libby financial accounting chapter8

Chapter 08 - Reporting and Interpreting Property, Plant, and Equipment; Natural Resources; and Intangibles

Chapter 08 Reporting and Interpreting Property,

Plant, and Equipment; Natural Resources; and Intangibles

ANSWERS TO QUESTIONS

1. Long-lived assets are noncurrent assets, which a business retains beyond one year, not for sale, but for use in the course of normal operations. Long-lived assets include land in use, plant and equipment, natural resources, and certain intangibles such as a patent used in operating the business. Long-lived assets are acquired because of the future use that is expected of them. Thus, they may be thought of as a bundle of future services to be used over a period of time to earn revenue. As those services are used, as in the case of a machine, the cost of the asset is allocated as a periodic expense (i.e., matched with revenue).

2. The fixed asset turnover ratio = Net sales

[(Beginning net fixed asset balance + Ending net fixed asset balance) ÷ 2]

This ratio measures how efficiently a company utilizes its investment in property, plant, and equipment over time. The ratio can also be compared to the ratio for the company’s competitors.

3. Long-lived assets are classified as follows: (1) Tangible long-lived assets—assets that are tangible (i.e., have physical

substance) and long-lived (i.e., beyond one year); they are acquired for use in the operation of a business and are not intended for resale. They are comprised of three different kinds of assets: (a) Land—not subject to depreciation. (b) Plant and equipment—subject to depreciation. (c) Natural resources—mines, gravel pits, and timber tracts. Natural

resources are subject to depletion. (2) Intangible long-lived assets—assets held by the business because of the

special valuable rights that they confer; they have no physical substance. Examples are patents, copyrights, franchises, licenses, trademarks, technology, and goodwill. Intangible assets with definite lives are subject to amortization.

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4. When a long-lived asset is acquired, it is recorded in the accounts in conformity with the cost principle. That is, the acquisition cost of a long-lived asset is the cash equivalent price paid for it plus all incidental costs expended to obtain it, to place it in the location in which it is to be used, and to prepare it for use.

5. In measuring and reporting long-lived assets, the matching principle is applied. As a long-lived asset is used, revenues are earned over a period of time. Over that same period of time, the long-lived asset tends to be used up or worn out. As a consequence, under the matching principle, the acquisition cost of the asset must be allocated to the periods in which it is used to earn revenue. In this way the cost of the asset is matched, as expense, with the revenues as they are earned from period to period through the use of the asset.

6. a. Capital expenditures—expenditures of resources (i.e., assets given up or debt incurred) for a service or asset that will help earn revenue for periods beyond the current accounting period. Capital expenditures should be debited to appropriate asset accounts and then allocated to those future periods in which revenues will be earned and against which the expenditures will be matched.

Revenue expenditures—expenditures that help earn revenue only for the current period. Revenue expenditures are debited to appropriate expense accounts in the period in which incurred.

b. Ordinary repairs—expenditures for the normal maintenance and upkeep of machinery and other tangible long-lived assets that are necessary to keep the assets in their usual operating conditions. Generally, ordinary repairs are recurring in nature, involve relatively small amounts at each occurrence and do not extend the useful estimated life of the asset. Ordinary repairs are debited to expense in the period in which incurred.

Improvements—unusual, nonrecurring, major renovations that are necessary because of unusual conditions. Generally, they are large in amount, not recurring, and tend to either make the asset more efficient or to extend its useful life. Extraordinary repairs are debited to the appropriate asset accounts (or alternatively to the accumulated depreciation accounts) and in that way affect the amount of depreciation expense for the remaining estimated life of the asset.

7. Depreciation—allocation of the cost of a tangible long-lived asset over its useful life. Depreciation refers to allocation of the costs of such items as plant and equipment, buildings, and furniture. Depletion—allocation of the cost of a natural resource over its useful life. It is identical in concept to depreciation except that it relates to a different kind of asset, depletable natural resources. Amortization—allocation of the cost of an intangible asset over its estimated useful life. Conceptually, it is the same as depreciation and depletion except it relates to an intangible asset.

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8. To compute depreciation, the three values that must be known or estimated are: Cost—the actual total expenditures incurred in acquiring the asset in conformity with the cost principle. Estimated useful life—the estimated length of time that the asset will be used by the present owner for the purposes for which it was acquired.

Residual value—the estimated amount of cash that is expected to be recovered at the end of the estimated useful life of the asset. The residual value is the estimated cash recovery amount minus the estimated cost of removing and disposing of the asset at the end of its estimated useful life. Notice that, on the acquisition date, the first of these values is an actual known amount, while the latter two are estimates.

