CHAPTER Cash discounts are reductions in original cost, not income.

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1 CHAPTER Tangible assets are those that can be seen and touched. Intangible assets are those rights or economic benefits that are not physical in nature. 8-2 All three terms refer to an allocation of costs over time. Reduction of intangible assets is generally called amortization. Depreciation is a reduction in buildings and equipment and other tangible assets. Depletion is a reduction in natural resources. 8-3 Cash discounts are reductions in original cost, not income. 8-4 When an expenditure is capitalized, it is not credited to stockholders' equity. Rather, it becomes an asset with a useful life in excess of one year. An asset is debited and generally either cash or a liability is credited. 8-5 Accumulated depreciation is not cash; if specific cash is being accumulated for the replacement of assets, such cash will be an asset specifically labeled as a "cash fund for replacement and expansion" or a "fund of marketable securities for replacement and expansion." Accumulated depreciation is the cumulative amount of an asset s depreciable value that has been expensed. 8-6 Valuation implies some measure of present market value. In contrast, depreciation is the systematic allocation of the original cost of the asset as an expense on the income statement over the useful life of the asset. 8-7 Depreciation is a method of cost allocation, not valuation. It simply allocates the cost of an asset to the periods that benefit from its use. Chapter 8 Long-Lived Assets and Depreciation 371

2 8-8 No. Keeping two sets of books is necessary if two separate purposes are being legally fulfilled. In many cases two sets of books are required, sometimes more than two. Requirements include external financial reporting, internal managerial needs and tax reporting. 8-9 Both choices are between initially greater current income and asset values (straight-line and FIFO) versus initially smaller current income and asset values (accelerated and LIFO). This statement assumes rising price levels for inventory items. The choices differ because the FIFO-LIFO choice affects cash flows via its tax consequences. Why? Because the IRS requires all firms using LIFO for tax purposes to use it for financial reporting purposes as well. On the other hand the accelerated versus straight-line choice does not affect cash flow because a firm does not have to change its depreciation method used for tax reporting because of this choice for financial reporting No. Depreciation, by itself, generates no cash Accelerated depreciation used for tax purposes usually leads to higher depreciation expense early in an asset s life and hence lower pretax income. Because pretax income is lower, taxes are lower. Depreciation does not affect cash, but taxes do. Lower taxes mean more cash. Remember, however, that many firms use accelerated MACRS depreciation for tax purposes and straight-line for financial reporting to the public The costs of repairs and maintenance are expenses of the current period. They maintain a fixed asset in operating condition. In contrast, capital improvements or betterments are capitalized and then depreciated because they add to the future benefits of an existing asset, often by either extending its life or decreasing its operating costs. 372

3 8-13 The division's expenditures, including cash outlays to acquire new assets, are likely to fall, but expenses (which include depreciation on the new capital facilities) will probably not fall Gain on sale of equipment is a net result: revenue (that is, proceeds) minus expense (that is, book value) equals gain. Complete reporting would show the proceeds, the book value, and the gain Patents grant the inventor exclusive rights to the invention for a specified period of time. Copyrights give similar rights to printed or artistic items. Trademarks are distinctive identifications of a product or service. Franchises are privileges granted to sell a specific product or service under defined conditions. Goodwill is the excess of the cost of an acquired company over the net market value of the identifiable individual assets and liabilities acquired Internally acquired patents are essentially research costs, which must be written off to expense as they are incurred. Externally acquired patents are assets that are subject to amortization and/or impairment review The preoccupation with physical evidence often results in the expensing of outlays that many think should be treated as assets. Thus, expenditures for research, advertising, employee training, and the like are usually expensed, although it seems clear that, in an economic sense, such expenditures represent expected future benefits No. Improvements to leased property are capitalized just like capital improvements or betterments except that they are amortized over the remaining life of the lease if it is shorter than the useful life of the improvements or betterments. Chapter 8 Long-Lived Assets and Depreciation 373

4 8-19 The $5,000 gain is double-counted. The increase in cash was $20,000, not $25,000. The $20,000 proceeds includes the $5,000 gain. Under the indirect method of the statement of cash flows, the gain must be subtracted from net income in the operating section of the statement of cash flows. Under the direct method it does not appear in the statement at all The asset was sold for $5,000 + $4,000 = $9,000. The entire $9,000 should be reported as a cash inflow from investing activities. In an indirect method statement of cash flows, the $4,000 gain must be deducted from net income in computing net cash provided by operating activities No. In a basket purchase, different assets are often depreciated over different time periods. For example, basket purchases sometimes include land and a building. The building is depreciated while the land remains on the books at original cost No. The recoverability test determines whether or not there is evidence of impairment. The impairment loss is the amount by which the book value of the asset exceeds its fair value The manager has a point. However, under cost-based accounting the historical cost of long-lived assets is allocated to the periods during which the assets will be used. We do not recognize income from the appreciation of long-lived assets. The complaint that the depreciation is large is worth considering. Normally we depreciate the asset over its useful life down to its residual value. Thus, it may be that the company has underestimated both the residual values and the lives of these assets. 374

5 8-24 Treating research and development costs as assets is generally more consistent with the corporate perspective of the value inherent in R&D. Companies undertake R&D in hopes of creating future benefits, as asset accounting would suggest The statement of cash flows has a section that reports on the financing actions the company has taken during the accounting period. Both borrowing and issuing of common stock would appear there. Of course, some capital is also generated by operations and some could be generated by the sale of assets. These sources of capital are revealed in the operating and investing segments of the statement of cash flows Due to continual changes in the purchasing power of the dollar, we normally observe an increase in the value of land over time. Over 90 years have passed since the land was acquired, so the value today is likely to have little relationship to the value when it was purchased. In contrast, the equipment is recently acquired and is being depreciated over its useful life. Its book value is likely to be closer to its market value (10-15 min.) Land: Cash, $600,000 + $150,000 demolition $ 750,000 Note 3,000,000 Total cost $ 3,750,000 Building: Cash $ 3,000,000 Mortgage 7,000,000 Total cost $10,000,000 The important point here is to see that the $150,000 demolition cost is a cost of land because the outlay is necessary to get the land ready for its intended use. Chapter 8 Long-Lived Assets and Depreciation 375

