Chapter 11 Operational Assets: Utilization and

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1 Chapter 11 Operational Assets: Utilization and Impairment QUESTIONS FOR REVIEW OF KEY TOPICS Question 11-1 The terms depreciation, depletion, and amortization all refer to the process of allocating the cost of an operational asset to periods of use. The only difference between the terms is that they refer to different types of operational assets; depreciation for plant and equipment, depletion for natural resources, and amortization for intangibles. Question 11-2 The term depreciation often is confused with a decline in value or worth of an asset. Depreciation is not measured as decline in value from one period to the next. Instead, it involves the distribution of the cost of an asset, less any anticipated residual value, over the asset's estimated useful life in a systematic and rational manner that attempts to match revenues with the use of the asset. Question 11-3 The process of cost allocation for operational assets requires that three factors be established at the time the asset is put into use. These factors are: 1. Service (useful) life The estimated use that the company expects to receive from the asset. 2. Allocation base The value of the usefulness that is expected to be consumed. 3. Allocation method The pattern in which the usefulness is expected to be consumed. Question 11-4 Physical life provides the upper bound for service life. Physical life will vary according to the purpose for which the asset is acquired and the environment in which it is operated. Service life may be less than physical life for several reasons. For example, the expected rate of technological changes may shorten service life. Management intent also may shorten the period of an asset s usefulness below its physical life. For instance, a company may have a policy of using its delivery trucks for a three-year period before trading the trucks for new models. Question 11-5 The total amount of depreciation to be recorded during an asset s service life is called its depreciable base. This amount is the difference between the initial value of the asset at its acquisition (its cost) and its residual value. Residual or salvage value is the amount the company expects to receive for the asset at the end of its service life less any anticipated disposal costs. Solutions Manual, Vol.1, Chapter

2 Answers to Questions (continued) Question 11-6 Activity-based allocation methods estimate service life in terms of some measure of productivity. Periodic depreciation or depletion is then determined based on the actual productivity generated by the asset during the period. Time-based allocation methods estimate service life in years. Periodic depreciation or amortization is then determined based on the passage of time. Question 11-7 The straight-line depreciation method allocates an equal amount of depreciable base to each year of an asset s service life. Accelerated depreciation methods allocate higher portions of depreciable base to the early years of the asset s life and lower amounts of depreciable base to later years. Total depreciation is the same by either approach. Question 11-8 Theoretically, the use of activity-based depreciation methods would provide a better matching of revenues and expenses. Clearly, the productivity of a plant asset is more closely associated with the benefits provided by that asset than the mere passage of time. However, activity-based methods quite often are either infeasible or too costly to use. For example, buildings do not have an identifiable measure of productivity. For assets such as machinery, there may be an identifiable measure of productivity, such as machine hours or units produced, but it is more costly to determine the amount each period than it is to simply measure the passage of time. For these reasons, most companies use time-based depreciation methods. Question 11-9 Companies might use the straight-line method because they consider that the benefits derived from the majority of plant assets are realized approximately evenly over these assets useful lives. It also is the easiest method to understand and apply. The effect on net income also could explain why so many companies prefer the straight-line method to the accelerated methods. Straight line produces a higher net income in the early years of an asset s life. Net income can affect bonuses paid to management, or debt agreements with lenders. Income taxes are not a factor in determining the depreciation method because a company is not required to use the same depreciation method for both financial reporting and income tax purposes. Question The group approach to aggregation is applied to a collection of depreciable assets that share similar service lives and other attributes. For example, group depreciation could be used for fleets of vehicles or collections of machinery. The composite approach to aggregation is applied to dissimilar operating assets, such as all of the depreciable assets in one manufacturing plant. Individual assets in the composite may have diverse service lives. Both approaches are similar in that they involve applying a single straight-line rate based on the average service lives of the assets in the group or composite Intermediate Accounting, 4/e

3 Answers to Questions (continued) Question The allocation of the cost of a natural resource to periods of use is called depletion. The process otherwise is identical to depreciation. The activity-based units-of-production method is the predominant method used to calculate depletion, not the time-based straight-line method. Question The amortization of intangible assets is based on the same concepts as depreciation and depletion. The capitalized cost of an intangible asset that has a finite useful life must be allocated to the periods the company expects the asset to contribute to its revenue generating activities. Intangibles, though, generally have no residual values, so the amortizable base is simply cost. Also, intangibles possess no physical life to provide an upper bound to service life. However, most intangibles have a legal or contractual life that limits useful life. Intangible assets that have indefinite useful lives, including goodwill, are not amortized. Question A company can calculate depreciation based on the actual number of days or months the asset was used during the year. A common simplifying convention is to record one-half of a full year s expense in the years of acquisition and disposal. This is known as the half-year convention. The modified half-year convention records a full year s expense when the asset is acquired in the first half of the year or sold in the second half. No expense is recorded when the asset is acquired in the second half of the year or sold in the first half. Question A change in the service life of an operational asset is accounted for as a change in an estimate. The change is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life. Question A change in depreciation method is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life using the new depreciation method, exactly as we would account for a change in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle and therefore requires a clear justification as to why the new method is preferable. A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods. Solutions Manual, Vol.1, Chapter

