After studying this chapter, you should be able to:
Do They Matter?
The axiom on Wall Street has been that huge one-time charges don't really count. These highly unusual events don't truly reflect how a company is faring, so Wall Street ignores them. In the last few years write-offs have approached all-time highs. For example, over one-third of the companies surveyed by Accounting Trends and Techniques in 2007 reported asset impairments.
However, some companies have taken write-offs so regularly that they really are a reflection of ongoing business. When you adjust for the write-offs, earnings turn out to be far worse—and the companies' shares of stock turn out to be far more expensive. Presented below are data from three companies that had charges every year for five consecutive years.
For example, the data show that International Paper's adjusted earnings come in closer to $0.46 per share than $2.82. This means that its price-to-earnings ratio is closer to 90 than to 15. In short, these companies may be overpriced and are likely set for stock price declines.
One reason for more write-offs may be the tougher U.S. guidelines to determine when companies should consider property, plant, and equipment as impaired. These impairment rules are catching on internationally. Twenty-six Japanese companies adopted impairment standards similar to the U.S. standards, resulting in a combined loss of ¥814.1 billion (yen) in a recent year. Adoption of the impairment standard both signals that the recent economic downturn was behind these companies and introduces more transparent accounting. Thus, while impairments are on the rise in the United States and elsewhere, investors are now receiving better information about fixed-asset values in financial statements.
Source: Adapted from "Were Profits Inflated?" Business Week (March 4, 2002), p. 14, and from Michael K. Ozanian, "The Secret Charges, Forbes (March 4, 2002), p. 102. See also "Losses Pile Up under Stricter Accounting," International Herald Tribune (June 2, 2004).
PREVIEW OF CHAPTER 11
As noted in the opening story, both U.S. and foreign companies are affected by impairment rules. These rules recognize that when economic conditions deteriorate, companies may need to write off an asset's cost to indicate the decline in its usefulness. The purpose of this chapter is to examine the depreciation process and the methods of writing off the cost of tangible assets and natural resources. The content and organization of the chapter are as follows.
Most individuals at one time or another purchase and trade in an automobile. The automobile dealer and the buyer typically discuss what the trade-in value of the old car is. Also, they may talk about what the trade-in value of the new car will be in several years. In both cases a decline in value is considered to be an example of depreciation.
To accountants, however, depreciation is not a matter of valuation. Rather, depreciation is a means of cost allocation. Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. For example, a company like Goodyear (one of the world's largest tire manufacturers) does not depreciate assets on the basis of a decline in their fair market value. Instead, it depreciates through systematic charges to expense.
This approach is employed because the value of the asset may fluctuate between the time the asset is purchased and the time it is sold or junked. Attempts to measure these interim value changes have not been well received because values are difficult to measure objectively. Therefore, Goodyear charges the asset's cost to depreciation expense over its estimated life. It makes no attempt to value the asset at fair market value between acquisition and disposition. Companies use the cost allocation approach because it matches costs with revenues and because fluctuations in market value are uncertain and difficult to measure.
When companies write off the cost of long-lived assets over a number of periods, they typically use the term depreciation. They use the term depletion to describe the reduction in the cost of natural resources (such as timber, gravel, oil, and coal) over a period of time. The expiration of intangible assets, such as patents or copyrights, is called amortization.
Before establishing a pattern of charges to revenue, a company must answer three basic questions:
What depreciable base is to be used for the asset?
What is the asset's useful life?
What method of cost apportionment is best for this asset?
The answers to these questions involve combining several estimates into one single figure. Note the calculations assume perfect knowledge of the future, which is never attainable.
The base established for depreciation is a function of two factors: the original cost, and salvage or disposal value. We discussed historical cost in Chapter 10. Salvage value is the estimated amount that a company will receive when it sells the asset or removes it from service. It is the amount to which a company writes down or depreciates the asset during its useful life. If an asset has a cost of $10,000 and a salvage value of $1,000, its depreciation base is $9,000.
From a practical standpoint, companies often assign a zero salvage value. Some long-lived assets, however, have substantial salvage values.
The service life of an asset often differs from its physical life. A piece of machinery may be physically capable of producing a given product for many years beyond its service life. But a company may not use the equipment for all that time because the cost of producing the product in later years may be too high. For example, the old Slater cotton mill in Pawtucket, Rhode Island, is preserved in remarkable physical condition as an historic landmark in U.S. industrial development, although its service life was terminated many years ago.[148]
Companies retire assets for two reasons: physical factors (such as casualty or expiration of physical life) and economic factors (obsolescence). Physical factors are the wear and tear, decay, and casualties that make it difficult for the asset to perform indefinitely. These physical factors set the outside limit for the service life of an asset.
We can classify the economic or functional factors into three categories:
Inadequacy results when an asset ceases to be useful to a company because the demands of the firm have changed. An example would be the need for a larger building to handle increased production. Although the old building may still be sound, it may have become inadequate for the company's purpose.
Supersession is the replacement of one asset with another more efficient and economical asset. Examples would be the replacement of the mainframe computer with a PC network, or the replacement of the Boeing 767 with the Boeing 787.
Obsolescence is the catchall for situations not involving inadequacy and super-session.
Because the distinction between these categories appears artificial, it is probably best to consider economic factors collectively instead of trying to make distinctions that are not clear-cut.
To illustrate the concepts of physical and economic factors, consider a new nuclear power plant. Which is more important in determining the useful life of a nuclear power plant—physical factors or economic factors? The limiting factors seem to be (1) ecological considerations, (2) competition from other power sources, and (3) safety concerns. Physical life does not appear to be the primary factor affecting useful life. Although the plant's physical life may be far from over, the plant may become obsolete in 10 years.
For a house, physical factors undoubtedly are more important than the economic or functional factors relative to useful life. Whenever the physical nature of the asset primarily determines useful life, maintenance plays an extremely vital role. The better the maintenance, the longer the life of the asset.[149]
In most cases, a company estimates the useful life of an asset based on its past experience with the same or similar assets. Others use sophisticated statistical methods to establish a useful life for accounting purposes. And in some cases, companies select arbitrary service lives. In a highly industrial economy such as that of the United States, where research and innovation are so prominent, technological factors have as much effect, if not more, on service lives of tangible plant assets as physical factors do.
Some companies try to imply that depreciation is not a cost. For example, in their press releases they will often make a bigger deal over earnings before interest, taxes, depreciation, and amortization (often referred to as EBITDA) than net income under GAAP. They like it because it "dresses up" their earnings numbers. Some on Wall Street buy this hype because they don't like the allocations that are required to determine net income. Some banks, without batting an eyelash, even let companies base their loan covenants on EBITDA.
For example, look at Premier Parks, which operates the Six Flags chain of amusement parks. Premier touts its EBITDA performance. But that number masks a big part of how the company operates—and how it spends its money. Premier argues that analysts should ignore depreciation for big-ticket items like roller coasters because the rides have a long life. Critics, however, say that the amusement industry has to spend as much as 50 percent of its EBITDA just to keep its rides and attractions current. Those expenses are not optional—let the rides get a little rusty, and ticket sales start to tail off. That means analysts really should view depreciation associated with the costs of maintaining the rides (or buying new ones) as an everyday expense. It also means investors in those companies should have strong stomachs.
What's the risk of trusting a fad accounting measure? Just look at a recent year's bankruptcy numbers. Of the 147 companies tracked by Moody's that defaulted on their debt, most borrowed money based on EBITDA performance. The bankers in those deals probably wish they had looked at a few other factors. Investors should as well.
Source: Adapted from Herb Greenberg, Alphabet Dupe: "Why EBITDA Falls Short," Fortune (July 10, 2000), p. 240.
The third factor involved in the depreciation process is the method of cost apportionment. The profession requires that the depreciation method employed be "systematic and rational." Companies may use a number of depreciation methods, as follows.
Depreciation attempts to match the cost of an asset to the periods that benefit from the use of that asset.
Activity method (units of use or production).
Straight-line method.
Decreasing charge methods (accelerated):
Sum-of-the-years'-digits.
Declining-balance method.
Special depreciation methods:
Group and composite methods.
Hybrid or combination methods.[150]
To illustrate these depreciation methods, assume that Stanley Coal Mines recently purchased an additional crane for digging purposes. Illustration 11-2 contains the pertinent data concerning this purchase.
The activity method (also called the variable-charge or units-of-production approach) assumes that depreciation is a function of use or productivity, instead of the passage of time. A company considers the life of the asset in terms of either the output it provides (units it produces), or an input measure such as the number of hours it works. Conceptually, the proper cost association relies on output instead of hours used, but often the output is not easily measurable. In such cases, an input measure such as machine hours is a more appropriate method of measuring the dollar amount of depreciation charges for a given accounting period.
The crane poses no particular depreciation problem. Stanley can measure the usage (hours) relatively easily. If Stanley uses the crane for 4,000 hours the first year, the depreciation charge is:
The major limitation of this method is that it is inappropriate in situations in which depreciation is a function of time instead of activity. For example, a building steadily deteriorates due to the elements (time) regardless of its use. In addition, where economic or functional factors affect an asset, independent of its use, the activity method loses much of its significance. For example, if a company is expanding rapidly, a particular building may soon become obsolete for its intended purposes. In both cases, activity is irrelevant. Another problem in using an activity method is the difficulty of estimating units of output or service hours received.
In cases where loss of services results from activity or productivity, the activity method matches costs and revenues the best. Companies that desire low depreciation during periods of low productivity, and high depreciation during high productivity, either adopt or switch to an activity method. In this way, a plant running at 40 percent of capacity generates 60 percent lower depreciation charges. Inland Steel, for example, switched to units-of-production depreciation at one time and reduced its losses by $43 million, or $1.20 per share.
The straight-line method considers depreciation a function of time rather than a function of usage. Companies widely use this method because of its simplicity. The straight-line procedure is often the most conceptually appropriate, too. When creeping obsolescence is the primary reason for a limited service life, the decline in usefulness may be constant from period to period. Stanley computes the depreciation charge for the crane as follows.
If benefits flow on a "straight-line" basis, then justification exists for matching the cost of the asset on a straight-line basis with these benefits.
The major objection to the straight-line method is that it rests on two tenuous assumptions: (1) The asset's economic usefulness is the same each year, and (2) the repair and maintenance expense is essentially the same each period.
One additional problem that occurs in using straight-line—as well as some others—is that distortions in the rate of return analysis (income/assets) develop. Illustration 11-5 indicates how the rate of return increases, given constant revenue flows, because the asset's book value decreases.
The decreasing-charge methods provide for a higher depreciation cost in the earlier years and lower charges in later periods. Because these methods allow for higher early-year charges than in the straight-line method, they are often called accelerated depreciation methods.
What is the main justification for this approach? The rationale is that companies should charge more depreciation in earlier years because the asset is most productive in its earlier years. Furthermore, the accelerated methods provide a constant cost because the depreciation charge is lower in the later periods, at the time when the repair and maintenance costs are often higher. Generally, companies use one of two decreasing-charge methods: the sum-of-the-years'-digits method, or the declining-balance method.
The matching concept does not justify a constant charge to income. If the benefits from the asset decline as the asset ages, then a decreasing charge to income better matches cost to benefits.
