CHAPTER 8
8-1
Tangible assets are those that can be seen and touched.
Intangible assets are those rights or economic benefits that
are not physical in nature.
8-2
All three terms refer to an allocation of costs over time.
Reduction of intangible assets is generally called amortization.
Depreciation is a reduction in buildings and equipment and
other tangible assets. Depletion is a reduction in natural
resources.
8-3
Cash discounts are reductions in original cost, not income.
8-4
When an expenditure is capitalized, it is not credited to
stockholders' equity. Rather, it becomes an asset with a
useful life in excess of one year. An asset is debited and
generally either cash or a liability is credited.
8-5
Accumulated depreciation is not cash; if specific cash is being
accumulated for the replacement of assets, such cash will be
an asset specifically labeled as a "cash fund for replacement
and expansion" or a "fund of marketable securities for
replacement and expansion." Accumulated depreciation is
the cumulative amount of an asset’s depreciable value that
has been expensed.
8-6
Valuation implies some measure of present market value. In
contrast, depreciation is the systematic allocation of the
original cost of the asset as an expense on the income
statement over the useful life of the asset.
8-7
Depreciation is a method of cost allocation, not valuation. It
simply allocates the cost of an asset to the periods that benefit
from its use.
Chapter 8
Long-Lived Assets and Depreciation
371
8-8
No. Keeping two sets of books is necessary if two separate
purposes are being legally fulfilled. In many cases two sets of
books are required, sometimes more than two. Requirements
include external financial reporting, internal managerial needs
and tax reporting.
8-9
Both choices are between initially greater current income and
asset values (straight-line and FIFO) versus initially smaller
current income and asset values (accelerated and LIFO). This
statement assumes rising price levels for inventory items. The
choices differ because the FIFO-LIFO choice affects cash
flows via its tax consequences. Why? Because the IRS
requires all firms using LIFO for tax purposes to use it for
financial reporting purposes as well. On the other hand the
accelerated versus straight-line choice does not affect cash
flow because a firm does not have to change its depreciation
method used for tax reporting because of this choice for
financial reporting.
8-10 No. Depreciation, by itself, generates no cash.
8-11 Accelerated depreciation used for tax purposes usually leads
to higher depreciation expense early in an asset’s life and
hence lower pretax income. Because pretax income is lower,
taxes are lower. Depreciation does not affect cash, but taxes
do. Lower taxes mean more cash. Remember, however, that
many firms use accelerated MACRS depreciation for tax
purposes and straight-line for financial reporting to the public.
8-12 The costs of repairs and maintenance are expenses of the
current period. They maintain a fixed asset in operating
condition. In contrast, capital improvements or betterments
are capitalized and then depreciated because they add to the
future benefits of an existing asset, often by either extending
its life or decreasing its operating costs.
372
8-13 The division's expenditures, including cash outlays to acquire
new assets, are likely to fall, but expenses (which include
depreciation on the new capital facilities) will probably not fall.
8-14 Gain on sale of equipment is a net result: revenue (that is,
proceeds) minus expense (that is, book value) equals gain.
Complete reporting would show the proceeds, the book value,
and the gain.
8-15 Patents grant the inventor exclusive rights to the invention for
a specified period of time. Copyrights give similar rights to
printed or artistic items.
Trademarks are distinctive
identifications of a product or service. Franchises are
privileges granted to sell a specific product or service under
defined conditions. Goodwill is the excess of the cost of an
acquired company over the net market value of the identifiable
individual assets and liabilities acquired.
8-16 Internally acquired patents are essentially research costs,
which must be written off to expense as they are incurred.
Externally acquired patents are assets that are subject to
amortization and/or impairment review.
8-17 The preoccupation with physical evidence often results in the
expensing of outlays that many think should be treated as
assets.
Thus, expenditures for research, advertising,
employee training, and the like are usually expensed, although
it seems clear that, in an economic sense, such expenditures
represent expected future benefits.
8-18 No. Improvements to leased property are capitalized just like
capital improvements or betterments except that they are
amortized over the remaining life of the lease if it is shorter
than the useful life of the improvements or betterments.
Chapter 8
Long-Lived Assets and Depreciation
373
8-19 The $5,000 gain is double-counted. The increase in cash was
$20,000, not $25,000. The $20,000 proceeds includes the
$5,000 gain. Under the indirect method of the statement of
cash flows, the gain must be subtracted from net income in the
operating section of the statement of cash flows. Under the
direct method it does not appear in the statement at all.
8-20 The asset was sold for $5,000 + $4,000 = $9,000. The entire
$9,000 should be reported as a cash inflow from investing
activities. In an indirect method statement of cash flows, the
$4,000 gain must be deducted from net income in computing
net cash provided by operating activities.
8-21 No. In a basket purchase, different assets are often depreciated
over different time periods. For example, basket purchases
sometimes include land and a building. The building is
depreciated while the land remains on the books at original
cost.
8-22 No. The recoverability test determines whether or not there is
evidence of impairment. The impairment loss is the amount by
which the book value of the asset exceeds its fair value.
8-23 The manager has a point. However, under cost-based
accounting the historical cost of long-lived assets is allocated
to the periods during which the assets will be used. We do not
recognize income from the appreciation of long-lived assets.
The complaint that the depreciation is large is worth
considering. Normally we depreciate the asset over its useful
life down to its residual value. Thus, it may be that the
company has underestimated both the residual values and the
lives of these assets.
374
8-24 Treating research and development costs as assets is
generally more consistent with the corporate perspective of the
value inherent in R&D. Companies undertake R&D in hopes of
creating future benefits, as asset accounting would suggest.
8-25 The statement of cash flows has a section that reports on the
financing actions the company has taken during the
accounting period. Both borrowing and issuing of common
stock would appear there. Of course, some capital is also
generated by operations and some could be generated by the
sale of assets. These sources of capital are revealed in the
operating and investing segments of the statement of cash
flows.
8-26 Due to continual changes in the purchasing power of the dollar,
we normally observe an increase in the value of land over time.
Over 90 years have passed since the land was acquired, so the
value today is likely to have little relationship to the value when
it was purchased. In contrast, the equipment is recently
acquired and is being depreciated over its useful life. Its book
value is likely to be closer to its market value.
8-27 (10-15 min.)
Land:
Cash, $600,000 + $150,000 demolition
Note
Total cost
Building:
Cash
Mortgage
Total cost
$
750,000
3,000,000
$ 3,750,000
$ 3,000,000
7,000,000
$10,000,000
The important point here is to see that the $150,000 demolition
cost is a cost of land because the outlay is necessary to get the land
ready for its intended use.
Chapter 8
Long-Lived Assets and Depreciation
375
8-27 (continued)
Land
3,600,000
600,000
3,000,000
Cash
Note payable
Land
150,000
150,000
Cash
This could also be accomplished by the following compound
entry:
Land
3,750,000
750,000
3,000,000
Cash
Note payable
The second entry is:
Building
Cash
Mortgage note payable
10,000,000
3,000,000
7,000,000
The payment terms of the note and the mortgage are irrelevant
until financial statements must be prepared or payments must be
made. Some students may prepare entries for the first year.
Assuming end of year payment, these would be:
376
Note payable
Interest expense
Cash
300,000
300,000
Mortgage note payable
Interest expense
Cash
250,000
700,000
600,000
950,000
8-28 (5-10 min.)
The sales commission, the purchasing manager's salary, and
the cost of repairs after the equipment is placed in use are irrelevant.
The pertinent costs are:
Invoice price, gross
Deduct: 2% cash discount
Invoice price, net
Freight-in
Installation costs
Repair costs prior to use
Total acquisition cost
$400,000
8,000
$392,000
4,400
8,000
9,000
$413,400
8-29 (5-10 min.)
In the absence if more reliable data, the assessed values for
property taxes are frequently used as a guide to allocating the costs
of a basket purchase.
(1)
Assessed
Value
Land
Building
Total
Chapter 8
(2)
(3)
Weighting
Total Cost
to Allocate
$200,000
20/60
400,000
40/60
$600,000
Long-Lived Assets and Depreciation
(2) x (3)
Allocated
Costs
$720,000 $240,000
720,000
480,000
$720,000
377
8-30 (10 min.)