6 8-27 (continued) Land 3,600,000 Cash 600,000 Note payable 3,000,000 Land 150,000 Cash 150,000 This could also be accomplished by the following compound entry: Land 3,750,000 Cash 750,000 Note payable 3,000,000 The second entry is: Building 10,000,000 Cash 3,000,000 Mortgage note payable 7,000,000 The payment terms of the note and the mortgage are irrelevant until financial statements must be prepared or payments must be made. Some students may prepare entries for the first year. Assuming end of year payment, these would be: Note payable 300,000 Interest expense 300,000 Cash 600,000 Mortgage note payable 250,000 Interest expense 700,000 Cash 950,

7 8-28 (5-10 min.) The sales commission, the purchasing manager's salary, and the cost of repairs after the equipment is placed in use are irrelevant. The pertinent costs are: Invoice price, gross $400,000 Deduct: 2% cash discount 8,000 Invoice price, net $392,000 Freight-in 4,400 Installation costs 8,000 Repair costs prior to use 9,000 Total acquisition cost $413, (5-10 min.) In the absence if more reliable data, the assessed values for property taxes are frequently used as a guide to allocating the costs of a basket purchase. (1) (2) (3) (2) x (3) Assessed Total Cost Allocated Value Weighting to Allocate Costs Land $200,000 20/60 $720,000 $240,000 Building 400,000 40/60 720, ,000 Total $600,000 $720,000 Chapter 8 Long-Lived Assets and Depreciation 377

8 8-30 (10 min.) Player contracts may be amortized for tax purposes, but the sports franchise itself may not. Allen would want to allocate $299,999,999 to the contracts. In this way, he could get tax deductions. No part of the amount allocated to the franchise is deductible as amortization. Note: Through the years, the Internal Revenue Service has developed a rule for these transactions. The amount the buyer allocates to player contracts may not exceed what the seller allocates. This is limited to no more than 50 percent, unless the taxpayer can prove a greater allocation is proper. 378

9 8-31 (15 min.) Accumulated Equipment Depreciation, Equipment Depreciation Expense, Equpiment 594,000 54,000 54,000 Cash 594, Equipment Cash 594, ,000 To record acquisition of assembly robots. Depreciation expense, equipment 54,000 Accumulated depreciation, equipment 54,000 To record annual depreciation: ($594,000 $54,000) 10 = $54, Cash 42,000 Accumulated depreciation, equipment Loss on sale of equipment 18,000 6,000 Equipment 66,000 To record sale of equipment: Cash proceeds $42,000 Original cost $66,000 Accumulated depreciation, 3 x $6,000 = 18,000 Book value (or carrying amount) 48,000 Loss $ 6, Cash 52,000 Accumulated depreciation, equipment 18,000 Gain on sale of equipment 4,000 Equipment 66,000 To record sale of equipment: Cash proceeds Book value (see above) $52,000 48,000 Gain $ 4,000 Chapter 8 Long-Lived Assets and Depreciation 379

10 8-32 (10-15 min.) You may want to use T-accounts too. 1. Depreciation expense, equipment 160,000 Accumulated depreciation, equipment 160,000 To record annual depreciation: ($880,000-$80,000) 5 = $160, Cash 160,000 Accumulated depreciation, equipment 80,000 Equipment 220,000 Gain on sale of equipment 20,000 To record sale of equipment: Cash proceeds $160,000 Original cost $220,000 Accumulated depreciation, 2 x $40,000 = 80,000 Book value (or carrying amount) 140,000 Gain on sale $ 20, Cash 110,000 Accumulated depreciation, equipment 80,000 Loss on sale of equipment 30,000 Equipment 220,000 To record sale of equipment: Cash proceeds $110,000 Book value (see above) 140,000 Loss on sale $ 30,

11 8-33 (10-15 min.) You may want to use T-accounts too. 1. Depreciation expense, equipment 300,000 Allowance for depreciation, equipment 300,000 To record annual depreciation: ($1,800,000 $300,000) 5 = $300, Cash 32,000 Allowance for depreciation, equipment 22,000 Loss on sale of equipment 6,000 Equipment 60,000 To record sale of equipment: Cash proceeds $32,000 Original cost $60,000 Allowance for depreciation, 2 x $11,000 22,000 Book value (or carrying amount) 38,000 Loss $ 6, Cash 40,000 Allowance for depreciation, equipment 22,000 Equipment 60,000 Gain on sale of equipment 2,000 To record sale of equipment: Cash proceeds $40,000 Book value (see above) 38,000 Gain $ 2,000 Chapter 8 Long-Lived Assets and Depreciation 381

12 8-34 (10-15 min.) Year Conveyor* Truck** 1 $6,600 2/3 x $18,000 = $12,000 2 $6,600 2/3 x $ 6,000 = $ 4,000 3 $6,600 $500*** * Each year is 1/5 x ($38,000 $5,000) = $6,600. ** DDB rate is 2 x (1/3) = 2/3. *** $500 of depreciation reduces the book value to the $1,500 residual value. If the DDB schedule had continued, the depreciation of 2/3 x $2,000 = $1,333 would have reduced the book value below the residual value (10 min.) 1. D C R ($80,000 $5,000) = n (250,000) = = $.30 per mile Depreciation expense: Year 1: $.30 x 60,000 = $18,000 Year 2: $.30 x 90,000 = $27, Net book value when sold: $80,000 $18,000 $27,000 = $35,000. Gain on sale: $40,000 $35,000 = $5,

