Assefs Operolionol Acquisifion ofLong-Term ond Use

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When you are finished studying this chapter' you should be able to: 1- Explain how long-term assetsare classified and how their cost is computed. are 2" Explain and compute how tangible assets written off over their useful lives and reported on the financial statements. 3. Explain and compute how intangible assetsare written off over their useful lives and reported on the financial statements. 4. Explain how decreasesin value, repairs, changes in productive capacity, and changesin estimatesof useful life and salvagevalue of assetsare reported on the financial statements. 5. Explain how the disposal ofan assetis reflected in the financial statements. {r. Recognize and explain how long-term assetsare reported on the financial statements, and preparefinancial statementsthat include long-term assets. 7, Use return on assets(ROA) and the assetturnover ratio to help evaluatea firm's performance. 8. Identify and describe the businessrisks associatedwith long-term assetsand the controls that can minimize those risks. 9. (Appendix) Explain how depreciationfor financial statementsdiffers from depreciation for taxes. 153

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CHAPTER . ACQ UI SI TI O N 4 AND Us E O F L O N G - T E R M P E R A T I O N A A S S E T S O L

€fAtesJdaffers
The bankruptcy WorldComin 2002was the culminationof an of fraud,the largest record. on $11 billionaccounting ScottSullivan, the former chief financialofficer (CFO) received 5-yearprison a sentence his part in the fraud. Sentencing for guidelines suggest 25 yearsfor his crimes, but he was rewardedfor his cooperation with government prosecutors the case against former CEO in BernardEbbers. Ebbers was sentenced 25 yearsbut is appealto ing both the conviction and the sentence, Besides Sullivan and Ebbers, who will pay for the $11 billionfraud? Eleven former membersof the WorldCom board of directorsagreed to pay investors for losses. directors $20 millionas partialcompensation the investors' The will pay this money from their own pockets, addition to any amountspaid by in the insurance companies that providedliabilityinsurance the directors. for The resultof this type of settlement, similarto the agreementby the Enrondirectorsto pay $13 million to investors, could be harmful to all investors pubin licfy traded companies. Accordingto Daniel Akst, a writer for The New york Times,"it's hard to imaginea better systemfor driving away the kind of experienced, carefulpeopleyou would want most to serveon any board." So,who paysfor fraudssuchasthoseat WorldComand Enron? Employees, shareholders, members the board are just a few of the groups.ALL inand of vestors sharethe costs the unethical of behavior corporate of criminals ways in we are just beginningto recognize.

L"{}.1 Ex plain how long- te rm assets classified are and how their cost is computed.

Acquiring Plant Assets
So far, you have studied the accounting cycle and know how transactionsmake their way to the financial statements. this chapter,we will look at the purchaseof long-term assets In that are used in the operation of a business.Long-term assetspurchasedas investmentsor to resell are not consideredoperational assets,so the information in this chapter does not apply to them. All businessespurchase long-term operational assetssuch as computers, copy machines, and furniture as well as short-term assetssuch as folders, paper, and pens. Acquiring long-term assets,often called fixed assets, usually more complicated than acquiring is short-term assets.Purchasinglong-term assetsis complex for severalreasons.With longterm assets, firm must put a great deal ofcare in selectingthe vendor because relationa the ship could last for a significant amount of time. The monetary investment in long-term assetsis typically much greaterthan the investmentin short-term assets, and it is more difficult to disposeof long-term assetsif the company makes a bad decision. For example, a new computer system for tracking inventory would cost a firm like Staples thousandsof dollars more than the purchaseof a new telephonefor the employeelounge. If Staples'manager did not like the kind of phone that was purchased,it would be simple to give it away or donate it to the local Goodwill and buy another.What happensif the manager decides the wrong computerized inventory system was purchased?It is significantly harder to get rid of the long-term asset,and it could reflect poorly on the managerwho made the decision to purchasethe system in the first place. Before a firm purchasesa long-term asset,it must determine how much revenuethat assetwill generateand how much the assetwill cost. The cost of a long-term assetmust include all of the coststo get the assetready for use.Long-term assetsoften require extensive setup and preparationbefore they become operational,and employeesneed to be trained to use them. If Staplespurchasesa new computerized inventory system, it may require new

C H A P T E 4 . A C Q U I R I N GP L A N TA S S E T S R

155

plans. part of any firm'sstrategic Wal-Mart Capital expenditures an important are In yearto remodel update stores. fact,in early its and spends billions dollars of every at Why was 2006,Wal-Marts for expenditures estimated $17 billion. budget capital growth Sales at for and woulda firmspend thatmuchmoney renovations remodeling? pace and is with rivals such Target, Wal-Mart deas many itsstores failed keep of has to financial statements see to termined turnthat trendaround. Check Wal-Mart's out to plans. if thefirmhasactuallv carried itsambitious out
L---

hardware and software, and employeeswill need to be trained to use the new system.All of these costs will be recorded as part of the cost of the asset. Consideringall of thesecostsis part of the processof acquiring a long-term asset.AcWhat assets to countantsthen use thesecoststo accountfor the purchaseand useof the asset. at buy and how to pay for them are decisionsthat do not affect the income statement the time of the purchase. Recordingthe purchaseof a long-term assetaffectsthe balancesheetand podefersrecognizing tentially the statement cashflows. As you saw in Chapter3, a business of usedin the business. When the asthe expenseof a long-term assetuntil the assetis actually This dedepreciationexpense. setis usedand the expense recognized,the expense called is is purchaseda long-term assetat one point ferral is an exampleof a timing difference.We have period of time. in time in the past, and we will use that assetover a subsequent

Types Long-Lived of Assets: Tangible and Intangible
There are two categoriesoflong-term assets: tangible assetsand intangible assets.Exhibit sheet,where you will seeboth 4.1 showsthe long-term assetsectionof Staples'balance types of long-termassets. Common tangible assetsare property, plant, and equipment (PPE). Common intangible assets trademarks,patents,and copyrights.We will discussthesein detail later in the are chapter.
Tangibleassetsare assets with physical substance; they can be seenand touched. Intangible assetsare rights, privileges, benefitsthat or resultfrom owning long-lived assets that do not have physical substance.

Acquisition Costs
Considerthe purchaseof a long-term asset. The historical cost principle requiresa company to record an assetat the amount paid for the asset-its cost. The cost for property,plant, and

EXHIBIT4.1 From the Balance Sheet of Staples, Inc.
( in tho us ands )

Fromthe Balance Sheetof Staples
You won't know the meanins of some terms Stapleshas used, but you will learn about them in this chaoter.

January 28, January 29, 2006 2005

ffi"."J] tangnbte
N

I r-::l1 |

l-'

ruffit

I intangible ff,

lryq I

Property and equipment: $ 705,978$ 649,175 Land and buildings . . 884,953 762,946 Leasehold improvements 1,330,191 1,140,234 Equipment Fumiture and fixtures 672,931 597,293 Totalpropertyandequipment ..... 3,593,9433,149,648 Less accumulated depreciation and amortization 1,835,549t,548,774 1,758,3941,600,874 Net property and equipment Lease acquisition costs net of accumulated 34,885 38,400 amortization 240,395 222,520 Intangible assetsnet of accumulated amortization . . r,378,752 1,321,464 Goodwill 119,619 106,578 Other assets $3,532,045 $3,289,836 Total long-term assets

156

O L AND USEO F L O N G - T E R M P E R A T I O N A A S S E T S CHAPTER . ACQ UI SI TI O N 4

equipment includes all expendituresthat are reasonableand necessaryto get an assetin place and ready for use.The reasonfor recording all of thesecosts on the balance sheet,as part of the cost of the asset,is to defer recognition of the expenseuntil the assetis actually used to generaterevenue.This is, as you know, the matching principle, which provides the foundation for accrual basis accounting. The assetsare put on the balance sheet and then over the accountingperiods in which they are used to generaterevwritten off as expenses enue. The following are some common components of the cost of property, plant, and equipment. 1. When a firm purchasesland to use as the location of a building or factory, the acquisition cost includes: a. Price paid for the land commissions b. Realestate c. Attorneys'fees d. Costs ofpreparing the land for use, such as clearing or draining e. Costs of tearing down existing structures In general,land is not depreciated.Becauseland typically retains its usefulnessand is not consumedto produce revenue,its cost remains unchangedon the balance sheetas financial statements will show the a long-term asset.Even if the land's value increases, land at cost. 2. When a firm purchasesa physical plant, the acquisition cost includes: a. Purchasecost ofbuildings or factories b. Costs to update or remodel the facilities c. Any other costs to get the plant operational 3. When a firm purchasesequipment, the acquisition cost includes: a. Purchasecost b. Freight-in-cost to have the equipment delivered c. Insurancewhile in transit d. Installationcosts,including test runs e. Cost of training employeesto use the new equipment 4. When a firm constructsor renovatesa building, the acquisition cost includes: fees a. Architects'or contractors' b. Constructioncosts c. Cost of renovating or repairing the building In contrastto the accountingtreatment of land, even if a firm expectsa building to increase In usedin a business generto in value,the assetwill be depreciated. practice,most assets ate revenueswill decreasein value as they are used. Recall that depreciationis not meant to value an assetat its market value. Rather,it is the systematicallocation of the cost of an assetto the periods in which the assetis used by the firm to generaterevenue.

Your Turn4-l

'W-mww.w'w recordedas an expenseat the time of the transaction. or -h$muww 1. Paymentfor employee salaries
2. Purchase new delivery truck of 3. Rent paid in advance 4. Rent paid in arrears(after use of the building)
Relativefair market value method is a way to allocate the total costfor several purchasedtogether to assets eachof the individualassets. Thismethod is basedon the assets' individualmarket varues.

For eachof the following costs,tell whether it should be recordedas an asset

BasketPurchase Allocation
can Calculating the acquisition cost of certain assets be diffrcult. Buying a building with the land it occupiesis an example of a "basket purchase"becausetwo assetsare acquired for a cost for each assingle price. For the accountingrecords,the firm must calculatea separate set.Why? The f,rrmwill depreciatethe building but it will not depreciatethe land. The firm divides the purchaseprice betweenthe building and land by using the relative fair market

. C H A P T E R 4 A C Q U I R I N GP L A N TA S S E T S

157

dil\i$-ru h.u #usine ilF -E #$ Li $"T. il*
Lease Buy? or
(GAAP) to principles Generally accepted try accounting makesurethe financial reflectthe substatements stance a companys of transactions instead the form of of thetransaction. financial stateBecausecompany's a ments soimportant investors, are to creditors, anyand performance, onewho wantsto evaluate company's a is how a transaction reflected thosestatements is on veryimportant the company. recording a to Sometimes transaction based itssubstance not beveryapon may pealing. classic A is longexample buying leasing or termassets. it Whena company an asset, isshown buys on the balance sheet, anyamount and that the company owes thepurchase theasset for mustbeshown of on the balance as sheet a liability. Supposecompany a does wantto put anyaddinot tional liabilities itsbalance would comon sheet. Then a panylease asset instead buyingit? Couldthe an of company simply record expense leasing asset the of the payments made? the form of the as the lease are lf transaction a lease the substance morelikea is but is purchase, lease called capital the is lease, GAAP and a says transaction the mustbe recorded a purchase. like "hide"future Inother words, company finana cannot cialcommitments related long-term leases calling by to the transaction lease simply a and recognizing exthe pense whenthe payments made. are Thatmeans the company mustrecord asset the balance the on sheet andalsorecord related the long-term obligation the of payments a liability. the asset defuturelease Then is as

ss

just preciated, likeanyotherdepreciable owned asset by the company. The accounting haveveryspecific rules standards abouthowto account long-term for leases. criteria The qualifies a capital if lease very for deciding a lease as are numerous, highly technical, and debated discussed and suchas the Financial Acby standards-setting boards (FASB) theSecurities Standards Board and counting and (SEC). accountant An in Exchange Commission comes whenthisissue handy comes up. In the long-term assets section a company's of balyou ancesheet, will oftenseeitems called capitalized leases leasehold or improvements. leases Capitalized represent assets company has,in substance, a bought is Leasehold imbut the form of the purchase a lease. provements long-term assets the form of addiin are tions and improvements leasedproperty.For to if example, a company remodels interior a leased the of building, cost the remodeling becalled office the of will leasehold improvements. A company whether lease asset to decides to an or purchase asset an based business on factors as(1 the such ) (2) typeof asset the riskof obsolescence,the interest and payments rate thelease of compared theinterest with rate (3) purchase, the lease's purchase renewal of a and op(4) tions, the acceptable alterations leased to assets, and (5)theestimated useful of theleased life asset the busito Howeve6 accounting ness. the treatment should influnot goes otherway-the ence economic the decision. lt the decision influences accountinq the economic treatment.

value method. Supposea company purchaseda building and its land togetherfor one price of $ 100,000.The company would obtain a market price, usually in the form of an appraisal, for each item separately. Then, the company usesthe relative amountsof the individual appraisalsto divide the purchaseprice of $ 100,000betweenthe two assets. Supposethe building appraisedat $90,000 and the land appraisedat $30,000. The total appraisedvalue is

($90,000 $30,000). + $120,000
Thebuildingaccounts three-quarters thetotal appraised for value. of $90,000+$120,000:3/4 purchase. So,theaccountant records buildingatthree-fourths the ofthe totalcostofthebasket

3/4x$100,000:$7 5 , 0 0 0

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L CHAPTER . ACQ UI SI TI oNAND Us E oF L o N G - T E R MO P E R A T I O N A A S S E T S 4

The cost assignedto the land will be the remaining $25,000. $100,000 $7s,000: $2s,000 Or if you want to calculate it, 1/4x$100,000:$25,000 This same method-using an asset'sproportion of the total appraisedvalue of a group of assets-can be used for any number of assetspurchasedtogether for a single price.

Your Turn 4-2
Wffimpm' Wmpwwru

for BargainCompany paid $480,000 a building and the land on which it is located. Independentappraisalsvalued the building at $400,000and the land at $100,000.How much should Bargain €ompany record as the cost of the building and how much as the cost of the land?Why does the company need to record the costs separately?

[,.o.2
Ex plain and c om p u teh o w tangible assets written are off over their useful lives and reported on the financialstatements.

Tangible Assets: Long-Term Using Depreciation Depletion and
Now that you are familiar with the types of assetsa firm may have and the costs associated Until property, plant, and with their acquisition, we are ready to talk about using the assets. equipment are put into use,their costsremain as assetson the balancesheet.As soon as the firm uses the asset to help generate revenue, the financial statementswill show some amount of expense on the income statement.Recording a cost as an asset, rather than recording it as an expense,is called capitalizing the cost. That cost will be recognized as an expenseduring the periods in which the assetis used. Recall from Chapter 3 that depreciation is a systematicand rational allocation processto recognizethe expenseoflong-term assetsover the periods in which the assetsare used. Depreciation is an example of the matching principle-matching the cost of an assetwith the revenueit helps generate.For each year a company plans to use an asset,the company will recognize depreciation expenseon the income statement. If you hear or read, "The assetis worth $10,000 on our books," that does not mean the assetis actually worth that amount if it were sold. Instead,it meansthat $10,000 is the carrying value or book value of the assetin the accountingrecords-it is the amount not yet depreciated. is called the carrying value because It that is the amount at which we is carry our assetson the balancesheet.The amount not yet depreciated also known as it the book value because is the value of the asseton the accountingrecords.As you read refer to the vocabularyof depreciation about the specific methodsof depreciatingassets, inBxhlbrt 4.2. Accountants primarily use three terms to describe how a cost is written off over several accounting periods. Amortization is the most general expressionfor writing off the cost of a long-term asset.Depreciation is the specific word that describesthe amortization of certain kinds of property, plant, or equipment. Depletion is the specific term that describes the amortization of a natural resource.There is no specific term for writing off inso use the generaltermamortizationto describewriting off the tangible assets, accountants cost of intangibleassets. All of theseterms-amortization, depreciation,and depletion-refer to allocating the cost of an assetto more than one accountingperiod. Accountants use severalmethods of depreciationfor the financial statements. will We discussthree of the most common: 1. Straight-line depreciation 2. Activity (units-of-production) depreciation 3. Declining balance depreciation

To capitalize is to record a cost as an assetrather than to recordit as an expense.

Amortization meansto write off the cost of a long-term asset over more than one accountingperiod. Depreciationis a systematic and rationalallocation process recognize to the expenseof long-term assets over the periodsin which the assets are used. Depletionis the amortization of a natural resource.

. T A : N CHAPTER4 USI NGLO N G - T E R M A N G I B L E S S E T SD E P R E C I A T I OA N D D E P L E T I O N

159

EXHIBIT4.2 DepreciationTermi nology
Term
Deflnition The amount paid for the asset, including all amounts necessa:tr1 get the asset up to and runninq Example Staples purchases computer cash registers for its new store for $21.000.

Cost or acquisition

cost

Estimated useful life

How long the company plans to use the asset; may be measured in years or in units that the asset will produce

Staples plans to use these cash registers for 10 years.

Salvage value or residual value

Estimated value the asset will have when the company is done with it-the salvage value is the estimated market value on the anticipated disposal date Cost minus saluage aa,lue

When Staples is done using the cash registers, the company plans to seII them for $1,000.

The depreciable base is $21,000$1.000= $20.000.

Depreciable base

Cost less tota,l d,epreciation taken to date Book value or carrying value

If Staples uses the straight-line method, the company's depreciation expense wiII be $2,000per year. After the first yeax, the book value will be (= $19,000 $21,000- $2,000).