Player contracts may be amortized for tax purposes, but the
sports franchise itself may not. Allen would want to allocate
$299,999,999 to the contracts. In this way, he could get tax
deductions. No part of the amount allocated to the franchise is
deductible as amortization.
Note: Through the years, the Internal Revenue Service has developed
a rule for these transactions. The amount the buyer allocates to
player contracts may not exceed what the seller allocates. This is
limited to no more than 50 percent, unless the taxpayer can prove a
greater allocation is proper.
378
8-31 (15 min.)
Equipment
594,000
Accumulated
Depreciation,
Equipment
54,000
Depreciation
Expense, Equpiment
54,000
Cash
594,000
1. Equipment
Cash
To record acquisition of assembly robots.
594,000
Depreciation expense, equipment
Accumulated depreciation, equipment
To record annual depreciation:
($594,000 – $54,000) ÷ 10 = $54,000
54,000
594,000
54,000
2. Cash
Accumulated depreciation, equipment
Loss on sale of equipment
Equipment
To record sale of equipment:
Cash proceeds
Original cost
Accumulated depreciation,
3 x $6,000 =
Book value (or carrying
amount)
Loss
42,000
18,000
6,000
66,000
$42,000
$66,000
18,000
48,000
$ 6,000
3. Cash
Accumulated depreciation, equipment
Gain on sale of equipment
Equipment
To record sale of equipment:
Cash proceeds
Book value (see above)
Gain
Chapter 8
Long-Lived Assets and Depreciation
52,000
18,000
4,000
66,000
$52,000
48,000
$ 4,000
379
8-32 (10-15 min.) You may want to use T-accounts too.
1. Depreciation expense, equipment
Accumulated depreciation, equipment
To record annual depreciation:
($880,000-$80,000) ÷ 5 = $160,000
160,000
2. Cash
Accumulated depreciation, equipment
Equipment
Gain on sale of equipment
160,000
80,000
To record sale of equipment:
Cash proceeds
Original cost
Accumulated depreciation,
2 x $40,000 =
Book value (or carrying
amount)
Gain on sale
3.
380
220,000
20,000
$160,000
$220,000
80,000
140,000
$ 20,000
Cash
Accumulated depreciation, equipment
Loss on sale of equipment
Equipment
To record sale of equipment:
Cash proceeds
Book value (see above)
Loss on sale
160,000
$110,000
140,000
$ 30,000
110,000
80,000
30,000
220,000
8-33 (10-15 min.) You may want to use T-accounts too.
1. Depreciation expense, equipment
Allowance for depreciation, equipment
To record annual depreciation:
($1,800,000 – $300,000) ÷ 5 = $300,000
300,000
300,000
2.
32,000
22,000
6,000
60,000
Cash
Allowance for depreciation, equipment
Loss on sale of equipment
Equipment
To record sale of equipment:
Cash proceeds
Original cost
Allowance for depreciation, 2 x $11,000
Book value (or carrying
amount)
Loss
$32,000
$60,000
22,000
38,000
$ 6,000
3. Cash
Allowance for depreciation, equipment
Equipment
Gain on sale of equipment
To record sale of equipment:
Cash proceeds
Book value (see above)
Gain
Chapter 8
Long-Lived Assets and Depreciation
40,000
22,000
60,000
2,000
$40,000
38,000
$ 2,000
381
8-34 (10-15 min.)
Year
1
2
3
Conveyor*
$6,600
$6,600
$6,600
Truck**
2/3 x $18,000 = $12,000
2/3 x $ 6,000 = $ 4,000
$500***
*
Each year is 1/5 x ($38,000 – $5,000) = $6,600.
** DDB rate is 2 x (1/3) = 2/3.
*** $500 of depreciation reduces the book value to the $1,500 residual
value. If the DDB schedule had continued, the depreciation of 2/3 x
$2,000 = $1,333 would have reduced the book value below the residual
value.
8-35 (10 min.)
1.
D=
C − R ($80,000 − $5,000)
=
n
(250,000)
= $.30 per mile
Depreciation expense:
Year 1: $.30 x 60,000 = $18,000
Year 2: $.30 x 90,000 = $27,000
2.
382
Net book value when sold: $80,000 – $18,000 – $27,000 =
$35,000.
Gain on sale: $40,000 – $35,000 = $5,000.
8-36 (15-25 min.) Numbers are in thousands.
Straight-Line*
Annual
Book
Depreciation
Value
At acquisition
$1,200
Year
1
$250
950
2
250
700
3
250
450
4
250
200
Total
$1,000
Declining Balance at
Twice the Straight
Line Rate (DDB)**
Annual
Book
Depreciation
Value
$1,200
$600
300
100
0
$1,000
600
300
200
200
* Depreciation is the same each year, 25% of ($1,200,000 – $200,000).
** Straight-line rate is 100% ÷ 4 = 25%. The DDB rate is 50%.
Depreciation in the first year is 50% of $1,200,000; in the second year it
is 50% of ($1,200,000 – $600,000); in the third year depreciation is 50%
of [$1,200,000 – ($600,000 + $300,000)] etc. This continues until the
residual value is reached. Therefore, using DDB in this instance,
depreciation for the third year would be 50% of $300,000, or $150,000;
however, only $100,000 is shown because the residual value of
$200,000 is thereby reached. Although not requested in this problem,
another alternative is to use Modified DDB.
8-37 (10-15 min.)
Unit
Year
Depreciation Straight-Line*
DDB**
1 (60 ÷ 150) x $400,000 =
$160,000
$133,333 $293,333
2 (45 ÷ 150) x $400,000 =
120,000
133,333
97,778
3 (45 ÷ 150) x $400,000 =
120,000
133,333
8,889***
Total depreciation
$400,000
$400,000 $400,000
* (1/3) x $400,000 = $133,333 each year
** 2 x (1/3) x $440,000 = $293,333; 2 x (1/3) x ($440,000 – $293,333) =
$97,778
Chapter 8
Long-Lived Assets and Depreciation
383
*** Application of DDB would result in depreciation of 2 x 1/3 x ($440,000 $293,333 - $97,778) = $32,593. However, this would depreciation the
asset below its residual value of $40,000. Therefore, depreciation is
only $8,889.
384
8-38 (20-30 min.)
(Equipment costs $32,000, five-year life, predicted residual value of
$2,000)
Straight-Line*
Annual
Book
Depreciation
Value
At acquisition
Year
1
2
3
4
5
Total
Declining Balance at
Twice the Straight
Line Rate (DDB)**
Annual
Book
Depreciation
Value
$32,000
$ 6,000
6,000
6,000
6,000
6,000
$30,000
26,000
20,000
14,000
8,000
2,000
$32,000
$12,800
7,680
4,608
2,765
1,659***
$29,512
19,200
11,520
6,912
4,147
2,488
* Depreciation is the same each year, 20% of ($32,000 – $2,000).
** Straight-line rate is 100% ÷ 5 = 20%. The DDB rate is 40%. Depreciation
in the first year is 40% of $32,000; in the second year it is 40% of
($32,000 – $12,800); in the third year it is 40% of [$32,000($12,800+$7,680)]; etc.
*** Unmodified, this method will never fully depreciate the existing book
value. Therefore, in the later years of an asset's life, companies
typically switch to a straight-line method. See the text for a fuller
explanation. If a switch to straight-line were used here, it would occur in
year 5 and the annual depreciation would be $2,147, the amount
required to reduce the book value to the end of period salvage value,
instead of $1,659.
If both methods were available for tax purposes, a company
would typically choose DDB because it records the depreciation
more quickly and reduces early tax payments. This provides an
interest free loan from the government.
Chapter 8
Long-Lived Assets and Depreciation
385
8-39 (20-30 min.) Amounts are in thousands of dollars.
Accelerated
Depreciation
Straight-Line*
Annual
Book
Depreciation
Value
At acquisition
280
Year
1
32.5
247.5
2
32.5
215.0
3
32.5
182.5
Declining Balance at
Twice the Straight
Line Rate (DDB)**
Annual
Book
Depreciation Value
280
70.0
52.5
39.4
210.0
157.5
118.1
* Depreciation is the same each year, 1/8 x [($280,000 – $20,000)] =
32,500.