9. The estimated useful life and estimated residual value of a long-lived asset when used for depreciation purposes relate to the current owner-user and not to all potential users of the asset because the asset’s cost must be allocated to the revenue that it generates during the period in which it is to be used by the current owner. The fact that the current owner may dispose of the asset and others may use it to earn revenues for a number of periods after that is of no consequence to the measurement of the asset and income for the current owner (other than for the effect of estimated residual value).

10. a. The straight-line method of depreciation causes an equal amount of depreciation expense to be apportioned to, or matched with, the revenues of each period. It is especially appropriate for tangible long-lived assets that are used at an approximately uniform level from period to period.

b. The units-of-production method of depreciation causes a depreciation expense pattern that varies in amount with the rate at which the asset is used productively each year. For example, if in the current year the asset is used twice as much as in the prior year, twice as much depreciation expense would be matched with the revenue of the current year as compared with the previous year. Usually use is measured in terms of productive output. The units-of-production method of depreciation is particularly appropriate for those assets that tend to earn revenue with use rather than with the passage of time. Thus, it normally would apply to assets that are not used at a uniform rate from period to period.

c. The double-declining-balance method of depreciation is a form of accelerated depreciation, causing a higher amount of depreciation expense to be matched with revenue in early periods of the estimated useful life of the asset. The double-declining-balance method is particularly appropriate when the long-lived assets perform more efficiently and therefore produce more revenue in the early years of their useful life than in the later years.

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11. The cost of an addition to an existing long-lived asset should be depreciated over the shorter of the estimated life of the addition or the remaining life of the existing asset to which it relates. This rule is necessary because an addition to an existing long-lived asset has no use after the useful life of the existing asset has expired.

12. Asset impairment—when events or changes in circumstances cause the book value of long-lived assets to be higher than their related estimated future cash flows. It is accounted for by writing down the asset to the asset’s fair value and recording a loss.

13. When equipment is sold, the Equipment account is credited for the asset’s historical cost. Its related Accumulated Depreciation account is debited for the amount representing prior usage. The Cash account is debited for the sales price. If the cash received exceeds the cost less accumulated depreciation (net book value), a Gain on Sale of Equipment is recorded for the difference. If the cash received is lower than the net book value, a Loss on Sale of Equipment is recorded for the difference. Net book value is the asset’s historical cost less accumulated depreciation on the asset.

14. An intangible asset is acquired and held by the business for use in operations and not for sale. Intangible assets are acquired because of the special rights they confer on ownership. They have no physical substance but represent valuable rights that will be used up in the future. Examples are patents, copyrights, trademarks, technology, franchises, goodwill, and licenses.

When an intangible asset is purchased, managers determine if it has a definite or indefinite life. If it has a definite life, the intangible asset’s cost is amortized on a straight-line basis over its expected useful life. However, an intangible asset with an indefinite life is not amortized, but is tested annually for probable impairment.

15. Goodwill represents an intangible asset that exists because of the good reputation, customer appeal, and general acceptance of a business. Goodwill has value because other parties often are willing to pay a substantial amount for it when they buy a business. Goodwill should be recorded in the accounts and reported in the financial statements only when it has been purchased at a measurable cost. The cost of goodwill is measured in conformity with the cost principle. Because it is considered to have an indefinite life, goodwill is not amortized, but it is reviewed annually for impairment of value.

16. Depreciation expense is a noncash expense. That is, each period when depreciation is recorded, no cash payment is made. (The cash outflow associated with depreciation occurs when the related asset is first acquired.) Since no cash payment is made for depreciation, the effect of the depreciation expense on net income needs to be reversed in the reconciliation to cash flows. Depreciation expense was originally subtracted to arrive at net income; thus, to reverse its effect, depreciation expense needs to be added back to net income on the statement of cash flows (indirect method).

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ANSWERS TO MULTIPLE CHOICE 1. a 2. c 3. b 4. b 5. a 6. d 7. a 8. d 9. d

10. c

EXERCISES

E8–1. Hasbro, Inc.

