CHAPTER 9
PLANT AND INTANGIBLE ASSETS
OVERVIEW OF EXERCISES, PROBLEMS, CASES,
AND INTERNET ASSIGNMENT
Exercises
9–1
9–2
9–...
Cases
9–1
9–2
*9–3

Topic
Issues involving useful lives
Departures from GAAP
Depreciation disclosures

Business Week
Assig...
DESCRIPTIONS OF PROBLEMS, CASES,
AND INTERNET ASSIGNMENT
Below are brief descriptions of each problem, case, and the Inter...
Cases
9–1

Ethics Case: Extending Useful Lives
A look into the responsibilities of management accountants. Do they do as t...
SUGGESTED ANSWERS TO DISCUSSION QUESTIONS
1. Coca-Cola’s trademark name was not purchased from another company, but rather...
12. Most companies use only the straight-line method of depreciation in their financial statements. However,
these compani...
21. Depletion in the amount of $10,000,000 should be deducted from revenue in the current year. The other
$2,000,000 of de...
SOLUTIONS TO EXERCISES
Ex. 9–1

a. Two factors have caused the truck to depreciate: (1) physical deterioration and (2)
obs...
Ex. 9–3
Year
1
2
3
4
5
6
7
8
9
Totals

(1)
(2)
(3)
(4)
(5)

a.
Straight-Line
(Half-Year Convention)
$ 59,375 (1)
118,750 (...
Ex. 9–4
a. (1) Straight-Line Schedule
Year
1
2
3
4
5

Computation
$35,000× 1⁄5
35,000× 1⁄5
35,000× 1⁄5
35,000× 1⁄5
35,000×...
Ex. 9–5

a. No, the use of different depreciation methods in financial statements and in income tax
returns does not viola...
Ex. 9–6

a. 2001
Jan. 11 Machinery..........................................................................
Cash............
Ex. 9–8

Ex. 9–9

Average earnings...........................................................................................
Ex. 9–11 a. Inventory....................................................................................
Accumulated Depl...
Ex. 9–14 a. The company uses both straight-line and accelerated methods to compute depreciation
expense for financial repo...
SOLUTIONS TO PROBLEMS
25 Minutes, Easy

PROBLEM 9–1
PRESCOTT COLLEGE

a. The cost of plant and equipment includes all expe...
c.

Expenditures that should be debited to the Computing
Equipment account:
Purchase price
Sales tax
Freight charges
Insta...
a. (1) Straight-Line Schedule:
Year
2001
2002
2003
2004
2005
2006

Computation
$100,000 × 1⁄5 × 1⁄2
100,000 × 1⁄5
100,000 ...
2. 200% Declining-Balance:
Cash proceeds
Book value on 12/31/04
Gain on disposal

$30,000
18,662
$11,338

3. 150% Declinin...
2001
2002
2003
2004

$16,000 × 7.5% × 1⁄2
15,400 × 7.5%
14,245 × 7.5%
13,177 × 7.5%

$ 600
1,155
1,068
988

$

600
1,755
2...
a.
General Journal

Feb 10 Loss on Disposal of Plant Assets
Accumulated Depreciation: Office Equipment
Office Equipment
Sc...
a. Operating expense. Although the training of employees probably has some benefit extending beyond
the current period, th...
SOLUTIONS TO CASES
20 Minutes, Strong

CASE 9–1
ARE USEFUL LIVES “FLEXIBLE”?
AN ETHICS CASE

a. Lengthening the period ove...
a. Showing plant assets at current market values is not in conformity with generally accepted
accounting principles (GAAP)...
The unused patents should not be reported in the balance sheet at the minimum intended selling price of
$250,000. Instead,...
SOLUTION TO INTERNET ASSIGNMENT
No time estimate

