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Acquisifion ofLong-Term

ondUse Assefs
Operolionol

| | / \ A tl \/ | n
iere s VVnereYouve Seen
InChopter3, you leorned:
. Accruols in whichtheexchonge
ore tronsoctions
of therelotedqoodsond services
. Deferrols of coshcomesbeforetheexchonge
in whlchtheexchonge
oretronsoctions
of therelctedgoodsond services.
Bothore portof occruolbosisoccounting.

Here'sWhereYou'reGoino
. Youwillleornto occount
forthepurchose mcnufocturing
onduseof bulldings, plonts,
equipment, noturol ond intongible
resources, ossetsl
. Youwlll leornhow tronsoctions on thefl-
ossetsore presented
relotedto long-term
nonciolstotemenls.

ffieruw"{ryW$laefives
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.

2" Explain and compute how tangible assetsare 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 state-
ments, 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 depre-


ciation for taxes.
153
154 CHAPTER4 . ACQ UI SI TI O NAND Us E O F L O N G - T E R MO P E R A T I O N A A
L SSETS

€fAtesJdaffers
The bankruptcyof WorldComin 2002was the culminationof an
$11 billionaccountingfraud,the largeston record.ScottSullivan,
the former chief financialofficer (CFO)receiveda 5-yearprison
sentencefor his part in the fraud. Sentencingguidelinessuggest
25 yearsfor his crimes,but he was rewardedfor his cooperation
with government prosecutorsin the case against former CEO
BernardEbbers.Ebberswas sentencedto 25 yearsbut is appeal-
ing both the convictionand the sentence,
Besides Sullivanand Ebbers,who will pay for the $11 billionfraud? Eleven
former membersof the WorldCom board of directorsagreed to pay investors
$20 millionas partialcompensationfor the investors'losses. The directorswill
pay this money from their own pockets,in addition to any amountspaid by
the insurance companiesthat providedliabilityinsurance for the directors.The
resultof this type of settlement,similarto the agreementby the Enrondirec-
torsto pay $13 million to investors,could be harmful to all investorsin pub-
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 expe-
rienced,carefulpeopleyou would want most to serveon any board."
So,who paysfor fraudssuchasthoseat WorldComand Enron?Employees,
shareholders, and membersof the board are just a few of the groups.ALL in-
vestorssharethe costsof the unethicalbehaviorof corporatecriminalsin ways
we are just beginningto recognize.

L"{}.1 AcquiringPlantAssets
Ex plainhow long- te rm
assetsare classifiedand So far, you have studied the accounting cycle and know how transactionsmake their way
how their cost is computed. to the financial statements.In this chapter,we will look at the purchaseof long-term assets
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 ma-
chines, and furniture as well as short-term assetssuch as folders, paper, and pens. Acquir-
ing long-term assets,often called fixed assets,is usually more complicated than acquiring
short-term assets.Purchasinglong-term assetsis complex for severalreasons.With long-
term assets,a firm must put a great deal ofcare in selectingthe vendor becausethe relation-
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 dif-
ficult 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'man-
ager 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 deci-
sion 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 in-
clude 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 4R . A C Q U I R I N GP L A N TA S S E T S 155

Capitalexpenditures are an importantpart of any firm'sstrategicplans.Wal-Mart


spendsbillionsof dollarseveryyearto remodeland updateits stores.In fact,in early
2006,Wal-Marts budgetfor capitalexpenditureswasestimated at $17 billion. Why
woulda firmspendthatmuchmoneyfor renovations andremodeling? Salesgrowth at
manyof itsstoreshasfailedto keeppacewith rivals
suchasTarget,andWal-Martisde-
terminedto turnthat trendaround.Checkout Wal-Mart's financial
statements to see
if thefirmhasactuallvcarried plans.
out itsambitious
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.Ac-
countantsthen use thesecoststo accountfor the purchaseand useof the asset.What assetsto
buy and how to pay for them are decisionsthat do not affect the income statementat the time
of the purchase.Recordingthe purchaseof a long-term assetaffectsthe balancesheetand po-
tentially the statementof cashflows. As you saw in Chapter3, a businessdefersrecognizing
the expenseof a long-term assetuntil the assetis actually usedin the business.When the as-
setis usedand the expenseis recognized,the expenseis called depreciationexpense.This de-
ferral is an exampleof a timing difference.We havepurchaseda long-term assetat one point
in time in the past, and we will use that assetover a subsequentperiod of time.

Typesof Long-LivedAssets:Tangibleand Intangible


There are two categoriesoflong-term assets:tangible assetsand intangible assets.Exhibit Tangibleassetsare assetswith
4.1 showsthe long-term assetsectionof Staples'balancesheet,where you will seeboth physicalsubstance;they can
be seenand touched.
types of long-termassets.
Common tangible assetsare property, plant, and equipment (PPE). Common intangi- Intangible assetsare rights,
ble assetsare trademarks,patents,and copyrights.We will discussthesein detail later in the privileges,or benefitsthat
chapter. resultfrom owning long-lived
assetsthat do not have
Acquisition
Costs physicalsubstance.

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
January
28, January
29, You won't know the meanins
2006 2005 of some terms Stapleshas
used, but you will learn about
Property and equipment:
ffi"."J]
tangnbte
Land and buildings . .
Leasehold improvements
$ 705,978$ 649,175
884,953 762,946
them in this chaoter.

N l-'
1,330,1911,140,234
I r-::l1 | Equipment
Fumiture and fixtures 672,931 597,293
Totalpropertyandequipment ..... 3,593,9433,149,648
Less accumulated depreciation and amortization 1,835,549t,548,774
Net property and equipment 1,758,3941,600,874

ruffit
I intangible ff,
Lease acquisition costs net of accumulated
amortization
Intangible assetsnet of accumulated amortization . .
34,885 38,400
240,395 222,520
lryq I Goodwill
Other assets
r,378,752 1,321,464
119,619 106,578
Total long-term assets $3,532,045$3,289,836
156 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

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
written off as expensesover the accountingperiods in which they are used to generaterev-
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 acquisi-
tion cost includes:
a. Price paid for the land
b. Realestatecommissions
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
a long-term asset.Even if the land's value increases,financial statementswill show the
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:
a. Architects'or contractors'fees
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 value,the assetwill be depreciated.In practice,most assetsusedin a businessto gener-
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 For eachof the following costs,tell whether it should be recordedas an asset
'W-mww.w'wor recordedas an expenseat the time of the transaction.
-h$muww 1. Paymentfor employee salaries
2. Purchaseof new delivery truck
3. Rent paid in advance
4. Rent paid in arrears(after use of the building)
Relativefair market value
method is a way to allocate BasketPurchase
Allocation
the total costfor several
assetspurchasedtogether to Calculating the acquisition cost of certain assetscan be diffrcult. Buying a building with the
eachof the individualassets. land it occupiesis an example of a "basket purchase"becausetwo assetsare acquired for a
Thismethod is basedon the single price. For the accountingrecords,the firm must calculatea separatecost for each as-
assets'individualmarket set.Why? The f,rrmwill depreciatethe building but it will not depreciatethe land. The firm
varues.
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

il\i
ilF
$- -E
Li rud-h.u
$"T. #$il*#usine ss
Leaseor Buy? preciated, just likeanyotherdepreciable assetowned
by the company.
Generally accepted accounting principles (GAAP) try to The accounting standards haveveryspecificrules
makesurethe financialstatements reflectthe sub-
abouthowto account for long-term leases. Thecriteria
stanceof a companys transactions instead of the form if a leasequalifies
for deciding asa capitalleasearevery
of thetransaction. Because a company's financial state- numerous,
technical, andhighlydebated anddiscussed
mentsaresoimportant to investors, creditors, andany-
by standards-setting boardssuchas the Financial Ac-
onewho wantsto evaluate a company's performance,
countingStandards Board(FASB) andtheSecurities and
how a transaction is reflected on thosestatements is (SEC).
Exchange Commission An accountant comesin
veryimportant to the company. Sometimes recording a
handywhenthisissue comesup.
transactionbasedon itssubstance maynot beveryap- In the long-term assets sectionof a company's bal-
pealing. A classic example is buyingor leasing long-
ancesheet,you will oftenseeitemscalledcapitalized
termassets. Whena company buysan asset, it isshown
leasesor leasehold improvements. Capitalized leases
on the balance sheet,andanyamountthat the com- represent assets a companyhas,in substance, bought
panyowesfor thepurchase of theassetmustbeshown but the form of the purchase is a lease.Leasehold im-
on the balance sheetasa liability. provements are long-termassetsin the form of addi-
Suppose a company doesnotwantto put anyaddi- tions and improvements to leasedproperty.For
tionalliabilities
on itsbalance sheet. Thenwoulda com-
example, if a company remodels the interiorof a leased
panyleasean assetinsteadof buyingit? Couldthe
officebuilding, thecostof the remodeling will becalled
company simplyrecordthe expense of leasing the asset leasehold improvements.
as the leasepayments are made?lf the form of the A companydecides whetherto leasean assetor to
transaction is a leasebut the substance is morelikea purchase anasset based on business factorssuchas(1) the
purchase, the leaseis calleda capitallease,and GAAP (2)the interest
typeof assetandthe riskof obsolescence,
saysthe transaction mustbe recorded likea purchase.
rateof theleasepayments compared withtheinterest rate
Inotherwords,a company cannot"hide"futurefinan- purchase, (3) purchase
of a the lease's renewaland op-
cialcommitments related to long-term leases by calling
tions,(4)the acceptable alterations to leasedassets, and
the transaction a leaseand simplyrecognizing the ex- (5)theestimated usefullifeof theleased assetto the busi-
pensewhenthe payments aremade.Thatmeansthe ness.Howeve6 theaccounting treatment shouldnotinflu-
companymustrecordthe asseton the balancesheet goes
encethe economic decision. lt the otherway-the
andalsorecordthe relatedlong-term obligation of the
economic decision influences theaccountinq treatment.
futureleasepayments asa liability.
Thenthe assetisde-