13 8-36 (15-25 min.) Numbers are in thousands. Declining Balance at Twice the Straight Straight-Line* Line Rate (DDB)** Annual Book Annual Book Depreciation Value Depreciation Value At acquisition $1,200 $1,200 Year 1 $ $ Total $1,000 $1,000 * Depreciation is the same each year, 25% of ($1,200,000 $200,000). ** Straight-line rate is 100% 4 = 25%. The DDB rate is 50%. Depreciation in the first year is 50% of $1,200,000; in the second year it is 50% of ($1,200,000 $600,000); in the third year depreciation is 50% of [$1,200,000 ($600,000 + $300,000)] etc. This continues until the residual value is reached. Therefore, using DDB in this instance, depreciation for the third year would be 50% of $300,000, or $150,000; however, only $100,000 is shown because the residual value of $200,000 is thereby reached. Although not requested in this problem, another alternative is to use Modified DDB (10-15 min.) Unit Year Depreciation Straight-Line* DDB** 1 (60 150) x $400,000 = $160,000 $133,333 $293,333 2 (45 150) x $400,000 = 120, ,333 97,778 3 (45 150) x $400,000 = 120, ,333 8,889*** Total depreciation $400,000 $400,000 $400,000 * (1/3) x $400,000 = $133,333 each year ** 2 x (1/3) x $440,000 = $293,333; 2 x (1/3) x ($440,000 $293,333) = $97,778 Chapter 8 Long-Lived Assets and Depreciation 383

14 384 *** Application of DDB would result in depreciation of 2 x 1/3 x ($440,000 - $293,333 - $97,778) = $32,593. However, this would depreciation the asset below its residual value of $40,000. Therefore, depreciation is only $8,889.

15 8-38 (20-30 min.) (Equipment costs $32,000, five-year life, predicted residual value of $2,000) Declining Balance at Twice the Straight Straight-Line* Line Rate (DDB)** Annual Book Annual Book Depreciation Value Depreciation Value At acquisition $32,000 $32,000 Year 1 $ 6,000 26,000 $12,800 19, ,000 20,000 7,680 11, ,000 14,000 4,608 6, ,000 8,000 2,765 4, ,000 2,000 1,659*** 2,488 Total $30,000 $29,512 * Depreciation is the same each year, 20% of ($32,000 $2,000). ** Straight-line rate is 100% 5 = 20%. The DDB rate is 40%. Depreciation in the first year is 40% of $32,000; in the second year it is 40% of ($32,000 $12,800); in the third year it is 40% of [$32,000- ($12,800+$7,680)]; etc. *** Unmodified, this method will never fully depreciate the existing book value. Therefore, in the later years of an asset's life, companies typically switch to a straight-line method. See the text for a fuller explanation. If a switch to straight-line were used here, it would occur in year 5 and the annual depreciation would be $2,147, the amount required to reduce the book value to the end of period salvage value, instead of $1,659. If both methods were available for tax purposes, a company would typically choose DDB because it records the depreciation more quickly and reduces early tax payments. This provides an interest free loan from the government. Chapter 8 Long-Lived Assets and Depreciation 385

16 8-39 (20-30 min.) Amounts are in thousands of dollars. Accelerated Depreciation Declining Balance at Twice the Straight Straight-Line* Line Rate (DDB)** Annual Book Annual Book Depreciation Value Depreciation Value At acquisition Year * Depreciation is the same each year, 1/8 x [($280,000 $20,000)] = 32,500. ** Straight-line rate is 100% 8 = 12.5%. The DDB rate is 25%. Depreciation in the first year is 25% of $280; in the second year it is 25% of ($280 $70.0); in the third year it is 25% of ($280 $70.0 $52.5); etc. Unmodified, this method will never fully depreciate the existing book value. In the later years of an asset's life, companies typically switch to a straight-line method. The asset is never depreciated below its estimated residual value, even though the latter is ignored when applying the depreciation rate. 386

17 8-40 (10 min.) BOEING COMPANY Property, Plant, and Equipment December 31, 2003 (In Millions) Land $ 457 Buildings 9,171 Machines and equipment 10,824 Construction in progress 943 Less: Accumulated depreciation (12,963)* Net property, plant, and equipment $ 8,432 *$457 + $9,171 + $10,824 + $943 - $8,432 = $12, (10-15 min.) Amounts are in thousands. 1. Historical cost = $477,581 + $440,607 = $918, Most of Oregon Steel s assets are slightly less than 9 years old. We know this because the accumulated depreciation is less than half of the original cost of the property, plant, and equipment: $440,607 $918,888 =.48, which is slightly less than.5. or: 18 x.48 = 8.64 years average age Chapter 8 Long-Lived Assets and Depreciation 387

18 8-42 (15 min.) Amounts are in the thousands of dollars. Original Revised Straight-line* Straight-line** Annual Book Annual Book Depreciation Value Depreciation Value At acquisition year Total $70 $73 *Depreciation is the same each year, 1/10 x (75,000-5,000) = $7,000. ** Depreciation is the same for the first four years (2004 though 2007). In 2008, Nowling must recompute depreciation for the years 2008, 2009 and 2010 based on revised estimates: 1/3 x (47,000 1,000) ] = $15, (30-45 min.) 1. See Exhibit 8-43 on the following page. 388

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20 EXHIBIT FLECK COMPANY Income Statement For the Year Ended December 31, 20X2 (In Thousands of Dollars) Before Taxes After Taxes Straight line DDB Straight line DDB Depreciation Depreciation Depreciation Depreciation Income Statement Cash sales $180 $180 $180.0 $180 Operating expenses Depreciation expense* Pretax income Income taxes Net income $ 71 $ 60 $ 42.6 $ 36 Statement of Cash Flows Cash $180 $180 $180.0 $180 Cash operating expenses Cash tax payments Net cash provided by operations $ 80 $ 80 $ 51.6 $ 56 * SL = 1/5 ($50,000 - $5,000) = $9,000; DDB = 2 x (1/5) x $50,000 = $20,