INTERNET 9–1
R&D EXPENDITURES

A keyword search of Pharmaceutical Compan...
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  1. 1. CHAPTER 9 PLANT AND INTANGIBLE ASSETS OVERVIEW OF EXERCISES, PROBLEMS, CASES, AND INTERNET ASSIGNMENT Exercises 9–1 9–2 9–3 9–4 9–5 9–6 9–7 9–8 9–9 Topic You as a student Capital vs. revenue expenditures Depreciation for partial years Accelerated vs. Straight-line Depreciation disclosures Revision of depreciation estimates Accounting for trade-ins Estimating goodwill Impaired assets Learning Objectives 2, 3 1, 2 3 3 3 3 4 5 4, 7 9–10 9–11 9–12 *9–13 9–14 Fair market value and goodwill Natural resources Annual report presentations Alternative depreciation methods Examining an annual report 5 6 5, 7 8 1, 3 Problems 9–1 9–2 9–3 Cost determination and depreciation Straight-line vs. accelerated methods Multiple depreciation issues 1, 2, 3 3, 4 1, 2, 3, 4 9–4 Disposal of plant assets 4 9–5 9–6 Intangible assets under GAAP Accounting for goodwill 5 5 Characteristics Conceptual Conceptual Mechanical, conceptual Mechanical, conceptual Conceptual, real—H.J. Heinz Co. Mechanical, conceptual Mechanical, conceptual Mechanical, conceptual Mechanical, conceptual, real— Food Lion, Inc. Conceptual, analytical, ethics Mechanical, analytical Conceptual, group Mechanical, conceptual Conceptual, mechanical, real— Tootsie Roll Industries, Inc. Mechanical, conceptual Mechanical, conceptual Mechanical, conceptual, analytical Mechanical, conceptual, analytical Conceptual Mechanical, conceptual ____________ *Supplemental Topic, “Other Depreciation Methods.” © The McGraw-Hill Companies, Inc., 2002 35
  2. 2. Cases 9–1 9–2 *9–3 Topic Issues involving useful lives Departures from GAAP Depreciation disclosures Business Week Assignment 9–4 Business Week assignment Internet Assignment 9–1 Researching R&D expenditures Learning Objectives 3 1 3, 8 1, 2, 5 2 Character of Assignment Conceptual, communication, ethics Conceptual, communication, ethics Group assignment, communication, real —International Paper Co. Conceptual, real—Yet2.com Internet, communication ___________ *Supplemental Topic, “Other Depreciation Methods.” 36 © The McGraw-Hill Companies, Inc., 2002
  3. 3. DESCRIPTIONS OF PROBLEMS, CASES, AND INTERNET ASSIGNMENT Below are brief descriptions of each problem, case, and the Internet assignment. These descriptions are accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the partially filled-in working papers. Problems 9–1 Prescott College Students are required to distinguish between capital and revenue expenditures and compute depreciation expense. 25  Easy 9–2 Miller & Hiller, Inc. Students must prepare depreciation schedules using both straight-line and accelerated methods. They must also evaluate income and cash flow issues as they relate to depreciation and the disposal of assets. 45  Medium 9–3 Cole’s Hardware After determining the cost of a depreciable asset, students are required to prepare depreciation schedules under straight-line and accelerated methods. They must also (1) discuss the use of straight-line for financial purposes and accelerated depreciation for income taxes, (2) interpret the meaning of an asset’s book value, and (3) compute the gain or loss resulting from the disposal of a depreciable asset. 50  Strong 9–4 Escola Developers Numerous asset disposal transactions are presented for which students must compute appropriate gains or losses. In addition, students are asked to discuss how gains and losses on the disposal of plant assets are reported in the income statement, and how the reporting of realized gains and losses differs from the reporting of unrealized gains and losses as illustrated in Chapter 7. 25  Medium 9–5 King Carpet Various transactions must be evaluated in order to determine which result in the recording of an intangible asset and which are treated as expenses of the current period. 25  Medium 9–6 Kivi Service Stations Students are asked to compute estimated goodwill using an earnings multiplier approach and a capitalization of excess earnings approach. In addition, they must distinguish between the accounting treatment of purchased goodwill versus the accounting treatment of internally generated goodwill. 20  Medium © The McGraw-Hill Companies, Inc., 2002 37
  4. 4. Cases 9–1 Ethics Case: Extending Useful Lives A look into the responsibilities of management accountants. Do they do as they are told, or is there more to it? 20  Strong 9–2 Ethics Case: “Non-GAAP Reporting” The owner of a closely held business asks the company’s accountant to prepare financial statements that depart from GAAP, and these statements will be presented to lenders. Is there a problem? 20  Strong *9–3 International Paper Company Students are asked to explain who determines a company’s depreciation policies, comment upon the propriety of depreciating different assets by different methods, and explain why accelerated depreciation methods are used for income tax purposes. Based upon the financial disclosures of a well-known corporation. 20  Easy Business Week Assignment 9–4 Business Week Assignment Students are asked to explain whether a company’s patent portfolio should be reported in the balance sheet at its estimated fair market value. The case is based on a Business Week article that highlights an Internet company specializing in finding buyers willing to purchase a company’s unused patents. 20  Easy Internet Assignment 9–1 R&D Expenditures An Internet research problem that requires students to research R&D expenditures in the pharmaceutical industry. No time estimate ____________ *Supplemental Topic, “Other Depreciation Methods.” 38 © The McGraw-Hill Companies, Inc., 2002