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 ap-
praisalsto divide the purchaseprice of $ 100,000betweenthe two assets.Supposethe build-
ing appraisedat $90,000 and the land appraisedat $30,000. The total appraisedvalue is
($90,000
$120,000 + $30,000).
Thebuildingaccountsfor three-quarters
of thetotal appraised
value.
$90,000+$120,000:3/4
So,theaccountant ofthe totalcostofthebasketpurchase.
recordsthebuildingatthree-fourths
3/4x$100,000:$7 5 , 0 0 0
158 CHAPTER4 . 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
L SSETS

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 BargainCompany paid $480,000for a building and the land on which it is lo-
cated. Independentappraisalsvalued the building at $400,000and the land
Wffimpm'
Wmpwwru 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 Tangible
UsingLong-Term Assets:
Ex plainand c om p u teh o w
tangible assetsare written
andDepletion
Depreciation
off over their useful lives Now that you are familiar with the types of assetsa firm may have and the costs associated
and reported on the with their acquisition, we are ready to talk about using the assets.Until property, plant, and
financialstatements. 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
To capitalize is to record a recording it as an expense,is called capitalizing the cost. That cost will be recognized as
cost as an assetrather than to an expenseduring the periods in which the assetis used. Recall from Chapter 3 that depre-
recordit as an expense.
ciation 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 ex-
penseon 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.It is called the carrying value becausethat is the amount at which we
carry our assetson the balancesheet.The amount not yet depreciatedis also known as
the book value becauseit is the value of the asseton the accountingrecords.As you read
about the specific methodsof depreciatingassets,refer to the vocabularyof depreciation
inBxhlbrt 4.2.
Accountants primarily use three terms to describe how a cost is written off over sev-
Amortization meansto write eral accounting periods. Amortization is the most general expressionfor writing off the
off the cost of a long-term cost of a long-term asset.Depreciation is the specific word that describesthe amortization
assetover more than one
of certain kinds of property, plant, or equipment. Depletion is the specific term that de-
accountingperiod.
scribes the amortization of a natural resource.There is no specific term for writing off in-
Depreciationis a systematic tangible assets,so accountantsuse the generaltermamortizationto describewriting off the
and rationalallocation cost of intangibleassets.
processto recognizethe All of theseterms-amortization, depreciation,and depletion-refer to allocating the
expenseof long-term assets cost of an assetto more than one accountingperiod.
over the periodsin which the
Accountants use severalmethods of depreciationfor the financial statements.We will
assetsare used.
discussthree of the most common:
Depletionis the amortization 1. Straight-line depreciation
of a natural resource.
2. Activity (units-of-production) depreciation
3. Declining balance depreciation
CHAPTER4. USI NGLO N G - T E R MT A N G I B L EA S S E T SD
: E P R E C I A T I OANN D D E P L E T I O N 159

EXHIBIT4.2
DepreciationTerminology

Term Deflnition Example

The amount paid for the asset, Staples purchases computer cash
including all amounts registers for its new store for
to get the asset up
necessa:tr1 $21.000.
Cost or acquisition cost and runninq

How long the company plans Staples plans to use these cash
to use the asset; may be registers for 10 years.
measured in years or in units
Estimated useful life
that the asset will produce

Estimated value the asset will When Staples is done using the
have when the company is cash registers, the company plans
Salvage value or done with it-the salvage value to seII them for $1,000.
residual value is the estimated market value
on the anticipated disposal
date

Cost minus saluage aa,lue The depreciable base is $21,000-


$1.000= $20.000.
Depreciable base

Cost less tota,l d,epreciation If Staples uses the straight-line


taken to date method, the company's
Book value or depreciation expense wiII be
carrying value $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-tineDepreciation
StraightJine depreciation is the simplestway to allocatethe cost of an assetto the peri- Straight-line
depreciation
isa
ods in which the assetis used.This is the methodwe usedin Chapter3. Using this method, depreciationmethodin which
the depreciationexpenseis the sameevery period. To calculatethe appropriateamountof the depreciation
expenseis
the sameeachperiod'
depreciationexpensefbr eachaccountingperiod,you fbllow severalsteps.
First, you must estimatethe useful life of the asset.The firm should consider this esti-
mate when purchasing an assetand use the estimateafter the purchaseto properly account
for the cost of that asset.
Second,you estimatethe salvagevalue, the amountyou believethe assetwill be worth Salvagevalue(alsoknownas
when the company is finished using it. Salvagevalue is the amount you think someonewill residualvalue)isthe
pay you for the usedasset.Someonewho knows a lot about the assetand the relationship estimatedvalueof an assetat
the end of its usefullife'
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.
150 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L S5ETs

The useful life and the salvagevalue are related, and the hrm should have made theseesti-
mates as part of the acquisition decision.
Third, you calculatethe depreciablebase-the amount you want to depreciate-by de-
ducting 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 depre-
ciation methods.
SupposeHoliday Hotels purchasesa new squeeze-your-ownorangejuice machinefor its
self-servicebreakfastbar. Such a machineis expensiveandrequireslarge suppliesof fresh or-
anges.After considering the risks and rewards of purchasing the machine and evaluating the
effect sucha purchasewould haveon the financial statements,Holiday Hotels decidesto pur-
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
thesecostsaspart of the acquisitioncost of the asset.Holiday estimatesthat the machinewill
have a salvagevalue of $500 at the end of 6 years.After someonein the firm who is knowl-
edgeableabout the characteristicsof the assetreviewsand confirms thejudgments aboutuse-
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


=
Salvagevalue $500
Depreciablebase: $12,500- $500: $12,000

EXHIBIT4.3
HolidayHotel'sOrange
J ui ceM ach in e

$11,500invoice price
Cost + 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 GL ON G-TE RTA
M N GIB LE
A S S E TS
D:E P R E C IA TION
A N D D E P LE TION 161

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 accu-
mulated 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 com-
pany's fiscal year ends on December 3 1, then the income statementfor the year endedDe-
cember31,2006, would include depreciationexpenseof $2,000.The balancesheetwould
show the acquisitioncost-$12,500-and the accumulateddepreciationat December31,
2006-$2,000. This is how the adjustmentfor depreciation expensewould look in the ac-
counting equation:

Assets Liabilities + Shareholder'sequity


Contributed + Retained
capital earnings
Accumulated
depreciation- Depreciation
Equipment expense
(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
31,2006
Equipment $12,soo
Lessaccumulated
depreciation (2,000)
Net bookvalue $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 depreciatedeachyear, 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 accumu-
lated 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 declin-
ing, becauseon that date Holiday has used it for 2 years.

December31,2007
E quip me n t $12,s00
Lessaccumulateddepreciation (4,000)
Net book value $ 8,soo

Exhibit 4.4 shows the depreciationexpenseand accumulateddepreciationamountsfor the


year-endfinancial statementsduring 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 esti-
mated that it could sell the assetat the end of its useful life for a price equal to its carrying
value-$500.
162 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L sSETs

EXHIBIT4.4 Accumulated Garrying or Book


Depreciation Depreciation Value on the
Expense on the on Year-End Y e a r - E nd
Straight-Line Year lncome Statement Balance Sheet Balance Sheet
Depreciation
The depreciationexpenseeach 2006 $2,000 $ 2,000 $10,500
year is always $2,000, as shown
2007 $2,000 $ 4,000 $ 8,500
2008 $2,000 $ 6,000 $ 6,500
in the table and accompanying
2009 $2,000 $ 8,000 $ 4,500
graph. The carrying value
2010 $2,000 $10,000 $ 2,500
decreasesover time, from
2011 $2,000 $12,000 $ 500
$10.500at December31. 2006 to
$500 at December31.2011.

