use either the historical cost model or the revaluation model. GAAP does not permit revaluations of property, plant, and equipment or mineral resources. • In testing for impairments of long-lived assets, GAAP uses a two-step model to test for impairments (details of the GAAP impairment test is presented in the About the Numbers discussion). As long as future undiscounted cash flows exceed the carrying amount of the asset, no impairment is recorded. The IFRS impairment test is stricter. However, unlike GAAP, reversals of impairment losses are permitted. ABOUT THE NUMBERS Component Depreciation Under IFRS, companies are required to use component depreciation. IFRS requires that each part of an item of property, plant, and equipment that is significant to the total cost of the asset must be depreciated separately. Companies therefore have to exercise judgment to determine the proper allocations to the components. As an example, when a company like Nokia purchases a building, it must determine how the various building components (e.g., the foundation, structure, roof, heating and cooling system, and elevators) should be segregated and depreciated. To illustrate the accounting for component depreciation, assume that EuroAsia Airlines purchases an airplane for $100,000,000 on January 1, 2012. The airplane has a useful life of 20 years and a residual value of $0. EuroAsia uses the straight-line method of depreciation for all its airplanes. EuroAsia identifies the following components, amounts, and useful lives, as shown in
ILLUSTRATION IFRS11-1. Components Component Amount Component Useful Life Airframe $60,000,000 20 years Engine components 32,000,000 8 years Other components 8,000,000 5 years
ILLUSTRATION IFRS11-1 Airplane Components
ILLUSTRATION IFRS11-2 shows the computation of depreciation expense for EuroAsia for 2012.
ILLUSTRATION IFRS11-2 Computation of Component Depreciation Components Component Amount 4 Useful Life 5 Component Depreciation Airframe $ 60,000,000 20 $3,000,000 Engine components 32,000,000 8 4,000,000 Other components 8,000,000 5 1,600,000 Total $100,000,000 $8,600,000 In many situations, a company may not have a good understanding of the cost of the individual components purchased. In that case, the cost of individual components should be estimated based on reference to current market prices (if available), discussion with experts in valuation, or use of other reasonable approaches. Recognizing Impairments As discussed in the text, the credit crisis starting in late 2008 has affected many financial and nonfinancial institutions. As a result of this global slump, many companies are considering write-offs of some of their long-lived assets. These write-offs are referred to as impairments. The accounting for impairments is different under GAAP and IFRS. A long-lived tangible asset is impaired when a company is not able to recover the asset’s carrying amount either through using it or by selling it. To determine whether an asset is impaired, on an annual basis, companies review the asset for indicators of impairments—that is, a decline in the asset’s cash-generating ability through use or sale. This review should consider internal sources (e.g., adverse changes in performance) and external sources (e.g., adverse changes in the business or regulatory environment) of information. If impairment indicators are present, then an impairment test must be conducted. This test compares the asset’s recoverable amount with its carrying amount. If the carrying amount is higher than the recoverable amount, the difference is an impairment loss. If the recoverable amount is greater than the carrying amount, no impairment is recorded. Recoverable amount is defined as the higher of fair value less costs to sell or valuein- use. Fair value less costs to sell means what the asset could be sold for after deducting costs of disposal. Value-in-use is the present value of cash flows expected from the future use and eventual sale of the asset at the end of its useful life.