21 8-43 (continued) 2. By itself, depreciation expense does not provide cash. This point is illustrated by the part of requirement 1 that compares the amounts shown before taxes. Note that the cash provided by operations is exactly the same under straight-line and DDB depreciation methods. No matter what depreciation expense is allocated to the year (whether $9,000, $20,000, $45,000, or zero), the $80,000 cash provided by operations will be unaffected. Examine the part of requirement 1 that compares amounts after taxes. Again, by itself, depreciation does not affect the cash inflow provided by operations. Only sales to customers can provide more cash receipts from operations. However, depreciation does affect the cash outflow for income taxes. The use of accelerated depreciation, such as DDB, results in a strange combination of showing less net income but conserving more cash. The DDB method shows net income of $36,000 (compared with $42,600 using straight-line), but DDB shows an increase in net cash provided by operations (less income taxes) of $56,000 (compared with $51,600 using straight-line). Accordingly, the final cash balance is $4,400 higher for DDB than for straight-line. Chapter 8 Long-Lived Assets and Depreciation 391

22 8-43 (continued) 3. The doubling of depreciation would cause net income to decrease but would have no effect on the $80,000 of cash provided by operations (shown on the third line of the following table): Straight-line DDB Depreciation Depreciation Before Doubled Before Doubled Sales $180 $180 $180 $180 Cash operating expenses Cash provided by operations $ 80 $ 80 $ 80 $ 80 Depreciation expense Income before income taxes $ 71 $ 62 $ 60 $ 40 Income tax expense Net income $ 71 $ 62 $ 60 $ (5-10 min.) 1. Acceleration of depreciation for tax purposes is caused by a 3- year instead of a 5-year depreciation schedule and the use of the DDB method instead of the straight-line method. DDB charges twice the straight-line rate in the first year. 2. Shareholder reporting: $1.8 million 5 = $360,000 Tax purposes: 2 x (1/3) x $1.8 million = $1,200,

23 8-45 (5 min.) Leasehold Improvements would be increased, and Cash would be decreased by $120,000. The annual amortization would be based on the remaining life of the lease: $120,000 4 years = $30,000 per year. Note that amortization is over the remaining lease term, not the physical life of the improvements (10 min.) 1. and 2. Neither expenses "charged to the P & L" nor "depreciation and amortization" generate cash. Only revenue generates cash. However, although Riccardo's statements are misleading, they have a certain logic. If operating income is zero, revenue is equal to cash expenses plus noncash expenses (primarily depreciation and amortization). Therefore, revenue generates enough cash to cover cash expenses (including the $3.75 billion charged to the P & L) and have an amount equal to depreciation and amortization left over (60% x $3.75 billion = $2.25 billion in this case). Positive operating income (less taxes on that income) will contribute to covering the remaining $1.5 billion that is needed. The key to interpreting Riccardo's statement is that he presumes that revenues are high enough to cover all expenses; these presumed revenues generate the cash to which he refers. Chapter 8 Long-Lived Assets and Depreciation 393

24 8-47 (10 min.) 1. a, c 2. b, d, g, h, i, j. The key questions to ask are whether the expenditure should be capitalized as an asset (a, c) or written off immediately as an expense (b, d, g, h, i, and j). The other outlays (e,f) are neither capitalized nor expensed (10 min.) a. E e. C b. C f. C c. E g. E d. E 394

25 8-49 (10-15 min.) The first two items would reduce cash and increase Repairs and Maintenance Expense by $200 and $450, respectively. The third item would reduce cash and increase Equipment by $21,000. However, the increase in the residual value from $10,000 to $11,000, results in an increase in the new depreciable amount of only $20,000. Subsequent depreciation would be revised so that the new unexpired cost is spread over the remaining three years as follows: Original Revised Depreciation Depreciation Schedule Schedule Year Amount Year Amount 1 $16,000 1 $ 16, , , , , , ,000 a 5 16, , , ,000 Accumulated depreciation $80,000 b $100,000 b a New depreciable amount is ($90,000 $64,000 + $21,000) $11,000 residual value = $36,000. New depreciation expense is $36,000 divided by remaining useful life of 3 years, or $12,000 per year. b Recapitulation: Net Book Value Original Revised Original outlay $90,000 $ 90,000 Major overhaul 21,000 Total $90,000 $111,000 Accumulated depreciation 80, ,000 Chapter 8 Long-Lived Assets and Depreciation 395

26 396 Residual value $10,000 $ 11,000

27 8-50 (10-15 min.) 1. Proceeds $12,000 Net book value of equipment sold is $29,000 - (4 x $5,000) a 9,000 Gain on sale of equipment $ 3,000 A = L + SE Accumulated Depreciation, Retained Cash + Equipment + Equipment Earnings +12,000-29, ,000 = +3,000* *Gain on sale of equipment. a Annual depreciation is 1/5 x [$29,000 $4,000] = $5,000. Accumulated depreciation for four years is 4 x $5,000 = $20,000. The effect on assets of removing the net book value is a decrease of $9,000, consisting of a decrease in Equipment of $29,000 and a decrease in Accumulated Depreciation of $20,000. Note that the effect of a decrease in Accumulated Depreciation (by itself) is an increase in assets. This $9,000 decrease in assets is offset by the $12,000 in cash received, resulting in a net $3,000 increase in assets. b The $3,000 is usually carried separately in the general ledger until the end of the year as Gain on Sale of Equipment, or Gain on Disposal of Equipment. Income statement effects: Gain on Sale of Equipment may be shown as a separate item on an income statement as a part of "other income" or some similar category. Chapter 8 Long-Lived Assets and Depreciation 397