** Straight-line rate is 100% ÷ 8 = 12.5%. The DDB rate is 25%.
Depreciation in the first year is 25% of $280; in the second year it is 25%
of ($280 – $70.0); in the third year it is 25% of ($280 – $70.0 – $52.5); etc.
Unmodified, this method will never fully depreciate the existing book
value. In the later years of an asset's life, companies typically switch to
a straight-line method. The asset is never depreciated below its
estimated residual value, even though the latter is ignored when
applying the depreciation rate.
386
8-40 (10 min.)
BOEING COMPANY
Property, Plant, and Equipment
December 31, 2003
(In Millions)
Land
Buildings
Machines and equipment
Construction in progress
Less: Accumulated depreciation
Net property, plant, and equipment
$
457
9,171
10,824
943
(12,963)*
$ 8,432
*$457 + $9,171 + $10,824 + $943 − $8,432 = $12,963
8-41 (10 - 15 min.)
Amounts are in thousands.
1.
Historical cost = $477,581 + $440,607 = $918,188
2.
Most of Oregon Steel’s assets are slightly less than 9 years old.
We know this because the accumulated depreciation is less
than half of the original cost of the property, plant, and
equipment:
$440,607 ÷ $918,888 = .48, which is slightly less than .5.
or: 18 x .48 = 8.64 years average age
Chapter 8
Long-Lived Assets and Depreciation
387
8-42 (15 min.) Amounts are in the thousands of dollars.
Original
Straight-line*
Annual
Book
Depreciation
Value
At acquisition
year
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
Total
7
7
7
7
7
7
7
7
7
7
$70
75
68
61
54
47
40
33
26
19
12
5
Revised
Straight-line**
Annual
Book
Depreciation
Value
7
7
7
7
15.33
15.33
15.34
75
68
61
54
47
31.67
16.34
1
$73
*Depreciation is the same each year, 1/10 x (75,000- 5,000) = $7,000.
** Depreciation is the same for the first four years (2004 though 2007). In
2008, Nowling must recompute depreciation for the years 2008, 2009 and
2010 based on revised estimates: 1/3 x (47,000 – 1,000) ] = $15,333.
8-43 (30-45 min.)
1. See Exhibit 8-43 on the following page.
388
EXHIBIT 8-43
1.
FLECK COMPANY
Income Statement
For the Year Ended December 31, 20X2
(In Thousands of Dollars)
Before Taxes
After Taxes
Straight–line
DDB
Straight–line
DDB
Depreciation Depreciation Depreciation Depreciation
Income Statement
Cash sales
Operating expenses
Depreciation expense*
Pretax income
Income taxes
Net income
Statement of Cash Flows
Cash
Cash operating expenses
Cash tax payments
Net cash provided by operations
$180
100
9
71
–
$ 71
$180
100
20
60
–
$ 60
$180.0
100.0
9.0
71.0
28.4
$ 42.6
$180
100
20
60
24
$ 36
$180
100
–
$ 80
$180
100
–
$ 80
$180.0
100
28.4
$ 51.6
$180
100
24
$ 56
* SL = 1/5 ($50,000 − $5,000) = $9,000; DDB = 2 x (1/5) x $50,000 = $20,000
390
8-43 (continued)
2.
By itself, depreciation expense does not provide cash. This
point is illustrated by the part of requirement 1 that compares
the amounts shown before taxes. Note that the cash provided
by operations is exactly the same under straight-line and DDB
depreciation methods. No matter what depreciation expense is
allocated to the year (whether $9,000, $20,000, $45,000, or
zero), the $80,000 cash provided by operations will be
unaffected.
Examine the part of requirement 1 that compares amounts
after taxes. Again, by itself, depreciation does not affect the
cash inflow provided by operations. Only sales to customers
can provide more cash receipts from operations. However,
depreciation does affect the cash outflow for income taxes.
The use of accelerated depreciation, such as DDB, results in a
strange combination of showing less net income but
conserving more cash. The DDB method shows net income of
$36,000 (compared with $42,600 using straight-line), but DDB
shows an increase in net cash provided by operations (less
income taxes) of $56,000 (compared with $51,600 using
straight-line). Accordingly, the final cash balance is $4,400
higher for DDB than for straight-line.
Chapter 8
Long-Lived Assets and Depreciation
391
8-43 (continued)
3.
The doubling of depreciation would cause net income to
decrease but would have no effect on the $80,000 of cash
provided by operations (shown on the third line of the following
table):
Straight-line
Depreciation
Before Doubled
Sales
$180
$180
Cash operating expenses
100
100
Cash provided by operations $ 80
$ 80
Depreciation expense
9
18
Income before income taxes
$ 71
$ 62
Income tax expense
–
–
Net income
$ 71
$ 62
DDB
Depreciation
Before Doubled
$180
$180
100
100
$ 80
$ 80
20
40
$ 60
$ 40
–
–
$ 60
$ 40
8-44 (5-10 min.)
1.
Acceleration of depreciation for tax purposes is caused by a 3year instead of a 5-year depreciation schedule and the use of
the DDB method instead of the straight-line method. DDB
charges twice the straight-line rate in the first year.
2.
Shareholder reporting: $1.8 million ÷ 5 = $360,000
Tax purposes: 2 x (1/3) x $1.8 million = $1,200,0000
392
8-45 (5 min.)
Leasehold Improvements would be increased, and Cash
would be decreased by $120,000. The annual amortization would be
based on the remaining life of the lease: $120,000 ÷ 4 years =
$30,000 per year. Note that amortization is over the remaining lease
term, not the physical life of the improvements.
8-46 (10 min.)
1. and 2. Neither expenses "charged to the P & L" nor "depreciation
and amortization" generate cash. Only revenue generates cash.
However, although Riccardo's statements are misleading, they have
a certain logic.
If operating income is zero, revenue is equal to cash expenses
plus noncash expenses (primarily depreciation and amortization).
Therefore, revenue generates enough cash to cover cash expenses
(including the $3.75 billion charged to the P & L) and have an
amount equal to depreciation and amortization left over (60% x $3.75
billion = $2.25 billion in this case). Positive operating income (less
taxes on that income) will contribute to covering the remaining $1.5
billion that is needed.
The key to interpreting Riccardo's statement is that he
presumes that revenues are high enough to cover all expenses;
these presumed revenues generate the cash to which he refers.
Chapter 8
Long-Lived Assets and Depreciation
393
8-47 (10 min.)
1.
a, c
2.
b, d, g, h, i, j.
The key questions to ask are whether the expenditure should
be capitalized as an asset (a, c) or written off immediately as an
expense (b, d, g, h, i, and j). The other outlays (e,f) are neither
capitalized nor expensed.
8-48 (10 min.)
a.
b.
c.
d.
394
E
C
E
E
e. C
f. C
g. E
8-49 (10-15 min.)
The first two items would reduce cash and increase Repairs
and Maintenance Expense by $200 and $450, respectively.
The third item would reduce cash and increase Equipment by
$21,000. However, the increase in the residual value from $10,000 to
$11,000, results in an increase in the new depreciable amount of
only $20,000. Subsequent depreciation would be revised so that the
new unexpired cost is spread over the remaining three years as
follows:
Original
Revised
Depreciation
Depreciation
Schedule
Schedule
Year
Amount Year
Amount
1
$16,000 1
$ 16,000
2
16,000 2
16,000
3
16,000 3
16,000
4
16,000 4
16,000a
5
16,000 5
12,000
6
12,000
7
12,000
Accumulated depreciation
$80,000b
$100,000b
a New depreciable amount is ($90,000 – $64,000 + $21,000) –
$11,000 residual value = $36,000.
New depreciation expense is $36,000 divided by remaining useful
life of 3 years, or $12,000 per year.
b Recapitulation:
Original outlay
Major overhaul
Total
Accumulated depreciation
Chapter 8
Long-Lived Assets and Depreciation
Net Book Value
Original
Revised
$90,000
$ 90,000
–
21,000
$90,000
$111,000
80,000
100,000
395
Residual value
396
$10,000
$ 11,000
8-50 (10-15 min.)
1.
Proceeds
Net book value of equipment sold is
a
$29,000 − (4 x $5,000)
Gain on sale of equipment
A
Cash
$12,000
9,000
$ 3,000
=L+
Accumulated
Depreciation,
+ Equipment + Equipment
+12,000
-29,000
*Gain on sale of equipment.