4 Answers to Questions (concluded) Question If a material error is discovered in an accounting period subsequent to the period in which the error is made, previous years financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share. Question An impairment in the value of an operational asset results when there has been a significant decline in value below carrying value (book value). For tangible operational assets and intangibles with finite useful lives, GAAP require an entity to recognize an impairment loss only when the undiscounted sum of estimated future cash flows from an asset is less than the asset s book value. The loss recognized is the amount by which the book value exceeds the fair value of the asset or group of assets when the fair value is readily determinable. If fair value is not determinable, it must be estimated. One method of estimating fair value is to compute the present value of estimated future cash flows from the asset or group of assets. For intangible operational assets other than goodwill, if book value exceeds fair value, an impairment loss is recognized for the differences. For goodwill, an impairment loss is indicated if the fair value of the reporting unit is less than its book value. A goodwill impairment loss is measured as the excess of book value of goodwill over its implied fair value. For operational assets held for sale, if book value exceeds fair value, an impairment loss is recognized for the difference. Question Repairs and maintenance are expenditures made to maintain a given level of benefits provided by the asset and do not increase future benefits. Expenditures for these activities should be expensed in the period incurred. Additions involve adding a new major component to an existing asset. These expenditures usually are capitalized. Improvements are expenditures for the replacement of a major component of an operational asset. The costs of improvements usually are capitalized. Rearrangements are expenditures to restructure an operational asset without addition, replacement, or improvement. The objective is to create a new capability for the asset and not necessarily to extend useful life. The costs of material rearrangements should be capitalized if they clearly increase future benefits Intermediate Accounting, 4/e

5 BRIEF EXERCISES Brief Exercise 11-1 Depreciation is a process of cost allocation, not valuation. Koeplin should not record depreciation expense of $18,000 for year one of the machine s life. Instead, it should distribute the cost of the asset, less any anticipated residual value, over the estimated useful life in a systematic and rational manner that attempts to match revenues with the use of the asset, not the periodic decline in its value. Solutions Manual, Vol.1, Chapter

6 Brief Exercise 11-2 a. Straight-line: $30,000-2,000 4 years = $7,000 per year b. Sum-of-the-years digits: Sum-of-the-digits is ([4 (4 + 1)] 2) = $28,000 x 4/10 = $11, $28,000 x 3/10 = $ 8,400 c. Double-declining balance: Straight-line rate is 25% (1 4 years) x 2 = 50% DDB rate 2006 $30,000 x 50% = $15, ($30,000-15,000) x 50% = $ 7,500 d. Units-of-production: $30,000-2,000 10,000 hours = $2.80 per unit depreciation rate ,200 hours x $2.80 = $6, ,000 hours x $2.80 = $8, Intermediate Accounting, 4/e

7 Brief Exercise 11-3 a. Straight-line: $30,000-2,000 4 years = $7,000 per year 2006 $7,000 x 9/12 = $5, $7,000 x 12/12 = $7,000 b. Sum-of-the-years digits: Sum-of-the-digits is ([4 (4 + 1)] 2) = $28,000 x 4/10 x 9/12 = $8, $28,000 x 4/10 x 3/12 = $2,800 + $28,000 x 3/10 x 9/12 = 6,300 $9,100 c. Double-declining balance: Straight-line rate is 25% (1 4 years) x 2 = 50% DDB rate 2006 $30,000 x 50% x 9/12 = $11, $30,000 x 50% x 3/12 = $ 3,750 + ($30,000 15,000) x 50% x 9/12 = 5,625 $ 9,375 or, 2007 ($30,000 11,250) x 50% = $ 9,375 Solutions Manual, Vol.1, Chapter

8 Brief Exercise 11-4 Annual depreciation will equal the group rate multiplied by the depreciable base of the group: ($425,000 40,000) x 18% = $69,300 Since depreciation records are not kept on an individual asset basis, dispositions are recorded under the assumption that the book value of the disposed item exactly equals any proceeds received and no gain or loss is recorded. Any actual gain or loss is implicitly included in the accumulated depreciation account. Journal entry (not required): Cash... 35,000 Accumulated depreciation (difference)... 7,000 Equipment (account balance)... 42,000 Brief Exercise 11-5 $8,250,000 Depletion per ton = = $2.75 per foot 3,000,000 cubic feet 2006 depletion = $2.75 x 700,000 feet = $1,925, depletion = $2.75 x 800,000 feet = $2,200, Intermediate Accounting, 4/e

9 Brief Exercise 11-6 Expenses for 2006 include: In-process R & D = $2,000,000 Amortization of the patent = 400,000 Amortization of the developed technology * = 300,000 Total $2,700,000 Goodwill is not amortized. Amortization of the patent: ($4,000,000 5) x 6/12 = $400,000 *Amortization of the developed technology: ($3,000,000 5) x 6/12 = $300,000 Brief Exercise 11-7 Calculation of annual depreciation after the estimate change: $9,000,000 Cost $320,000 Old annual depreciation ($8 million 25 years) x 2 years 640,000 Depreciation to date ( ) 8,360,000 Undepreciated cost 500,000 Revised residual value 7,860,000 Revised depreciable base 18 Estimated remaining life - 18 years (20-2) $ 436, depreciation Solutions Manual, Vol.1, Chapter

10 Brief Exercise 11-8 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Robotics reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the double-declining balance method from now on. The undepreciated cost remaining at the time of the change would be depreciated DDB over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Asset s cost $9,000,000 Accumulated depreciation to date* (640,000) Undepreciated cost, Jan. 1, 2006 $8,360,000 x 2/23 Double-declining balance depreciation for 2006 $ 726,957 *$8,000, = $320,000 x 2 years = $640,000 Remaining life is 23 years. Twice the straight-line rate is 2/ Intermediate Accounting, 4/e

11 Brief Exercise 11-9 If a material error is discovered in an accounting period subsequent to the period in which the error is made, previous years financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share. In this case, depreciation of $32,000 should have been $320,000 ($8,000, years). Therefore, 2004 income before tax is overstated by $288,000 ($320,000 32,000) and accumulated depreciation is understated by the same amount. The following journal entry is needed to record the error correction (ignoring income tax): Retained earnings ,000 Accumulated depreciation ,000 Depreciation for 2006 would be $320,000. Brief Exercise Because the undiscounted sum of future cash flows of $28 million exceeds book value of $26.5 million, there is no impairment loss. Solutions Manual, Vol.1, Chapter