Foreachof the following,givethe term for writing off the costof the asset. YOUf TUfn 4-3 1. Equipment Wqmw-wN'. .fum"w:$ 2. Building 3 . Oilwe ll Straight-tine Depreciation
StraightJine depreciation is the simplestway to allocatethe cost of an assetto the periods in which the asset used.This is the methodwe usedin Chapter3. Using this method, is the depreciation expense the sameevery period. To calculatethe appropriate is amountof depreciation expense eachaccountingperiod,you fbllow severalsteps. fbr First, you must estimatethe useful life of the asset.The firm should consider this estimate when purchasing an assetand use the estimateafter the purchaseto properly account for the cost of that asset. you estimate salvagevalue, the amountyou believethe asset Second, the will be worth when the company is finished using it. Salvagevalue is the amount you think someonewill pay you for the usedasset.Someone who knows a lot about the assetand the relationship betweenthe use of the assetand its market value will estimatethe salvagevalue. Salvag" value is an estimatethat vou mav need to revise more than once durins the life of the asset. Straight-line depreciation a is depreciation methodin which the depreciation expense is the same eachperiod'

Salvage value(alsoknownas residualvalue)isthe estimated valueof an asset at the end of its usefullife'

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O L AND USEO F L O N G - T E R M P E R A T I O N A A S 5 E T s CHAPTER . ACQ UI SI TI O N 4

The useful life and the salvagevalue are related, and the hrm should have made theseestimates as part of the acquisition decision. Third, you calculatethe depreciablebase-the amount you want to depreciate-by deducting the salvagevalue from the acquisition cost of the asset.This calculation gives the depreciablebase. Fourth, you divide the depreciablebase-the difference between the asset'scost and its estimatedsalvagevalue-by the estimateof the number of yearsof the asset'suseful life. This gives you the annual depreciationexpense. [Acquisition cost - Salvagevalue] + Estimated useful life in years : Annual depreciationexpense We will use an orangejuice machine purchasedby Holiday Hotels to demonstrateall of the depreciationmethods.Exhibit 4.3 summarizesthe information we need for all three depreciation methods. a orangejuice machinefor its Holiday Hotels purchases new squeeze-your-own Suppose andrequireslarge suppliesof fresh orbreakfastbar. Such a machineis expensive self-service anges.After considering the risks and rewards of purchasing the machine and evaluating the Holiday Hotels decidesto pureffect sucha purchasewould haveon the financial statements, chasean $11,500machinewith an estimateduseful life of 6 years.In addition to the invoice price of $11,500, delivery and installation costs amount to $1,000. Holiday will capitalize Holiday estimates that the machinewill thesecostsaspart of the acquisitioncost of the asset. have a salvagevalue of $500 at the end of 6 years.After someonein the firm who is knowlof about the characteristics the assetreviewsand confirms thejudgments aboutuseedgeable ful life and salvagevalue, Holiday will calculatethe yearly depreciationexpense. First, Holiday calculates the depreciable base by subtracting the salvagevalue from the cost.

: + Cost= $11,500 $1,000 $12,500 = $500 value Salvage base Depreciable : $12,500 $500: $12,000

EXHIBIT 4.3 HolidayHotel's Orange J ui ce ach in e M

Cost

invoice price $11,500 + 1,000delivery and installation costs $12,500

Useful life

6 years

Salvage value

$500

Estimated production during its useful life

240,000glassesof juice

. C H AP T ER 4U SIN G ON G-TE RTA N GIB LES S E TS :E P R E C IA TIOND D E P LE TION 161 L M A D AN Then, Holiday divides the depreciablebaseby the number of years of useful life. Annual depreciationexpense: $12,000/6 yea"rs: $2,000 per year Each year the income statement will include depreciation expense of $2,000, and each year the carrying value of the assetwill be reduced by $2,000. This reduction in carrying value is accumulated over the life of the asset,so that the carrying value decreaseseach year.A company's accountingrecords always preservethe acquisition cost of the assetand disclose the cost on the balance sheetor in the notes, so Holiday will keep the total accumulated depreciation in a separateaccount and subtract it from the acquisition cost of the asseton the balancesheet.If Holiday bought the machine on January I,2006, and the company's fiscal year ends on December 3 1, then the income statementfor the year endedDecember31,2006, would include depreciation expense $2,000.The balancesheetwould of show the acquisitioncost-$12,500-and the accumulated depreciationat December31, 2006-$2,000. This is how the adjustmentfor depreciation expensewould look in the accounting equation:

Assets

Liabilities

+

Shareholder's equity Contributed + Retained capital earnings
Depreciation expense

Accumulated depreciationEquipment (2,000)

(2,000)

The equipmentaccountwill have a balanceof $12,500during the entire life of the asset. The accumulateddepreciationaccountwill have a balanceof $2,000 after the 2006 depreciation is recorded.Here is how the assetis reoortedon the balancesheetat December31.2006:

December 2006 31, Equipment Less accumulated depreciation Net bookvalue

2,soo $1 (2,000) $10,s00

In the following year, 2007, the income statementfor the year would again include $2,000 depreciationexpense.The straight-line method gets its name from the fact that the sameamount is depreciated eachyear, so the depreciationexpensecould be graphed as a straighthorizontal line acrossthe life ofthe asset. The adjustmentat the end of 2007 will be identical to the adjustmentat the end of 2006.It will add $2,000 to the accumulated depreciationaccount,so the new balanceis $4,000.Becausethe income statement is only for a single year, the depreciationexpensewill again be $2,000. The balance sheetat December 31,2007 , would show how the carrying value of our assetis declining, becauseon that date Holiday has used it for 2 years.

December 31,2007
E quip me n t Less accumulated depreciation Net book value

$12,s00 (4,000) $ 8,soo

Exhibit 4.4 shows the depreciationexpenseand accumulateddepreciationamountsfor the year-endfinancial statements during the entire life of the asset.At the end of the useful life of the asset,the carrying value will equal the salvagevalue. Holiday has previously estimated that it could sell the assetat the end of its useful life for a price equal to its carrying value-$500.

162

O L CHAPTER . ACQ UI SI TI O N 4 AND USEO F L O N G - T E R M P E R A T I O N A A s S E T s Accumulated Depreciation on Year-End Balance Sheet Garrying or Book Value on the Y e a r - E nd Balance Sheet

EXHIBIT4.4

Straight-Line Depreciation
The depreciationexpenseeach year is always $2,000, as shown in the table and accompanying graph. The carrying value decreases over time, from $10.500at December31. 2006 to $500 at December31.2011.

Year 2006 2007 2008 2009 201 0 2011

Depreciation Expense on the lncome Statement

$2,000 $2,000 $2,000 $2,000 $2,000 $2,000

$ 2,000 $ 4,000 $ 6,000 $ 8,000 0,000 $1 2,000 $1

0,500 $1 $ 8,500 $ 6,500 $ 4,500 $ 2,500 $ 500

Depreciation Expense o $2,000

2009 Year

Your Turn 4-4

purchased new computer for Company a system 1,2006,Access On January with system was 5 years, usefullife of the computer The $15,000. estimated '.Nkwm--wwlN*ilt.u,t*owlw, estimated how Usingstraight-line depreciation, salvage valueof $3,000. an include the income statewillAccess Company on expense muchdepreciation 31, Determine bookvalueof the the mentfor the yearendedDecember 2007? 31, on asset December 2007. Depreciation Activity (Units-of-Production)
is Another way a firm determinesdepreciationexpense by estimatingthe productivity of the asset-how much the assetwill produceduring its useful life. How many units will the asset produce,or how much work will the assetdo during its useful life? This way of determining depreciationexpenseis called the activity method, also known as the units-of-production method.Examplesof activitiesare miles driven or units produced.If a companybuys a car, it may decide to use it for 100,000miles before trading it in. The activity method is similar to the straighrline method.The differenceis that an estimateof the number of units of activity life over the asset's is usedasthe allocationbaseinsteadof an estimateof the numberof years of useful life. Acquisition cost Salvagevalue Rate per activity unit Annual depreciationexpense

Activity method depreciation is the method of deoreciation in which usefullife is expressed terms of the total in units of activityor production expectedfrom the asset,and the assetis written off in proportionto its activity during the accountingperiod.

Estimate useful life in activity units Rate X Actual activity level for the year

To use the activity method, Holiday needsto estimatehow many units the machine will be able to produce during its useful life. SupposeHoliday estimatesthe machine will be able to produce 240,000 glassesofjuice during its useful life. You calculate the depreciable basein exactly the sameway when using activity depreciationas when using straightline depreciation-subtract the expectedsalvagevalue from the cost. In this example, the baseby the depreciable baseis $12,000($12,500- $500).You then divide the depreciable total number of units you expect to produce with the machine during its useful life.

. A C H A PT E R 4U S IN G O N G-TE RTA N GIB LES S E TS :E P R E C IA TIOND D E P LE TION 153 L M D AN Here is how the activity method of depreciationcan be applied to Holiday's orange juice machine.Start by dividing the depreciablebase-$12,000-by the estimatednumber of glasses orangejuice the machinewill produce.That gives the depreciationrate. of $12,000+ 240,000glasses: $0.05 per glass Holiday will use this rate of 90.05 per glassto depreciatethe machine for eachglassof juice it produces. Suppose machinehas a built-in counterthat showed36,000glasses the ofjuice were squeezed during the first year. The depreciationexpenseshown on the income statement for that year would be $1,800. 36,000glassesX $0.05 per glass : $1,800deprecratron expense That is the depreciationexpensefor the year, and the book value ofthe assetwould decline by that amount during the year. It is important to keep a record of the book value of the assetso that Holiday Hotels doesnot depreciatethe assetlower than its $500 estimatedsalvage value. The salvagevalue will equal the carrying value when the assethas reachedthe end of Holiday's estimateof the useful life. Exhibit 4.5 shows the depreciation schedulefor the orange juice machine, given the production levels for each year as shown. EXH I B I T 4. 5

ActivityDepreciation
Production Each YearNumber of Glassesof Orange Juice Depreciation Rate x Number of Glassesof Juice *Rate:$0.05per Glass Depreciation Expense (lncome Statementl Accumulated Depreciation (BalanceSheet at the End of the Yearl Book Value of the Asset (BalanceSheet at the End of the Year) 0,700 $1 $ 8,650 $ 6,700 $ 4,400 $ 2,250 $ 500

Year

2006 2007 2008 2009 2010 2011

36,000 41,000 39,000 46,000 43,000 35,000

x $0.05 36,000 x $0.05 41,000 x $0.05 39,000 x $0.05 46,000 x $0.05 43,000 x $0.05 35,000

$1,800 $2,050 $1,950 $2,300 50 $2,1 $1,750

$ 1,800 $ 3,850 s s,800 $ 8,100 0,250 $1 2,000 $1

gives depreciable of$12,000. Cost machine $12,500 of of minus salvage value $500, of a base production240,000 glasses. Total estimated is = + per "Rate= $12,000240,000$0.05 glass. Withtheactivity produces year. depreciation method, depreciation the expense year each depends howmany on units asset the each This method matches expense theamount workperformed theasset. the to of value decreasing year, amount depreciation is by Although book the each the of expense likely fromyear-to-year,shown both table graph. always, will vary as in the and As accumulated depreciation isworking wayupuntil its it reaches depreciable the base-costminus will salvage value. That means book the value beequal theestimated to salvage value theendof itsuseful at life.

Depreciation Expense
D

4,167

The flnal year's depreciation varies in amount, depending on how much is needed to make the book value equal to the salvage value.

Year

O L AND USEO F L O N G - T E R M P E R A T I O N A A S S E T S 4 CHAPTER . ACQ UI SI TI O N

Your Turn 4-5
Kwwe. ffimspee

The Hopper Company purchasedequipment on January1, 2005,for $44,000. its salvage expected useful life is 10 years or 100,000units of activity, and value is estimatedat $4,000.In 2005,3,000units were produced,and in 2006, the depreciationexpensefor 2005 and 14,000units were produced.Calculate 2005 using activity depreciation.

Balance Depreciation Declining
Decliningbalance depreciation is an accelerated depreciation method in which is depreciation expense based on th e de clin ingb ook v alue of the asset. Accelerateddepreciation is a depreciation method in which is more depreciation expense taken in the earlyyearsof the asset's and lessin the later life years.

You have learned about the straight-line depreciationmethod and the activity depreciation method. The third method is declining balance depreciation. This method is considered an accelerated depreciation method, one that allows more depreciationin the early years of an asset'slife and less in the later years. The higher depreciation chargeswill occur in the early, more productive yeilrs when the equipment is generatingmore revenue.Deprecirelated ating more ofthe assetin the first few years also helps even out the total expenses lower but repair expensesare likely to an asset.In later years, the depreciation expenseis to be increasing. up The declining balancemethod speeds an asset'sdepreciationby applying a constant rate to the declining book value of an asset.Frequently,f,rrmsuse a version of the declining balancemethod called double-declining balance.The firm takes200Voof the straight-line rate to use as the annual depreciationrate. For example, if the useful life of an assetwere That is because20Voof the asset 5 years,the straight-line rate would be one-fifth, or 2OVo. would be depreciatedeach year for 5 years using straight-line depreciation.The rate used or for double-declining balance depreciation would be 40Vo, which is 20OVo, twice, the straight-line rate. Here is how this method works and why it is called double-declining balance.Every year, the accountantdepreciatesthe carrying value, or book value, of the asset by an amount equal to two divided by the useful life in years. Book value X (2fEstimateduseful life in years) : Yearly expense An example will help you seehow this method works. Supposethe useful life of an asset is 4 years.The double-declining rate would be 2+ 4years= l /2 Alternatively, you could calculate the straight-line rate and then double it. l00%o+ 4 years = 25Voper year : Straight-line rate Double it: 50Vo: Double-declining balancerate Using this depreciation method for Holiday Hotel's orangejuice machine, the book value at the beginning of the first year is $12,500-its acquisition cost. Notice that the calculation of the annual depreciation expense ignores any salvage value becausebook value equalscost minus accumulateddepreciation.Recall that the useful life of the juice machine is 6 years. So the depreciationrate is 2+ 6years:I/3 The depreciationexpensefor the first year is l /3 x $12.500: $4.167 The book value on the balance sheetat December 31,2006, will be $12,500- $4,167: $8,333 For the secondyear, the accountantagain calculatesthe amount ofdepreciation as one-third of the bookvalue (notthe cost). For the secondyear, the depreciationexpenseis 1/3 x $8,333 : $2,778(rounded) The accumulateddepreciation at the end ofthe secondyear is

+ $4,167 $2,778: $6,945

. L M A C H AP T ER 4U SIN G ON G-TE RTA N GIB LES S E TS :E P R E C IA TIOND D E P LE TION 165 D AN The book value on the December 3I.2007 . balance sheetis

: $12,s00 $6,945 $5,55s
Although salvagevalue is ignored in the calculation of each year's expense,you must always keep the salvagevalue in mind so that the book value of the assetis never lower than its salvagevalue. Exhibit 4.6 shows how Holiday Hotel's orangejuice machine would be depreciatedusing double-declining balancedepreciation. Sometimesdepreciationexpensefor the last year of the asset'suseful life is more than the amount calculated by multiplying the book value by the double-declining rate, and sometimesit is less.When the assethas alarge salvagevalue, the depreciationexpensein the last year of the asset's must be less than the amount calculated using the doubledeclining depreciationrate and the carrying value. When the assethas no salvagevalue, the depreciation expensein the last year must be more than the calculated amount. The last year's depreciation expensewill be the amount neededto get the book value of the asset equal to the salvagevalue.

EXH I B I T 4. 5

Double-Declining-Balance Depreciation
Book Value Before Depreciating the Asset for the Year Accumulated Depreciation (At the End of the Year) Book Value at the End of the Year:$12,500Accumulated Depreciation

Year

Depreciation Rate = 1/3 or 33.333%
?e??? ?e???

Depreciation Expense for the Year

2006 2007 2008 2009 201 0 201 1

2,500 $1 $ 8,333
( EqFE

.33333 .33333 .33333

$ 3,703 $ 2,469 $ 1,646

67 $4,1 $2,778 $1,852 $1,234 $ 823 46* $1,1

$ 4,167 $ 6,94s $ 8,797 0,031 $1 0,8s4 $1 2,000 $1

$8,333 $5,555 $3,703 $2,469 $1,646 $ 500**

yearof itsuseful andthebook of x $1,646) indicates depreciation expense $549. of Because isthelast this life value after "Thecalculation (0.33333 thisyear's depreciation should $500, depreciation be must $1,146 bring totalaccumulated to the the expense be depreciation$12,000. to **The depreciation expense Year must calculated make thebook for 6 be to this value theendof theuseful at life-because book the value should betheestimated salvage value.

years theasset's andsmaller thelater Withdouble-declining years. book depreciation, depreciation is in of life expense larger theearly in The value is decreasing a decreasing Still, balance Accumulated at rate. the Depreciation is working wayupuntil reaches costminus its in it the salvage value. firm A always wants book the value theasset beequal theestimated of to to salvage value theendof itsuseful at life.

Depreciation Expense
D

The final year's depreciation varies in amount, depending on how much is needed to make the book value equal to the salvage value.

20tl
Year

16 6

O A AND Us E O F L O N G - T E R M P E R A T I O N A L s s E T S CHAPTER . ACQ UI SI TI O N 4 Method Formula for Depreciation Expense cost value= yearly Acquisition - salvage depreciation expense useful in vears life Estimated cost value = Acquisition - Salvage Unit deoreciation rate Estimated useful in activitv life units x level theyear= Yearly for depreciation expense Rate Actualactivity Yearly depreciation expense

EXHIBIT4.7 DepreciationMethods

line Straight Activity

= book useful in years) life D o u b l e -d e c l ibal ance Beginning-of-the-year valuex (2/Estimated ni ng

EXHIBIT4.8
Year

StraightLine $ $ $ $ $ $ 2,000 2,000 2,000 2,000 2,000 2,000

Activity

Double-Declinirg Balance $ 4,167 $ 2,778 $ 1,852 $ 1,234 $ 823 $ 1,146

Comparison of Depreciation Expense by Yearover the Life of the Orange Juice M ach in e r fo HolidayHotels
Notice that the annual depreciation expensediffers among the three methods,but the total depreciation expensetaken over the life of assetis the same for all methods.

