11

Investments in Noncurrent Operating Assets—Utilization and Retirement

Overview

Asset utilization really means the expensing of an asset over its useful life. For tangible, fixed assets, this is called depreciation. For most intangible assets, the same thing as depreciation happens, but it is referred to as amortization. Finally, for natural resources, the same process is called depletion. Assets can also become impaired, which means that they are expensed faster than their previous useful life would have indicated because of some change of events. The calculation and process by which impairment is indicated varies depending on the type of asset. Assets can also be disposed of, sold, or exchanged. When this happens, the company removes the asset from the book (along with any contra account like Accumulated Depreciation if such an account exists) and records a gain or loss for the difference between the book value and the amount received (if any). Companies generally keep multiple sets of fixed asset records. This is because the assets frequently have different useful lives, or methods by which they are depreciated, for financial accounting and income tax accounting purposes. One common convention that is usually different for book and income tax purposes is when to begin and finish depreciation. For financial accounting (book) purposes, most companies use a monthly convention. For income tax purposes, most assets must be depreciated using a half-year convention, which means that the asset is depreciated for half a year in the year in which it is purchased and disposed regardless of the actual date.

Learning Objectives

Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered.

11-2 Chapter 11

If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with. The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.

Tips, Hints, and Things to Remember

LO1 – Use straight-line, accelerated, use-factor, and group depreciation methods to compute annual depreciation expense. How? Students don’t usually have a problem with straight-line depreciation. It is the method they are most familiar with, and it is the easiest to calculate anyway. Since very few companies use the sum-of-the-years’-digits method, professors may not bother testing you on it. Ask your professor before completely skipping the sum-of-the-years’-digits method. The main thing with the sum-of-the-years’-digits method is to realize that it is an accelerated method. Use-factor methods are pretty intuitive. You probably don’t need to memorize anything with regards to these methods. Just do what makes sense, and you are likely to get use-factor methods right. That leaves declining-balance depreciation methods as the area to focus your learning on. Declining-balance methods aren’t as popular as the straight-line method for financial accounting purposes, but it is the most widely used method for income tax purposes. Expect to be tested on this method. There are four things to keep in mind with declining-balance methods:

1. The straight-line rate is doubled with the double-declining-balance method (and multiplied by 1.5 if the 150 percent-declining balance method is used).

2. The rate is applied to the book value, not the depreciable cost as is the case with most other methods.

3. Residual values are ignored in the early years. Depreciation essentially stops when the residual value and book value meet.

4. This is an accelerated method so expect more depreciation in early years and less depreciation in later years when compared to the straight-line method.

Chapter 11 11-3

LO2 – Apply the productive-output method to the depletion of natural resources. How? The productive-output method is essentially the same as the use-factor methods discussed in LO1 for fixed assets. Once the quantity of the natural resource is known (or reasonably estimated), the calculation is merely a matter of allocating the total cost to the individual units in the resource and then depleting the resource as it is extracted and sold (mined, harvested, removed, etc.) at that rate. Buy 10 trees for $10 and you have $1 of depletion that each tree harvested. It’s as simple as that.

LO3 – Incorporate changes in estimates and methods into the computation of depreciation for current and future periods. How? Changes are accounted for in the current and future periods. This is done through a simple two-step process:

Step 1: Calculate the book value of the asset as of the end of the prior period. Step 2: Calculate the new deprecation with the new facts provided by the change

the same way you would for LO1 with a newly acquired asset. Use this new figure for the current period (and for future periods as well if using the straight-line method).

Changes will be gone over in much more detail (and include changes other than depreciation) in Chapter 20. The other key item to note at this point is that changes must be disclosed in the notes to the financial statements.

LO4 – Identify whether an asset is impaired, and measure the amount of the impairment loss using both U.S. GAAP and international accounting standards. How? For those of you who think better with graphics laid out in front of you, here is a pictoral description of how impairment losses are handled.

$ $$ $$$ $$$$ $$$$$ Book value Book value Book value

Discounted future cash

flows

Undiscounted future cash

flows Impairment

No Impairment

No Impairment Write asset down to $$

11-4 Chapter 11

Looking at the table, representing five different dollar amounts (three hypothetical book values, discounted future cash flows, and undiscounted future cash flows), will hopefully make things clearer. What it means is that impairment will only exist when the book value of the asset is greater than the undiscounted future cash flows ($$$$ Undiscounted future cash flows < $$$$$ Book value = Impairment). Impairment does not exist when the book value is less than undiscounted future cash flows ($$$ Book value < $$$$ Undiscounted future cash flows ≠ Impairment). However, when book value is more than undiscounted future cash flows, the asset is written down to discounted future cash flows, not to undiscounted future cash flows. In other words, it is only when impairment already exists that discounted future cash flows are considered.

