CHAPTER 7 LONG-LIVED NONMONETARY ASSETS AND THEIR AMORTIZATION Changes from Eleventh Edition Updated from Eleventh Edition. Approach Students find it difficult to accept the basic fact that deprecation is a process of writing off an asset's cost, rather than a process that has something to do with asset valuation. (A great many business people have the same difficulty.) Instinctively, they think depreciation is related to some physical change in the asset, or to changes in its market value. Basically, this point is made only after repeated emphasis of it. Since the text summarizes APB Opinion No. 17 on goodwill, FASB Statement No, 2 on rescarch and development, FASB Statement No. 13 on leases, FASB Statement No. 86 on computer software, and FASB Statement No 142 on goodwill and other intangible assets, instructors may wish to refer to this ‘material for additional background. Cases Stern Corporation (B) is a straightforward problem in analyzing fixed asset transactions, Joan Holt: (C) describes several debatable items that might or might not be included in the asset amounts. Stafford Press describes a series of transactions related to amounts to be capitalized. The case probably cannot be covered in one session and, therefore, either the case should be used for two days or the instructor should assign only about half the transactions, Problems Problem 7-1 With units-of-production depreciation, one finds the cost of one production unit, and then multiplies this by the units used ina year to determine the year’s depreciation: $300,000- $18,000 oF one ani eo S08 Units of Production SYD Years Units x $8 = Depreciation Charge 1 930,000 x $.08 $ 74400 $80,571 (6/21 x $282,000) 2 800,000 x 08 64,000 67,143__(5/21 x 282,000) 3 580,000 x 08 46,400 53,714 (4/21 x 282,000) 4 500,000 x 08 40,000 40,286 (3/21 x 282,000) 5 415,000 x 08 33,200 26,857 (2/21 x 282,000) 6 3 x08 24 3.429 (1/21 x 282,000) 3,525,000 $282,000 282,000Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Problem 7-2 Equipment 1D #103 Dr. Cash ‘Accumulated Depreciatio Cr. Equipment... Gain on Sale of Equipment 14,300. 59,755. (0.300710) x8 ¥ Equipment 1D #415 years = $59, Dr. Cash 63,000. ‘Accumulated Deprecation sm Loss on Sale of Equipment... 360... Cr. Equipment. "Year I, ($96,000 x 30%)" year) = $14,400, *Year 2, ($81,600 x 30%) Yew) = 12.240, Equipment ID #573 Dr. Cash ‘Accumulated Depreciation... Loss on Sale of Equipment, Cr. Equipment. SBSH ATLA = $49,500. Problem 7-3 Automobile (new). Sea 9,900... ‘Accumulated Depreciation (old) 14,500. Automobile (old). Cash. (No gain or loss was involved, because the two assets were of like kind.) FIM sone Accumulated Depreciation. Loss on Disposal of Truck... Sn Truck, 19.860, Calbiniecinmineninminacanuanacnuanenunnamcancmneamemieanien aA SO Problem 7-4 ()) Land... 80,600... Cash 30,600. 2) Building. ‘Common Stock Notes Payable. 38.000, Cash, (3) Desks and Chairs (80% x $8,700) 6,960. Bookeases (80% x $2,200)....:nnennennsnt 1,760. Filing Cabinets (80% x $1,100)...©2007 MeGraw-Hillirwin Chapter 7 CASH rn 9,600. - ‘The above does not treat the equipment purchase as a fortunate acquisition. An argument can be made to record the equipment as a fortunate acquisition, giving rise to this entry instead: Desks and Chairs. 8,700 Bookeases...n tinction POO, Filing Cabinets. sestenennennnnsnended Drnnnesvnsnns Cash 9,600. Retained Earnings. ener cera ADD, Problem 7-5 Deplstable Asscis Land... sais .$.21,700,000... Tests ~ successful 35.250, ‘Tests — unsuccessful... vd 6,250.. Permits... SL LOM)... $21,892,500 Salvage Vale... (2,325,000) Net Cos! i $19.567,500.. 19,567,500/800,000 tons = $24.46/ton, = $24.46 x 30,000 tons = $733,800 $24.46 x 70,000 tons = $1,712,200 $24.46 x 75,000 tons = $1,834,500 Unit depletion Depreciation year Depreciation year Depreciation year Land I $387,500/10 years = $38,750/year amortization. Amortization year | = $38,750 Amortization year 2~ 38,750 Amortization year 3= 38,750 Buildings $271,250/10 years = $27,12S/year depreciation Deprecation year | = $27,125 Deprecation year 2 = 27,125 Deprecation year 3 = 27,125 Machinery. = $1,162,500 x 10/55 = $211,364 $1,162,500 x 9/55 = $190,227 $1,162,500 x 8/55 = $169,091 Depreciation year Depreciation year Depreciation year Cases Case 7-1: Stern Corporation (B)" Not rhis case is updated from the Eleventh Edition. Approach ‘This is a straightforward problem, designed for use in connection with study of the text, [find it useful to “This teaching nose was propared by Robert N. Anthony. Copyright © Robert N. AnthonyAccounting: Text and Cases 12e— Instructor's Manual Ambvony/Hasskins/Mercham put T-accounts on the board or on a Vugraph and post entries to them as they are given, The account titles given in the balance sheet should be used. ‘The case assumes individual unit depreciation, It may be desirable to ask at some point what the entries would be if composite or group depreciation were used. Comments on Questions Question | 1 Cash. a . wn BASE ‘Accumulated Depreciation, Factory Machinery 22,367. Factory Machinery 31,233 2 ‘Tools Used (Expense) . ntsc STIRS, an Tools 7,850 (Note the contrast between depreciation and a direct write-off.) 3. (a) Depreciation Expense. 