12 Brief Exercise Because the undiscounted sum of future cash flows of $24 million is less than book value of $26.5 million, there is an impairment loss. The impairment loss is calculated as follows: Book value Fair value Impairment loss $26.5 million 21.0 million $ 5.5 million Brief Exercise Recoverability: Because the book value of SCC s net assets of $42 million exceeds fair value of $40 million, an impairment loss is indicated. Determination of implied value of goodwill: Fair value of SCC Less: Fair value of SCC s assets (excluding goodwill) Implied goodwill Measurement of impairment loss: Book value of goodwill Less: Implied value of goodwill Impairment loss $40 million 31 million $ 9 million $15 million 9 million $ 6 million Brief Exercise Recoverability: Because the book value of SCC s net assets of $42 million is less than the fair value of $44 million, an impairment loss is not indicated Intermediate Accounting, 4/e

13 Brief Exercise Annual maintenance on machinery, $5,400 - This is an example of normal repairs and maintenance. Future benefits are not increased; therefore the expenditure should be expensed in the period incurred. Remodeling of offices, $22,000 - This is an example of an improvement. The cost of the remodeling should be capitalized and depreciated, either by (1) substitution, (2) direct capitalization of the cost, or (3) a reduction of accumulated depreciation. Rearrangement of the shipping and receiving area, $35,000 - This is an example of a rearrangement. Because the rearrangement increased productivity, the cost should be capitalized and depreciated. Addition of a security system, $25,000 - This is an example of an addition. The cost of the security system should be capitalized and depreciated. Solutions Manual, Vol.1, Chapter

14 EXERCISES Exercise Straight-line: $33,000-3,000 5 years = $6,000 per year 2. Sum-of-the-years digits: Year Depreciable Base X Depreciation Rate per Year = Depreciation 2006 $30,000 5 $10, , , , , , , , , Total $30, Intermediate Accounting, 4/e

15 Exercise 11-1 (concluded) 3. Double-declining balance: Straight-line rate of 20% (1 5 years) x 2 = 40% DDB rate. Book Value Beginning of Year Depreciation Rate per Year = Book Value End of Year Year X Depreciation 2006 $33,000 40% $ 13,200 $19, ,800 40% 7,920 11, ,880 40% 4,752 7, ,128 40% 2,851 4, ,277 * 1,277 * 3,000 Total $30,000 * Amount necessary to reduce book value to residual value 4. Units-of-production: $33,000-3, ,000 miles = $.30 per mile depreciation rate Actual Miles Driven X Depreciation Rate per Mile = Book Value End of Year Year Depreciation ,000 $.30 $6,600 $26, , ,200 19, , ,500 14, , ,000 8, ,000 * 5,700 * 3,000 Totals 102,000 $30,000 * Amount necessary to reduce book value to residual value Solutions Manual, Vol.1, Chapter

16 Exercise Straight-line: $115,000-5, years = $11,000 per year 2. Sum-of-the-years digits: Sum-of-the-digits is ([10 (10 + 1)] 2) = $110,000 x 10/55 = $20, $110,000 x 9/55 = $18, Double-declining balance: Straight-line rate is 10% (1 10 years) x 2 = 20% DDB rate 2006 $115,000 x 20% = $23, ($115,000-23,000) x 20% = $18, One hundred fifty percent declining balance: Straight-line rate is 10% (1 10 years) x 1.5 = 15% rate 2006 $115,000 x 15% = $17, ($115,000-17,250) x 15% = $14, Units-of-production: $115,000-5, ,000 units = $.50 per unit depreciation rate ,000 units x $.50 = $15, ,000 units x $.50 = $12, Intermediate Accounting, 4/e

17 Exercise Straight-line: $115,000-5, years = $11,000 per year 2006 $11,000 x 3/12 = $ 2, $11,000 x 12/12 = $11, Sum-of-the-years digits: Sum-of-the-digits is {[10 (10 + 1)]/2} = $110,000 x 10/55 x 3/12 = $ 5, $110,000 x 10/55 x 9/12 = $15,000 + $110,000 x 9/55 x 3/12 = 4,500 $19, Double-declining balance: Straight-line rate is 10% (1 10 years) x 2 = 20% DDB rate 2006 $115,000 x 20% x 3/12 = $5, $115,000 x 20% x 9/12 = $17,250 + ($115,000-23,000) x 20% x 3/12 = 4,600 $21,850 or, 2007 ($115,000-5,750) x 20% = $21, One hundred fifty percent declining balance: Straight-line rate is 10% (1 10 years) x 1.5 = 15% rate 2006 $115,000 x 15% x 3/12 = $ 4, $115,000 x 15% x 9/12 = $12,937 + ($115,000-17,250) x 15% x 3/12 = 3,666 $16,603 Or, Solutions Manual, Vol.1, Chapter

18 2007 ($115,000-4,313) x 15% = $16, Intermediate Accounting, 4/e

19 Exercise 11-3 (concluded) 5. Units-of-production: $115,000-5, ,000 units = $.50 per unit depreciation rate ,000 units x $.50 = $ 5, ,000 units x $.50 = $12,500 Exercise 11-4 Building depreciation: $5,000, , years = $160,000 per year Building addition depreciation: Remaining useful life from June 30, 2006 is 27.5 years. $1,650, years = $60,000 per year 2006 $60,000 x 6/12 = $30, $60,000 x 12/12 = $60,000 Solutions Manual, Vol.1, Chapter

