Solution manual intermediate accounting 9e by nicolai ch10

Q10-2 The four factors used in a company’s computation of the periodic depreciation Q10-3 The depreciation base is the cost of an asset less the estimated residual value.. Depreciation

CHAPTER 10

DEPRECIATION AND DEPLETION

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

Time Range (minutes) E10-1 Depreciation Methods Straight-line, hours worked, units of

output

5-10

E10-2 Depreciation Methods Straight-line, sum-of-the-years'-digits,

double-declining balance Return on assets

5-10

E10-3 Acquisition Cost and Depreciation Computation of acquisition

cost and annual depreciation under units of production and sum-of-the-years'-digits methods

10-15

E10-4 Depreciation Methods Recognition of method used given the

E10-5 Rate of Return Determination under straight-line and

E10-6 Acquisition Cost Computation under straight-line,

sum-of-the-years'-digits, and double-declining-balance methods 5-10 E10-7 Group Depreciation Straight-line Journal entries to record

E10-10 (AICPA adapted) Depreciation Determination of amount to

be capitalized and expensed

10-15

E10-11 Partial Periods Straight-line to nearest day, to nearest month,

to nearest whole year, to one-half year

10-15

E10-12 Asset Impairment Determine if asset impaired Compute

impairment loss Journal entry

15-20

E10-13 Depreciation Financial statements, income taxes, straight-line,

Number Content

Time Range (minutes) E10-14 Changes and Corrections Straight-line to sum-of-the-years'-

digits Increased asset life Residual value ignored Journal entries

15-20

E10-15 (AICPA adapted) Change in Depreciation Method Compute

book value under straight-line depreciation and effect of switch to sum-of-years'-digits method

15-20

E10-16 Depletion Determination of depletion cost per unit, inventory

cost, and cost of goods sold

10-15 E10-17 (AICPA adapted) Depletion Expense determination 5-10 P10-1 Depreciation Methods Straight-line, hours worked, units of

output, sum-of-the-years'-digits, double-declining-balance, 150% declining-balance Return on assets

20-25

P10-2 Depreciation Methods Straight-line, hours worked, units of

output

15-20

P10-3 Depreciation Methods Straight-line, sum-of-the-years'-digits,

double-declining-balance, 150% declining-balance Return on assets

20-25

P10-4 Declining Balance Fixed percentage Computation of

depreciation rate and yearly deduction 10-15 P10-5 Changing Depreciation Double-declining-balance to straight-

line at varying points in asset's life 20-30 P10-6 Cost of Asset 150% declining-balance Determination of

acquisition cost and depreciation expense 10-20 P10-7 Partial Periods Depreciation computed to one-half year

Journal entries to record depreciation and sale 20-30 P10-8 Group and Composite Depreciation Straight-line Journal

entries to record various transactions (depreciation, retirement)

30-40

P10-9 Composite Depreciation Straight-line Journal entries to

record various transactions (depreciation, acquisition, retirement)

15-20

P10-10 Asset Impairment Determine if asset impaired Compute

impairment loss Journal entry Effects of changed assumptions

20-30

P10-11 Depreciation and Income Taxes Straight-line and ACRS

Prepare income statements for financial reporting and income tax purposes

20-30

Number Content

Time Range (minutes) P10-12 Depletion FIFO Calculation of depletion amount in ending

inventory and the income statement Balance sheet preparation

20-30

P10-13 Depletion FIFO Calculation of expense and cost of inventory

Recalculation of per unit amount and expense 20-30 P10-14 Changes and Corrections Double-declining-balance to

straight-line Change in service life Residual value included in depreciation computation Journal entries

20-30

P10-15 (AICPA adapted) Adjusting Entries Straight-line depreciation

to one-half year Construction, donation, parking lot Journal entries

40-60

P10-16 Comprehensive: Various Issues Journal entries to record

various transactions Determination of account balances

Includes topics from Chapter 8

40-60

P10-17 (AICPA adapted) Comprehensive: Capitalized Costs and

Depreciation Prepare schedules to determine land and building costs, and depreciation expense

30-40

P10-18 (AICPA adapted) Comprehensive: Depreciation Completion

of the fixed asset and depreciation schedule Acquisition, exchange, construction, donation, sale

40-60

P10-19 Errors Calculate increase or decrease in prior four years

earnings resulting from errors Group depreciation Sale, exchange, acquisition, retirement Journal entry to correct the books

40-60

P10-20 (AICPA adapted) Comprehensive: Depreciation and PPE

Schedules for depreciation and amortization expense, accumulated depreciation and amortization, and gain or loss from disposal Balance sheet disclosure

40-60

P10-21 (AICPA adapted) Comprehensive: Acquisitions, Disposals,

Depreciation Schedules for changes in plant assets, depreciation expense, and gain or loss on asset disposal

40-60

P10-22 Comprehensive: Financial Statements Preparation of income

statement, statement of retained earnings, and balance sheet based on journal entries for various transactions (including material from previous chapters)

40-60

ANSWERS TO QUESTIONS

Q10-1 All three terms depreciation, depletion, and amortization refer to the process of

allocating the cost of an asset to the periods in which the benefits are recognized as revenues It is the nature of the asset that distinguishes the three terms Depreciation

is used in reference to tangible assets; depletion refers to natural resources such as oil

or gas; and amortization is the allocation of the cost of intangible assets such as goodwill or leased property Amortization is sometimes used as the general term to describe the periodic allocation of costs