Depreciation
Expense
o

$2,000

2009

Year

Your Turn 4-4 On January1,2006,AccessCompanypurchased a new computersystemfor


'.Nkwm--ww- $15,000.Theestimatedusefullife of the computersystemwas 5 years,with
lN*ilt.u,t*owlw, how
an estimatedsalvagevalueof $3,000.Usingstraight-linedepreciation,
muchdepreciation expensewillAccessCompanyincludeon the incomestate-
mentfor the yearendedDecember 31,2007?Determine the bookvalueof the
asseton December 31,2007.

Activity (Units-of-Production)
Depreciation
Another way a firm determinesdepreciationexpenseis 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
Activity method depreciation depreciationexpenseis called the activity method, also known as the units-of-production
is the method of deoreciation method.Examplesof activitiesare miles driven or units produced.If a companybuys a car, it
in which usefullife is
may decide to use it for 100,000miles before trading it in. The activity method is similar to
expressedin terms of the total
units of activityor production the straighrline method.The differenceis that an estimateof the number of units of activity
expectedfrom the asset,and over the asset'slife is usedasthe allocationbaseinsteadof an estimateof the numberof years
the assetis written off in of useful life.
proportionto its activity
during the accountingperiod. Acquisition cost - Salvagevalue
Rate per activity unit
Estimate useful life in activity units

Rate X Actual activity level for the year Annual depreciationexpense

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 deprecia-
ble basein exactly the sameway when using activity depreciationas when using straight-
line depreciation-subtract the expectedsalvagevalue from the cost. In this example, the
depreciablebaseis $12,000($12,500- $500).You then divide the depreciablebaseby the
total number of units you expect to produce with the machine during its useful life.
C H A PT E R. 4U S IN GL O N G-TE RTA
M N GIB LE
A S S E TS
D:E P R E C IA TION
A N D D E P LE TION 153

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 estimatednum-
ber of glassesof orangejuice the machinewill produce.That gives the depreciationrate.

$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.Supposethe machinehas a built-in counterthat showed36,000glassesofjuice
were squeezedduring the first year. The depreciationexpenseshown on the income state-
ment for that year would be $1,800.

36,000glassesX $0.05 per glass : $1,800deprecratronexpense

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 estimatedsal-
vage 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 Accumulated Book Value of
Each Year- Depreciation Depreciation Depreciation the Asset
Number of Rate x Number Expense (BalanceSheet (BalanceSheet
Glassesof of Glassesof Juice (lncome at the End of at the End of
Year Orange Juice *Rate:$0.05per Glass Statementl the Yearl the Year)
2006 36,000 x 36,000
$0.05 $1,800 $ 1,800 $10,700
2007 41,000 x 41,000
$0.05 $2,050 $ 3,850 $ 8,650
2008 39,000 x 39,000
$0.05 $1,950 s s,800 $ 6,700
2009 46,000 x 46,000
$0.05 $2,300 $ 8,100 $ 4,400
2010 43,000 x 43,000
$0.05 50
$2,1 $10,250 $ 2,250
2011 35,000 x 35,000
$0.05 $1,750 $12,000 $ 500
Costof machine
of $12,500
minussalvage givesa depreciable
valueof$500, baseof$12,000.
production
Totalestimated glasses.
is 240,000
"Rate= $12,000 = $0.05perglass.
+ 240,000

Withtheactivity
depreciationmethod,thedepreciation
expenseeachyeardependsonhowmanyunitstheassetproduces eachyear.Thismethod
matchestheexpense to theamountof workperformed
bytheasset. thebookvalueis decreasing
Although eachyear,theamountof depreciation
expensewilllikelyvaryfromyear-to-year,
asshownin boththetableandgraph.
As always,accumulated depreciation
isworking
itswayupuntilit
reachesthedepreciable base-costminussalvagevalue.
Thatmeans thebookvaluewillbeequalto theestimated
salvagevalueattheendof itsuseful
life.

The flnal year's


Depreciation depreciation varies in
Expense amount, depending on
D
how much is needed to
make the book value
4,167 equal to the salvage
value.

Year
CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

Your Turn 4-5 Hopper Company purchasedequipment on January1, 2005,for $44,000.The


expected useful life is 10 years or 100,000units of activity, and its salvage
Kwwe.ffimspee value is estimatedat $4,000.In 2005,3,000units were produced,and in 2006,
14,000units were produced.Calculatethe depreciationexpensefor 2005 and
2005 using activity depreciation.

DecliningBalanceDepreciation
You have learned about the straight-line depreciationmethod and the activity depreciation
Decliningbalance method. The third method is declining balance depreciation. This method is considered
depreciation is an accelerated an accelerated depreciation method, one that allows more depreciationin the early years
depreciationmethod in which of an asset'slife and less in the later years. The higher depreciation chargeswill occur in
depreciationexpenseis based
on th e de clin ingb ook v alue
the early, more productive yeilrs when the equipment is generatingmore revenue.Depreci-
of the asset. ating more ofthe assetin the first few years also helps even out the total expensesrelated
to an asset.In later years, the depreciation expenseis lower but repair expensesare likely
Accelerateddepreciation is a to be increasing.
depreciationmethod in which The declining balancemethod speedsup an asset'sdepreciationby applying a constant
more depreciationexpenseis
rate to the declining book value of an asset.Frequently,f,rrmsuse a version of the declining
taken in the earlyyearsof the
asset'slife and lessin the later
balancemethod called double-declining balance.The firm takes200Voof the straight-line
years. rate to use as the annual depreciationrate. For example, if the useful life of an assetwere
5 years,the straight-line rate would be one-fifth, or 2OVo.That is because20Voof the asset
would be depreciatedeach year for 5 years using straight-line depreciation.The rate used
for double-declining balance depreciation would be 40Vo, which is 20OVo,or twice, the
straight-line rate. Here is how this method works and why it is called double-declining bal-
ance.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 calcula-
tion 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


C H AP T ER. 4U SIN GL ON G-TE RTA
M N GIB LE
A S S E TS
D:E P R E C IA TION
A N D D E P LE TION 165

The book value on the December 3I.2007 . balance sheetis


: $5,55s
- $6,945
$12,s00
Although salvagevalue is ignored in the calculation of each year's expense,you must al-
ways 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 double-
declining 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 Book Value at
Before Accumulated the End of the
Depreciation Depreciating Depreciation Depreciation Year:$12,500-
Rate = 1/3 the Asset for Expense (At the End Accumulated
Year or 33.333% the Year for the Year of the Year) Depreciation
2006 $12,500 67
$4,1 $ 4,167 $8,333
2007 ?e???
$ 8,333 $2,778 $ 6,94s $5,555
2008 ?e??? ( EqFE $1,852 $ 8,797 $3,703
2009 .33333 $ 3,703 $1,234 $10,031 $2,469
2010 .33333 $ 2,469 $ 823 $10,8s4 $1,646
2011 .33333 $ 1,646 46*
$1,1 $12,000 $ 500**
of (0.33333
"Thecalculation x $1,646)
indicates
depreciation
expenseof $549.
Because thisisthelastyearof itsusefullifeandthebookvalueafter
thisyear'sdepreciation
shouldbe$500,thedepreciation
expensemustbe$1,146to bringthetotalaccumulated depreciationto $12,000.
**Thedepreciationexpense forYear6 mustbecalculated
to makethisthebookvalueattheendof theusefullife-because thebookvalueshould
betheestimatedsalvage value.

Withdouble-declining
depreciation,
depreciationexpense is largerin theearlyyearsof theasset'slifeandsmallerin thelateryears.
Thebookvalueis
decreasing
at a decreasing
rate.Still,the balance
in AccumulatedDepreciation is workingitswayupuntilit reachesthecostminussalvagevalue.A firm
alwayswantsthebookvalueoftheassetto beequalto theestimated salvagevalueat theendof itsusefullife.

The final year's


Depreciation depreciation varies in
amount, depending on
Expense
D
how much is needed to
make the book value
equal to the salvage
value.