+20,000 =
SE
Retained
Earnings
+3,000*
a Annual depreciation is 1/5 x [$29,000 – $4,000] = $5,000. Accumulated
depreciation for four years is 4 x $5,000 = $20,000. The effect on assets
of removing the net book value is a decrease of $9,000, consisting of a
decrease in Equipment of $29,000 and a decrease in Accumulated
Depreciation of $20,000. Note that the effect of a decrease in Accumulated
Depreciation (by itself) is an increase in assets. This $9,000 decrease in
assets is offset by the $12,000 in cash received, resulting in a net $3,000
increase in assets.
b The $3,000 is usually carried separately in the general ledger until
the end of the year as Gain on Sale of Equipment, or Gain on
Disposal of Equipment.
Income statement effects:
Gain on Sale of Equipment may be shown as a separate item
on an income statement as a part of "other income" or some similar
category.
Chapter 8
Long-Lived Assets and Depreciation
397
8-50 (continued)
In single-step income statements the gain is shown at the top
along with other revenue items, for example:
Revenue:
Sales of products
Interest income
Other income: gain on sale of equipment
Total sales and other income
$XXX
X
X
$XXX
In multiple-step income statements, the gain is often shown after the
operating income generated by the sales of major products.
2.
a.
b.
398
Cash
Accumulated depreciation
Equipment
Gain on sale of equipment
12,000
20,000
Cash
Accumulated depreciation
Loss on sale of equipment
Equipment
7,000
20,000
2,000
29,000
3,000
29,000
8-51 (10 min.)
1.
Cash received
Book value, $45,000 – (3 x $8,000)
Gain on sale of fixed assets
Cash
Accumulated depreciation
Equipment (van)
Gain on sale of fixed assets
2.
$25,000
21,000
$ 4,000
25,000
24,000
45,000
4,000
Cash received
Book value (see above)
Loss on sale of fixed assets
$17,000
21,000
$ 4,000
Cash
Accumulated depreciation
Loss on sale of fixed assets
Equipment (van)
17,000
24,000
4,000
Chapter 8
Long-Lived Assets and Depreciation
45,000
399
8-52 (10 min.)
1.
2.
The only effect would be a $30,000 cash inflow
listed with the investing activities:
Proceeds from the sale of equipment
$30,000
The proceeds should be listed as an investing activity:
Proceeds from the sale of equipment
$40,000
In addition, a $10,000 gain appeared on Icarus’s income
statement, calculated as: proceeds of $40,000 less book value
of $30,000 ($120,000 cost less $90,000 of accumulated
depreciation). In the statement reconciling net income and net
cash provided by operating activities, the gain must be
removed from net income by deducting the $10,000 from net
income in the reconciliation of net income to net cash
provided by operating activities:
Net income
Deduct: gain on sale of equipment
3.
$XXXXXX
10,000
The proceeds should be listed as an investing activity:
Proceeds from the sale of equipment
$20,000
In addition, a $10,000 loss appeared in Icarus’s income
statement (proceeds of $20,000 less book value of $30,000).
The loss must be added back to net income in the
reconciliation of net income to net cash provided by operating
activities:
Net income
Add: loss on sale of equipment
400
$XXXXXX
10,000
8-53 (10-20 min.)
1.
$3,000,000 ÷ 2 = $1,500,000
2.
Company C must record the $6 million as an expense of 20X1,
whereas Company D must show the $6 million as an asset—
Patents -- on its balance sheet of December 31, 20X1.
Company D must then amortize the $6 million on a straight-line
basis over the useful life of the patents. The useful life of an
intangible asset is the shorter of its economic life and lit legal
life, if any.
3.
$420,000 ÷ 4 = $105,000
4.
a)
b)
Goodwill
Assets
Liabilities
Cash
Yes. The journal entry is:
Impairment loss
Goodwill
4,000,000
22,000,000
16,000,000
10,000,000
1,000,000
1,000,000
8-54 (10-15 min.)
1.
$800,000 ÷ 5 = $160,000
2.
Income statement:
a) Total amount charged as an expense.
b) Nothing charged as an expense. This assumes that the
purchase was late enough in December that no
amortization is charged in 2002.
Balance sheet:
a) Nothing recorded.
b) $1,000 million recorded as an asset, to be amortized over
the useful life of patents.
Chapter 8
Long-Lived Assets and Depreciation
401
8-54 (continued)
3.
The key is that in a stable process, year-to-year expense
recognition would not change but the amount shown on the
balance sheet would be larger.
Assume all projects are finished at year end and appear in the
balance sheet at full cost and then are amortized over the next
three years. At any year-end the asset account would reflect
that year’s spending, plus 2/3 of the prior year, plus 1/3 of the
second year prior for a total of 1 + 2/3 + 1/3 = 2 times spending.
The expense each year would be 3 x (1/3) = 1 times spending.
If the amortization period changes to four years, the balance
sheet asset account would rise to 1 + 3/4 + 2/4 + 1/4 = 2.5 times
spending.
The annual amortization in year five and
subsequent years would be the same as the annual amount
spent as long as annual spending was constant. The expense
would be 4 x (1/4) = 1 times spending.
8-55 (10 min.)
Step 1: Recoverability test. The net book value of $11 million
exceeds the undiscounted expected future cash flows of $9 million,
so there is evidence of impairment.
Step 2: The net book value of $11 million exceeds the fair value of
$7.5 million so Vincent must record an impairment loss of $11 million
- $7.5 million = $3.5 million.
402
8-56 (5-10 min.)
1.
Depletion rate is $14,400,000 ÷ 900,000 = $16.00 per ton
Depletion for 20X4: $16.00 x 120,000 = $1,920,000
2.
Depletion for 20X5: $16.00 x 100,000 = $1,600,00
8-57 (20-30 min.) Amounts are in thousands of dollars.
Straight-Line*
Annual
Book
Depreciation
Value
At acquisition
30,000
Year
1
1,200
28,800
2
1,200
27,600
3
1,200
26,400
Accelerated Depreciation
Declining Balance at
Twice the Straight
Line Rate (DDB)**
Annual
Book
Depreciation
Value
30,000
3,000
2,700
2,430
27,000
24,300
21,870
* Depreciation is the same each year, 5% of ($30 million – $6 million).
** Straight-line rate is 100% ÷ 20 = 5%. The DDB rate is 10%.
Depreciation in the first year is 10% of $30,000; in the second year is
10% of ($30,000 – $3,000); in the third year is 10% of ($30,000 –
$3,000 − $2,700); etc. Unmodified, this method will never fully
depreciate the existing book value. In the later years of an asset's
life, companies typically switch to a straight-line method. The asset
is never depreciated below its estimated residual value, even though
the latter is ignored when applying the depreciation rate.
Chapter 8
Long-Lived Assets and Depreciation
403
8-58 (10-15 min.) Amounts are in millions of dollars.
1.
Let X = amount written off.
Land, Buildings, and Equipment
Balance
4,618
Write-offs
Additions
711
Balance
4,929
X
4,618 + 711 – X = 4,929
X = 400
2.
Let Y = accumulated depreciation written off
Accumulated Depreciation
Write-offs
Y Balance
1,854
Depreciation 365
Balance
1,949
1,854 + 365 – Y =
Y =
3.
1,949
270
Book value of assets written off = $400 – 270 = $130. The
amounts in requirements 1 and 2 can be checked using the
information that there was no gain or loss on disposal of
assets:
Gain or loss = cash received – book value
0 = 130 – 130
404
8-59 (15 min.) Amounts are in millions.
1.
Buildings
Machinery and equipment
¥1,031,913
Land
Construction in progress
Other
¥158,424 + ¥216,865 = ¥375,289
¥156,156 + ¥875,757 =
¥63,150
¥22,089
¥15,374 + ¥86,795 = ¥102,169
2.
Land is not depreciated, and depreciation has not started yet
on the construction in progress.
3.
If Asahi had used straight-line depreciation, the net values of
the assets would be larger and the accumulated depreciation
would be less. It is more difficult to determine the average age
of a company’s assets if a company uses declining-balance
depreciation rather than straight-line depreciation.