  5. 5. SUGGESTED ANSWERS TO DISCUSSION QUESTIONS 1. Coca-Cola’s trademark name was not purchased from another company, but rather was developed internally. Thus, the development costs probably were not material and were treated as revenue expenditures. Even if these costs had been capitalized, they would be amortized over a period of 40 years or less. Thus, any costs associated with this trademark now would be fully amortized, leaving a zero book value. 2. There are three basic “accountable events” in the life of a plant asset: (1) acquisition, (2) allocation of the acquisition cost to expense, and (3) disposal. The second event, allocation of the acquisition cost to expense, typically has the greatest effect upon net income. However, any gain or loss on disposal also affects net income. The allocation of acquisition cost to expense has no effect upon cash flows (other than income taxes). However, the acquisition of plant assets requires cash outlays, and disposals often result in cash receipts. 3. (d) Held for sale in the regular course of business and (e) not capable of rendering benefits to the business in the future. 4. (a) Freight charges, (b) sales taxes on the machine, and (d) wages of employees for time spent in installing and testing the machine before it was placed in service. 5. A capital expenditure is one that is material in amount and will benefit several accounting periods and is therefore charged to an asset account. A revenue expenditure is assumed to benefit only the current period (or is not material in amount) and is charged to an expense account so that it will be deducted from revenue of the current period in the determination of net income. 6. If a capital expenditure (acquisition of an asset) is erroneously treated as a revenue expenditure (an expense), expenses of the current year will be overstated and net income, therefore, will be understated. Since this error also results in the failure to record an asset, net income will be overstated in all future periods in which depreciation should have been recognized on this asset. 7. The entire $220,000 cost should be charged to the land account. The existing structures are of no value to Shoppers’ Market, and soon will be torn down. Thus, the only “asset” being acquired by Shoppers’ is the building site, which is classified as land. 8. (d) Allocation of the cost of a plant asset to the periods in which benefits are received. 9. Yes, depreciation of the building should be continued regardless of rising market value. The building will render useful services for only a limited number of years and its cost should be allocated as expense of those years regardless of fluctuations in market value. 10. An accelerated depreciation method is one that recognizes greater amounts of depreciation expense in the early years of an asset’s life, and less in the later years. These methods are most widely used in income tax returns, as larger deductions for depreciation will reduce both taxable income and the income tax payments due in the immediate future. 11. Under the fixed-percentage-of-declining-balance depreciation method, a fixed depreciation rate is applied to the asset’s undepreciated cost. The “fixed-percentage” is a percentage of the straight-line depreciation rate. This percentage is said to be “fixed” because it does not change over the life of the asset. The declining balance is the asset’s undepreciated cost (or book value), which gets lower every year. The declining-balance method is most widely used in income tax returns. © The McGraw-Hill Companies, Inc., 2002 39
  6. 6. 12. Most companies use only the straight-line method of depreciation in their financial statements. However, these companies also may compute depreciation by several other methods for income tax purposes. For example, they may use MACRS depreciation in their federal income tax returns, and various forms of the declining-balance method in their state income tax returns. 13. The balance of the Accumulated Depreciation account does not consist of cash. It is an account with a credit balance showing how much of the original cost of the plant assets now owned has been written off as depreciation expense. Cash is required to pay for new assets, and the cash owned by the company is shown by the asset account Cash. 14. Two widely used approaches to computing depreciation for a fraction of a year are (1) to round the computation to the nearest full month and (2) the half-year convention, which takes six months of depreciation on all assets (of a given type) acquired during the year. (The half-year convention also requires that six months’ depreciation be recorded in the last year of the asset’s life or year of disposal.) 15. a. No; a company may use different depreciation methods for different assets. The principle of consistency means only that once depreciation begins on a given asset, the same method should be applied throughout its useful life. b. Yes; a corporation may use different depreciation methods in its financial statements and its income tax returns. In fact, most corporations use straight-line depreciation in their financial statements and a variety of accelerated depreciation methods in their tax returns. 16. The usual method of revising depreciation rates to reflect a changed estimate of useful life is to spread the undepreciated cost over the years of remaining useful life. This results in raising or lowering the annual depreciation charge. In this case, the undepreciated cost is $9,000, that is, cost of $15,000 less accumulated depreciation of $6,000. The revised estimate calls for 8 more years of use, so the new depreciation charge will be $9,000 ÷ 8, or $1,125. This method is acceptable for income tax purposes. It also has the theoretical merit of ensuring that depreciation expense as shown in the income statements over the life of the asset will equal the total depreciable cost of the asset. 17. Intangible assets are a subcategory of plant assets which are lacking in physical substance and are noncurrent. An account receivable of the type described is clearly a current asset and hence excluded on that ground from qualifying as an intangible asset even though it is lacking in physical substance. 18. The cost of each type of intangible asset should be amortized over the period estimated to be benefited. This period, however, is not to exceed 40 years. The straight-line method is generally used for the amortization of intangible assets. 19. Goodwill is recorded in the accounts only when purchased. The most common example is that of an ongoing business being purchased as an entity by new owners. If the purchase price is in excess of a fair value of the net identifiable assets of the business, the transaction provides objective evidence that goodwill exists and also provides a basis for objective valuation of this asset. 20. Since average annual earnings of $50,000 represent a return of only 5% on the net tangible assets of $1 million, the goodwill appears to be unsupported by operating performance. Goodwill is defined as the present value of expected excess future earnings, and Digital Products Company appears to have substandard earnings rather than excess earning power. The financial statements therefore give the impression of overstated assets and owners’ equity. Elimination of the item of goodwill would appear to be called for. 40 © The McGraw-Hill Companies, Inc., 2002