20tl

Year
16 6 CHAPTER4 . ACQ UI SI TI O NAND Us E O F L O N G - T E R MO P E R A T I O N A L
AssETS

EXHIBIT4.7 Method Formula for Depreciation Expense

DepreciationMethods cost- salvage


Acquisition value= yearly
line
Straight depreciation
expense
Estimatedusefullifein vears

cost- Salvage
Acquisition value =
Activity Unitdeoreciation
rate
Estimated
usefullifein activitvunits
Ratex Actualactivitylevelfor theyear= Yearlydepreciation
expense

D o u b l e -d e c l ibal
ni ng bookvaluex (2/Estimated
ance Beginning-of-the-year usefullifein years)=
Yearlydepreciation
expense

EXHIBIT4.8 Double-Declinirg
Year StraightLine Activity Balance
Comparison of 2006 2,000 1,800 $ 4,167
$ $
Depreciation Expense 2007 $ 2,000 $ 2,050 $ 2,778
by Yearover the Life 2008 $ 2,000 $ 1,950 $ 1,852
of the OrangeJuice 2009 $ 2,000 $ 2,300 $ 1,234
M ach in efo r 2010 $ 2,000 $ 2,150 $ 823
HolidayHotels 2011 $ 2,000 $ 1,750 $ 1,146
Totaldepreciation
Notice that the annual
expense the
during
depreciation expensediffers
lifeoftheasset $12,000 $12,000 $12,000
among the three methods,but the
total depreciation expensetaken
over the life of assetis the same
Exhibit 4.7 summarizesthe calculationsfor the three depreciationmethods.
for all methods.
Over the useful life of the asset,the sametotal depreciationexpensewill be recognized
no matter which method is used. Exhibit 4.8 comparesthe depreciationexpenseof the or-
angejuice machine with the three different depreciationmethods.

Your Turn 4-6 An assetcosts$50,000, hasan estimatedsalvagevalueof $5,000,and hasa


usefullife of 5 years,Calculate expensefor the
the amountof depreciation
Skwwmw
Wfuw-ww secondyearusingthe double-declining balancemethod.

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 deple-
tion 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 Cleveland-Cliffs
from Cleveland-Cliffs FYomthe Balance Sheet
BalanceSheet December31, 2005
( i n m i l l i ons )
at December31,2005

Properties
Plant and equipment $557.50
Minerals 42t.80
979.30
Allowances* for depreciation and depletion (176.50)
Total properties .. . .. $802.80

+TFriE is arcther waA of eupressing "accwulated," d'eprwi,qtion md dppleti,on anaunts


C H A P TE Ro4U S IN GIN TA N GIB LE
A S S E TS
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 nat-
ural 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 dur-
ing the period.
Supposethat, on Januaryl,2005, a companypurchasesthe rights to an oil well in Texas
for $100,000,estimatingthe well will produce200,000barrelsof oil during its life. The deple-
tion 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 bar-
rels 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:

- $25,000= $75.000
$100,000

UsingIntangibleAssets:
Amortization L"{"}.3
E xpl ai nand computehow
In addition to tangible assets,most firms have intangible assets,which are rights, privi- i ntangi bl eassetsare
leges,or benefitsthat result from owning long-lived assets.Intangible assetshave long- written off over their useful
term value to the firm, but they are not visible or touchable.Their value residesin the rights livesand reported on the
and privilegesgiven to the ownersofthe asset.Theserights are often representedby con- fi nanci alstatements.
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 as-
set 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.

Copyrights
Copyright is a form of legal protection for authorsof "original works of authorship,"pro- A copyrightis a form of legal
vided by U.S. law. When you hear the term copyright, you probably think of written works protection for authors of
such as books and magaztnearticles. Copyright protection extendsbeyond written works "original works of
to musical and artistic works and is availableto both published and unpublishedworks. Ac- authorship,"providedby U.S.
taw.
cording to the 1976 Copyright Act, the owner of the copyright can
. copy the work
. use the work to prepa.rerelated 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 choreo-
graphic works
168 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A L
ASSETS

. 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 A patent is a property right that the U.S. governmentgrantsto an inventor "to exclude oth-
that the U.S.government ers from making, using, offering for sale, or selling the invention throughout the United
grantsto an inventor "to
Statesor importing the invention into the United Statesfor a specifiedperiod of time in ex-
excludeothersfrom making,
change for public disclosure of the invention when the patent is granted." For example,
using,offering for sale,or
sellin gthe in ve ntio n Micron Technology filed for a patentfor a computermemory device in February 2004. IBM
throughout the United States obtained a patent for a vibration-driven wireless network in April 2000. Did you know that
or importingthe invention universities apply for hundredsof patentseach year for their inventions?In20O4, the Uni-
into the United Statesfor a versity of California applied for 424 patents-more patentsthan any other university.
specifiedperiod of time."
As with copyrights, coststo defend patents arecapitalized as part of the cost of the as-
set.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 pe-
riod for amortizing the asset.

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

Franchises
A franchiseis an agreement A franchise is an agreementthat authorizes someone to sell or distribute a company's
that authorizessomeoneto goods or servicesin a certain area.The initial cost of buying a franchiseis the franchisefee,
sell or distributea company's and this is the intangible assetthat is capitalized.It is amortized over the life of the fran-
goodsor servicesin a certain
area.
chise if there is a limited life. If the life of the franchise is indefinite, it will not be amor-
tized. 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 excessof cost Goodwitl is the excessof cost over market value of the net assetswhen one company pur-
over market value of the net chasesanothercompany.When theterm goodwill is usedin everydayconversation,it refers
assetswhen one company to favorable qualities. However, when you seegoodwill on a company's balancesheet,you
purchases another company.
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 in-
ventory and building-all of Pop's assets-were appraisedat $750,000;and the small hard-
ware 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
to recognize its internally developedgoodwill, so Pop's financial statementsdo not include
goodwill. Now that The Home Depot has decided to purchasePop's Hardware, however,
CH A P TE4R. C H A N GEASFTE R
TH EP U R C H A SOF
E TH EA S S E T 159

the goodwill will be recorded. Here is how the transactionaffects the accounting equation
for Home Depot:

Assets = Liabilities + Shareholder's equitv


Contributed + Retained
capital earnings
(950,000)
Cash
750,000Variousassets
200,000Goodwill

What happensto the intangible assetgoodwill? Goodwill is not amortized becauseit is as-
sumed 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
and DevelopmentCosts
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 assetbecauseit is not clear that thesecostsrepresentsomethingofvalue. Softwarede-
velopment costs are consideredresearchcosts until they result in a product that is techno-
logically 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 mak-
ing accounting decisions. The firm's developers and computer experts would make this
judgment.

Changes
after the Purchase
of the Asset L"O-4
Exolainhow decreases in
We startedthe chapter with a discussionof the types and costs of long-term assets.Then, val ue,repai rs,changesi n
we discussedhow the accountingrecordsshow the firm's use of thoseassets.Now we dis- productivecapacity,and
cuss how to adjust financial statementsto record three things that may take place after an changesin estimatesof
assethas beenin use. First, the assetmay lose value due to circumstancesoutside the firm's usefull i fe and sal vage
control. Second,the firm may make expendituresto maintain or improve the assetduring value of assetsare reoorted
its useful life. And third, the firm may need to revise its prior estimatesof an asset'sesti- on the fi nanci alstateme nt s.
mated life and salvagevalue.

Assetlmpairment
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 state-
ments 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 lmpairmentis a permanent
value-if certain changeshave occurred. Such changesinclude d e c l i n ei n t h e f a i r m a r k e t
value of an assetsuchthat its
1.. A downturn in the economy that causesa significant decreasein the market value of a book value exceedsits fair
long-lived asset market value.
2. A changein how the company usesan asset
3. A changein the businessclimate that could affect the asset'svalue

An assetis consideredimpaired when the book value of the assetor group of assetsis greater
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.Becausetesting 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.
17O CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

E XHtBtT4 .10
FYomthe Notes to the Financial Statements
DisclosureAbout Asset of Darden Restaurants,Inc.
lmpairment in Darden
Restaurants'Notes to
the Financial In the fourth quarter of fiscal 2004,we recognized asset impairment charges of $37 million
Statements ($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
The Notes to the Financial
based on an evaluation of expected cash flows. During flscal 2005,we recognizedassetimpairment
Statementsprovide important
charges of $6 million ($4 million after-tax) for the write-down of two Olive Garden restaurants, one
information about the amounts in Red Lobster restauant and one Smokey Bones restaura.ntbased on an evaluation of expected cash
the financial statements. flows. The Smokey Bones restaurant was closed subsequentto frscal 2005while the two Olive
Garden restaurants and one Red Lobster restaurant continued to operate.