28 8-50 (continued) In single-step income statements the gain is shown at the top along with other revenue items, for example: Revenue: Sales of products Interest income Other income: gain on sale of equipment Total sales and other income $XXX X X $XXX In multiple-step income statements, the gain is often shown after the operating income generated by the sales of major products. 2. a. Cash 12,000 Accumulated depreciation 20,000 Equipment 29,000 Gain on sale of equipment 3,000 b. Cash 7,000 Accumulated depreciation 20,000 Loss on sale of equipment 2,000 Equipment 29,

29 8-51 (10 min.) 1. Cash received $25,000 Book value, $45,000 (3 x $8,000) 21,000 Gain on sale of fixed assets $ 4,000 Cash 25,000 Accumulated depreciation 24,000 Equipment (van) 45,000 Gain on sale of fixed assets 4, Cash received $17,000 Book value (see above) 21,000 Loss on sale of fixed assets $ 4,000 Cash 17,000 Accumulated depreciation 24,000 Loss on sale of fixed assets 4,000 Equipment (van) 45,000 Chapter 8 Long-Lived Assets and Depreciation 399

30 8-52 (10 min.) 1. The only effect would be a $30,000 cash inflow listed with the investing activities: Proceeds from the sale of equipment $30, The proceeds should be listed as an investing activity: Proceeds from the sale of equipment $40,000 In addition, a $10,000 gain appeared on Icarus s income statement, calculated as: proceeds of $40,000 less book value of $30,000 ($120,000 cost less $90,000 of accumulated depreciation). In the statement reconciling net income and net cash provided by operating activities, the gain must be removed from net income by deducting the $10,000 from net income in the reconciliation of net income to net cash provided by operating activities: Net income $XXXXXX Deduct: gain on sale of equipment 10, The proceeds should be listed as an investing activity: Proceeds from the sale of equipment $20,000 In addition, a $10,000 loss appeared in Icarus s income statement (proceeds of $20,000 less book value of $30,000). The loss must be added back to net income in the reconciliation of net income to net cash provided by operating activities: Net income $XXXXXX Add: loss on sale of equipment 10,

31 8-53 (10-20 min.) 1. $3,000,000 2 = $1,500, Company C must record the $6 million as an expense of 20X1, whereas Company D must show the $6 million as an asset Patents -- on its balance sheet of December 31, 20X1. Company D must then amortize the $6 million on a straight-line basis over the useful life of the patents. The useful life of an intangible asset is the shorter of its economic life and lit legal life, if any. 3. $420,000 4 = $105, a) Goodwill 4,000,000 Assets 22,000,000 Liabilities 16,000,000 Cash 10,000,000 b) Yes. The journal entry is: Impairment loss 1,000,000 Goodwill 1,000, (10-15 min.) 1. $800,000 5 = $160, Income statement: a) Total amount charged as an expense. b) Nothing charged as an expense. This assumes that the purchase was late enough in December that no amortization is charged in Balance sheet: a) Nothing recorded. b) $1,000 million recorded as an asset, to be amortized over the useful life of patents. Chapter 8 Long-Lived Assets and Depreciation 401

32 8-54 (continued) 3. The key is that in a stable process, year-to-year expense recognition would not change but the amount shown on the balance sheet would be larger. Assume all projects are finished at year end and appear in the balance sheet at full cost and then are amortized over the next three years. At any year-end the asset account would reflect that year s spending, plus 2/3 of the prior year, plus 1/3 of the second year prior for a total of 1 + 2/3 + 1/3 = 2 times spending. The expense each year would be 3 x (1/3) = 1 times spending. If the amortization period changes to four years, the balance sheet asset account would rise to 1 + 3/4 + 2/4 + 1/4 = 2.5 times spending. The annual amortization in year five and subsequent years would be the same as the annual amount spent as long as annual spending was constant. The expense would be 4 x (1/4) = 1 times spending (10 min.) Step 1: Recoverability test. The net book value of $11 million exceeds the undiscounted expected future cash flows of $9 million, so there is evidence of impairment. Step 2: The net book value of $11 million exceeds the fair value of $7.5 million so Vincent must record an impairment loss of $11 million - $7.5 million = $3.5 million. 402

33 8-56 (5-10 min.) 1. Depletion rate is $14,400, ,000 = $16.00 per ton Depletion for 20X4: $16.00 x 120,000 = $1,920, Depletion for 20X5: $16.00 x 100,000 = $1,600, (20-30 min.) Amounts are in thousands of dollars. Accelerated Depreciation Declining Balance at Twice the Straight Straight-Line* Line Rate (DDB)** Annual Book Annual Book Depreciation Value Depreciation Value At acquisition 30,000 30,000 Year 1 1,200 28,800 3,000 27, ,200 27,600 2,700 24, ,200 26,400 2,430 21,870 * Depreciation is the same each year, 5% of ($30 million $6 million). ** Straight-line rate is 100% 20 = 5%. The DDB rate is 10%. Depreciation in the first year is 10% of $30,000; in the second year is 10% of ($30,000 $3,000); in the third year is 10% of ($30,000 $3,000 - $2,700); etc. Unmodified, this method will never fully depreciate the existing book value. In the later years of an asset's life, companies typically switch to a straight-line method. The asset is never depreciated below its estimated residual value, even though the latter is ignored when applying the depreciation rate. Chapter 8 Long-Lived Assets and Depreciation 403

34 8-58 (10-15 min.) Amounts are in millions of dollars. 1. Let X = amount written off. Land, Buildings, and Equipment Balance 4,618 Write-offs X Additions 711 Balance 4,929 4, X = 4,929 X = Let Y = accumulated depreciation written off Accumulated Depreciation Write-offs Y Balance 1,854 Depreciation 365 Balance 1,949 1, Y = 1,949 Y = Book value of assets written off = $ = $130. The amounts in requirements 1 and 2 can be checked using the information that there was no gain or loss on disposal of assets: Gain or loss = cash received book value 0 =