LO5 – Discuss the issues impacting proper recognition of amortization or impairment for intangible assets. How? Most of this section is the same as, or similar to, issues already raised. Amortization is basically the same thing as straight-line depreciation except that it is applied to intangibles with a finite life instead of tangible assets. Where this section becomes more difficult is with impairment of goodwill or other intangibles with an indefinite life. Goodwill has an infinite life so it is not amortized for financial accounting purposes. It does, however, need to be tested on an annual basis for impairment (unlike other assets which are tested whenever there has been a material change in the way they are used, a change in the business environment, or if management obtains information suggesting that the market value of an asset has declined). Goodwill is usually impaired if the fair value of the reporting unit is less than the book value of the net assets. The amount of the impairment, if any, is the difference between the amount of goodwill on record and the goodwill currently assignable to the reporting unit (i.e., the difference between the fair value of the reporting unit and the reporting unit’s fair value of the net assets). So if Company A buys Company B for $1,000,000 when Company B’s fair value of their net assets is $900,000, then $100,000 of goodwill is recorded. If the book value drops to $850,000 due to $50,000 in depreciation and what once was Company B can be sold for over $850,000, then there is nothing to worry about. If what once was Company B has declined in value and can now only be sold for $800,000, then goodwill is impaired. The $100,000 of goodwill should be written off.

Chapter 11 11-5

LO6 – Account for the sale of depreciable assets in exchange for cash and in exchange for other depreciable assets. How? Students frequently have trouble with the journal entry related to the disposition of depreciable assets. Recall from earlier chapters that you should approach journal entries by filling in the things you know should be there, and then the rest of the entry should come easier. Also, recall that you shouldn’t leave things on the books that are no longer there. With those two things in mind, assuming cash is received, you know that Cash is going to receive a debit. If the asset has been depreciated, then you have to get the Accumulated Depreciation for that asset off the books with a debit. The other debit you may have would be to a Loss account (assuming there is a loss on the deal). Remember that losses have the same effect as expenses, so they are both increased with a debit. To remove the asset from the books requires a credit to the asset account. The other credit you may have would be to a Gain account. First, set up the entry with the five skeleton accounts mentioned above. Then plug in the items you know (Cash, Accumulated Depreciation, and the asset). If you are missing a credit, you have a gain which should be plugged to the gain with a subsequent removal of the loss part of the entry. If you are missing a debit, it is just the opposite with the difference going to the loss and the removal of the gain portion of the journal entry. How? What if cash isn’t the item received? Things don’t usually change much if something other than cash is received. Instead the item received gets the debit instead of Cash. There are a few exceptions or items that are noteworthy to keep in mind as follows:

Indicated gains are not recognized when essentially the same assets are exchanged.

Sometimes cash is given up in an exchange, and in those cases, Cash receives a credit rather than a debit.

When large amounts of cash are involved, then indicated gains are recognized.

LO7 – Compute depreciation for partial periods, using both straight-line and accelerated methods. Why? Conventions such as mid-month, monthly (frequently used for financial accounting purposes), or half-year (usually required for income tax purposes) make depreciation computations simpler in the year of acquisition and disposition. Otherwise, companies would have to compute how many days an asset was in use both during the first and the last year of use. That process can be cumbersome for a company with thousands of acquisitions and dispositions each year.

11-6 Chapter 11

LO8 – Understand the depreciation methods underlying the MACRS income tax depreciation system. Why? MACRS is less flexible than financial accounting depreciation. Certain assets are lumped into certain categories and follow a set of fixed procedures for income tax depreciation purposes. Companies that may be depreciating an asset over, say, ten years for financial accounting purposes may be forced to depreciate the same asset over five years for MACRS income tax purposes. The purposes of this are several: simplicity, tax benefits (to encourage companies to purchase more fixed assets since they can write off the expense quicker and pay less in income taxes sooner), and less wiggle room for companies to choose how they want to take their deductions. Double-declining-balance method is the norm for most assets (other than real estate) under MACRS. The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format. The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.

Multiple Choice

MC11-1 (LO1) Depreciation of operating assets is an accounting process for the purpose of a. reporting declining asset values on the balance sheet. b. accounting for costs to reflect the change in general price levels. c. allocating asset costs over the periods benefited by use of the assets. d. setting aside funds to replace assets when their economic usefulness

expires.

Chapter 11 11-7

MC11-2 (LO1) Which of the following statements is the assumption on which straight-line depreciation is based? a. The operating efficiency of the asset decreases in later years. b. Physical wear and tear is more important than economic obsolescence. c. Service value declines as a function of obsolescence rather than time. d. Service value declines as a function of time rather than use. MC11-3 (LO1) Cragun Company purchased a machine that was installed and placed in service on January 2, 2010, at a total cost of $480,000. Residual value was estimated at $80,000. The machine is being depreciated over ten years using the double-declining-balance method. For the year 2011, Cragun should record depreciation expense of a. $64,000. b. $76,800. c. $80,000. d. $96,000. MC11-4 (LO1) On December 30, Blue Corporation entered into a contract to acquire a new machine for its factory. The machine was placed into service early in January. The machine, which could have been purchased for a cash price of $280,000, was instead paid for as follows: Down payment $ 10,000 Note payable in ten equal monthly installments 240,000 1,000 shares of Blue common stock valued at $50 per

share 50,000

$300,000 Prior to the machine’s use, installation costs of $15,000 were incurred. The machine has an estimated useful life of ten years and an estimated salvage value of $20,000. What should Blue record as depreciation expense for the first year under the straight-line method? a. $26,000 b. $27,500 c. $28,000 d. $29,500