Exhibit 4.10 showsa portion of the disclosuremadeby Darden RestaurantsInc. regard-


ing its reported assetimpairment charges(losses)of $37 million in20}4 and $6 million in
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 lmprovean Assetor Extendlts UsefulLife


Expenditures
Another changein the value of an assetmay be the result of the firm spendingmoney to im-
prove its assets.Any expenditurethat will benefit more than one accountingperiod is called
A capital expenditure is a cost a capital expenditure. A capital expenditureis recordedas an assetwhen it is incurred, and
that is recorded as an asset, it is expensedor amortized over the accounting periods in which it is used'
not an expense,at the time it Just the oppositeof a capital expenditureis an expenditurethat doesnot extendthe use-
is incurred.This is alsocalled
ful life or improve the asset.Any expenditurethat will benefit only the current accounting
capitalizing a cost.
period is expensedin the period in which it is incuned. It is sometimescalled a revenueex-
penditure, although expensereally capturesits meaning in a more logical way.
Many companiesestablishpolicies that categorizepurchaseditems as capital ex-
pendituresor revenueexpenditures-expenses,often basedon dollar amounts.The ac-
counting constraint of materiality applies here so that small dollar amounts can simply
be expensed.
Remodeling and improvement projects are capital expendituresbecausethey will of-
fer firms benefits over a number of years.
. remodeling, such as a new wiring systemto increasethe efficiency of the electrical sys-
tem of a building
. improvements,such as a more energy-efficient air-conditioning system

Ordinary repairs are recognizedas current expensesbecausethey are routine and do not in-
creasethe useful life ofthe assetor its efficiency. Ordinary repairs, such as painting, tune-
ups 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.

RevisingEstimatesof UsefulLife and SalvageValue


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 ac-
counting for long-term assets,revising an estimateis not treatedlike an error-you do not
go back and correct any previous records or financial statements.Those amountswere cor-
rect at the time-because the best estimatesat that time were used for the calculation. Sup-
pose managersbelieve that a smoothly running machine will offer a useful life beyond the
C H A P TE4R. S E LLINLON
G G-TE RAMS S E TS 171

original estimate.The undepreciatedbalance-the book value of the asset-reduced by the


estimatedsalvagevalue would be spreadover the new estimatedremaining useful life. Sim-
ilarly, 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 undepreciatedbalancelike the cost of the assetat the time
of the revised estimatesand using the new estimatesof useful life and salvagevalue to cal-
culate the depreciationexpensefor the remaining years of the asset'slife.
SupposeStaplespurchaseda copy machine that cost $50,000, with an estimateduse-
ful life of 4 years and an estimated salvagevalue of $2,000. Using straight-line deprecia-
tion, a single year's depreciationis

$s0,000- $2,000 : $48,000 :


$12,000peryear
4 years 4 years
SupposeStapleshas depreciatedthe machine for 2 years.That would make the book value
s26.000.
$50,000 $i2,000 $12,000 $26,000
Cost Depreciation Depreciation = Book value
year I yezr2
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 estimated-
but now believesthe salvagevalue at the end of that time will be $1,000-not $2,000 as orig-
inally estimated.
The depreciationexpensefor the first 2 years will not be changed.For the next 3 years,
however,the depreciation expensewill be different than it was for the first 2 years.The acqui-
sition costof $50,000less$24,000of accumulateddepreciationgivesus the undepreciatedbal-
anceof $26,000.This amountis treatedas if it were now the cost of the asset.The estimated
salvagevalue is $1,000,and the estimatedremaininguseful life is 3 years.The calculationis
- 1,000
$26,000 $25,000
$8,333peryear
3 years 3 years
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 beginningof 2005,WhiteCompanyhireda mechanic to performa ma- Your .$.k-wm


Turn 4-7
jor overhaulof its mainpieceof equipmentat a costof $2,400. Theequipment
originallycost$10,000at the beginningof 2001,and the book valueof the
.\mwsm. w"m
equipmenton the December 31,2004,balancesheetwas $5,000.At the time
of the purchase, White Companyestimatedthat the equipmentwould have
a usefullife of 10yearsand no salvagevalue.Theoverhaulat the beginning
of 2005extendedthe usefullife of the equipment.WhiteCompany's new es-
timateisthat the equipmentwill now lastuntilthe endof 2012-8 yearsfrom
the date of the overhaul.Expectedsalvagevalue is still zero.White uses
straight-linedepreciationfor all of its assets.Calculate
the depreciation
ex-
pensefor White'sincomestatementfor the yearendedDecember 31,2006.

Sellinglong-TermAssets L.O.5
E xpl ai nhow the di spo salof
We have bought the long-term assetand used it-depreciating, depleting, or amortizing it
an assetis reflectedin the
over its useful life. Now, we deal with getting rid of an asset.Disposing of an assetmeans financialstatements.
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 as-
set 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
172 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

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:
Book value : Cost - Accumulated depreciation
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'sequity
Contributed + Retained
capital earnings
8,000Cash
(25,000)Equipment 500
17,500 gainon sale
Accumulateddepreciation of equipment
Now suppose,instead,you sell the assetafter 7 yearsfor $5,000 rather than $8,000.Is there
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.
: -$2,s00
- $7,s00
$s,000
Becausethe proceedsare less than the book value, there is a loss on the sale.A loss is a spe-
cial 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 as-
set for its book value.
Assets = Liabilities + Shareholder'sequity
Contributed + Retained
capital earnings
7,500Cash
(25,000)Equipment
17,500
Accumulateddepreciation
There is no gain or loss. Selling an assetfor its book value, therefore, does not affect the
income statement.
CHAPTER4. PRESENTAT I OONF L O N G - T E R MA S S E T SO N T H E F I N A N C I A LS T A T E M E N T S 173

Perry PlantsCompanyowned an assetthat originally cost $24,000.The com- Your Turn 4-8
pany sold the asseton January 1,2005, for $8,000cash.Accumulateddepre-
ciation on the day of sale was $18,000.Determine whether Perry should
Y*asr Wesvm
recognizea gain or a losson the sale.lf so, how much?

Presentationof Long-Term
Assets H,.{J.6
R ecogni zeand expl ai nh ow
on the Financial
Statements long-termassetsare
ReportingLong-Term
Assets reported on the financial
statements,and prepare
In this chapteryou have seenthat both tangible and intangible long-term assetsale recorded
financialstatementsthat
at the amount the firm paid for them. The assetsare shown on the balance sheetin the last include long-termassets.
halfofthe assetsection, after current assets.Becausethe carrying value ofproperty, plant,
and equipment (PPE) is the difference betweenthe cost of the assetand its accumulatedde-
preciation, 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,approxi-
mate 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.Remem-
ber 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 state-
ment 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 accumu-
lated 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 de-
tails for the notes to the financial statements.In anv case.vou should be able to find or cal-
culatethe cost of a firm's long-termassets.

Preparing
Statements
for Tom'sWear
Since beginning in January2006, Tom's Wear Company has now finished 3 months of busi-
ness.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 account-
ing equation worksheet in Exhibit 4.13. Then, we will make the end-of-the-month adjust-
ments 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 fi-
nancedthe $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, set-
tling the $2,000 accountsreceivableon the March 3I,2006, balance sheet.
174 ASSETS
CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A L

EXH|S|T4.11

Presentation of Long- BestBuy Co.,Inc.


Term Assets and ConsolidatedBalanceSheets(partial)
AccompanyingNote
howBestBuy
Thisshows
presents information about its
fixed assetsin the frnancial $ i,nmi,ll:ions February 25, February 26,
2006 2005
statements.
Assets
Current assets:
Cashandcashequivalents..... $ 681 $ 354
Shod-term investments 3,051 2,994
Receivables 506 375
Merchandise inventories 3,338 2,85L
Other current assets 409 329
Tota] current assets 7,985 6,903

Property and equiPment


Landandbuil d i n g s . . . . 580 506
Leasehold improvements 1,326 1,139
F'ixtures and equipment 2,898 2,458
Property under master and capital lease 33 89
4,836 4,r92
Lessaccumulateddepreciation ...' 2,124 1,728
Netproperty and equiPment'. ...' 2,712 2,464
Goodwill DD/ 513
Thadename M 40
Long-term investments 218 148
Other assets 848 226
Total assets $i1,864 $1-d,t0a

Transaction4Tom'sWearfoundseveralsportinggoodsstoresto buy its shirts,sothe


firm mustdramaticallyincreasetheinventory.Tom'sWearpurchases 1'000T-shirts
at $4 eachon account.
Transaction5Tom'sWearrenteda warehouse in whichto storeits inventory.On April
15,thecompanypaid $2,400for 2 months rent.
of

EXHIBIT4,12
BalanceSheetfor Tom's Tom's Wear, Inc.
Wearat March31,2006 Balance Sheet
At March 31, 2006

Liabilities and Shareholder's Equity

Current assets Current Iiabilities


Cash .. $ 3,995 I n t e r e s t p a y a b l e. . . . . . . . . . $ 30
Accountsreceivable ...... 2,000 Notespayable .... 3,000
Inventory. 300 Totalcurrentliabilities....... 3'030
........
Pre p a i d i n surance 75 Shareholder's equity
Total current assets 6,370 Common stock . . 5,000
Computer (net of $100 Retained eamings.
accumulated Total shareholder'sequity ....
depreciation) ..... 3,900
Total liabilities and
Total assets . $10,270 shareholder's equity. .. .... $10,270
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176 CHAPTER4 . 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

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 depreciatedat $100 per month.
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 ($29,000depreciablebasedivided
by 200,000miles). The depreciationexpensefor April is $0.145per mile X 5,000
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 ApplyingYourKnowledge-RatioAnalysis
Usereturnon assets (ROA)
andthe assetturnoverratio You know how a firm recordsthe purchaseoflong-term assetsand how it accountsfor the
to helpevaluatea firm's use of the assets.Now we will look at how you can use the information about long-term as-
performance. setsto help evaluatethe performance of the firm.