Q10-2 The four factors used in a company’s computation of the periodic depreciation

Q10-3 The depreciation base is the cost of an asset less the estimated residual value This is

the amount that is allocated over the estimated service life of the asset

Q10-4 The objective of accounting for depreciation is to match the cost of an asset with the

revenues, or benefits, derived from the asset in a systematic and rational manner Since the cost of an asset less any expected residual value is the total lifetime

expense, it is recognized systematically against the revenues, or benefits, received Q10-5 Note: Part c involves an understanding of cash flow concepts discussed briefly in

Chapter 4 The recording of depreciation affects a company’s financial statements

as follows:

a Income statement - the company expenses depreciation directly or through cost of goods sold (for manufacturing assets) In either case, it decreases income before income taxes, income tax expense, and net income

b Balance sheet - the Accumulated Depreciation account offsets the related asset account Thus, recording depreciation reduces the book value of a company's assets Depreciation included in manufacturing costs on unsold inventory affects the cost of the inventory on the balance sheet Since net income is reduced, retained earnings are also reduced

c Statement of cash flows - depreciation is an expense that does not require an outlay of cash Consequently, it is added back to net income to show net cash provided by operating activities under the indirect method Under the direct method, it is omitted from the statement.

Q10-6 Depreciation is not a means of generating funds for the replacement of an asset It is

only a method of allocating the cost of an asset over its life The availability of funds for replacement is a separate consideration

Q10-7 By definition, a cost is considered variable if it changes in proportion to changes in

production Thus, when depreciation is based on activity levels, such as hours worked

or output produced, it is a variable cost In contrast, depreciation based on time is a fixed cost

Q10-8 Depreciation results primarily from physical causes and functional causes Wear and

tear, which is due to operational usage, suggests the use of an activity method of depreciation Deterioration and decay are more dependent upon time and thus a time method of depreciation, such as the straight-line, declining-balance, or sum-of- the-years'-digits method, is more appropriate The functional causes of depreciation- -obsolescence or inadequacy seem to relate more to time methods of depreciation However, each situation must be evaluated separately because there are no

steadfast rules for a depreciation method only that it be "systematic and rational." The requirement that all companies use the same method of depreciation is not desirable because different patterns of benefits do exist for different types of assets If the purpose of such a requirement is to reduce the differences in financial

statements, this would not accomplish it Even if two companies are using the same method of depreciation, by assuming different useful lives or salvage values, the depreciation amount can be markedly different Such a requirement would be an example of form over economic substance

Q10-9 Accelerated methods of depreciation are the most appropriate when it can be

assumed that the benefits derived from the asset will be declining each year during its service life

Q10-10 The group and composite methods of depreciation are similar in that they are both

applied to a combination of assets The group method is used when the assets are similar in nature and are expected to have similar service lives and residual values The composite method is for assets that are heterogeneous; they have similar

purposes or characteristics but do not necessarily have similar service lives or residual values Under both methods gains or losses on disposal are not recognized until all the assets are retired

Q10-11 Both the retirement and replacement methods of expense recognition record the

expense when an asset is retired The retirement method expenses the cost of the old asset, less any residual value, at the time of retirement Under the replacement method, it is the cost of the new asset, again less any residual value, that is expensed Q10-12 A manufacturing company debits depreciation on manufacturing assets to a Goods

in Process account (an inventory account) In this way, it recognizes the expense of depreciation when it sells the inventory rather than when it records the depreciation Thus, if a company manufactures more goods than it sells and these goods remain in inventory, the depreciation included in the income statement is less than the asset's depreciation amount

Q10-13 The depreciation on an asset is not intended to produce a book value equal to the

market value It is a method of cost allocation Therefore, even though the cost of replacement goes up, a company records depreciation as long as the estimated residual value is less than the book value

Q10-14 Depreciation of an asset is not an attempt to measure the value of an asset Thus, a

company should use an accelerated method of depreciation if the benefits of the asset are greater in the early years and decline in later years, not because of the loss

in value during the early years

Q10-15 The manager seems to be using the term "depreciate" in another sense With regular

repairs and maintenance, perhaps the transmission lines have extended useful lives and do not lose their value In the accounting sense, depreciation is the allocation

of the cost of an asset Unless the lines have an unlimited useful life, or an estimated residual value greater than their cost, the cost should be allocated over the service life Depreciation is not a means of valuing an asset and does not represent a

decline in the value of an asset

Q10-16 The required disclosures for depreciation as set forth in APB Opinion No 12 are as

follows:

1 Depreciation expense for the period

2 Balances of depreciable assets, classified by nature or function, at balance sheet date

3 Accumulated depreciation, by major classification or total, at balance sheet date

4 A description of the method(s) used in computing depreciation with respect to the major classes of depreciable assets

Q10-17 Because the underlying purposes behind depreciation are different for financial

reporting and for income tax reporting, the method for each is different Accounting principles require the depreciation method to be "systematic and rational" and that it match the depreciation amounts to the benefits received from the assets For

income tax purposes, a company uses the Accelerated Cost Recovery System

(ACRS) for assets purchased from 1981 through 1986, and uses the Modified ACRS for assets purchased in 1987 and later years (For assets purchased before 1981, it uses accelerated depreciation methods) The MACRS allows the expensing of more of the cost early in the life of the asset and thus increases the net benefits to the

company (on a present value basis) The acceleration of the expensing under MACRS results from the use of a shorter life, the accelerated methods (for assets with lives of 3, 5, 7, 10, 15, and 20 years), and the use of a zero residual value