20 Exercise 11-5 Asset A: Straight-line rate is 20% (1 5 years) x 2 = 40% DDB rate $24, = $60,000 = Book value at the beginning of year 2 Cost - (Cost x 40%) = $60,000.60Cost = $60,000 Cost = $100,000 Asset B: Sum-of-the-digits is 36 {[8 (8 + 1)] 2} ($40,000 - residual) x 7/36 = $7,000 $280,000-7residual = $252,000 7residual = $28,000 Residual = $4,000 Asset C: $65,000-5,000 Life = $6,000 Life = 10 years Asset D: $230,000 - $10,000 = $220,000 depreciable base $220, years = $22,000 per year Method used is straight-line. Asset E: Straight-line rate is 12.5% (1 8 years) x 1.5 = 18.75% rate Year 1 $200,000 x 18.75% = $37,500 Year 2 ($200,000-37,500) x 18.75% = $30, Intermediate Accounting, 4/e

21 Exercise b 2. b 3. b 4. a Exercise 11-7 Requirement 1 Asset Cost Residual Value Depreciable Base Estimated Life(yrs.) Depreciation per Year (straight line) Stoves $15,000 $3,000 $12,000 6 $2,000 Refrigerators 10,000 1,000 9, ,800 Dishwashers 8, , ,875 Totals $33,000 $4,500 $28,500 $5,675 Group depreciation rate = $5,675 $33,000 = 17.2% (rounded) Group life = $28,500 $5,675 Requirement 2 To record the purchase of new refrigerators. = 5.02 years (rounded) Refrigerators... 2,700 Cash... 2,700 To record the sale of old refrigerators. Cash Accumulated depreciation (difference)... 1,300 Refrigerators... 1,500 Solutions Manual, Vol.1, Chapter

22 Exercise 11-8 Requirement 1 Cost of the equipment: Purchase price $154,000 Freight charges 2,000 Installation charges 4,000 $160,000 Straight-line rate of 12.5% (1 8 years) x 2 = 25% DDB rate. Year Book Value Beginning of Year Depreciation X Rate per Year = Depreciation Book Value End of Year 2006 $160,000 25% $ 40,000 $120, ,000 25% 30,000 90, ,000 25% 22,500 67, ,500 25% 16,875 50, ,625 * 5,000 45, ,625 * 5,000 40, ,625 * 5,000 35, ,625 * 5,000 30,625 Total $129,375 * Switch to straight-line in 2010: Straight-line depreciation: $50,625-30,625 4 years = $5,000 per year Requirement 2 For plant and equipment used in the manufacture of a product, depreciation is a product cost and is included in the cost of inventory. Eventually, when the product is sold, depreciation will be included in cost of goods sold Intermediate Accounting, 4/e

23 Exercise 11-9 Requirement 1 $4,500,000 Depletion per ton = = $5.00 per ton 900,000 tons 2006 depletion = $5.00 x 240,000 tons = $1,200,000 Requirement 2 Depletion is part of product cost and is included in the cost of the inventory of coal, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion is then included in cost of goods sold in the income statement when the coal is sold. Solutions Manual, Vol.1, Chapter

24 Exercise Requirement 1 Cost of copper mine: Mining site $1,000,000 Development costs 600,000 Restoration costs 303,939 $1,903,939 $300,000 x 25% = $ 75, ,000 x 40% = 160, ,000 x 35% = 210,000 $445,000 x.68301* = $303,939 *Present value of $1, n = 4, i = 10% Depletion: Depletion per pound = $1,903,939 10,000,000 pounds = $.1904 per pound 2006 depletion = $.1904 x 1,600,000 pounds = $304, depletion = $.1904 x 3,000,000 pounds = $571,200 Depreciation: Depreciation per pound = $120,000-20,000 10,000,000 pounds = $.01 per pound 2006 depreciation = $.01 x 1,600,000 pounds = $16, depreciation = $.01 x 3,000,000 pounds = $30,000 Requirement 2 Depletion of natural resources and depreciation of assets used in the extraction of natural resources are part of product cost and are included in the cost of the inventory of copper, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion and depreciation are then included in cost of goods sold in the income statement when the copper is sold Intermediate Accounting, 4/e

25 Exercise Requirement 1 a. To record the purchase of a patent. January 1, 2004 Patent ,000 Cash ,000 To record amortization on the patent. December 31, 2004 and 2005 Amortization expense ($700, years)... 70,000 Patent... 70,000 b. To record the purchase of a franchise Franchise ,000 Cash ,000 c. To record research and development expenses Research and development expense ,000 Cash ,000 Solutions Manual, Vol.1, Chapter

26 Exercise (concluded) Year-end adjusting entries Patent: To record amortization on the patent. December 31, 2006 Amortization expense (determined below) ,000 Patent ,000 Calculation of annual amortization after the estimate change: ($ in thousands) $700 Cost $70 Old annual amortization ($ years) x 2 years 140 Amortization to date ( ) 560 Unamortized cost (balance in the patent account) 5 Estimated remaining life $112 New annual amortization Franchise: To record amortization of franchise. December 31, 2006 Amortization expense ($500, years)... 50,000 Franchise... 50,000 Requirement 2 Intangible assets: Patent $448,000 [1] Franchise 450,000 [2] Total intangibles $898,000 [1] $560, , Intermediate Accounting, 4/e

27 [2] $500,000-50,000 Exercise To record the purchase of a patent. January 2, 2006 Patent ,000 Cash ,000 To record amortization of a patent for the year Amortization expense ($500,000 8 years)... 62,500 Patent... 62,500 To record amortization of the patent for the year Amortization expense ($500,000 8 years)... 62,500 Patent... 62,500 To record costs of successfully defending a patent infringement suit. January, 2008 Patent... 45,000 Cash... 45,000 Solutions Manual, Vol.1, Chapter