278. Accumulated Depreciation, Automotive Equipment. 278. (The additional depreciation is 16x .20 x $8,354, Note that the half-year convention is not used. Note that if the depreciation incurred in 2006 is, disregarded, the loss will be overstated.) (b) Cash. sa ‘Accumulated Depreciation, Automotive Equipment. Loss on Sale of Other Assets, Automotive Equipment... 354. (There can be a discussion ofthe proper showing of the loss on the income statement.) 4 Patent Amortization Expense 11,250. Patent. 5. Cash. se ‘Accumulated Depreciation, Office Machines... 1.027, . Gain on Sale of Other Assets 75. Office Machines... rare IA (he gain is preferably combined withthe loss on Item 3, with eniries to a “Loss or Gain” account. It is shown separately here for clarity.) 6 (a) Depreciation Expense....urnninnnninnninnnnn 31. - Accumulated Depreciation, 37. (15.10 x $490) CSE 80... Accumulated Depreciation, Fumiture and Fixtures. 432 Furniture and Fixtures. 490. Gain on Sale of Other Asset... pcs accumu rn 11,250, b) 1 Depreciation Expense. Accumulated Depreciation, Building.......c0nnennenennnn nA SLOS, Accumulated Depreciation, Factory Machinery. 330,935, Accumulated Depreciation, Furniture and Fixtures 5,599, Accumulated Depreciation, Automotive Equipment 9,989, Accumulated Depreciation, Office Machines... 4151.©2007 MeGraw-Hillirwin Chapter 7 (Note that depreciation is calculated after the earlier entries have been recorded and that depreciation on factory machinery is not calculated on the $85,000 of fully depreciated assets.) Question 2 Accumulated Gross Depreciation Land, Building... renevninntnnnneninnininennninnnnn SoTL ABA. . Factory machinery seen BMA,AS2 eel, 9A5,92B nd AB, A2G.. Furniture and fixtures 55,994, 45.604. 10,390 Automotive equipment .. omen 9904, AL,905., 9. Office machines 31,129 are Tools shld. Patent. _ 45,000. Total. + S2TIGUOS...... $3455.95. Note: This case is unchanged from the Eleventh Edition. Approach This case brings up a wide variety of problems that arise in applying the general principle that the cost of an asset includes all the costs involved in acquiring it and getting it ready to perform that service for which it is intended. The case discussion should bring out the difficulty of resolving these problems, the fact that people will differ on how to resolve them leads to differences in accounting treatment, and the necessity for solving these problems in some practical way. It may be desirable to bring up the different objectives of income tax accounting and financial accounting, Since income tax accounting generally seeks to minimize current income, the motive generally is to € off as much as possible as expense in the current year, Similarly, since some state taxes are based on the “value” of property, there are advantages in making this value as low as possible. In financial accounting, on the other hand, the presumed objective is to present the situation fairly, and there often are sttong practical reasons for making current income high, which is accomplished by capitalizing costs and charging them off against future periods. Although there is no absolute requirement that a given item be treated the same way for tax purposes as it is treated for book purposes, it is reasonable to expect that the tax examiner will raise questions about expensing for tax purposes an item that the company has decided should be capitalized for book purposes. Thus, there is a conflict of objectives, and companies often have interesting discussions of where, on balance, is the best place to draw the line. ‘Comments on Questions Question | 1 find it useful to approach this problem as if the new wing were being constructed by an outside firm, Under these circumstances, the price would include all the items listed except (g) mistakes made during construction, and (i) losses not covered by