Q10-18 A company’s depletion for income tax purposes and financial reporting are the

same if it uses the cost method for both However, for income tax purposes it may use the percentage-depletion method, which departs from the concept of cost allocation Under this tax method, the company may deduct a stated percentage

of gross income as depletion expense over the life of the asset In addition, the total depletion expense during the asset's life may exceed the cost of that asset

ANSWERS TO CASES

C10-1 (AICPA adapted solution)

1 a The unit method of recording depreciation involves the treatment of fixed assets or

substantial additions thereto as individual items The method entails maintaining

detailed records of the costs of specific assets and related allowances for

depreciation Computation of depreciation is based on the estimated useful life of the individual asset The method is distinguished from group and composite-life methods under which the cost and estimated life of the assets are commingled Depreciation may be recorded by straight-line, accelerated, or other accepted computation

Depreciation under these methods requires development of a weighted average rate from the assets' depreciable cost and estimated life Separate accounts are

established for the total cost of each asset grouping and its related allowance for depreciation The asset grouping should be composed of a large number of units to obtain a reliable average life

2 Arguments for the use of the unit method of computing depreciation include:

(1) The method is simple in that it does not require involved mathematical computations (2) The gain or loss on the retirement of a particular asset can be computed

(3) For cost purposes, depreciation on idle equipment can be isolated

(4) The method results in a more accurately computed depreciation provision in any given year, as the total depreciation amount represents the best estimate of the

depreciation of each asset and is not the result of averaging the cost over a longer period of time

Arguments against the unit method are as follows:

(1) Considerable additional bookkeeping is necessary to account for each asset and its related depreciation (The advent of computer accounting methods reduces the work burden, however.)

(2) There is a point of diminishing returns in the accumulation of accounting data under this method; that is, additional accuracy may not justify the additional cost of record keeping

C10-1 (continued)

2 (continued)

(3) Under a decentralized financial control system where a measure of the division's

efficiency is the rate of return on the gross book value of the investment, a division manager might scrap fully or nearly fully depreciated equipment to improve a division's rate of return even though the equipment is still serviceable

(4) There may be reluctance on the part of a division manager to replace equipment not fully depreciated with more efficient equipment because of the effect of the loss on the division's profits in the year of replacement

Among arguments for the use of the group and composite-life methods are the following: (1) The methods require less detailed bookkeeping

(2) The application of depreciation to the whole group tends to average out or offset errors, economic or operating, caused by underdepreciation or overdepreciation (3) Periodic income is not distorted by gains or losses on disposal of assets

(4) A more useful deduction from income is derived from these methods because of their recognition that depreciation estimates are based on averages and that gains and losses on individual assets are of little significance

Arguments against the use of the group and composite-life methods would include:

(1) The methods would conceal faulty estimates for a long period of time

(2) When there is an early heavy retirement of assets a debit balance might appear in the Allowance for Depreciation account and present an accounting problem

(3) Information is not available regarding a particular machine for cost-calculation

purposes

(4) Under a decentralized financial control system where a measure of the division's

efficiency is the rate of return on the gross book value of the investment, to improve a division's financial reports a division manager might scrap idle but serviceable

equipment or equipment that is not earning a satisfactory return on book value The company would sustain an actual loss in the amount of the value of the equipment scrapped

(5) Under the same situation as in argument 4, except that net book value is used, where the assets, although serviceable, are fully or almost fully depreciated, the division manager might hesitate to replace them because of the high rate of return on

investment

3 Under the unit method, retirements are recorded by removing from the accounts the cost

of the asset and its related accumulated depreciation The difference between the two accounts, adjusted for salvage and disposal costs, if any, is recognized as a gain or loss

C10-2 (AICPA adapted solution)

1 The costs that should be capitalized when equipment is purchased for cash include the gross invoice price of the equipment less discounts plus all incidental costs relating to its purchase or preparation for use Any available discounts whether taken or not should be deducted from the gross invoice price of the equipment

For equipment purchased under a long-term payment plan, the amount capitalized is the same as for equipment purchased for cash, i.e., the capitalizable cost represents the cash equivalent price The interest amounts should not be capitalized

2 The physical factors that cause the equipment to depreciate are wear and tear from operation, action of time and other elements, and deterioration and decay The functional factors that cause the equipment to depreciate are inadequacy, obsolescence, and supersession

3 The factors that should be considered in computing depreciation expense are the cost of the asset, the estimated residual (salvage) value, and the allocation over the estimated service life of the asset by a systematic and rational allocation procedure

4 Accelerated depreciation methods are justified based on the following assumptions:

a An asset is more efficient in the earlier years of its estimated useful life Therefore, larger depreciation amounts in the earlier years would be matched against the larger

revenues generated in the earlier years

b Repair expenses on an asset increase in the later years of its estimated useful life Therefore, smaller depreciation amounts in the later years would be combined with the larger repair expenses incurred in the later years resulting in a smooth or level pattern of these expenses