For
example, almost 85% (¥875,757 ÷ ¥1,031,913) of Asahi’s cost
of machinery and equipment has been depreciated. If straightline depreciation had been used, it would be clear that these
assets had passed the midpoint of their economic life. But with
declining-balance depreciation, it is possible that the assets are
still in the first half of their economic life because more than half
of the depreciation is taken before the midpoint of an asset’s
life.
Chapter 8
Long-Lived Assets and Depreciation
405
8-60 (30-40 min.)
Gradually, students should become familiar with the effects of
typical transactions. All numbers are in millions of dollars. Here are
the T-accounts:
Land, Plant, and Equipment
Balance
52,981
Disposals at
Acquisitions,
original cost
Z
at cost
ZZ
Balance
60,113
Accumulated Depreciation
Accum. depreciation
Balance
on disposals
YY
Depreciation for
current year
Balance
Balance
Acquisitions
Balance
26,568
Y
30,112
Special Tools, net
9,939
Amortization for
3,000
current year
Disposals, book
value
0
11,992
X
1.
Let X = special tool amortization
9,939 + 3,000 – X = 11,992
X = 947
2.
The cost of new acquisitions was $8,113. Using the Taccounts, this can be computed using the following three
steps:
a.
406
If depreciation plus amortization = $5,472, depreciation
was $5,472 − $947 = $4,525 = Y
8-60 (continued)
b.
There is now one unknown in the Accumulated
Depreciation T-account, so:
Let YY = Accumulated depreciation of items disposed
26,568 + 4,525 – YY = 30,112
YY = 981
c.
For fully depreciated assets accumulated depreciation is
the same as total historical cost so Z = $981
Use the T account.
Let ZZ = current acquisitions at cost
52,981 + ZZ – 981 = 60,113
ZZ = 8,113
Chapter 8
Long-Lived Assets and Depreciation
407
8-61 (15-25 min.)
This problem is not difficult, but it may appear so because the
topic was not discussed in the text. It forces students to think about
the meaning of accumulated depreciation and net book value.
Amounts are in millions.
1.
Total depreciable value ÷ average useful life = average annual
depreciation.
131,755 ÷ X = 8,500
X = 131,755 ÷ 8,500 = 15.5 years
2.
Accumulated depreciation ÷ average age of assets = average
annual depreciation.
83,265 ÷ X = 8,500
X = 83,265 ÷ 8,500 = 9.8 years.
or
Average age of assets = (Accumulated depreciation ÷ total
depreciable value) x average useful
life
= ($83,265 ÷ $131,755) x 15.5 = 9.8
years
408
8-62 (25-35 min.) Amounts in tables are in thousands of dollars.
1. Zero Income Taxes 2. 40% Income Taxes
Straight-line
Depreciation
Revenues (in cash)
Cash operating expenses
Cash provided by operations
before income taxes
Depreciation expense
Operating income
Income tax expense
Net income
Supplementary analysis:
Cash provided by operations
before income taxes
Income tax payments
Net cash provided by
operations
Chapter 8
Long-Lived Assets and Depreciation
Accelerated
Depreciation
Straight-line Accelerated
Depreciation Depreciation
900
600
900
600
900
600
900
600
300
50
250
–
250
300
100
200
–
200
300
50
250
100
150
300
100
200
80
120
300
–
300
–
300
100
300
80
300
300
200
220
409
8-62 (continued)
3.
By itself, depreciation expense does not provide cash. This
point is illustrated by part 1 that compares the amounts shown
before taxes. Note that the cash provided by operations (and
the ending cash balances) are exactly the same. No matter
what depreciation expense is allocated to the year (whether
$50,000, $100,000, or zero), the $300,000 cash provided by
operations and the ending cash will be unaffected.
Examine part 2, that compares amounts after taxes. Again, by
itself, depreciation does not affect the cash inflow provided by
operations. However, depreciation does affect the cash
outflow for income taxes. The use of accelerated depreciation
results in a strange combination of showing less net income
but conserving more cash. The accelerated method shows
net income of $120,000 (compared with $150,000 using
straight-line), but accelerated shows a net increase in cash
provided by operations (less income taxes) of $220,000
(compared with $200,000 using straight-line). Accordingly, the
final cash balance is $20,000 higher for accelerated than for
straight-line.
4.
Journal entries (not required) may clarify the effects:
Depreciation expense
Accumulated depreciation
50,000 more
Income tax expense
Cash
20,000 less
50,000 more
20,000 less
Note: A smaller credit to cash increases the balance in cash.
410
8-62 (continued)
The reduction of retained earnings would be $50,000 – $20,000.
That is, net income (and hence retained earnings) would be $30,000
lower. In summary:
Cash, increase by tax savings, .40 x $50,000 = $20,000
Accumulated depreciation, increase by $50,000
Operating income, decrease by $50,000
Income tax expense, decrease by $20,000
Retained earnings, decrease by $30,000
5.
The doubling of depreciation would cause net income to
decrease but in the absence of tax effects would have no
effect on cash provided by operations:
Straight-line
Depreciation
Revenues (all cash)
Cash operating expenses
Cash provided by operations
Depreciation expense
Income before income taxes
Income tax expense
Net income
Chapter 8
Before
900
600
300
50
250
−
250
Long-Lived Assets and Depreciation
Doubled
900
600
300
100
200
−
200
Accelerated
Depreciation
Before
900
600
300
100
200
−
200
Doubled
900
600
300
200
100
−
100
411
8-63 (25-35 min.) Amounts are in millions of dollars.
1. Zero Income Taxes 2. 40% Income Taxes
Straight-line
Depreciation
Revenues
Cash operating expenses
Cash provided by operations
before income taxes
Depreciation expense
Operating income
Income tax expense
Net income
Accelerated Straight-line Accelerated
Depreciation Depreciation Depreciation
$246,525
229,449
$246,525
229,449
$246,525$246,525
229,449 229,449
17,076
3,432
13,644
17,076
5,432
11,644
−
$ 13,644
−
$ 11,644
17,076 17,076
3,432 5,432
13,644 11,644
5,458 4,658
$ 8,186 $ 6,986
Supplementary analysis:
Cash provided by operations
before income taxes
$17,076
Income tax expense
−
Net cash provided by operations $17,076
$17,076
3.
412
−
$17,076
$17,076 $17,076
5,458 4,658
$11,618 $12,418
By itself, depreciation expense does not provide cash. This
point is illustrated by part 1, which compares the amounts
shown with zero income taxes. Note that the cash provided by
operations (and the ending cash balances) are exactly the
same. No matter what depreciation expense is allocated to the
year (whether $3,432 million, $5,432 million, or zero), the
$17,076 million cash provided by operations and the ending
cash will be unaffected.
8-63 (continued)
Examine part 2, that compares amounts after taxes. Again, by
itself, depreciation does not affect the cash inflow provided by
operations. Only sales to customers can provide more cash
receipts from operations. However, depreciation does affect
the cash outflow for income taxes. The use of accelerated
depreciation results in a strange combination of showing less
net income but conserving more cash. The accelerated
method shows net income of $6,986 million (compared with
$8,186 million using straight-line), but accelerated shows a net
increase in cash provided by operations after considering
income taxes of $12,418 million (compared with $11,618 million
using straight-line). Accordingly, the final cash balance would
be $800 million higher for accelerated than for straight-line.
4.
Cash, increase by tax savings, .40 x $2,000 million = $800
million
Accumulated depreciation, increase by $2,000 million
Operating income, decrease by $2,000 million
Income tax expense, decrease by $800 million
Retained earnings, decrease by $1,200 million
New balances: cash, $2,758 million + $800 million = $3,558
million
Accumulated depreciation, $15,147 million + $2,000 million =
$17,147 million
Journal entries (not required) may clarify the effects (in
millions):
Depreciation expense
2,000 more
Accumulated depreciation
2,000 more
Income tax expense
800 less
Cash
800 less
Note: A smaller credit to cash increases the balance in cash.
Chapter 8
Long-Lived Assets and Depreciation
413
The effect on retained earnings would be $2,000 million – $800
million = $1,200 million. That is, net income (and hence
retained earnings) would be $1,200 million lower.
414
8-63 (continued)
5.