11-8 Chapter 11

MC11-5 (LO2) Battle Mountain Mining Company acquired a tract of land containing silver. Battle Mountain Mining is required by the purchase contract to restore the land to a condition suitable for recreational use after it has extracted the silver. Geological surveys estimate that the recoverable reserves will be 2,500,000 tons and that the land will have a value of $2,000,000 after restoration. Other relevant cost information is as follows: Land $18,000,000 Estimated restoration costs 3,000,000 What should be the depletion charge per ton of extracted silver? a. $8.00 b. $7.60 c. $7.20 d. $6.40 MC11-6 (LO3) When the estimate of an asset’s useful life is changed, a. depreciation expense for all past periods must be recalculated. b. there is a change in the amount of depreciation expense recorded for years

after the current year. c. only the depreciation expense in the current year is changed. d. depreciation expense will change for the current year and future years but

not for past periods. MC11-7 (LO3) The Dahlman Company purchased a tooling machine at the beginning of 2001 for $120,000. The machine was being depreciated on the straight-line method over an estimated useful life of 20 years, with no salvage value. At the beginning of 2011, when the machine had been in use and depreciated consistently for ten years, the company paid $20,000 to overhaul the machine. As a result of this improvement, the company estimated that the useful life of the machine would be extended an additional five years. What would be the depreciation expense recorded for the above machine in 2011? a. $4,000 b. $5,333 c. $6,000 d. $7,333 MC11-8 (LO5) In accordance with generally accepted accounting principles, which of the following methods of amortization is normally recommended for intangible assets? a. productive-output b. straight-line c. group composite d. double-declining-balance

Chapter 11 11-9

MC11-9 (LO6) The sale of a depreciable asset resulting in a gain indicates that the proceeds from the sale were a. greater than book value. b. greater than cost. c. greater than market value. d. less than cost. MC11-10 (LO6) When an exchange of depreciable assets that do NOT have commercial substance involves a gain, the recorded amount of the new asset is a. the cost of the old asset plus any cash paid if the amount was small. b. its fair market value less any cash paid if the amount was small. c. the net book value of the old asset plus any cash paid if the amount was

small. d. the net book value of the old asset plus any cash paid if the amount was

small plus the gain recognized. MC11-11 (LO6) On January 1, 2011, Rupert Corporation purchased drilling equipment for $11,500. The equipment has an estimated useful life of four years and a salvage value of $200. Assuming that Rupert uses the straight-line method of depreciation, if it trades the equipment for new similar equipment with a list price of $15,500 on December 31, 2012, and pays $4,050 in the exchange, the new equipment should be recorded at a. $15,500. b. $11,450. c. $9,850. d. $9,900. MC11-12 (LO8) Simple Company doesn’t have to prepare their financial statements in accordance with GAAP as Simple Company is solely funded by their owner, Mr. Simple. Mr. Simple would like to see financial statements, however. His accountant has advised him to depreciate his assets using MACRS rules (to keep things simple). Simple Company purchased some office furniture on March 1, 2011, for $100,000. At the time of acquisition, the office furniture was estimated to have a useful life of ten years and an estimated salvage value of $1,000. The MACRS cost recovery period for this asset is seven years, the half-year convention is in effect, and the method is 200 percent declining balance. How much depreciation should Simple Company record for this furniture in 2011? a. $14,290 b. $14,147 c. $10,000 d. $8,250

11-10 Chapter 11

Matching

Matching 11-1 (LO1) Listed below are the terms and associated definitions from the chapter for LO1. Match the correct definition letter with each term number. ___ 1. book value ___ 2. straight-line

depreciation ___ 3. useful life ___ 4. unit

depreciation ___ 5. composite

depreciation ___ 6. double-

declining-balance depreciation

___ 7. time-factor depreciation

___ 8. service-hours depreciation

___ 9. sum-of-the-years’-digits depreciation

___ 10. declining-balance depreciation

___ 11. productive-output depreciation

___ 12. accelerated depreciation

___ 13. use-factor depreciation

___ 14. group depreciation

___ 15. residual (salvage) value

a. estimate of the amount for which an asset can be sold when it is retired

b. computation of periodic depreciation expense based on how much the asset is used during the period

c. computation of depreciation on groups of similar assets as if they were one asset

d. method of computing depreciation that yields higher annual depreciation in the early years of an asset’s life than in later years

e. computation of periodic depreciation expense based on how many hours of service were used during the period relative to estimated total lifetime service hours

f. computation of periodic depreciation expense with a decreasing amount of depreciation recognized in each successive period, based on a fraction derived, in part, from the asset’s original useful life

g. computation of depreciation on an entire group of related but dissimilar assets as if they were one asset

h. computation of depreciation on each individual asset i. computation of periodic depreciation expense based on

the passage of time j. the long-term asset cost remaining to be allocated to

future periods; computed as historical cost less accumulated depreciation

k. computation of periodic depreciation expense with depreciation equal to twice the straight-line rate multiplied by an ever-decreasing book value

l. computation of periodic depreciation expense with a decreasing amount of depreciation recognized in each successive period, based on depreciation of a fixed percentage of an ever-decreasing book value

m. computation of periodic depreciation expense with an equal amount of depreciation recognized in each year

n. length of time over which a long-term asset is forecasted to provide economic benefits

o. computation of periodic depreciation expense based on how many units of output were produced during the period relative to estimated total lifetime output units