C10-3 (AICPA adapted solution)

1 a The capitalized cost for the computer includes all costs reasonable and necessary to

prepare it for its intended use Examples of such costs are the cash purchase price, delivery, installation, testing, and set up

b The objective of depreciation accounting is to allocate the depreciable cost of an asset over its estimated useful life in a systematic and rational manner This process matches the depreciable cost of the asset with revenues generated from its use Depreciable cost is the capitalized cost less its estimated residual (salvage) value

C10-3 (continued)

2 The rationale for using accelerated depreciation methods is based on the following

assumptions:

An asset is more productive in the earlier years of its estimated useful life

Therefore, larger depreciation amounts in the earlier years are matched against the larger revenues generated in the earlier years

An asset may become technologically obsolete prior to the end of its originally estimated useful life The risk associated with estimated long-term cash flows is greater than the risk associated with near-term cash flows Accelerated depreciation recognizes this condition

3 Patrick should record depreciation expense to the date of disposal Recording

depreciation updates the carrying amount of the automobile If the carrying amount of the automobile (capitalized cost less accumulated depreciation) differs from the cash

proceeds from the disposal, a gain or loss results Patrick should report gain or loss on

disposal as part of income from continuing operations

C10-4 (AICPA adapted solution)

1 Portland should have selected the straight-line depreciation method when approximately the same amount of an asset's service potential is used up each period If the reasons for the decline in service potential are unclear, then the selection of the straight-line method could be influenced by the ease of recordkeeping, its use for similar assets, and its use by others in the industry

2 Portland should record depreciation expense to the date of the exchange If the original truck's carrying amount is greater than its fair value, a loss results The truck's capitalized cost and accumulated depreciation are eliminated, and the loss on trade-in is reported as part

of income from continuing operations The newly acquired truck is recorded at fair value If the original truck's carrying amount is less than its fair value at trade-in, then there is an unrecognized gain The newly acquired truck is recorded at fair value less the

unrecognized gain Cash is decreased by the amount paid

3 a By associating depreciation with a group of machines instead of each individual

machine, Portland's bookkeeping process is greatly simplified Also, since actual

machine lives vary from the average depreciable life, unrecognized net losses on early dispositions are expected to be offset by continuing depreciation on machines usable beyond the average depreciable life Periodic income does not fluctuate as a result

of recognizing gains and losses on manufacturing machine dispositions

b Portland should divide the depreciable cost (capitalized cost less residual value) of each machine by its estimated life to obtain its annual depreciation The sum of the individual annual depreciation amounts should then be divided by the sum of the individual capitalized costs to obtain the annual composite depreciation rate

C10-5 (AICPA adapted solution)

Note to Instructor: This case requires a brief discussion of the statement of cash flows Students should be able to provide an answer based on the discussion in Chapter 4

1 Relative to plant assets, a cost incurred or an expenditure made, that is assumed to benefit only the current accounting period is called an operating (revenue) expenditure and is expensed in the period believed to benefit A capital expenditure is similarly a cost incurred

or an expenditure made but is expected to yield benefits either in all future accounting periods (acquisition of land) or in a limited number of accounting periods Capital

expenditures (if material in amount) are capitalized, that is, recorded as assets, and, if related to assets of limited life, amortized over the periods believed to benefit

The distinction between capital and operating expenditures is of significance because it involves the timing of the recognition of expense and, consequently, the determination of periodic earnings It also affects the amounts reported as assets whose costs generally have to be recouped from future periods' revenues

If an operating expenditure is improperly capitalized, current earnings are overstated, assets are overstated, and future earnings are understated for all the periods to which the

improperly capitalized cost is amortized If the cost is not amortized, future earnings will not

be affected but assets and retained earnings will continue to be overstated for as long as the cost remains on the books If a nonamortizable

capital expenditure is improperly expensed, current earnings are understated and assets and retained earnings are understated for all foreseeable periods in the future If an

amortizable capital expenditure is improperly expensed, current earnings are understated, assets and retained earnings are understated, and future earnings are overstated for all periods to which the cost should have been amortized

2 Depreciation is the accounting process of allocating an asset's historical cost (recorded amount) to the accounting periods benefitted by the use of the asset It is a process of cost allocation, not valuation Depreciation is not intended to provide cash for an asset's

replacement; it is merely an application of the matching concept

3 The factors relevant in determining the annual depreciation for a depreciable asset are the initial recorded amount (cost), estimated salvage value, estimated useful life, and

The useful life is also a judgment factor It involves selecting the "unit" of measure of service life and estimating the number of such units embodied in the asset Such units may be measured in terms of time periods or in terms of activity (for example, years or machine hours) When selecting the life, one should select the lower (shorter) of the physical life or the economic life to this user Physical life involves wear and tear and casualties; economic life involves such things as technological obsolescence and inadequacy.