2006 2007 2008 2009 2010 2011 Total depreciation the expense during lifeoftheasset

$ $ $ $ $ $

1,800 2,050 1,950 2,300 2,150 1,750

$12,000

2,000 $1

2,000 $1

Exhibit 4.7 summarizesthe calculationsfor the three depreciationmethods. Over the useful life of the asset,the sametotal depreciationexpensewill be recognized no matter which method is used. Exhibit 4.8 comparesthe depreciationexpenseof the orangejuice machine with the three different depreciationmethods.

Your Turn 4-6 Skwwmw Wfuw-ww

valueof $5,000, and hasa has salvage An asset costs$50,000, an estimated expense the for the Calculate amountof depreciation usefullife of 5 years, yearusingthe double-declining method. balance second
Depletion. Now that you know how equipment and similar kinds of fixed assetsare written off using various depreciation methods, we turn our attention to the way natural resourcesare written off. When a company uses a natural resource to obtain benefits for the operationof its business,the write-off of the assetis called depletion.For example, Cleveland-Cliffs, the largest producer of iron ore pellets in North America, uses depletion to expenseiron ore. The company shows depreciation and depletion together on the balance sheet. Exhibit 4.9 shows the fixed asset portion of the firm's balance sheet.

EXHIBIT4.9

FixedAssets from Cleveland-Cliffs Balance Sheet at December 2005 31,

Cleveland-Cliffs FYomthe Balance Sheet December31, 2005
( i n m i l l i ons )

Properties Plant and equipment Minerals Allowances* for depreciation and depletion Total properties .. . ..

$557.50 42t.80 979.30 (176.50) $802.80

+TFriE is arcther

waA of eupressing

"accwulated,"

d'eprwi,qtion

md dppleti,on anaunts

o C H A P TE R 4U S IN G TA N GIB LE S E TS : IN AS A MOR TTZA TTO N167 Often, all amounts of depreciation, depletion, and amortization are captured in a single total on the balance sheet. Depletion is similar to the activity depreciationmethod, but it applies only to writing off the cost of natural resources. Examples of suchnatural resourcesare land being usedfor oil wells and mines. A depletion cost per unit is calculated by dividing the cost of the natural resource less any salvagevalue by the estimated units of activity or output available from that natural resource. The depletion cost per unit is then multiplied by the units pumped,mined, or cut per period to determinethe total depletion related to the activity during the period. Suppose that, on Januaryl,2005, a companypurchases rights to an oil well in Texas the for $100,000,estimatingthe well will produce200,000barrelsof oil during its life. The depletion rate per barrel is: $100,000+ 200,000barrels : $0.50per barrel If 50,000 banels are producedin the year 2005, then the depletion related to the 50,000 barrels produced in 2005 will be: $0.50per barrel X 50,000barrels : $25,000 On the December 3I,2005, balaace sheet,the book value of the oil rights will be:

= $100,000 $25,000 $75.000

Using Intangible Assets: Amortization
In addition to tangible assets,most firms have intangible assets,which are rights, privileges,or benefitsthat result from owning long-lived assets. Intangible assets have longterm value to the firm, but they are not visible or touchable.Their value residesin the rights and privilegesgiven to the ownersofthe asset. Theserights are often represented conby tracts.Like tangibleassets, they are recordedat cost,which includesall ofthe costsa firm incurs to obtain the asset. If an intangible assethas an indefinite useful life, the assetis not amortized. However, the firm will periodically evaluate the assetfor any permanent decline in value and then write it down if necessily. The idea here is that the balance sheetshould include any asset that has future value to produce revenuefor the firm, but the assetshould never be valued at more than its fair value. Writing down an assetbecauseof a permanentdecline in value means reducing the amount of the assetand recording a loss that will go on the income statement, Intangible assetsthat have a limited life are written off over their useful life or legal life, whichever is shorter,using straight-line amortization. That means an equal amount is expensedeachyear.Firms use an accumulatedamortization accountfor eachintangible asset becausethe accumulatedamortization must be reported.Accumulated depreciationand accumulated amortization are often added together for the balance sheet presentation. Firms often have one or more intansible assets.

L"{"}.3
E xpl ai n and computehow i ntangi bl eassets are written off over their useful livesand reported on the fi nanci alstatements.

Copyrights
Copyright is a form of legal protection for authorsof "original works of authorship,"provided by U.S. law. When you hear the term copyright, you probably think of written works such as books and magaztnearticles. Copyright protection extendsbeyond written works to musical and artistic works and is availableto both published and unpublishedworks. According to the 1976 Copyright Act, the owner of the copyright can . copy the work . use the work to prepa.re related material . distribute copies of the work to the public by sale,rental, or lending . perform the work publicly, in the case of literary, musical, dramatic, and choreographic works
A copyrightis a form of legal protection for authors of "original works of authorship,"providedby U.S. taw.

168

A O AND USEO F L O N G - T E R M P E R A T I O N A L S S E T S CHAPTER . ACQ UI SI TI O N 4

. perform the work publicly by means of a digital audio transmission, in the case of sound recordings All costs to obtain and defend copyrights are part of the cost of the asset.Copyrights arc amortized using straight-line amortization over their legal life or their useful life, whichever is shorter.

Patents
A patent is a propertyright government that the U.S. grantsto an inventor "to excludeothersfrom making, using,offering for sale,or sellin gthe in ve ntio n throughout the United States or importingthe invention for into the United States a period of time." specified

A patent is a property right that the U.S. governmentgrantsto an inventor "to exclude others from making, using, offering for sale, or selling the invention throughout the United Statesor importing the invention into the United Statesfor a specifiedperiod of time in exchange for public disclosure of the invention when the patent is granted." For example, Micron Technology filed for a patentfor a computermemory device in February 2004. IBM obtained a patent for a vibration-driven wireless network in April 2000. Did you know that universities apply for hundredsof patentseach year for their inventions?In20O4, the University of California applied for 424 patents-more patentsthan any other university. As with copyrights, coststo defend patents arecapitalized as part of the cost of the asset.Patentsarc amortizedusing straight-line amortization over their useful life or legal life, whichever is shorter.For example, most patentshave a legal life of 20 years. However, a company may believe the useful life of a patent is less than that. If the company believes the patent will provide value for only 10 years,the company should use the shortertime period for amortizing the asset.

Trademarks
is A trademark a symbol, word,phrase, logothat or legally one distinguishes product from any company's others. one company's A trademark is a symbol,word, phrase,or logo that legally distinguishes product from any others, One of the most recognizedtrademarksis Nike's swooshsymbol. In many cases,trademarksare not amortized becausetheir useful lives are indefinite. Registering a trademark with the U.S. Patent and Trademark Office provides 10 years of protection, renewableas long as the trademark is in use.

Franchises
A franchiseis an agreement to that authorizes someone sell or distributea company's goodsor services a certain in area.

A franchise is an agreementthat authorizes someone to sell or distribute a company's goods or servicesin a certain area.The initial cost of buying a franchiseis the franchisefee, and this is the intangible assetthat is capitalized.It is amortized over the life of the franchise if there is a limited life. If the life of the franchise is indefinite, it will not be amortized. In addition to the initial fee, franchiseowners pay an ongoing fee to the company that is usually a percentageof sales.You might be surprised at some of the top franchisesfor 2005.They include Subway,Curves,and Quiznos.

Goodwill
Goodwill is the excess cost of over market value of the net assets when one company purchases another company.

Goodwitl is the excessof cost over market value of the net assetswhen one company purchasesanothercompany.When theterm goodwill is usedin everydayconversation,it refers to favorable qualities. However, when you seegoodwill on a company's balancesheet,you know that it is a result of purchasing anothercompany for more than the fair market value of its net assets.Goodwill is an advancedtopic for intermediate or advancedaccounting courses.However, you should have a generalunderstandingof goodwill becauseit appears on the balance sheetof many firms. Supposethat The Home Depot purchasedPop's Hardware store for $950,000.The inventory and building-all of Pop's assets-were appraisedat $750,000;and the small hardware store had no debt. Why would The Home Depot pay more than the market value for the net tangible assetsof Pop's Hardware? Pop's Hardware store had been in businessfor many years, and the store had a terrific location and a loyal customer base. All of this is goodwill that Pop's had developedover years of business.GAAP doesnot allow a company do to recognize its internally developedgoodwill, so Pop's financial statements not include goodwill. Now that The Home Depot has decided to purchasePop's Hardware, however,

CH A P TE R C H A N GEA FTE R EP U R C H A S E TH EA S S E T 4 . S TH OF the goodwill will be recorded. Here is how the transactionaffects the accounting equation for Home Depot:

159

Assets

=

Liabilities

+

Shareholder's equitv

Contributed capital (950,000) Cash 750,000 Various assets 200,000 Goodwill

+

Retained earnings

What happensto the intangible assetgoodwill? Goodwill is not amortized becauseit is assumed to have an indefinite life. Even though goodwill is not amortized, companiesmust evaluategoodwill to make sure it is not overvaluedon the balancesheet.Goodwill that has lost some of its value must be written down-that is, the asset is reduced and a loss is recorded.You can read about a frm's goodwill in the notes to the financial statements.

Research Development and Costs
Researchand development (R&D) costs have benefits to the firm-at least that is the goal of R&D. However, R&D costs are expensedand are not capitalized as part of the cost of an assetbecause is not clear that thesecostsrepresentsomethingofvalue. Softwaredeit velopment costs are consideredresearchcosts until they result in a product that is technologically feasible, so these costs must also be expensed as they are incurred. However, once the software is consideredtechnologically feasible, the costs incurred from that point on are capitalized as part of the cost of the software. Deciding when a piece of software is technologically feasible is anotherexample of how firms needto usejudgment when making accounting decisions. The firm's developers and computer experts would make this judgment.

Changes after the Purchase the Asset of
We startedthe chapter with a discussionof the types and costs of long-term assets. Then, we discussed how the accountingrecordsshow the firm's use of thoseassets. Now we discuss how to adjust financial statementsto record three things that may take place after an assethas beenin use. First, the assetmay lose value due to circumstances outside the firm's control. Second,the firm may make expendituresto maintain or improve the assetduring its useful life. And third, the firm may need to revise its prior estimatesof an asset'sestimated life and salvagevalue.

L"O-4 Exolainhow decreases in val ue,repai rs, changes n i productivecapacity, and changesin estimates of usefull i fe and sal vage value of assets reoorted are on the fi nanci alstateme nt s.

Asset lmpairment
By now you know that accountantswant to avoid overstatingassetson the balance sheetor revenueon the income statement.A firm that is getting ready to prepareits financial statements must evaluateits long-term assets, including goodwill and other intangible assets, for impairment-a permanent reduction in the fair market value of an assetbelow its book value-if certain changeshave occurred. Such changesinclude 1.. A downturn in the economy that causesa significant decrease the market value of a in long-lived asset 2. A changein how the company usesan asset 3. A changein the businessclimate that could affect the asset'svalue An assetis considered impaired when the book value of the assetor group of assets greater is than its fair market value. Impairment is not easy to measure,but you will read about it in the notesto almost every set of financial statements. Because testing an assetfor impairment can be quite diff,cult, it is a topic reseryedfor more advancedcourses.However, you should be familiar with the terminology becauseyou will seeit in almost every annual report.

lmpairmentis a permanent d e c l i n ei n t h e f a i r m a r k e t value of an asset suchthat its book value exceeds fair its market value.

17O

O L AND USEO F L O N G - T E R M P E R A T I O N A A S S E T S 4 CHAPTER . ACQ UI SI TI O N

4 E XHtBtT .10
Disclosure About Asset lmpairment in Darden Notes to Restaurants' the Financial Statements
The Notes to the Financial Statementsprovide important information about the amounts in the financial statements.

FYomthe Notes to the Financial Statements of Darden Restaurants,Inc.

In the fourth quarter of fiscal 2004,we recognized asset impairment charges of $37 million ($23 million after-tax) for the closing of six Bahama Breeze restaurants and the write-down of four other Bahama Breeze restaurarts, one Olive Garden restaurant and one Red Lobster restauant based on an evaluation of expected cash flows. During flscal 2005,we recognizedassetimpairment charges of $6 million ($4 million after-tax) for the write-down of two Olive Garden restaurants, one based on an evaluation of expected cash Red Lobster restauant and one Smokey Bones restaura.nt flows. The Smokey Bones restaurant was closed subsequentto frscal 2005while the two Olive Garden restaurants and one Red Lobster restaurant continued to operate.

Inc. regardExhibit 4.10 showsa portion of the disclosuremadeby Darden Restaurants (losses)of $37 million in20}4 and $6 million in ing its reported assetimpairment charges 2005. A company must disclose in the notes to the financial statementsa description of the impaired assetand the facts and circumstancesleading to the impairment.

to Expenditures lmprovean Assetor Extendlts UsefulLife
Another changein the value of an assetmay be the result of the firm spendingmoney to imAny expenditurethat will benefit more than one accountingperiod is called prove its assets. a capital expenditure. A capital expenditureis recordedas an assetwhen it is incurred, and it is expensedor amortized over the accounting periods in which it is used' Just the oppositeof a capital expenditureis an expenditurethat doesnot extendthe useful life or improve the asset.Any expenditurethat will benefit only the current accounting period is expensedin the period in which it is incuned. It is sometimescalled a revenueexreally capturesits meaning in a more logical way. penditure, although expense Many companiesestablishpolicies that categorizepurchaseditems as capital expendituresor revenueexpenditures-expenses,often basedon dollar amounts.The accounting constraint of materiality applies here so that small dollar amounts can simply be expensed. Remodeling and improvement projects are capital expendituresbecausethey will offer firms benefits over a number of years. . remodeling, such as a new wiring systemto increasethe efficiency of the electrical system of a building . improvements,such as a more energy-efficient air-conditioning system becausethey are routine and do not inOrdinary repairs are recognizedas current expenses creasethe useful life ofthe assetor its efficiency. Ordinary repairs, such as painting, tuneups for vehicles, or cleaning and lubricating equipment are expendituresthat are necessary to maintain an assetin good operating condition and are expensedas incurred' Supposethe computer terminals at Staples' corporate offices need a monthly tune-up and cleaning.The cost of this maintenancewould be an expense-recognized in the period the work was done. But suppose Staples upgraded its computer hardware to expand its capability or its useful life. This cost would be considered a capital expenditure and capitalized-recorded as part of the cost of the assetand depreciatedalong with the asset over its remaining useful life.

A capital expenditure is a cost that is recorded as an asset, not an expense, the time it at is incurred. This is alsocalled capitalizing a cost.

Value of Estimates UsefulLife and Salvage Revising
Sometimesmanagershaveusedan assetfor a period of time when it becomesclear that they need to revise their estimatesof the useful life or the salvagevalue of the asset.Evaluating estimatesrelated to fixed assetsis an ongoing part of accounting for those assets.In acrevising an estimateis not treatedlike an error-you do not counting for long-term assets, Those amountswere corgo back and correct any previous records or financial statements. the best estimatesat that time were used for the calculation. Suprect at the time-because pose managersbelieve that a smoothly running machine will offer a useful life beyond the

C H A P TE R S E LLINLON G-TE RA S S E TS 171 4 . G M original estimate.The undepreciated balance-the book value of the asset-reduced by the estimatedsalvagevalue would be spreadover the new estimatedremaining useful life. Similarly, if managerscome to believe that the salvagevalue of the machine will be greaterthan their earlier estimate,the depreciationwill be recalculatedwith the new salvagevalue. This approachis similar to treating the undepreciated balancelike the cost of the assetat the time of the revised estimatesand using the new estimatesof useful life and salvagevalue to calculate the depreciationexpensefor the remaining years of the asset'slife. SupposeStaplespurchaseda copy machine that cost $50,000, with an estimateduseful life of 4 years and an estimated salvagevalue of $2,000. Using straight-line depreciation, a single year's depreciationis

$s0,000 $2,000 :
4 years

$48,000 :
4 years

per $12,000 year

SupposeStapleshas depreciatedthe machine for 2 years.That would make the book value

s26.000.
$50,000 Cost $i2,000 Depreciation
year I

$12,000 Depreciation = yezr2

$26,000 Book value

As Staplesbegins the third year of the asset'slife, the managerrealizesthat Stapleswill be able to use it for threemore years-rather than two more years as we originally estimatedbut now believesthe salvagevalue at the end of that time will be $1,000-not $2,000 as originally estimated. The depreciationexpense the first 2 years will not be changed.For the next 3 years, for however,the depreciation expensewill be different than it was for the first 2 years.The acquisition costof $50,000less$24,000of accumulated givesus the undepreciated depreciation balanceof $26,000.This amountis treatedas if it were now the cost of the asset. The estimated salvagevalue is $1,000,and the estimated remaininguseful life is 3 years.The calculationis

$26,000 1,000 3 years

$25,000 3 years

per $8,333 year

The assetwill now be depreciatedfor 3 years at $8,333 per year.At the end of that time the book value ofthe assetwill be $1,000 [$26,000- ($8,333per year x 3 years)].

At the beginning 2005, WhiteCompany hireda mechanic performa mato of jor overhaul its mainpiece equipment a costof $2,400. equipment of The of at originallycost$10,000 the beginning 2001, at of and the book valueof the equipment the December on At 31,2004, balance sheetwas $5,000. the time of the purchase, White Company would have estimated that the equipment a usefullife of 10yearsand no salvage value.Theoverhaul the beginning at of 2005extended usefullife of the equipment. WhiteCompany's esnew the timateisthat the equipment now lastuntilthe endof 2012-8 years will from the date of the overhaul.Expected value is still zero.White uses salvage straight-line depreciation all of its assets. for the Calculate depreciation expense White'sincome for statement the yearendedDecember 2006. for 31,

Your .$.k-wm Turn 4-7
.\mwsm. w"m

Selling long-Term Assets
We have bought the long-term assetand used it-depreciating, depleting, or amortizing it over its useful life. Now, we deal with getting rid of an asset.Disposing of an assetmeans to sell it, trade it in, or simply toss it in the trash. When would a company sell an asset? Sometimesan assetis sold becauseit is no longer useful to the company.Other times an asset is replaced with a newer model, even though there is remaining productive capacity in the current asset. You calculate the gain or loss on the disposalof an assetby comparing the

L.O.5 E xpl ai n how the di spo sal of an assetis reflectedin the financialstatements.