Chapter 11 11-11

Matching 11-2 (LO2, LO3, LO4, LO5) Listed below are the terms and associated definitions from the chapter for LO2 through LO5. Match the correct definition letter with each term number. ___ 1. natural

resources ___ 2. impairment ___ 3. amortization ___ 4. depletion ___ 5. depreciation

a. reduction in the expected cash flow to be generated by a long-term asset sufficient to warrant reducing the recorded value of the asset

b. the process of allocating the cost of mineral and other natural resource assets to periodic expense

c. the process of allocating the cost of tangible long-term assets to periodic expense

d. the process of allocating the cost of intangible assets to periodic expense

e. products of the earth, such as oil, gold, and timber; also called wasting assets

Matching 11-3 (LO6, LO7, LO8) Listed below are the terms and associated definitions from the chapter for LO6 through LO8. Match the correct definition letter with each term number. ___ 1. gain ___ 2. loss ___ 3. indicated gain ___ 4. indicated loss ___ 5. deferred gain ___ 6. accelerated

cost recovery system (ACRS)

___ 7. half-year convention

___ 8. modified accelerated cost recovery system (MACRS)

a. based on declining-balance depreciation, fixed cost recovery periods, and no residual values; introduced for tax purposes in 1986

b. accounting recognition is delayed until a future period c. the amount by which the proceeds from disposing of an

asset are less than the book value of the asset (not inventory)

d. the amount by which the proceeds from disposing of an asset exceed the book value of the asset (not inventory)

e. adaptation of the declining-balance depreciation method introduced for tax purposes in 1981

f. an assumption sometimes used in computing depreciation; depreciation is the same amount in the year assets are acquired or disposed of

g. the excess of the market value over the book value of the asset given up in an exchange of assets

h. the excess of the book value over the market value of the asset given up in an exchange of assets

11-12 Chapter 11

Problems

Problem 11-1 (LO1) Nihon Manufacturing, Inc., purchased a new machine on January 2, 2011, that was built to perform one function on its assembly line. Data pertaining to this machine are as follows: Acquisition cost $330,000 Residual value $30,000 Estimated service life 5 years Service hours 250,000 Production output 300,000 Using each of the following methods, compute the annual depreciation rate and charge for the years ended December 31, 2011, and 2012: 1. Straight-line 2. Service hours (assume 32,000 hours for 2011 and 36,000 hours for 2012) 3. Productive-output (assume 31,000 units for 2011 and 37,000 units for 2012) 4. Double-declining-balance What is the book value of the asset under each of the four methods at the end of 2012? Problem 11-2 (LO4) Cain Company purchased equipment eight years ago for $1,000,000. The equipment has been depreciated using the straight-line method with a 20-year useful life and 10 percent residual value. Cain’s operations have experienced significant losses for the past two years, and as a result, the company has decided that the equipment should be evaluated for possible impairment. The management of Cain Company estimates that the equipment has a remaining useful life of seven years. Net cash inflow from the equipment will be $80,000 per year. The fair value of the equipment is $240,000. 1. Determine if an impairment loss should be recognized. 2. Determine the amount of the loss, if any, and prepare the journal entry to record the

loss if applicable. 3. How would your answer to 1. change if the fair value of the equipment was, instead,

$500,000? 4. Assuming the same facts as parts 1. and 2. and that the residual value is still

estimated to be 10 percent, compute depreciation expense for each of the last seven years of the asset’s life after any impairment adjustment.

Chapter 11 11-13

Problem 11-3 (LO5) Super Slugger, Inc., purchased for $750,000 a trademark for a very successful baseball bat drink it markets under the name BLAST! The trademark was determined to have an indefinite life. A competitor recently introduced a product that is in direct competition with the BLAST! product, thus suggesting the need for an impairment test. Data gathered by Super Slugger suggests that the useful life of the trademark is still indefinite, but the cash flows expected to be generated by the trademark have been reduced either to $30,000 per year (with a probability of 80 percent) or to $60,000 per year (with 20 percent probability). The appropriate risk-free interest rate is 5 percent. Prepare the appropriate journal entry (if needed) to record the effect of the events described above. Problem 11-4 (LO5) Absorption Company acquired Tiny Company on January 1, 2011. As part of the acquisition, $500,000 in goodwill was recognized and assigned to Tiny Company’s reporting unit. For 2011, earnings from the Tiny reporting unit were $440,000. Separately traded companies with operations similar to the Tiny reporting unit had market values approximately equal to five times earnings. As of December 31, 2011, book values and fair values of the Tiny reporting unit were as follows: Book Values Fair Values Assets (except Goodwill) $4,000,000 $4,300,000 Goodwill 500,000 ? Liabilities 2,200,000 $2,200,000 Prepare the impairment test of goodwill as well as any journal entry needed to record an impairment loss. How much goodwill amortization will take place, if any, after the impairment loss, if any, is recorded?