The $2,500 million increase of depreciation would cause net
income to decrease but would have no effect on cash
provided by operations.
Straight-line
Accelerated
Depreciation
Depreciation
Before
After
Before
After
Sales
$246,525 $246,525 $246,525$246,525
Cash operating expenses
229,449
229,449 229,449 229,449
Cash provided by operations
17,076
17,076
17,076 17,076
Depreciation expense
3,432
5,932
5,432
7,932
Income before income taxes
13,644
11,144
11,644 9,144
Income tax expense
−
−
−
−
Net income
13,644
11,144
11,644 9,144
Chapter 8
Long-Lived Assets and Depreciation
415
8-64 (25-35 min.) Amounts in table and narrative are in millions of
Euros.
1. Zero Income Taxes 2. 60% Income Taxes
Straight-line
Depreciation
Revenues (all cash)
Cash operating expenses
(47,884 – 1,974)
Cash provided by operations
before income taxes
Depreciation expense
Operating income
Income tax expense
Net income
Supplementary analysis:
Cash provided by operations
before income taxes
Income tax expense
1,142
Net cash provided by operations
3.
416
−
Accelerated
Depreciation
Straight-line
Depreciation
Accelerated
Depreciation
50,288
50,288
50,28850,288
45,910
45,910
45,91045,910
4,378
1,974
2,404
4,378
2,474
1,904
−
4,378
1,974
2,404
1,442
962
4,378
2,474
1,904
1,142
762
2,404
1,904
4,378
4,378
4,378 4,378
1,442
4,378
2,936 3,236
−
−
4,378
By itself, depreciation expense does not provide cash. This
point is illustrated by part 1, which compares the amounts
shown before taxes. Note that the cash provided by
operations and the ending cash balances are exactly the same.
No matter what depreciation expense is allocated to the year
(whether €1,974, €2,474, or zero), the €4,378 cash provided by
operations and the ending cash will be unaffected.
8-64 (continued)
Examine part 2, which compares amounts after taxes. Again,
by itself, depreciation does not affect the cash inflow provided
by operations. Only sales to customers can provide more
cash receipts from operations. However, depreciation does
affect the cash outflow for income taxes. The use of
accelerated depreciation results in a strange combination of
showing less net income but conserving more cash. The
accelerated method shows net income of €762 (compared
with €962 using straight-line), but accelerated depreciation
shows a net increase in cash provided by operations (less
income taxes) of €3,236 (compared with €2,936 using straightline). Accordingly, the final cash balance is €300 higher for
accelerated than for straight-line depreciation.
4.
Journal entries (not required) may clarify the effects:
Depreciation expense
Accumulated depreciation
500 more
Income tax expense
Cash
300 less
500 more
300 less
Note: A smaller credit to cash increases the balance in cash.
The effects on retained earnings would be €500 – €300. That
is, net income (and hence retained earnings) would be €200
lower. In summary:
Chapter 8
Long-Lived Assets and Depreciation
417
8-64 (continued)
Cash, increase by reduction in taxes, .60 x €500 = €300
Accumulated depreciation, increase by €500
Operating income, decrease by €500
Income tax expense, decrease by €300
Retained earnings, decrease by €200
New balances: Cash, €7,666 + €300 = €7,966
Accumulated Depreciation €17,230 + €500
= €17,730
5.
The doubling of depreciation would cause net income to
decrease but would have no effect on cash provided by
operations:
Straight-line
Accelerated
Depreciation
Depreciation
Before Doubled Before Doubled
Sales
50,288
50,288
50,288 50,288
Cash operating expenses
45,910
45,910
45,910 45,910
Cash provided by operations
4,378
4,378
4,378 4,378
Depreciation expense
1,974
3,948
2,474 4,948
Income before income taxes
2,404
430
1,904 (570)
Income tax expense
−
−
−
−
Net income (loss)
2,404
430
1,904 (570)
418
8-65 (30 min.) All amounts are stated in thousands of
Deutchmarks.
1. and 2.
Part (1)
Change
20X8
Revenue
Operating expense
other than
depreciation
Cash (C) provided
by operations
Depreciation
Income before
income taxes
DM2,100
1,700
20X8
DM1,000 DM3,100
800
DM2,100
2,500
1,700
20X9
DM1,000 DM3,100
800
2,500
DM 400
200
DM 200 DM 600
100
300
DM 400
200
DM 200
50
DM 600
250
DM 200
DM 100 DM 300
DM 200
DM 150
DM 350
20X8
Part (3b)
Change
20X9
3.
20X8
Income before
income taxes
DM 200
Income taxes at 30%
60
Net income after
income taxes
DM 140
Cash provided by
operations after
income taxes [(C)
above minus
income taxes]
DM 340
4.
20X9
Part (2)
Change
Part (3a)
Change 20X9
DM 100
30
DM 300
90
DM 200
60
DM 150
45
DM 350
105
DM 70
DM 210
DM 140
DM 105
DM 245
DM 170 DM 510
DM 340
DM 155
DM 495
By itself, depreciation does not provide "cash inflow" (cash
provided by operations). Note in parts (1) and (2) that the cash
provided by operations went up from DM400 to DM600, a
DM200 increase, because revenues (the basic source of cash)
increased by DM1,000 and operating expenses increased by
DM800. Whether depreciation is DM50, DM100, DM1,000, or
zero will not affect cash provided by operations (if income
taxes are ignored).
Chapter 8
Long-Lived Assets and Depreciation
419
8-65 (continued)
Depreciation does affect the amount of income tax cash
outflow. If only DM50 rather than DM100 is deducted as
depreciation, the income tax bill will be DM15 higher, 30% of
(DM100 - DM50). That is why cash provided by operations is
less by DM15 in part (3b). The important point is that income
tax cash outflows are affected by depreciation. Otherwise,
depreciation has no direct effect on cash inflows or outflows.
8-66 (15-25 min.)
This problem is more challenging than most because it raises
conceptual issues regarding how to account for depreciation. Dollar
amounts are in millions.
1.
2.
420
Depreciation expense
4.5
Accumulated depreciation
To record 3 months of depreciation:
Acquisition cost
$70.0
Predicted residual value
52.0
Depreciable amount
$18.0
Amount per month, $18 ÷ 12
$ 1.5
For 3 months: $1.5 per month x 3 months $ 4.5
Depreciation expense
Accumulated depreciation
To record 9 months of depreciation
(9 months x $1.5 per month)
4.5
13.5
13.5
8-66 (continued)
3.
Cash
Accumulated depreciation
Revenue-earning equipment
Depreciation expense
To record the sale of equipment
58
18
70
6
Note the entry to depreciation expense instead of gain on sale
of automobiles. This method recognizes that, if the autos were
sold for $58, the residual value was underestimated, and
therefore too much depreciation was charged. The entry
adjusts the depreciation expense for this estimation error.
4.
This part illustrates how the predictions of useful lives and
residual values can affect depreciation expenses. It also
underscores the general "prospective" approach to
depreciation expense. That is, 2003 depreciation charges
would not be "corrected" retroactively. However, up-to-date
knowledge can affect depreciation being taken currently (2004).
2003
2004
As
Perfect
As
Perfect
Reported Prediction Reported Prediction
Depreciation in millions
4.5
3
7.5*
9
*$13.5 – $6
Depreciation expense for the 12 months of ownership spread
over the two calendar years is $12. Under the same circumstances,
some companies would show depreciation expense of 9 x $1.5 =
$13.5 for 2004 for a total of $18 and show a $6 gain on sale of
equipment. This underscores the fact that the final gains or losses
on sales of fixed assets are affected by the depreciation policies
followed while the assets are in service.
Chapter 8
Long-Lived Assets and Depreciation
421
8-67 (10-15 min.)
Conceptually, a strong case can be made for deferring the $2
million and amortizing it over the useful life of the product or process
developed. However, the FASB requires that research and
development costs be written off to expense as they are incurred.
The history of accounting for research and development may
be of interest as an illustration of a long debate about the meaning
and measurement of an asset. Until the FASB requirement for
expensing this cost as incurred became effective in 1975, many
companies deferred research costs and amortized them. There was
no uniformity, to say the least. For example, in 1973, the American
Institute of CPAs issued an audit guide that pertained to companies
"in the development stage."