35 8-59 (15 min.) Amounts are in millions. 1. Buildings 158, ,865 = 375,289 Machinery and equipment 156, ,757 = 1,031,913 Land 63,150 Construction in progress 22,089 Other 15, ,795 = 102, Land is not depreciated, and depreciation has not started yet on the construction in progress. 3. If Asahi had used straight-line depreciation, the net values of the assets would be larger and the accumulated depreciation would be less. It is more difficult to determine the average age of a company s assets if a company uses declining-balance depreciation rather than straight-line depreciation. For example, almost 85% ( 875,757 1,031,913) of Asahi s cost of machinery and equipment has been depreciated. If straightline depreciation had been used, it would be clear that these assets had passed the midpoint of their economic life. But with declining-balance depreciation, it is possible that the assets are still in the first half of their economic life because more than half of the depreciation is taken before the midpoint of an asset s life. Chapter 8 Long-Lived Assets and Depreciation 405

36 8-60 (30-40 min.) Gradually, students should become familiar with the effects of typical transactions. All numbers are in millions of dollars. Here are the T-accounts: Land, Plant, and Equipment Balance 52,981 Disposals at Acquisitions, original cost Z at cost ZZ Balance 60,113 Accumulated Depreciation Accum. depreciation Balance 26,568 on disposals YY Depreciation for current year Y Balance 30,112 Special Tools, net Balance 9,939 Amortization for Acquisitions 3,000 current year X Disposals, book value 0 Balance 11, Let X = special tool amortization 9, ,000 X = 11,992 X = The cost of new acquisitions was $8,113. Using the T- accounts, this can be computed using the following three steps: a. If depreciation plus amortization = $5,472, depreciation was $5,472 - $947 = $4,525 = Y 406

37 8-60 (continued) b. There is now one unknown in the Accumulated Depreciation T-account, so: Let YY = Accumulated depreciation of items disposed 26, ,525 YY = 30,112 YY = 981 c. For fully depreciated assets accumulated depreciation is the same as total historical cost so Z = $981 Use the T account. Let ZZ = current acquisitions at cost 52,981 + ZZ 981 = 60,113 ZZ = 8,113 Chapter 8 Long-Lived Assets and Depreciation 407

38 8-61 (15-25 min.) This problem is not difficult, but it may appear so because the topic was not discussed in the text. It forces students to think about the meaning of accumulated depreciation and net book value. Amounts are in millions. 1. Total depreciable value average useful life = average annual depreciation. 131,755 X = 8,500 X = 131,755 8,500 = 15.5 years 2. Accumulated depreciation average age of assets = average annual depreciation. or 83,265 X = 8,500 X = 83,265 8,500 = 9.8 years. Average age of assets = (Accumulated depreciation total depreciable value) x average useful life = ($83,265 $131,755) x 15.5 = 9.8 years 408

39 8-62 (25-35 min.) Amounts in tables are in thousands of dollars. 1. Zero Income Taxes 2. 40% Income Taxes Straight-line Accelerated Straight-line Accelerated Depreciation Depreciation Depreciation Depreciation Revenues (in cash) Cash operating expenses Cash provided by operations before income taxes Depreciation expense Operating income Income tax expense Net income Supplementary analysis: Cash provided by operations before income taxes Income tax payments Net cash provided by operations Chapter 8 Long-Lived Assets and Depreciation 409

40 8-62 (continued) 3. By itself, depreciation expense does not provide cash. This point is illustrated by part 1 that compares the amounts shown before taxes. Note that the cash provided by operations (and the ending cash balances) are exactly the same. No matter what depreciation expense is allocated to the year (whether $50,000, $100,000, or zero), the $300,000 cash provided by operations and the ending cash will be unaffected. Examine part 2, that compares amounts after taxes. Again, by itself, depreciation does not affect the cash inflow provided by operations. However, depreciation does affect the cash outflow for income taxes. The use of accelerated depreciation results in a strange combination of showing less net income but conserving more cash. The accelerated method shows net income of $120,000 (compared with $150,000 using straight-line), but accelerated shows a net increase in cash provided by operations (less income taxes) of $220,000 (compared with $200,000 using straight-line). Accordingly, the final cash balance is $20,000 higher for accelerated than for straight-line. 4. Journal entries (not required) may clarify the effects: Depreciation expense Accumulated depreciation 50,000 more 50,000 more Income tax expense 20,000 less Cash 20,000 less Note: A smaller credit to cash increases the balance in cash. 410

41 8-62 (continued) The reduction of retained earnings would be $50,000 $20,000. That is, net income (and hence retained earnings) would be $30,000 lower. In summary: Cash, increase by tax savings,.40 x $50,000 = $20,000 Accumulated depreciation, increase by $50,000 Operating income, decrease by $50,000 Income tax expense, decrease by $20,000 Retained earnings, decrease by $30, The doubling of depreciation would cause net income to decrease but in the absence of tax effects would have no effect on cash provided by operations: Straight-line Accelerated Depreciation Depreciation Before Doubled Before Doubled Revenues (all cash) Cash operating expenses Cash provided by operations Depreciation expense Income before income taxes Income tax expense Net income Chapter 8 Long-Lived Assets and Depreciation 411