insurance. (Even these would be included under certain circumstances.) The contractor would charge for interest, either explicitly, or as part of its fee. An outside “This teaching nose was propared by Robert N. Anthony. Copyright © Robert N. AnthonyAccounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant contractor has its own overhead costs, comparable to those of the Bruce maintenance department, and it would include a fair share of these in the bid. Many companies do not use such an analogy. They approach the problem on a direct cost basis, and students who have had a course in economics may also want to talk about marginal costs as being the relevant costs here. Thus, they would eliminate overhead (h) and possibly taxes (f). I do not believe the conceptual argument for this approach is strong, but it is commonly made, in effect, in practice, Formerly, many companies did not charge interest as a cost. For years, public utility commissions specifically have allowed this cost (including imputed equity interest) as a part of the cost of fixed plant, and FASB Statement No. 34 requires this same treatment for all companies, unless the interest cost is immaterial Question 2 Since revenues are being eamed from the existing buildings and will continue to be eamed until they are razed, it is appropriate to charge depreciation on these buildings against these revenues in order to measure income, It may not, however, be appropriate to calculate this charge by spreading the entire cost of the buildings over the remaining periods before they are expected to be razed. To do so would imply that the buildings were purchased for the purpose of earning income from the existing theater, stores, and apartment buildings, which is clearly not the case. Only a portion of the purchase price should be so charged, therefore. There is no very good way of determining what this portion should be, and the practical solution must therefore be somewhat arbitrary. Perhaps there is a going rate of annual depreciation per square foot for buildings of this type in this neighborhood, and this could be used in the absence of any other measure, Note that the cost of the new hotel and office building is affected by the decision made on this question because the more of the purchase price that is charged against current revenue, the less remains to become part of the nondepreciable land cost associated with the new buildings. Demolition costs should be capitalized as part of the cost of the parcel of land, as described in the text, ‘The situation assumed in Part (c) points up an important distinction. Archer Company established the value, and hence the cost, of the property by purchasing it in what was presumably an arm’s-length transaction, The Part (c) company engaged in no such transaction, and its cost was therefore the book value (cost) of the property. The net book value of the old buildings would be written off when they were razed. Since book values of real property are typically less than market value, the “cost” of the new buildings (including land) if built under the situation assumed in Part (c) would be less than the “cost” of buildings built by the Archer Company, even if the physical facts were identical. This is one of the prices we pay for adhering to the cost concept in accounting (but for reasons suggested in Chapter 2, [believe it is a price worth paying). The construction cost and demolition costs arc accounted for in the same way in either situation, Question 3 Here is perhaps the easiest piece to bring out the difference between tax accounting and finan accounting. The company will want to “bury” as many of these extra costs as possible for tax purposes, simply by recording them as normal operating expenses. Thus, it is motivated to include some or all of the installation costs as part of the ordinary expenses of the maintenance department. Conceptually, a case can be made for including each and every one of the items listed in (a)-(c) as part of the cost of the ‘machinery as they all bear on the objective of getting itready to provide future service.