172

O L CHAPTER . ACQ UI SI TI O N 4 AND USEO F L O N G - T E R M P E R A T I O N A A S S E T S

cashreceivedfor the sale of the asset-also known as cashproceeds-and the asset'sbook value at the time of disposal.One of three situations will exist: 1. Cash proceeds are greaterthan the book value. There will be a gain. 2. Cash proceedsare less than the book value. There will be a loss. 3. Cash proceedsare equal to the book value. There will be no gain or loss. Supposeyou decide to sell equipment that was purchased7 years ago. At the time of the purchase,you estimated it would last 10 years. The assetcost $25,000, and you used straight-line depreciationwith an estimatedsalvagevalue of zero.The depreciationexpense each year was $2,500. Now, 7 years later, you sell the assetfor $8,000. Is there a gain or loss on the sale?First, calculate the book value on the date you sold the asset: - Accumulated depreciation Book value : Cost Book value : $25,000 - (7 years X $2,500 per year) Book value : $25,000- $17,500 : $7,500 Then, subtract the book value from the cash proceedsto calculate the gain or loss on the sale.

$ 8 , 0 0 0 -$ 7 , 5 0 0 = $ 5 0 0
Becausethe proceedsof $8,000 are larger than the book value of $7,500, there is a gain on the sale.A gain is a special kind of revenuethat is shown on the income statement.A gain is special becauseit is not a normal part ofbusiness operations.You are not in businessto buy and sell the equipmentyou use in your business,so the income from such a transaction is called a gain rather than simply called revenue. Another way to calculate the gain or loss on the sale of an assetis to record the three amountsyou know. 1. Record the receipt of cash. 2. Remove the assetand its accumulateddepreciation. 3. Balance the transactionin the accounting equation with a gain or loss.

Assets

=

Liabilities

+

Shareholder's equity Contributed + Retained capital earnings 500 gainon sale of equipment

Cash 8,000 (25,000) Equipment 17,500 Accumulated depreciation

instead,you sell the assetafter 7 yearsfor $5,000 rather than $8,000.Is there Now suppose, a gain or loss on the sale?Youalreadyknow the book value is $7,500 at the date ofthe sale. Subtract the book value from the cashproceeds.

: $s,000 $7,s00 -$2,s00
Becausethe proceedsare less than the book value, there is a loss on the sale.A loss is a special kind of expense,and it is shown on the income statement. Supposeyou sold the assetfor exactly the book value, $7,500.There would be no gain or loss on the sale.Look at the accountingequation below to seethe effect of selling an asset for its book value.

Assets

=

Liabilities

+

Shareholder's equity Contributed + Retained capital earnings

7,500Cash (25,000) Equipment 17,500 Accumulated depreciation
There is no gain or loss. Selling an assetfor its book value, therefore, does not affect the income statement.

. A CHAPTER4 PRESENTAT I OO F L O N G - T E R M S S E T S N T H E F I N A N C I A L T A T E M E N T S N O S

173

Perry PlantsCompanyowned an assetthat originally cost $24,000. The company sold the asseton January 1,2005, for $8,000cash.Accumulateddepreciation on the day of sale was $18,000.Determine whether Perry should recognizea gain or a losson the sale.lf so, how much?

Your Turn 4-8
Y*asr Wesvm

Presentation Long-Term of Assets on the Financial Statements
Reporting Long-Term Assets
In this chapteryou have seenthat both tangible and intangible long-term assets recorded ale at the amount the firm paid for them. The assetsare shown on the balance sheetin the last halfofthe assetsection, after current assets. Becausethe carrying value ofproperty, plant, and equipment (PPE) is the difference betweenthe cost of the assetand its accumulateddepreciation, accountantssay that PPE is reported atits amortized cost or its depreciatedcost. The notes to the financial statementsare a good place to learn the types of assets,approximate age of the assets, and depreciationmethod(s) used. The use of long-term assetsis shown on the income statement with depreciation, depletion, aad amortization expense.Often, the amount is included in the total of several accountsfor presentationon the income statement. The statementof cash flows will indicate any cash expendituresfor PPE as cash used for investing activities. Any cash received from the sale of long-term assetswill be shown as an inflow in the samesection-cash from investing activities-of the statement. Remember that the gain or loss on the sale of a long-term asset,reported on the income statement, is not the cashrelated to the sale.The cash collected from the sale will appearon the statement of cashflows. Exhibit 4.11 showsthe assetsectionof Best Buy's balancesheet.The firm showsthe various categoriesof fixed assetsat their cost and then shows the deduction for accumulated depreciation.This is all the depreciationthat the firm has taken on its property, plant, and equipment since their purchase.Some firms show only the net amount, leaving the details for the notes to the financial statements. anv case.vou should be able to find or calIn culatethe cost of a firm's long-termassets.

H,.{J.6 R ecogni ze and expl ai nh ow long-termassets are reported on the financial statements, and prepare financialstatements that include long-termassets.

Preparing Statements Tom's for Wear
Since beginning in January2006, Tom's Wear Company has now finished 3 months of business.Refresh your memory by reviewing Tom's March 31 balance sheet in Exhibit 4.12, before Tom's Wear begins the month of April. Tom's Wear has been struggling along, but Tom believesthat he can make a big profit breakthroughif he can expandhis business.His researchindicates a large demand for his T-shirts, so he plans a major expansionin April. Read through eachofthe transactionsand study how they havebeenenteredin the accounting equation worksheet in Exhibit 4.13. Then, we will make the end-of-the-month adjustments and preparethe four financial statements. Transaction 1 In April, Tom's Wear purchaseda van for $25,000. The company paid an additional $5,000 to have it equipped with the racks for T-shirrs. Tom's Wear financedthe $30,000at I}Vo per year for 5 yearswith a local bank. On March 31 of each year beginning in2007, Tom's Wear will pay the bank the interest it owes for the year plus $6,000 of the $30,000 principal. Tom's Wear expects the van to be driven for approximately 200,000 miles and have a residual value of $1,000 at the end of its useful life. The company decided to depreciatethe van using the activity method,basedon miles. Transaction 2 Tom's Wear hired an employee, Sam Cubby, for 20 hours per week to fold, sort, and deliver the shirts. Sam will earn $1,000 per month, payable on the ftfth of the following month. Sam will not begin work until May. Transaction 3 Tom's Wear received cash for the prior month of saleson account, settling the $2,000 accountsreceivableon the March 3I,2006, balance sheet.

174

A O AND USEO F L O N G - T E R M P E R A T I O N A L S S E T S 4 CHAPTER . ACQ UI SI TI O N

EXH|S|T4.11 Presentation of LongTerm Assets and AccompanyingNote Buy how Thisshows Best
presents information about its fixed assetsin the frnancial statements.
$ i,nmi,ll:ions

BestBuy Co.,Inc. (partial) BalanceSheets Consolidated

February 25, 2006

February 26, 2005

Assets Current assets: Cashandcashequivalents..... Shod-term investments Receivables Merchandise inventories Other current assets Tota] current assets Property and equiPment Landandbuil d i n g s . . . . Leasehold improvements F'ixtures and equipment Property under master and capital lease Lessaccumulateddepreciation ...' Netproperty and equiPment'. ...' Goodwill Thadename Long-term investments Other assets Total assets

$

681 3,051 506 3,338 409 7,985 580 1,326 2,898 33 4,836 2,124 2,712
DD/

$

354 2,994 375 2,85L 329 6,903 506 1,139 2,458 89 4,r92 1,728 2,464 513 40 148 226

M 218 848 $i1,864

$1-d,t0a

goodsstores buy its shirts,sothe to sporting Tom'sWearfoundseveral Transaction4 1'000T-shirts Tom'sWearpurchases inventory. the increase firm mustdramatically at $4 eachon account. On in Tom'sWearrenteda warehouse whichto storeits inventory. April Transaction5 of rent. paid $2,400 2 months for 15,thecompany

EXHIBIT4,12 Balance Sheetfor Tom's Wearat March31,2006
Tom's Wear, Inc. Balance Sheet At March 31, 2006
Liabilities and Shareholder's Equity

Current assets $ 3,995 Cash .. 2,000 ...... Accountsreceivable 300 Inventory. 75 ........ Pre p a i d i n surance 6,370 Total current assets
Computer (net of $100 accumulated depreciation) Total assets ..... 3,900 . $10,270

Current Iiabilities . Interestpayable......... .... Notespayable Totalcurrentliabilities....... Shareholder's equity Common stock . . Retained eamings. equity .... Total shareholder's

$

30 3,000 3'030

5,000

Total liabilities and equity. .. .... $10,270 shareholder's

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CHAPTER . ACQ UI SI TI oNAND USEoF L o N G - T E R Mo P E R A T I o N A LA S S E T S 4

Transaction6 Tom's Wear arrangedthe salesof its shirts to a number of sporting good stores in the area. Each month Tom's Wear will deliver 800 shirts for $10 each to six different shops.The delivery will be made on the 15th of each month, and the customer will pay by the 10th of the subsequentmonth. The first deliveries are on April 15. Transaction 7 Tom's Wear paid cash for $300 worth of operating expenses. After you understandeach of the transactionsshown in Exhibit 4.13, you are ready to make the needed adjustmentsbefore the April financial statementscan be prepared. As you read each of the explanations for the adjustments,follow along on the worksheet in Exhibit 4.14. Adjustment 1 Tom's Wear needsto adjust prepaid insurance.On April 1, there was $75 worth of prepaid insurance on the balance sheet.Recall, Tom's Wear purchased3 months of insuranceon February 15 for a total cost of $ 150,which is $50 per month. Adjustment 2 Another item that needsto be adjustedis prepaid rent. Tom's Wear paid $2,400 for 2 months of rent, beginning on April 15. On April 30, half a month's rent should be expensed. Adjustment 3 Depreciation expensefor the computer needsto be recorded.Recall, it is being depreciated $100 per month. at Adjustment 4 Depreciation expense for the new van needs to be recorded, It cost $30,000 and has an estimatedresidual value of $ 1,000. It is being depreciatedusing the activity method basedon an estimated200,000 miles. During April, the van was driven 5,000 miles. The rate is $0.145per mile ($29,000depreciable basedivided by 200,000miles). The depreciation expense April is $0.145per mile X 5,000 for miles : $725. Adjustment 5 Interest expenseon the note for the computer needsto be accrued.The 3-month,$3,000note at l2%awas signedon March 1. Interestfor April will be $30

($3,000x 0 . 1 2 x U1 2 ).
Adjustment 6lnterest expenseon the note for the van needsto be accrued.The $30,000 note at lj%o was signed on April 1. Interest for April will be $250 ($30,000 X 0. 10

x I/12).
Using the accounting equation worksheet in Exhibit 4.14, yol can see how the financial statementsare derived. Study each of them by tracing the numbers from the worksheet to the appropriatefinancial statement,shown in Exhibit 4.15.

L"{t;l (ROA) Usereturnon assets andthe asset turnover ratio to helpevaluate firm's a performance.

Applying YourKnowledge-Ratio Analysis
You know how a firm recordsthe purchaseoflong-term assetsand how it accountsfor the use of the assets. Now we will look at how you can use the information about long-term assetsto help evaluatethe performance of the firm.

Return Assets on
A company purchasesassetsto help generatefuture revenue. Recall the definition of an asset-something of value used by a businessto generaterevenue.A ratio that measures how well a company is using its assetsto generaterevenueis return on assets(ROA). ROA is an overall measureof a company'sprohtability. Like much of the terminology in accounting, the name of this ratio is descriptive.A company's return is what the company is getting back. We want to measurethat return as a percentageof assets.So return on assetsis literally return-net income--divided by assets. Return on assets _ Net income * Interest expense Average total assets

This ratio measuresa company's successin using its assetsto earn income for the people financing the business-both owners and creditors.Becauseinterest expenseis

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EXHTB|T 4.15 FinancialStatementsfor Tom'sWear
The arrows should help you seethe relationships between the financial statements.

lom'swGal
Tom's Wear,Inc. Income Statement For the Month Ended April30 Tom's Wear,Inc. Statement of Changesin Shareholder's Equity For the Month Ended April 30

Sales revenue Costsofgoods sold . . . Gross profit Other expenses Insura nce Ren t . Depreciation Interest Other operating expenses Net income

$8,000 3,200 4,800
...... ......... $ 50 600 825 280 . . 300

Common stock $5,000 Beginning balance +N e w s t o c k i s s u e d . . . . : : : : : : Ending balance Retained earnings $2,240 Beginningbalance.... 2,745 + Net income

$ 5oo0o

2,055

vJ45

shareholder's equity.

4,985 . . . $9,985

Tom'sWear, Inc. Statement CashFlows of For the Month EndedApril 30

Tom's Wear,Inc. Balance Sheet AtApril30

Cash from operating activities Cash collected from customers Cash paid for operating expenses Net cash from operating activities Cash from investing activities Cash from ffnancing activities Net increase (decrease) in cash Add begiruring cash balance Ending cash balance

$ 2,000 (2,700) (700) 0 0 (700)

Cash .

$3,295

Inventory
Prepaid insurance Prepaid rent Total cr-urent & equipment (net of $925 accumulated depreciation) Total assets LiabiHties & Shareholder's Equity Liabilities . A c c o u n t s p a y a b l e. . . . Interestpayable .... Short-term notes payable Tota] current liabilities Long-term notes payable Shareholder's Equity Common stock Retained earnings Total liabilites and SH equrf .

8,000 1,100 25
1,800 t4,220 33,075 $47,295 4,000 310 3,000 7,310 30, 4,985 $47,295

174

. A Y CH A P T E R 4 A P P L Y I N G O U R K N O WL E D G E - R A T I O N A L Y S I S

179

EXHIBIT4.16 Apple Computer,Inc. For the year ended September 24,2005 Dell,Inc. For the year ended February 3, 2006

Returnon Assets for AppleComputer a n d De ll

(dnllus

inmi,lliore)

Net income plus interest expense A vera ge Assets ..... Retum onAssets. .. .

mf
$ 1,335 $ 9,800
13.620/o

.... $ 3' 600 . . .. $23,162 L5.540/o

part of what has been earned to pay creditors, it is added back to the numerator. Net income is the return to the owners, and interest expenseis the return to the creditors. So you add interestexpenseback to net income for the numerator.The denominatoris averagetotal assets. Using a ratio such as ROA gives financial statementusersa way to standardizenet income acrosscompanies.Exhibit 4.16 provides an example. For the fiscal year ended September24,2005, Apple Computershad a net income $1,335and average assets $9,800 of (both in millions). The firm had no interest expenseduring the year. For the fiscal year endedFebruary3,2006, Dellhadnetincome of $3,572andinterestexpenseof $28, with averageassetsof $23,162 (all dollars in millions). Clearly, Dell is outperforming Apple Computers in total net income. But that comparison does not tell us how well each company is using its assetsto make that net income. If we divide net income plus interest expenseby averagetotal assets, will get the return on assetsfor the year. we It is clear in this comparisonthat Dell is earning a better return with its total assets than Apple Computer is earning with its assets. The industry averagefor firms in this industry for return on assets 12.6%o. using the and is Apple's ROA is 13.62Vo Dell's ROA is 15.54Vo results from the fiscal years shown in Exhibit 4.16. You can find up-to-dateinformation on the firms' ROA at www.moneycentral.msn.com.

Asset Turnover Ratio
Another ratio that helps us evaluatea frrm's use of its assetsis the assetturnover ratio. This ratio indicateshow effrciently a company is using its assets. The ratio is defined as net sales divided by averagetotal assets. The ratio answersthe question: How many dollars of sales are generatedby each dollar investedin assets? Asset turnover ratio : Net sales Averagetotal assets

Look at Apple Computer and Dell again. Sales for Apple Computer for the fiscal year ended September24,2005, were $13,931 million, and salesfor Dell for the fiscal year endedFebruary3,2006, totaled $55,908million. The assetturnoverratio for eachis:

(dollars millions) in
S ales Average Assets AssetTurnover Ratio

AppleComputer $13,931 $9,800 1.42

D el l

$ss,908 $23,152
2.41

180

CHAPTER o ACQ UI SI TI oNAND Us E oF L o N G - T E R Mo P E R A T I o N A LA S S E T S 4

Asset turnover ratios vary signif,rcantlyfrom industry to industry, so it is important to compare firms only in the sameindustry. Dell's use of its assetsto generaterevenuewas quite a bit better than that of Apple Computer during this time period. Rememberthat all ratios have this in common: To be meaningful, ratios must be compared to the ratios from other years with the same company or with other companies.Industry standardsare also often available for common ratios to help investors and analysts evaluatea company's performanceusing ratio analysis.

I".f).8 l dent if yand des c ri b e e th business risksassociated with long-term assets and the controlsthat can minim iz et hos e r is k s .

Business Control, Risk, and Ethics
A firm risks losing long-term assets due to theft. This risk is not a problem with some large assets,such as a factory, but it is a very seriousproblem with smaller, mobile, fixed assets, such as cars,computers,and furniture and fixtures. Even large assets, such as buildings and factories, are at risk for damagedue to vandalism,hurricanes,or terrorist activities. One of the major functions of any company's internal control systemis to safeguardall assets from theft and damage-whether intentional or unintentional. The cost of safeguardingassets can be tremendous,as can the cost of replacing them if they are destroyed.The damage done to long-term assetsby Hurricane Katrina in August 2005 to the Gulf Coast has amountedto billions of dollars. Physical controls to safeguardassetsmay be as simple as a lock on a warehouse door, a video camerain a retail store,or a security guard who remains in an office complex overnight. Even when assetsare protectedin a securefacility with guards,fences, or alarms,the company must be sure that only the appropriatepeople have access the to assets. Complete and reliable record keeping for the assetsis also part of safeguardingassets. With assetssuch as cash and inventory, the people who are responsible for the record keeping for long-term assetsshould be different than the people who have physical custody of the assets.This is called segregation of duties and is a very common control. Monitoring is another control to safeguardassets. This means that someoneneedsto make sure the other controls-physical controls, segregationof duties, and any other policies and proceduresrelated to protecting assets-are operating properly. Often, firms have internal auditors-their own employees-who perform this function as part of their job responsibilities.You may recall that it was an internal auditor who first blew the whistle on the Enron fraud. Intangible assetspresent special risks to a firm. Google's attempt to digitize all the books in the libraries of severalmajor universitieshas brought new concernsover copyright laws. The value of these intangible assetson a frrm's balance sheetand the potential costs of defending theserights can amount to signifrcant sums of money. Technology and ethics have collided, resulting in many questionsabout the legal and ethical dimensionsof current copyright laws.