Solutions, Approaches, and Explanations

MC11-1 Answer: c Approach and explanation: Make sure you understand the first paragraph in the chapter before moving on or things will be confusing. Depreciation is an estimate only. It is based on an allocation of costs—not appraisals, asset values, price levels, or cash. Amounts for depreciation will vary for the same asset based on the method chosen, life chosen, and convention used (for the first and last year at least).

11-14 Chapter 11

Some companies will have six or more different depreciation expense numbers for a single asset during a single year! How can this happen you may ask? Again, depreciation isn’t set in stone; it’s only an estimate. Since it isn’t based on an appraisal, etc., merely picking a different method will produce a different allocation of the asset’s original cost. MC11-2 Answer: d Approach and explanation: Choice a would be a good reason to use something other than straight-line deprecation; an accelerated method or a use-factor method would better match expenses with revenues if the operating efficiency of an asset decreases in later years. Choice b sounds like a good reason to use a non-time-based depreciation method like service-hours or productive-output depreciation. Straight-line depreciation doesn’t really take physical wear and tear into consideration; rather, it assumes that the asset may be wearing out equally or that it is obsolete after a certain amount of time. An accelerated method could also be chosen if the physical wear and tear is assumed to occur in the early life of the asset (which is frequently the case—especially with technological assets). Choices c and d are almost opposites, so there is a good chance that one of them is the correct answer. Obsolescence is one of the main reasons why an accelerated method should be chosen over the straight-line method. A company that chooses the straight-line method may have to write an asset down (impairment), change depreciation estimates (to a shorter life), or change depreciation methods (to an accelerated one) should the asset (or assets) be found to be obsolete before the original straight-line method useful life is fully exhausted. If, say, the double-declining-balance method was chosen instead, the asset will be mostly depreciated after just the first few years. Impairments or changes due to obsolescence will likely be immaterial and, hence, unnecessary to perform, in such instances.

Chapter 11 11-15

MC11-3 Answer: b Approach and explanation: There are three things to be careful with when answering questions like this:

1. Know how to apply the method (in this case, the double-declining-balance method).

2. Check the year for which depreciation is being computed (in this case 2011—not

2010, the year of acquisition).

3. Use the residual value correctly (in this case, not at all unless the depreciation has taken the book value down to the residual value).

With the above factors in mind, here is the calculation: Straight-line rate = 10 percent (100%/10-year life) Double-declining-balance rate = 20 percent (10% × 2). Here is a chart of the depreciation of this asset for the first two years, assuming a full year was taken in 2010:

End of Year

Computation

Depreciation Amount

Accumulated Depreciation

Asset Book Value

$480,000 2010 480,000 × 20% = $96,000 $ 96,000 384,000 2011 384,000 × 20% = 76,800 172,800 307,200

Note that the $80,000 residual value doesn’t come into play since the asset’s book value is above $80,000 at the end of the year in question. If you selected choice a, you factored the residual value into the problem when you shouldn’t have. If you selected choice c, you factored the residual value into the problem and you answered the question for the wrong year (2010 instead of 2011). If you selected choice d, you answered the question for the wrong year.

11-16 Chapter 11

MC11-4 Answer: b Approach and explanation: This question tests how well you remember the information in Chapter 10 as much as it tests Chapter 11. What should assets be recorded at? The answer is the fair market value that equals the present value of the payments. You weren’t provided with enough information to figure out what the present value of the $240,000 note payable is (although you can back into the fact that it must be $220,000 without knowing the interest rate or when the monthly installments begin). The fair market value of the machine is $280,000 or the cash price. Since the equivalent of $60,000 ($10,000 + $50,000) is being paid at the outset, the note payable must have a present value of about $220,000 or the seller wouldn’t have entered into the deal. So $280,000 is our starting place. But then we need to add in other costs incurred to get the machine up and running. In this case, we have $15,000 in installation costs, so we are up to $295,000 as the book value before depreciation. Note that the salvage value does not decrease or increase the book value. It merely goes into the depreciation calculation under some methods. For the straight-line method, assuming a full year’s worth of depreciation, the calculation is ($295,000 – $20,000)/10 = $27,500. Depreciation for each of the ten years under this method is, therefore, $27,500. At the end of the first year, the book value will be $267,500. After ten years, it will be $20,000. If you selected choice a, then you forgot to capitalize and depreciate the installation costs. If you selected choice c, then you didn’t capitalize the fair market value of the machine or include the installation costs. If you selected choice d, then you forgot to subtract the residual value in your depreciation calculation. MC11-5 Answer: b Approach and explanation: Normally, if depreciable assets are constructed in conjunction with a natural resource, they are depreciated along with the depletion of the natural resource. In this case, depreciable assets aren’t constructed, but additional costs are incurred with regard to the natural resource. Since land isn’t depreciated, it should be depleted based on these additional costs incurred. Therefore, the calculation for depletion per ton should be ($18,000,000 + $3,000,000 – $2,000,000)/2,500,000 = $7.60. What if a building had also been constructed at a cost of $250,000 for temporary residences of the workers and the eventual building disposal at the end of the project was part of the restoration costs?

