Chapter 11 Operational Assets: Utilization and Impairment 1 Question 11-1 The terms depreciation, depletion, and amortization all refer to the process of allocating the cost of an operational asset to periods of use. The only difference between the terms is that they refer to different types of operational assets; depreciation for plant and equipment, depletion for natural resources, and amortization for intangibles. Question 11-2 The term depreciation often is confused with a decline in value or worth of an asset. Depreciation is not measured as decline in value from one period to the next. Instead, it involves the distribution of the cost of an asset, less any anticipated residual value, over the asset's estimated useful life in a systematic and rational manner that attempts to match revenues with the use of the asset. Question 11-3 The process of cost allocation for operational assets requires that three factors be established at the time the asset is put into use. These factors are: 1. Service (useful) life — The estimated use that the company expects to receive from the asset. 2. Allocation base — The value of the usefulness that is expected to be consumed. 3. Allocation method — The pattern in which the usefulness is expected to be consumed. Question 11-4 Physical life provides the upper bound for service life. Physical life will vary according to the purpose for which the asset is acquired and the environment in which it is operated. Service life may be less than physical life for several reasons. For example, the expected rate of technological changes may shorten service life. Management intent also may shorten the period of an asset’s usefulness below its physical life. For instance, a company may have a policy of using its delivery trucks for a three-year period before trading the trucks for new models. Question 11-5 The total amount of depreciation to be recorded during an asset’s service life is called its depreciable base. This amount is the difference between the initial value of the asset at its acquisition (its cost) and its residual value. Residual or salvage value is the amount the company expects to receive for the asset at the end of its service life less any anticipated disposal costs. Chapter 11 Operational Assets: Utilization and Impairment QUESTIONS FOR REVIEW OF KEY TOPICS 2 Answers to Questions (continued) Question 11-6 Activity-based allocation methods estimate service life in terms of some measure of productivity. Periodic depreciation or depletion is then determined based on the actual productivity generated by the asset during the period. Time-based allocation methods estimate service life in years. Periodic depreciation or amortization is then determined based on the passage of time. Question 11-7 The straight-line depreciation method allocates an equal amount of depreciable base to each year of an asset’s service life. Accelerated depreciation methods allocate higher portions of depreciable base to the early years of the asset’s life and lower amounts of depreciable base to later years. Total depreciation is the same by either approach. Question 11-8 Theoretically, the use of activity-based depreciation methods would provide a better matching of revenues and expenses. Clearly, the productivity of a plant asset is more closely associated with the benefits provided by that asset than the mere passage of time. However, activity-based methods quite often are either infeasible or too costly to use. For example, buildings do not have an identifiable measure of productivity. For assets such as machinery, there may be an identifiable measure of productivity, such as machine hours or units produced, but it is more costly to determine the amount each period than it is to simply measure the passage of time. For these reasons, most companies use time-based depreciation methods. Question 11-9 Companies might use the straight-line method because they consider that the benefits derived from the majority of plant assets are realized approximately evenly over these assets’ useful lives. It also is the easiest method to understand and apply. The effect on net income also could explain why so many companies prefer the straight-line method to the accelerated methods. Straight line produces a higher net income in the early years of an asset’s life. Net income can affect bonuses paid to management, or debt agreements with lenders. Income taxes are not a factor in determining the depreciation method because a company is not required to use the same depreciation method for both financial reporting and income tax purposes. Question 11-10 The group approach to aggregation is applied to a collection of depreciable assets that share similar service lives and other attributes. For example, group depreciation could be used for fleets of vehicles or collections of machinery. The composite approach to aggregation is applied to dissimilar operating assets, such as all of the depreciable assets in one manufacturing plant. Individual assets in the composite may have diverse service lives. Both approaches are similar in that they involve applying a single straight-line rate based on the average service lives of the assets in the group or composite. 3 Answers to Questions (continued) Question 11-11 The allocation of the cost of a natural resource to periods of use is called depletion. The process otherwise is identical to depreciation. The activity-based units-of-production method is the predominant method used to calculate depletion, not the time-based straight-line method. Question 11-12 The amortization of intangible assets is based on the same concepts as depreciation and depletion. The capitalized cost of an intangible asset that has a finite useful life must be allocated to the periods the company expects the asset to contribute to its revenue generating activities. Intangibles, though, generally have no residual values, so the amortizable base is simply cost. Also, intangibles possess no physical life to provide an upper bound to service life. However, most intangibles have a legal or contractual life that limits useful life. Intangible assets that have indefinite useful lives, including goodwill, are not amortized. Question 11-13 A company can calculate depreciation based on the actual number of days or months the asset was used during the year. A common simplifying convention is to record one-half of a full year’s expense in the years of acquisition and disposal. This is known as the half-year convention. The modified half-year convention records a full year’s expense when the asset is acquired in the first half of the year or sold in the second half. No expense is recorded when the asset is acquired in the second half of the year or sold in the first half. Question 11-14 A change in the service life of an operational asset is accounted for as a change in an estimate. The change is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life. Question 11-15 A change in depreciation method is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life using the new depreciation method, exactly as we would account for a change in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable. A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods. 4 Answers to Questions (concluded) Question 11-16 If a material error is discovered in an accounting period subsequent to the period in which the error is made, previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders’ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share. Question 11-17 An impairment in the value of an operational asset results when there has been a significant decline in value below carrying value (book value). For tangible operational assets and intangibles with finite useful lives, GAAP require an entity to recognize an impairment loss only when the undiscounted sum of estimated future cash flows from an asset is less than the asset’s book value. The loss recognized is the amount by which the book value exceeds the fair value of the asset or group of assets when the fair value is readily determinable. If fair value is not determinable, it must be estimated. One method of estimating fair value is to compute the present value of estimated future cash flows from the asset or group of assets. For intangible operational assets other than goodwill, if book value exceeds fair value, an impairment loss is recognized for the differences. For goodwill, an impairment loss is indicated if the fair value of the reporting unit is less than its book value. A goodwill impairment loss is measured as the excess of book value of goodwill over its “implied” fair value. For operational assets held for sale, if book value exceeds fair value, an impairment loss is recognized for the difference. Question 11-18 Repairs and maintenance are expenditures made to maintain a given level of benefits provided by the asset and do not increase future benefits. Expenditures for these activities should be expensed in the period incurred. Additions involve adding a new major component to an existing asset. These expenditures usually are capitalized. Improvements are expenditures for the replacement of a major component of an operational asset. The costs of improvements usually are capitalized. Rearrangements are expenditures to restructure an operational asset without addition, replacement, or improvement. The objective is to create a new capability for the asset and not necessarily to extend useful life. The costs of material rearrangements should be capitalized if they clearly increase future benefits. 