28 Exercise (concluded) To record amortization of patent for the year Amortization expense (determined below)... 70,000 Patent... 70,000 Calculation of revised annual amortization: ($ in thousands) $500 Cost $62.5 Old annual amortization ($500 8 years) x 2 years 125 Amortization to date ( ) 375 Unamortized cost (balance in the patent account) 45 Add 420 New unamortized cost 6 Estimated remaining life (8 years 2 years) $ 70 New annual amortization Exercise ($ in millions) Amortization expense (determined below) Patent Calculation of annual amortization after the estimate change: $ in millions) $9 Cost $1 Old annual amortization ($9 9 years) x 4 years 4 Amortization to date ( ) 5 Unamortized cost (balance in the patent account) 2 Estimated remaining life (6 years 4 years) $2.5 New annual amortization Intermediate Accounting, 4/e

29 Exercise Requirement 1 Depreciation expense (determined below)... 3,088 Accumulated depreciation - computer... 3,088 Calculation of annual depreciation after the estimate change: $40,000 Cost $7,200 Old annual depreciation ($36,000 5 years) x 2 years 14,400 Depreciation to date ( ) 25,600 Undepreciated cost 900 Revised residual value 24,700 Revised depreciable base 8 Estimated remaining life (10 years - 2 years) $ 3,088 New annual depreciation Requirement 2 Depreciation expense (determined below)... 3,889 Accumulated depreciation - computer... 3,889 Calculation of annual depreciation after the estimate change: $40,000 Cost Old depreciation: $12, ($36,000 x 5/15) 9, ($36,000 x 4/15) 21,600 Depreciation to date ( ) 18,400 Undepreciated cost 900 Revised residual value 17,500 Revised depreciable base x 8/36 Estimated remaining life - 8 years $ 3, depreciation Solutions Manual, Vol.1, Chapter

30 Exercise SYD depreciation [ x ($ ) million] = $589, $1,500,000 Cost 589,091 Depreciation to date, SYD ( ) 910,909 Undepreciated cost as of 1/1/06 300,000 Less residual value 610,909 Depreciable base 7 yrs. Remaining life (10 years - 3 years) $ 87,273 New annual depreciation Adjusting entry (2006 depreciation): Depreciation expense (calculated above)... 87,273 Accumulated depreciation... 87, Intermediate Accounting, 4/e

31 Exercise Requirement 1 In general, we report voluntary changes in accounting principles retrospectively. However, a change in depreciation method is considered a change in accounting estimate resulting from a change in accounting principle. In other words, a change in the depreciation method reflects a change in the (a) estimated future benefits from the asset, (b) the pattern of receiving those benefits, or (c) the company s knowledge about those benefits, and therefore the two events should be reported the same way. Accordingly, Clinton reports the change prospectively; previous financial statements are not revised. Instead, the company simply employs the straight-line method from now on. The undepreciated cost remaining at the time of the change would be depreciated straight-line over the remaining useful life. A disclosure note should justify that the change is preferable and describe the effect of the change on any financial statement line items and per share amounts affected for all periods reported. Requirement 2 Asset s cost $2,560,000 Accumulated depreciation to date (given) (1,650,000) Undepreciated cost, Jan. 1, 2006 $ 910,000 Estimated residual value (160,000) To be depreciated over remaining 3 years $ 750,000 3 years Annual straight-line depreciation $ 250,000 Adjusting entry: Depreciation expense (calculated above) ,000 Accumulated depreciation ,000 Solutions Manual, Vol.1, Chapter

32 Exercise Requirement 1 Analysis: Correct (Should Have Been Recorded) Incorrect (As Recorded) 2003 Machine 350,000 Expense 350,000 Cash 350,000 Cash 350, Expense 70,000 Depreciation entry omitted Accum. deprec. 70, Expense 70,000 Depreciation entry omitted Accum. deprec. 70, Expense 70,000 Depreciation entry omitted Accum. deprec. 70,000 During the three-year period, depreciation expense was understated by $210,000, but other expenses were overstated by $350,000, so net income during the period was understated by $140,000, which means retained earnings is currently understated by that amount. During the three-year period, accumulated depreciation was understated, and continues to be understated by $210,000. To correct incorrect accounts Machine ,000 Accumulated depreciation ($70,000 x 3 years).. 210,000 Retained earnings ($350, ,000) ,000 Requirement 2 Correcting entry: Assuming that the machine had been disposed of, no correcting entry would be required because, after five years, the accounts would show appropriate balances Intermediate Accounting, 4/e

33 Exercise Requirement 1 Book value Fair value Impairment loss $6.5 million 3.5 million 3.0 million Requirement 2 Because the undiscounted sum of future cash flows of $6.8 million exceeds book value of $6.5 million, there is no impairment loss. Exercise Requirement 1 Determination of implied goodwill: Fair value of Centerpoint, Inc. Fair value of Centerpoint s net assets (excluding goodwill) Implied value of goodwill Measurement of impairment loss: Book value of goodwill Implied value of goodwill Impairment loss $220 million 200 million $ 20 million $50 million 20 million $30 million Requirement 2 Because the fair value of the reporting unit, $270 million, exceeds book value, $250 million, there is no impairment loss. Solutions Manual, Vol.1, Chapter

34 Exercise To record the replacement of the heating system. Accumulated depreciation - building ,000 Cash , To record the addition to the building. Building ,000 Cash , To expense annual maintenance costs. Maintenance expense... 14,000 Cash... 14, To capitalize rearrangement costs. Machinery... 50,000 Cash... 50, Intermediate Accounting, 4/e

35 Exercise Requirement 1 Cash... 17,000 Accumulated depreciation - lathe (determined below)... 56,250 Loss on sale (difference)... 6,750 Lathe (balance)... 80,000 Accumulated depreciation: $80,000-5,000 Annual depreciation = = $15,000 5 years 2002 $15,000 x 1/2 = $ 7, , , , $15,000 x 1/4 = 3,750 Total $56,250 Solutions Manual, Vol.1, Chapter