Segregationof duties means that the person who has physicalcustody of an assetis not the samepersonwho has record-keepirrg responsibilities that asset. for.

'hawefhsA
in Google scanning is millions books an effortto advance mission organize of its to all knowledge; in 2005,someauthors publishing but and companies Google sued for publishers copyright infringement. argument not overthe books The is keep currently "orphans." isvery in print; isover 25 million it the books considered lt difficult track to downtheowner thecopyright of Jane Friedman, CEO HarperCollins the of Publishers, doesnot expect lawsuit be settled herlifetime. Kevin this to in But Kelly, a NewYork in (May14,2006), Irmes feels surethat the technology article willwin out. He predicts

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. CHAPTER4 CHAPTER UMMARYPROBLEMS S

181

Points Chapter Summary
. Assetsthat last longer than a year are classified as noncuffent (or long term) on the balto ance sheet.They are recordedat cost, including all of the costsnecessary get the asset ready for use. . Long-term assetsare written off over their useful lives. For plant and equipment,an asset may be written off using either straight-line, activity, or double-declining balance depreciation methods. Intangible assetswith a definite life are written off, or amortized, using the straighrline method. . Routine repair and maintenancecostsare expensedas incurred, whereasimprovements as to the productive capacity or the useful life of an assetare capitaTized part of the cost of the asset. . Any revisions in the useful life or the estimated salvagevalue of an assetare implemented at the time of the revision and in the future periods. Any past depreciationexpenseis rot revised. . When an assetis sold, the gain or loss is calculated as the difference between the proceeds(salesamount) and the book value (cost - accumulateddepreciation)of the asset.

Chapter Problems Summary
and Suppose PencilsOffice Supply started fiscal yearwith the following accounts balances: the Balances January1, 2008 at Account Cash Accountsreceivable Inventory Prepaid ur anc e ins Eq uipm ent Ac c um ulat ed dep re c i a ti o n -E q u i p me n t Accountspayable pay Sa lar ies able Unear ned ev enu e r Long-termnote payable Ot her long- t er ml i a b i l i ti e s Commonstock Ret ained ning s ear

$390,000 136,000 106,350 3,000 261,000 (7s,800) 26,700 13,500 3s,000 130,000 85,000 2s0,000 280,350

ss0 $820,

$820.ss0

Supposethe company engagedin the following transactionsduring its frscal year ended December31, 2008: 1. The company purchasednew equipment at the beginning of the fiscal year. The invoice price was $158,500, but the manufacturer of the equipment gave Pencils a 37odiscount for paying cash for the equipment on delivery. Pencils paid shipping costs of $1,500 and paid $700 for a special insurance policy to cover the equipment while in transit. Installation cost was $3,000, and Pencils spent $6,000 training employees to use the new equipment. Additionally, Pencils hired a new supervisorat an annual salary of $40,000to be responsiblefor the printing services area where the new equipment will be used. All payments were made in cash as the costs were incurred. 2. The company sold some old equipment with an original cost of $12,300 and related to accumulated from the saleamounted $1,500. depreciation $11,100.Proceeds of 3. The comDanv receivable. collectedcashof $134.200on accounts

142

CHAPTER . ACQ UI SI TI O N 4 AND USEO F L O N G - T E R M P E R A T I O N A A S S E T S O L

4. The company purchased $365,500 worth of inventory during the year, paying
$200,000 cash, with the remainder purchasedon account. The company paid insurancepremiums of $12,000. payable. The companypaid $170,000on accounts The company paid employees total cash for salaries of $72,250. (This includes the amountowed at the beginning of the year and the salaryexpense the new supervisor.) for The company made sales to customers in the amount of $354,570. They collected $200,000in cash,and the remainderwas on account.(Inventorysold cost $110,000.) The company usesonly one revenueaccount: Salesand service revenue. The company paid $50,000 to reduce principal of the long-term note and paid interest

6. 7. 8.

9.

of $10,400. paidoperating 10. Thecompany expenses theamount $30,000 cash. in of in

Otherlnformation
A-1. A-2, A-3. A-4. A-5. The company owed salariesof $10,250 to employees at year-end (earnedbut not paid). Insuranceleft unused at year-endamountedto $2,000. The company estimatesthat the new equipmentwill last for 20 years and have a salvage value of $2,945 at the end of its useful life. Previously purchasedfixed assetsare being depreciatedat a rate of lOVoper year. Unearned service revenueof $21.000 has been earnedat vear-end.

lnstructions
Set up an accounting equation worksheet. Enter the beginning balances,the transactions, and any neededadjustmentsat year-end.Then, preparean income statement,statementof changesin shareholders'equity, the statementof cashflows-all for the fiscal year, and the balancesheetat December31, 2008.

S C H A P T E4 . C H A P T E R U M M A R Y P R O B L E M S R

183

Solution
Pencils Office Supply Income Statement For the Year Ended December 31, 2008

Pencils Office Supply Statement of Changes in Shareholder's Equity For the Year Ended December 31, 2008

Sales revenue Cost of goods sold

$375,570

Grossprofit Gain on sale of asset Other expenses Insuranceexpense ... $ 13,000 Salariesexpense 69,000 Depreciationexpense 32,970 Interestexpense ..... 10,400 Otheroperatingexpense ...... 30,000 Net income

1f 0,000 ZAS,SZO 300

Commonstock Beginningbalance + New contributions
Ending balance Retained earnings Beginning balance

..... $250'000 ..... $25fr,000 $280,350 110,500 si]90,860 $ 640,850

(155,370) $110,500

- Dividends inglSSlance Total shareholder's equity

Pencils Offlce Supply Statement of Cash Flows For the Year Ended December 31, 2008

Pencils Office Supply Balance Sheet At December 31, 2008

Cash faom operating activities Cashcollectedfrom customers $ 334,200 (370,000) Cashpaid to vendors . (12,000) Cashpaid for insurance (72,250) Cashpaid to employees (10,400) Cashpaid for interest (30,000) Cashpaid for other operatingexpenses (160,450) Net cashfrom (usedfor) operatingactivities Cash from investing activities 1,500 Proceeds from saleof equipment (164,945) Cashpaid for purchaseof equipment Net cashfrom (usedfor) investingactivities . . . (163,445) Cash from ffnancing activities (50,000) Cashpaid on long-termnote payable Increase(decrease) cash during the yeax . . . . (373,895) in Add begirmingcashbalance 390,000 Cash balance at April 30 $16, 10 5 ,

Assets Cash Accountsreceivable Inventory Prepaidinsurance Total current assets . Equipment(net of $97,670
depreciation)

$ 16,105

/ t56,370 361,850 2,000 536,325 315,975 $ 852,300 22,200 10,250 14,000 46,450 80,000
250 .?$0,{450 $852,300

Total assets Liabilities & S

Tota.lcurrent liabilities Long-termnotespayable Other lons-termliabilities
Shareholder's Equity Common stock . Retainedeamings Total l i abi l i ti esandS H equi ty

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T C H A P T E4 . A N S WE R S O Y O U R T U R N Q U E S T I O N S R

185

KeyTerms Chapter for 4
Accelerateddepreciation

(p.rca)
Activity method (p.162) depreciation Amortization (p. 158) Capital expenditure (p. 170) Capitalize (p. 158) Copyright(p.16l)

Declining balance depreciation(p. 164) Depletion(p. 158) Depreciation(p. 158) (p. Franchise 168) Goodwill (p. 168) Impairment(p. 169) (p. lntangible assets 155) Patent(p. 168)

Relative fair market value method(p. 156) Salvagevalue (p. 159) Segregationof duties (p. 180) Straight-line depreciation

(p.1se)
(p. Tangibleassets 155) Trademark (p. 168)

Answers YOUR to TURN Questions
Chapter 4 Your Turn 4-I 1. Expense 2. Asset 3. Asset 4. Expense Your Turn 4-2 : (400,000/500,000$480,000) $384,000 X should recorded be as Four-fifths ofthe costs : X thecostof thebuilding, one-fifth thecost( I 00,000/500,000$480,000) $96,000 of and to because the two need be separated should recorded thecostof theland.These costs be as company depreciate buildingbut not the land. will the Your Turn 4-3 1. Depreciation 2. Depreciation 3. Depletion Your Turn 4-4 years] year,sothatamount per Eachyear's depreciation $2,400 is [($15,000 $3,000y5 . 31, 3 will be on the incomestatement the yearended December 2001 At December 1, for so 2007 thecompany will havetaken2 years'worth of depreciation, the book valuewill , ($15,000 $4,800). be$10,200 Your Turn 4-S : per Rate: ($44,000 $4,000) 100,000 $0.40 unit + : $1,200 2005: 3,000 unitsx $0.40 2006:14,000 unitsx $0.40= $5,600 Your Turn 4-6 for $50,000x 215: $20,000 thefirst year : Newbookvalue: $50,000 $20,000 $30,000 : $12,000 thesecond x year for $30,000 215 Your Turn 4-7 newdepreciable amount $6,000+ $2,400: $8,400 years per remaining : $1,050 year life $8,400/8 Your Turn 4-8 thanthe bookvalue are Thereis a $2,000gainon the sale. Theproceeds $8,000 greater of of $6.000.

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Questions 1. Describe the difference between tangible and intangible assets. 2. What is the difference between capitalizing and expensinga cost? 3. What is depreciation? 4. What does amortization mean? 5. Explain the difference between depreciationand depletion. 6. How do firms determine the cost of property, plant, and equipment? 7. What is a basket purchase?What accounting problem does this type of purchasecreate, and how do firms remedy the accounting problem? 8. What is the carrying value, or book value, of an asset?Is this value equal to the market value of the asset?Explain your answer. 9. What is the residual value, or salvagevalue, of an asset? 10. What is the difference between depreciation expenseand accumulateddepreciation? On which financial statement(s)do depreciation expenseand accumulateddepreciation appear? 11. How does depreciationapply the matching principle? 12. Explain the difference between the three depreciationmethods allowed by GAAP. 13. What is a copyright and how is it accountedfor? 14. What is a patent and how is it accountedfort 15. What does it mean for an assetto be impaired? 16. What types of costs related to long-term operational assetsare capitalized and what types are expensed? 17. How is a gain or loss on the disposalof an assetcalculated? which financial stateOn ment(s) would the gain or loss appear? 18. How doesgoodwill arise? 19. How is the return on assets(ROA) ratio calculated and what does this ratio measure? 20. How is the assetturnover ratio calculated and what does this ratio measure? 21. List two typesofcontrols that safeguard assets.

Multiple-Choice Questions
1. Which of the following is an intangibleasset? a. Franchise b. Oil reserves c. Land d. Repairs 2, Depreciation is the systematicallocation of the cost of an asset a. Over the periods during which the assetis paid for b. Over the periods during which the market value of the assetdecreases c. Over the periodsduring which the companyusesthe asset d. Over the life of the company 3. Writing off a cost means a. Putting the cost on the balance sheetas an asset b. Evaluating the useful life ofthe asset c. Recording the cost as an expense d. Deferring the expense 4. Supposea firm purchasesa new building for $500,000 and spendsan additional $50,000 making alterationsto it before it can be used. How much will the firm record as the cost ofthe asset? a. $500,000

b. $s50,000 c. $450,000
d. It dependson who performed the alterations. 5. Suppose firm buys a piece of land with a building for $100,000. a The firm's accountant wants to divide the cost between the land and building for the firm's financial records.Why? a. Land is always more expensivethan buildings.

4 . E C H A P TE R S H OR T X E R C IS E S 187 b. Land will not be depreciatedbut the building will be depreciated,so the accountantneedstwo different amounts. c. Land will appreciateand its recordedcost will increaseover time, whereasthe building will be depreciated. d. Depreciation expensewill be separated from accumulateddepreciation after the year. first When an expenditureto repair an existing assetextendsthe useful life of the asset,the cost shouldbe a. Classified as a revenueexpenditurebecauseit will result in increasedrevenue b. Capitalized and written off over the remaining life of the asset c. Expensed the period ofthe reparr in d. Presentedon the income statementor in the notes When goodwill is determinedto be impaired, a firm will a. Increaseits book value to market value b. Sell it immediately c. Reducethe value of the goodwill with a chargeagainstincome (impairmentloss) d. Reducethe value of the goodwill with a chargeto paid-in capital (reducepaid-in capital) When a company's balance sheet shows goodwill for $300,000, what does that mean? a. The companyhas developed strongreputationvaluedat $300,000ifthe a companywere to be sold. b. The companyis worth $300,000more than the balancesheetindicates. c. The company purchasedanothercompany and paid $300,000 more than the fair market value of the company'snet assets. d. The companyhas invested$300,000in new equipmentduring the period. on Suppose firm purchased asset $100,000and estimated, the dateofthe pura an for chase,its useful life as 10 years with no salvagevalue. The firm uses straight-line depreciation. After using the asset for 5 years, the firm changes its estimate of the remaining useful life to 4 years(a total of9 yearsratherthan the original 10 years).How life? much depreciation in expense will the firm recognize the sixth year of the asset's a. $12, 500 b. $10, 000 c . $11, 111 d. $31, 111 it Supposea firm purchased assetfor $50,000and depreciated using straight-line an value.At the end of the seventh depreciation its l0-year usefullife, with no salvage for year ofuse, the firm decidedto sell the asset.Proceeds from the sale were $17,500. What was the gain or loss from the sale of the asset?How did the sale affect the statement of cashflows? a. $2,500loss; $2,500cashoutflow from investingactivities b. $32,500loss; $17,500cashinflow from investingactivities c. $17,500gain; $17,500cashinflow from investingactivities d. $2,500gain; $17,500cashinflow from investingactivities

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ShortExercises
SE4-1. Calculatethe cost of an asset.(LO 1) Gruber Window Fashionsbought a new wood-cutting machine as a part of its venture into manufacturing interior shutters.The invoice price of the machine was $90,000.Gruber also had the following expenses associatedwith purchasingthis machtne. Delivery charge Installation Power to run the machine for the first year $2,850 2,500 450

What amount should Gruber record on the books for this machine?

O L AND USEO F L O N G - T E R M P E R A T I O N A A S S E T S

SE4-2. Calculate the cost of an asset.(LO 1) Settler Company was quickly outgrowing its rented office space.The company decidedthat it could raise enough capital to buy land and build a new office building. The building was completed on September15. Consider the following costs incurred for the new building. Building materials Labor costs (including architect's fees) Rental of equipment used in the construction Maintenance the building from Sept. 15 to Dec. 31 on

$110,000 205,000 9,000
14,000

What amount should Settler Company record on the books for its new building? purchase.(LO 1) SE4-3.Accountfor basket Tylo Corporation obtained a building, its surrounding land, and a delivery truck in a lumpthe for An sum purchase $230,000. appraisalsetthe value of land at $180,000, building at and the truck at $25,000.At what amountshouldTylo record eachnew asseton $145,000, its books? purchase.(LO 1) SE4-4.Accountfor basket Villa Corporation purchasedthree buildings at a total cost of $960,000.The appraisedvalues of the individual buildings were as follows: Building I Building 2 Building 3 $600,000 400,000 200,000

What amounts should be recorded as the cost for each of the buildings in Villa Corporation's accounts? SE4-5. Calculate depreciation expense:straight-line. (LO 2) depreciation expense an asset for that cost $12,000,hasa Calculatethe annualstraight-line useful life of 5 years, and has an estimatedsalvagevalue of $2,000. SE4-6. Calculate depreciation expense:activity method. (LO 2) Using the activity method, calculate the first 2 yearc of depreciation expensefor a copy machinethat cost $14,000,has an estimateduseful life of 5 years or 50,000 copies,and has an estimatedsalvagevalue of $4,000.The number of copiesproducedeachyear is as follows: Year 1 Year 2 Year 3 Year4 Year 5 12,000 10,500 9,100 9,100 8,700

double-declining balance.(LO 2) SE4-7. Calculatedepreciationexpense: Using the double-declining balancemethod, calculatethe annual depreciationexpensethat will be recordedeachyear for an assetthat cost $12,000,has a useful life of 5 years,and has an estimated salvagevalue of $2,000. Explain what accounting issue arises,if any, in the fourth and fifth years. SE4-8.Determinethe cost of an asset.(LO 1,2) If an assetwith no salvagevalue is being depreciatedat a rate of $1,000 per year using the straight-line method over a useful life of 6 years,how much did the assetcost? straight-line.(LO 2) SE4-9. Calculatedepreciationexpense: A machine is purchasedon January2,2006, for $50,000,and it has an expectedlife of 4 years and no estimated salvagevalue. If the machine is still in use 5 years later, what amount of depreciationexpensewill be reported for the fifth year?