5 Brief Exercise 11-1 Depreciation is a process of cost allocation, not valuation. Koeplin should not record depreciation expense of $18,000 for year one of the machine’s life. Instead, it should distribute the cost of the asset, less any anticipated residual value, over the estimated useful life in a systematic and rational manner that attempts to match revenues with the use of the asset, not the periodic decline in its value. BRIEF EXERCISES 6 Brief Exercise 11-2 a. Straight-line: $30,000 - 2,000 = $7,000 per year 4 years b. Sum-of-the-years’ digits: Sum-of-the-digits is ([4 (4 + 1)] ÷ 2) = 10 2006 $28,000 x 4/10 = $11,200 2007 $28,000 x 3/10 = $ 8,400 c. Double-declining balance: Straight-line rate is 25% (1 ÷ 4 years) x 2 = 50% DDB rate 2006 $30,000 x 50% = $15,000 2007 ($30,000 - 15,000) x 50% = $ 7,500 d. Units-of-production: $30,000 - 2,000 = $2.80 per unit depreciation rate 10,000 hours 2006 2,200 hours x $2.80 = $6,160 2007 3,000 hours x $2.80 = $8,400 7 Brief Exercise 11-3 a. Straight-line: $30,000 - 2,000 = $7,000 per year 4 years 2006 $7,000 x 9/12 = $5,250 2007 $7,000 x 12/12 = $7,000 b. Sum-of-the-years’ digits: Sum-of-the-digits is ([4 (4 + 1)] ÷ 2) = 10 2006 $28,000 x 4/10 x 9/12 = $8,400 2007 $28,000 x 4/10 x 3/12 = $2,800 + $28,000 x 3/10 x 9/12 = 6,300 $9,100 c. Double-declining balance: Straight-line rate is 25% (1 ÷ 4 years) x 2 = 50% DDB rate 2006 $30,000 x 50% x 9/12 = $11,250 2007 $30,000 x 50% x 3/12 = $ 3,750 + ($30,000 – 15,000) x 50% x 9/12 = 5,625 $ 9,375 or, 2007 ($30,000 – 11,250) x 50% = $ 9,375 Brief Exercise 11-4 8 Annual depreciation will equal the group rate multiplied by the depreciable base of the group: ($425,000 – 40,000) x 18% = $69,300 Since depreciation records are not kept on an individual asset basis, dispositions are recorded under the assumption that the book value of the disposed item exactly equals any proceeds received and no gain or loss is recorded. Any actual gain or loss is implicitly included in the accumulated depreciation account. Journal entry (not required): Cash ................................................................................ 35,000 Accumulated depreciation (difference) ............................ 7,000 Equipment (account balance) .......................................... 42,000 Brief Exercise 11-5 $8,250,000 Depletion per ton = = $2.75 per foot 3,000,000 cubic feet 2006 depletion = $2.75 x 700,000 feet = $1,925,000 2007 depletion = $2.75 x 800,000 feet = $2,200,000 Brief Exercise 11-6 Expenses for 2006 include: 9 In-process R & D = $2,000,000 Amortization of the patent † = 400,000 Amortization of the developed technology* = 300,000 Total $2,700,000 Goodwill is not amortized. †Amortization of the patent: ($4,000,000 ÷ 5) x 6/12 = $400,000 *Amortization of the developed technology: ($3,000,000 ÷ 5) x 6/12 = $300,000 Brief Exercise 11-7 Calculation of annual depreciation after the estimate change: $9,000,000 Cost $320,000 Old annual depreciation ($8 million ÷ 25 years) x 2 years 640,000 Depreciation to date (2004-2005) 8,360,000 Undepreciated cost 500,000 Revised residual value 7,860,000 Revised depreciable base ÷ 18 Estimated remaining life - 18 years (20-2) $ 436,667 2006 depreciation Brief Exercise 11-8 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other 10 words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Robotics reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the double-declining balance method from now on. The undepreciated cost remaining at the time of the change would be depreciated DDB over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Asset’s cost $9,000,000 Accumulated depreciation to date* (640,000) Undepreciated cost, Jan. 1, 2006 $8,360,000 x 2/23 † Double-declining balance depreciation for 2006 $ 726,957 *$8,000,000 ÷ 25 = $320,000 x 2 years = $640,000 † Remaining life is 23 years. Twice the straight-line rate is 2/23. 11 Brief Exercise 11-9 If a material error is discovered in an accounting period subsequent to the period in which the error is made, previous years’ financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders’ equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share. In this case, depreciation of $32,000 should have been $320,000 ($8,000,000 ÷ 25 years). Therefore, 2004 income before tax is overstated by $288,000 ($320,000 – 32,000) and accumulated depreciation is understated by the same amount. The following journal entry is needed to record the error correction (ignoring income tax): Retained earnings ............................................................ 288,000 Accumulated depreciation ......................................... 288,000 Depreciation for 2006 would be $320,000. Brief Exercise 11-10 Because the undiscounted sum of future cash flows of $28 million exceeds book value of $26.5 million, there is no impairment loss. Brief Exercise 11-11 12 Because the undiscounted sum of future cash flows of $24 million is less than book value of $26.5 million, there is an impairment loss. The impairment loss is calculated as follows: Book value $26.5 million Fair value 21.0 million Impairment loss $ 5.5 million Brief Exercise 11-12 Recoverability: Because the book value of SCC’s net assets of $42 million exceeds fair value of $40 million, an impairment loss is indicated. Determination of implied value of goodwill: Fair value of SCC $40 million Less: Fair value of SCC’s assets (excluding goodwill) 31 million Implied goodwill $ 9 million Measurement of impairment loss: Book value of goodwill $15 million Less: Implied value of goodwill 9 million Impairment loss $ 6 million Brief Exercise 11-13 Recoverability: Because the book value of SCC’s net assets of $42 million is less than the fair value of $44 million, an impairment loss is not indicated. Brief Exercise 11-14 13 Annual maintenance on machinery, $5,400 - This is an example of normal repairs and maintenance. Future benefits are not increased; therefore the expenditure should be expensed in the period incurred. Remodeling of offices, $22,000 - This is an example of an improvement. The cost of the remodeling should be capitalized and depreciated, either by (1) substitution, (2) direct capitalization of the cost, or (3) a reduction of accumulated depreciation. Rearrangement of the shipping and receiving area, $35,000 - This is an example of a rearrangement. Because the rearrangement increased productivity, the cost should be capitalized and depreciated. Addition of a security system, $25,000 - This is an example of an addition. The cost of the security system should be capitalized and depreciated. 14 Exercise 11-1 1. Straight-line: $33,000 - 3,000 = $6,000 per year 5 years 2. Sum-of-the-years’ digits: Year Depreciable Base X Depreciation Rate per Year = Depreciation 2006 $30,000 5 15 $10,000 2007 30,000 4 15 8,000 2008 30,000 3 15 6,000 2009 30,000 2 15 4,000 2010 30,000 1 15 2,000 Total $30,000 EXERCISES 15 Exercise 11-1 (concluded) 3. Double-declining balance: Straight-line rate of 20% (1 ÷ 5 years) x 2 = 40% DDB rate. Year Book Value Beginning of Year X Depreciation Rate per Year = Depreciation Book Value End of Year 2006 $33,000 40% $ 13,200 $19,800 2007 19,800 40% 7,920 11,880 2008 11,880 40% 4,752 7,128 2009 7,128 40% 2,851 4,277 2010 4,277 * 1,277 * 3,000 Total $30,000 * Amount necessary to reduce book value to residual value 4. Units-of-production: $33,000 - 3,000 = $.30 per mile depreciation rate 100,000 miles Year Actual Miles Driven X Depreciation Rate per Mile = Depreciation Book Value End of Year 2006 22,000 $.30 $6,600 $26,400 2007 24,000 .30 7,200 19,200 2008 15,000 .30 4,500 14,700 2009 20,000 .30 6,000 8,700 2010 21,000 * 5,700 * 3,000 Totals 102,000 $30,000 * Amount necessary to reduce book value to residual value 16 Exercise 11-2 1. Straight-line: $115,000 - 5,000 = $11,000 per year 10 years 2. Sum-of-the-years’ digits: Sum-of-the-digits is ([10 (10 + 1)] ÷ 2) = 55 2006 $110,000 x 10/55 = $20,000 2007 $110,000 x 9/55 = $18,000 3. Double-declining balance: Straight-line rate is 10% (1 ÷ 10 years) x 2 = 20% DDB rate 2006 $115,000 x 20% = $23,000 2007 ($115,000 - 23,000) x 20% = $18,400 4. One hundred fifty percent declining balance: Straight-line rate is 10% (1 ÷ 10 years) x 1.5 = 15% rate 2006 $115,000 x 15% = $17,250 2007 ($115,000 - 17,250) x 15% = $14,663 5. Units-of-production: $115,000 - 5,000 = $.50 per unit depreciation rate 220,000 units 2006 30,000 units x $.50 = $15,000 2007 25,000 units x $.50 = $12,500 17 Exercise 11-3 1. Straight-line: $115,000 - 5,000 = $11,000 per year 10 years 2006 $11,000 x 3/12 = $ 2,750 2007 $11,000 x 12/12 = $11,000 2. Sum-of-the-years’ digits: Sum-of-the-digits is {[10 (10 + 1)]/2} = 55 2006 $110,000 x 10/55 x 3/12 = $ 5,000 2007 $110,000 x 10/55 x 9/12 = $15,000 + $110,000 x 9/55 x 3/12 = 4,500 $19,500 3. Double-declining balance: Straight-line rate is 10% (1 ÷ 10 years) x 2 = 20% DDB rate 2006 $115,000 x 20% x 3/12 = $5,750 2007 $115,000 x 20% x 9/12 = $17,250 + ($115,000 - 23,000) x 20% x 3/12 = 4,600 $21,850 or, 2007 ($115,000 - 5,750) x 20% = $21,850 4. One hundred fifty percent declining balance: Straight-line rate is 10% (1 ÷ 10 