  7. 7. 21. Depletion in the amount of $10,000,000 should be deducted from revenue in the current year. The other $2,000,000 of depletion applicable to the current year’s operations will be included in the valuation of the ending inventory. Depletion is a cost of producing inventory. Costs assigned to inventory represent current assets until the goods are sold, at which time the costs are transferred to the Cost of Goods Sold account. 22. An asset is “impaired” when the owner cannot recover the undepreciated cost either through use or sale. In such situations, the carrying value of the asset should be reduced (written down) to net realizable value, which results in the recognition of a loss. 23. The owner of March Metals is in error. When the company discontinued use of the trademark, the unamortized cost of this asset should have been written off immediately. A trademark or other intangible should not be carried as an asset after its usefulness has ended. The 40-year amortization period referred to in the question is the maximum period for amortizing an intangible asset. There is no minimum period of amortization. © The McGraw-Hill Companies, Inc., 2002 41
  8. 8. SOLUTIONS TO EXERCISES Ex. 9–1 a. Two factors have caused the truck to depreciate: (1) physical deterioration and (2) obsolescence. The miles driven during the past six years have caused wear and tear on all of the truck’s major components, including its engine, transmission, brakes, and tires. As these components deteriorate, their fair market values, in turn, depreciate. Furthermore, during the time that you have owned the truck, innovations have been developed leading to improved fuel economy, higher horsepower, better handling, and more corrosionresistant materials. These innovations have made the truck obsolete in many respects. As the design and engineering technologies associated with the truck become more and more outdated, its fair market value will continue to depreciate. b. No. It is not likely that the bank will lend you an additional $5,000, even if you agree to pledge your truck as collateral. Your truck will continue to depreciate rapidly in value each year. By the time you begin repayment of your loan, it will be worth far less to the bank than its current fair market value. c. Depreciation is a process of cost allocation, not a process of valuation. As such, accounting records do not attempt to show the current fair market values of business assets. Only by coincidence would the balance sheet show $10,000 in accumulated depreciation on this truck. Ex. 9–2 42 a. b. c. d. e. f. Capital expenditure Revenue expenditure Revenue expenditure Capital expenditure Revenue expenditure (too small in amount to capitalize regardless of length of useful life) Capital expenditure © The McGraw-Hill Companies, Inc., 2002
  9. 9. Ex. 9–3 Year 1 2 3 4 5 6 7 8 9 Totals (1) (2) (3) (4) (5) a. Straight-Line (Half-Year Convention) $ 59,375 (1) 118,750 (2) 118,750 118,750 118,750 118,750 118,750 118,750 59,375 (1) $950,000 b. 200% Declining-Balance (Half-Year Convention) $125,000 (3) 218,750 (4) 164,063 123,047 92,285 69,214 52,547(5) 52,547 52,547 $950,000 $950,000 × 1⁄8 × 1⁄2 = $59,375 $950,000 × 1⁄8 = $118,750 $1,000,000 × 25% × 1⁄2 = $125,000 ($1,000,000 – $125,000) × 25% = $218,750 Switch to straight-line: ($207,641 –$50,000) ÷ 3 years = $52,547 c. During the first four years of the asset’s life depreciation expense under the straight-line method is significantly less that it is under the accelerated method. Thus, the straight-line method results in the highest net income for these years. © The McGraw-Hill Companies, Inc., 2002 43
  10. 10. Ex. 9–4 a. (1) Straight-Line Schedule Year 1 2 3 4 5 Computation $35,000× 1⁄5 35,000× 1⁄5 35,000× 1⁄5 35,000× 1⁄5 35,000× 1⁄5 Depreciation Expense $7,000 7,000 7,000 7,000 7,000 Accumulated Depreciation $ 7,000 14,000 21,000 28,000 35,000 Book Value $33,000 26,000 19,000 12,000 5,000 Depreciation Expense $16,000 9,600 5,760 3,456 184 Accumulated Depreciation $16,000 25,600 31,360 34,816 35,000 Book Value $24,000 14,400 8,640 5,184 5,000 Depreciation Expense $12,000 8,400 5,880 4,360 4,360 Accumulated Depreciation $12,000 20,400 26,280 30,640 35,000 Book Value $28,000 19,600 13,720 9,360 5,000 (2) 200% Declining-Balance Schedule Year 1 2 3 4 5 Computation $40,000× 40% 24,000× 40% 14,400× 40% 8,640× 40% $5,184 – $5,000 (3) 150% Declining-Balance Schedule Year Computation 1 $40,000× 30% 2 28,000× 30% 3 19,600 × 30% 4* ($13,720 – $5,000) ÷ 2 yrs. 5* ($13,720 – $5,000) ÷ 2 yrs. * Switch to straight-line b. Both accelerated methods result in a higher depreciation expense than the straight-line method in the first two years of the asset’s life. This pattern reverses in years 3 through 5. After four years, 99% of the asset’s total depreciation expense has been recorded under the 200% declining-balance method, as compared to only 88% under the 150% declining-balance method. 44 © The McGraw-Hill Companies, Inc., 2002
  11. 11. Ex. 9–5 a. No, the use of different depreciation methods in financial statements and in income tax returns does not violate the accounting principle of consistency. The principle of consistency means only that a company should not change from year to year the method used to depreciate a given asset. This principle does not prohibit using a different depreciation method for income tax purposes. Also, the principle does not prevent management from using different depreciation methods to depreciate different assets. b. The company probably uses accelerated depreciation methods for income tax purposes because these methods postpone the payment of income taxes. Accelerated depreciation methods transfer the cost of plant assets to expense more quickly than does the straightline method. The resulting larger charges to depreciation expense reduce “taxable income” in the current period and, therefore, reduce the amount of income taxes due currently. c. Use of accelerated depreciation methods in the financial statements would be more “conservative” than the current practice of straight-line depreciation. Accelerated methods more quickly transfer the costs of plant assets to expense. Thus, in the immediate future, accelerated depreciation methods produce more conservative (lower) balance sheet valuations of plant assets and more conservative (lower) measurements of net income. © The McGraw-Hill Companies, Inc., 2002 45