ILLUSTRATION IFRS11-4 highlights the nature of the impairment test. As indicated, EuroAsia records depreciation expense of $8,600,000 in 2012 as follows. Depreciation Expense 8,600,000 Accumulated Depreciation—Airplane 8,600,000 On the statement of financial position at the end of 2012, EuroAsia reports the airplane as a single amount. The presentation is shown in
ILLUSTRATION IFRS11-3 Presentation of Carrying Amount of Airplane Non-current assets Airplane $100,000,000 Less: Accumulated depreciation—airplane 8,600,000 $ 91,400,000 IFRS Insights 655 Recoverable Amount Fair Value Less Costs to Sell Value-in-Use Carrying Amount Compared to Higher of
ILLUSTRATION IFRS11-4 Impairment Test If either the fair value less costs to sell or value-in-use is higher than the carrying amount, there is no impairment. If both the fair value less costs to sell and value-in-use are lower than the carrying amount, a loss on impairment occurs. Example: No Impairment Assume that Cruz Company performs an impairment test for its equipment. The carrying amount of Cruz’s equipment is $200,000, its fair value less costs to sell is $180,000, and its value-in-use is $205,000. In this case, the value-in-use of Cruz’s equipment is higher than its carrying amount of $200,000. As a result, there is no impairment. (If a company can more readily determine value-in-use (or fair value less costs to sell) and it determines that no impairment is needed, it is not required to compute the other measure.) Example: Impairment Assume the same information for Cruz Company above except that the value-in-use of Cruz’s equipment is $175,000 rather than $205,000. Cruz measures the impairment loss as the difference between the carrying amount of $200,000 and the higher of fair value less cost to sell ($180,000) or value-in-use ($175,000). Cruz therefore uses the fair value less cost of disposal to record an impairment loss of $20,000 ($200,000 2 $180,000). Cruz makes the following entry to record the impairment loss. Loss on Impairment 20,000 Accumulated Depreciation—Equipment 20,000 The Loss on Impairment is reported in the income statement in the “Other income and expense” section. The company then either credits Equipment or Accumulated Depreciation—Equipment to reduce the carrying amount of the equipment for the impairment. For purposes of homework, credit accumulated depreciation when recording an impairment for a depreciable asset. Reversal of Impairment Loss After recording the impairment loss, the recoverable amount becomes the basis of the impaired asset. What happens if a review in a future year indicates that the asset is no longer impaired because the recoverable amount of the asset is higher than the carrying amount? In that case, the impairment loss may be reversed. To illustrate, assume that Tan Company purchases equipment on January 1, 2012, for $300,000, with a useful life of three years, and no residual value. Its depreciation and related carrying amount over the three years is as follows. At December 31, 2012, Tan determines it has an impairment loss of $20,000 and therefore makes the following entry. Loss on Impairment 20,000 Accumulated Depreciation—Equipment 20,000 Tan’s depreciation expense and related carrying amount after the impairment is as indicated in
ILLUSTRATION IFRS11-5. Year Depreciation Expense Carrying Amount 2012 $100,000 ($300,000/3) $200,000 2013 $100,000 ($300,000/3) $100,000 2014 $100,000 ($300,000/3) 0 At the end of 2013, Tan determines that the recoverable amount of the equipment is $96,000, which is greater than its carrying amount of $90,000. In this case, Tan reverses the previously recognized impairment loss with the following entry. Accumulated Depreciation—Equipment 6,000 Recovery of Impairment Loss 6,000 The recovery of the impairment loss is reported in the “Other income and expense” section of the income statement. The carrying amount of Tan’s equipment is now $96,000 ($90,000 1 $6,000) at December 31, 2013. The general rule related to reversals of impairments is as follows: The amount of the recovery of the loss is limited to the carrying amount that would result if the impairment had not occurred. For example, the carrying amount of Tan’s equipment at the end of 2013 would be $100,000, assuming no impairment. The $6,000 recovery is therefore permitted because Tan’s carrying amount on the equipment is now only $96,000. However, any recovery above $10,000 is not permitted. The reason is that any recovery above $10,000 results in Tan carrying the asset at a value above its historical cost. Revaluations Up to this point, we have assumed that companies use the cost principle to value longlived tangible assets after acquisition. However, under IFRS companies have a choice: They may value these assets at cost or at fair value. Recognizing Revaluations Network Rail (a company in Great Britain) is an example of a company that elected to use fair values to account for its railroad network. Its use of fair value led to an increase of ￡4,289 million to its long-lived tangible assets. When companies choose to fair value their long-lived