Sum-of-the-Years'-Digits. The sum-of-the-years'-digits method results in a decreasing depreciation charge based on a decreasing fraction of depreciable cost (original cost less salvage value). Each fraction uses the sum of the years as a denominator (5 + 4 + 3 + 2 + 1 = 15). The numerator is the number of years of estimated life remaining as of the beginning of the year. In this method, the numerator decreases year by year, and the denominator remains constant (5/15, 4/15, 3/15, 2/15, and 1/15). At the end of the asset's useful life, the balance remaining should equal the salvage value. Illustration 11-6 shows this method of computation.[151]
Declining-Balance Method. The declining-balance method utilizes a depreciation rate (expressed as a percentage) that is some multiple of the straight-line method. For example, the double-declining rate for a 10-year asset is 20 percent (double the straight-line rate, which is 1/10 or 10 percent). Companies apply the constant rate to the declining book value each year.
Unlike other methods, the declining-balance method does not deduct the salvage value in computing the depreciation base. The declining-balance rate is multiplied by the book value of the asset at the beginning of each period. Since the depreciation charge reduces the book value of the asset each period, applying the constant-declining-balance rate to a successively lower book value results in lower depreciation charges each year. This process continues until the book value of the asset equals its estimated salvage value. At that time the company discontinues depreciation.
Companies use various multiples in practice. For example, the double-declining-balance method depreciates assets at twice (200 percent) the straight-line rate. Illustration 11-7 shows Stanley's depreciation charges if using the double-declining approach.
Companies often switch from the declining-balance method to the straight-line method near the end of the asset's useful life to ensure that they depreciate the asset only to its salvage value.[152]
Sometimes companies adopt special depreciation methods. Reasons for doing so might be that a company's assets have unique characteristics, or the nature of the industry. Two of these special methods are:
Group and composite methods.
Hybrid or combination methods.
Companies often depreciate multiple-asset accounts using one rate. For example, AT&T might depreciate telephone poles, microwave systems, or switchboards by groups.
Two methods of depreciating multiple-asset accounts exist: the group method and the composite method. The choice of method depends on the nature of the assets involved. Companies frequently use the group method when the assets are similar in nature and have approximately the same useful lives. They use the composite approach when the assets are dissimilar and have different lives. The group method more closely approximates a single-unit cost procedure because the dispersion from the average is not as great. The computation for group or composite methods is essentially the same: find an average and depreciate on that basis.
Companies determine the composite depreciation rate by dividing the depreciation per year by the total cost of the assets. To illustrate, Mooney Motors establishes the composite depreciation rate for its fleet of cars, trucks, and campers as shown in Illustration 11-8.
If there are no changes in the asset account, Mooney will depreciate the group of assets to the residual or salvage value at the rate of $56,000 ($224,000 × 25%) a year. As a result, it will take Mooney 3.39 years to depreciate these assets. The length of time it takes a company to depreciate it assets on a composite basis is called the composite life.
We can highlight the differences between the group or composite method and the single-unit depreciation method by looking at asset retirements. If Mooney retires an asset before, or after, the average service life of the group is reached, it buries the resulting gain or loss in the Accumulated Depreciation account. This practice is justified because Mooney will retire some assets before the average service life and others after the average life. For this reason, the debit to Accumulated Depreciation is the difference between original cost and cash received. Mooney does not record a gain or loss on disposition.
To illustrate, suppose that Mooney Motors sold one of the campers with a cost of $5,000 for $2,600 at the end of the third year. The entry is:
If Mooney purchases a new type of asset (mopeds, for example), it must compute a new depreciation rate and apply this rate in subsequent periods.
Illustration 11-9 presents a typical financial statement disclosure of the group depreciation method for Ampco-Pittsburgh Corporation.
The group or composite method simplifies the bookkeeping process and tends to average out errors caused by over- or underdepreciation. As a result, gains or losses on disposals of assets do not distort periodic income.
On the other hand, the unit method has several advantages over the group or composite methods: (1) It simplifies the computation mathematically. (2) It identifies gains and losses on disposal. (3) It isolates depreciation on idle equipment. (4) It represents the best estimate of the depreciation of each asset, not the result of averaging the cost over a longer period of time. As a consequence, companies generally use the unit method. Unless stated otherwise, you should use the unit method in homework problems.[153]
In addition to the depreciation methods already discussed, companies are free to develop their own special or tailor-made depreciation methods. GAAP requires only that the method result in the allocation of an asset's cost over the asset's life in a systematic and rational manner.
For example, the steel industry widely uses a hybrid depreciation method, called the production variable method, that is a combination straight-line/activity approach. The following note from WHX Corporation's annual report explains one variation of this method.
Which depreciation method should management select? Many believe that the method that best matches revenues with expenses should be used. For example, if revenues generated by the asset are constant over its useful life, select straight-line depreciation. On the other hand, if revenues are higher (or lower) at the beginning of the asset's life, then use a decreasing (or increasing) method. Thus, if a company can reliably estimate revenues from the asset, selecting a depreciation method that best matches costs with those revenues would seem to provide the most useful information to investors and creditors for assessing the future cash flows from the asset.
Managers in the real estate industry face a different challenge when considering depreciation choices. Real estate managers object to traditional depreciation methods because in their view, real estate often does not decline in value. In addition, because real estate is highly debt-financed, most real estate concerns report losses in earlier years of operations when the sum of depreciation and interest exceeds the revenue from the real estate project. As a result, real estate companies, like Kimco Realty, argue for some form of increasing-charge method of depreciation (lower depreciation at the beginning and higher depreciation at the end). With such a method, companies would report higher total assets and net income in the earlier years of the project.[154]
We still need to discuss several special issues related to depreciation:
How should companies compute depreciation for partial periods?
Does depreciation provide for the replacement of assets?
How should companies handle revisions in depreciation rates?
Companies seldom purchase plant assets on the first day of a fiscal period or dispose of them on the last day of a fiscal period. A practical question is: How much depreciation should a company charge for the partial periods involved?
In computing depreciation expense for partial periods, companies must determine the depreciation expense for the full year and then prorate this depreciation expense between the two periods involved. This process should continue throughout the useful life of the asset.
Assume, for example, that Steeltex Company purchases an automated drill machine with a 5-year life for $45,000 (no salvage value) on June 10, 2009. The company's fiscal year ends December 31. Steeltex therefore charges depreciation for only 6⅔ months during that year. The total depreciation for a full year (assuming straight-line depreciation) is $9,000 ($45,000/5). The depreciation for the first, partial year is therefore:
The partial-period calculation is relatively simple when Steeltex uses straight-line depreciation. But how is partial-period depreciation handled when it uses an accelerated method such as sum-of-the-years'-digits or double-declining-balance? As an illustration, assume that Steeltex purchased another machine for $10,000 on July 1, 2009, with an estimated useful life of five years and no salvage value. Illustration 11-11 shows the depreciation figures for 2009, 2010, and 2011.
Sometimes a company like Steeltex modifies the process of allocating costs to a partial period to handle acquisitions and disposals of plant assets more simply. One variation is to take no depreciation in the year of acquisition and a full year's depreciation in the year of disposal. Other variations charge one-half year's depreciation both in the year of acquisition and in the year of disposal (referred to as the half-year convention), or charge a full year in the year of acquisition and none in the year of disposal.
In fact, Steeltex may adopt any one of these several fractional-year policies in allocating cost to the first and last years of an asset's life so long as it applies the method consistently. However, unless otherwise stipulated, companies normally compute depreciation on the basis of the nearest full month.
Illustration 11-12 shows depreciation allocated under five different fractional-year policies using the straight-line method on the $45,000 automated drill machine purchased by Steeltex Company on June 10, 2009, discussed earlier.
A common misconception about depreciation is that it provides funds for the replacement of fixed assets. Depreciation is like other expenses in that it reduces net income. It differs, though, in that it does not involve a current cash outflow.
To illustrate why depreciation does not provide funds for replacement of plant assets, assume that a business starts operating with plant assets of $500,000 that have a useful life of five years. The company's balance sheet at the beginning of the period is:
If we assume that the company earns no revenue over the five years, the income statements are:
Total depreciation of the plant assets over the five years is $500,000. The balance sheet at the end of the five years therefore is:
This extreme example illustrates that depreciation in no way provides funds for the replacement of assets. The funds for the replacement of the assets come from the revenues (generated through use of the asset). Without the revenues, no income materializes and no cash inflow results.
When purchasing a plant asset, companies carefully determine depreciation rates based on past experience with similar assets and other pertinent information. The provisions for depreciation are only estimates, however. They may need to revise them during the life of the asset. Unexpected physical deterioration or unforeseen obsolescence may decrease the estimated useful life of the asset. Improved maintenance procedures, revision of operating procedures, or similar developments may prolong the life of the asset beyond the expected period.[155]
For example, assume that International Paper Co. purchased machinery with an original cost of $90,000. It estimates a 20-year life with no salvage value. However, during year 11, International Paper estimates that it will use the machine for an additional 20 years. Its total life, therefore, will be 30 years instead of 20. Depreciation has been recorded at the rate of 1/20 of $90,000, or $4,500 per year by the straight-line method. On the basis of a 30-year life, International Paper should have recorded depreciation as 1/30 of $90,000, or $3,000 per year. It has therefore overstated depreciation, and understated net income, by $1,500 for each of the past 10 years, or a total amount of $15,000. Illustration 11-13 shows this computation.
International Paper should report this change in estimate in the current and prospective periods. It should not make any changes in previously reported results. And it does not adjust opening balances nor attempt to "catch up" for prior periods. The reason? Changes in estimates are a continual and inherent part of any estimation process. Continual restatement of prior periods would occur for revisions of estimates unless handled prospectively. Therefore, no entry is made at the time the change in estimate occurs. Charges for depreciation in subsequent periods (assuming use of the straight-line method) are determined by dividing the remaining book value less any salvage value by the remaining estimated life.
The entry to record depreciation for each of the remaining 20 years is:
The amount of depreciation expense recorded depends on both the depreciation method used and estimates of service lives and salvage values of the assets. Differences in these choices and estimates can significantly impact a company's reported results and can make it difficult to compare the depreciation numbers of different companies.
For example, when Willamette Industries extended the estimated service lives of its machinery and equipment by five years, it increased income by nearly $54 million.
An analyst determines the impact of these management choices and judgments on the amount of depreciation expense by examining the notes to financial statements. For example, Willamette Industries provided the following note to its financial statements.
The general accounting standard of lower-of-cost-or-market for inventories does not apply to property, plant, and equipment. Even when property, plant, and equipment has suffered partial obsolescence, accountants have been reluctant to reduce the asset's carrying amount. Why? Because, unlike inventories, it is difficult to arrive at a fair value for property, plant, and equipment that is not subjective and arbitrary.
For example, Falconbridge Ltd. Nickel Mines had to decide whether to write off all or a part of its property, plant, and equipment in a nickel-mining operation in the Dominican Republic. The project had been incurring losses because nickel prices were low and operating costs were high. Only if nickel prices increased by approximately 33 percent would the project be reasonably profitable. Whether a write-off was appropriate depended on the future price of nickel. Even if the company decided to write off the asset, how much should be written off?
The going concern concept assumes that the company can recover the investment in its assets. Under GAAP companies do not report the fair value of long-lived assets because a going concern does not plan to sell such assets. However, if the assumption of being able to recover the cost of the investment is not valid, then a company should report a reduction in value.
As discussed in the opening story, the FASB and international accounting standard-setters have developed rules for recognizing impairments on long-lived assets. [1] According to these standards, when the carrying amount of an asset is not recoverable, a company records a write-off. This write-off is referred to as an impairment.