E 4 . CHAPTER S H O R T X E R C I S E S 1 8 9

SE4-10.Determinethe usefullife of an asset.(LO 2) value of $2,000.At the end of salvage Suppose asset an cost $20,000and has an estimated As3 years,the carrying value of the assetis $11,000.What is the useful life of the asset? sume straight-line depreciation. SE4-11. Calculatedepletion.(LO 2) CNA Enterprisespurchasesan oil field and expectsit to produce 1,000,000barrels of oil. The oil field, acquiredin January2006, cost CNA $1.5 million. In20O6,280,000 barrels were produced. In 2001, the oil field produced 350,000 barrels. What is the depletion for each of theseyears? SE4-12. Calculatedepletion.(LO 2) Earthlink Mining purchaseda copper mine for $12,000,000.The company expectsthe mine to produce 6,000,000 tons of copper over its 5-year useful life. During the first year of operations,the company extracts750,000 tons of copper.How much depletion should Earthlink Mining record for the first year? (LO 3) SE4-13.Amortizationof intangibleassets. Edgewood Company obtained a patent for a new invention. The costs associatedwith the patent totaled $35,000.With the rapid developmentof new technology, Edgewood's engineershave estimatedthe invention will not have any value after 10 years.The patent has a legal life of 20 years. How will Edgewood amofiize the cost of the patent? (LO 3) SE4-14.Amortizationof intangibleassets. usea Barclay Companypurchased patentfor $50,000on JanuaryI,2007 . The estimated for the fisful life is 10 years.The legal life is 20 years.What is the amortization expense cal year endedDecember31,2007? (LO 4) and capital expenditures. SE4-15.Analyzerevenue For each of the following, tell whether it should be classified as (a) a revenueexpenditure (expensed),(b) a capital expenditure(capitalized), or (c) neither. a. Paid $2,000 for routine repairs b. Paid cash dividends to shareholders useful life c. Paid $6,000for repairsthat will extendthe asset's d. Purchased patentfor $5,000cash a e. Purchased machinefor $10,000and gavea2-year note a f. Paid $50,000 for an addition to a building g. Paid $1,000for routine maintenance a machine on SE4-16. Analyze revenueand capital expenditures.(LO 4) Categorizeeach of the following as a capital expenditure or a revenue expenditure (expense)for Dalton & Sonsand explain why. a. In accordancewith the long-term maintenanceplan, paid for a newly reshingled roof (replacingsimilar old shingles) b. Built an annex to the building for the executiveoffices c. Improved the ventilation systemto increaseenergy efficiency in the building d. Replacedparts in major equipment as needed with changein estimateof salvagevalue.(LO 4) SE4-17. Calculatedepreciationexpense a On Januaryl,2OO7, the Lance Corporationpurchased machineat a cost of $55,000.The machine was expectedto have a useful life of 10 years and no salvagevalue. The straightline depreciationmethod was used. In January 2009, the estimate of salvagevalue was revised from $0 to $6,000. How much depreciationshould Lance Company record for 2009? SE4-18.Accountfor assetimpairment.(LO 4) Delta Airlines has determinedthat severalof its planesare impaired. The book value of the planesis $10 million, but the fair market value of the planesis $9 million. How should Delta treat this decline?

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SE4-19.Accountfor disposalof an asset.(LO 5) A machineis purchased January2,2005, for $100,000. has an expected on It useful life of 10 years and no salvagevalue.After 9 years,the machine is sold for $3,000 cash.Will there be a gain or loss on the sale?How much? SE4-20.Accountfor disposalof an asset.(LO 5) The Topspin Company sold someold equipmentfor $65,000.The equipmentoriginally cost useful life of l0 years,and had no estimatedsalvagevalue.It $100,000,had an estimated was depreciatedfor 5 years using the straight-line method. In the year of the sale, what amount of gain or loss, if any, should Topspin Company report on its income statement? SE4-2I. Preparefinancial statemenls.(LO 6) At what value are fixed assetssuch as property, plant, and equipment shown on the balance sheet?How is that amount calculated? SE4-22. Calculate ratio analysis. (LO 7) Financial ratios are often used to evaluatea company's performance.What ratio(s) would provide information about how effrciently a company is using its assets? SE4-23,Identify risks and controls. (LO 8) Write a paragraphdescribing a specific risk associated with long-term assets and somepossible controls that might minimize the risk. SE4-24.ldentifi risks and controls. (LO 8) Give an example of an industry with a particular interest in copyright laws. What risks do f,rrmsin that industry face? SE4-25. (Appendix) Explain depreciationfor taxes. (LO 9) What kind of depreciation firms usefor taxes?Explain.Why would the IRS allow such do depreciation?

Exercise-Set A
E4-1A. Accountfor basket purchase.(LO I,2) Coca-Colapurchases building and land for $180,000. independent a An appraiser provides the following market values:building-$ 150,000;land-$50,000. a. How much of the purchase price shouldCoca-Colaallocateto eachof the assets? b. Ifthe building has a useful life of 10 yearsand an estimated salvagevalue of expense shouldCoca-Colarecordeachyear $35,000,how much depreciation using the straight-line method? c. Using the double-declining balancemethod,what would the book value of the building be at the end of 3 years? E4-24. Calculate the cost of an assetand depreciation expense. (LO l, 2) CoronaCompanypurchased land for $75,000cashand a building for $300,000cash.The companypaid real estateclosingcostsof $8,000and allocatedthat cost to the building and the land basedon the purchaseprice. Renovation costs on the building were $35,000. Use the accountingequation to record the purchaseofthe property, including all related expenditures.Assume that all transactionswere for cashand that all purchasesoccurredat the beginning of the year. a. Compute the annual straight-line depreciation,assuming a2}-year estimated useful life and a $10,000 estimatedsalvagevalue for the building. b. What would be the book value of the building at the end of the secondyear? c. What would be the book value of the land at the end of the secondyear? E4-3A. Calculate depreciation expense:straight-line and activity methods.(LO 2) Best-GoodsCompany purchaseda delivery truck for $35,000 on January 1, 2006. The truck had an estimated useful life of 7 yearsor 210,000miles. Best-Goodsestimated the

. CHAPTER4 EXERCISES 191

truck's salvage value to be $5,000.The truck was driven 21,000miles in 2006 and 31,500 miles in 2007. a. Compute the depreciationexpensefor 2006 and 2007, first using the straight-line method, then the activity method. b. Which method portrays more accuratelythe actual use of this asset?Explain your answer. E4-4A. Calculate depreciation expense:straight-line and double-declining balance methods. (LO 2\ On January I,2006, Norris Company purchasedequipment for $42,000. Norris also paid $1,200 for shipping and installation. The equipment is expectedto have a useful life of 10 yearsand a salvagevalueof $3,200. a. Compute the depreciationexpensefor the years 2006 through 2008, using the straight-line method. b. Compute the depreciationexpensefor the years 2006 through 2008, using the double-declining balancemethod. (Round your answersto the nearestdollar.) c. What is the book value of the equipment at the end of 2008 under each method? E4-5A. Calculate depreciation under alternative methods.(LO 2) Avery Corporation bought a new piece of equipment at the beginning of the year at a cost of $15,400.The estimateduseful life of the machineis 5 years,and its estimatedproductivity is 75,000 units. Its salvagevalue is estimatedto be $400. Yearly production was: Year 1-15,000 units;Year2-18,750 units;Year 3-I1,250 units;Year4-22,500units; depreciationschedulefor eachof the three andYear 5-7,500 units. Completea separate methodsgiven for all 5 years.(Round your answersto the nearestdollar.) a. Straight-linemethod b. Activity method c. Double-declining balancemethod E4-6L. Calculate depreciation under alternative methods,(LO 2) Using the information from E4-5A, supposethe production in Year 5 was actually 9,000 rather than 7,500 units. How would this difference in production changethe amount of depreciation for Year 5 under each method? Explain. E4-7 L, Calculate depreciation under alternative methods.(LO 2) Propel Company bought a machine for $65,000 cash at the beginning of 2006. The estimated useful life is 5 years and the estimated salvagevalue is $5,000. The estimatedproductivity is 150,000 units.Units actuallyproducedwere49,500in 2006 and 36,000in 2007. Calculate the depreciation expense for 2006 and 2007 under each of the three methods given. (Round your answersto the nearestdollar.) a. Straight-line method b. Activity method c. Double-declining balancemethod E4-8A. Calculate depletion. (LO 2) On January l,z}OS,American Oil Company purchasedthe rights to an offshore oil well for $45,000,000.The company expectsthe oil well to produce 9,000,000 barrels of oil during its life. During 2008, American Oil removed 315,000 barrels of oil. a. How much depletion should American Oil Company record for 2008? b. What is the book value of the oil rishts at December 31, 2008, the end of the fiscal year? E4-9A. Amortize intangible assets.(LO 3) Becker and Associatesregistereda patent with the U.S. Patent and Trademark Offrce. The total cost of obtaining the patent was $165,000.Although the patent has a legal life of 20 years,the firm believesit will be useful for only 10 years.What will Becker and Associates

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record for its annual amortization expense? Show how it would be recordedin the accounting equation. E4-10A. Calculategoodwill. (LO 3) Carpenter Tools decides to acquire a small local tool company called Local Tools. Local Tools has net assetswith a market value of $230,000 but Carpenterpays $250,000.Why? Use the accounting equation to record the purchase. E4-11A. Evaluateassetimpairment.(LO 4) During its most recent hscal year, Bargain Airlines grounded 10 of its '147 dte to a potens tial problem with the wing flaps. Although the planes had been repaired by the end of the fiscal year, the company believed the problems indicated the need for an evaluation of potential impairment of theseplanes.The results of the analysisindicated that the planes had petmanently declined in fair value by $120 million below their book value. What effect would this decline in value have on Bargain Airlines' net income for the year? (LO 1, 4) E4-124. Distinguish betweencapital and revenueexpenditures(expenses). Classify the following items as either a capital expenditure or a revenue expenditure (an expense). a. Changedoil in the delivery truck b. Replacedthe engine in the delivery truck c. Paid salestax on the new delivery truck d. Installed a new, similar roof on the office building e. Paid freight and installation chargesfor a new computer system f. Repaintedthe administrative offices g. Purchasedand installed a new toner cartridge in the laser printer h. Replacedseveralmissing shingleson the roof i. Trained an employee prior to using the new computer system j. Replacedthe brake pads on the delivery truck E4-13A. Accountfor capital and revenueexpenditures(expenses) and calculate deprecia(LO 2,4) tion expense. Yester Mfg. Co. has had a piece of equipment for 6 years.At the beginning of the seventh year, the equipment was not performing as well as expected.First, Yester relubricated the equipment, which cost $150.Then,the companyreplacedsomeworn-outparts,which cost $520. Finally, at the beginning of the seventhyear, the company completed a major overhaul of the equipment that not only fixed the machine but also addednew functionality and extendedits useful life by 3 years (to a total of 10 years) with no salvagevalue. The overhaul cost $10,000.(Originally, the machinecost $60,000,had a salvagevalue of $4,000, and had an estimated useful life of 7 years.) a. Which of thesecosts are capital expenditures? How would theseamounts appear on the financial statements? b. Which are revenueexpenditures?How would these amounts appearon the financial statements? c. Assuming YesterMfg. usesthe straight-line method of depreciation,how much depreciationexpensewill be repofted on the income statements years 7 for through 10? E4-14A. Accountfor capital and revenueexpenditures(expenses) and calculate deprecia(LO 2,4) tion expense. SharperCompany operatesa small repair facility for its products.At the beginning of 2006, the accountingrecordsfor the company showedthe following balancesfor its only piece of equipment,purchasedat the beginning of 2004: Equipment Accumulated depreciation $115,000 20,000

4 . C H A P TE R E X E R C IS E S 193 on During 2006,the following costswere incurredfor repairsandmaintenance the equipment: Routine maintenanceand repairs Major overhaul of the equipment that improved efficiency $ 650 22'000

:"

The companyusesthe straightJine method, and it now estimatesthe equipmentwill last for value.The company'sfiscal year endson salvage a total of 11 yearswith $5,000estimated December 31. a. How much depreciationdid ShaperCompany record on the equipment at the end of 2005? b. After the overhaul at the beginning of 2006, what is the remaining estimatedlife of the equipment? c. What is the amount of depreciationexpensethe company will record for 2006? E4-15A. Accountfor disposalof an asset.(LO 5) Zeltwiger Plumbing bought a van for $60,000. The van is expectedto have a 10-yearuseful life and a salvagevalue of $4,000. a. If Zellwiger sells the van after 3 years for $20,000, would the company realize a depreciation.) gain or loss?How much? (Assumestraight-line b. What would be the gain or loss if the company sold the van for $30,000 after 6 years? E4-16A. Accountfor disposalofan asset.(LO 5) a Troy Wilson Athletic Gear purchased packagingmachine4 years ago for $18,000.The machinery was expectedto have a salvagevalue of $2,000 after an 8-year useful life. Asif suming straight-line depreciationis used, calculatethe gain or loss rcaTized after 4 years the machinery was sold for: a. $11, 400

b. s7.800
E4-17A. Account for disposal of an asset.(LO 5) Dave's Delivery disposedof a delivery truck after using it 4 years.The records of the company provide the following information: Delivery truck Accumulated depreciation $38,000 23,000

Calculate the gain or loss on the disposalof the truck for each of the following independent situations: a. Dave'sDelivery sold the truck to PapaJohn'sPizzafor $12,000. b. Dave's Delivery sold the truck to CornerstoneGrocery for $15'000. c. Dave'sDelivery sold the truck to John'sPlumbing for $16,000. d. The truck was stolen out of Dave's parking lot, and the company had no insurance. E4-18A. Accountfor disposalof an asset.(LO 5) SweetTooth Bakery disposedof an oven after using itfor 4 years.The oven originally cost accumulateddepreciationof $29,000.Calculatethe gain or loss $40,000 and had associated on the disposalofthe oven for eachofthe following situations: shelterfor $8,000. a. The companysold the oven to a homeless b. The sold the oven to a local restaurantfor $10,000. "o-puny c. The company gave the oven to a hauling company in return for hauling the oven to the local dump. The oven was totally worthless. E4-19A. Calculate gain or loss and cashflow. (LO 5, 6) Arco Incorporated sold assetswith an original cost of $15,000 and accumulateddepreciafrom the salewere $7,000,what was the gain or loss on tion of $9,000.If the cashproceeds

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194

CHA P T E4 . A C QU ISIT IoAN D U s Eo F L o N G-TE R M E R A TIoN A L R N oP A ssE Ts the sale?On which financial statementwould that amount be shown?How much would be shown on the statementof cash flows and in which section? (LO 6) E4-20L. Preparefinancial statemenrs. For each of the following, give the financial statementon which it would appear. a. Book value of frxed assetsof $56,900 b. Proceedsfrom sale of f,rxedassetsof $20,000 c. Loss on saleof fixed assets $ l 2,500 of d. Accumulated depreciationon equipment of $10,000 e. Depreciation expenseon equipment of $2,000 f. Impairment write-down on assetsof $45,000 E4-21A. Calculate return on assetsand assetturnover ratios. (LO 7) Using the Staplesannual report in the appendix at the back of the book, calculate the following ratios for the most recent fiscal year and explain what eachratio measures: a. Return on assetsROA) b. Asset turnover ratio E4-22A,Identify risksand controls,(LO 8) Look at Staples' annual report in the appendix at the back of the book. What types of fixed assetsdoes the firm have?What risks do you think Staplesfaces with respectto these assets,and how is the f,rrmcontrolling those risks?

Exercise-Set B (LO purchase. 7,2) E4-lB.Accountfor basket
Premium Bottling Company purchases a building and land for a total cash price of $200,000. An independent appraiser provides the following market values: building$ 175,000;land-$75,000. a. How much of the purchaseprice should the company allocate to each of the assets? b. Ifthe building has a useful life of 10 years and an estimatedsalvagevalue of $40,000, how much depreciationexpenseshould Premium record each year using the straight-line method? c. Using the double-declining balance method, what would the book value of the building be at the end of 3 years? (LO 1,2) E4-28. Calculate the cost of an assetand depreciation expense. Wilson, Smith & Knight Beer Brewers purchaseda building for $125,000cashand the land for $275,000 cash.The company paid real estateclosing costs of $6,000 and allocatedthat cost to the building and the land basedon the purchaseprice. Renovationcostson the building were $45,000. Use the accountingequationto record the purchaseofthe property,including all related expenditures.Assume that all transactionswere for cashand that all purchases occurredat the beginning of the year. a. Compute the annual straight-line depreciation,assuming a2}-year estimated useful life and an $11,875estimated salvage value for the building. b. What would be the book value of the building at the end of the hfth year? c. What would be the book value of the land at the end of the tenth year? E4-3B. Calculate depreciation expense:straight-line and activity methods.(LO 2) Walt's Water PressureCompany purchaseda van for $45,000 on July 1, 2008. The van had an estimateduseful life of 6 yearsor 250,000miles. Walt's estimatedthe van's salvagevalue to be $3,000.The van was driven 25,000 miles in the year endedJune 30,2009, and 30,000 miles in the year ended June 30,2010. a. Compute the depreciationexpensefor 2009 and20I0, first using the straight-line method, then the activity method. b. Which method portrays more accuratelythe actual use of this asset?Explain your answer.