  12. 12. Ex. 9–6 a. 2001 Jan. 11 Machinery.......................................................................... Cash........................................................................ To record purchase of machinery. Dec. 31 Depreciation Expense: Machinery.................................... ............................................................................................ Accumulated Depreciation: Machinery................ To record depreciation for first year: ($90,000 − $18,000) × 1⁄12. 2002-2004 Dec. 31 Depreciation Expense: Machinery.................................... ............................................................................................ Accumulated Depreciation: Machinery................ To record depreciation for years 2002-2004 2005 Dec. 31 Depreciation Expense: Machinery.................................... ............................................................................................ Accumulated Depreciation: Machinery................ To record depreciation for fifth year, based on revised estimate of useful life, determined as follows: Cost of machine.............................................. Less: Depreciation for 2001-2004.................. Book value at end of 2004.............................. Less: Residual value....................................... Amount to be depreciated over 16 remaining years in new estimated useful life....................................................... Depreciation per year ($48,000 ÷ 16)............ 90,000 90,000 6,000 6,000 6,000 6,000 3,000 3,000 $90,000 24,000 $66,000 18,000 $48,000 $ 3,000 b. Several factors that may have caused the company to revise its estimate: (1) The equipment may be deteriorating physically more quickly than originally anticipated, (2) new technology may be contributing to the equipment’s obsolescence, or (3) management may have made a decision that it will trade the equipment after 20 years rather than after 12 years. Ex. 9–7 a. $53,000 ($65,000 less $12,000 trade-in allowance) b. Trade-in allowance................................................................................................ $12,000 18,000 Less: Book value ($52,000 − $34,000).................................................................. Loss on trade-in..................................................................................................... ($ 6,000) c. The $6,000 loss on trade-in will be reported in Bedford’s income statement following the computation of income from operations. 46 © The McGraw-Hill Companies, Inc., 2002
  13. 13. Ex. 9–8 Ex. 9–9 Average earnings................................................................................................... Normal earnings, 15% of $3,000,000................................................................... Excess earnings...................................................................................................... Goodwill ($90,000 ÷ .25)....................................................................................... Fair market value of net identifiable assets........................................................... Price to be offered for Goldtone Appliance Co.................................................... $ 540,000 450,000 $ 90,000 $ 360,000 3,000,000 $3,360,000 a. If the cost of an asset cannot be recovered through future use or sale, the asset should be written-down to its net realizable value. Failure to do so may cause investors and creditors to draw erroneous conclusions concerning the company’s profitability and future cash flow potential. b. The write-down of impaired plant assets reduces income and the asset’s carrying value, but has no immediate impact on the company’s cash flows. Thus, such charges against income are considered noncash transactions. Ex. 9–10 a. Goodwill is the present value of future earnings in excess of normal returns on identifiable assets. It is important to realize that the valuation of goodwill does not attempt to measure past earnings performance. For 30 years Gladstone’s business generated returns in excess of what may be considered normal for a small service station. However, the competitive threat of a new station coming to town, combined with the potential environmental threat of a leaky storage tank, reduces expectations that future performance will equal or exceed past performance. Thus, these issues should reduce, or eliminate completely, Gladstone’s $50,000 estimate of goodwill. b. We have all heard the expression, “let the buyer beware.” To a certain extent, buyers have an obligation to exercise due diligence before making major business decisions. Thus, one could probably argue that Gladstone does not have an ethical “obligation” to disclose that a new service station will soon be built across the street. The situation involving his potentially leaky tank is a different story, however. If he is reasonably certain about the failing condition of the tank, he may have both an ethical and a legal obligation to disclose this information. Again, however, a potential buyer should exercise due diligence prior to buying Gladstone’s business to determine whether an environmental threat exists. Note to instructor: Before making large loans to finance business acquisitions, banks normally require that borrowers engage in certain due diligence procedures which, in many situations, include an “environmental audit.” © The McGraw-Hill Companies, Inc., 2002 47
  14. 14. Ex. 9–11 a. Inventory.................................................................................... Accumulated Depletion: Northern Tier Mine............... To record depletion on the Northern Tier Mine: 50,000 tons mined × $8 per ton [($21,000,000 − $1,000,000) ÷ 2,500,000 tons = $8 per ton]. 400,000 400,000 b. Property, plant, & equipment: Mining property: Northern Tier Mine................................. $21,000,000 Less: Accumulated depletion................................................. 