36 Exercise (concluded) Requirement 2 Cash... 17,000 Accumulated depreciation - lathe (determined below)... 67,500 Gain on sale (difference)... 4,500 Lathe (balance)... 80,000 Accumulated depreciation: Sum-of-the-digits is ([5 (5 + 1)]/2) = $75,000 x 5/15 x 6/12 = $12, $75,000 x 5/15 x 6/12 = $12,500 + $75,000 x 4/15 x 6/12 = 10,000 22, $75,000 x 4/15 x 6/12 = $10,000 + $75,000 x 3/15 x 6/12 = 7,500 17, $75,000 x 3/15 x 6/12 = $ 7,500 + $75,000 x 2/15 x 6/12 = 5,000 12, $75,000 x 2/15 x 3/12 = 2,500 Total $67,500 Exercise d 2. b 3. b 4. a Intermediate Accounting, 4/e

37 Exercise List A List B g 1. Depreciation a. Cost allocation for natural resource. d 2. Service life b. Accounted for prospectively. f 3. Depreciable base c. When there has been a significant decline in value. e 4. Activity-based method d. The amount of use expected from an operational asset. m 5. Time-based method e. Estimates service life in units of output. h 6. Double-declining balance f. Cost less residual value. j 7. Group method g. Cost allocation for plant and equipment. k 8. Composite method h. Does not subtract residual value from cost. a 9. Depletion i. Accounted for the same way as a change in estimate. l 10. Amortization j. Aggregates assets that are similar. b 11. Change in useful life k. Aggregates assets that are physically unified. i 12. Change in depreciation method l. Cost allocation for an intangible asset. c 13. Write-down of asset m. Estimates service life in years. Solutions Manual, Vol.1, Chapter

38 Exercise d. Because 50% of the original estimate of quality ore was recovered during the years 1997 through 2004, recorded depletion of $250,000 [50% x ($600,000 - $100,000 salvage value)]. In 2005, the earlier depletion of $250,000 is deducted from the $600,000 cost along with the $100,000 salvage value. The remaining depletable cost of $250,000 will be allocated over the 250,000 tons believed to remain in the mine. The $1 per ton depletion is then multiplied times the tons mined each year.. 2. a. The cost should be amortized over the remaining legal life or useful life, whichever is shorter. In addition to the initial costs of obtaining a patent, legal fees incurred in the successful defense of a patent should be capitalized as part of the cost, whether it was internally developed or purchased from an inventor. The legal fees capitalized then should be amortized over the remaining useful life of the patent. 3. a. Given that the company paid $6,000,000 for net assets acquired with a fair value of $5,496,000, goodwill was $504,000. Under SFAS 142, Goodwill and Other Intangible Assets, purchased goodwill is not amortized but is tested annually for impairment Intermediate Accounting, 4/e

39 Exercise Requirement 1 To record the acquisition of small tools Small tools... 8,000 Cash... 8,000 To record additional small tool acquisitions Small tools... 2,500 Cash... 2,500 To record the sale/depreciation of small tools Cash Depreciation expense (difference)... 1,750 Small tools... 2,000 Solutions Manual, Vol.1, Chapter

40 Exercise (concluded) Requirement 2 To record the acquisition of small tools Small tools... 8,000 Cash... 8,000 To record the replacement/depreciation of small tools Depreciation expense... 2,500 Cash... 2,500 To record the sale of small tools Cash Depreciation expense Intermediate Accounting, 4/e

41 PROBLEMS Problem 11-1 Requirement 1 Determine useful life: $200,000 depreciable base $10,000 annual depreciation = 20-year useful life Determine age of assets: $40,000 accumulated depreciation $10,000 annual depreciation = 4 years old Double-declining balance in 4th year of life: Year 1 (2003) $200,000 x 10% = $20,000 Year 2 (2004) 180,000 x 10% = 18,000 Year 3 (2005) 162,000 x 10% = 16,200 Year 4 (2006) 145,800 x 10% = 14,580 Requirement 2 Depreciation expense (below)... 20,000 Accumulated depreciation... 20,000 $200,000 Cost 30,000 Depreciation to date, SL 3 years ( ) $170,000 Undepreciated cost as of 1/1/06 Seventeen-year remaining life, or 1/17 x 2 = 2/17 = x $170,000 = $20,000 A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods. Solutions Manual, Vol.1, Chapter

42 Problem 11-2 Requirement 1 Cord Company ANALYSIS OF CHANGES IN PLANT ASSETS For the Year Ending December 31, 2006 Balance Balance 12/31/05 Increase Decrease 12/31/06 Land $ 175,000 $ 312,500 [1] $ -- $ 487,500 Land improvements , ,000 Buildings 1,500, ,500 [1] -- 2,437,500 Machinery and equipment 1,125, ,000 [2] 17,000 1,493,000 Automobiles and trucks 172,000 12,500 24, ,500 Leasehold improvements 216, ,000 $3,188,000 $1,839,500 $41,000 $4,986,500 Explanations of Amounts: [1] Plant facility acquired from King 1/6/06 allocation to Land and Building: Fair value 25,000 shares of Cord common stock at $50 market price $1,250,000 Allocation in proportion to appraised values at date of exchange: % of Amount Total Land $187, Building 562, $750, Land $1,250,000 x 25% = $ 312,500 Building $1,250,000 x 75% = 937,500 $1,250,000 [2] Machinery and equipment purchased 7/1/06: Invoice cost $325,000 Delivery cost 10,000 Installation cost 50,000 Total acquisition cost $385, Intermediate Accounting, 4/e