C10-5 (continued)

3 (continued)

Selecting the depreciation method is generally a judgment decision; but, a method may

be inherent in the definition adopted for the units of service life, as discussed earlier For example, if such units are machine hours, the method is a function of the number of

machine hours used during each period A method should be selected that will best

measure the portion of services expiring each period Once a method is selected, it may

be objectively applied by using a predetermined, objectively derived formula

4 Because revenue usually represents an inflow of cash, and expense usually represents an outflow of cash, net earnings represent a net inflow of cash Depreciation reduces reported net earnings but does not involve an outflow of cash Therefore, it is added back to

reported net earnings to calculate the cash provided by operations On a statement of cash flows, depreciation should be clearly shown as an adjustment to net earnings not requiring a use of cash Depreciation is not a direct source of cash It can be considered

an indirect source only through income tax savings

C10-6 (AICPA adapted solution)

1 a The conventional concept of depreciation accounting usually is defined as a system of

accounting that aims to distribute the cost or other basic value of tangible capital assets, less salvage (if any), over the estimated useful life of the unit (which may be a group of assets) in a systematic and rational manner It is a process of allocation, not

of valuation Depreciation for the year is the portion of the total amount under such a system that is allocated to the year

b (1) This is a static concept of depreciation in which the initial cost or other value is not changed during the life of the asset; thus, total depreciation over the life of an asset is equal to the initial cost or value of the asset less any salvage value

This concept is based upon the cost, realization, and matching concepts of

conventional financial accounting Cost represents the amount that is recorded as the value of the asset to the entity at the date of acquisition In subsequent periods, cost less accumulated depreciation is considered to represent the minimum value to the entity of the services to be received from the plant asset during the remainder of its life The realization concept requires that during the life of an asset its valuation should not

be greater than cost or cost less accumulated depreciation; if a higher valuation were recorded, the entity would recognize unrealized income

(2) The matching concept requires that the portion of the cost (or value basis) of the asset to be allocated to each accounting period should be matched with the

expected revenue or net revenue contribution of the period Matching can take the form of (a) adjusting depreciation amounts for the effects of interest during the entire life of the asset, (b) associating depreciation allocations with net revenue contributions

of the asset so that they are proportional to the net revenue contributions of each period, (c) associating depreciation allocations with nonmonetary, physical service units (for example, input or output measures, such as machine-hours or miles of

operation or number of units produced) so that they are proportional to the units of service provided each period, or (d) associating depreciation allocations with units of time (for example, months or years) so that they are equal for periods of equal length

C10-6 (continued)

1 b (continued)

(3) Since this concept merely requires that the allocation be systematic and rational, much discretion is left to management in the selection of a depreciation method But the requirement that the allocation be rational probably means that it should be related to the expected benefits to be received from the asset

2 a Since the conventional accounting concept of depreciation is a process of cost

allocation, not valuation, the concern here is with determining what portion of the cost

of the computer system should be assigned to expense in a given accounting period The estimate of periodic depreciation is dependent upon three separate variables: (1) Establishing the depreciation base Since an asset may be sold before its service value is completely consumed, the depreciation base is the cost of asset services that will be used by the firm and expensed during the asset's service life; this usually is less than the original cost of the asset The depreciable base of an asset is its acquisition cost plus removal costs at the time of retirement and minus gross salvage value

(2) Estimating the service life This involves selecting the unit in which the service life of the asset is to be measured and then estimating the total number of units of service embodied in the asset

Although service life usually is measured in units of time, it may be more appropriate to use units of output or activity, which usually are expressed in physical units such as tons, gallons, miles, or machine-hours

In selecting the appropriate unit of service for each asset, consideration should be given to the factors that decrease the service life of an asset These factors may be divided into two classes: (a) physical causes, including casualties, and (b) economic and functional causes

The physical causes are the physical deterioration and impaired utility of the asset that result (a) from wear and tear that is due to operating use and (b) from other forms of decay that are due to the action of the elements Damage resulting from unusual events such as accidents, earthquakes, floods, hurricanes, and tornadoes also may reduce or end asset usefulness

An asset that is in good physical condition may lose its economic usefulness as a result

of technological obsolescence and inadequacy (or economic obsolescence)

Technological obsolescence results from innovations and improvements that make the existing plant obsolete Inadequacy usually results from the effects of growth and changes in the scale of a firm's operations that reduce or terminate the service life of assets

(3) Choosing the method of cost apportionment The issue here is to determine the relative portion of services that has expired in each accounting period This might be approached by estimating whether all units of service are equally valuable (and have

an equal cost) or whether some service units have a higher value and cost than others

C10-6 (continued)

2 a (continued)

The two major variables to be considered in reaching the systematic and rational solution to this issue are (a) whether the quantity of services withdrawn from the bundle will be equal or will vary during the periods of service life and (b) whether the value or cost of various units of service will be equal or will vary during the periods of service life

b There are a number of systematic depreciation methods that recognize these factors in varying degrees and could be used for the computer system These may be classified

as follows:

(1) On the basis of time

(a) A constant amount per period; that is, the straight-line method

(b) A decreasing amount per period; that is, a declining-balance or the the-years'-digits method

sum-of-(c) An interest (increasing-amount) method in which the depreciation is adjusted using the entity's average internal rate of return

(2) On an output measure basis

(a) An amount based upon a ratio of a constant cost to net revenue contribution; that is, the cost allocation for each period would be a constant proportion of the net revenue contribution of the computer system