Chapter 11 11-17

Then, the building should be depreciated based on production/depletion, not time, at a rate of $0.10 ($250,000/2,500,000) per ton of silver extracted. MC11-6 Answer: d Approach and explanation: It doesn’t matter what the change is (useful life, residual value, or depreciation method); the treatment is the same. Depreciation expense will change in the current and future periods. There is no retroactive restatement of the financial statements or recalculations for the past. The change must also be disclosed in the notes to the financial statements in the period of the change. MC11-7 Answer: b Approach and explanation: When a change in estimate takes place, the book value must first be calculated. Since half of this machine has been depreciated, you can easily shortcut a more detailed calculation and know that half of the original price, or $60,000, has been depreciated, leaving a $60,000 book value at the beginning of 2011. A more detailed calculation would include figuring out the annual rate ($120,000/20 = $6,000) and then multiplying it by 10 to arrive at the same number. Choice c would, therefore, be the correct answer if the question were asking what the prior, annual depreciation amounts were. What happens with the $20,000 overhaul? Recall from the prior chapter that the overhaul should be capitalized (since it extends the useful life of the machine) with the following journal entry: Machine 20,000

Cash 20,000 That brings the book value of the machine, after the overhaul, up to $80,000. If you missed that point, then you probably came up with incorrect choice a. The final step is to compute the depreciation now that things have changed. Since there is no stated salvage/residual value, the numerator will be the new book value of $80,000. The denominator will be the remaining years, which have now changed from 10 to 15. Therefore, the calculation is $80,000/15 = $5,333.

11-18 Chapter 11

MC11-8 Answer: b Approach and explanation: Amortization is almost always on a straight-line, monthly basis. This is true not only for GAAP purposes but for income tax purposes as well. The textbook discusses an Accumulated Amortization account that receives the credit, similar to Accumulated Depreciation. It is more common to see the credit go directly against the intangible asset. It is extremely rare to see Accumulated Amortization on a balance sheet, whereas Accumulated Depreciation is frequently shown separately on the face of the balance sheet itself. The other method of presentation is to show a fixed asset or intangible with “(net)” next to it—meaning that Accumulated Amortization or Accumulated Depreciation has already been subtracted to arrive at the figure shown. MC11-9 Answer: a Approach and explanation: While choices b, c, and d could all be correct given the right numbers to work with, they aren’t necessarily correct in all, or even most, cases. Choice a, on the other hand, will always be correct. If these theoretical kinds of questions are problematic for you, then try putting some real numbers behind them. Bring the questions to life if that helps. For example, let’s throw some numbers out there—any numbers are OK—and say that a depreciable asset had a cost of $10, is halfway depreciated down to a $5 book value, and was sold for $7 (the market value). What would the journal entry look like? First, show the cash coming in with a debit of $7 to Cash. Also, create a skeleton entry for the possible rest of the journal entry. Cash 7 Accumulated Depreciation ? Loss ?

Depreciable Asset ? Gain ?

Next, fill in the other known pieces of the entry as follows: Cash 7 Accumulated Depreciation 5 Loss ?

Depreciable Asset 10 Gain ?

Chapter 11 11-19

Since the amount of debits exceeds the credits by 2, you know that there wasn’t a loss and there should be a gain as follows: Cash 7 Accumulated Depreciation 5

Depreciable Asset 10 Gain 2

So getting back to the original question, a gain indicates what? The proceeds were greater than the book value, equal to market value, and less than cost, so only choices a and d work for this example. How can we falsify one of the choices? Let’s try changing the proceeds to be more than cost and see if we still get a gain: Cash 12 Accumulated Depreciation 5

Depreciable Asset 10 Gain 7

We do still have a gain, so choice d need not always be correct. Just to check choice a, let’s pick some proceeds that are less than book value and see what happens. Cash 4 Accumulated Depreciation 5 Loss 1

Depreciable Asset 10 Since a loss results, we can clearly see that choice a must hold, but the other choices need not always, or even usually, be true. MC11-10 Answer: c Approach and explanation: Fair market value is the normal value at which to book nonmonetary assets received in an exchange (a process which can result in gains being recognized). However, when there is no commercial substance to the exchange (the textbook uses the example of car dealers swapping cars that are the same except for color), then gains are not recognized (if the amount of money exchanged is zero or small). If the amount of cash involved in the exchange is large, then the transaction must be considered to have commercial substance and gains can be recognized if they exist. In this question, we are looking at a transaction that lacks commercial substance and may or may not include cash. According to the choices, if cash is involved, it is a small amount (otherwise, it would have commercial substance as mentioned above). Therefore, a gain should not be recognized.