43 Problem 11-2 (continued) Requirement 2 Cord Company DEPRECIATION AND AMORTIZATION EXPENSE For the Year Ended December 31, 2006 Land Improvements: Cost $192,000 Straight-line rate (1 12 years) x 8 1/3% Annual depreciation 16,000 Depreciation on land improvements for 2006: (3/25 to 12/31/06) x 3/4 $ 12,000 Buildings: Book value, 1/1/06 ($1,500, ,900) $1,171,100 Building acquired 1/6/06 937,500 Total amount subject to depreciation 2,108, % declining balance rate: (1 25 years = 4% x 1.5) x 6% 126,516 Machinery and equipment: Balance, 1/1/06 $1,125,000 Straight-line rate (1 10 years) x 10% 112,500 Purchased on 7/1/06 385,000 Depreciation for one-half year x 5% 19,250 Depreciation on machinery and equipment for ,750 Automobiles and trucks: Book value, 1/1/06 ($172, ,325) $71,675 Deduct 1/1/06 book value of truck sold on 9/30 ($9, ,650) (11,750) Amount subject to depreciation 59, % declining balance rate: (1 5 years = 20% x 1.5) x 30% 17,978 Automobile purchased 8/30/06 12,500 Depreciation for 2006 (30% x 4/12) x 10% 1,250 Truck sold on 9/30/06 - depreciation (given) 2,650 Depreciation on automobiles and trucks 21,878 Solutions Manual, Vol.1, Chapter

44 Problem 11-2 (concluded) Leasehold improvements: Book value, 1/1/06 ($216, ,000) $108,000 Amortization period (1/1/06 to 12/31/10) 5 years Amortization of leasehold improvements for ,600 Total depreciation and amortization expense for 2006 $313,744 Problem 11-3 Pell Corporation DEPRECIATION EXPENSE For the Year Ended December 31, 2006 Land improvements: Cost $ 180,000 Straight-line rate (1 15 years) x 6 2/3% $ 12,000 Building: Book value 12/31/05 ($1,500, ,000) $1,150, % declining balance rate: (1 20 years = 5% x 1.5) x 7.5% 86,250 Machinery and Equipment: Balance, 12/31/05 $1,158,000 Deduct machine sold (58,000) $1,100,000 Straight-line rate (1 10 years) x 10% 110,000 Purchased 1/2/06 287,000 Depreciation x 10% 28,700 Machine sold 3/31/06 58,000 Depreciation for three months x 2.5% 1,450 Total depreciation on machinery and equipment 140,150 Automobiles: Book value on 12/31/05 ($150, ,000) $38, % declining balance rate: (1 3 years = % x 1.5) x 50% 19,000 Total depreciation expense for 2006 $257, Intermediate Accounting, 4/e

45 Problem Depreciation for 2004 and December 31, 2004 Depreciation expense ($48,000 8 years x 9 / 12 )... 4,500 Accumulated depreciation - equipment... 4,500 December 31, 2005 Depreciation expense ($48,000 8 years)... 6,000 Accumulated depreciation - equipment... 6, The year 2006 expenditure. January 4, 2006 Repair and maintenance expense... 2,000 Equipment... 10,350 Cash... 12, Depreciation for the year December 31, 2006 Depreciation expense (determined below)... 5,800 Accumulated depreciation - equipment... 5,800 Calculation of annual depreciation after the estimate change: $ 48,000 Cost 10,500 Depreciation to date ($4,500 + $6,000) 37,500 Undepreciated cost 10,350 Asset addition 47,850 New depreciable base 8 1/4 Estimated remaining life (10 years - 1 3/4 years) Solutions Manual, Vol.1, Chapter

46 $ 5,800 New annual depreciation Problem 11-5 (1) $65,000 Allocation in proportion to appraised values at date of exchange: % of Amount Total Land $72,000 8 Building 828, $900, Land $812,500 x 8% = $ 65,000 Building $812,500 x 92% = 747,500 $812,500 (2) $747,500 (3) 50 years $747,500-47,500 $14,000 annual depreciation (4) $ 14,000 Same as prior year, since method used is straight-line. (5) $ 85,400 3,000 shares x $25 per share = $75,000 Plus demolition of old building 10,400 $85,400 (6) None No depreciation before use. (7) $ 16,000 Fair market value. (8) $ 2,400 $16,000 x 15% (1.5 x Straight-line rate of 10%). (9) $ 2,040 ($16,000-2,400) x 15%. (10) $ 99,000 Total cost of $110,000 - $11,000 in normal repairs. (11) $ 17,000 ($99,000-5,500) x 10/55. (12) $ 5,100 ($99,000-5,500) x 9/55 x 4/12. (13) $ 30,840 PVAD = $4,000 ( * ) * Present value of an annuity due of $1: n = 11, i = 8% (from Table 6) (14) $ 2,056 $30, Intermediate Accounting, 4/e

47 Problem 11-6 Requirement 1 Building: 15 years $500, years = $20,000 per year x 9/12 = $15,000 Machinery: $240,000 - (10% x $240,000) 8 years = $27,000 per year x 9/12 = $20,250 Equipment: Sum-of-the-digits is ([6 (6 + 1)] 2) = 21 ($160,000-13,000) x 6/21 = $42,000 x 9/12 = $31,500 Requirement 2 (1) June 29, 2007 Depreciation expense (determined below)... 5,625 Accumulated depreciation - machinery... 5,625 $100,000 - (10% x $100,000) 8 years = $11,250 x 6/12 = $5,625 Solutions Manual, Vol.1, Chapter

48 Problem 11-6 (concluded) (2) June 29, 2007 Cash... 80,000 Accumulated depreciation - machinery (below)... 14,063 Loss on sale of machinery (difference)... 5,937 Machinery ,000 Accumulated depreciation on machinery sold: 2006 depreciation = $11,250 x 9/12 = $ 8, depreciation = $11,250 x 6/12 5,625 Total $14,063 Requirement 3 Building: $500, years = $20,000 Machinery: $140,000 - (10% x $140,000) 8 years = $15,750 Equipment: ($160,000-13,000) x 6/21 = $42,000 x 3/12 = $10,500 + ($160,000-13,000) x 5/21 = $35,000 x 9/12 = 26,250 $36, Intermediate Accounting, 4/e