(b) An amount based upon the expected physical services from the computer system; that is, the cost allocation would be in terms of hours, days, or months of operation or some other measure of input or output related to the computer services

C10-7

1 Depreciation is a method for allocating the cost of an asset over its service life Even

though the plant was shut down for part of the year, its service life may have been reduced and, therefore, it should be depreciated The further allocation of depreciation to inventory

is made so as to include all of the costs associated with the manufacture of the goods Since the depreciation of an idle building is not a cost of manufacturing, it should not be allocated to the inventory, but expensed directly

Alternatively, if there were no decline in the remaining benefits associated with the asset, the argument is correct and the asset should not be depreciated

2 Depreciation does not provide funds for the replacement of an asset Also, depreciation is

an attempt to allocate the cost of an asset over the time when benefits are derived from it The increasing-amount method does not follow this matching concept unless the asset increases in productivity or usefulness during its later years (which is very unlikely) If

maintenance costs are increasing during the later years, this would suggest a method of depreciation that declines during later years

The increasing-amount method of accounting is not acceptable for income tax purposes However, even if it were, the concept of present value shows that income tax savings taken now are more valuable than those same tax savings several years from now, unless there was a significant rise in the income tax rates

C10-8 (AICPA adapted solution)

1 Accounting for depreciation is a system of accounting to distribute the cost (or other book value) of tangible capital assets, less salvage, over their useful lives in a systematic and rational manner Under generally accepted accounting principles as presently understood, depreciation accounting is a process of allocation, not of valuation, through which the productive effort (cost) to be matched with productive accomplishment (revenue) for the period is measured Depreciation accounting, therefore, is concerned with the timing of the expiration of the cost of tangible fixed assets

2 The proposed depreciation method is, of course, systematic Whether it is rational in terms

of cost allocation depends on the facts of the case It produces an increasing

depreciation amount, which is usually not justifiable in terms of the benefit from the use of the asset because manufacturers typically prefer to use their new equipment as much as possible and their old equipment only as needed to meet production quotas during periods

of peak demand As a general rule, then, the benefit declines with age Assuming that the actual operations (including equipment usage) of each year are identical, maintenance and repair costs are likely to be higher in the later years of usage than in the earlier years Hence the proposed method would couple light depreciation and repair amounts in the early years, and would couple heavy depreciation and repair amounts in the later years Reported net income in the early years would be much higher than reported net income in the later years of asset life an unreasonable and undesirable variation during periods of identical operation

On the other hand, if the expected level of operations (including equipment usage) in early years of asset life is expected to be low as compared with that of later years because of slack demand or production policies, the pattern of the depreciation amounts of the proposed method approximately parallels expected benefits (and revenues) and hence is reasonable Although the units-of-production depreciation method is the usual selection to fit this case, the proposed method also conforms to generally accepted accounting

principles in this case

3 a Depreciation neither recovers nor creates funds Revenue-producing activities are the

sources of funds from operations: If revenues exceed out-of-pocket costs during a fiscal period, funds are available to cover other than out-of-pocket costs; if revenues

do not exceed out-of-pocket costs, no funds are made available no matter how much, or little, depreciation is recorded

b Depreciation may affect funds in two ways First, depreciation affects reported

income and hence may affect managerial decisions such as those regarding pricing, product selection, and dividends For example, the proposed method would result initially in higher reported income than would the straight-line method; consequently, shareholders might demand higher dividends in the earlier years than they would otherwise expect The straight-line method, by causing a lower reported income during the early years of asset life and thereby reducing the amount of possible

dividends in early years as compared with the proposed method, could encourage earlier reinvestments in other profit-earning assets in order to meet increasing demand Second, depreciation affects reported taxable income and hence affects directly the amount of income taxes payable in the year of deduction

C10-8 (continued)

3 b (continued)

Using the proposed method for tax purposes would reduce the total tax bill over the life

of the assets (1) if the tax rates were increased in future years or (2) if the business were doing poorly now but were to do significantly better in the future The first condition is political and speculative, but the second condition may be applicable to May

Manufacturing Company in view of its recent origin and its rapid expansion program Consequently, more funds might be available for reinvestment in fixed assets in years of larger deductions if the business is always profitable If May is not profitable now, it would not benefit from higher deductions now and should consider an increasing- amount method for tax purposes, such as the one proposed If May is quite profitable now, the president should reconsider his proposal because it will delay the availability

of tax-paid dollars This decision should not affect the decision to use a depreciation method for stockholder reporting that is systematic and rational in terms of cost

allocation under generally accepted accounting principles as presently understood C10-9

1 Since there were no generally accepted accounting principles for asset write-downs, CBS and NBC had two alternatives:

A Continue to report the asset (the rights) at cost until the sporting event has occurred and report any profit or loss in that period The profit or loss is the difference between the revenues from advertising and syndication fees and the expenses of producing the event and the cost of the rights This approach has the advantage of producing reliable information because it is based on events and amounts that have occurred This approach may be appropriate for a single event such as the Olympics when it is particularly difficult to estimate advertising sales prior to the event The 1992 summer Olympic Games also created an issue because for the first time NBC was attempting to recover some of its costs on pay-per-view TV - "the TripleCast." The approach may be less appropriate when there is a multi-year contract, such as for baseball and football