©2007 MeGraw-Hillirwin Chapter 7 The trade-in problem depends on whether the old machine was similar to the new one. If not, the issue should be solved by referring to the market value of the old machine, if such can be established. The difference between book value and market value is a gain on disposal of the old machine. If the machines are similar, the net book value of the old is added to the cash consideration given for the new to establish the cost of the new; no gain is recorded, Question 4 In its Statement No. 2 on Research and Development, the FASB espoused a general philosophy that costs should be expensed if related future revenue is uncertain, and that this applies to a whole class of costs, such as research and development, even though some items in this class are almost certain to produce revenue (such as development costs on a product whose future profitability has been confirmed by market tests). Ifthe same reasoning is applied to applications engineering costs, these costs should be expensed. To do this, however, results in the peculiar effect mentioned in the question, namely, that profits do not go up to match increased sales volume. Moreover, from the customers standpoint, these services are “bundled” with the computer to constitute a working system; the customer is buying this system, not just the computer. Thus, if the system is leased, these costs should be capitalized along with the hardware costs. ‘The argument against capitalization is that the lease revenue is uncertain. Although past experience has shown that computers are leased for four years, if the company produces a lemon, the machines will be returned in a year or two, and the profits will then tum out to have been overstated if the applications engineering costs are capitalized. Moreover, expensing the costs as incurred better reflects the cash flows of the business Question § This item illustrates the ambiguity firms face when they attempt to interpret standards and apply them to actual situations. It is not simply “black or white.” Considerable judgment is required to interpret and apply the standard, especially when firms encounter situations different from those with which they have typically dealt. The result can be a dilemma. Conceptually, one alternative may seem more appropriate. Practically, however, it may be difficult to accomplish, Some firms may opt for the “easier” solution as being the most practical, especially when the differences do not have a material effect on the financial statements. Others may make the extra effort to implement the alternative they consider conceptually ‘more appropriate. ‘The costs that are capitalized for fixed assets are “all expenditures that are necessary to make the asset ready for its intended use.” In the situation described in item 6, the intended use is to manufacture product at the 65 ppm quality standard (or better)' Thus, conceptually, it would be reasonable for the electronics component manufacturer to capitalize all of the costs required to enable the machine to meet the 65 ppm quality standard However, the firm faced a dilemma when one of its major customers, cager for the functionality of the new component, agreed to purchase product that did not quite meet the 65 ppm quality standard. Thus, on ‘one hand, when the machine begins to generate revenue, the manufacturer must match the related costs: including depreciation which is based on the cost of the machine—with the revenue generated, On the other hand, when the machine begins to generate revenue, the complete cost of the machine—that is, the complete cost required to achieve the 65 ppm standard—is not known; hence, the amount of depreciation to charge is not known, ‘cis becoming inereasingly common for customers to impose quality standards on their suppliers or to require suppliers to meet industry defined standards,Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant The electronics component manufacturing firm faced two basic altematives. Under the first altemative, they could consider the cost of the machine as the expenditures-to-date when the machine begins to generate revenue ($500,000), and they would expense this cost through depreciation over the service life of the machine.’ Under the second altemative, they could choose to capitalize the additional costs required to achieve the 65 ppm standard. Conceptually, the choice between these two basic alternatives hhinges on whether you believe that the “intended use” for the machine is to produce electronic components that can be sold, or whether you believe that the “intended use" for the machine is to produce electronic components af the 65 ppm standard. If the second alternative is chosen, several issues must be dealt with. First, what is the depreciation expense for the initial product that is produced below standard and sold? Should it be based on the expenditures-to-date ($500,000), or should it be based on a cost that also includes an