years) x 1.5 = 15% rate 2006 $115,000 x 15% x 3/12 = $ 4,313 2007 $115,000 x 15% x 9/12 = $12,937 + ($115,000 - 17,250) x 15% x 3/12 = 3,666 $16,603 Or, 2007 ($115,000 - 4,313) x 15% = $16,603 18 Exercise 11-3 (concluded) 5. Units-of-production: $115,000 - 5,000 = $.50 per unit depreciation rate 220,000 units 2006 10,000 units x $.50 = $ 5,000 2007 25,000 units x $.50 = $12,500 Exercise 11-4 Building depreciation: $5,000,000 - 200,000 = $160,000 per year 30 years Building addition depreciation: Remaining useful life from June 30, 2006 is 27.5 years. $1,650,000 = $60,000 per year 27.5 years 2006 $60,000 x 6/12 = $30,000 2007 $60,000 x 12/12 = $60,000 19 Exercise 11-5 Asset A: Straight-line rate is 20% (1 ÷ 5 years) x 2 = 40% DDB rate $24,000 = $60,000 = Book value at the beginning of year 2 .40 Cost - (Cost x 40%) = $60,000 .60Cost = $60,000 Cost = $100,000 Asset B: Sum-of-the-digits is 36 {[8 (8 + 1)]÷2} ($40,000 - residual) x 7/36 = $7,000 $280,000 - 7residual = $252,000 7residual = $28,000 Residual = $4,000 Asset C: $65,000 - 5,000 = $6,000 Life Life = 10 years Asset D: $230,000 - $10,000 = $220,000 depreciable base $220,000 ÷ 10 years = $22,000 per year Method used is straight-line. Asset E: Straight-line rate is 12.5% (1 ÷ 8 years) x 1.5 = 18.75% rate Year 1 $200,000 x 18.75% = $37,500 Year 2 ($200,000 - 37,500) x 18.75% = $30,469 20 Exercise 11-6 1. b 2. b 3. b 4. a Exercise 11-7 Requirement 1 Asset Cost Residual Value Depreciable Base Estimated Life(yrs.) Depreciation per Year (straight line) Stoves $15,000 $3,000 $12,000 6 $2,000 Refrigerators 10,000 1,000 9,000 5 1,800 Dishwashers 8,000 500 7,500 4 1,875 Totals $33,000 $4,500 $28,500 $5,675 $5,675 Group depreciation rate = = 17.2% (rounded) $33,000 Group life = $28,500 = 5.02 years (rounded) $5,675 Requirement 2 To record the purchase of new refrigerators. Refrigerators ................................................................... 2,700 Cash ............................................................................ 2,700 To record the sale of old refrigerators. Cash ................................................................................ 200 Accumulated depreciation (difference) ............................. 1,300 Refrigerators ............................................................... 1,500 21 Exercise 11-8 Requirement 1 Cost of the equipment: Purchase price $154,000 Freight charges 2,000 Installation charges 4,000 $160,000 Straight-line rate of 12.5% (1 ÷ 8 years) x 2 = 25% DDB rate. Year Book Value Beginning of Year X Depreciation Rate per Year = Depreciation Book Value End of Year 2006 $160,000 25% $ 40,000 $120,000 2007 120,000 25% 30,000 90,000 2008 90,000 25% 22,500 67,500 2009 67,500 25% 16,875 50,625 2010 50,625 * 5,000 45,625 2011 45,625 * 5,000 40,625 2012 40,625 * 5,000 35,625 2013 35,625 * 5,000 30,625 Total $129,375 * Switch to straight-line in 2010: Straight-line depreciation: $50,625 - 30,625 = $5,000 per year 4 years Requirement 2 For plant and equipment used in the manufacture of a product, depreciation is a product cost and is included in the cost of inventory. Eventually, when the product is sold, depreciation will be included in cost of goods sold. 22 Exercise 11-9 Requirement 1 $4,500,000 Depletion per ton = = $5.00 per ton 900,000 tons 2006 depletion = $5.00 x 240,000 tons = $1,200,000 Requirement 2 Depletion is part of product cost and is included in the cost of the inventory of coal, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion is then included in cost of goods sold in the income statement when the coal is sold. 23 Exercise 11-10 Requirement 1 Cost of copper mine: Mining site $1,000,000 Development costs 600,000 Restoration costs 303,939 † $1,903,939 † $300,000 x 25% = $ 75,000 400,000 x 40% = 160,000 600,000 x 35% = 210,000 $445,000 x .68301* = $303,939 *Present value of $1, n = 4, i = 10% Depletion: $1,903,939 Depletion per pound = = $.1904 per pound 10,000,000 pounds 2006 depletion = $.1904 x 1,600,000 pounds = $304,640 2007 depletion = $.1904 x 3,000,000 pounds = $571,200 Depreciation: $120,000 - 20,000 Depreciation per pound = = $.01 per pound 10,000,000 pounds 2006 depreciation = $.01 x 1,600,000 pounds = $16,000 2007 depreciation = $.01 x 3,000,000 pounds = $30,000 Requirement 2 Depletion of natural resources and depreciation of assets used in the extraction of natural resources are part of product cost and are included in the cost of the inventory of copper, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion and depreciation are then included in cost of goods sold in the income statement when the copper is sold. 24 Exercise 11-11 Requirement 1 a. To record the purchase of a patent. January 1, 2004 Patent .............................................................................. 700,000 Cash ............................................................................ 700,000 To record amortization on the patent. December 31, 2004 and 2005 Amortization expense ($700,000 ÷ 10 years) ...................... 70,000 Patent .......................................................................... 70,000 b. To record the purchase of a franchise. 2006 Franchise ......................................................................... 500,000 Cash ............................................................................ 500,000 c. To record research and development expenses. 2006 Research and development expense ............................... 380,000 Cash ............................................................................ 380,000 25 Exercise 11-11 (concluded) Year-end adjusting entries Patent: To record amortization on the patent. December 31, 2006 Amortization expense (determined below) ......................... 112,000 Patent .......................................................................... 112,000 Calculation of annual amortization after the estimate change: ($ in thousands) $700 Cost $70 Old annual amortization ($700 ÷ 10 years) x 2 years 140 Amortization to date (2004-2005) 560 Unamortized cost (balance in the patent account) ÷ 5 Estimated remaining life $112 New annual amortization Franchise: To record amortization of franchise. December 31, 2006 Amortization expense ($500,000 ÷ 10 years) ...................... 50,000 Franchise ..................................................................... 50,000 Requirement 2 Intangible assets: Patent $448,000 [1] Franchise 450,000 [2] Total intangibles $898,000 [1] $560,000 - 112,000 [2] $500,000 - 50,000 26 Exercise 11-12 To record the purchase of a patent. January 2, 2006 Patent .............................................................................. 500,000 Cash ............................................................................ 500,000 To record amortization of a patent for the year 2006. Amortization expense ($500,000 ÷ 8 years) ....................... 62,500 Patent .......................................................................... 62,500 To record amortization of the patent for the year 2007. Amortization expense ($500,000 ÷ 8 years) ....................... 62,500 Patent .......................................................................... 62,500 To record costs of successfully defending a patent infringement suit. January, 2008 Patent .............................................................................. 45,000 Cash ............................................................................ 45,000 27 Exercise 11-12 (concluded) To record amortization of patent for the year 2008. Amortization expense (determined below) ......................... 70,000 Patent .......................................................................... 70,000 Calculation of revised annual amortization: ($ in thousands) $500 Cost $62.5 Old annual amortization ($500 ÷ 8 years) x 2 years 125 Amortization to date (2006-2007) 375 Unamortized cost (balance in the patent account) 45 Add 420 New unamortized cost ÷ 6 Estimated remaining life (8 years – 2 years) $ 70 New annual amortization Exercise 11-13 ($ in millions) Amortization expense (determined below) ......................... 2.5 Patent .......................................................................... 2.5 Calculation of annual amortization after the estimate change: $ in millions) $9 Cost $1 Old annual amortization ($9 ÷ 9 years) x 4 years 4 Amortization to date (2002-2005) 5 Unamortized cost (balance in the patent account) ÷ 2 Estimated remaining life (6 years – 4 years) $2.5 New annual amortization 28 Exercise 11-14 Requirement 1 Depreciation expense (determined below) .......................... 3,088 Accumulated depreciation - computer ........................ 3,088 Calculation of annual depreciation after the estimate change: $40,000 Cost $7,200 Old annual depreciation ($36,000 ÷ 5 years) x 2 years 14,400 Depreciation to date (2004-2005) 25,600 Undepreciated cost 900 Revised residual value 24,700 Revised depreciable base ÷ 8 Estimated remaining life (10 years - 2 years) $ 3,088 New annual depreciation Requirement 2 Depreciation expense (determined below) .......................... 3,889 Accumulated depreciation - computer ........................ 