Various events and changes in circumstances might lead to an impairment. Examples are:
A significant decrease in the market value of an asset.
A significant change in the extent or manner in which an asset is used.
A significant adverse change in legal factors or in the business climate that affects the value of an asset.
An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset.
A projection or forecast that demonstrates continuing losses associated with an asset.
These events or changes in circumstances indicate that the company may not be able to recover the carrying amount of the asset. In that case, a recoverability test is used to determine whether an impairment has occurred.
To apply the first step of the recoverability test, a company like UPS estimates the future net cash flows expected from the use of that asset and its eventual disposition. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, UPS considers the asset impaired. Conversely, if the sum of the expected future net cash flows (undiscounted) is equal to or greater than the carrying amount of the asset, no impairment has occurred.
The recoverability test therefore screens for asset impairment. For example, if the expected future net cash flows from an asset are $400,000 and its carrying amount is $350,000, no impairment has occurred. However, if the expected future net cash flows are $300,000, an impairment has occurred. The rationale for the recoverability test relies on a basic presumption: A balance sheet should report long-lived assets at no more than the carrying amounts that are recoverable.
If the recoverability test indicates an impairment, UPS computes a loss. The impairment loss is the amount by which the carrying amount of the asset exceeds its fair value. How does UPS determine the fair value of an asset? It is measured based on the market value if an active market for the asset exists. If no active market exists, UPS uses the present value of expected future net cash flows to determine fair value.
To summarize, the process of determining an impairment loss is as follows.
Review events or changes in circumstances for possible impairment.
If the review indicates impairment, apply the recoverability test. If the sum of the expected future net cash flows from the long-lived asset is less than the carrying amount of the asset, an impairment has occurred.
Assuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market value or the present value of expected future net cash flows.
iGAAP also uses a fair value test to measure the impairment loss. However, iGAAP does not use the first-stage recoverability test used under U.S. GAAP—comparing the undiscounted cash flows to the carrying amount. As a result, the iGAAP test is more strict than U.S. GAAP.
M. Alou Inc. has an asset that, due to changes in its use, it reviews for possible impairment. The asset's carrying amount is $600,000 ($800,000 cost less $200,000 accumulated depreciation). Alou determines the expected future net cash flows (undiscounted) from the use of the asset and its eventual disposal to be $650,000.
The recoverability test indicates that the $650,000 of expected future net cash flows from the asset's use exceed the carrying amount of $600,000. As a result, no impairment occurred. (Recall that the undiscounted future net cash flows must be less than the carrying amount for Alou to deem an asset to be impaired and to measure the impairment loss.) Therefore, M. Alou Inc. does not recognize an impairment loss in this case.
Assume the same facts as in Example 1, except that the expected future net cash flows from Alou's asset are $580,000 (instead of $650,000). The recoverability test indicates that the expected future net cash flows of $580,000 from the use of the asset are less than its carrying amount of $600,000. Therefore an impairment has occurred.
The difference between the carrying amount of Alou's asset and its fair value is the impairment loss. Assuming this asset has a market value of $525,000, Illustration 11-15 shows the loss computation.
M. Alou records the impairment loss as follows.
M. Alou Inc. reports the impairment loss as part of income from continuing operations, in the "Other expenses and losses" section. Generally, Alou should not report this loss as an extraordinary item. Costs associated with an impairment loss are the same costs that would flow through operations and that it would report as part of continuing operations. Alou will continue to use these assets in operations. Therefore, it should not report the loss below "Income from continuing operations."
A company that recognizes an impairment loss should disclose the asset(s) impaired, the events leading to the impairment, the amount of the loss, and how it determined fair value (disclosing the interest rate used, if appropriate).
After recording an impairment loss, the reduced carrying amount of an asset held for use becomes its new cost basis. A company does not change the new cost basis except for depreciation or amortization in future periods or for additional impairments.
To illustrate, assume that Damon Company at December 31, 2009, has equipment with a carrying amount of $500,000. Damon determines this asset is impaired and writes it down to its fair value of $400,000. At the end of 2010, Damon determines that the fair value of the asset is $480,000. The carrying amount of the equipment should not change in 2010 except for the depreciation taken in 2010. Damon may not restore an impairment loss for an asset held for use. The rationale for not writing the asset up in value is that the new cost basis puts the impaired asset on an equal basis with other assets that are unimpaired.
What happens if a company intends to dispose of the impaired asset, instead of holding it for use? Recently Kroger recorded an impairment loss of $54 million on property, plant, and equipment it no longer needed due to store closures. In this case, Kroger reports the impaired asset at the lower of cost or net realizable value (fair value less cost to sell). Because Kroger intends to dispose of the assets in a short period of time, it uses net realizable value in order to provide a better measure of the net cash flows that it will receive from these assets.
Kroger does not depreciate or amortize assets held for disposal during the period it holds them. The rationale is that depreciation is inconsistent with the notion of assets to be disposed of and with the use of the lower of cost or net realizable value. In other words, assets held for disposal are like inventory; companies should report them at the lower of cost or net realizable value.
iGAAP permits write-ups for subsequent recoveries of impairment, back up to the original amount before the impairment. U.S. GAAP prohibits those write-ups, except for assets to be disposed of.
Because Kroger will recover assets held for disposal through sale rather than through operations, it continually revalues them. Each period, the assets are reported at the lower of cost or net realizable value. Thus Kroger can write up or down an asset held for disposal in future periods, as long as the carrying value after the write-up never exceeds the carrying amount of the asset before the impairment. Companies should report losses or gains related to these impaired assets as part of income from continuing operations.
Illustration 11-16 summarizes the key concepts in accounting for impairments.
Natural resources, often called wasting assets, include petroleum, minerals, and timber. They have two main features: (1) the complete removal (consumption) of the asset, and (2) replacement of the asset only by an act of nature. Unlike plant and equipment, natural resources are consumed physically over the period of use and do not maintain their physical characteristics. Still, the accounting problems associated with natural resources are similar to those encountered with fixed assets. The questions to be answered are:
How do companies establish the cost basis for write-off?
What pattern of allocation should companies employ?
Recall that the accounting profession uses the term depletion for the process of allocating the cost of natural resources.
How do we determine the depletion base for natural resources? For example, a company like ExxonMobil makes sizable expenditures to find natural resources, and for every successful discovery there are many failures. Furthermore, it encounters long delays between the time it incurs costs and the time it obtains the benefits from the extracted resources. As a result, a company in the extractive industries, like Exxon-Mobil, frequently adopts a conservative policy in accounting for the expenditures related to finding and extracting natural resources.
Computation of the depletion base involves four factors: (1) acquisition cost of the deposit, (2) exploration costs, (3) development costs, and (4) restoration costs.
Acquisition cost is the price ExxonMobil pays to obtain the property right to search and find an undiscovered natural resource. It also can be the price paid for an already-discovered resource. A third type of acquisition cost can be lease payments for property containing a productive natural resource; included in these acquisition costs are royalty payments to the owner of the property.
Generally, the acquisition cost of natural resources is recorded in an account titled Undeveloped Property. ExxonMobil later assigns that cost to the natural resource if exploration efforts are successful. If the efforts are unsuccessful, it writes off the acquisition cost as a loss.
As soon as a company has the right to use the property, it often incurs exploration costs needed to find the resource. When exploration costs are substantial, some companies capitalize them into the depletion base. In the oil and gas industry, where the costs of finding the resource are significant and the risks of finding the resource are very uncertain, most large companies expense these costs. Smaller oil and gas companies often capitalize these exploration costs. We examine the unique issues related to the oil and gas industry on pages 557–559 (see "Continuing Controversy").
Companies divide development costs into two parts: (1) tangible equipment costs and (2) intangible development costs. Tangible equipment costs include all of the transportation and other heavy equipment needed to extract the resource and get it ready for market. Because companies can move the heavy equipment from one extracting site to another, companies do not normally include tangible equipment costs in the depletion base. Instead, they use separate depreciation charges to allocate the costs of such equipment. However, some tangible assets (e.g., a drilling rig foundation) cannot be moved. Companies depreciate these assets over their useful life or the life of the resource, whichever is shorter.
Intangible development costs, on the other hand, are such items as drilling costs, tunnels, shafts, and wells. These costs have no tangible characteristics but are needed for the production of the natural resource. Intangible development costs are considered part of the depletion base.
Companies sometimes incur substantial costs to restore property to its natural state after extraction has occurred. These are restoration costs. Companies consider restoration costs part of the depletion base. The amount included in the depletion base is the fair value of the obligation to restore the property after extraction. A more complete discussion of the accounting for restoration costs and related liabilities (sometimes referred to as asset retirement obligations) is provided in Chapter 13. Similar to other long-lived assets, companies deduct from the depletion base any salvage value to be received on the property.
Once the company establishes the depletion base, the next problem is determining how to allocate the cost of the natural resource to accounting periods.
Normally, companies compute depletion (often referred to as cost depletion) on a units-of-production method (an activity approach). Thus, depletion is a function of the number of units extracted during the period. In this approach, the total cost of the natural resource less salvage value is divided by the number of units estimated to be in the resource deposit, to obtain a cost per unit of product. To compute depletion, the cost per unit is then multiplied by the number of units extracted.
For example, MaClede Co. acquired the right to use 1,000 acres of land in Alaska to mine for gold. The lease cost is $50,000, and the related exploration costs on the property are $100,000. Intangible development costs incurred in opening the mine are $850,000. Total costs related to the mine before the first ounce of gold is extracted are, therefore, $1,000,000. MaClede estimates that the mine will provide approximately 100,000 ounces of gold. Illustration 11-17 shows computation of the depletion cost per unit (depletion rate).
If MaClede extracts 25,000 ounces in the first year, then the depletion for the year is $250,000 (25,000 ounces × $10). It records the depletion as follows:
MaClede debits Inventory for the total depletion for the year and credits Accumulated Depletion to reduce the carrying value of the natural resource. MaClede credits Inventory when it sells the inventory. The amount not sold remains in inventory and is reported in the current assets section of the balance sheet.[156]
Sometimes companies do not use an Accumulated Depletion account. In that case, the credit goes directly to the natural resources asset account. MaClede's balance sheet would present the cost of the natural resource and the amount of accumulated depletion entered to date as follows:
In the income statement, the depletion cost is part of the cost of goods sold.
MaClede may also depreciate on a units-of-production basis the tangible equipment used in extracting the gold. This approach is appropriate if it can directly assign the estimated lives of the equipment to one given resource deposit. If MaClede uses the equipment on more than one job, other cost allocation methods such as straight-line or accelerated depreciation methods would be more appropriate.
Sometimes companies need to change the estimate of recoverable reserves. They do so either because they have new information or because more sophisticated production processes are available. Natural resources such as oil and gas deposits and some rare metals have recently provided the greatest challenges. Estimates of these reserves are in large measure merely "knowledgeable guesses."
This problem is the same as accounting for changes in estimates for the useful lives of plant and equipment. The procedure is to revise the depletion rate on a prospective basis: A company divides the remaining cost by the new estimate of the recoverable reserves. This approach has much merit because the required estimates are so uncertain.
Recent cuts in the estimates of oil and natural gas reserves at Royal Dutch/Shell, El Paso Corporation, and other energy companies highlight the importance of reserve disclosures. Investors appear to believe that these disclosures provide useful information for assessing the future cash flows from a company's oil and gas reserves. For example, when Shell's estimates turned out to be overly optimistic (to the tune of 3.9 billion barrels or 20 percent of reserves), Shell's stock price fell.