11-20 Chapter 11

Choice a could be correct if no depreciation had been taken on the asset. However, since the question specifically states that the assets were depreciable, it is likely they have been depreciated, at least a bit. So cost isn’t the number to use; book value is the correct starting point. Choice b could be correct if two things were changed. If the assets have commercial substance and the words “less any cash paid” were stricken from the choice, then this choice could be correct. Choice d could be correct if the word “small” was changed to “large,” turning the transaction into one that has commercial substance. MC11-11 Answer: a Approach and explanation: Fair market value is the normal amount to book the asset(s) received in a nonmonetary exchange at. This situation is not an exception, even though the assets are similar, as the transaction has commercial substance. Why is this, you may ask? Because a large amount of cash is involved in the transaction, it becomes one of commercial substance even though the assets are similar. What is the book value of the asset being transferred? ($11,500 – $200)/4 = $2,825 depreciation per year, or $5,650 of Accumulated Depreciation to this point, and a book value of $5,850 ($11,500 – $5,650) on December 31, 2012. Therefore, the complete journal entry to record this transaction on Rupert Corporation’s books (assuming the entry has already been made for depreciation expense for the year) is as follows: Drilling Equipment (new) 15,500 Accumulated Depreciation (old) 5,650

Drilling Equipment (old) 11,500 Cash 4,050 Gain 5,600

If the amount of cash paid (or received if the facts were different) was small instead of large, then the $5,600 gain would not be recognized and choice d would be the correct answer.

Chapter 11 11-21

MC11-12 Answer: a Approach and explanation: The first thing to recognize is that for MACRS purposes things like day placed into service (assuming the half-year convention is in effect), salvage value, and estimated useful life go out the window. They are meaningless for MACRS and don’t figure into the calculation. Office furniture will always be depreciated over seven years under MACRS even if the estimated useful life is more or less than seven years. The calculation is as follows: 1/7 = 14.29% 14.29% is the straight-line rate. Therefore,: 14.29 × 200% = 28.57% 28.57% × 50% (for half-year convention) = 14.29% rate in first year (2011) Since the amount of salvage/residual value ignored for MACRS is $100,000 the amount of depreciation to record for furniture in 2011 is $14,290 ($100,000 × 14.29%). How much will depreciation expense be in 2012? $100,000 – $14,290 = $85,710 $85,710 × 28.57% = $24,487 The amount of depreciation expense in 2012 is $24,487. Matching 11-1 1. j 2. m 3. n 4. h 5. g 6. k 7. i 8. e 9. f 10. l 11. o 12. d 13. b 14. c 15. a

11-22 Chapter 11

Complete these terminology matching exercises without looking back at the textbook or on to the glossary. After all, you probably won’t have those as a reference at test time. Learning through trial and error causes the item to be learned better and to stick in your memory longer than if you just look at the textbook, glossary, or a dictionary and “cook book” the answers. Sure you may get the answer correct on your first attempt, but missing something is sometimes best for retention. Don’t be afraid of failure while studying and practicing. Matching 11-2 1. e 2. a 3. d 4. b 5. c Matching 11-3 1. d 2. c 3. g 4. h 5. b 6. e 7. f 8. a Problem 11-1 1. Straight line:

2011: ($330,000 – $30,000)/5 = $60,000 2012: ($330,000 – $30,000)/5 = $60,000

2. Service hours: ($330,000 – $30,000)/250,000 = $1.20 per hour depreciation rate

2011: $1.20 × 32,000 = $38,400 2012: $1.20 × 36,000 = $43,200

3. Productive-output: ($330,000 – $30,000)/300,000 = $1.00 per hour depreciation rate

2011: $1.00 × 31,000 = $31,000 2012: $1.00 × 37,000 = $37,000

4. Double-declining-balance: 2X the straight-line rate of 20% (1/5), or 40%

2011: $330,000 × 0.40 = $132,000 2012: ($330,000 – 132,000) × 0.40 = $79,200

Chapter 11 11-23

Book value: a. ($330,000 – $60,000) – $60,000 = $210,000 b. ($330,000 – $38,400) – $43,200 = $248,400 c. ($330,000 – $31,000) – $37,000 = $262,000 d. ($330,000 – $132,000) – $79,200 = $118,800 Problem 11-2 1. Annual depreciation for the equipment has been $45,000 [($1,000,000 –

$100,000)/20]. Current book value of the equipment is as follows:

Original cost $1,000,000 Accumulated depreciation 360,000* Book value $ 640,000

*$45,000 × 8 = $360,000

The book value of $640,000 is compared to the undiscounted sum of the future cash flows to determine whether the equipment is impaired. The sum of the future cash flows is less at $560,000 ($80,000 × 7), so an impairment loss should be recognized.

2. The impairment loss is equal to the $400,000 ($640,000 – $240,000) difference

between the book value of the equipment and its fair value. The impairment loss would be recorded as follows:

Accumulated Depreciation—Equipment 360,000 Loss on Impairment of Equipment 400,000

Equipment 760,000

*$1,000,000 – $240,000 = $760,000 3. The answer to 1. is unaffected by the fair value of the asset. The existence of an

impairment loss is determined solely by using the undiscounted sum of estimated future cash flow, not the fair value of the asset. The answer to 2. would change with a different fair value, however.

4. Since the equipment now has a book value of $240,000, with no accumulated

depreciation attached to it, the depreciation starts fresh as if an asset was just purchased for $240,000.

($240,000 – $24,000)/7 = $30,857 in depreciation expense each year for the next seven years.