3,889 Calculation of annual depreciation after the estimate change: $40,000 Cost Old depreciation: $12,000 2004 - ($36,000 x 5/15) 9,600 2005 - ($36,000 x 4/15) 21,600 Depreciation to date (2004-2005) 18,400 Undepreciated cost 900 Revised residual value 17,500 Revised depreciable base x 8/36 Estimated remaining life - 8 years $ 3,889 2006 depreciation 29 Exercise 11-15 SYD depreciation [10+9+8 x ($1.5 - .3) million] = $589,091 55 $1,500,000 Cost 589,091 Depreciation to date, SYD (2003 - 2005) 910,909 Undepreciated cost as of 1/1/06 300,000 Less residual value 610,909 Depreciable base ÷ 7 yrs. Remaining life (10 years - 3 years) $ 87,273 New annual depreciation Adjusting entry (2006 depreciation): Depreciation expense (calculated above) ........................... 87,273 Accumulated depreciation .......................................... 87,273 30 Exercise 11-16 Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company’s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Clinton reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2 Asset’s cost $2,560,000 Accumulated depreciation to date (given) (1,650,000) Undepreciated cost, Jan. 1, 2006 $ 910,000 Estimated residual value (160,000) To be depreciated over remaining 3 years $ 750,000 ÷ 3 years Annual straight-line depreciation 2006-8 $ 250,000 Adjusting entry: Depreciation expense (calculated above) ........... 250,000 Accumulated depreciation ............................. 250,000 31 Exercise 11-17 Requirement 1 Analysis: Correct Incorrect (Should Have Been Recorded) (As Recorded) 2003 Machine 350,000 Expense 350,000 Cash 350,000 Cash 350,000 2003 Expense 70,000 Depreciation entry omitted Accum. deprec. 70,000 2004 Expense 70,000 Depreciation entry omitted Accum. deprec. 70,000 2005 Expense 70,000 Depreciation entry omitted Accum. deprec. 70,000 During the three-year period, depreciation expense was understated by $210,000, but other expenses were overstated by $350,000, so net income during the period was understated by $140,000, which means retained earnings is currently understated by that amount. During the three-year period, accumulated depreciation was understated, and continues to be understated by $210,000. To correct incorrect accounts Machine ............................................................. 350,000 Accumulated depreciation ($70,000 x 3 years) .. 210,000 Retained earnings ($350,000 – 210,000) ............. 140,000 Requirement 2 Correcting entry: Assuming that the machine had been disposed of, no correcting entry would be required because, after five years, the accounts would show appropriate balances. 32 Exercise 11-18 Requirement 1 Book value $6.5 million Fair value 3.5 million Impairment loss 3.0 million Requirement 2 Because the undiscounted sum of future cash flows of $6.8 million exceeds book value of $6.5 million, there is no impairment loss. Exercise 11-19 Requirement 1 Determination of implied goodwill: Fair value of Centerpoint, Inc. $220 million Fair value of Centerpoint’s net assets (excluding goodwill) 200 million Implied value of goodwill $ 20 million Measurement of impairment loss: Book value of goodwill $50 million Implied value of goodwill 20 million Impairment loss $30 million Requirement 2 Because the fair value of the reporting unit, $270 million, exceeds book value, $250 million, there is no impairment loss. 33 Exercise 11-20 1. To record the replacement of the heating system. Accumulated depreciation - building ............................. 250,000 Cash ............................................................................ 250,000 2. To record the addition to the building. Building .......................................................................... 750,000 Cash ............................................................................ 750,000 3. To expense annual maintenance costs. Maintenance expense ...................................................... 14,000 Cash ............................................................................ 14,000 4. To capitalize rearrangement costs. Machinery ....................................................................... 50,000 Cash ............................................................................ 50,000 34 Exercise 11-21 Requirement 1 Cash ................................................................................ 17,000 Accumulated depreciation - lathe (determined below) ....... 56,250 Loss on sale (difference) ................................................... 6,750 Lathe (balance) .............................................................. 80,000 Accumulated depreciation: $80,000 - 5,000 Annual depreciation = = $15,000 5 years 2002 $15,000 x 1/2 = $ 7,500 2003 15,000 2004 15,000 2005 15,000 2006 $15,000 x 1/4 = 3,750 Total $56,250 35 Exercise 11-21 (concluded) Requirement 2 Cash ................................................................................ 17,000 Accumulated depreciation - lathe (determined below) ....... 67,500 Gain on sale (difference) ............................................... 4,500 Lathe (balance) .............................................................. 80,000 Accumulated depreciation: Sum-of-the-digits is ([5 (5 + 1)]/2) = 15 2002 $75,000 x 5/15 x 6/12 = $12,500 2003 $75,000 x 5/15 x 6/12 = $12,500 + $75,000 x 4/15 x 6/12 = 10,000 22,500 2004 $75,000 x 4/15 x 6/12 = $10,000 + $75,000 x 3/15 x 6/12 = 7,500 17,500 2005 $75,000 x 3/15 x 6/12 = $ 7,500 + $75,000 x 2/15 x 6/12 = 5,000 12,500 2006 $75,000 x 2/15 x 3/12 = 2,500 Total $67,500 Exercise 11-22 1. d 2. b 3. b 4. a 36 Exercise 11-23 List A List B g 1. Depreciation a. Cost allocation for natural resource. d 2. Service life b. Accounted for prospectively. f 3. Depreciable base c. When there has been a significant decline in value. e 4. Activity-based method d. The amount of use expected from an operational asset. m 5. Time-based method e. Estimates service life in units of output. h 6. Double-declining balance f. Cost less residual value. j 7. Group method g. Cost allocation for plant and equipment. k 8. Composite method h. Does not subtract residual value from cost. a 9. Depletion i. Accounted for the same way as a change in estimate. l 10. Amortization j. Aggregates assets that are similar. b 11. Change in useful life k. Aggregates assets that are physically unified. i 12. Change in depreciation method l. Cost allocation for an intangible asset. c 13. Write-down of asset m. Estimates service life in years. 37 Exercise 11-24 1. d. Because 50% of the original estimate of quality ore was recovered during the years 1997 through 2004, recorded depletion of $250,000 [50% x ($600,000 - $100,000 salvage value)]. In 2005, the earlier depletion of $250,000 is deducted from the $600,000 cost along with the $100,000 salvage value. The remaining depletable cost of $250,000 will be allocated over the 250,000 tons believed to remain in the mine. The $1 per ton depletion is then multiplied times the tons mined each year.. 2. a. The cost should be amortized over the remaining legal life or useful life, whichever is shorter. In addition to the initial costs of obtaining a patent, legal fees incurred in the successful defense of a patent should be capitalized as part of the cost, whether it was internally developed or purchased from an inventor. The legal fees capitalized then should be amortized over the remaining useful life of the patent. 3. a. Given that the company paid $6,000,000 for net assets acquired with a fair value of $5,496,000, goodwill was $504,000. Under SFAS 142, Goodwill and Other Intangible Assets, purchased goodwill is not amortized but is tested annually for impairment. 38 Exercise 11-25 Requirement 1 To record the acquisition of small tools. 2004 Small tools ..................................................................... 8,000 Cash ............................................................................ 8,000 To record additional small tool acquisitions. 2006 Small tools ...................................................................... 2,500 Cash ............................................................................ 2,500 To record the sale/depreciation of small tools. 2006 Cash ............................................................................... 250 Depreciation expense (difference) ..................................... 1,750 Small tools .................................................................. 2,000 39 Exercise 11-25 (concluded) Requirement 2 To record the acquisition of small tools. 2004 Small tools ..................................................................... 8,000 Cash ............................................................................ 8,000 To record the replacement/depreciation of small tools. 2006 Depreciation expense ..................................................... 2,500 Cash ............................................................................ 2,500 To record the sale of small tools. 2006 Cash ............................................................................... 250 Depreciation expense .................................................. 250 40 Problem 11-1 Requirement 1 Determine useful life: $200,000 depreciable base = 20-year useful life $10,000 annual depreciation Determine age of assets: $40,000 accumulated depreciation = 4 years old $10,000 annual depreciation Double-declining balance in 4th year of life: Year 1 (2003) $200,000 x 10% = $20,000 Year 2 (2004) 180,000 x 10% = 18,000 Year 3 (2005) 162,000 x 10% = 16,200 Year 4 (2006) 145,800 x 10% = 14,580 Requirement 2 Depreciation expense (below) ...................... 