The experience at Shell and other companies has led the SEC to look at how companies are estimating their "proved" reserves. Proved reserves are quantities of oil and gas that can be shown "... with reasonable certainty to be recoverable in future years...." The phrase "reasonable certainty" is crucial to this guidance, but differences in interpretation of what is reasonably certain can result in a wide range of estimates.
In one case, for example, ExxonMobil's estimate was 29 percent higher than an estimate the SEC developed. ExxonMobil was more optimistic about the effects of new technology that enables the industry to retrieve more of the oil and gas it finds. Thus, to ensure the continued usefulness of RRA disclosures, the SEC may have to work on a measurement methodology that keeps up with technology changes in the oil and gas industry.
Source: S. Labaton and J. Gerth, "At Shell, New Accounting and Rosier Outlook," New York Times (nytimes.com) (March 12, 2004); and J. Ball, C. Cummins, and B. Bahree, "Big Oil Differs with SEC on Methods to Calculate the Industry's Reserves," Wall Street Journal (February 24, 2005), p. C1.
A company often owns as its only major asset a property from which it intends to extract natural resources. If the company does not expect to purchase additional properties, it may gradually distribute to stockholders their capital investments by paying liquidating dividends, which are dividends greater than the amount of accumulated net income.
The major accounting problem is to distinguish between dividends that are a return of capital and those that are not. Because the dividend is a return of the investor's original contribution, the company issuing a liquidating dividend should debit Paid-in Capital in Excess of Par for that portion related to the original investment, instead of debiting Retained Earnings.
To illustrate, at year-end, Callahan Mining had a retained earnings balance of $1,650,000, accumulated depletion on mineral properties of $2,100,000, and paid-in capital in excess of par of $5,435,493. Callahan's board declared a dividend of $3 a share on the 1,000,000 shares outstanding. It records the $3,000,000 cash dividend as follows.
Callahan must inform stockholders that the $3 dividend per share represents a $1.65 ($1,650,000 ÷ 1,000,000 shares) per share return on investment and a $1.35 ($1,350,000 ÷ 1,000,000 shares) per share liquidating dividend.
A major controversy relates to the accounting for exploration costs in the oil and gas industry. Conceptually, the question is whether unsuccessful ventures are a cost of those that are successful. Those who hold the full-cost concept argue that the cost of drilling a dry hole is a cost needed to find the commercially profitable wells. Others believe that companies should capitalize only the costs of successful projects. This is the successful-efforts concept. Its proponents believe that the only relevant measure for a project is the cost directly related to that project, and that companies should report any remaining costs as period charges. In addition, they argue that an unsuccessful company will end up capitalizing many costs that will make it, over a short period of time, show no less income than does one that is successful.[157]
The FASB has attempted to narrow the available alternatives, with little success. Here is a brief history of the debate.
1977—The FASB required oil and gas companies to follow successful-efforts accounting. Small oil and gas producers, voicing strong opposition, lobbied extensively in Congress. Governmental agencies assessed the implications of this standard from a public interest perspective and reacted contrary to the FASB's position.[158]
1978—In response to criticisms of the FASB's actions, the SEC reexamined the issue and found both the successful-efforts and full-cost approaches inadequate. Neither method, said the SEC, reflects the economic substance of oil and gas exploration. As a substitute, the SEC argued in favor of a yet-to-be developed method, reserve recognition accounting (RRA), which it believed would provide more useful information. Under RRA, as soon as a company discovers oil, it reports the value of the oil on the balance sheet and in the income statement. Thus, RRA is a fair value approach, in contrast to full-costing and successful-efforts, which are historical cost approaches. The use of RRA would make a substantial difference in the balance sheets and income statements of oil companies. For example, Atlantic Richfield Co. at one time reported net producing property of $2.6 billion. Under RRA, the same properties would be valued at $11.8 billion.
1979–1981—As a result of the SEC's actions, the FASB issued another standard that suspended the requirement that companies follow successful-efforts accounting. Therefore, full costing was again permissible. In attempting to implement RRA, however, the SEC encountered practical problems in estimating (1) the amount of the reserves, (2) the future production costs, (3) the periods of expected disposal, (4) the discount rate, and (5) the selling price. Companies needed an estimate for each of these to arrive at an accurate valuation of existing reserves. Estimating the future selling price, appropriate discount rate, and future extraction and delivery costs of reserves that are years away from realization can be a formidable task.
1981—The SEC abandoned RRA in the primary financial statements of oil and gas producers. The SEC decided that RRA did not possess the required degree of reliability for use as a primary method of financial reporting. However, it continued to stress the need for some form of fair value–based disclosure for oil and gas reserves. As a result, the profession now requires fair value disclosures for those natural resources.
Currently, companies can use either the full-cost approach or the successful-efforts approach. It does seem ironic that Congress directed the FASB to develop one method of accounting for the oil and gas industry, and when the FASB did so, the government chose not to accept it. Subsequently, the SEC attempted to develop a new approach, failed, and then urged the FASB to develop the disclosure requirements in this area. After all these changes, the two alternatives still exist.[159]
This controversy in the oil and gas industry provides a number of lessons. First, it demonstrates the strong influence that the federal government has in financial reporting matters. Second, the concern for economic consequences places pressure on the FASB to weigh the economic effects of any required standard. Third, the experience with RRA highlights the problems that accompany any proposed change from an historical cost to a fair value approach. Fourth, this controversy illustrates the difficulty of establishing standards when affected groups have differing viewpoints. Finally, it reinforces the need for a conceptual framework with carefully developed guidelines for recognition, measurement, and reporting, so that interested parties can more easily resolve issues of this nature in the future.
Failure to consider the economic consequences of accounting principles is a frequent criticism of the profession. However, the neutrality concept requires that the statements be free from bias. Freedom from bias requires that the statements reflect economic reality, even if undesirable effects occur.
A company should disclose the basis of valuation—usually historical cost—for property, plant, equipment, and natural resources along with pledges, liens, and other commitments related to these assets. It should not offset any liability secured by property, plant, equipment, and natural resources against these assets. Instead, this obligation should be reported in the liabilities section. The company should segregate property, plant, and equipment not currently employed as producing assets in the business (such as idle facilities or land held as an investment) from assets used in operations.
When depreciating assets, a company credits a valuation account normally called Accumulated Depreciation. Using an Accumulated Depreciation account permits the user of the financial statements to see the original cost of the asset and the amount of depreciation that the company charged to expense in past years.
When depleting natural resources, some companies use an Accumulated Depletion account. Many, however, simply credit the natural resource account directly. The rationale for this approach is that the natural resources are physically consumed, making direct reduction of the cost of the natural resources appropriate.
Because of the significant impact on the financial statements of the depreciation method(s) used, companies should disclose the following.
Depreciation expense for the period.
Balances of major classes of depreciable assets, by nature and function.
Accumulated depreciation, either by major classes of depreciable assets or in total.
A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. [2][160]
Special disclosure requirements relate to the oil and gas industry. Companies engaged in these activities must disclose the following in their financial statements: (1) the basic method of accounting for those costs incurred in oil and gas producing activities (e.g., full-cost versus successful-efforts), and (2) how the company disposes of costs relating to extractive activities (e.g., dispensing immediately versus depreciation and depletion). [3][161]
The 2007 annual report of International Paper Company in Illustration 11-19 shows an acceptable disclosure. It uses condensed balance sheet data supplemented with details and policies in notes to the financial statements.
Analysts evaluate assets relative to activity (turnover) and profitability.
How efficiently a company uses its assets to generate sales is measured by the asset turnover ratio. This ratio divides net sales by average total assets for the period. The resulting number is the dollars of sales produced by each dollar invested in assets. To illustrate, we use the following data from the Tootsie Roll Industries 2007 annual report. Illustration 11-20 shows computation of the asset turnover ratio.
The asset turnover ratio shows that Tootsie Roll generated sales of $0.62 per dollar of assets in the year ended December 31, 2007.
Asset turnover ratios vary considerably among industries. For example, a large utility like Ameren has a ratio of 0.32 times. A large grocery chain like Kroger has a ratio of 2.73 times. Thus, in comparing performance among companies based on the asset turnover ratio, you need to consider the ratio within the context of the industry in which a company operates.
Another measure for analyzing the use of property, plant, and equipment is the profit margin on sales ratio (rate of return on sales). Calculated as net income divided by net sales, this profitability ratio does not, by itself, answer the question of how profitably a company uses its assets. But by relating the profit margin on sales to the asset turnover during a period of time, we can ascertain how profitably the company used assets during that period of time in a measure of the rate of return on assets. Using the Tootsie Roll Industries data shown on page 560, we compute the profit margin on sales ratio and the rate of return on assets as follows.
The rate of return a company achieves through use of its assets is the rate of return on assets (ROA). Rather than using the profit margin on sales, we can compute it directly by dividing net income by average total assets. Using Tootsie Roll's data, we compute the ratio as follows.
The 6.4 percent rate of return computed in this manner equals the 6.4 percent rate computed by multiplying the profit margin on sales by the asset turnover. The rate of return on assets measures profitability well because it combines the effects of profit margin and asset turnover.
iGAAP adheres to many of the same principles of U.S. GAAP in the accounting for property, plant, and equipment. iGAAP related to property, plant, and equipment is found in IAS 16 ("Property, Plant and Equipment") and IAS 23 ("Borrowing Costs").
Under both iGAAP and U.S. GAAP, interest costs incurred during construction must be capitalized. Recently iGAAP converged to U.S. GAAP.
iGAAP, like U.S. GAAP, capitalizes all direct costs in self-constructed assets. iGAAP does not address the capitalization of fixed overhead, although in practice these costs are generally capitalized.
The accounting for exchanges of nonmonetary assets has recently converged between iGAAP and U.S. GAAP. U.S. GAAP, per SFAS No. 153, now requires that gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. This is the same framework used in iGAAP.
iGAAP also views depreciation as allocation of cost over an asset's life. iGAAP permits the same depreciation methods (straight-line, accelerated, units-of-production) as U.S. GAAP.
As discussed in the Chapter 4 Convergence Corner, iGAAP permits asset revaluations (which are not permitted in U.S. GAAP). Consequently, companies that use the revaluation framework must follow revaluation depreciation procedures. We illustrate revaluation depreciation in the "About the Numbers" discussion.
iGAAP also uses a fair value test to measure the impairment loss. However, iGAAP does not use the first-stage recoverability test used under U.S. GAAP—comparing the undiscounted cash flows to the carrying amount. Thus, the iGAAP test is more strict than U.S. GAAP.
As indicated, iGAAP permits companies to carry assets at historical cost or use a revaluation model for fixed assets. According to IAS 16, if revaluation is used, it must be applied to all assets in a class of assets and assets must be revalued on an annual basis. What about depreciation? To illustrate, assume Pernice Company applies revaluation accounting to plant assets with a carrying value of $1,000,000, a useful life of 5 years, and no salvage value. At the end of year 1, independent appraisers determine that the asset has a fair value of $900,000. Pernice makes the following journal entries in year 1, assuming straight-line depreciation.
To record depreciation expense in Year 1
To adjust the plant assets to fair value and record revaluation surplus
Thus, there is a two-step process. First, Pernice records depreciation based on the cost basis of $1,000,000. As a result, it reports depreciation expense of $200,000 on the income statement. Second, it records the revaluation of $100,000, which is the difference between the fair value of $900,000 and the book value of $800,000. Recall that the revaluation surplus is reported in stockholders' equity as a component of "Other comprehensive income." Pernice now reports the following information at the end of year 1 for its plant assets.