tangible assets subsequent to acquisition, they account for the change in the fair value by adjusting the appropriate asset account and establishing an unrealized gain on the revalued long-lived tangible asset. This unrealized gain is often referred to as revaluation surplus. Revaluation—Land. To illustrate revaluation of land, assume that Siemens Group purchased land for $1,000,000 on January 5, 2012. The company elects to use revaluation accounting for the land in subsequent periods. At December 31, 2012, the land’s fair value is $1,200,000. The entry to record the land at fair value is as follows. Land 200,000 Unrealized Gain on Revaluation—Land 200,000 The land is reported on the statement of financial position at $1,200,000, and the Unrealized Gain on Revaluation—Land increases other comprehensive income in the statement of comprehensive income. In addition, if this is the only revaluation adjustment to date, the statement of financial position reports accumulated other comprehensive income of $200,000. Revaluation—Depreciable Assets. To illustrate the accounting for revaluations of depreciable assets, assume that Lenovo Group purchases equipment for $500,000 on January 2, 2012. The equipment has a useful life of five years, is depreciated using the straight-line method of depreciation, and its residual value is zero. Lenovo IFRS Insights 657 Year Depreciation Expense Carrying Amount 2013 $90,000 ($180,000/2) $90,000 2014 $90,000 ($180,000/2) 0
ILLUSTRATION IFRS11-5 Carrying Value of Impaired Asset chooses to revalue its equipment to fair value over the life of the equipment. Lenovo records depreciation expense of $100,000 ($500,000 4 5) at December 31, 2012, as follows. December 31, 2012 Depreciation Expense 100,000 Accumulated Depreciation—Equipment 100,000 (To record depreciation expense in 2012) After this entry, Lenovo’s equipment has a carrying amount of $400,000 ($500,000 2 $100,000). Lenovo receives an independent appraisal for the fair value of equipment at December 31, 2012, which is $460,000. To report the equipment at fair value, Lenovo does the following. 1. Reduces the Accumulated Depreciation—Equipment account to zero. 2. Reduces the Equipment account by $40,000—it then is reported at its fair value of $460,000. 3. Records Unrealized Gain on Revaluation—Equipment for the difference between the fair value and carrying amount of the equipment, or $60,000 ($460,000 2 $400,000). The entry to record this revaluation at December 31, 2012, is as follows. December 31, 2012 Accumulated Depreciation—Equipment 100,000 Equipment 40,000 Unrealized Gain on Revaluation—Equipment 60,000 (To adjust the equipment to fair value and record revaluation increase) The equipment is now reported at its fair value of $460,000 ($500,000 2 $40,000). As an alternative to the one shown here, companies restate on a proportionate basis the cost and accumulated depreciation of the asset, such that the carrying amount of the asset after revaluation equals its revalued amount. The increase in the fair value of $60,000 is reported on the statement of comprehensive income as other comprehensive income. In addition, the ending balance is reported in accumulated other comprehensive income on the statement of financial position in the equity section.
ILLUSTRATION IFRS11-6 shows the presentation of revaluation elements.
ILLUSTRATION IFRS11-6 Financial Statement Presentation— Revaluations On the statement of comprehensive income: Other comprehensive income Unrealized gain on revaluation—equipment $ 60,000 On the statement of financial position: Non-current assets Equipment ($500,000 2 $40,000) $460,000 Accumulated depreciation—equipment ($100,000 2 $100,000) –0– Carrying amount $460,000 Equity Accumulated other comprehensive income $ 60,000 As indicated, at December 31, 2012, the carrying amount of the equipment is now $460,000. Lenovo reports depreciation expense of $100,000 in the income statement and an Unrealized Gain on Revaluation—Equipment of $60,000 in “Other comprehensive income.” Assuming no change in the useful life of the equipment, depreciation in 2013 is $115,000 ($460,000 4 4). In summary, a revaluation increase generally goes to equity. A revaluation decrease is reported as an expense (as an impairment loss), unless it offsets previously recorded revaluation increases. If the revaluation increase offsets a revaluation decrease that went to expense, then the increase is reported in income. Under no circumstances can the Accumulated Other Comprehensive Income account related to revaluations have a negative balance.
ON THE HORIZON With respect to revaluations, as part of the conceptual framework project, the Boards will examine the measurement bases used in accounting. It is too early to say whether a converged conceptual framework will recommend fair value measurement (and revaluation accounting) for property, plant, and equipment. However, this is likely to be one of the more contentious issues, given the long-standing use of historical cost as a measurement basis in GAAP.
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