. C H A P TE R 4E X E R C IS E S 195 F,4-48. Calculate depreciation expense:straight-line and double-declining balance methods. (LO 2\ On January 1, 2008, Hsieh & Wen's Gourmet Taste of Asia purchasedkitchen equipment for $51,500. Hsieh & Wen's was also charged $1,650 for shipping and installation. The equipment is expectedto have a useful life of 8 years and a salvagevalue of $3,150. a. Compute the depreciationexpensefor the years 2008 through 2010, using the straight-line method (December31 is the fiscal year-end.). b. compute the depreciationexpensefor the years 2008 through 2010, using the double-declining balancemethod. (Round your answersto the nearestdollar.) c. What is the book value of the equipment at the end of 2008 under each method? E4-5B. Calculate depreciation under alternative methods.(LO 2) Designer Jeansbought a new piece of equipment at the beginning of the year at a cost of $24,500.The estimateduseful life of the machine is 4 years, and its estimatedproductivity is 85,000 units. Its salvagevalue is estimatedto be $500. Yearly production forYear 1 was 34.000units:Year2 was 25.500unitslYear3 was 19,125units; andYear4 was 6,375units. Complete a separatedepreciation schedule for each of the three methods given for all 4 years. (Round your answersto the nearestdollar.) a. Straighrline method b. Activity method c. Double-declining balancemethod E4-68. Calculate depreciation under alternative methods.(LO 2) Using the information from E4-58, supposethe production in Year 4 was actually 8,500 rather than 6,375 units. How would this changethe amount of depreciation for Year 4 under each method? Explain. E4-78, Calculate depreciation under alternative methods.(LO 2) Brother's Helper Manufacturing bought a machine for $172,000 cash at the beginning of 200T.Theestimateduseful life is 8 years and the estimatedsalvagevalue is $4,000.The estimated productivity is 265,000 units. Units actually produced were 92,750 in200'7 and 55,650 in 2008, Calculate the depreciation expense for 2007 and 2008 under each of the three methods given. (Round your answersto the nearestdollar.) a. Straight-linemethod b. Activity method c. Double-declining balance method E4-88. Calculate depletion. (LO 2) On January t, 2007, West Mountain Mining Company purchasedthe rights to a coal mine for $15,000,000.The company expectsthe coal mine to produce 10,000,000poundsof coal. During 2007, West Mountain Mining removed 550,000 pounds of coal' a. How much depletion should West Mountain Mining Company record for 2007? b. What is the book value of the coal rishts at December 3I,2007 , the end of the fiscal year? E4-98. Amortize intangible assets.(LO 3) Microtech registereda trademark with the U.S. Patentand Trademark Office. The total cost of obtaining the trademarkwas $55,000.Although the trademarkhas a legal life of 20 years, the flum believes it will be renewed indefinitely. What will Microtech record for its annual amortization expense? E4-108. Calculategoodwill. (LO 3) Evans has decidedto acquire a competitor fum. The competitor firm has assetswith a market value of $430,000 and liabilities with a market value of $210'000' and Evans pays $250,000.Why? Use the accounting equation to record the purchase. F,A-llB. Evaluate asset impairment. (LO 4) During its fiscal year endedJune 30, SuperShippersDelivery Servicehad to decommission 1,500 delivery trucks due to a potential problem with the fuel tank. Although the trucks had

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been repaired by the end of the fiscal year, the company determinedthe problems required an evaluation of potential impairment of thesetrucks. The results of the analysisindicated that the trucks had permanently declined in fair value by $7.5 million below their book value. What effect would this decline have on Super Shippers' net income for the year? (LO 1, 4) F,4-12ts.Distinguish betweencapital and revenueexpenditures(expenses). Classifythe following items aseithera capitalexpenditure a revenueexpenditure(expense). or a. Changedthe hlter in the moving van b. Painted movingvan the c. Paid salestax on the new moving van d. Installed a new energy-efficient air-conditioning system for the office building e. Cleaned and lubricated sewing equipment f. Performed routine yearly maintenanceon copy machine g. Purchasedand installed a new set ofenergy-efficient deep fryers h. Replacedseveralcracked tiles in company bathroom floor i. Trained an employee prior to using the new energy-efficient deep fryers j. Replacedthe tires on the moving van E4-13B. Accountfor capital and revenueexpenditures(expenses) and calculate deprecia(LO 2,4) tion expense. Shiny & New Auto Mechanic Shop has had a piece of equipmentfor five years.At the beginning of the sixth year, it wasn't performing as well as it should have been. First, Shiny & New had the equipmentserviced,which cost $175. Then, the companytried replacing some worn-out parts,which cost $480. Finally, at the beginningof the sixth year, it completeda major overhaulof the equipmentthat not only fixed the machine,but also addednew functionality to it and extendedthe useful life by four years (to a total of ten yearswith five remaining)with no salvagevalue.The overhaulcost $20,000.(Originally, the machine cost $65,000,had a salvagevalue of $5,000,and an estimateduseful life of six years.) a. Which of thesecostsare capitalexpenditures? How would theseamountsappear on the financial statements? b. Which are revenueexpenditures?How would theseamounts appearon the financial statements? c. Assuming Shiny & New usesthe straight-line methodof depreciation, how much depreciationexpensewill be reported on the income statementsfor years six through ten? E4-148, Accountfor capital and revenueexpenditures(expenses) and calculate deprecia(LO 2,4) tion expense. Global Electronics operatesa manufacturingplant for production of its products.At the beginning of 2008, the accountingrecordsfor the company showedthe following balancesfor its only piece of equipment,purchasedat the beginning of 2005: Equipment Accumulated depreciation $94,000 54,000

During 2008, the following cash costs were incurred for repairs and maintenanceon the equipment: Routine maintenanceand repairs Major overhaul of the equipment that improved effrciency $ 575 30,000

The companyusesstraight-linedepreciationand estimates equipmentwill last for 5 years the beginning in 2008 with a $4,000 estimatedsalvagevalue.The company'sfiscal year endson December31. a. How much did the firm record for depreciationon the equipment at the end of 2008?

. C H A P TE R 4E X E R C IS ES 197 b. After the overhaul, at the beginning of 2008, what is the remaining estimatedlife? c. What is the amount of depreciationexpensethe company will record for 2008? Account for disposal of an asset.(LO 5) F,4-15B.. ChesneyFlower Shop purchaseda delivery van for $51,000.The company expectsthe van to have an S-yearuseful life and a salvagevalue of $3,000. a. If Chesneysells the van after 2 yearsfor $40,500, would it realize a gain or loss? How much? (Assume straight-line depreciation.) b. What would be the gain or loss if the van were sold for $18,250after 5 years? E4-168. Accountfor disposalof an asset.(LO 5) Brenda Sue's Stitch & Sew purchaseda sewing machine 4 years ago for $29,000.The company expectsthe machine to have a salvagevalue of $4,000 after a l0-year useful life. Assuming the company usesstraight-line depreciation,calculatethe gain or loss realized if the company sells the machine after 4 years for: a. $ 14,250 b. $ 18,600 E4-178. Account for disposal of an asset.(LO 5) tanning bed that had been used in the Kat & Jen's Solar Tan disposedof a high-pressure company provide the following information: businessfor 3 years.The records of the tanningbed High-pressure Accumulateddepreciation $39,000 18,000

Calculate the gain or loss on the disposalof the tanning bed for each of the following independentsituations: a. Kat & Jen'ssold the tanningbed to Dark Bodies for $21,000. b. Kat & Jen'ssold the tanningbed to a customerfor $22,550' c. Kat & Jen'ssold the tanningbed to Angela's FitnessCenterfor $18,000. d. The tanningsalonwas broken into and the tanningbed was stolen;Kat & Jen's had no insurance. E4-188. Accountfor disposalof an asset.(LO 5) Crystal Clean Steamersdisposedof an industrial wet/dry vacuum that had been used in the accumulated business 5 years.The vacuumoriginally cost $51,000and had associated for of depreciation $32,500.Calculatethe gain or loss on the disposalof the vacuumfor each of the following situations: a. The companysold the vacuumto a local churchfor $16,250. b. The companysold the vacuumto a competitotfor $21,475. c. The company called the city trash collectors to pick up the vacuum becauseit was totally worthless. E4-19B. Calculategain or lossand cashflow. (LO 5, 6) Safin Incorporated sold assetswith an original cost of $37,000 and accumulateddepreciafrom the salewere $4,000,what was the gain or loss tion of $30,000.If the cashproceeds on the sale?On which financial statementwould that amount be shown?How much would be shown on the statementof cash flows and in which section? (LO 6) E4-20B. Preparefinancial statemenrs. For each of the following, give the financial statementon which it would appear. of a. Book value of fixed assets $56,900 b. Proceedsfrom sale of fixed assetsof $20,000 of c. Loss on saleof fixed assets $12,500 d. Accumulated depreciationon equipment of $10,000 e. Depreciation expenseon equipment of $2,000 f. Impairment write-down on assetsof $45,000

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Fl4-21B. Calculate return on assetsand asset turnover ratios. (LO 7) this text, calculate Using the Office Depot annualreport from the website that accompanies ratios for the most recent fiscal year and explain what each measures: the following a. Return on assetsROA) b. Asset turnover ratio E4-22B.Identifi risks and conffols. (LO 8) Firms with large hxed assetssuch as land and factories often think that their assetsare safe becausethey are too large to be stolen. What risks do you think exist for these firms with respectto such assets,and how might those risks be controlled? Problem Set A (LO 1,2) P4-lA. Calculatecapitalizedcost and depreciationexpense. Acme Print Shop purchaseda new printing pressin 200'7.The invoice price was $158,500, but the manufacturerof the pressgaveAcme a2%odiscountfor paying cashfor the machine on delivery. Delivery costs amounted to $1,500, and Acme paid $500 for a special insurancepolicy to coverthe presswhile in transit.Installationcostwas $1,350,andAcme spent $3,000 training the employeesto use the new press.Additionally, Acme hired a new supervisor at an annual salary of $65,000 to be responsiblefor keeping the press online during hours. business

Required
a. What amount should be capitalized for this new asset? b. To calculate the depreciationexpensefor 2007, what other information do you need?Do you think the company should gather this information before purchasingthe asset? Why or why not? P4-2A. Calculate and analyze depreciation under alternative methods.(LO 2) On January l, 2007, the Oviedo Manufacturing Company purchased equipment for salvage useful life of the equipmentis 4 years,and the estimated The estimated $170,000. value is $10,000.The company expectsthe equipment to produce 480,000 units during its service life. Actual units produced were: Year

200'7 2008 2009 20to Required

Units 100,800 130,080 139,200 r09,920

a. Calculate the depreciationexpensefor each year ofthe 4-year life ofthe equipment using method 1. StraighGline balancemethod 2. Double-declining 3. Activity method (Round your answersto the nearestdollar.) b. How does the choice of depreciationmethods affect net income in each of the years?How does the choice ofdepreciation methods affect the balancesheetin each of the years? P4-3A. Calculate and analyze depreciation under alternative methods.(LO 2) Federal Express purchaseda new truck on January I , 2007, at a cost of $ 100,000. The estimated useful life is 5 years with a salvagevalue of $10,000. Required a. Preparetwo different depreciation schedulesfor the truck-one using the straightJine method, and the other using the double-declining balancemethod. (Round to the nearestdollar.)

ir

,'

:,: :.:':: -.
. , I . -r:

|

,.r 1;;'_

. CHAPTER4 PROBLEMS

199

T.:I I-

b. Determine which method would result in the greatestnet income for the year 2001. c. (Appendix) How would taxes affect management'schoice between thesetwo methods for the financial statements? P4-4A. Calculate and analyze depreciation under alternative methods.(LO 2) PepsCo. purchased new machineat the beginningof 2006 for $6,400.The companyexa propectsthe machineto last for 5 yearsand have a salvagevalue of $400. The estimated ductive life of the machine is 100,000 units. Yearly production: in 2006-28,000 units; in200'7-22.000 units; in 2008-16,000 units; in2OO9-I4,000 units; in 2010-20,000 units. Required for expense eachyear ofthe 5-yearlife ofthe machine a. Calculatethe depreciation uslng 1. Straight-line method 2. Double-declining balancemethod (Round to the nearestdollar.) 3. Activity method using units b. For each method, give the amount of accumulateddepreciationthat would be shown on the balance sheetat the end of each year. c. Calculate the book value of the machine at the end of each year for each method. (LO 3) P4-5A. Accountfor intangibleassers. LB Company had the following balancesin its intangible assetsaccountsat the beginning ofthe year.The patentshave a remaining useful life of l0 years,and the copyright has a remaining useful life of 7 years. Patents Copyright Goodwill $35,000 21,000 40.000

=,"#;,:,i"7T.I,;f;;,

Transactions during the year: 1. At the beginning of the year, LB f,rledfor a new patent. The costs totaled $20,000. Its at useful life is estimated 10 years. 2. LB incurred R&D costsof $60,000 related to new product development'No new products havebeenidentified. 3. LB evaluatedthe goodwill for impairment and reduced its book value by $2,000. one of its patentsin court. Feestotaled$24,000. 4. LB successfully defended

Required
Show each of the transactionsin the accounting equation, including any adjustmentsthat Then, preparethe intangible would need to be made for the year-endfinancial statements. sheetat year-end. assets sectionof the balance P4-6A. Account for change in estimates depreciation. (LO 4) for In January 2004, Harvey's Hoola Hoop Company purchaseda computer system that cost $37,000.Harvey's estimatedthat the systemwould last for 5 years and have a salvagevalue of $2,000 at the end of 2008. The company usesthe straight-line method of depreciation. Analyze each of the following independentscenanos. a. Before the depreciationexpenseis recordedfor the year 2006, computer experts tell Harvey's that the system can be used until the end of 2008 as planned but that it will be worth only $500. b. Before depreciationexpenseis recorded for the year2O06, Harvey's decidesthat the computer system will last only until the end of 2007. The company anticipatesthe value of the system at that time will still be $2,000. c. Before depreciationexpenseis recordedfor the year 2006, Harvey's decidesthat the computer system will last until the end of 2008, but that it will be worth only at $ 1.000 thattime.

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d. Before the depreciationexpenseis recordedfor the year 2006, compurer expens tell Harvey's that the system can be used until the end of 2012 if the company spends$4,000 on upgrades.However, the estimatedsalvagevalue at that time would be $0. Harvey's decidesto follow the experts' advice and upgrade the computer system.

Required
Calculatethe amountof depreciationexpense relatedto the computersystemHarvey's Hoola Hoop Company would report on its income statementfor the year ended December 31, 2006, for eachscenario. P4-7A. Accountfor disposal of an asset.(LO 5) Analyze each of the following independentscenaflos. a. A truck that cost $25,000 had an estimateduseful life of 5 years and no salvage value. After 4 years of using straight-line depreciation,the company sold the truck for $6.000. b. A machine that cost $50,000 had an estimateduseful life of 12 years and a salvagevalue of $2,000. After 10 years of using straight-line depreciation,the company sold the completely worn-out machine for $400 as scrap. c. An assetthat cost $40,000 had an estimateduseful life of 4 years and a salvage value of $2,000. After 3 years of using double-declining balancedepreciation, the companysold the assetfor $11,000. d. A machinethat cost $15,000had an estimated useful life of 5 yearsand no salvagevalue. After 4 years of using straight-line depreciation,the company deemedthe assetworthless and hauled it to the dump.

Required
For each scenario,calculatethe gain or loss, if any, that would result upon disposal. P4-8A. Calculate depreciation under alternative methodsand account for disposal of an (LO 2,5) asset. Bella Interiorspurchased new sewingmachineon JanuaryZ,2007,for 948,000. a The company expectsthe machine to have a useful life of 5 years and a salvagevalue of $3,000.The company'sfiscal year endson December31.

Required
a. Calculate the depreciationexpensefor the fiscal years 2007 and2008 using each of the following methods: 1. Straight-linemethod 2. Double-declining balancemethod b. Assume that Bella Interiors decided to use the straight-line method and that the sewing machine was sold at the end of December 2009, for $27,000.what was the gain or loss on the sale?On which financial statementwould the gain or loss appear?What information does this accounting calculation provide for future decisions? P4-94. Calculate depreciation under alternative methodsand accountfor clisposalof an (LO 2,5) asset. Perfect Heating and Air purchaseda truck 3 years ago for $50,000. The company expects the truck to have a useful life of 5 yearswith no salvagevalue.The company has taken three full years of depreciationexpense. Required a. Assume that the company usesstraight-line depreciation.If the truck is sold for $25,000, will there be a gain or loss on the sale?If so, how much? How will the sale affect the financial statementsfor the year?

. CHAPTER4 PROBLEMS

201

b. Assume that the company usesdouble-declining balancedepreciation.If the truck is sold for $15,000, will there be a gain or loss on the sale?If so, how much? How will the sale affect the frnancial statementsfor the year? c. Assume the company usesstraight-line depreciationand sells the truck for $20,000.Would there be a gain or loss on the sale?How would that changeif the company had been using double-declining balance depreciation? P4-10A. (Appendix) Analyze and correct accounting errors related to long-term assets.

(Lo 9)
Due to an umpire strike early in 2006, Umpire's Empire had sometrouble with its informaEvaluate tion processingand some effors were made in accountingfor certain transactions. the following independentsituations that occurred during the year: a. At the beginning of 2006, a building and land were purchasedtogether for that9}Vo of the price shouldbe determined $100,000.Even though the appraisers allocated to the building, Umpire's decided to allocate the entire purchaseprice to the building. The building is being depreciatedusing the straight-line method value of $10,000. salvage over 40 years,with an estimated b. During the year, Umpire did some R&D on a new gadget to keep track of balls and strikes. The R&D cost $20,000, and Umpire capitalizedit. The company intends to write it off over 5 years,using straight-line depreciationwith no salvage value. c. Near the beginning of the year, Umpire spent$ 10,000on routine maintenance for its equipment, and the accountant decided to capitalize these costs as part over 5 yearswith no salvage of the equipment.(Equipmentis depreciated value.) d. Umpire spent $5,000 to extend the useful life of some of its equipment.The accountantcapitalizedthe cost.

Required
a. For each, describethe error made and list the effect, if any, that the uncorrected error would have on the following items for Umpire's 2006 financial statements: If net income,long-termassets, retainedearnings. thereis no error, simply and write N/A next to the item. b. Describethe adjustments that would correctthe company'saccountingrecords and make the 2006 financial statementsaccurate.If there is no error, write N/A next to the item. Problem Set B (LO 1,2) P4-18. Calculatecapitalizedcost and depreciationexpense. The executivesfor SeaWorld bought a piece of property adjacentto the park with an old, Real estatecomrun-downmotel. The cost of the land with the old motel was $1,500,000. missions and fees including the title searchwere $317,850.SeaWorld paid its attorney ofthe land on July 1, 2008.The $15,000to review the contractand completethe purchase and an additional$17,850for sugar resortpaid $25,750for the old motel to be demolished white sandto be hauled in to preparethe land for use.The company paid $80,000 for some palm trees for the new area.SeaWorld hired three new employeesat a salary of $35,000 a year each to maintain the landscapingfor the new area.