As indicated, $900,000 is the new basis of the asset. Pernice reports depreciation expense of $200,000 in the income statement and $100,000 in "Other comprehensive income." Assuming no change in the useful life, depreciation in year 2 will be $225,000 ($900,000 ÷ 4). On the other hand, any decline in value results in a revaluation loss in the income statement.
With respect to revaluations, as part of the conceptual framework project, the Boards will examine the measurement bases used in accounting. It is too early to say whether a converged conceptual framework will recommend fair value measurement (and revaluation accounting) for property, plant, and equipment. However, this is likely to be one of the more contentious issues, given the long-standing use of historical cost as a measurement basis in U.S. GAAP.
After a company records an impairment loss, the reduced carrying amount of the long-lived asset is its new cost basis. Impairment losses may not be restored for assets held for use. If the company expects to dispose of the asset, it should report the impaired asset at the lower of cost or net realizable value. It is not depreciated. It can be continuously revalued, as long as the write-up is never to an amount greater than the carrying amount before impairment.
For the most part, a financial accounting course does not address issues related to the computation of income taxes. However, because the concepts of tax depreciation are similar to those of book depreciation, and because tax depreciation methods are sometimes adopted for book purposes, we present an overview of this subject.
Congress passed the Accelerated Cost Recovery System (ACRS) as part of the Economic Recovery Tax Act of 1981. The goal was to stimulate capital investment through faster write-offs and to bring more uniformity to the write-off period. For assets purchased in the years 1981 through 1986, companies use ACRS and its preestablished "cost recovery periods" for various classes of assets.
In the Tax Reform Act of 1986 Congress enacted a Modified Accelerated Cost Recovery System, known as MACRS. It applies to depreciable assets placed in service in 1987 and later. The following discussion is based on these MACRS rules. Realize that tax depreciation rules are subject to change annually.[162]
The computation of depreciation under MACRS differs from the computation under GAAP in three respects: (1) a mandated tax life, which is generally shorter than the economic life; (2) cost recovery on an accelerated basis; and (3) an assigned salvage value of zero.
Each item of depreciable property belongs to a property class. The recovery period (depreciable tax life) of an asset depends on its property class. Illustration 11A-1 presents the MACRS property classes.
Companies compute depreciation expense using the tax basis—usually the cost—of the asset. The depreciation method depends on the MACRS property class, as shown below.
Depreciation computations for income tax purposes are based on the half-year convention. That is, a half year of depreciation is allowable in the year of acquisition and in the year of disposition.[163] A company depreciates an asset to a zero value so that there is no salvage value at the end of its MACRS life.
Use of IRS-published tables, shown in Illustration 11A-3, simplifies application of these depreciation methods.
To illustrate depreciation computations under both the MACRS system and GAAP straight-line accounting, assume the following facts for a computer and peripheral equipment purchased by Denise Rode Company on January 1, 2009.
Acquisition Date | January 1, 2009 |
|---|---|
Cost | $100,000 |
Estimated useful life | 7 years |
Estimated salvage value | $16,000 |
MACRS class life | 5 years |
MACRS method | 200% declining-balance |
GAAP method | Straight-line |
Disposal proceeds—January 2, 2016 | $11,000 |
Using the rates from the MACRS depreciation rate schedule for a 5-year class of property, Rode computes depreciation as follows for tax purposes.
Rode computes the depreciation under GAAP straight-line method, with $16,000 of estimated salvage value and an estimated useful life of 7 years, as shown in Illustration 11A-5.
The MACRS depreciation recovers the total cost of the asset on an accelerated basis. But, a taxable gain of $11,000 results from the sale of the asset at January 2, 2016. Therefore, the net effect on taxable income for the years 2009 through 2016 is $89,000 ($100,000 depreciation – $11,000 gain).
Under GAAP, the company recognizes a loss on disposal of $5,000 ($16,000 book value – $11,000 disposal proceeds). The net effect on income before income taxes for the years 2009 through 2016 is $89,000 ($84,000 depreciation + $5,000 loss), the same as the net effect of MACRS on taxable income.
Even though the net effects are equal in amount, the deferral of income tax payments under MACRS from early in the life of the asset to later in life is desirable. The different amounts of depreciation for income tax reporting and financial GAAP reporting in each year are a matter of timing and result in temporary differences, which require interperiod tax allocation. (See Chapter 19 for an extended treatment of this topic.)
An alternate MACRS method exists for determining depreciation deductions. Based on the straight-line method, it is referred to as the optional (elective) straight-line method. This method applies to the six classes of property described earlier. The alternate MACRS applies the straight-line method to the MACRS recovery periods. It ignores salvage value.
Under the optional straight-line method, in the first year in which the property is put in service, the company deducts half of the amount of depreciation that would be permitted for a full year (half-year convention). Use the half-year convention for homework problems.
GAAP requires that companies allocate the cost of depreciable assets to expense over the expected useful life of the asset in a systematic and rational manner. Some argue that from a cost-benefit perspective it would be better for companies to adopt the MACRS approach in order to eliminate the necessity of maintaining two different sets of records.
However, the tax laws and financial reporting have different objectives: The purpose of taxation is to raise revenue from constituents in an equitable manner. The purpose of financial reporting is to reflect the economic substance of a transaction as closely as possible and to help predict the amounts, timing, and uncertainty of future cash flows. Because these objectives differ, the adoption of one method for both tax and book purposes in all cases is not in accordance with GAAP.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 11A
FASB Codification References
FASB ASC 360-10-05. [Predecessor literature: "Accounting for the Impairment or Disposal of Long-lived Assets," Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: 2001).]
FASB ASC 360-10-50-1. [Predecessor literature: "Omnibus Opinion—1967," Opinions of the Accounting Principles Board No. 12 (New York: AICPA, 1967), par. 5.]
FASB ASC 932-235-50-1. [Predecessor literature: "Disclosures about Oil and Gas Producing Activities," Statement of Financial Accounting Standards Board No. 69 (Stamford, Conn.: FASB, 1982).]
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendices to the chapter.
Distinguish among depreciation, depletion, and amortization.
Identify the factors that are relevant in determining the annual depreciation charge, and explain whether these factors are determined objectively or whether they are based on judgment.
Some believe that accounting depreciation measures the decline in the value of fixed assets. Do you agree? Explain.
Explain how estimation of service lives can result in unrealistically high valuations of fixed assets.
The plant manager of a manufacturing firm suggested in a conference of the company's executives that accountants should speed up depreciation on the machinery in the finishing department because improvements were rapidly making those machines obsolete, and a depreciation fund big enough to cover their replacement is needed. Discuss the accounting concept of depreciation and the effect on a business concern of the depreciation recorded for plant assets, paying particular attention to the issues raised by the plant manager.
For what reasons are plant assets retired? Define inadequacy, supersession, and obsolescence.
What basic questions must be answered before the amount of the depreciation charge can be computed?
Workman Company purchased a machine on January 2, 2010, for $800,000. The machine has an estimated useful life of 5 years and a salvage value of $100,000. Depreciation was computed by the 150% declining-balance method. What is the amount of accumulated depreciation at the end of December 31, 2011?
Silverman Company purchased machinery for $162,000 on January 1, 2010. It is estimated that the machinery will have a useful life of 20 years, salvage value of $15,000, production of 84,000 units, and working hours of 42,000. During 2010 the company uses the machinery for 14,300 hours, and the machinery produces 20,000 units. Compute depreciation under the straight-line, units-of-output, working hours, sum-of-the-years'-digits, and double-declining-balance methods.
What are the major factors considered in determining what depreciation method to use?
Under what conditions is it appropriate for a business to use the composite method of depreciation for its plant assets? What are the advantages and disadvantages of this method?
If Remmers, Inc. uses the composite method and its composite rate is 7.5% per year, what entry should it make when plant assets that originally cost $50,000 and have been used for 10 years are sold for $14,000?
A building that was purchased December 31, 1986, for $2,500,000 was originally estimated to have a life of 50 years with no salvage value at the end of that time. Depreciation has been recorded through 2010. During 2011 an examination of the building by an engineering firm discloses that its estimated useful life is 15 years after 2010. What should be the amount of depreciation for 2011?
Charlie Parker, president of Spinners Company, has recently noted that depreciation increases cash provided by operations and therefore depreciation is a good source of funds. Do you agree? Discuss.
Andrea Torbert purchased a computer for $8,000 on July 1, 2010. She intends to depreciate it over 4 years using the double-declining-balance method. Salvage value is $1,000. Compute depreciation for 2011.
Walkin Inc. is considering the write-down of its long-term plant because of a lack of profitability. Explain to the management of Walkin how to determine whether a write-down is permitted.
Last year Wyeth Company recorded an impairment on an asset held for use. Recent appraisals indicate that the asset has increased in value. Should Wyeth record this recovery in value?
Toro Co. has equipment with a carrying amount of $700,000. The expected future net cash flows from the equipment are $705,000, and its fair value is $590,000. The equipment is expected to be used in operations in the future. What amount (if any) should Toro report as an impairment to its equipment?
Explain how gains or losses on impaired assets should be reported in income.
It has been suggested that plant and equipment could be replaced more quickly if depreciation rates for income tax and accounting purposes were substantially increased. As a result, business operations would receive the benefit of more modern and more efficient plant facilities. Discuss the merits of this proposition.
Neither depreciation on replacement cost nor depreciation adjusted for changes in the purchasing power of the dollar has been recognized as generally accepted accounting principles for inclusion in the primary financial statements. Briefly present the accounting treatment that might be used to assist in the maintenance of the ability of a company to replace its productive capacity.
List (a) the similarities and (b) the differences in the accounting treatments of depreciation and cost depletion.
Describe cost depletion and percentage depletion. Why is the percentage depletion method permitted?
In what way may the use of percentage depletion violate sound accounting theory?
In the extractive industries, businesses may pay dividends in excess of net income. What is the maximum permissible? How can this practice be justified?
The following statement appeared in a financial magazine: "RRA—or Rah-Rah, as it's sometimes dubbed—has kicked up quite a storm. Oil companies, for example, are convinced that the approach is misleading. Major accounting firms agree." What is RRA? Why might oil companies believe that this approach is misleading?
Shumway Oil uses successful-efforts accounting and also provides full-cost results as well. Under full-cost, Shumway Oil would have reported retained earnings of $42 million and net income of $4 million. Under successful-efforts, retained earnings were $29 million, and net income was $3 million. Explain the difference between full-costing and successful-efforts accounting.
Target Corporation in 2007 reported net income of $2.9 billion, net sales of $61.5 billion, and average total assets of $41.0 billion. What is Target's asset turnover ratio? What is Target's rate of return on assets?
* What is a modified accelerated cost recovery system (MACRS)? Speculate as to why this system is now required for tax purposes.
Asset
Cost
Salvage
Estimated Useful Life
A
$70,000
$ 7,000
10 years
B
50,000
5,000
5 years
C
82,000
4,000
12 years
Compute the composite depreciation rate and the composite life of Dickinson's assets.
Instructions
Compute the amount of depreciation for each of Years 1 through 3 using the straight-line depreciation method.
Compute the amount of depreciation for each of Years 1 through 3 using the sum-of-the-years'-digits method.