20,000 Accumulated depreciation ..................... 20,000 $200,000 Cost 30,000 Depreciation to date, SL 3 years (2003-2005) $170,000 Undepreciated cost as of 1/1/06 Seventeen-year remaining life, or 1/17 x 2 = 2/17 = x $170,000 = $20,000 A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods. PROBLEMS 41 Problem 11-2 Requirement 1 Cord Company ANALYSIS OF CHANGES IN PLANT ASSETS For the Year Ending December 31, 2006 Balance Balance 12/31/05 Increase Decrease 12/31/06 Land $ 175,000 $ 312,500 [1] $ -- $ 487,500 Land improvements -- 192,000 -- 192,000 Buildings 1,500,000 937,500 [1] -- 2,437,500 Machinery and equipment 1,125,000 385,000 [2] 17,000 1,493,000 Automobiles and trucks 172,000 12,500 24,000 160,500 Leasehold improvements 216,000 -- -- 216,000 $3,188,000 $1,839,500 $41,000 $4,986,500 Explanations of Amounts: [1] Plant facility acquired from King 1/6/06 — allocation to Land and Building: Fair value — 25,000 shares of Cord common stock at $50 market price $1,250,000 Allocation in proportion to appraised values at date of exchange: % of Amount Total Land $187,500 25 Building 562,500 75 $750,000 100 Land $1,250,000 x 25% = $ 312,500 Building $1,250,000 x 75% = 937,500 $1,250,000 [2] Machinery and equipment purchased 7/1/06: Invoice cost $325,000 Delivery cost 10,000 Installation cost 50,000 Total acquisition cost $385,000 42 Problem 11-2 (continued) Requirement 2 Cord Company DEPRECIATION AND AMORTIZATION EXPENSE For the Year Ended December 31, 2006 Land Improvements: Cost $192,000 Straight-line rate (1 ÷ 12 years) x 8 1/3% Annual depreciation 16,000 Depreciation on land improvements for 2006: (3/25 to 12/31/06) x 3/4 $ 12,000 Buildings: Book value, 1/1/06 ($1,500,000 - 328,900) $1,171,100 Building acquired 1/6/06 937,500 Total amount subject to depreciation 2,108,600 150% declining balance rate: (1 ÷ 25 years = 4% x 1.5) x 6% 126,516 Machinery and equipment: Balance, 1/1/06 $1,125,000 Straight-line rate (1 ÷ 10 years) x 10% 112,500 Purchased on 7/1/06 385,000 Depreciation for one-half year x 5% 19,250 Depreciation on machinery and equipment for 2006 131,750 Automobiles and trucks: Book value, 1/1/06 ($172,000 - 100,325) $71,675 Deduct 1/1/06 book value of truck sold on 9/30 ($9,100 + 2,650) (11,750) Amount subject to depreciation 59,925 150% declining balance rate: (1 ÷ 5 years = 20% x 1.5) x 30% 17,978 Automobile purchased 8/30/06 12,500 Depreciation for 2006 (30% x 4/12) x 10% 1,250 Truck sold on 9/30/06 - depreciation (given) 2,650 Depreciation on automobiles and trucks 21,878 43 Problem 11-2 (concluded) Leasehold improvements: Book value, 1/1/06 ($216,000 - 108,000) $108,000 Amortization period (1/1/06 to 12/31/10) ÷ 5 years Amortization of leasehold improvements for 2006 21,600 Total depreciation and amortization expense for 2006 $313,744 Problem 11-3 Pell Corporation DEPRECIATION EXPENSE For the Year Ended December 31, 2006 Land improvements: Cost $ 180,000 Straight-line rate (1 ÷ 15 years) x 6 2/3% $ 12,000 Building: Book value 12/31/05 ($1,500,000 - 350,000) $1,150,000 150% declining balance rate: (1 ÷ 20 years = 5% x 1.5) x 7.5% 86,250 Machinery and Equipment: Balance, 12/31/05 $1,158,000 Deduct machine sold (58,000) $1,100,000 Straight-line rate (1 ÷ 10 years) x 10% 110,000 Purchased 1/2/06 287,000 Depreciation x 10% 28,700 Machine sold 3/31/06 58,000 Depreciation for three months x 2.5% 1,450 Total depreciation on machinery and equipment 140,150 Automobiles: Book value on 12/31/05 ($150,000 - 112,000) $38,000 150% declining balance rate: (1 ÷ 3 years = 33.333% x 1.5) x 50% 19,000 Total depreciation expense for 2006 $257,400 44 Problem 11-4 1. Depreciation for 2004 and 2005. December 31, 2004 Depreciation expense ($48,000 ÷ 8 years x 9/12) ................. 4,500 Accumulated depreciation - equipment ...................... 4,500 December 31, 2005 Depreciation expense ($48,000 ÷ 8 years) .......................... 6,000 Accumulated depreciation - equipment ...................... 6,000 2. The year 2006 expenditure. January 4, 2006 Repair and maintenance expense .................................... 2,000 Equipment ....................................................................... 10,350 Cash ............................................................................ 12,350 3. Depreciation for the year 2006. December 31, 2006 Depreciation expense (determined below) .......................... 5,800 Accumulated depreciation - equipment ...................... 5,800 Calculation of annual depreciation after the estimate change: $ 48,000 Cost 10,500 Depreciation to date ($4,500 + $6,000) 37,500 Undepreciated cost 10,350 Asset addition 47,850 New depreciable base ÷ 8 1/4 Estimated remaining life (10 years - 1 3/4 years) $ 5,800 New annual depreciation 45 Problem 11-5 (1) $65,000 Allocation in proportion to appraised values at date of exchange: % of Amount Total Land $72,000 8 Building 828,000 92 $900,000 100 Land $812,500 x 8% = $ 65,000 Building $812,500 x 92% = 747,500 $812,500 (2) $747,500 (3) 50 years $747,500 - 47,500 $14,000 annual depreciation (4) $ 14,000 Same as prior year, since method used is straight-line. (5) $ 85,400 3,000 shares x $25 per share = $75,000 Plus demolition of old building 10,400 $85,400 (6) None No depreciation before use. (7) $ 16,000 Fair market value. (8) $ 2,400 $16,000 x 15% (1.5 x Straight-line rate of 10%). (9) $ 2,040 ($16,000 - 2,400) x 15%. (10) $ 99,000 Total cost of $110,000 - $11,000 in normal repairs. (11) $ 17,000 ($99,000 - 5,500) x 10/55. (12) $ 5,100 ($99,000 - 5,500) x 9/55 x 4/12. (13) $ 30,840 PVAD = $4,000 (7.71008 * ) * Present value of an annuity due of $1: n = 11, i = 8% (from Table 6) (14) $ 2,056 $30,840 15 years 46 Problem 11-6 Requirement 1 Building: $500,000 = $20,000 per year x 9/12 = $15,000 25 years Machinery: $240,000 - (10% x $240,000) = $27,000 per year x 9/12 = $20,250 8 years Equipment: Sum-of-the-digits is ([6 (6 + 1)]÷2) = 21 ($160,000 - 13,000) x 6/21 = $42,000 x 9/12 = $31,500 Requirement 2 (1) June 29, 2007 Depreciation expense (determined below) .......................... 5,625 Accumulated depreciation - machinery ...................... 5,625 $100,000 - (10% x $100,000) = $11,250 x 6/12 = $5,625 8 years 47 Problem 11-6 (concluded) (2) June 29, 2007 Cash ................................................................................ 80,000 Accumulated depreciation - machinery (below) .............. 14,063 Loss on sale of machinery (difference) ............................. 5,937 Machinery ................................................................... 100,000 Accumulated depreciation on machinery sold: 2006 depreciation = $11,250 x 9/12 = $ 8,438 2007 depreciation = $11,250 x 6/12 5,625 Total $14,063 Requirement 3 Building: $500,000 = $20,000 25 years Machinery: $140,000 - (10% x $140,000) = $15,750 8 years Equipment: ($160,000 - 13,000) x 6/21 = $42,000 x 3/12 = $10,500 + ($160,000 - 13,000) x 5/21 = $35,000 x 9/12 = 26,250 $36,750 48 Problem 11-7 Requirement 1 Cost of mineral mine: Purchase price $1,600,000 Development costs 600,000 $2,200,000 Depletion: $2,200,000 - 100,000 Depletion per ton = = $5.25 per ton 400,000 tons 2006 depletion = $5.25 x 50,000 tons = $262,500 2007 depletion: Revised depletion rate = ($2,200,000 - 262,500) - 100,000 = $4.20 487,500 - 50,000 tons 2007 depletion = $4.20 x 80,000 tons = $336,000 Depreciation: Structures: $150,000 Depreciation per ton = = $.375 per ton 400,000 tons 2006 depreciation = $.375 x 50,000 tons = $18,750 2007 depreciation: Revised depreciation rate = $150,000 - 18,750 = $.30 487,500 - 50,000 tons 2007 depreciation = $.30 x 80,000 tons = $24,000 49 Problem 11-7 (continued) Equipment: $80,000 - 4,000 Depreciation per ton = = $.19 per ton 400,000 tons 2006 depreciation = $.19 x 50,000 tons = $9,500 2007 depreciation: Revised depreciation rate = ($80,000 - 9,500) - 4,000 = $.152 487,500 - 50,000 tons 2007 depreciation = $.152 x 80,000 tons = $12,160 Requirement 2 Mineral mine: Cost $ 2,200,000 Less accumulated depletion: 2006 depletion $262,500 2007 depletion 336,000 598,500 Book value, 12/31/07 $1,601,500 Structures: Cost $ 150,000 Less accumulated depreciation: 2006 depreciation $18,750 2007 depreciation 24,000 42,750 Book value, 12/31/07 $107,250 Equipment: Cost $ 80,000 Less accumulated depreciation: 2006 depreciation $ 9,500 2007 depreciation 12,160 21,660 Book value, 12/31/07 $58,340 50 Problem 11-7 (concluded) Requirement 3 Depletion of natural resources and depreciation of assets used in the extraction of natural resources are part of product cost and are included in the cost of the inventory of the mineral, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion and depreciation are then included in cost of goods sold in the income statement when the mineral is sold. In 2006, since all of the ore was sold, all of 2006’s depletion and depreciation is included in cost of goods sold. In 2007, since not all of the extracted ore was sold, a portion of both 2007’s depletion and depreciation remains in inventory. 51 Problem 11-8 Requirement 1 Calculation of goodwill: Purchase price $2,000,000 Less: Fair market value of net identifiable assets 1,700,000 $ 300,000 The cost of goodwill is not amortized. To record amortization of patent. Amortization ($80,000 ÷ 8 years x 6/12) ............................... 