11-24 Chapter 11

Problem 11-3 The estimate of the fair value of the intangible is computed as follows:

Future Cash Inflows

Present Value of Indefinite Annual Cash

Flows*

Probability

Probability- Weighted

Present ValueScenario 1 $30,000 $ 600,000 80% $480,000 Scenario 2 $60,000 1,200,000 20% 240,000 Total estimated fair value $720,000 *The present value of a stream of indefinite, or infinite, annual cash flows is a perpetuity calculated by dividing the annual cash flow by the discount rate. Since the estimated fair value of the trademark is less than its book value ($720,000 < $750,000), the intangible asset is impaired. The impairment loss is recognized with the following journal entry: Impairment Loss 30,000*

Trademark 30,000 *750,000 – $720,000 = $30,000 Problem 11-4 Using the earnings multiple, the fair value of the Tiny reporting unit is estimated to be $2,200,000 ($440,000 × 5). The book value of the net assets of the Tiny reporting unit is: ($4,000,000 + $500,000) – $2,200,000 = $2,300,000. Since the fair value of $2,200,000 is less than the book value of the net assets of $2,300,000, goodwill is likely to be impaired. The implied fair value of goodwill is computed as follows: Estimated fair value of Tiny reporting unit $2,200,000 Fair value of identifiable net assets 2,100,000* Implied fair value of goodwill $ 100,000 *4,300,000 – $2,200,000 = $2,100,000

Chapter 11 11-25

The implied fair value of goodwill is less than the recorded amount of goodwill ($100,000 < $500,000). The journal entry to record the goodwill impairment loss, therefore, is as follows: Goodwill Impairment Loss 400,000

Goodwill 400,000* *$500,000 – $100,000 = $400,000 The final question in this problem is a bit of a trick question. Don’t fall for it and start computing goodwill amortization. Since goodwill is an indefinite-life intangible asset, it is not amortized for financial accounting purposes, ever. Therefore, there will be no amortization before, or after, the impairment loss reduces the amount of goodwill recorded on Absorption Company’s books.

Glossary

Note that Appendix C in the rear portion of the textbook contains a comprehensive glossary for all of the terms used in the textbook. That is the place to turn to if you need to look up a word but don’t know which chapter(s) it appeared in. The glossary below is identical with one major exception: It contains only those terms used in Chapter 11. This abbreviated glossary can prove quite useful when reviewing a chapter, when studying for a quiz for a particular chapter, or when studying for an exam which covers only a few chapters including this one. Use it in those instances instead of wading through the 20 or so pages of comprehensive glossary in the textbook trying to pick out just those words that were used in this chapter.

accelerated cost recovery system (ACRS) Adaptation of the declining-balance depreciation method introduced for tax purposes in 1981 and subsequently modified.

accelerated depreciation Method of computing depreciation that yields higher annual depreciation in the early years of an asset’s life than in later years.

amortization The process of allocating the cost of intangible assets to periodic expense.

book value The long-term asset cost remaining to be allocated to future periods; computed as historical cost less accumulated depreciation.

composite depreciation Computation of depreciation on an entire group of related but dissimilar assets as if the group were one asset.

declining-balance depreciation Computation of periodic depreciation expense with a decreasing amount of depreciation recognized in each successive period, based on depreciation of a fixed percentage of a declining book value.

11-26 Chapter 11

deferred gain A gain for which accounting recognition is delayed until a future period.

depletion Process of allocating the cost of mineral and other natural resource assets to periodic expense.

depreciation Process of allocating the cost of tangible long-term assets to periodic expense.

double-declining-balance depreciation Computation of periodic depreciation expense with depreciation equal to double the straight-line rate multiplied by a declining book value.

gain Amount by which the proceeds from disposing of an asset exceed the book value of the asset.

group depreciation Computation of depreciation on an entire group of similar assets as if the group were one asset.

half-year convention Assumption sometimes used in computing depreciation; one-half of a year’s depreciation is recognized for assets acquired or disposed of during a year.

impairment Reduction in the expected cash flow to be generated by a long-term asset sufficient to warrant reducing the recorded value of the asset.

indicated gain The excess of the market value over the book value of the asset given up in an exchange of assets.

indicated loss The excess of the book value over the market value of the asset given up in an exchange of assets.

loss Amount by which the proceeds from disposing of an asset are less than the book value of the asset.

modified accelerated cost recovery system (MACRS) Modification of the ACRS tax depreciation method that is based on declining-balance depreciation, fixed cost recovery periods, and no residual values.

natural resources Products of the earth, such as oil, gold, and timber. Also called wasting assets.

productive-output depreciation Computation of periodic depreciation expense based on how many units of output were produced during the period relative to estimated total lifetime output units.

residual (salvage) value Estimate of the amount for which an asset can be sold when it is retired.

service-hours depreciation Computation of periodic depreciation expense based on how many hours of service were used during the period relative to estimated total lifetime service hours.

straight-line depreciation Computation of periodic depreciation expense with an equal amount of depreciation recognized in each year.

Chapter 11 11-27

sum-of-the-years’-digits depreciation Computation of periodic depreciation expense with a decreasing amount of depreciation recognized in each successive period, based on a fraction derived from the sum of the digits from one to the asset’s original useful life.

time-factor depreciation Computation of periodic depreciation expense based on the passage of time.

unit depreciation Computation of depreciation on an individual asset as a separate unit.

use-factor depreciation Computation of periodic depreciation expense based on how much the asset is used during the period.

useful life Length of time over which a long-term asset is forecasted to provide economic benefits.