The accounting for the Mori
Pharmaceuticals Company would have been covered by this audit
guide, which required the capitalization of these costs as
"investments for the future" unless such costs were clearly
unrecoverable. In a sense, then, one set of principles was applicable
to companies in the development stage that may not have been
equally applicable to mature companies having similar outlays.
Incidentally, the audit guide took the following position
regarding established companies:
"The guide does not apply to established companies
developing new products, services, or markets, or to the
development activities of their subsidiaries, even though
the subsidiaries are in the development stage, when
included in consolidated financial statements. It does,
however, apply to separate financial statements of a
subsidiary in the development stage and is applicable to
consolidated financial information when the group as a
whole is considered to be in the development stage."
422
8-68 (15-20 min.) The purpose of this problem is to stress the
limitations of the use of historical costs, particularly where there are
significant amounts of property, plant, and equipment.
The balance sheet values do not come close to the current
market value of the land and building, $1,800,000 ÷ .60, or
$3,000,000. Consequently, in terms of current values before
expansion and modernization, stockholders' equity is understated
(in thousands):
Market value of land and building
Net book value:
Land
Building
Excess of market value over net book value
$3,000
$500
200
700
$2,300
As conventionally prepared after the expansion
modernization, the balance sheet would be (in thousands):
Cash
Land
Building at cost
Accumulated
depreciation
Net book value
liabilities and
Total assets
$ 300
500
$2,600
600
Liabilities:
Mortgage
payable
Stockholders'
equity
2,000
$2,800
and
$1,800
1,000
Total
stockholders’ equity
The balance sheet would be unusually deceiving. The
mortgage would appear to be exceedingly high in relation to the
book value of the assets. The historical costs and resulting
stockholders' equity have lost all meaning.
Note that, on a market value basis, the land and building are
worth $3,000,000 before the borrowing and the renovation and
therefore worth $4,800,000 after. This is $2,300,000 above the book
Chapter 8
Long-Lived Assets and Depreciation
423
$2,800
value of the land and building of $2,500,000. Measured at market
values, the stockholders' equity would be $3,300,000.
424
8-69 (10-15 min.)
The answers are drawn from The Accountant's Weekly Report,
published by Prentice Hall, Inc. Sometimes drawing a line is difficult.
Legal fees paid in connection with a taxpayer's business are
deductible as business expenses. But no current deduction is
allowed for capital expenditures, and such expenses as the cost of
defending or perfecting title to business property are considered
capital expenditures.
1.
(a) Yes, it’s deductible. Here the litigation was to allow Rock to
continue in business. Since the claim arose out of his
profit-seeking activities, the legal expense is deductible.
2.
(b) They’re capital expenditures. Here the suit originated in
Rock's wish to expand the business by adding to the
property.
Since the crusher was a permanent
improvement, all the expenses of acquiring it, including
legal fees, must be capitalized -- and recovered through
depreciation.
Chapter 8
Long-Lived Assets and Depreciation
425
8-70 (20-30 min.)
This problem illustrates how some companies follow "more
conservative" accounting policies than others -- even though the
equipment is identical and the industry is the same.
1.
The change may not be judged as material in relation to the
total depreciation expense. However, in relation to net income,
it is material. Additional depreciation of $9,000,000 would have
decreased net income by .54 x $9,000,000 = $4,860,000. This is
11.5 percent of reported net income.
2.
All other things being equal, depreciation would be halved: .5 x
$220,979,000 = $110,489,500. Accordingly, net income would
be higher by .54 x $110,489,500 = $59,664,330. The latter is
40.7 percent of reported net income.
3.
†
Depreciation
Net income
†
Useful Lives in Years
10
20
72,000,000
36,000,000
22,793,000* 42,233,000
($800 million – residual value of $80 million) ÷ useful life
* $42,233,000 – [.54 x ($72,000,000 – $36,000,000)] or $42,233,000 –
$19,440,000
426
8-71 (15-20 min.) Data are in millions.
1.
Proceeds
Net book value of equipment sold is $26 − (6 x $1)
Gain on sale of equipment
A
Cash
=L+
Accumulated
Depreciation,
+ Equipment + Equipment
+22,000
+2,000b
-26,000
$22
20
$ 2
SE
Retained
Earnings
+6,000a
=
a Accumulated depreciation for six years is 6 x $1 = $6. The effect of
removing the net book value is $20, consisting of a decrease in
Equipment of $26 and a decrease in Accumulated Depreciation of
$6. Thus, $22 – $20 = $2. Note that the effect of a decrease in
Accumulated Depreciation (by itself) is an increase in assets.
b The $2 is usually carried separately until the end of the year as Gain
on Sale of Equipment, or Gain on Disposal of Equipment.
Income statement effects:
Alaska would include the Gain on Sale of Equipment as a part
of "other income (expense)."
2.
a.
b.
Chapter 8
Cash
Accumulated depreciation
Equipment
Gain on sale of equipment
Cash
Accumulated depreciation
Loss on sale of equipment
Long-Lived Assets and Depreciation
22
6
26
2
19
6
1
427
Equipment
428
26
8-72 (15-20 min.) Amounts are in millions of dollars.
1.
Proceeds
Net book value of equipment sold
$4 − ($8.5) =
Loss on sale of equipment (given)
$ 4.0
12.5
$ 8.5
Loss
Decrease




of
−




SE
Equipment
on
Sale
=
b




8.5
d
+




= L+
on



a



52.5



Equipment
Decrease
Cash
4
+



65
Increase
A
Accumulate
Depreciati
Decrease
Book value = Original cost – Accumulated depreciation
$12.5 = $65
– Accumulated depreciation
Accumulated depreciation = $65 – $12.5
= $52.5
a Accumulated depreciation is $52.5. The effect on assets of
removing the net book value is a decrease of $12.5, consisting of a
decrease in Equipment of $65 and a decrease in Accumulated
Depreciation of $52.5. Note that the net effect of a decrease in
Accumulated Depreciation (by itself) is an increase in assets.
b The $8.5 is usually carried separately until the end of the year as
Loss on Sale of Equipment, or Loss on Disposal of Equipment.
Income statement effects:
Loss on Sale of Equipment may be shown as a separate item
on an income statement as a part of "other expense" or some
similar category.
In single-step income statements the loss is shown along with
other expense items, for example:
Chapter 8
Long-Lived Assets and Depreciation
429
8-72 (continued)
Revenue:
Sales of products
Interest income
Total sales and other income
Cost of goods sold
Selling, general and administrative expense
Other expense: loss on sale of equipment
Income before taxes
$XXX
X
$XXX
X
X
X
$XXX
In multiple-step income statements, the loss is often shown
after the operating income generated by the sales of major
products.
2.
a.
Loss on sale of equipment
Cash
Accumulated depreciation
Equipment
Cash
4
Accumulated Depreciation, Equip.
52.5
8.5
4.0
52.5
65
Equipment
65
Loss on Sale of Equipment
8.5
b. Assume that the equipment and accumulated
depreciations amounts from part a do not change:
Cash
Accumulated depreciation
Equipment
Gain on sale of equipment
Cash
14
Accumulated Depreciation, Equip.
430
14.0
52.5
65.0
1.5
Equipment
65
Gain on Sale of Equipment
52.5
Chapter 8
Long-Lived Assets and Depreciation
1.5
431
8-73 (10-20 min.)
A lively discussion usually ensues. This problem could also be
assigned near the end of the course as an example of the strengths
and weaknesses of accounting theory.
1. There would be a "gain from insurance on crashed airplane"
recognized on the income statement:
Insurance payment received
Book value of airplane
Gain from insurance on crashed airplane
$6,500,000
962,000
$5,538,000
Total assets would increase by $5,538,000, the amount of the
gain. The fleet of airplanes would be the same as before the
crash, but a 727 with a book value of $6.5 million has replaced a
similar 727 with a book value of only $962,000.
2.
Accounting for casualties is very controversial. It gets to the
heart of the question of what is income and what is capital.
Does the $6.5 million insurance payment represent a return of
capital or a payment of both capital and income?