400,000 $20,600,000 c. No; the $400,000 of depletion of the mine should not all be deducted from revenue during the first year of operations. Since only 40,000 of the 50,000 tons of ore mined were sold, only 80% of the depletion cost ($320,000) should be deducted from revenue as part of the cost of goods sold. The remaining 20% of this amount ($80,000) relates to the 10,000 tons of ore still on hand and remains in the inventory account. d. The journal entry in part a increases the current ratio, because it reclassifies an amount of plant assets as inventory, which is a current asset. Thus, current assets are increased. Extracting ore from the ground does make the company more liquid. Mined ore is a more liquid asset than ore that is still in the ground. Ex. 9–12 The purpose of this exercise is to: (1) show students that gains and losses on disposals can be very material in amount, (2) demonstrate that such gains and losses do not directly involve cash flows and, therefore, are typically shown as adjustments to income in the statement of cash flows, and (3) illustrate that the reasons for disposing of fixed assets may include restructuring activities, damage caused by natural disasters, the need to upgrade manufacturing processes, etc. Ex. 9–13 a. $13,000 − $4,000 $9,000 50,000 miles = 50,000 miles = $0.18 per mile b. 1,650,000 miles × $0.18 per mile = $297,000 c. Yes. The units-of-output method recognizes more depreciation in periods in which the cars are driven more—which means that the cars are generating more revenue. The straight-line method would recognize the same amount of depreciation expense regardless of how much the automobiles were used (driven). 48 © The McGraw-Hill Companies, Inc., 2002
  15. 15. Ex. 9–14 a. The company uses both straight-line and accelerated methods to compute depreciation expense for financial reporting purposes. b. The company uses accelerated methods for income tax purposes. c. The following information was taken from the notes to the company’s consolidated financial statements: “Intangible assets represent the excess of cost over the acquired net tangible assets of operating companies and is amortized on a straight-line basis over a 40-year period. Based on this information, one may conclude that the company’s primary intangible asset is goodwill. © The McGraw-Hill Companies, Inc., 2002 49
  16. 16. SOLUTIONS TO PROBLEMS 25 Minutes, Easy PROBLEM 9–1 PRESCOTT COLLEGE a. The cost of plant and equipment includes all expenditures that are reasonable and necessary in acquiring the asset and placing it in a position and condition for use in the operation of the business. b. (1) The purchase price of $250,000 is part of the cost of the equipment. The list price ($275,000) is not relevant, as this is not the actual price paid by Prescott. The $4,500 in interest charges are a charge for borrowing money, not part of the cost of the equipment. These interest charges should be recognized as interest expense over the 90-day life of the note payable. (2) Sales tax is a reasonable and necessary expenditure in the purchase of plant assets and should be included in the cost of the equipment. (3) Freight charges are part of the cost of getting the equipment to a usable location and, therefore, are part of the cost of the equipment. (4) To be used in College operations, the equipment must first be installed. Thus, normal installation charges should be included as part of the cost of the equipment. (5) The accidental damage to one of the terminals was not a “reasonable and necessary” part of the installation process and, therefore, should not be included in the cost of the equipment. The repairs do not make the equipment any more useful than it was before the damage was done. Therefore, the $500 cost of repairing the damage should be offset against revenue of the current period. (Technically, this amount should be classified as a loss in the current period. For practical purposes, however, it probably would be charged to an expense account such as Repairs and Maintenance.) (6) Advertising is viewed by accountants as a revenue expenditure—that is, charged to expense when the advertising occurs. There is not sufficient objective evidence of future benefit for accountants to regard advertising expenditures as creating an asset. PROBLEM 9–1 PRESCOTT COLLEGE (concluded) 50 © The McGraw-Hill Companies, Inc., 2002
  17. 17. c. Expenditures that should be debited to the Computing Equipment account: Purchase price Sales tax Freight charges Installation charges Total cost of the equipment $2500 150 10 50 $2710 0 0 0 0 0 0 0 0 0 0 d. General Journal Dec 31 Depreciation Expense: Computing Equipment Accumulated Depreciation: Computing Equipment To record depreciation of computing equipment in the year of acquisition ($271,000 cost ÷ 5 years) x 1/2. 45 Minutes, Medium © The McGraw-Hill Companies, Inc., 2002 27100 27100 PROBLEM 9–2 MILLER & HILLER, INC. 51
  18. 18. a. (1) Straight-Line Schedule: Year 2001 2002 2003 2004 2005 2006 Computation $100,000 × 1⁄5 × 1⁄2 100,000 × 1⁄5 100,000 × 1⁄5 100,000 × 1⁄5 100,000 × 1⁄5 $100,000 × 1⁄5 × 1⁄2 Depreciation Expense $10,000 20,000 20,000 20,000 20,000 10,000 Accumulated Depreciation $ 10,000 30,000 50,000 70,000 90,000 100,000 Book Value $98,000 78,000 58,000 38,000 18,000 8,000 Depreciation Expense $21,600 34,560 20,736 12,442 7,465 3,197 Accumulated Depreciation $ 21,600 56,160 76,896 89,338 96,803 100,000 Book Value $86,400 51,840 31,104 18,662 11,197 8,000 Depreciation Expense $16,200 27,540 19,278 13,495 11,744 11,743 Accumulated Depreciation $ 16,200 43,740 63,018 76,513 88,257 100,000 Book Value $91,800 64,260 44,982 31,487 19,743 8,000 (2) 200% Declining-Balance Schedule: Year 2001 2002 2003 2004 2005 2006 Computation $108,000 × 40% x 1⁄2 86,400 × 40% 51,840 × 40% 31,104 × 40% 18,662 × 40% 100,000 – 96,803 (3) 150% Declining-Balance Schedule: Year Computation 2001 $108,000 × 30% x 1⁄2 2002 91,800 × 30% 2003 64,260 × 30% 2004 44,982 × 30% 2005* ($31,487 – $8,000) ÷ 2 yrs. 2006* ($31,487 – $8,000) ÷ 2 yrs. * Switch to straight-line PROBLEM 9–2 MILLER & HILLER, INC. (concluded) b. Miller & Hiller will probably use the straight-line method for financial reporting purposes, as this method results in the least amount of depreciation expense in the early years of the asset’s useful life. c. Computation of gains or losses upon disposal: 1. Straight-Line Cash proceeds Book value on 12/31/04 Loss on disposal 52 $30,000 38,000 ($ 8,000) © The McGraw-Hill Companies, Inc., 2002
  19. 19. 2. 200% Declining-Balance: Cash proceeds Book value on 12/31/04 Gain on disposal $30,000 18,662 $11,338 3. 150% Declining-Balance: Cash proceeds Book value on 12/31/04 Loss on disposal $30,000 (31,487) $ 1,487 The reported gain or loss on the sale of an asset has no direct cash effects. The only direct cash effect associated with the sale of this machine is the $30,000 received by Miller & Hiller from the buyer. 50 Minutes, Strong PROBLEM 9–3 COLE’S HARDWARE a. Costs to be depreciated include: Cost of shelving Freight charges Sales taxes Installation Total cost to be depreciated $12,000 520 780 2,700 $16,000 (1) Straight-Line (nearest whole month): Depreciation Expense $600 800 800 800 Accumulated Depreciation $ 600 1,400 2,200 3,000 Book Value $15,400 14,600 13,800 13,000 (2) 200% Declining-Balance (half-year convention): Depreciation Year Computation Expense 1 2001 $ 800 $16,000 × 10% × ⁄2 2002 1,520 15,200 × 10% 2003 1,368 13,680 × 10% 2004 1,231 $12,312 × 10% Accumulated Depreciation $ 800 2,320 3,688 4,919 Book Value $15,200 13,680 12,312 11,081 (3) 150% Declining-Balance (half-year convention): Depreciation Year Computation Expense Accumulated Depreciation Book Value Year 2001 2002 2003 2004 Computation $16,000 × 1⁄20 × 9⁄12 16,000 × 1⁄20 16,000 × 1⁄20 16,000 × 1⁄20 © The McGraw-Hill Companies, Inc., 2002 53