Returnon Assets
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 account-
ing, the name of this ratio is descriptive.A company's return is what the company is get-
ting back. We want to measurethat return as a percentageof assets.So return on assetsis
literally return-net income--divided by assets.

Net income * Interest expense


Return on assets _
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
a a ro
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177
EXHTB|T4.15
FinancialStatementsfor Tom'sWear
The arrows should help you seethe relationships between the financial statements.

lom'swGal

Tom's Wear,Inc. Tom's Wear,Inc.


Income Statement Statement of Changesin Shareholder's Equity
For the Month Ended April30 For the Month Ended April 30

Sales revenue $8,000 Common stock


Costsofgoods sold . . . 3,200 Beginning balance $5,000
Gross profit 4,800 +N e w s t o c k i s s u e d . . . . : : : : : :
Other expenses Ending balance $ 5oo0o
Insura nce ...... $ 50 Retained earnings
Ren t . ......... 600 Beginningbalance.... $2,240
Depreciation 825 + Net income 2,745
Interest 280
Other operating expenses . . 300 2,055 4,985
Net income vJ45 shareholder's equity. . . . $9,985

Tom'sWear,Inc. Tom's Wear,Inc.


Statementof CashFlows Balance Sheet
For the Month EndedApril 30 AtApril30

Cash from operating activities


Cash collected from customers $ 2,000 Cash . $3,295
Cash paid for operating expenses (2,700) 8,000
Net cash from operating activities (700) Inventory 1,100
Cash from investing activities 0 Prepaid insurance 25
Cash from ffnancing activities 0 Prepaid rent 1,800
Net increase (decrease) in cash (700) Total cr-urent t4,220

Add begiruring cash balance & equipment (net of $925 accumulated


Ending cash balance depreciation) 33,075
Total assets $47,295
LiabiHties & Shareholder's Equity
Liabilities
A c c o u n t s p a y a b l e. . . . . 4,000
Interestpayable .... 310
Short-term notes payable 3,000
Tota] current liabilities 7,310
Long-term notes payable 30,
Shareholder's Equity
Common stock
Retained earnings 4,985
Total liabilites and SH equrf . $47,295

174
CH A P T E R 4. A P P L Y I N GY O U R K N O WL E D G E - R A T I OA N A L Y S I S 179

EXHIBIT4.16
Apple Computer,Inc. Dell,Inc. Returnon Assets
For the year ended For the year ended for AppleComputer
September 24,2005 February 3, 2006 a n d De ll

(dnllus

Net income
inmi,lliore)

plus interest expense


A vera ge Assets.....
$ 1,335
$ 9,800
.... $ 3' 600
. . .. $23,162
mf
Retum onAssets. .. . 13.620/o L5.540/o

part of what has been earned to pay creditors, it is added back to the numerator. Net in-
come 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 av-
eragetotal assets.
Using a ratio such as ROA gives financial statementusersa way to standardizenet in-
come acrosscompanies.Exhibit 4.16 provides an example. For the fiscal year ended Sep-
tember24,2005, Apple Computershad a net income $1,335and averageassetsof $9,800
(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 com-
pany is using its assetsto make that net income. If we divide net income plus interest ex-
penseby averagetotal assets,we will get the return on assetsfor the year.
It is clear in this comparisonthat Dell is earning a better return with its total assetsthan
Apple Computer is earning with its assets.The industry averagefor firms in this industry
for return on assetsis 12.6%o. Apple's ROA is 13.62Voand Dell's ROA is 15.54Vousing the
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.

AssetTurnoverRatio
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?

Net sales
Asset turnover ratio :
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
in millions) AppleComputer D el l

S ales $13,931 $ss,908


Average Assets $9,800 $23,152
AssetTurnover Ratio 1.42 2.41
180 CHAPTER4 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

Asset turnover ratios vary signif,rcantlyfrom industry to industry, so it is important to com-


pare 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 com-
pared to the ratios from other years with the same company or with other companies.In-
dustry standardsare also often available for common ratios to help investors and analysts
evaluatea company's performanceusing ratio analysis.

I".f).8 Business
Risk,Control,and Ethics
l dent if yand des c ri b eth e
businessrisksassociated A firm risks losing long-term assetsdue to theft. This risk is not a problem with some large
with long-term assetsand assets,such as a factory, but it is a very seriousproblem with smaller, mobile, fixed assets,
the controlsthat can such as cars,computers,and furniture and fixtures. Even large assets,such as buildings and
minim iz et hos e r is k s . 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 assetsfrom
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 com-
plex overnight. Even when assetsare protectedin a securefacility with guards,fences,
or alarms,the company must be sure that only the appropriatepeople have accessto the
assets.
Complete and reliable record keeping for the assetsis also part of safeguardingas-
sets. 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 phys-
Segregationof duties means ical custody of the assets.This is called segregation of duties and is a very common
that the person who has control.
physicalcustody of an assetis
Monitoring is another control to safeguardassets.This means that someoneneedsto
not the samepersonwho has
record-keepirrg make sure the other controls-physical controls, segregationof duties, and any other poli-
responsibilities
for.that asset. cies 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 re-
sponsibilities.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.

'hawefhsA
Googleisscanning of booksin an effortto advance
millions its missionto organize all
knowledge; but in 2005,someauthorsand publishing companies suedGooglefor
copyright infringement. Theargumentis not overthe bookspublishers currently keep
in print;it isoverthe25 millionbooksconsidered "orphans."
lt isverydifficult
to track
downtheownerof thecopyright JaneFriedman, theCEOof HarperCollins Publishers,
doesnot expectthislawsuitto be settledin herlifetime. ButKevinKelly, in a NewYork
Irmesarticle(May14,2006),feelssurethat the technology willwin out. He predicts
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C H A P T E R 4. C H A P T E RS U M M A R Y P R O B L E M S 181

Points
ChapterSummary
. Assetsthat last longer than a year are classified as noncuffent (or long term) on the bal-
ance sheet.They are recordedat cost, including all of the costsnecessaryto get the as-
set ready for use.
. Long-term assetsare written off over their useful lives. For plant and equipment,an as-
set may be written off using either straight-line, activity, or double-declining balance
depreciation methods. Intangible assetswith a definite life are written off, or amor-
tized, using the straighrline method.
. Routine repair and maintenancecostsare expensedas incurred, whereasimprovements
to the productive capacity or the useful life of an assetare capitaTizedas part of the cost
of the asset.
. Any revisions in the useful life or the estimated salvagevalue of an assetare imple-
mented at the time of the revision and in the future periods. Any past depreciationex-
penseis 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.

ChapterSummary
Problems
SupposePencilsOffice Supply startedthe fiscal yearwith the following accountsandbalances:

Balancesat January1, 2008


Account
Cash $390,000
Accountsreceivable 136,000
Inventory 106,350
Prepaidins ur anc e 3,000
Eq uipm ent 261,000
Ac c um ulat eddep re c i a ti o n -E q u i p me n t (7s,800) ss0
$820,
Accountspayable 26,700
pay able
Sa lar ies 13,500
Unear nedr ev enu e 3s,000
Long-termnote payable 130,000
Ot her long- t er ml i a b i l i ti e s 85,000
Commonstock 2s0,000
Ret ainedear ning s 280,350 $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 in-
voice 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 equip-
ment while in transit. Installation cost was $3,000, and Pencils spent $6,000 train-
ing 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
accumulateddepreciationof $11,100.Proceedsfrom the saleamountedto $1,500.
3. The comDanvcollectedcashof $134.200on accountsreceivable.
142 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

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.
6. The companypaid $170,000on accountspayable.
7. The company paid employees total cash for salaries of $72,250. (This includes the
amountowed at the beginning of the year and the salaryexpensefor the new supervisor.)
8. 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.
9. The company paid $50,000 to reduce principal of the long-term note and paid interest
of $10,400.
10. Thecompanypaidoperating
expenses
in theamountof $30,000in cash.