Excerpts from Balance Sheet (in millions)

ASSETS Current Assets

Cash and cash equivalents $ 630 Accounts receivable (net of allowance for doubtful accounts, $32) 612 Inventories 300 Prepaid expenses and other current assets 171

Total current assets 1,713

Property, Plant, and Equipment Machinery and equipment 413 Buildings and improvements 196 Land and improvements 7

Property, plant, and equipment (at cost) 616 Less: Accumulated depreciation 403 Total property, plant, and equipment (net) 213

Other Assets Goodwill 474 Other intangibles (net of accumulated amortization, $800) 568 Other noncurrent assets 200

Total other assets 1,242 Total Assets $3,168

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E8–3

Req. 1

Building (+A) ............................................................... 97,000Land (+A) ................................................................... 113,000

Cash (−A) .......................................................... 210,000

Cash paid + renovations to prepare for use + share of transfer costs

Building $71,000

23,000 3,000

$97,000

Land $107,000

6,000 $113,000

Req. 2

Straight-line depreciation computation:

($97,000 cost - $15,000 residual value) x 1/10 = $8,200 depreciation expense per year

Note: Land is not depreciated.

Req. 3

Computation of the book value of the property at the end of year 2:

Building $ 97,000 Less: Accumulated depreciation ($8,200 x 2 years) (16,400) $ 80,600

Land 113,000 Net book value $193,600

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E8–5.

Req. 1

Adjusting entry for 2010: Depreciation expense (+E, −SE) ....................................... 6,000

Accumulated depreciation, equipment (+XA, −A) ........ 6,000 ($100,000 – $10,000) x 1/15 = $6,000

Req. 2 ( beginning of 2011)

Estimated life 15 years Less: Used life -

$54,000 accumulated depreciation ÷ $6,000 annual expense = 9 years Remaining life 6 years

Req. 3 (during 2011):

Repair and maintenance expense (+E, −SE) .................... 1,000 Cash (−A)..................................................................... 1,000

(Ordinary repairs incurred.)

Equipment (+A) ................................................................. 12,000 Cash (−A)..................................................................... 12,000

Extraordinary repairs incurred and capitalized.

E8–8.

Req. 1 a. Straight-line:

Depreciation Accumulated Net Year Computation Expense Depreciation Book Value

At acquisition $580,000 1 ($580,000 - $60,000) x 1/5 $104,000 $104,000 476,000 2 ($580,000 - $60,000) x 1/5 104,000 208,000 372,000 3 ($580,000 - $60,000) x 1/5 104,000 312,000 268,000 4 ($580,000 - $60,000) x 1/5 104,000 416,000 164,000 5 ($580,000 - $60,000) x 1/5 104,000 520,000 60,000

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b. Units-of-production: ($580,000 – $60,000) ÷ 260,000 = $2.00 per unit of output Depreciation Accumulated Net

Year Computation Expense Depreciation Book Value At acquisition $580,000

1 $2.00 x 73,000 units $146,000 $146,000 434,000 2 $2.00 x 62,000 units 124,000 270,000 310,000 3 $2.00 x 30,000 units 60,000 330,000 250,000 4 $2.00 x 53,000 units 106,000 436,000 144,000 5 $2.00 x 42,000 units 84,000 520,000 60,000

c. Double-declining-balance: Depreciation Accumulated Net


1 ($580,000 - 0) x 2/5 $232,000 $232,000 348,000 2 ($580,000 - $232,000) x 2/5 139,200 371,200 208,800 3 ($580,000 - $371,200) x 2/5 83,520 454,720 125,280 4 ($580,000 - $454,720) x 2/5 50,112 504,832 75,168 5 ($580,000 - $504,832) x 2/5 30,067 534,899 45,101

15,168 520,000 60,000

Too large. Net book value cannot be below residual value.

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E8–8. (continued)

Req. 2 If the machine is used evenly throughout its life and its efficiency (economic value in use) is expected to decline steadily each period over its life, then straight-line depreciation would be preferable. If the machine is used at a consistent rate but the efficiency is expected to decline faster in the earlier years of its useful life, then an accelerated method would be appropriate [such as, double-declining-balance]. If the machine is used at different rates over its useful life and its efficiency declines with output, then the units-of-production method would be preferable because it would result in a better matching of depreciation expense with revenue earned.

E8–16.

Req. 1 Computation of acquisition cost of the deposit in 2012:

February 2012: March 2012:

Purchase of mineral deposit Preparation costs

Total acquisition cost in 2012

$ 700,000 74,000

$ 774,000

Req. 2 Computation of depletion for 2012:

$774,000 cost ÷ 900,000 cubic yards = $.86 per cubic yard depletion rate 60,000 cubic yards in 2012 x $.86 = $51,600

Req. 3 Computation of net book value of the deposit after the developmental work:

Total acquisition cost in 2012 $ 774,000 Less: 2012 depletion (51,600) January 2013 developmental costs 6,000

Net book value $ 728,400

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E8–18.