  20. 20. 2001 2002 2003 2004 $16,000 × 7.5% × 1⁄2 15,400 × 7.5% 14,245 × 7.5% 13,177 × 7.5% $ 600 1,155 1,068 988 $ 600 1,755 2,823 3,811 $15,400 14,245 13,177 12,189 PROBLEM 9–3 COLE’S HARDWARE (concluded) b. Cole’s may use the straight-line method in its financial statements to achieve the least amount of depreciation expense in the early years of the shelving’s useful life. In its federal income tax return, Cole’s may use an accelerated method (called MACRS). The use of MACRS will reduce Cole’s taxable income as much as possible in the early year’s of the shelving’s useful life. Thus, management’s goals are really not in conflict. c. The 200% declining-balance method results in the lowest reported book value at the end of 2004 ($11,081). Depreciation, however, is not a process of valuation. Thus, the $11,081 book value is not an estimate of the shelving’s fair market value at the end of 2004. d. A book value of $400 means that accumulated depreciation at the time of the disposal was $8,600. 1. Journal entries assuming that the shelving was sold for $1,000: Cash Accumulated Depreciation: Shelving Shelving Gain on Disposal of Assets 1,000 8,600 9,000 600 To record sale of shelving for $1,000 cash. 2. Journal entries assuming that the shelving was sold for $300: Cash Accumulated Depreciation: Shelving Loss on Sale of Asset Shelving 300 8,600 100 9,000 To record sale of shelving for $300 cash. 25 Minutes, Medium PROBLEM 9–4 ESCOLA DEVELOPERS 54 © The McGraw-Hill Companies, Inc., 2002
  21. 21. a. General Journal Feb 10 Loss on Disposal of Plant Assets Accumulated Depreciation: Office Equipment Office Equipment Scrapped office equipment; received no salvage value. Apr 200 25800 26000 1 Cash Notes Receivable Accumulated Depreciation: Building Land Building Gain on Sale of Plant Assets Sold land and building for a $100,000 cash down payment and a 5-year, 9% note for the balance. 100000 800000 250000 Aug 15 Vehicles (new truck) Accumulated Depreciation: Vehicles (old truck) Vehicles (old truck) Gain on Disposal of Plant Assets Cash To record trade-in of old truck on new; trade-in allowance exceeded book value by $2,000. 39000 18000 Oct 8000 3500 11000 1 Office Equipment (new computer) Loss on Trade-in of Plant Assets Accumulated Depreciation: Office Equip. (old computer) Office Equipment (old computer) Cash Notes Payable Acquired new computer system by trading in old computer, paying part cash, and issuing a 1-year, 8% note payable. Recognized loss equal to book value of old computer ($4,000) minus trade-in allowance ($500). 50000 550000 550000 26000 2000 29000 15000 2500 5000 b. Gains and losses on asset disposals do not affect gross profit because they are not part of the cost of goods sold. Such gains and losses do, however, affect net income reported in a firm’s income statement. c. Unlike realized gains and losses on asset disposals, unrealized gains and losses on marketable securities are not generally reported in a firm’s income statement. Instead, they are reported in the balance sheet as a component of stockholders’ equity. 25 Minutes, Medium © The McGraw-Hill Companies, Inc., 2002 PROBLEM 9–5 KING CARPET CORPORATION 55
  22. 22. a. Operating expense. Although the training of employees probably has some benefit extending beyond the current period, the number of periods benefited is highly uncertain. Therefore, current accounting practice is to expense routine training costs. b. Intangible asset. Goodwill represents the present value of future earnings in excess of what is considered normal. The goodwill associated with King’s purchase of the vinyl flooring company should be amortized over a period not exceeding 15 years. c. Operating expense. Because of the great uncertainty surrounding the potential benefits of R&D programs, the FASB has ruled that research and development costs should be charged to expense in the period in which these costs are incurred. Although the FASB’s position is controversial, it at least has the benefit of reducing the number of alternative accounting practices previously in use, thereby increasing the comparability of financial statements. d. Intangible asset. A patent grants its owner the exclusive right to produce a particular product. If the patent has significant cost, this cost should be regarded as an intangible asset and expensed over the period of time that ownership of the patent will contribute to revenue. In this case, revenue is expected to be earned only over the 6-year period during which the product will be produced and sold. e. Operating expense. Advertising costs are regarded as operating expense because of the difficulty in objectively determining the existence or life of any future benefit. 20 Minutes, Medium PROBLEM 9–6 KIVI SERVICE STATIONS a. Estimated goodwill associated with the purchase of Phil’s Garage: Actual average net income per year $ 250,000 p/e ratio multiplier 9.25 Estimated fair market value of Phil’s Garage $2,312,500 Fair market value of identifiable assets of Phil’s Garage (950,000) Estimated goodwill of Phil’s Garage $1,362,500 b. Estimated goodwill associated with the purchase of Gas N’Go: Actual average net income per year $260,000 Normal earnings for Gas N’Go ($980,000 x 20%) 196,000 Estimated excess earnings of Gas N’ Go $ 64,000 Divided by management’s desired capitalization rate ÷ 25% Estimated goodwill of Gas N’ Go $256,000 c. Due to the difficulties in objectively estimating the value of goodwill, it is recorded only when it is purchased. Kivi may actually have generated internally a significant amount of goodwill associated with its existing service stations. However, because there is no way to objectively measure the excess return potential of these stations, any goodwill they have generated should not be recorded in Kivi’s accounting records. 56 © The McGraw-Hill Companies, Inc., 2002