Otherlnformation
A-1. The company owed salariesof $10,250 to employees at year-end (earnedbut not
paid).
A-2, Insuranceleft unused at year-endamountedto $2,000.
A-3. The company estimatesthat the new equipmentwill last for 20 years and have a sal-
vage value of $2,945 at the end of its useful life.
A-4. Previously purchasedfixed assetsare being depreciatedat a rate of lOVoper year.
A-5. 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.
C H A P T E 4R . C H A P T E RS U M M A R Y P R O B L E M S 183

Solution

Pencils Office Supply


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

Sales revenue $375,570


Cost of goods sold 1f 0,000 Commonstock
Grossprofit ZAS,SZO Beginningbalance ..... $250'000
Gain on sale of asset 300 + New contributions .....
Other expenses Ending balance $25fr,000
Insuranceexpense ... $ 13,000 Retained earnings
Salariesexpense 69,000 Beginning balance $280,350
Depreciationexpense 32,970 110,500
Interestexpense..... 10,400 - Dividends
Otheroperatingexpense...... 30,000 (155,370) inglSSlance si]90,860
Net income $110,500 Total shareholder's equity $ 640,850

Pencils Offlce Supply Pencils Office Supply


Statement of Cash Flows Balance Sheet
For the Year Ended December 31, 2008 At December 31, 2008

Cash faom operating activities Assets


Cashcollectedfrom customers $ 334,200 Cash $ 16,105
Cashpaid to vendors . (370,000) Accountsreceivable / t56,370
Cashpaid for insurance (12,000) Inventory 361,850
Cashpaid to employees (72,250) Prepaidinsurance 2,000
Cashpaid for interest (10,400) Total current assets . 536,325
Cashpaid for other operatingexpenses (30,000) Equipment(net of $97,670
Net cashfrom (usedfor) operatingactivities (160,450) depreciation) 315,975
Cash from investing activities
Proceedsfrom saleof equipment 1,500 Total assets $ 852,300
Cashpaid for purchaseof equipment (164,945) Liabilities & S
Net cashfrom (usedfor) investingactivities . . . (163,445)
Cash from ffnancing activities 22,200
Cashpaid on long-termnote payable (50,000) 10,250
Increase(decrease)in cash during the yeax . . . . (373,895) 14,000
Add begirmingcashbalance 390,000 Tota.lcurrent liabilities 46,450
Cash balance at April 30 $16, 10 5 , Long-termnotespayable 80,000
Other lons-termliabilities
Shareholder's Equity
Common stock . 250
Retainedeamings ... .?$0,{450
Total l i abi l i ti esandS H equi ty ..... $852,300
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C H A P T E4R . A N S WE R ST O Y O U R T U R N Q U E S T I O N S 185

KeyTermsfor Chapter4
Accelerateddepreciation Declining balance Relative fair market value
(p.rca) depreciation(p. 164) method(p. 156)
Activity method Depletion(p. 158) Salvagevalue (p. 159)
depreciation(p.162) Depreciation(p. 158) Segregationof duties
Amortization (p. 158) Franchise(p. 168) (p. 180)
Capital expenditure Goodwill (p. 168) Straight-line depreciation
(p. 170) Impairment(p. 169) (p.1se)
Capitalize (p. 158) lntangibleassets(p. 155) Tangibleassets(p. 155)
Copyright(p.16l) Patent(p. 168) Trademark (p. 168)

Answersto YOUR
TURNQuestions
Chapter4
Your Turn 4-I
1. Expense
2. Asset
3. Asset
4. Expense
Your Turn 4-2
Four-fifthsofthe costs(400,000/500,000 X $480,000): $384,000shouldbe recordedas
thecostof thebuilding,andone-fifthof thecost( I 00,000/500,000 : $96,000
X $480,000)
shouldberecordedasthecostof theland.Thesetwo costsneedto be separatedbecausethe
companywill depreciate thebuildingbut not the land.
Your Turn 4-3
1. Depreciation
2. Depreciation
3. Depletion
Your Turn 4-4
Eachyear'sdepreciation is $2,400[($15,000- $3,000y5years]peryear,sothatamount
will be on the incomestatement for the yearendedDecember31, 2001. At December31,
2007, thecompanywill havetaken2 years'worth of depreciation, so the book valuewill
be$10,200 ($15,000- $4,800).
Your Turn 4-S
Rate: ($44,000- $4,000)+ 100,000: $0.40perunit
2005:3,000unitsx $0.40: $1,200
2006:14,000unitsx $0.40= $5,600
Your Turn 4-6
$50,000x 215: $20,000for thefirst year
Newbookvalue: $50,000- $20,000: $30,000
$30,000x 215: $12,000for thesecondyear
Your Turn 4-7
$6,000+ $2,400: $8,400newdepreciable amount
$8,400/8yearsremaininglife : $1,050peryear
Your Turn 4-8
Thereis a $2,000gainon the sale.Theproceedsof $8,000aregreaterthanthe bookvalue
of $6.000.
186 CHAPTER4 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

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 purchasecre-
ate, 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 mar-
ket 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 accumulateddeprecia-
tion 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?On which financial state-
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 safeguardassets.

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. Supposea firm buys a piece of land with a building for $100,000.The firm's accoun-
tant 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 R. S H OR T
C H A P TE E 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 separatedfrom accumulateddepreciation after the
first year.
6. 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. Expensedin the period ofthe reparr
d. Presentedon the income statementor in the notes
7. 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)
8. When a company's balance sheet shows goodwill for $300,000, what does that
mean?
a. The companyhas developeda strongreputationvaluedat $300,000ifthe
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.
9. Supposea firm purchasedan assetfor $100,000and estimated,on the dateofthe pur-
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
much depreciationexpensewill the firm recognizein the sixth year of the asset'slife?
a. $12, 500
b. $10, 000
c . $11, 111
d. $31, 111
10. Supposea firm purchasedan assetfor $50,000and depreciatedit using straight-line
depreciationfor its l0-year usefullife, with no salvagevalue.At the end of the seventh
year ofuse, the firm decidedto sell the asset.Proceedsfrom the sale were $17,500.
What was the gain or loss from the sale of the asset?How did the sale affect the state-
ment 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

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 expensesassociatedwith purchasingthis machtne.

Delivery charge $2,850


Installation 2,500
Power to run the machine for the first year 450

What amount should Gruber record on the books for this machine?
AND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

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 $110,000


Labor costs (including architect's fees) 205,000
Rental of equipment used in the construction 9,000
Maintenanceon the building from Sept. 15 to Dec. 31 14,000

What amount should Settler Company record on the books for its new building?

SE4-3.Accountfor basketpurchase.(LO 1)
Tylo Corporation obtained a building, its surrounding land, and a delivery truck in a lump-
sum purchasefor $230,000.An appraisalsetthe value of land at $180,000,the building at
$145,000,and the truck at $25,000.At what amountshouldTylo record eachnew asseton
its books?

SE4-4.Accountfor basketpurchase.(LO 1)
Villa Corporation purchasedthree buildings at a total cost of $960,000.The appraisedval-
ues of the individual buildings were as follows:

Building I $600,000
Building 2 400,000
Building 3 200,000

What amounts should be recorded as the cost for each of the buildings in Villa Corpora-
tion's accounts?

SE4-5. Calculate depreciation expense:straight-line. (LO 2)


Calculatethe annualstraight-linedepreciationexpensefor an assetthat cost $12,000,hasa
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 12,000
Year 2 10,500
Year 3 9,100
Year4 9,100
Year 5 8,700

SE4-7. Calculatedepreciationexpense:double-decliningbalance.(LO 2)
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?

SE4-9. Calculatedepreciationexpense:straight-line.(LO 2)
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?
4 . S H O R TE X E R C I S E S 1 8 9
CHAPTER

SE4-10.Determinethe usefullife of an asset.(LO 2)


Supposean assetcost $20,000and has an estimatedsalvagevalue of $2,000.At the end of
3 years,the carrying value of the assetis $11,000.What is the useful life of the asset?As-
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 op-
erations,the company extracts750,000 tons of copper.How much depletion should Earth-
link Mining record for the first year?

SE4-13.Amortizationof intangibleassets.(LO 3)
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 engi-
neershave 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?

SE4-14.Amortizationof intangibleassets.(LO 3)
Barclay Companypurchaseda patentfor $50,000on JanuaryI,2007 . The estimateduse-
ful life is 10 years.The legal life is 20 years.What is the amortization expensefor the fis-
cal year endedDecember31,2007?