42 8-63 (25-35 min.) Amounts are in millions of dollars. 1. Zero Income Taxes 2. 40% Income Taxes Straight-line Accelerated Straight-line Accelerated Depreciation Depreciation Depreciation Depreciation Revenues $246,525 $246,525 $246,525$246,525 Cash operating expenses 229, , , ,449 Cash provided by operations before income taxes 17,076 17,076 17,076 17,076 Depreciation expense 3,432 5,432 3,432 5,432 Operating income 13,644 11,644 13,644 11,644 Income tax expense - - 5,458 4,658 Net income $ 13,644 $ 11,644 $ 8,186 $ 6,986 Supplementary analysis: Cash provided by operations before income taxes $17,076 $17,076 $17,076 $17,076 Income tax expense - - 5,458 4,658 Net cash provided by operations $17,076 $17,076 $11,618 $12, By itself, depreciation expense does not provide cash. This point is illustrated by part 1, which compares the amounts shown with zero income taxes. Note that the cash provided by operations (and the ending cash balances) are exactly the same. No matter what depreciation expense is allocated to the year (whether $3,432 million, $5,432 million, or zero), the $17,076 million cash provided by operations and the ending cash will be unaffected. 412

43 8-63 (continued) Examine part 2, that compares amounts after taxes. Again, by itself, depreciation does not affect the cash inflow provided by operations. Only sales to customers can provide more cash receipts from operations. However, depreciation does affect the cash outflow for income taxes. The use of accelerated depreciation results in a strange combination of showing less net income but conserving more cash. The accelerated method shows net income of $6,986 million (compared with $8,186 million using straight-line), but accelerated shows a net increase in cash provided by operations after considering income taxes of $12,418 million (compared with $11,618 million using straight-line). Accordingly, the final cash balance would be $800 million higher for accelerated than for straight-line. 4. Cash, increase by tax savings,.40 x $2,000 million = $800 million Accumulated depreciation, increase by $2,000 million Operating income, decrease by $2,000 million Income tax expense, decrease by $800 million Retained earnings, decrease by $1,200 million New balances: cash, $2,758 million + $800 million = $3,558 million Accumulated depreciation, $15,147 million + $2,000 million = $17,147 million Journal entries (not required) may clarify the effects (in millions): Depreciation expense 2,000 more Accumulated depreciation 2,000 more Income tax expense 800 less Cash 800 less Note: A smaller credit to cash increases the balance in cash. Chapter 8 Long-Lived Assets and Depreciation 413

44 414 The effect on retained earnings would be $2,000 million $800 million = $1,200 million. That is, net income (and hence retained earnings) would be $1,200 million lower.

45 8-63 (continued) 5. The $2,500 million increase of depreciation would cause net income to decrease but would have no effect on cash provided by operations. Straight-line Accelerated Depreciation Depreciation Before After Before After Sales $246,525 $246,525 $246,525$246,525 Cash operating expenses 229, , , ,449 Cash provided by operations 17,076 17,076 17,076 17,076 Depreciation expense 3,432 5,932 5,432 7,932 Income before income taxes 13,644 11,144 11,644 9,144 Income tax expense Net income 13,644 11,144 11,644 9,144 Chapter 8 Long-Lived Assets and Depreciation 415

46 8-64 (25-35 min.) Amounts in table and narrative are in millions of Euros. 1. Zero Income Taxes 2. 60% Income Taxes Straight-line Accelerated Straight-line Accelerated Depreciation Depreciation Depreciation Depreciation Revenues (all cash) 50,288 50,288 50,28850,288 Cash operating expenses (47,884 1,974) 45,910 45,910 45,91045,910 Cash provided by operations before income taxes 4,378 4,378 4,378 4,378 Depreciation expense 1,974 2,474 1,974 2,474 Operating income 2,404 1,904 2,404 1,904 Income tax expense - - 1,442 1,142 Net income 2,404 1, Supplementary analysis: Cash provided by operations before income taxes 4,378 4,378 4,378 4,378 Income tax expense - - 1,442 1,142 Net cash provided by operations 4,378 4,378 2,936 3, By itself, depreciation expense does not provide cash. This point is illustrated by part 1, which compares the amounts shown before taxes. Note that the cash provided by operations and the ending cash balances are exactly the same. No matter what depreciation expense is allocated to the year (whether 1,974, 2,474, or zero), the 4,378 cash provided by operations and the ending cash will be unaffected. 416

47 8-64 (continued) Examine part 2, which compares amounts after taxes. Again, by itself, depreciation does not affect the cash inflow provided by operations. Only sales to customers can provide more cash receipts from operations. However, depreciation does affect the cash outflow for income taxes. The use of accelerated depreciation results in a strange combination of showing less net income but conserving more cash. The accelerated method shows net income of 762 (compared with 962 using straight-line), but accelerated depreciation shows a net increase in cash provided by operations (less income taxes) of 3,236 (compared with 2,936 using straightline). Accordingly, the final cash balance is 300 higher for accelerated than for straight-line depreciation. 4. Journal entries (not required) may clarify the effects: Depreciation expense Accumulated depreciation Income tax expense Cash 500 more 300 less 500 more 300 less Note: A smaller credit to cash increases the balance in cash. The effects on retained earnings would be That is, net income (and hence retained earnings) would be 200 lower. In summary: Chapter 8 Long-Lived Assets and Depreciation 417

48 8-64 (continued) Cash, increase by reduction in taxes,.60 x 500 = 300 Accumulated depreciation, increase by 500 Operating income, decrease by 500 Income tax expense, decrease by 300 Retained earnings, decrease by 200 New balances: Cash, 7, = 7,966 Accumulated Depreciation 17, = 17, The doubling of depreciation would cause net income to decrease but would have no effect on cash provided by operations: Straight-line Accelerated Depreciation Depreciation Before Doubled Before Doubled Sales 50,288 50,288 50,288 50,288 Cash operating expenses 45,910 45,910 45,910 45,910 Cash provided by operations 4,378 4,378 4,378 4,378 Depreciation expense 1,974 3,948 2,474 4,948 Income before income taxes 2, ,904 (570) Income tax expense Net income (loss) 2, ,904 (570) 418