In these situations, evidence may accumulate early in the contract that indicates a writedown is appropriate

B Write down the asset as soon as evidence is available that the cost of the asset will not

be recovered through revenues (advertising sales and syndication fees) This approach may be considered to provide more relevant information since it avoids reporting the asset at more than its realizable value However, the information is less reliable since it

is based on estimates Since all the networks have incurred losses on recent Olympic contracts, an issue is when should CBS write down its 1994 Winter Olympic rights Should

it be as soon as the evidence is obtained from the 1992 Winter Olympics? But each Olympics is unique and is affected by the economic conditions at that time - the 1992 Winter Olympics occurred during a period of recession and low consumer confidence

2 Two primary opportunities exist for earnings management First, the company can influence the period in which the write-down is recognized Although FASB Statement No 121 has established rules that require the writedown in the period that "events or changes in

circumstances indicate that the carrying amount of an asset may not be recoverable," there is still some discretion required by management Second, the amount of the

writedown is subject to management discretion since the Statement specifies that the asset

is reported at its "fair value."

C10-10

1 Coca Cola is using the straight-line method (p 63), presumably because it expects

approximately constant (or increasing) benefits over the lives of its assets

2 Age = Allowances for depreciation Depreciation expense

Note: 8.7 years x 0.85 = 3.3 years which is similar to the 3.7 years computed earlier

4 Property, Plant, and Equipment 769 c

C10-11

Note to Instructor: This case does not have a definitive answer From a financial reporting perspective, GAAP is identified and summarized From an ethical perspective, various issues are raised for discussion purposes

From a financial reporting perspective, the issues involve the estimates of lives of

depreciable assets and the selection of depreciation methods Accounting principles allow for judgment on these issues and it is expected that professional judgment be exercised More specifically, the life used to depreciate the building should be based on economic factors; the tax life should not be used as a substitute for a realistic estimate of the useful (economic) life of the building Also, the life of the machinery should be based on a

meaningful evaluation of the useful life and not on a "best guess." Similarly, the

depreciation method should be based on the expected pattern of benefits and not

because it is "easy." Finally, since the company uses FIFO for some of its inventory it may be expecting declining (or constant) cost for that inventory If declining costs are expected, then declining selling prices may follow This would suggest that declining benefits may be expected from some of the assets, and therefore accelerated depreciation would provide appropriate matching and income measurement

From an ethical perspective, the primary issue is the apparent lack of concern by the CFO about applying professional judgment and the inappropriate measurement of income and assets that may result The primary stakeholders are the company's current and potential stockholders and creditors The lack of concern by the CFO could be because different selections of lives and methods might not have a material impact on income Alternatively, the CFO might be attempting to conceal that the amounts were chosen because they increase income and the compensation of the top executives The general way in which some accounting principles are phrased do provide opportunities for such "earnings

management" as long as the selections are "reasonable." However, as discussed above there may be an inappropriate inconsistency in the use of FIFO and the straight-line method

if the plant and equipment is used to produce inventory that sells at declining prices,

thereby resulting in declining benefits over the life of the property and equipment

C10-12

Note to Instructor: Students are expected to cite paragraphs from the accounting literature

in their research of this issue

1 To: President, Magic Movie Company

From: Student

I have researched the issues of accounting for the production of movies The applicable principles are defined by AICPA Statement of Position No 00-2, (see the Journal of

Accountancy, August, 2000) The major issues are:

A What costs are included in film assets (asset valuation)? Costs to produce a film are capitalized as film cost inventory and include the cost of the story and the costs to produce the film such as salaries, set construction and operations, wardrobe,

production overhead (including depreciation of studio equipment), and rentals per Mo6.109 and 413 (par 10 and 17)

C10-12 (continued)

1 (continued)

B How is the film asset amortized (income recognition)? The asset is amortized by the individual-film-forecast method in which the cost of the film is multiplied by a ratio The numerator of the ratio is the gross revenues of the period The denominator is the anticipated total gross revenues from the film during its useful life, including future estimated gross revenues from sales in all markets per Mo6.110 (par 11)

2 Two primary opportunities exist for earnings management First, the company can maximize the costs that are capitalized to each movie, thereby reducing expenses during the filming period and raising income Second, the company can maximize its estimate of the revenue that each movie will produce, thereby decreasing the depreciation expense during the early periods of the movie's life

C10-13

Note to Instructor: Students are expected to cite paragraphs from AICPA Statement of Position 91-1 (SOP) and the FASB Original Pronouncements in their research of this issue The SOP is not included in the FASB Current Text, but is in AICPA Technical Practice Aids Also, since the FASB Statement of Concepts are not included in the FASB Current Text, reference

is made to the Intermediate Accounting book

1 To: President, Scientific Software

From: Student

I have researched the issues of revenue recognition and amortization as follows:

A According to the AICPA Statement of Position 91-1, par 32, revenue cannot be

recognized when the licensing agreement is signed Instead, it is recognized when the software is delivered which is consistent with the general concept that revenue is recognized when earned and realizable -FASB Statement of Concepts No 5, par 83 (Intermediate Accounting p 114)