Compute the amount of depreciation for each of Years 1 through 3 using the double-declining-balance method. (In performing your calculations, round constant percentage to the nearest one-hundredth of a point and round answers to the nearest dollar.)
Instructions
Answer the following questions.
What is the cost of the asset being depreciated?
What amount, if any, was used in the depreciation calculations for the salvage value for this asset?
Which method will produce the highest charge to income in Year 1?
Which method will produce the highest charge to income in Year 4?
Which method will produce the highest book value for the asset at the end of Year 3?
If the asset is sold at the end of Year 3, which method would yield the highest gain (or lowest loss) on disposal of the asset?
Instructions
Compute the depreciation for this asset for 2010 and 2011 using the sum-of-the-years'-digits method.
Compute the depreciation for this asset for 2010 and 2011 using the double-declining-balance method.
Instructions
From the information given, compute the depreciation charge for 2011 under each of the following methods. (Round to the nearest dollar.)
Straight-line.
Units-of-output.
Working hours.
Sum-of-the-years'-digits.
Double-declining-balance.
Instructions
Compute the depreciation expense under the following methods. Each of the following should be considered unrelated.
Straight-line depreciation for 2010.
Activity method for 2010, assuming that machine usage was 800 hours.
Sum-of-the-years'-digits for 2011.
Double-declining-balance for 2011.
Instructions
Compute depreciation expense under each of the following methods. Agazzi is on a calendar-year basis ending December 31.
Straight-line method for 2010.
Activity method (units of output) for 2010.
Activity method (working hours) for 2010.
Sum-of-the-years'-digits method for 2012.
Double-declining-balance method for 2011.
Instructions
Complete the table for the year ended December 31, 2011. The company depreciates all assets using the half-year convention.
On June 1, 2012, the company buys a new machine of greater capacity for $35,000, delivered, trading in the old machine which has a fair market value and trade-in allowance of $20,000. To prepare the old machine for removal from the plant cost $75, and expenditures to install the new one were $1,500. It is estimated that the new machine has a useful life of 10 years, with a salvage value of $4,000 at the end of that time. The exchange has commercial substance.
Instructions
Assuming that depreciation is to be computed on the straight-line basis, compute the annual depreciation on the new equipment that should be provided for the fiscal year beginning June 1, 2012.
Asset
Cost
Estimated Salvage
Estimated Life (in years)
A
$40,500
$5,500
10
B
33,600
4,800
9
C
36,000
3,600
8
D
19,000
1,500
7
E
23,500
2,500
6
Instructions
Compute the rate of depreciation per year to be applied to the plant assets under the composite method.
Prepare the adjusting entry necessary at the end of the year to record depreciation for the year.
Prepare the entry to record the sale of Asset D for cash of $5,000. It was used for 6 years, and depreciation was entered under the composite method.
Instructions
Show calculations to determine for what particular year the depreciation amount for this asset will be $60,000.
Instructions
Prepare the entry to correct the prior years' depreciation, if necessary.
Prepare the entry to record depreciation for 2011.
Early in 1994, an addition to the building was constructed at a cost of $470,000. At that time it was estimated that the remaining life of the building would be, as originally estimated, an additional 30 years, and that the addition would have a life of 30 years, and a salvage value of $20,000.
In 2012, it is determined that the probable life of the building and addition will extend to the end of 2043 or 20 years beyond the original estimate.
Instructions
Using the straight-line method, compute the annual depreciation that would have been charged from 1984 through 1993.
Compute the annual depreciation that would have been charged from 1994 through 2011.
Prepare the entry, if necessary, to adjust the account balances because of the revision of the estimated life in 2012.
Compute the annual depreciation to be charged beginning with 2012.
In January 2011, a new roof was installed at a cost of $300,000, and it was estimated then that the building would have a useful life of 25 years from that date. The cost of the old roof was $180,000.
Instructions
What amount of depreciation should have been charged annually from the years 1991 to 2010? (Assume straight-line depreciation.)
What entry should be made in 2011 to record the replacement of the roof?
Prepare the entry in January 2011, to record the revision in the estimated life of the building, if necessary.
What amount of depreciation should be charged for the year 2011?
Instructions
Prepare any correcting entries necessary.
Assuming that depreciation is to be charged for a full year on the ending balance in the asset account, compute the proper depreciation charge for 2011 under each of the methods listed below. Assume an estimated life of 10 years, with no salvage value. The machinery included in the January 1, 2011, balance was purchased in 2009.
Straight-line.
Sum-of-the-years'-digits.
Instructions
Compute the depreciation charge on this equipment for 2005, for 2012, and the total charge for the period from 2006 to 2011, inclusive, under each of the six following assumptions with respect to partial periods.
Depreciation is computed for the exact period of time during which the asset is owned. (Use 365 days for the base.)
Depreciation is computed for the full year on the January 1 balance in the asset account.
Depreciation is computed for the full year on the December 31 balance in the asset account.
Depreciation for one-half year is charged on plant assets acquired or disposed of during the year.
Depreciation is computed on additions from the beginning of the month following acquisition and on disposals to the beginning of the month following disposal.
Depreciation is computed for a full period on all assets in use for over one-half year, and no depreciation is charged on assets in use for less than one-half year.
Briefly evaluate the methods above, considering them from the point of view of basic accounting theory as well as simplicity of application.
Cost
$9,000,000
Accumulated depreciation to date
1,000,000
Expected future net cash flows
7,000,000
Fair value
4,400,000
Assume that Pujols will continue to use this asset in the future. As of December 31, 2010, the equipment has a remaining useful life of 4 years.
Instructions
Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010.
Prepare the journal entry to record depreciation expense for 2011.
The fair value of the equipment at December 31, 2011, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value.
Instructions
Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2010.
Prepare the journal entry (if any) to record depreciation expense for 2011.
The asset was not sold by December 31, 2011. The fair value of the equipment on that date is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value. It is expected that the cost of disposal is still $20,000.
Instructions
Prepare the journal entry (if any) to record the impairment at December 31, 2010.
Where should the gain or loss (if any) on the write-down be reported in the income statement?
At December 31, 2011, the equipment's fair value increased to $300,000. Prepare the journal entry (if any) to record this increase in fair value.
What accounting issues did management face in accounting for this impairment?
Instructions
Determine the depreciation expense and the cost of timber sold related to depletion for 2001.
Hernandez has not logged since 2001. If Hernandez logged and sold 900,000 board feet of timber in 2012, when the timber cruise (appraiser) estimated 5,000,000 board feet, determine the cost of timber sold related to depletion for 2012.
The lease provided for an outright payment of $600,000 to the lessor (owner) before drilling could be commenced and an annual rental of $31,500. A premium of 5% of the sales price of every barrel of oil removed is to be paid annually to the lessor. In addition, Federer (lessee) is to clean up all the waste and debris from drilling and to bear the costs of reconditioning the land for farming when the wells are abandoned. The estimated fair value, at the time of the lease, of this clean-up and reconditioning is $30,000.
From the provisions of the lease agreement, compute the cost per barrel for the past year, exclusive of operating costs, to Federer Drilling Company.
Instructions
Determine the cost of timber sold related to depletion for 2010.
If Jonas depreciates the logging roads on the basis of timber cut, determine the depreciation expense for 2010.
If Jonas plants five seedlings at a cost of $4 per seedling for each tree cut, how should Jonas treat the reforestation?
Instructions
Compute the following information for 2010.
Per unit mineral cost.
Total material cost of December 31, 2010, inventory.
Total materials cost in cost of goods sold at December 31, 2010.
Instructions
Compute the following.
The total amount of depletion for 2010.
The amount that is charged as an expense for 2010 for the cost of the minerals sold during 2010.
Instructions
Compute the following ratios for Eastman Kodak for 2007.
Asset turnover ratio.
Rate of return on assets.
Profit margin on sales.
How can the asset turnover ratio be used to compute the rate of return on assets?
Instructions
Prepare income statements for 2010 and 2011. (The final amount reported on the income statement should be income before income taxes.)
Compute taxable income for 2010 and 2011.
Determine the total depreciation to be taken over the useful life of the delivery truck for both book and tax purposes.
Explain why depreciation for book and tax purposes will generally be different over the useful life of a depreciable asset.
Instructions
Assuming that the company uses the straight-line method for book and tax purposes, what is the depreciation expense reported in (1) the financial statements for 2010 and (2) the tax return for 2010?
Assuming that the company uses the double-declining-balance method for both book and tax purposes, what is the depreciation expense reported in (1) the financial statements for 2010 and (2) the tax return for 2010?
Why is depreciation for tax purposes different from depreciation for book purposes even if the company uses the same depreciation method to compute them both?
Price
$85,000
Credit terms
2/10, n/30
Freight-in costs
$ 800
Preparation and installation costs
$ 3,800
Labor costs during regular production operations
$10,500
It was expected that the machine could be used for 10 years, after which the salvage value would be zero. Alladin intends to use the machine for only 8 years, however, after which it expects to be able to sell it for $1,500. The invoice for Machine #201 was paid May 5, 2010. Alladin uses the calendar year as the basis for the preparation of financial statements.
Instructions
Compute the depreciation expense for the years indicated using the following methods. (Round to the nearest dollar.)
Straight-line method for 2010.
Sum-of-the-years'-digits method for 2011.
Double-declining-balance method for 2010.
Suppose Kate Crow, the president of Alladin, tells you that because the company is a new organization, she expects it will be several years before production and sales reach optimum levels. She asks you to recommend a depreciation method that will allocate less of the company's depreciation expense to the early years and more to later years of the assets' lives. What method would you recommend?
Instructions
Compute depreciation expense on the machine for the year ending December 31, 2010, and the year ending December 31, 2011, using the following methods.
Straight-line.
Units-of-output.
Working hours.
Sum-of-the-years'-digits.
Declining-balance (twice the straight-line rate).
The following transactions occurred during 2011.
On May 5, Asset A was sold for $13,000 cash. The company's bookkeeper recorded this retirement in the following manner in the cash receipts journal.
On December 31, it was determined that Asset B had been used 2,100 hours during 2011.
On December 31, before computing depreciation expense on Asset C, the management of Eshkol, Inc. decided the useful life remaining from January 1, 2011, was 10 years.
On December 31, it was discovered that a plant asset purchased in 2010 had been expensed completely in that year. This asset cost $28,000 and has a useful life of 10 years and no salvage value. Management has decided to use the double-declining-balance method for this asset, which can be referred to as "Asset E."
Instructions
Prepare the necessary correcting entries for the year 2011. Record the appropriate depreciation expense on the above-mentioned assets.
The Semi-trucks—Accumulated Depreciation account previously adjusted to January 1, 2008, and entered in the ledger, had a balance on that date of $30,200 (depreciation on the four trucks from the respective dates of purchase, based on a 5-year life, no salvage value). No charges had been made against the account before January 1, 2008.
Transactions between January 1, 2008, and December 31, 2011, which were recorded in the ledger, are as follows.
Entries for depreciation had been made at the close of each year as follows: 2008, $21,000; 2009, $22,500; 2010, $25,050; 2011, $30,400.
Instructions
For each of the 4 years compute separately the increase or decrease in net income arising from the company's errors in determining or entering depreciation or in recording transactions affecting trucks, ignoring income tax considerations.
Prepare one compound journal entry as of December 31, 2011, for adjustment of the Semi-trucks account to reflect the correct balances as revealed by your schedule, assuming that the books have not been closed for 2011.