5,000 Patent .......................................................................... 5,000 To record amortization of franchise. Amortization expense ($200,000 ÷ 10 years x 3/12) ............. 5,000 Franchise ..................................................................... 5,000 52 Problem 11-8 (concluded) Requirement 2 Intangible assets: Goodwill $300,000 [1] Patent 75,000 [2] Franchise 195,000 [3] Total intangibles $570,000 [1] $300,000 [2] $ 80,000 - 5,000 [3] $200,000 - 5,000 53 Problem 11-9 Requirement 1 Machine 101: $70,000 - 7,000 = $6,300 per year x 3 years = $ 18,900 10 years Machine 102: $80,000 - 8,000 = $9,000 per year x 1.5 years = 13,500 8 years Machine 103: $30,000 - 3,000 = $3,000 per year x 4/12 = 1,000 9 years Accumulated depreciation, 12/31/05 $33,400 Requirement 2 To record depreciation on machine 102 through date of sale. March 31, 2006 Depreciation expense ($9,000 per year x 3/12) .................... 2,250 Accumulated depreciation - equipment ...................... 2,250 To record sale of equipment. March 31, 2006 Cash ................................................................................ 52,500 Accumulated depreciation ($13,500 + 2,250) .................... 15,750 Loss on sale of equipment (determined below) .................. 11,750 Equipment ................................................................... 80,000 54 Problem 11-9 (continued) Loss on sale of machine 102: Proceeds $52,500 Less book value on 3/31/06: Cost $80,000 Less accumulated depreciation: Depreciation through 12/31/05 $13,500 Depreciation from 1/1/06 to 3/31/06 ($9,000 x 3/12) 2,250 15,750 64,250 Loss on sale $11,750 Requirement 3 Building: Useful life of the building: $200,000 = $40,000 in depreciation per year 5 years (2001-2005) $840,000 - 40,000 = 20-year useful life $40,000 To record depreciation on the building. Depreciation expense [($840,000 - 40,000) ÷ 20 years] ........ 40,000 Accumulated depreciation - building ......................... 40,000 55 Problem 11-9 (concluded) To record depreciation on the equipment. Depreciation expense (determined below) .......................... 15,775 Accumulated depreciation - equipment ...................... 15,775 Equipment: Machine 103 (determined above) $ 3,000 Machine 101: Cost $70,000 Less: Accumulated depreciation 18,900 Book value, 12/31/05 51,100 Revised remaining life (7 years - 3 years) ÷ 4 years 12,775 $15,775 56 Problem 11-10 a. This is a change in estimate. No entry is needed to record the change. 2006 adjusting entry: Depreciation expense (determined below) ......................... 37,500 Accumulated depreciation ......................................... 37,500 Calculation of annual depreciation after the estimate change: $1,000,000 Cost $25,000 Old depreciation ($1,000,000 ÷ 40 years) x 3 yrs (75,000) Depreciation to date (2003-2005) 925,000 Undepreciated cost (700,000) New estimated salvage value 225,000 New depreciable base ÷ 6 yrs. Estimated remaining life (6 years: 2006-2011) $ 37,500 New annual depreciation A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per-share amounts for the current period. 57 Problem 11-10 (concluded) b. This is a change in accounting principle that is accounted for as a change in estimate. Depreciation expense (below) ...................... 21,000 Accumulated depreciation ............. 21,000 SYD 2002 depreciation $ 60,000 ($330,000 x 10/55) 2003 depreciation 54,000 ($330,000 x 9/55) 2004 depreciation 48,000 ($330,000 x 8/55) 2005 depreciation 42,000 ($330,000 x 7/55) Accumulated depreciation $204,000 $330,000 Cost 204,000 Depreciation to date, SYD (above) 126,000 Undepreciated cost as of 1/1/06 0 Less residual value 126,000 Depreciable base ÷ 6 yrs. Remaining life (10 years - 4 years) $ 21,000 New annual depreciation A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods. c. This is a change in accounting principle accounted for as a change in estimate. Because the change will be effective only for assets placed in service after the date of change, depreciation schedules do not require revision because the change does not affect assets depreciated in prior periods. A disclosure note still is required to provide justification for the change and to report the effect of the change on current year’s income. 58 Problem 11-11 Requirement 1 Analysis: Correct Incorrect (Should Have Been Recorded) (As Recorded) 2004 Equipment 1,900,000 Equipment 2,000,000 Expense 100,000 Cash 2,000,000 Cash 2,000,000 2004 Expense 475,000 [1] Expense 500,000 [2] Accum. deprec. 475,000 Accum. deprec. 500,000 2005 Expense 356,250 [3] Expense 375,000 [4] Accum. deprec. 356,250 Accum. deprec. 375,000 [1] $1,900,000 x 25% (2 times the straight-line rate of 12.5%) [2] $2,000,000 x 25% [3] ($1,900,000 - 475,000) x 25% [4] ($2,000,000 - 500,000 ) x 25% During the two-year period, depreciation expense was overstated by $43,750, but other expenses were understated by $100,000, so net income during the period was overstated by $56,250, which means retained earnings is currently overstated by that amount. During the two-year period, accumulated depreciation was overstated, and continues to be overstated by $43,750. To correct incorrect accounts Retained earnings .................................................. 56,250 Accumulated depreciation ................................................ 43,750 Equipment ......................................................... 100,000 59 Problem 11-11 (concluded) Requirement 2 This is a change in accounting principle accounted for as a change in estimate. No entry is needed to record the change. 2006 adjusting entry: Depreciation expense (determined below) .................. 178,125 Accumulated depreciation ...................................... 178,125 A change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. Accordingly, the Collins Corporation reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change is depreciated straight-line over the remaining useful life. Asset’s cost (after correction) $1,900,000 Accumulated depreciation to date ($475,000 + 356,250) (831,250) Undepreciated cost, Jan. 1, 2006 1,068,750 Estimated residual value (0) To be depreciated over remaining 6 years 1,068,750 ÷ 6 years Annual straight-line depreciation 2006-2011 $ 178,125 60 Problem 11-12 Requirement 1 Plant and equipment: Depreciation to date: $150 million ÷ 10 years = $15 million per year x 3 years = $45 million Book value: $150 million – $45 million = $105 million Patent: Amortization to date: $40 million ÷ 5 years = $8 million per year x 3 years = $24 million Book value: $40 million – $24 million = $16 million Requirement 2 Tangible operational assets and finite life intangibles are tested for impairment only when events or changes in circumstances indicate book value may not be recoverable. Requirement 3 Goodwill should be tested for impairment on an annual basis and in between annual test dates if events or circumstances indicate that the fair value of the reporting unit is below its book value. Requirement 4 Plant and equipment: An impairment loss is indicated because the book value of the assets, $105 million, is greater than the $80 undiscounted sum of future cash flows. The amount of the impairment loss is determined as follows: Book value $105 million Fair value (60) million Impairment loss 45 million Patent: There is no impairment loss because the undiscounted sum of future cash flows, $20 million, exceeds book value of $16 million. 61 Problem 11-12 (concluded) Goodwill: An impairment loss is indicated because the book value of the assets of the reporting unit, $470 million, is greater than the $450 million fair value of the reporting unit. The amount of the impairment loss is determined as follows: Determination of implied goodwill: Fair value of Ellison Technology $450 million Fair value of Ellison’s net assets (excluding goodwill) (390) million Implied value of goodwill $ 60 million Measurement of impairment loss: Book value of goodwill $100 million Implied value of goodwill (60) million Impairment loss $40 million 62 Analysis Case 11-1 The terms depreciation, depletion, and amortization all refer to the same process of allocating the cost of an operational asset to the periods benefited by their use. However, each term is applied to a different type of operational asset; depreciation is used for plant and equipment, depletion for natural resources, and amortization for intangibles. There are differences in determining the factors necessary to calculate depreciation, depletion, and amortization but the concepts involved are the same. The service life of plant and equipment and natural resources is limited to physical life, while the service life of intangible assets is limited to the asset’s legal or contractual life, or 40 years, whichever is shorter. The majority of companies use straight-line depreciation and straight-line amortization. Natural resources usually are depleted using the units-of-production method. CASES 63 Communication Case 11-2 Suggested Grading Concepts and Grading Scheme: Content (70%) _____ 50 Explains the concept of depreciation as a process of cost allocation, not valuation. ____ Rational match versus market fluctuations. ____ Numerical example. _____ 10 Purpose of the balance sheet is to provide information about financial position, not to directly measure