B According to the FASB Statement of Concepts No 6, par 149, many assets yield their benefits over several periods Expenses resulting from their use are reported in the periods of their estimated lives by a "systematic and rational" allocation procedure There is no question that the cost of the software produced is an asset of this type and should be amortized over its useful life The issue is what is the appropriate life? In the current environment of technological change, it is hard to believe that the expected life of software is 13 years Therefore, I recommend that the company determine what

is the expected life of the software Alternatively, the company could survey other software companies to determine if there is an industry "norm" for amortization periods

2 The company probably selected such a long amortization period in order to reduce the expense recognized each period, thereby raising net income and asset values

ANSWERS TO MULTIPLE CHOICE

baseonDepreciati

Sum-of-the-years' digits method:

Return on total assets = Net income Total assets

E10-2 (continued)

4 (continued)

Double-declining balance method:

Return on total assets = Net income Total assets

ionDepreciait

expenseon

Depreciati

The straight-line rate is 25%, which indicates a life of 4 years

2006 $16,000 x 2/10 = $3,200

2007 $16,000 x 1/10 = $1,600 Method c:

*(Beginning + Ending book value) 2

Double-declining balance method: Rate = 2 x

*To reduce to zero residual value

Year Net Income Book Value* Average Rate of Return

E10-6

1 Straight-line method:

Depreciation = (Cost - Residual value) Life

Let X = Acquisition cost $20,000 = (X - $5,000) 10

3 Double-declining balance method:

Depreciation = Book value x (2 x Straight-line rate)

To find the original cost at the beginning of 2003:

Method 1: Working backward from 2005:

Book value at 1/1/05 = Book value 1/1/04 less 2004 depreciation

$100,000 = X - 0.2X

$125,000 = X (This is the book value at 1/1/04)

Book value at 1/1/04 = Book value 1/1/03 less 2003 depreciation

$125,000 = X - 0.2X

$125,000 = 0.8X

$156,250 = X Acquisition cost

$103,000

$2,000 1,000 5,000 -

$103,00015,000

$

To record the first year's depreciation

on disposition of single assets are often immaterial

E10-10 (AICPA adapted solution)

Cost

=

10

$3,000-

$51,700 = $4,870

The pollution-control additions are depreciated over the remaining economic life of the asset (9 years)

9

$3,600Total depreciation for 2005 = $4,870 + $400

May 10 - December 31 = 7 months, 20 days (using 30 days per month) = 230 days

Depreciation = Days owned x Depreciation per day

Depreciation per year =

5

$25,000 = $5,000 per year Depreciation = $5,000

4 Half-year:

Depreciation per year = $5,000

Depreciation = ½ year's depreciation

= $175,000

a$1,000,000 5

b$825,000 5

Since $175,000 is less than $400,000, the machinery is impaired and an

impairment loss is recognized

E10-12 (continued)

1 (continued)

Measurement of the Impairment Loss

D)Appendixin

4Tablefrom

0.10i

5,(n3.790787x

$35,000value)

(fairflowscash

net

expectedthe

ofvaluePresent

= $132,678 (rounded)

Impairment loss = $132,678 fair value - $400,000 book value

2 Change in estimate accounted for prospectively:

Book value at beginning of year 5 = $210,000 - $80,000 = $130,000

Depreciation =

lifeRemaining

valueResidual

valuebook

Remaining

8

$120,0008

E10-14 (continued)

3 Error prior period adjustment:

Depreciation computed without salvage =

10

$210,000 = $21,000 per year Incorrect accumulated depreciation = $84,000

Correct depreciation =

10

$10,000-

To record depreciation in the fifth year

E10-15 (AICPA adapted solution)

Note to Instructor: This exercise assumes simple knowledge of material in Chapter

Excess of sum-of-the-years digits depreciation

method over straight-line depreciation method

Depreciation for 2004, using sum-of-the-years

digits method ($220,000 x 7/55 Computation

E10-15 (continued)

1 (continued)

Schedule 1: Computation of Depreciation for 2001, 2002, and 2003

Computation of Cumulative Effect on Prior Years of Changing

to a Different Depreciation Method For the Year Ended December 31, 2004

Straight- line method

Sum-of- the-years digits

$ 40,000 36,000 32,000 $108,000

($220,000 x 10/55) ($220,000 x 9/55) ($220,000 x 8/55)

$18,000 14,000 10,000 $42,000 50%

E10-16

1 Depletion cost per ton:

Depletion rate per ton =

tonnageEstimated

valueresidual

Estimated-

Cost

$10,000)-

E10-16 (continued)

2 Total cost of inventory:

Inventory = Units produced - Units sold = 80,000 - 60,000 = 20,000 tons

Cost per ton = $4 production costs + $0.275 depletion = $4.275

Cost of inventory = 20,000 x $4.275 = $85,500

3 Total cost of goods sold:

Units sold = 60,000 tons Cost per ton = $4.00 direct cost + $0.275 depletion = $4.275

Cost of goods sold = 60,000 x $4.275 = $256,500 E10-17 (AICPA adapted solution)

Depletion rate per ton =

tonnageEstimated

valueresidual

Estimated-

$1,200,0000

SOLUTIONS TO PROBLEMS

P10-1

1 Straight-line:

yearper

$32,500years

$6.50hours

per

$0.68units