The historical-cost model (using nominal dollars) ignores
changes in general purchasing power and intervening
changes in specific prices while an asset is held. When an
asset is disposed of, the gain or loss is measured in nominal
dollars (almost always without regard to the intended use of the
proceeds).
432
8-73 (continued)
Many theorists and practitioners define the income of a going
concern to be a function of whether the proceeds will be
reinvested in the same types of assets. These individuals
maintain that no gain is realized on the airplane crash, because
the $6.5 million is really a return of capital (where capital is
thought of in physical terms as airplanes, inventories, etc.).
Thus, the "gain" would not be shown in the income statement.
Instead, it would appear as a special balance sheet item called
Revaluation Equity, or a similar title.
8-74 (10-15 min.) Amounts are in millions.
This case highlights how current values of equipment may
have little relation to book values.
1.
Sales price, 7 x $25
Book value:
Acquisition cost, 7 x $25 =
Accumulated depreciation:
7 x 8 yrs. x
$25 − $2.5
=
10yrs.
Gain on sale
2.
Cash (or Receivables)
Accumulated depreciation
Aircraft
Gain on sale of aircraft
Chapter 8
Long-Lived Assets and Depreciation
$175
175
126
49
$126
175
126
175
126
433
8-75 (15 min.)
1.
20X1: Research and development expense
Cash
20X2: Research and development expense
Cash
Capitalized software development
costs
Cash
800,000
800,000
400,000
400,000
1,000,000
1,000,000
2.
The capitalized software development costs must be
amortized .
Note: The amortization of capitalized software costs was not
discussed in the text. However, the instructor may be interested
in discussing the amortization process. If total estimated sales
are $4,000,000 and 20X3 actual sales revenue is $800,000,
amortization would be computed as follows.
20X3 Revenue ÷ Total Revenue = $800,000 ÷ $4,000,000 = .20
20X3 Amortization = .20 x $1,000,000 = $200,000
Amortization of capitalized
software development costs
Capitalized software development costs
434
200,000
200,000
8-76 (10-15 min.)
This problem illustrates how choices among accounting
alternatives can be important to both managers and accountants.
Note that the covenant will be amortized over three years.
1.
The tangible assets are deductible over a period of ten years
compared to a three-year amortization of the covenant, so the
buyer should favor Allocation One. In this way, the buyer will
get larger deductions during the first three years, [($72,000 ÷ 3)
+ ($28,000 ÷ 10) = $26,800 per year, instead of ($48,000 ÷3) +
$52,000 ÷10) = $21,200], but smaller deductions in the next
seven years ($2,800 per year instead of $5,200).
2.
Managers and accountants differ as to proper reporting to
shareholders. Because the tangible assets are depreciated
over ten years and the covenant is amortized over three years
for shareholder reporting, many would favor Allocation Two
because reported income before taxes would be $5,600 higher
during each of the first three years (in dollars).
Allocation
Amortization expense:
Covenant
Tangible assets
Total
Each of
First three
Years
ONE
TWO
24,000 16,000
2,800
5,200
26,800 21,200
Effects on reported income
of Allocation Two
Chapter 8
Next
Seven
Years
ONE TWO
Long-Lived Assets and Depreciation
5,600 higher
--2,800 5,200
2,8005,200
2,400 lower
435
8-77 (10 min.)
Choosing a lengthy economic life for depreciation purposes is
not inherently unethical, provided it is within the guidelines of
generally accepted accounting principles (GAAP). However, GAAP
allows great flexibility in its depreciation rules, and when a company
uses methods that do not fairly reflect the underlying economics of
a situation, a possible ethical violation occurs.
Some accountants would maintain that any financial reporting
policies that are consistent with GAAP are ethical. These same
persons might maintain that any business practices that do not
violate the law are ethical. The authors do not advocate such a
position. Ethical standards go beyond the law. Therefore, even
reporting policies that meet GAAP are unethical if they deliberately
try to mislead users of the financial statements.
GAAP is intentionally flexible so that different economic
situations can be reflected differently. For example, one theater may
legitimately plan to remodel its theaters every five years while
another plans remodeling only every ten years. The economic life of
the seats, carpets, etc. should reflect this management philosophy.
Nevertheless, there are some economic assumptions that are so far
from reality as to be absurd. Often these can be identified when one
company's policies are far from the norm of the industry. Both
Cineplex Odeon and Blockbuster may fit this category.
Another sign that depreciable lives are chosen to manipulate
income rather than to reflect economic reality is when changes to
longer lives are made just when additional income is needed. It is
unethical to manipulate income by changing accounting policies
when the new policies are clearly in conflict with the economics of
the situation.
In summary, using different accounting policies than other
similar companies is not unethical if the underlying economics
support the differences. However, when differences are intended to
mislead users of the financial statements, there is a clear ethical
violation.
436
8-78 (60 min. or more)
The purpose of this exercise is to help students see what can
be learned from the fixed asset section of a company’s balance
sheet. They can estimate the average age of the company’s assets,
and they can see how this is affected by the depreciation method
used. Comparisons are especially insightful if some companies use
accelerated depreciation; students can see how difficult it is to
compare the fixed assets of a straight-line company to those of an
accelerated-depreciation company.
The ranking of companies by the ratio of their accumulated
depreciation to the original cost of assets can lead to insights into
how the average age of assets can depend on the industry, the
growth rate of the company, management strategies, and other
factors.
8-79 (30-60 min.)
Each solution will be unique and will change each year. The
purpose of this problem is to examine how using different
depreciation methods affects the financial statements.
Chapter 8
Long-Lived Assets and Depreciation
437
8-80 (20-30 min.) (Amounts in millions of dollars)
1.
Note 1 reveals that equipment is depreciated over two to seven
years; buildings over 30 to 40 years; and leasehold
improvements over the shorter of their estimated useful lives
or the related lease life, generally 10 years.
2.
If lives are increased by 50%, depreciation is reduced by one
third. For example a $400 asset amortized over 4 years is
$400÷ 4 =$100 per year, over 6 years it is $400 ÷6 = $66.67. If
depreciation and amortization were reduced by one third, it
would have been $158,538, $79,269 less than the reported
$237,807. But this would increase pretax earnings and taxes.
The apparent tax rate is $167,989/$436,335 = 38.5%. Thus net
earnings would go up by $79,269 (1-.385) = $48,750, rising from
$268,346 to $317,096, an increase of 18.2%
8-81 (30-60 min.)
NOTE TO INSTRUCTOR. This solution is based on the web site as it
was in late 2004. Be sure to examine the current web site before
assigning this problem, as the information there may have changed.
1. Gap is a global specialty retailer of casual apparel,
accessories and personal care products for men, women and
children. They sell their products under several brand names
including Gap, Banana Republic and Old Navy. Gap sells their
products through both traditional retail stores and online
stores. You would expect Gap to have buildings, furniture,
display equipment and leasehold improvements.
438
2. Information on the method of depreciation and amortization
used is found in Note A to the financial statements: Summary of
Significant Accounting Policies. The company uses straight-line
depreciation and amortization. Other information available in this
note are: 1) estimated useful lives of property and equipment, 2)
interest capitalized on property and equipment under construction,
3) the fact that property and equipment are stated at cost, and 4)
items listed under property and equipment.
3.
Technically leasehold improvements are intangible assets, but
they are listed in Note A as property and equipment. Leasehold
improvements are amortized over the life of the lease, not to exceed
12 years. Gap also has lease rights estimated at $170 million as of
January 31, 2004. These rights represent costs to acquire the lease
of specific commercial property. They are amortized over the
estimated useful lives of the leases, not to exceed 20 years. These
rights are probably included in “other assets” on the balance sheet.
At January 31, 2004, the balance sheet lists other assets of $286
million, so Gap may have other intangible assets.
4. The amount listed on the balance sheet for property and
equipment represents cost. If Gap purchases no additional property
and equipment, the net book value will decrease over time.
5.
Depreciation and amortization expense for the year ended
January 31, 2004 was $664 million. This number is found on the
statement of cash flows where it is added back to net income in
order to arrive at net cash provided by operating activities.
Depreciation and amortization expense is not obvious from looking
at the income statement because it is combined with other costs. It
likely appears in the line items called Cost of Goods Sold and
Occupancy Expenses and/or Operating Expenses.
Chapter 8
Long-Lived Assets and Depreciation
439