company value. _____ 10 Purpose of the income statement is to provide cash flow information, not to directly measure the change in company value. ____ _____ 70 points Writing (30%) _____ 6 Terminology and tone appropriate to the audience of a company president. _____ 12 Organization permits ease of understanding. ____ Introduction that states purpose. ____ Paragraphs that separate main points. _____ 12 English ____ Sentences grammatically clear and well organized, concise. ____ Word selection. ____ Spelling. ____ Grammar and punctuation. ____ _____ 30 points 64 Judgment Case 11-3 Requirement 1 Portland should have selected the straight-line depreciation method when approximately the same amount of an asset’s service potential is used up each period. If the reasons for the decline in service potential are unclear, then the selection of the straight-line method could be influenced by the ease of recordkeeping, its use for similar assets, and its use by others in the industry. Requirement 2 a. By associating depreciation with a group of machines instead of each individual machine, Portland’s bookkeeping process is greatly simplified. Also, since actual machine lives vary from the average depreciable life, unrecognized net losses on early dispositions are expected to be offset by continuing depreciation on machines usable beyond the average depreciable life. Periodic income does not fluctuate as a result of recognizing gains and losses on machine dispositions. b. Portland should divide the depreciable base of each machine by its estimated life to obtain its annual depreciation. The sum of the individual annual depreciation amounts should then be divided by the sum of the individual capitalized costs to obtain the annual composite depreciation rate. 65 Judgment Case 11-4 Requirement 1 a. The capitalized cost for the computer includes all costs reasonable and necessary to prepare it for its intended use. Examples of such costs are the purchase price, delivery, installation, testing, and setup. b. The objective of depreciation accounting is to allocate the depreciable base of an asset over its estimated useful life in a systematic and rational manner. This process matches the depreciable base of the asset with revenues generated from its use. Depreciable base is the capitalized cost less its estimated residual value. Requirement 2 The rationale for using accelerated depreciation methods is based on the assumption that an asset is more productive in the earlier years of its estimated useful life. Therefore, larger depreciation charges in the earlier years would be matched against the larger revenues generated in the earlier years. An accelerated depreciation method also would be appropriate when benefits derived from the asset are approximately equal over the asset’s life, but repair and maintenance costs increase significantly in later years. The early years record higher depreciation expense and lower repairs and maintenance expense, while the later years have lower depreciation and higher repairs and maintenance. Judgment Case 11-5 There is no necessarily correct answer to the question. The support made for the answer given is more important than the answer itself. Materiality is the critical consideration. Information is material if it can have an effect on a decision made by users. One consequence of materiality is that GAAP need be followed only if an item is material. The threshold for materiality will depend principally on the relative dollar amount of the transaction. In this case, is the $70,000 material? Net-of-tax income would be $49,000 higher if the expenditures were capitalized instead of expensed [$70,000 x (1-.30)]. This represents a 4.45% increase in income ($49,000 ÷ $1,100,000). The effect on the balance sheet is small. Shareholders' equity would be higher by $49,000 if the expenditures were capitalized. This represents an increase of less than one-half of one percent. Would these differences have an effect on decision-makers? There is no single answer to this question. The FASB has been reluctant to establish any quantitative materiality guidelines. The threshold for materiality has been left to subjective judgment of the company preparing the financial statement and its auditors. 66 Communication Case 11-6 There is no right or wrong answer to this case. Both views, expense and capitalize, can be defended once consideration is given to the materiality issue. The process of developing and synthesizing the arguments will likely be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. A significant benefit of this case is that it is forcing students to consider the subjective nature of materiality when applying GAAP. 67 Integrating Case 11-7 Requirement 1 a. ($ in millions) Inventory (understatement of 2007 beginning inventory) ........ 10 Retained earnings (understatement of 2006 income) ......... 10 Note: The 2005 error requires no adjustment because it has self-corrected by 2007. b. Retained earnings (2005-2006 patent amortization) .............. 6 Patent [($18 million ÷ 6 years) x 2] .................................. 6 2007 adjusting entry: Patent amortization expense ($18 million ÷ 6 years) ......... 3 Patent ........................................................................ 3 c. 2007 adjusting entry: Depreciation expense (below) ......................................... 4 Accumulated depreciation ........................................ 4 ($ in millions) SYD 2005 depreciation $10 ($30 x 5/15) 2006 depreciation 8 ($30 x 4/15) Accumulated depreciation $18 $30 Cost 18 Depreciation to date, SYD (above) 12 Undepreciated cost as of 1/1/07 0 Less residual value 12 Depreciable base ÷ 3 yrs. Remaining life (5 years - 2 years) $ 4 New annual depreciation 68 Case 11-7 (concluded) Requirement 2 Shareholders’ Net Assets Liabilities Equity Income Expenses 2005 $640 $330 $310 $210 $150 2005 inventory (12) (12) (12) 12 Patent amortization (3) (3) (3) 3 Depreciation no adjustments to prior years ____ ____ ____ ____ ____ $625 $330 $295 $195 $165 2006 $820 $400 $420 $230 $175 2005 inventory 12 (12) 2006 inventory 10 10 10 (10) Patent amortization (6) (6) (3) 3 Depreciation no adjustments to prior years ____ ____ ____ ____ ____ $824 $400 $424 $249 $156 69 Judgment Case 11-8 Requirement 1 A change from the sum-of-the-years’ digits method of depreciation to the straight-line method for previously recorded assets is a change in accounting principle that is accounted for as a change in estimate. Both the sum-of-the-years’ digits method and the straight-line method are generally accepted. A change in accounting principle results from the adoption of a generally accepted accounting principle different from the generally accepted principle used previously for reporting purposes. Requirement 2 A change in the expected service life of an asset arising because of more experience with the asset is a change in accounting estimate. A change in accounting estimate occurs because future events and their effects cannot be perceived with certainty. Estimates are an inherent part of the accounting process. Therefore, accounting and reporting for certain financial statement elements requires the exercise of judgment, subject to revision based on experience. Trueblood Accounting Case 11-9 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. 70 Research Case 11-10 Requirement 1 SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” and SFAS No. 142, “Goodwill and Other Intangible Assets,” are the two relevant accounts standards. Requirement 2 Tangible operational assets and finite life intangibles are tested for impairment only when events or changes in circumstances indicate book value may not be recoverable. Intangible assets with indefinite useful lives, including goodwill, should be tested for impairment on an annual basis and in between annual test dates if events or circumstances indicate that the fair value of the reporting unit is below its book value. Requirement 3 Tangible operational assets and finite life intangibles: Determining whether to record an impairment loss and actually recording the loss is a two-step process. The first step is a recoverability test - an impairment loss is required only when the undiscounted sum of estimated future cash flows from an asset is less than the asset’s book value. The measurement of impairment loss— step 2—is the difference between the asset’s book value and its fair value. Intangible operational assets with indefinite useful lives (other than goodwill): The measurement of an impairment loss for indefinite life intangibles other than goodwill is a one-step process. We compare the fair value of the asset with its book value. If book value exceeds fair value, an impairment loss is recognized for the difference. Goodwill: Determining whether to record an impairment loss and actually recording the loss is a two-step process. Step 1 - A goodwill impairment loss is indicated when the fair value of the reporting unit is less than its book value. Step 2 - A goodwill impairment loss is measured as the excess of the book value of the goodwill over its “implied” fair value. The implied fair value of goodwill is calculated in the same way that goodwill is determined in a business combination. That is, it’s a residual amount measured by subtracting the fair value of all identifiable net assets from the purchase price using the unit’s previously determined fair value as the purchase price. 