49 8-65 (30 min.) All amounts are stated in thousands of Deutchmarks. 1. and 2. Part (1) Part (2) 20X8 Change 20X9 20X8 Change 20X9 Revenue DM2,100 DM1,000 DM3,100 DM2,100 DM1,000 DM3,100 Operating expense other than depreciation 1, ,500 1, ,500 Cash (C) provided by operations DM 400 DM 200 DM 600 DM 400 DM 200 DM 600 Depreciation Income before income taxes DM 200 DM 100 DM 300 DM 200 DM 150 DM Part (3a) Part (3b) 20X8 Change 20X9 20X8 Change 20X9 Income before income taxes DM 200 DM 100 DM 300 DM 200 DM 150 DM 350 Income taxes at 30% Net income after income taxes DM 140 DM 70 DM 210 DM 140 DM 105 DM 245 Cash provided by operations after income taxes [(C) above minus income taxes] DM 340 DM 170 DM 510 DM 340 DM 155 DM By itself, depreciation does not provide "cash inflow" (cash provided by operations). Note in parts (1) and (2) that the cash provided by operations went up from DM400 to DM600, a DM200 increase, because revenues (the basic source of cash) increased by DM1,000 and operating expenses increased by DM800. Whether depreciation is DM50, DM100, DM1,000, or zero will not affect cash provided by operations (if income taxes are ignored). Chapter 8 Long-Lived Assets and Depreciation 419

50 8-65 (continued) Depreciation does affect the amount of income tax cash outflow. If only DM50 rather than DM100 is deducted as depreciation, the income tax bill will be DM15 higher, 30% of (DM100 - DM50). That is why cash provided by operations is less by DM15 in part (3b). The important point is that income tax cash outflows are affected by depreciation. Otherwise, depreciation has no direct effect on cash inflows or outflows (15-25 min.) This problem is more challenging than most because it raises conceptual issues regarding how to account for depreciation. Dollar amounts are in millions. 1. Depreciation expense 4.5 Accumulated depreciation 4.5 To record 3 months of depreciation: Acquisition cost $70.0 Predicted residual value 52.0 Depreciable amount $18.0 Amount per month, $18 12 $ 1.5 For 3 months: $1.5 per month x 3 months $ Depreciation expense 13.5 Accumulated depreciation 13.5 To record 9 months of depreciation (9 months x $1.5 per month) 420

51 8-66 (continued) 3. Cash 58 Accumulated depreciation 18 Revenue-earning equipment 70 Depreciation expense 6 To record the sale of equipment Note the entry to depreciation expense instead of gain on sale of automobiles. This method recognizes that, if the autos were sold for $58, the residual value was underestimated, and therefore too much depreciation was charged. The entry adjusts the depreciation expense for this estimation error. 4. This part illustrates how the predictions of useful lives and residual values can affect depreciation expenses. It also underscores the general "prospective" approach to depreciation expense. That is, 2003 depreciation charges would not be "corrected" retroactively. However, up-to-date knowledge can affect depreciation being taken currently (2004) As Perfect As Perfect Reported Prediction Reported Prediction Depreciation in millions * 9 *$13.5 $6 Depreciation expense for the 12 months of ownership spread over the two calendar years is $12. Under the same circumstances, some companies would show depreciation expense of 9 x $1.5 = $13.5 for 2004 for a total of $18 and show a $6 gain on sale of equipment. This underscores the fact that the final gains or losses on sales of fixed assets are affected by the depreciation policies followed while the assets are in service. Chapter 8 Long-Lived Assets and Depreciation 421

52 8-67 (10-15 min.) Conceptually, a strong case can be made for deferring the $2 million and amortizing it over the useful life of the product or process developed. However, the FASB requires that research and development costs be written off to expense as they are incurred. The history of accounting for research and development may be of interest as an illustration of a long debate about the meaning and measurement of an asset. Until the FASB requirement for expensing this cost as incurred became effective in 1975, many companies deferred research costs and amortized them. There was no uniformity, to say the least. For example, in 1973, the American Institute of CPAs issued an audit guide that pertained to companies "in the development stage." The accounting for the Mori Pharmaceuticals Company would have been covered by this audit guide, which required the capitalization of these costs as "investments for the future" unless such costs were clearly unrecoverable. In a sense, then, one set of principles was applicable to companies in the development stage that may not have been equally applicable to mature companies having similar outlays. Incidentally, the audit guide took the following position regarding established companies: "The guide does not apply to established companies developing new products, services, or markets, or to the development activities of their subsidiaries, even though the subsidiaries are in the development stage, when included in consolidated financial statements. It does, however, apply to separate financial statements of a subsidiary in the development stage and is applicable to consolidated financial information when the group as a whole is considered to be in the development stage." 422

53 8-68 (15-20 min.) The purpose of this problem is to stress the limitations of the use of historical costs, particularly where there are significant amounts of property, plant, and equipment. The balance sheet values do not come close to the current market value of the land and building, $1,800,000.60, or $3,000,000. Consequently, in terms of current values before expansion and modernization, stockholders' equity is understated (in thousands): Market value of land and building $3,000 Net book value: Land $500 Building Excess of market value over net book value $2,300 As conventionally prepared after the expansion and modernization, the balance sheet would be (in thousands): Cash $ 300 Liabilities: Land 500 Mortgage Building at cost $2,600 payable $1,800 Accumulated Stockholders' depreciation 600 equity 1,000 Net book value 2,000 Total liabilities and Total assets $2,800 stockholders equity $2, The balance sheet would be unusually deceiving. The mortgage would appear to be exceedingly high in relation to the book value of the assets. The historical costs and resulting stockholders' equity have lost all meaning. Note that, on a market value basis, the land and building are worth $3,000,000 before the borrowing and the renovation and therefore worth $4,800,000 after. This is $2,300,000 above the book Chapter 8 Long-Lived Assets and Depreciation 423