The company builds necessary structures and sheds on the site at a cost of $36,000. It is estimated that these structures can serve 15 years but, because they must be dismantled if they are to be moved, they have no salvage value. The company does not intend to use the buildings elsewhere. Mining machinery installed at the mine was purchased secondhand at a cost of $60,000. This machinery cost the former owner $150,000 and was 50% depreciated when purchased. Khamsah Mining estimates that about half of this machinery will still be useful when the present mineral resources have been exhausted but that dismantling and removal costs will just about offset its value at that time. The company does not intend to use the machinery elsewhere. The remaining machinery will last until about one-half the present estimated mineral ore has been removed and will then be worthless. Cost is to be allocated equally between these two classes of machinery.
Instructions
As chief accountant for the company, you are to prepare a schedule showing estimated depletion and depreciation costs for each year of the expected life of the mine.
Also compute the depreciation and depletion for the first year assuming actual production of 5,000 tons. Nothing occurred during the year to cause the company engineers to change their estimates of either the mineral resources or the life of the structures and equipment.
At the time of the eruption, O'Brien had logged 20% of the estimated 500,000 board feet of timber. Prior to the eruption, O'Brien estimated the land to have a value of $200 per acre after the timber was harvested. O'Brien includes the logging roads in the depletion base.
O'Brien estimates it will take 3 years to salvage the downed timber at a cost of $700,000. The timber can be sold for pulp wood at an estimated price of $3 per board foot. The value of the land is unknown, but must be considered nominal due to future uncertainties.
Instructions
Determine the depletion cost per board foot for the timber harvested prior to the eruption of Mount Leno.
Prepare the journal entry to record the depletion prior to the eruption.
If this tract represents approximately half of the timber holdings of O'Brien, determine the amount of the extraordinary loss due to the eruption of Mount Leno for the year ended December 31, 2010.
In March 2011, Bronson planted new seedlings in the area harvested during the winter. Cost of planting these seedlings was $120,000. In addition, Bronson spent $8,000 in road maintenance and $6,000 for pest spraying during calendar-year 2011. The road maintenance and spraying are annual costs. During 2011 Bronson harvested and sold 774,000 board feet of timber of the estimated 6,450,000 board feet available for cutting.
In March 2012, Bronson again planted new seedlings at a cost of $150,000, and also spent $15,000 on road maintenance and pest spraying. During 2012, the company harvested and sold 650,000 board feet of timber of the estimated 6,500,000 board feet available for cutting.
Instructions
Compute the amount of depreciation and depletion expense for each of the 3 years (2010, 2011, 2012). Assume that the roads are usable only for logging and therefore are included in the depletion base.
To be able to meet the quantity commitments of this agreement, Darby had to obtain additional manufacturing capacity. A real estate firm located an available factory in close proximity to Darby's Round-ball manufacturing facility, and Darby agreed to purchase the factory and used machinery from Encino Athletic Equipment Company on October 1, 2009. Renovations were necessary to convert the factory for Darby's manufacturing use.
The terms of the agreement required Darby to pay Encino $50,000 when renovations started on January 1, 2010, with the balance to be paid as renovations were completed. The overall purchase price for the factory and machinery was $400,000. The building renovations were contracted to Malone Construction at $100,000. The payments made, as renovations progressed during 2010, are shown below. The factory was placed in service on January 1, 2011.
On January 1, 2010, Darby secured a $500,000 line-of-credit with a 12% interest rate to finance the purchase cost of the factory and machinery, and the renovation costs. Darby drew down on the line-of-credit to meet the payment schedule shown above; this was Darby's only outstanding loan during 2010.
Bob Sprague, Darby's controller, will capitalize the maximum allowable interest costs for this project. Darby's policy regarding purchases of this nature is to use the appraisal value of the land for book purposes and prorate the balance of the purchase price over the remaining items. The building had originally cost Encino $300,000 and had a net book value of $50,000, while the machinery originally cost $125,000 and had a net book value of $40,000 on the date of sale. The land was recorded on Encino's books at $40,000. An appraisal, conducted by independent appraisers at the time of acquisition, valued the land at $290,000, the building at $105,000, and the machinery at $45,000.
Angie Justice, chief engineer, estimated that the renovated plant would be used for 15 years, with an estimated salvage value of $30,000. Justice estimated that the productive machinery would have a remaining useful life of 5 years and a salvage value of $3,000. Darby's depreciation policy specifies the 200% declining-balance method for machinery and the 150% declining-balance method for the plant. One-half year's depreciation is taken in the year the plant is placed in service and one-half year is allowed when the property is disposed of or retired. Darby uses a 360-day year for calculating interest costs.
Instructions
Determine the amounts to be recorded on the books of Darby Sporting Goods Inc. as of December 31, 2010, for each of the following properties acquired from Encino Athletic Equipment Company. (1) Land. (2) Building. (3) Machinery.
Calculate Darby Sporting Goods Inc.'s 2011 depreciation expense, for book purposes, for each of the properties acquired from Encino Athletic Equipment Company.
Discuss the arguments for and against the capitalization of interest costs.
(CMA adapted)
Instructions
Prepare the journal entry (if any) to record the impairment at December 31, 2010.
Prepare any journal entries for the equipment at December 31, 2011. The fair value of the equipment at December 31, 2011, is estimated to be $5,900,000.
Repeat the requirements for (a) and (b), assuming that Roland intends to dispose of the equipment and that it has not been disposed of as of December 31, 2011.
Depreciation is computed from the first of the month of acquisition to the first of the month of disposition.
Land A and Building A were acquired from a predecessor corporation. Kohlbeck paid $800,000 for the land and building together. At the time of acquisition, the land had an appraised value of $90,000, and the building had an appraised value of $810,000.
Land B was acquired on October 2, 2009, in exchange for 2,500 newly issued shares of Kohlbeck's common stock. At the date of acquisition, the stock had a par value of $5 per share and a fair value of $30 per share. During October 2009, Kohlbeck paid $16,000 to demolish an existing building on this land so it could construct a new building.
Construction of Building B on the newly acquired land began on October 1, 2010. By September 30, 2011, Kohlbeck had paid $320,000 of the estimated total construction costs of $450,000. It is estimated that the building will be completed and occupied by July 2012.
Certain equipment was donated to the corporation by a local university. An independent appraisal of the equipment when donated placed the fair market value at $40,000 and the salvage value at $3,000.
Machinery A's total cost of $182,900 includes installation expense of $600 and normal repairs and maintenance of $14,900. Salvage value is estimated at $6,000. Machinery A was sold on February 1, 2011.
On October 1, 2010, Machinery B was acquired with a down payment of $5,740 and the remaining payments to be made in 11 annual installments of $6,000 each beginning October 1, 2010. The prevailing interest rate was 8%. The following data were abstracted from present-value tables (rounded).
Present value of $1.00 at 8%
Present value of an ordinary annuity of $1.00 at 8%
10 years
.463
10 years
6.710
11 years
.429
11 years
7.139
15 years
.315
15 years
8.559
Instructions
For each numbered item on the schedule above, supply the correct amount. Round each answer to the nearest dollar.
Instructions
Compute the annual depreciation charges over the machine's life assuming a December 31 year-end for each of the following depreciation methods.
Straight-line method.
Activity method.
Sum-of-the-years'-digits method.
Double-declining-balance method.
Assume a fiscal year-end of September 30. Compute the annual depreciation charges over the asset's life applying each of the following methods.
Straight-line method.
Sum-of-the-years'-digits method.
Double-declining-balance method.
The following depreciation methods may be used: (1) straight-line; (2) double-declining-balance; (3) sum-of-the-years'-digits; and (4) units-of-output. For tax purposes, the class life is 7 years. Use the MACRS tables for computing depreciation.
Instructions
Which depreciation method would maximize net income for financial statement reporting for the 3-year period ending December 31, 2011? Prepare a schedule showing the amount of accumulated depreciation at December 31, 2011, under the method selected. Ignore present value, income tax, and deferred income tax considerations.
Which depreciation method (MACRS or optional straight-line) would minimize net income for income tax reporting for the 3-year period ending December 31, 2011? Determine the amount of accumulated depreciation at December 31, 2011. Ignore present value considerations.
(AICPA adapted)
CA11-1 (Depreciation Basic Concepts) Burnitz Manufacturing Company was organized January 1, 2010. During 2010, it has used in its reports to management the straight-line method of depreciating its plant assets.
On November 8 you are having a conference with Burnitz's officers to discuss the depreciation method to be used for income tax and stockholder reporting. James Bryant, president of Burnitz, has suggested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Following is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a salvage value of approximately $8,000.
Year
Years of Life Used
Fraction Rate
Depreciation Expense
Accumulated Depreciation at End of Year
Book Value at End of Year
1
1
1/15
$16,000
$ 16,000
$232,000
2
2
2/15
32,000
48,000
200,000
3
3
3/15
48,000
96,000
152,000
4
4
4/15
64,000
160,000
88,000
5
5
5/15
80,000
240,000
8,000
The president favors the new method because he has heard that:
It will increase the funds recovered during the years near the end of the assets' useful lives when maintenance and replacement disbursements are high.
It will result in increased write-offs in later years and thereby will reduce taxes.
Instructions
What is the purpose of accounting for depreciation?
Is the president's proposal within the scope of generally accepted accounting principles? In making your decision discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable.
The president wants your advice on the following issues.
Do depreciation charges recover or create funds? Explain.
Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations?
Instructions
Briefly describe the depreciation methods based on treating assets as (1) units and (2) a group or as having a composite life.
Present the arguments for and against the use of each of the two methods.
Describe how retirements are recorded under each of the two methods.
(AICPA adapted)
CA11-3 (Depreciation—Strike, Units-of-Production, Obsolescence) Presented below and on page 583 are three different and unrelated situations involving depreciation accounting. Answer the question(s) at the end of each situation.
Situation I
Recently, Broderick Company experienced a strike that affected a number of its operating plants. The controller of this company indicated that it was not appropriate to report depreciation expense during this period because the equipment did not depreciate and an improper matching of costs and revenues would result. She based her position on the following points.
It is inappropriate to charge the period with costs for which there are no related revenues arising from production.
The basic factor of depreciation in this instance is wear and tear, and because equipment was idle, no wear and tear occurred.
Instructions
Comment on the appropriateness of the controller's comments.
Situation II
Etheridge Company manufactures electrical appliances, most of which are used in homes. Company engineers have designed a new type of blender which, through the use of a few attachments, will perform more functions than any blender currently on the market. Demand for the new blender can be projected with reasonable probability. In order to make the blenders, Etheridge needs a specialized machine that is not available from outside sources. It has been decided to make such a machine in Etheridge's own plant.
Instructions
Discuss the effect of projected demand in units for the new blenders (which may be steady, decreasing, or increasing) on the determination of a depreciation method for the machine.
What other matters should be considered in determining the depreciation method? Ignore income tax considerations.
Situation III
Haley Paper Company operates a 300-ton-per-day kraft pulp mill and four sawmills in Wisconsin. The company is in the process of expanding its pulp mill facilities to a capacity of 1,000 tons per day and plans to replace three of its older, less efficient sawmills with an expanded facility. One of the mills to be replaced did not operate for most of 2010 (current year), and there are no plans to reopen it before the new sawmill facility becomes operational.
In reviewing the depreciation rates and in discussing the residual values of the sawmills that were to be replaced, it was noted that if present depreciation rates were not adjusted, substantial amounts of plant costs on these three mills would not be depreciated by the time the new mill came on stream.