71 Case 11-10 (concluded) Requirement 4 Operational assets to be sold should be classified as held for sale in the period in which all of the following criteria are met: a. Management commits to a plan to sell. b. The asset or asset group is available for immediate sale in its present condition. c. An active program to locate a buyer and other actions required to complete the plan to sell the asset or asset group have been initiated. d. The sale is probable. e. The asset or asset group is being actively marketed for sale at a price that is reasonable in relation to its current fair value. f. Actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.14 Requirement 5 An operational asset or group of assets classified as held for sale is measured at the lower of its book value or fair value less cost to sell. An impairment loss is recognized for any write-down to fair value less cost to sell. 14 “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 30. 72 Ethics Case 11-11 Requirement 1 2006 expense using CEO's approach: $42,000,000 Cost $4,200,000 Old annual depreciation ($42,000,000 ÷ 10 years) x 2 years 8,400,000 Depreciation to date (2004-2005) 33,600,000 Book value ÷ 3 Estimated remaining life (2006-2008) $11,200,000 New annual depreciation 2006 income would include only depreciation expense of $11,200,000. 2006 expense using Heather's approach: $42,000,000 Cost $4,200,000 Old annual depreciation ($42,000,000 ÷ 10 years) x 2 years 8,400,000 Depreciation to date (2004-2005) 33,600,000 Book value 12,900,000 Write-down 20,700,000 New depreciable base ÷ 3 Estimated remaining life (2006-2008) $ 6,900,000 New annual depreciation 2006 income would include depreciation expense of $6,900,000 and an asset write- down of $12,900,000 for a total income reduction of $19,800,000. Using Heather's approach, 2006's before tax income would be lower by $8,600,000 ($19,800,000 - 11,200,000). 73 Case 11-11 (concluded) Requirement 2 Discussion should include these elements. Facts: SFAS 144 provides guidance for recording impairment losses on partial write- downs of operational assets remaining in use. Assets should be written down if there has been a significant impairment of value such as in decreased product demand and full recovery of book value through use or resale is not expected. Although the decision and computation to record an impairment loss often is very subjective and difficult to measure, Heather is able to estimate an equipment impairment of $12,900,000, presumably using the best information available. The simple revision in service life approach is clearly an effort to enhance net income on the part of the CEO. Ethical Dilemma: Is Heather's obligation to challenge the questionable application of revision in service life more important than her obligation to her boss and to the company's effort to reflect a favorable net income? Who is affected? Heather CEO and other managers Other employees Shareholders Potential shareholders Creditors Company auditors 74 Judgment Case 11-12 Requirement 1 By changing its depreciation method, a company can shift reported income between periods. For example, a shift from an accelerated method to the straight- line method increases income in the year of the change. However, in some future period or periods, income will be lower than it would have been if the change had not been made. This is not an effective way to manage earnings because the effect on income of switching from one method to another must be disclosed. Requirement 2 A company can manage earnings by changing the estimated useful lives of depreciable assets. For example, reducing useful lives causes a decrease in income in one or more years including the year of the change, and increases income in some future years. This is not an effective way to manage earnings because the effect on income of changing useful lives, if material, must be disclosed. Requirement 3 One possible approach to answering this question is to assume a company overstates its impairment loss. For example, assume that the book value of depreciable assets is $20 million. The fair value of these assets is estimated to be $13 million, indicating an impairment loss of $7 million. If these assets are written down to $8 million, the company has effectively shifted $5 million in pre-tax income from the current period to future periods. By writing down the assets to $8 million instead of $13 million, future depreciation is $5 million less than it would have been with a more appropriate write-down. 75 Judgment Case 11-13 Transaction Disposition 1. Transaction is correctly recorded as repairs and maintenance expense. 2. Transaction is correctly recorded as repairs and maintenance expense. 3. Transaction is incorrectly recorded. The amount should be capitalized as part of the cost of the plant. 4. Transaction is incorrectly recorded. The amount should be capitalized either as part of the cost of the plant or as a reduction in the accumulated depreciation of the plant. 5. Transaction is correctly recorded as repairs and maintenance expense. 6. Transaction is correctly recorded as repairs and maintenance expense. 7. Transaction is incorrectly recorded. The amount should be capitalized as equipment. 8. Transaction is correctly recorded as repairs and maintenance expense. 76 Real World Case 11-14 Requirement 1 ($ in millions) Plant, rental machines and other property (Cost): Balance, beginning of 2004 $36,153 Add: Acquisitions during 2004 5,368 Less: Balance end of 2004 (36,385) Dispositions during 2004 $ 5,136 Plant, rental machines and other property (Accumulated depreciation): Balance, beginning of 2004 $21,464 Add: Depreciation for 2004 3,959 Less: Balance end of 2004 (21,210) Accumulated depreciation of 2004 dispositions $ 4,213 Gain (loss) on 2004 dispositions: Cost of dispositions $ 5,136 Less: Accumulated depreciation of dispositions (4,213) Book value of dispositions $ 923 Proceeds from dispositions $1,311 Less: Book value of dispositions (923) Gain on 2004 dispositions $ 388 Requirement 2 2004 depreciable assets: Plant, rental machines and other property $36,385 Less: Land and land improvements (840) Cost of depreciable assets $35,545 The disclosure note indicates that IBM uses the straight-line depreciation method. $35,545 ÷ $3,959 (2004 depreciation) = 8.98 years. The approximate average service life of IBM's depreciable assets is 9 years. 77 Real World Case 11-15 Requirement 3 The following was taken from the company’s 2003 financial statements. Your results could differ if the company changes any of its policies in years after 2003. a. The company's depreciation and depletion policies, disclosed in Note 1. Summary of Significant Account Policies, are as follows: Depreciation and depletion of all capitalized costs of proved oil and gas producing properties, except mineral interests, are expensed using the unit- of-production method by individual field as the proved developed reserves are produced. Depletion expenses for capitalized costs of proved mineral interests are recognized using the unit-of-production method by individual field as the related proved reserves are produced. Periodic valuation provisions for impairment of capitalized costs of unproved mineral interests are expensed. Depreciation and depletion expenses for coal assets are determined using the unit-of-production method as the proved reserves are produced. The capitalized costs of all other plant and equipment are depreciated or amortized over their estimated useful lives. In general, the declining- balance method is used to depreciate plant and equipment in the United States; the straight-line method generally is used to depreciate international plant and equipment and to amortize all capitalized leased assets. b. Expenditures for maintenance, repairs and minor renewals to maintain facilities in operating condition are generally expensed as incurred. Major replacements and renewals are capitalized. Environmental expenditures that relate to ongoing operations or to conditions caused by past operations are expensed. Expenditures that create future benefits or contribute to future revenue generation are capitalized. Maintenance and repair costs incurred, which are not significant improvements, are expensed. Environmental expenditures are expensed or capitalized as appropriate, depending upon their future economic benefit. 78 Analysis Case 11-16 Requirement 1 The statement of cash flows reports depreciation and amortization of $1,375 million. Requirement 2 FedEx uses the straight-line depreciation method for financial reporting. Service life ranges are as follows: Wide-body aircraft and related equipment 15 to 22 years Narrow-body and feeder aircraft and related equipment 5 to 15 years Package handling and ground support equipment and vehicles 3 to 30 years Computer and electronic equipment 3 to 10 years Other 2 to 40 years Substantially all property and equipment have no residual values. For income tax purposes, depreciation is generally computed using accelerated methods. Though not specifically indicated, presumably this is the Modified Accelerated Cost Recovery System (MACRS). Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482
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