49 Problem 11-7 Requirement 1 Cost of mineral mine: Depletion: Purchase price $1,600,000 Development costs 600,000 $2,200,000 Depletion per ton = $2,200, , ,000 tons = $5.25 per ton 2006 depletion = $5.25 x 50,000 tons = $262, depletion: Revised depletion rate = ($2,200, ,500) - 100, ,500-50,000 tons = $ depletion = $4.20 x 80,000 tons = $336,000 Depreciation: Structures: Depreciation per ton = $150, ,000 tons = $.375 per ton 2006 depreciation = $.375 x 50,000 tons = $18, depreciation: Revised depreciation rate = $150,000-18, ,500-50,000 tons = $ depreciation = $.30 x 80,000 tons = $24,000 Solutions Manual, Vol.1, Chapter

50 Problem 11-7 (continued) Equipment: Depreciation per ton = $80,000-4, ,000 tons = $.19 per ton 2006 depreciation = $.19 x 50,000 tons = $9, depreciation: Revised depreciation rate = ($80,000-9,500) - 4, ,500-50,000 tons = $ depreciation = $.152 x 80,000 tons = $12,160 Requirement 2 Mineral mine: Cost $ 2,200,000 Less accumulated depletion: 2006 depletion $262, depletion 336, ,500 Book value, 12/31/07 $1,601,500 Structures: Cost $ 150,000 Less accumulated depreciation: 2006 depreciation $18, depreciation 24,000 42,750 Book value, 12/31/07 $107,250 Equipment: Cost $ 80,000 Less accumulated depreciation: 2006 depreciation $ 9, depreciation 12,160 21,660 Book value, 12/31/07 $58, Intermediate Accounting, 4/e

51 Problem 11-7 (concluded) Requirement 3 Depletion of natural resources and depreciation of assets used in the extraction of natural resources are part of product cost and are included in the cost of the inventory of the mineral, just as the depreciation on manufacturing equipment is included in inventory cost. The depletion and depreciation are then included in cost of goods sold in the income statement when the mineral is sold. In 2006, since all of the ore was sold, all of 2006 s depletion and depreciation is included in cost of goods sold. In 2007, since not all of the extracted ore was sold, a portion of both 2007 s depletion and depreciation remains in inventory. Solutions Manual, Vol.1, Chapter

52 Problem 11-8 Requirement 1 Calculation of goodwill: Purchase price $2,000,000 Less: Fair market value of net identifiable assets 1,700,000 $ 300,000 The cost of goodwill is not amortized. To record amortization of patent. Amortization ($80,000 8 years x 6 / 12 )... 5,000 Patent... 5,000 To record amortization of franchise. Amortization expense ($200, years x 3 / 12 )... 5,000 Franchise... 5, Intermediate Accounting, 4/e

53 Problem 11-8 (concluded) Requirement 2 Intangible assets: Goodwill $300,000 [1] Patent 75,000 [2] Franchise 195,000 [3] Total intangibles $570,000 [1] $300,000 [2] $ 80,000-5,000 [3] $200,000-5,000 Solutions Manual, Vol.1, Chapter

54 Problem 11-9 Requirement 1 Machine 101: $70,000-7, years = $6,300 per year x 3 years = $ 18,900 Machine 102: $80,000-8,000 8 years = $9,000 per year x 1.5 years = 13,500 Machine 103: $30,000-3,000 9 years = $3,000 per year x 4/12 = 1,000 Accumulated depreciation, 12/31/05 $33,400 Requirement 2 To record depreciation on machine 102 through date of sale. March 31, 2006 Depreciation expense ($9,000 per year x 3 / 12 )... 2,250 Accumulated depreciation - equipment... 2,250 To record sale of equipment. March 31, 2006 Cash... 52,500 Accumulated depreciation ($13, ,250)... 15,750 Loss on sale of equipment (determined below)... 11,750 Equipment... 80, Intermediate Accounting, 4/e

55 Problem 11-9 (continued) Loss on sale of machine 102: Proceeds $52,500 Less book value on 3/31/06: Cost $80,000 Less accumulated depreciation: Depreciation through 12/31/05 $13,500 Depreciation from 1/1/06 to 3/31/06 ($9,000 x 3/12) 2,250 15,750 64,250 Loss on sale $11,750 Requirement 3 Building: Useful life of the building: $200,000 = $40,000 in depreciation per year 5 years ( ) $840,000-40,000 $40,000 = 20-year useful life To record depreciation on the building. Depreciation expense [($840,000-40,000) 20 years]... 40,000 Accumulated depreciation - building... 40,000 Solutions Manual, Vol.1, Chapter

56 Problem 11-9 (concluded) To record depreciation on the equipment. Depreciation expense (determined below)... 15,775 Accumulated depreciation - equipment... 15,775 Equipment: Machine 103 (determined above) $ 3,000 Machine 101: Cost $70,000 Less: Accumulated depreciation 18,900 Book value, 12/31/05 51,100 Revised remaining life (7 years - 3 years) 4 years 12,775 $15, Intermediate Accounting, 4/e

57 Problem a. This is a change in estimate. No entry is needed to record the change adjusting entry: Depreciation expense (determined below)... 37,500 Accumulated depreciation... 37,500 Calculation of annual depreciation after the estimate change: $1,000,000 Cost $25,000 Old depreciation ($1,000, years) x 3 yrs (75,000) Depreciation to date ( ) 925,000 Undepreciated cost (700,000) New estimated salvage value 225,000 New depreciable base 6 yrs. Estimated remaining life (6 years: ) $ 37,500 New annual depreciation A disclosure note should describe the effect of a change in estimate on income before extraordinary items, net income, and related per-share amounts for the current period. Solutions Manual, Vol.1, Chapter

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