Required
a. What amount should be capitalized for this new asset? b. Would there be any depreciationexpensefor land at the end of 2008? Explain your answer. P4-28. Calculate and analyze depreciation under alternative methods.(LO 2) WTA Tennis Academy purchaseda new ball machine at a cost of $18,000 at the beginning of January 2005. The machine was estimatedto have a salvagevalue of $2,000 at the end

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of its useful life of 4 years.A machine like this is supposed deliver 160,000hours of serto vice. The actual number of hours that the machine was used per year was:

Year 2005 2006 2001 2008

Hours 40,000 60,800 39,200 20,000

Required
expense eachyear ofthe 4-yearlife ofthe ball a. Calculatethe depreciation for machine using 1. Straighrline method 2. Activity method method 3. Double-declining b. How does the choice of depreciationmethods affect income in each of the years? c. How does the choice of depreciationmethods affect the balancesheetin each of the years? P4-3B. Calculate and analyze depreciation under alternative methods.(LO 2) Sugar'sCandyCompanypurchased automated an displayrack on January1, 2008,at a cost The companyestimates displayrack has a useful life of 5 yearswith a salthe of $35,000. vagevalue of $5,000.

Required
a. Preparetwo different depreciation schedulesfor the display rack-one using the straight-line method and the other using the double-declining balancemethod. (Round to the nearestdollar.) b. Determine which method would result in the greaternet income for the year 2010. c. How would taxes affect management'schoice between thesetwo methods for the financial statements? P4-48. Calculate and analyze depreciation under alternative methods.(LO 2) CleanWater Co. purchased new water fllter at the beginningof 2010 for $200,000.It is a expectedto last for 8 years and have a salvagevalue of $32,000.The estimatedproductive life of the machineis 200,000units.Yearly production:in20l0-45,000 units; in 201129,000 units; in 2012-4I,000 units; in 2013-22,000 units; in 2014-25,000 units: in 20 15- I 5,000 units; in 2016-1 6,000 units; andin 2017 -7,000 units.

Required
a. Calculate the depreciationfor each year using each ofthese depreciation methods: 1. Straight-linemethod 2. Activity method basedon units 3. Double-declining balance method (round to the nearestdollar) b. For each method, give the amount of accumulateddepreciationthat would be shown on the balance sheetat the end of each year. Calculate the book value of the water filter at the end of each year for each method. (LO 3) P4-5B. Accountfor intangibleassefs. Larkin Company had the following balancesin its intangible assetaccountsat the beginning of the year. The trademarkshave a remaining useful life of 5 years, and the copyright has a remaininguseful life of 10 years. Trademarks Copyright Goodwill

$85,000 50,000 80.000

. CHAPTER4 PROBLEMS

203

Transactionsduring the year: 1. At the beginning of the year, Larkin filed for a new trademark. The costs totaled $40,000. Its useful life is estimatedat 5 years. 2. Larkin incurred R&D costs of $30,000, related to new product development.No new products have been identified. 3. Larkin evaluatedthe goodwill for impairment and reducesits book value by $20,000. 4. Larkin successfullydefendedits copyrights in court. Feestotaled $10,000. Required Show each of the transactionsin the accounting equation, including any adjustmentsthat Then, preparethe intangible would need to be made for the year-endfinancial statements. assets sectionof the balancesheetat year-end. (LO 4) P4-6B. Accountfor changein estimates depreciation. for In July 2006, Hallmark Company purchaseda computer systemthat cost $7,000.The company estimates value of $2,000. that the systemwill last for 5 yearsand will havea salvage The company usesthe straightline method of depreciation and has a June 30 fiscal yearscenarios. end.Analyze eachof the following independent a. Before depreciationexpenseis recordedfor the fiscal year ended June 30,2009, Hallmark decidesthat the computer system will last until June 30,2011 but that it willbe worth only $800 at that time. b. Before depreciationexpenseis recordedfor the fiscal year endedJune 30, 2009, Hallmark decidesthat the computer systemwill last only until June 30, 2010. The company anticipatesthe value of the systemat that time will still be $2,000. c. Before depreciation expense recordedfor the fiscal year endedJune 30,2009, is Hallmark decidesthat the computersystemwill last until June30,201I but that it will be worth only $1,500at that time. d. Before depreciation expense recordedfor the fiscal year endedJune 30,2009, is Hallmark's computerexpertsdecidethat the systemcan be useduntil June30, salvage However,the estimated 2013 if the companyspends $1,000on upgrades. value at that time would be 0. Hallmark decidesto follow the experts' advice and upgradethe computer system.

Required
Calculatethe amount of depreciationexpenserelated to the computer systemHallmark will report on its income statementfor the fiscal year ended June 30,2009, for each scenarl0. P4-78. Accountfor disposalof an asset.(LO 5) Analyze each of the following independentscenarios. a. A company van that cost $32,000 had an estimateduseful life of 8 years and no salvagevalue. After 6 years of using straight-line depreciation,the company sold the van for $12,000. useful life of 5 yearsand a b. A copy machinethat cost $35,000had an estimated balance salvage value of $5,000. After 2 yearsof using double-declining depreciation, companysold the copy machinefor $10,000. the c. A company truck that cost $48,000 had an estimateduseful life of 7 years and a salvagevalue of $6,000. After 5 years of using straight-line depreciationand driving the truck many miles on tough terrain, the company sold the completely worn-out truck for $850 for spareparts. d. A state-of-the-artcomputer that cost $29,000 had an estimateduseful life of 4 years and a salvagevalue of $2,000. After 3 years of using double-declining balance depreciation,the company sold the computer for $6,000. Required For each scenario,calculate the gain or loss, if any, that would result upon disposal.

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P4-88. Calculate depreciation under alternative methods and accountfor disposal of an asset.(LO 2,5) A&W Root Beer Company bought new brewery equipment on January 1, 2008, for $64,000.The company expectsthe equipment to have a useful life of 8 years and a salvage value of $8,000.The company'sfiscal year endson December31.

Required
a. Calculate the depreciationexpensefor the frscal years 2008 and 2009 using each of the following methods: 1. Straight-line method 2. Double-declining balancemethod b. Assume that the company decided to use the double-declining balancemethod and that the brewery equipment was sold at the end of December 2009, for $42,000.What was the gain or loss on the sale?On which financial statement would the gain or loss appear?What information does this accounting calculation provide for future decisions? P4-98. Calculate depreciation under alternative methods and accountfor disposal of an (LO 2,5) asset. The Queen GrandeView Hotel purchaseda van 3 years ago for $62,000.The company expects the van to have a useful life of 4 years and a $10,000 salvagevalue. Queen Grande View has taken three full years of depreciationexpense.

Required
a. Assume that Queen GrandeView uses straight-line depreciation.If the van is sold for $20,000, will there be a gain or loss on the sale?If so, how much? How will it affect Queen GrandeView's financial statements the year? for b. Assume that Queen GrandeView usesdouble-declining balancedepreciation.If the van is sold for $9,750, will there be a gain or loss on the sale?If so, how much? How will it affect Queen GrandeView's financial statements the year? for c. Assume Queen GrandeView usesdouble-declining balancedepreciationand sells the van for $23,000.Would there be a gain or loss on the sale?How would that changeif Queen GrandeView had been using straight-line depreciation? P4-108. (Appendix) Analyze and correct accounting errors related to long-term assets. (L0 9) During 2007, Jule's Gym had some trouble with its information processingdue to several hurricanes,and someeffors were made in accountingfor certain transactions. The firm uses straight-line depreciationfor a1lof its long-term assets. Evaluatethe following independent situationsthat occurred during the year: a. At the beginning of the year, a basketpurchaseof a building and land was made for $350,000.The appraisersindicated that the market value of the land was $135,000and the market value of the building was $250,000.So, Jule's Gym allocated $135,000 of the purchaseprice to the land and the remainder of the purchaseprice to the building. The building has an estimateduseful life of 20 years and an estimatedsalvagevalue of $25,000. b. The plumber spent a great deal of time repairing broken toilets in one of the gym's buildings this year. Total cost, which Jule's Gym capitalizedo was $5,000. Jule's Gym decided it was best to leave it on the books as an assetand not write it off, becausethe toilets will be used for quite a few more years. (Use 20 years as the estimatedremaining useful life of the toilets.) c. Jule's Gym purchaseda new van. It cost $20,000 and is expectedto last 3 years. It has a salvagevalue of $2,000. To properly equip it for transporting gym equipment between locations, the inside was customized at a cost of $6,000. The cost of the van was capitalized,and the cost of the customization was expensed. d. Jule's Gym spent $5,500 on routine maintenanceof its exerciseequipment.The cost was expensed.

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Required
a. For each, describethe error made and list the effect, if any, that the uncorrected ertor would have on the following items for Jule's Gym's 200'7financial statements:net income, long-term assets,and retained earnings.If there is no error, simply write N/A next to the item. b. Use the accounting equation to show the adjustmentsthat would correct the company's accountingrecords and make the 2001 financial statementsaccurate. If there is no error, write N/A next to the problem.

Financial Statement Analysis
FSA4-1. Analyzelong-termassets the balancesheet.(LO 6) on Information from The Home Depot Annual Report is shown here. Required a. Can you tell how much The Home Depot paid for the buildings it owns? If so, how do you know? b. Can you tell how much the buildings are worth (the market value)? c. Explain what you think is included in each category of Property and Equipment. (Hint: To explain Capital Leases,be sure to read the UnderstandingBusiness feature in the chapter.) d. The Home Depot saysit is modernizing its storesand building many new stores. Is this supportedby any of the information? Fromthe Balance Sheetof The Home Depot, at ( dollar s m ill i o n s ) 29 in January

2006
Propertyand Equipmentat cost: Land B uildings F ur nit ur e, ix tu re s n d Eq u i p m e n t F a Leasehold lmprovements Construction Progress in CapitalLeases Less AccumulatedDeoreciation and Amortization Net P r oper ty n d E q u i p me n t a FSA4-2.Analyzelong-termassets the balancesheet.(LO 6) on Information from the 2005 Sony Annual Report is given here. Sheetsat March 31 Fromthe Sony CorporationBalance Ye n in mi l l i ons 2004 P r oper t yplan t a n d e q u i p m e n t , ( Not es9 and 1 2 ): Land B uildings M ac hiner y and e q u i p me n t Construction progress in Less-Accu lated depreciation mu I nt angible se ts as G oodwill,net I nt angiblesne t , 2005

January 30 2005
6,932 12,325 6,1 95 1,191 1,404 390 28,437 5,711 22,726

7,924 14,056 7,073 1,207 843 427 31,s30 6,629 24,901

D ol l arsn mi l l i ons i (Note 3)

200s

182,900 189,785 925,796 930,983 2,0s3,08s 2,192,038 98,480 92,611 3,272,333 3,393,345 1,907,289 2,020,946 1,365,044 1,372,399 299,024 307,O34 283,923 187,024

1,709 8,652 20,486 866 31,713 18,887 12,826

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CHAPTER . ACQ UI SI TI O N 4 AND USEO F L O N G - T E R M P E R A T I O N A A s s E T S O L

From the Notes to the Financial Statements Property, Plant and Equipment and Deprecintion Property,plant and equipmentare statedat cost.Depreciation ofproperty, plant and equipment is primarily computed on the declining-balance methodfor Sony Corporation and Japanese subsidiaries,exceptfor certain semiconductormanufacturingfacilities whosedepreciation is computedon the straight-line method,and on the straight-Iine methodfor foreign subsidiary companiesat rates basedon estimatedusefullives of the assets, principally, rangingfrom I 5 years up to 50 yearsfor buildings andfrom 2 years up to I 0 yearsfor machinery and equipment.Significant renewalsand additions are capitalized at cost. Maintenance and repairs, and minor renewalsand bettermentsare chargedto income as incurred. Goodwill and Other Intangible Assets Goodwill and certain other intangible assetsthat are determined to have an indefinite life are not amortized and are testedfor impairment on an annual basis and betweenannual testsif an eventoccurs or circumstanceschangethat would more likely than not reduce the fair value below its carrying amount. Fair value for those assetsis generally determined using a discountedcashflow analysis. Intangible assetsthat are determined not to have an indefinite life mainly consist of artist contracts, music catalogs, acquired patent rights and soffware to be sold, leasedor otherwise marketed.Artist contracts and music catalogs are amortized on a straight-line basis principally over a period of up to 40 years.Acquired patent rights and sofhuareto be sold, leasedor otherwise marketed are amortized on a straisht-line basis over 3 to I0 years.

Required
a. What is Sony's primary method for depreciatingits assets? b. How much did Sony pay for the machinery and equipment it owns? listed as property,plant, and equipmentnot being c. Are any ofthe assets depreciated? d. Can you tell how much depreciationexpenseSony had for the fiscal year ended March 3I,2005? e. Explain what the $18,877(in millions) of accumulated depreciation represents. f. Can you find a sentencein the notes that summarizesthe accounting treatment for major overhaul or additions to assetsdiscussedin the chapter? g. Describe how Sony evaluatesgoodwill for impairment. (LO 2,3,5,6) FSA4-3.Analyzelong-term on assets the balance sheet. Use the Staplesannual report from the appendix at the back of the book to help you answer the following questions. a. What type of depreciableassetsdoes Stapleshave?What methods does the company use to depreciatetheseassets? b. Does Stapleshave any intangible assets? What are they and how are they being written off? c. What can you tell about the age and/or condition of Stapleslong-term assets? Is the company continuing to invest in property, plant, and equipment? d. Is the company making good use of its assets? How can you evaluatethis?

Thinking Critical Problems
Riskand Control Whatkindsof risksdoesa firm like OfficeDepotfacewith respect safeguarding asto its sets? Whattypes controls you thinkit already in placeto minimizethese of do has risks? Are anyspecific controls mentioned the 10-Kreportprovided thewebsite thisbook? in on for

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Ethics Rachel works in a real estateoffice that is equipped with up-to-date copiers, scanners,and printers. She is frequently the only employee working in the offrce in the eveningsand often has sparetime to do personal work. She has begun to use the office equipment for her children's school reports and for her husband'sbusiness.Do you think Rachel's use of the office equipment is harmless,or is she behaving unethically? Why? If you believe her behavior is unethical, what controls could be in place to prevent it? Have you ever used office resourcesfor personal tasks?Under what conditions could such use of office resourcesbe justified?

GroupAssignment
Select one ofthe three depreciationmethodspresentedin the chapter.Discussreasonswhy the method should be used and reasonswhy the method is not a good choice. Determine the method you think is most consistentwith the objectives of financial reporting.

Best lnternetExercise: Buy
Best Buy is the number-onespecialtyretailer of consumerelectronics,personalcomputers, entertainment software, and appliances.Best Buy has about742 stores in 49 states,with heavy concentrationsin the Midwest, Texas,California, and Florida. IE4-1. Go to www.bestbuy.com,and select"For Our Investors" near the bottom of the page. Then, selectBest Buy's most recent annual report in the PDF format. Use the consolidated balance sheetsto answer the following questions.At the most recent year-end, examine Property and Equipment. a. What is the acguisitioncost of theseassets? b. What is the book value (carrying value)? c. What amount of the acquisition cost has already been expensed? listed not being depreciated? d. Are any ofthe assets to lE4-2. Use the notes to financial statements answerthe following questions(usually the information can be found in note 1): a. Find the heading Property and Equipment. What depreciationmethod does Best Buy use for property and equipment?What is the range of useful lives for buildings and for fixtures and equipment?Do theseuseful lives make sense? is b. Find the headingGoodwill. What type of an asset goodwill? Does Best Buy does. write off this asset?Explain what the company IE4-3. On page25 of Best Buy's annualreportfor its fiscal year endedFebruary25,2006, there is a 5-year summary of financial highlights. a. Identify the amountsreported for total assetsat the four most recent year-ends. b. Identify the amountsreported for Revenuesand Net Earnings (net income) for the three most recent years. c. Compute the assetturnover ratio for the two most recent fiscal years.In which How can you tell? fiscal year did the company make best use of its assets?

Appendix 4
Depreciation Taxes and
I.$ " 9 Ex plain how depr e c i a ti o n for financialstatements differsfrom depreciation for taxes.

Depreciation and Tbxes
The accounting information a company presents on its flnancial statements is not the same information the company reports to the IRS on its federal income tax retum. The company follows GAAP reporting standards when preparing financial statements because those statements are provided to shareholders, who are the owners of the company. The information for taxes is determined by the legal rules of the Intemal Revenue Code. GAAP and the IRS require different information to be reported, so companies will use an information system that can produce two sets of data. For depreciating fixed assets,corporations use a method called the Modified Accelerated Cost Recovery System (MACRS) to calculate the deduction for their tax returns. MACRS is allowed for tax puq)oses but not GAAP The goal of MACRS is to give companies incentive to invest in new property, plant, and equipment. If an asset can be written off quickly-large depreciation deductions over a small number of years-the tax benefit from the depreciation deductions leaves the company more cash to invest in new assets. How does more depreciation expense result in lower taxes? Suppose a company's income before depreciation and before taxes is $10,000.If depreciation expense for taxes is $2,000, then the company has taxable income of $8,000.Suppose the company's taxrate is 25o/o. Then, the company must pay $2,000(= $8,000 x 0.25) in taxes, (Net income will be $6,000.) Now, suppose the company can depreciate the assetsusing a more accelerated depreciation method that results in $4,000worth of depreciation expense. Income before depreciation and taxes is $10,000,so income before taxes will be $6,000(= $10,000- $4,000). the With a tax rate of 25o/o, company will have to pay $1,500in taxes. (Net income will be $4,500.) When depreciation expense is larger, the amount of taxes a company must pay is smaller. A smaller tax bill means less cash has to be paid to the IRS, so the company's net cash flow for the year will be greater. However, as we have seen from comparing straight-line depreciation and double-declining balance depreciation , oaer the life of an ossef, the total depreciation expense is the same no matter what method the company uses. The difference between the methods is reflected in the way the total depreciation is allocated to the years the asset is used. The reason a company wants to use an accelerated method like MACRS for tax purposes is so that the largest deductions are taken as soon as possible. Saving tax dollars l/zis year is prefer:red to saving them nent year because it is cash the company can use to buy assetsthat can increase production and therefore profits.

208