Instructions
What is the proper accounting for the four sawmills at the end of 2010?
The machines being depreciated are six automatic canning machines. All were put into use on January 1, 2010. Each cost $625,000, having a salvage value of $55,000 and a useful life of 12 years. San Francisco depreciates this and similar assets using double-declining-balance depreciation. Perriman has also pointed out that if you used straight-line depreciation the charge to his department would not be so great.
Instructions
Write a memo to Phil Perriman to clear up his misunderstanding of the term "depreciation." Also, calculate year-1 depreciation on all machines using both methods. Explain the theoretical justification for double-declining-balance and why, in the long run, the aggregate charge to depreciation will be the same under both methods.
Prior knows that depreciation is a major expense for Beeler. The company currently uses the double-declining-balance method for both financial reporting and tax purposes, and he's thinking of selling equipment that, given its age, is primarily used when there are periodic spikes in demand. The equipment has a carrying value of $2,000,000 and a market value of $2,180,000. The gain on the sale would be reported in the income statement. He doesn't want to highlight this method of increasing income. He thinks, "Why don't I increase the estimated useful lives and the salvage values? That will decrease depreciation expense and require less extensive disclosure, since the changes are accounted for prospectively. I may be able to save my job and those of my staff."
Instructions
Answer the following questions.
Who are the stakeholders in this situation?
What are the ethical issues involved?
What should Prior do?
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Refer to P&G's financial statements and the accompanying notes to answer the following questions.
What descriptions are used by P&G in its balance sheet to classify its property, plant, and equipment?
What method or methods of depreciation does P&G use to depreciate its property, plant, and equipment?
Over what estimated useful lives does P&G depreciate its property, plant, and equipment?
What amounts for depreciation and amortization expense did P&G charge to its income statement in 2007, 2006, and 2005?
What were the capital expenditures for property, plant, and equipment made by P&G in 2007, 2006, and 2005?
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
What depreciation methods are used by Coca-Cola and PepsiCo for property, plant, and equipment? How much depreciation was reported by Coca-Cola and PepsiCo in 2007, 2006, and 2005?
Compute and compare the following ratios for Coca-Cola and PepsiCo for 2007.
Asset turnover.
Profit margin on sales.
Rate of return on assets.
What amount was spent in 2007 for capital expenditures by Coca-Cola and PepsiCo? What amount of interest was capitalized in 2007?
McDonald's is the largest and best-known global food service retailer, with more than 31,000 restaurants in 118 countries. On any day, McDonald's serves approximately 1 percent of the world's population. Presented on the next page is information related to McDonald's property and equipment.
Instructions
What method of depreciation does McDonald's use?
Does depreciation and amortization expense cause cash flow from operations to increase? Explain.
What does the schedule of cash flow measures indicate?
McDonald's Corporation
Summary of Significant Accounting Policies Section
Property and Equipment. Property and equipment are stated at cost, with depreciation and amortization provided on the straight-line method over the following estimated useful lives: buildings—up to 40 years; leasehold improvements—lesser of useful lives of assets or lease terms including option periods; and equipment—3 to 12 years.
[In the notes to the financial statements:]
Property and Equipment
Net property and equipment consisted of:
[In the management discussion and analysis section, McDonald's provides the following schedule.]
Cash Provided by Operations
Companies following international accounting standards are permitted to revalue fixed assets above the assets' historical costs. Such revaluations are allowed under various countries' standards and the standards issued by the International Accounting Standards Board (IASB). Liberty International, a real estate company, headquartered in United Kingdom (U.K.), follows U.K. standards. In a recent year, Liberty disclosed the following information on revaluations of its tangible fixed assets. The revaluation reserve measures the amount by which tangible fixed assets are recorded above historical cost and is reported in Liberty's stockholders' equity.
Liberty reported the following additional data. Amounts for Kimco Realty (which follows U.S. GAAP) in the same year are provided for comparison.
Instructions
Compute the following ratios for Liberty and Kimco.
Return on assets.
Profit margin.
Asset turnover.
How do these companies compare on these performance measures?
Liberty reports a revaluation surplus of 1,952 pounds. Assume that 1,550 of this amount arose from an increase in the net replacement value of investment properties during the year. Prepare the journal entry to record this increase. (Hint: Credit the Revaluation Surplus account.)
Under U.K. (and IASB) standards, are Liberty's assets and equity overstated? If so, why? When comparing Liberty to U.S. companies, like Kimco, what adjustments would you need to make in order to have valid comparisons of ratios such as those computed in (a) above?
Matt Holmes recently joined Klax Company as a staff accountant in the controller's office. Klax Company provides warehousing services for companies in several midwestern cities.
The location in Dubuque, lowa, has not been performing well due to increased competition and the loss of several customers that have recently gone out of business. Matt's department manager suspects that the plant and equipment may be impaired and wonders whether those assets should be written down. Given the company's prior success, this issue has never arisen in the past, and Matt has been asked to conduct some research on this issue.
Instructions
Access the FASB Codification at http://www.asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses.
What is the authoritative guidance for asset impairments? Briefly discuss the scope of the standard (i.e., explain the types of transactions to which the standard applies).
Give several examples of events that would cause an asset to be tested for impairment. Does it appear that Klax should perform an impairment test? Explain.
What is the best evidence of fair value? Describe alternate methods of estimating fair value.
Go to the book's companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to the accounting for property, plant, and equipment.
[148] Taken from J. D. Coughlan and W. K. Strand, Depreciation Accounting, Taxes and Business Decisions (New York: The Ronald Press, 1969), pp. 10–12.
[149] The airline industry also illustrates the type of problem involved in estimation. In the past, aircraft were assumed not to wear out—they just became obsolete. However, some jets have been in service as long as 20 years, and maintenance of these aircraft has become increasingly expensive. As a result, some airlines now replace aircraft not because of obsolescence but because of physical deterioration.
[150] Accounting Trends and Techniques—2007 reports that of its 600 surveyed companies, for reporting purposes, 592 used straight-line, 16 used declining-balance, 5 used sum-of-the-years'-digits, 27 used an accelerated method (not specified), and 23 used units of production.
[151] What happens if the estimated service life of the asset is, let us say, 51 years? How would we calculate the sum-of-the-years'-digits? Fortunately mathematicians have developed the following formula that permits easy computation:
[152] A pure form of the declining-balance method (sometimes appropriately called the "fixed percentage of book value method") has also been suggested as a possibility. This approach finds a rate that depreciates the asset exactly to salvage value at the end of its expected useful life. The formula for determination of this rate is as follows:
The life in years is n. After computing the depreciation rate, a company applies it on the declining book value of the asset from period to period, which means that depreciation expense will be successively lower. This method is not used extensively in practice due to cumbersome computations. Further, it is not permitted for tax purposes.
[153] AcSEC has indicated in an exposure draft that companies should use the unit approach whenever feasible. In fact, it indicates that an even better way to depreciate property, plant, and equipment is to use component depreciation. Under component depreciation, a company should depreciate over its expected useful life any part or portion of property, plant, and equipment that can be separately identified as an asset. For example, a company could separate the various components of a building (e.g., roof, heating and cooling system, elevator, leasehold improvements) and depreciate each component over its useful life.
[154] In this regard, real estate investment trusts (REITs) often report (in addition to net income) an earnings measure, funds from operations (FFO), that adjusts income for depreciation expense and other noncash expenses. This method is not GAAP. There is mixed empirical evidence about whether FFO or GAAP income is more useful to real estate investment trust investors. See, for example, Richard Gore and David Stott, "Toward a More Informative Measure of Operating Performance in the REIT Industry: Net Income vs. FFO," Accounting Horizons (December 1998); and Linda Vincent, "The Information Content of FFO for REITs," Journal of Accounting and Economics (January 1999).
[155] As an example of a change in operating procedures, General Motors (GM) used to write off its tools—such as dies and equipment used to manufacture car bodies—over the life of the body type. Through this procedure, it expensed tools twice as fast as Ford and three times as fast as Chrysler. However, it slowed the depreciation process on these tools and lengthened the lives on its plant and equipment. These revisions reduced depreciation and amortization charges by approximately $1.23 billion, or $2.55 per share, in the year of the change. In Chapter 22, we provide a more complete discussion of changes in estimates.
[156] The tax law has long provided a deduction against revenue from oil, gas, and most minerals for the greater of cost or percentage depletion. The percentage (statutory) depletion allows some companies a write-off ranging from 5 percent to 22 percent (depending on the natural resource) of gross revenue received. As a result of this tax benefit, the amount of depletion may exceed the cost assigned to a given natural resource. An asset's carrying amount may be zero, but the company may take a depletion deduction if it has gross revenue. The significance of the percentage depletion allowance is now greatly reduced, since Congress repealed it for most oil and gas companies.
[157] Large international oil companies such as ExxonMobil use the successful-efforts approach. Most of the smaller, exploration-oriented companies use the full-cost approach. The differences in net income figures under the two methods can be staggering. Analysts estimated that the difference between full-cost and successful-efforts for ChevronTexaco would be $500 million over a 10-year period (income lower under successful-efforts).
[158] The Department of Energy indicated that companies using the full-cost method at that time would reduce their exploration activities because of the unfavorable earnings impact associated with successful-efforts accounting. The Justice Department asked the SEC to postpone adoption of one uniform method of accounting in the oil and gas industry until the SEC could determine whether the information reported to investors would be enhanced and competition constrained by adoption of the successful-efforts method.
[159] One requirement of the full-cost approach is that companies can capitalize costs only up to a ceiling, which is the present value of company reserves. Companies must expense costs above that ceiling. When the price of oil fell in the mid-1980s, so did the present value of companies' reserves, thus forcing expensing of costs beyond the ceiling. Companies lobbied for leniency, but the SEC decided that the write-offs had to be taken. Mesa Limited Partnerships restated its $31 million profit to a $169 million loss, and Pacific Lighting restated its $44.5 million profit to a $70.5 million loss.
[160] Some believe that companies should disclose the average useful life of the assets or the range of years of asset life to help users understand the age and life of property, plant, and equipment.
[161] Public companies, in addition to these two required disclosures, must include as supplementary information numerous schedules reporting reserve quantities; capitalized costs; acquisition, exploration, and development activities; and a standardized measure of discounted future net cash flows related to proved oil and gas reserve quantities. Given the importance of these disclosures, the SEC is now considering a new set of disclosures to help investors better understand the nature of oil and gas company operations (SEC Release Nos. 33-8870; 34-56945; File No. S7-29-07).
[162] For example, in an effort to jump-start the economy following the September 11, 2001, terrorist attacks, Congress passed the Job Creation and Worker Assistance Act of 2002 (the Act). The Act allows a 30 percent first-year bonus depreciation for assets placed into service after September 11, 2001, but before September 11, 2004. A follow-up provision enacted in 2003 extended the tax savings to assets placed in service before January 1, 2005. And in 2008, Congress was considering a 50% first-year bonus depreciation. These laws encourage companies to invest in fixed assets because they can front-load depreciation expense, which lowers taxable income and amount of taxes companies pay in the early years of an asset's life. Although the Act may be a good thing for the economy, it can distort cash flow measures—making them look artificially strong when the allowances are in place but reversing once the bonus depreciation expires. See D. Zion and B. Carcache, "Bonus Depreciation Boomerang," Credit Suisse First Boston Equity Research (February 19, 2004).
[163] The tax law requires mid-quarter and mid-month conventions for MACRS purposes in certain circumstances.