estimate of future expenditures expected to be required to meet the 65 ppm standard ($550,000 = $500,000 + $50,000)? Second, in either case, what adjustments will be required once the actual cost to meet the 65 ppm standard is known? The actual cost will clearly be different than the expenditures-to-date ($500,000), but itis also likely to be different form the estimated total cost ($550,000). How, if at all, should the financial statements be adjusted for these differences? Finally, what if the 65 ppm standard is never achieved? What should the firm do about the expenditures it made attempting to achieve that standard which it had intended to capitalize as part of the cost of the asset? ‘A midwestern electronics component manufacturer recently faced this dilemma, Their choice was to capitalize all of the costs required to meet the 65 ppm standard. Because expenditures on testing and debugging to achieve such a quality standard could easily exceed 10 percent of the asset's cost prior to testing and debugging, these expenditures were considered a significant component of the asset cost. However, when they began to produce the electronic components ordered by the customer before the 65 ppm standard had been achieved, they did not feel they could estimate the future expenditures required to meet the 65 ppm standard accurately enough to include them in the cost. As a result, the initial depreciation expense was based on expenditures-to-date ($500,000). Once the 65 ppm standard had been achieved and the complete cost to achieve it was known, the cost of the asset was adjusted and an adjustment was made to previous depreciation expense. (Presumably, not a great deal of time would have clapsed, so the amount of this depreciation expense adjustment would be small.) The firm considered the 65 ppm standard an extremely tough standard to achieve. They had been seriously concemed about what they would do—with respect to both the fixed asset accounting and with respect to their major customer if they had not achieved the standard. Case 1: Strafford Press” Note: This case is updated from the Eleventh Edition. Approach This case is, in effect, a series of short problems dealing with various aspects of fixed asset accounting, The problems illustrate issues of asset valuation, disposal gains and losses, and expense versus capitalization of certain items. In class | have students discuss the items sequentially, describing treatment ion; or, if it of each transaction with a journal entry. | try to keep income tax treatment out of the discu does enter in, to keep it clearly distinguished from the financial reporting issues of the case. ‘Comments on Questions 1. The journal entry recording this disposal would be: Cas 149.800... Under this alternative, any further expenditures required vo meet the 65 ppm standard would simply be expensed “This reaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony©2007 MeGraw-Hillirwin Chapter 7 Accumulated Depreciation (bldgs.). 199.056. Loss on Sale of Fixed Assets, 35,182, Land. 34,034. Buildings.. 50,064... that is, it is determined as a result of the following The $35,182 is a “plug” figu sequence: (1) the cost of the old land and building must be removed from the books (credits); (2) the accumulated depreciation on the building must also be removed (debit); 3) the cash consideration must be recorded (debit); (4) the balancing debit is $35,182, representing the difference between the net book value of the assets disposed of and the ‘cash proceeds from the disposal. Although extraordinary items have not yet been covered in the text, it should be made clear that such gains or losses on disposal of fixed assets are not extraordinary items. The entry for this disposal is completely analogous to the previous one, except in this instance there isa gain instead of a loss: Cash, 35.200. Accumulated Depreciation (eqpt.) 40890... — Equipment. ci 3,045. Gain on Sale of Fixed Assets 2.as. 3. The purchase price should probably be recorded at $109,868, although the company's policy may be to treat all cash discounts separately, in which case the cost would be $112,110, The $450 delivery cost should be capitalized, as should installation costs. The question on the latter is the appropriate hourly rate; I feel the 60 hours should be costed at $27.15, the retail billing rate less profit, for a total of $1,629. Others will argue for the $15 rate, or $900. One possible entry therefore is: Equipment (109,868 + 450 + 1,629)... Cash (possibly other items) L11.947.. 