Req. 1

Acquisition cost: Copyright $12,300 Goodwill 65,000 Patent 39,200

Req. 2

Amortization on December 31, 2011 (straight-line method with no residual value):

Copyright: $12,300 x 1/10 = $1,230 amortization expense

Goodwill: The goodwill is not amortized due to its indefinite life.

Patent: $39,200 x 1/16 remaining at time of purchase = $2,450 amortization exp.

Req. 3

Income statement for 2011: Operating expenses: Amortization expense ($1,230 + $2,450) $3,680

Balance sheet at December 31, 2011: (under noncurrent assets)

Intangibles: Copyright ($12,300 - $1,230) ............................... $11,070 Goodwill .............................................................. 65,000 Patent ($39,200 - $4,900*) ................................... 34,300 $110,370

* $2,450 amortization expense x 2 years

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P8–3.

Req. 1

Cost of each machine: Machine

A B C Total

Purchase price .................................... $11,000 $30,000 $8,000 $49,000 Installation costs.................................. 500 1,000 500 2,000 Renovation costs................................. 2,500 1,000 1,500 5,000 Total cost ......................................... $14,000 $32,000 $10,000 $56,000

Req. 2

Computation of depreciation at the end of year 1 for each machine: Machine

A Method

Straight-line Computation

($14,000 − $1,000) x 1/5 = $2,600 B Units-of-production ($32,000 − $2,000) ÷ 60,000 hours = $0.50

$0.50 x 4,800 hours = $2,400 C Double-declining-balance ($10,000 −$0) x 2/4 = $5,000

Adjusting entry: Depreciation expense ($2,600 + $2,400 + $5,000) (+E, −SE) 10,000

Accumulated depreciation, Machine A (+XA, −A) 2,600 Accumulated depreciation, Machine B (+XA, −A) 2,400 Accumulated depreciation, Machine C (+XA, −A) 5,000

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P8–5.

Req. 1 a. Straight-line:

Depreciation Accumulated Net Year Computation Expense Depreciation Book Value

At acquisition $106,000 1 ($106,000 - $2,000) x 1/13 $8,000 $ 8,000 98,000 2 ($106,000 - $2,000) x 1/13 $8,000 16,000 90,000

b. Units-of-production: ($106,000 – $2,000) ÷ 200,000 = $0.52 per unit of output Depreciation Accumulated Net


1 $0.52 x 20,000 units $10,400 $10,400 95,600 2 $0.52 x 16,000 units 8,320 18,720 87,280

c. Double-declining-balance:

Year Computation Depreciation

Expense* Accumulated Depreciation

Net Book Value

At acquisition $106,000 1 ($106,000 - $0) x 2/13 $16,308 $16,308 89,692 2 ($106,000 - $16,308) x 2/13 13,799 30,107 75,893

*Rounded to the nearest dollar.

Req. 2

Cash flow—For tax purposes, the declining-balance (DB) method usually is viewed as preferable because an early tax deduction is preferable to a later tax deduction. DB depreciation expense is highest; therefore, it yields lower taxable income and therefore lower income tax payable (and lower cash outflow) in the early years. In later years, this effect would reverse. Other than cash outflows for taxes, cash flows are unaffected by the method chosen by management for financial reporting purposes. Companies may select different methods for tax and financial reporting.

Fixed asset turnover—The DB method would be most favorable for fixed asset turnover. Because this depreciation method yields the highest amount of depreciation expense, it yields the lowest level of net fixed assets and thus the highest fixed asset turnover during the early years. In later years, this effect would reverse.

EPS—In terms of EPS, straight-line (SL) depreciation would be favorable. This depreciation method yields the lowest amount of depreciation expense, the highest net

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income, and therefore the highest EPS during the early years when compared with the accelerated methods. In later years, this comparative effect would reverse.

Recommendation to Ford Motor Company’s management—Companies may choose a different method for tax purposes than for financial reporting purposes. The goal of reducing taxes in year 1 is best accomplished by using the double-declining-balance method. The ease of use of the straight-line depreciation method for financial reporting would result in the highest EPS for year 1 (assuming no other method better reflects matching expenses with revenues). As time goes on (in years 2 and later), the relative advantages of one method over another will reverse. However, accounting methods should be used consistently over time. Changing methods in the future would require reasonable justification.

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libby financial accounting chapter8

Documents

assets historical cost

depreciation method yields

financial reporting purposes

ordinary repairs

noncurrent assets

intangible assets

lived assets

current owner