  23. 23. SOLUTIONS TO CASES 20 Minutes, Strong CASE 9–1 ARE USEFUL LIVES “FLEXIBLE”? AN ETHICS CASE a. Lengthening the period over which assets are depreciated for financial statement purposes will reduce the annual charges to depreciation expense. This will reduce expenses in the income statement and increase net income. But depreciation is only a computation—it is not “paid” in cash on an annual basis. Therefore, changing the estimated useful lives of plant assets will have no effect upon cash flows. b. “Management” is responsible for estimating the useful lives of plant assets. Obviously “management” involves a hierarchy, and in this case, Bedell is in charge. Thus, Bedell can establish the estimated lives as she wishes. Of course, other members of management do not have to go along with Bedell if they strongly disagree. But they do not have the authority to override her judgment— only to protest; and, perhaps, to resign. c. The ethical issue confronting Lynch is whether the change in estimated useful lives is reasonable, or whether it will cause the company’s financial statements to be misleading. On one hand, the fact that the company is experiencing financial difficulties may well indicate that it will not replace assets as quickly as it did in more prosperous times. On the other hand, if Lynch knows that these assets must be replaced after only 5 years, the use of a 10-year depreciation life would be misleading to users of the financial statements. In summary, Lynch must assess the reasonableness of Bedell’s instructions. If the change to a 10year life would not result in the financial statements being misleading, then there is no problem in revising the estimated useful lives. If he believes that this change will result in misleading financial statements, he must refuse to participate in developing such information. Given that he is the controller of the company, he should resign if the CEO insists upon issuing financial statements that he believes to be misleading. 20 Minutes, Strong CASE 9–2 IS “NON-GAAP” REPORTING ETHICAL? © The McGraw-Hill Companies, Inc., 2002 57
  24. 24. a. Showing plant assets at current market values is not in conformity with generally accepted accounting principles (GAAP). GAAP requires these assets to be shown at cost, less any accumulated depreciation (amortization or depletion), and less any write-downs for impairment. b. No. Delta is not a publicly owned company and has no external reporting obligations other than payroll and tax returns. Therefore, it has no obligation—legal or ethical—to issue financial statements conforming to generally accepted accounting principles. It does, however, have an obligation not to mislead anyone to whom it distributes financial information. c. The question facing O’Shaughnessey is whether users of the company’s balance sheet might assume that it was prepared in conformity with generally accepted accounting principles. In this case, they could be misled. In conclusion, there is no reason why Delta—and O’Shaughnessey—cannot prepare financial statements that reflect current market values. However, the basis of asset valuation should be prominently disclosed in the statements, along with an explanation that this valuation method does not conform with generally accepted accounting principles. (Disclosure of the departure from GAAP should be reflected in the titles of the financial statements, as, for example: Balance Sheet (Reflecting Current Market Values). 20 Minutes, Easy CASE 9–3 INTERNATIONAL PAPER COMPANY a. The depreciation methods used in financial statements are determined by management, not by income tax laws. b. No—different depreciation methods may be used for different assets. The principle of consistency only means that a company should not change from year to year the method used to compute depreciation expense on a particular asset. This principle does not prohibit using different methods for different assets, or using different depreciation methods in income tax returns. c. (1) 20 years (a 5% straight-line depreciation rate is equivalent to writing off 1/20 of the asset’s cost each year, indicating a useful life of 20 years). (2) 3 years (a 33% straight-line depreciation rate is equivalent to writing off 1/3 of the asset’s cost each year, indicating a useful life of 3 years). The useful lives over which assets are to be depreciated are determined by management. However, if the company is audited by a CPA firm, the auditors will review these estimates of useful lives to determine that they are reasonable. d. Accelerated depreciation methods transfer the costs of plant assets to expense more quickly than does the straight-line method. These larger charges to depreciation expense reduce the amount of “taxable income” and, therefore, reduce the amount of income taxes currently due. 15 Minutes, Medium 58 CASE 9–4 BUSINESS WEEK ASSIGNMENT © The McGraw-Hill Companies, Inc., 2002
  25. 25. The unused patents should not be reported in the balance sheet at the minimum intended selling price of $250,000. Instead, they should be reported in the balance sheet at their $50,000 cost, net of any accumulate amortization. This treatment is no different than reporting an unused piece of machinery in the balance sheet at historical cost net of accumulated depreciation. Should the equipment be sold for an amount in excess of its net book value, a gain would be recorded at the point of sale. Likewise, should the unused patents be sold for $250,000, a realized gain would be recorded at that time. © The McGraw-Hill Companies, Inc., 2002 59
  26. 26. SOLUTION TO INTERNET ASSIGNMENT No time estimate INTERNET 9–1 R&D EXPENDITURES A keyword search of Pharmaceutical Companies will result in an extensive list of firms. The list will include extremely profitable industry giants whose R&D expenditures typically amount to 15% to 25% of total costs and expenses. In addition, many smaller companies whose primary business activity is researching and developing new drugs will be listed. The R&D expenditures of these firms can amount to as much as 75% to 90% of total costs and expenses. Many of these companies will report very little (if any) sales activity, as all of their products are still in the development stage. Once they have developed a promising new drug, these smaller companies are usually acquired by large pharmaceutical firms which have the financial resources to manufacture and distribute the new drug on a large-scale basis. 60 © The McGraw-Hill Companies, Inc., 2002

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