111,947, 4. The company paid $140,000 to purchase the land for the new plant. Land, Cash 140.000, 140,000. AAs slated in the text, ne cost of land includes the cost of tearing down existing structures so as to make the land ready for its intended use. Land, 21,238 Cash. anspor a ra AS In either case, te drainage installation is an additional cost that should be capitalized, as follows: Land. 13,950, Cash 13,950. STAFFORD PRESS Condensed Balance Sheet (Revised to Refleet Move) Assets Current assets: Cash. $..121,912 ‘Longeterm liabilities. Other current assets... ee ne2SA TDD nn Cammen. SLO. ‘Total current Assets. 373.102. on. Retained earnings, Plant and equipment: Land, ATS15. Liabilities and Owner's Equity Current fiabilities.. $160.22...Accounting: Text and Cases 126 Instructor's Manual Amhons/Havskins/Merchant Buildings . $561,000. Less accumulated, . Depreciation. % 561,00 Equipment. 319.025 Less: accumulated depreciation 132,832. wu SO,193. Total liabilities and Total a8$018 orn vnee $296,080, owners!.cquity. 5. The item was intentionally stated ambiguously in the case so that the issue of similar (“like- kind”) trade-ins can be discussed. Ifthe equipment traded in was similar, then the journal entry is constructed so that no gain or loss on disposal is recorded: Equipment (new) (20,830 + 6,800)... eae re OS Accumulated Depreciation (old), ss sans ; CSB av seit 20,830. Equipment (old) 12,000. On the other hand, if it is assumed that the trade-in was not similar, the entry is as follows: Equipment (new) (20,830 + 6,050)... - 7 ne 26,880... Accumulated Depreciation (old), 5.200. Loss on Sale of Fixed Assets. 750. Cash... 20,830. Equipment (old) i = aeaanaaranarraerem nee OI Note that in either case the nominal trade-in allowance $7,200 is irrelevant, In the second treatment, the $750 loss is the difference between the fair value of the trade-in, $6,050, and its $6,800 net book value. 6. This is straightforward a8 g1VEM!...c0ncnnnnnninnnninnnnnennnennn Buildings 561,000. (Gaghigseeresapeerasese narra ca wea ammeter Le ON ed Morlgage Payableciscs cassie ceapaacamarnmaamemamamnmamanama ee OOO 7. Some might argue that these moving costs should be capitalized, on the grounds that there are future benefits associated with the move (that was the owner's motivation in moving). In response, | ask, “How would you feel if the move had been made out of necessity--say, the old property had been condermed or taken by eminent domain?” The response in that case usually is that the moving costs should not be capitalized. Since the benefits are speculative and (more importantly), since changing the location of equipment through a move does not alter its future productive capacity or useful life, I see no strong argument for capitalization. Thus, the entry would be (again using $27.15 per hour for the workers’ time, consistent with item 3): Moving Expense (8.440 + 3,394), . L834. Cash 11,834. (There would be labor, over and above this 125 hours, charged to moving expense, but the total number of workers’ hours devoted to the move is not given.) 8. ‘The repair of the damage during the move has not improved the equipment so as to constitute a betterment; thus itis expensed ‘Maintenance (or Moving) Expense 3.220. Cashiresrecmraa eee ‘The decrease in salvage value, $660, could be expensed immediately with an entry such 10©2007 MeGraw-Hillirwin Chapter 7 Moving Expense (or Deproc. Expense). 660, Equipment (or Accum. Deprec.) 660. However, I don’t think an event that changes a fixed asset's future salvage value is any more relevant, in terms of the cost concept, than an event that changes its current market value. Thus, in my view, rather than adjusting the cost of the asset, it is better to amortize the reduction in salvage value by adjusting the depreciation charge for the rest of the equipment’s useful life, which constitutes a change in an estimate, Since the accumulated depreciation was $3,220, and annual depreciation was $805, the asset was 4 years old, and thus had 6 years left of useful life ‘The amount of remaining depreciation is the net book value at the end of 4 years, $6,780, less the newly estimated S1,290 salvage value, or $5,490. Divided by 6 years, the new annual depreciation expense on this item would be $915. (Easier, though not quite as thorough: the $660 lesser salvage value, spread over 6 years, is $IL0 per year, added to the current depreciation charge of $805, makes a total of $915.) The revised balance sheet reflecting the above transactions is shown above. ul