SE4-15.Analyzerevenueand capital expenditures.(LO 4)


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
c. Paid $6,000for repairsthat will extendthe asset'suseful life
d. Purchaseda patentfor $5,000cash
e. Purchaseda machinefor $10,000and gavea2-year note
f. Paid $50,000 for an addition to a building
g. Paid $1,000for routine maintenanceon a machine

SE4-16. Analyze revenueand capital expenditures.(LO 4)


Categorizeeach of the following as a capital expenditure or a revenue expenditure (ex-
pense)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

SE4-17. Calculatedepreciationexpensewith changein estimateof salvagevalue.(LO 4)


On Januaryl,2OO7, the Lance Corporationpurchaseda machineat a cost of $55,000.The
machine was expectedto have a useful life of 10 years and no salvagevalue. The straight-
line depreciationmethod was used. In January 2009, the estimate of salvagevalue was re-
vised 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?
I ]: 190 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

SE4-19.Accountfor disposalof an asset.(LO 5)


A machineis purchasedon January2,2005, for $100,000.It has an expecteduseful 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
$100,000,had an estimateduseful life of l0 years,and had no estimatedsalvagevalue.It
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 associatedwith long-term assetsand somepos-
sible 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 depreciationdo firms usefor taxes?Explain.Why would the IRS allow such
depreciation?
Exercise-SetA
E4-1A. Accountfor basketpurchase.(LO I,2)
Coca-Colapurchasesa building and land for $180,000.An independentappraiserprovides
the following market values:building-$ 150,000;land-$50,000.
a. How much of the purchaseprice shouldCoca-Colaallocateto eachof the assets?
b. Ifthe building has a useful life of 10 yearsand an estimatedsalvagevalue of
$35,000,how much depreciationexpenseshouldCoca-Colarecordeachyear
using the straight-linemethod?
c. Using the double-decliningbalancemethod,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)


CoronaCompanypurchasedland 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 ex-
penditures.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 estimateduseful life of 7 yearsor 210,000miles. Best-Goodsestimatedthe
C H A P T E R 4. E X E R C I S E S 1 9 1

truck's salvagevalue 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 meth-


ods. (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 estimatedproduc-
tivity 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;
andYear 5-7,500 units. Completea separatedepreciationschedulefor eachof the three
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 de-
preciation 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 esti-
mated useful life is 5 years and the estimated salvagevalue is $5,000. The estimatedpro-
ductivity is 150,000units.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
192 CHAPTER4 . 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

record for its annual amortization expense?Show how it would be recordedin the account-
ing 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 '147s dte to a poten-
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 po-
tential 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?

E4-124. Distinguish betweencapital and revenueexpenditures(expenses).(LO 1, 4)


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-


tion expense.(LO 2,4)
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 over-
haul 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 over-
haul cost $10,000.(Originally, the machinecost $60,000,had a salvagevalue of $4,000,
and had an estimateduseful 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 statementsfor years 7
through 10?

E4-14A. Accountfor capital and revenueexpenditures(expenses)and calculate deprecia-


tion expense.(LO 2,4)
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 $115,000
Accumulated depreciation 20,000
4 R. E X E R C IS E S 193
C H A P TE :"

During 2006,the following costswere incurredfor repairsandmaintenanceon the equipment:

Routine maintenanceand repairs $ 650


Major overhaul of the equipment that improved efficiency 22'000

The companyusesthe straightJine method, and it now estimatesthe equipmentwill last for
a total of 11 yearswith $5,000estimatedsalvagevalue.The company'sfiscal year endson
December31.
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-yearuse-
ful life and a salvagevalue of $4,000.
a. If Zellwiger sells the van after 3 years for $20,000, would the company realize a
gain or loss?How much? (Assumestraight-linedepreciation.)
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)


Troy Wilson Athletic Gear purchaseda packagingmachine4 years ago for $18,000.The
machinery was expectedto have a salvagevalue of $2,000 after an 8-year useful life. As-
suming straight-line depreciationis used, calculatethe gain or loss rcaTizedif 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 com-
pany provide the following information:

Delivery truck $38,000


Accumulated depreciation 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
$40,000 and had associatedaccumulateddepreciationof $29,000.Calculatethe gain or loss , :l
on the disposalofthe oven for eachofthe following situations:
a. The companysold the oven to a homelessshelterfor $8,000.
l
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 accumulateddeprecia- , ', ' ,,,',
tion of $9,000.If the cashproceedsfrom the salewere $7,000,what was the gain or loss on , r,, , r,
L.,.

..: . ,.
,,,
r: , . , , . ,
194 CHA P T E4R . A C QU ISIT IoAN
N D U s Eo F L o N G-TE R M
oP E R A TIoN AALssE 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?

E4-20L. Preparefinancial statemenrs.(LO 6)


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 assetsof $ l 2,500
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 fol-
lowing 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 as-
sets,and how is the f,rrmcontrolling those risks?
Exercise-SetB
E4-lB.Accountfor
basket (LO 7,2)
purchase.
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?

E4-28. Calculate the cost of an assetand depreciation expense.(LO 1,2)


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 build-
ing were $45,000.
Use the accountingequationto record the purchaseofthe property,including all related ex-
penditures.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 an $11,875estimatedsalvagevalue 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 meth-


ods. (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 un-
der 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 es-
timated 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 mar-
ket 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
195 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L SSETS

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?

F,4-12ts.Distinguish betweencapital and revenueexpenditures(expenses).(LO 1, 4)


Classifythe following items aseithera capitalexpenditureor a revenueexpenditure(expense).
a. Changedthe hlter in the moving van
b. Paintedthe movingvan
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-


tion expense.(LO 2,4)
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 re-
placing 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-linemethodof depreciation,how much
depreciationexpensewill be reported on the income statementsfor years six
through ten?

E4-148, Accountfor capital and revenueexpenditures(expenses)and calculate deprecia-


tion expense.(LO 2,4)
Global Electronics operatesa manufacturingplant for production of its products.At the be-
ginning of 2008, the accountingrecordsfor the company showedthe following balancesfor
its only piece of equipment,purchasedat the beginning of 2005:

Equipment $94,000
Accumulated depreciation 54,000

During 2008, the following cash costs were incurred for repairs and maintenanceon the
equipment:

Routine maintenanceand repairs $ 575


Major overhaul of the equipment that improved effrciency 30,000

The companyusesstraight-linedepreciationand estimatesthe equipmentwill last for 5 years


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?

F,4-15B..Account for disposal of an asset.(LO 5)


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 com-
pany expectsthe machine to have a salvagevalue of $4,000 after a l0-year useful life. As-
suming 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)


Kat & Jen's Solar Tan disposedof a high-pressuretanning bed that had been used in the
businessfor 3 years.The records of the company provide the following information:

High-pressuretanningbed $39,000
Accumulateddepreciation 18,000

Calculate the gain or loss on the disposalof the tanning bed for each of the following inde-
pendentsituations:
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
businessfor 5 years.The vacuumoriginally cost $51,000and had associatedaccumulated
depreciationof $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 accumulateddeprecia-
tion of $30,000.If the cashproceedsfrom the salewere $4,000,what was the gain or loss
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?

E4-20B. Preparefinancial statemenrs.(LO 6)


For each of the following, give the financial statementon which it would appear.
a. Book value of fixed assetsof $56,900
b. Proceedsfrom sale of fixed assetsof $20,000
c. Loss on saleof fixed assetsof $12,500
d. Accumulated depreciationon equipment of $10,000
e. Depreciation expenseon equipment of $2,000
f. Impairment write-down on assetsof $45,000
198 CHAPTER4 . ACQ UI SI TI O NAND USEO F LO N G - T E R MO P E R A T I O N A A
L SSETS

Fl4-21B. Calculate return on assetsand asset turnover ratios. (LO 7)


Using the Office Depot annualreport from the website that accompaniesthis text, calculate
the following ratios for the most recent fiscal year and explain what each measures:
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
P4-lA. Calculatecapitalizedcost and depreciationexpense.(LO 1,2)
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 insur-
ancepolicy to coverthe presswhile in transit.Installationcostwas $1,350,andAcme spent
$3,000 training the employeesto use the new press.Additionally, Acme hired a new super-
visor at an annual salary of $65,000 to be responsiblefor keeping the press online during
businesshours.

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
$170,000.The estimateduseful life of the equipmentis 4 years,and the estimatedsalvage
value is $10,000.The company expectsthe equipment to produce 480,000 units during its
service life. Actual units produced were:

Year Units
200'7 100,800
2008 130,080
2009 139,200
20to r09,920
Required
a. Calculate the depreciationexpensefor each year ofthe 4-year life ofthe
equipment using
1. StraighGlinemethod
2. Double-decliningbalancemethod
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 es-
timated 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 | ,.r 1;;'_
:.:':::,:-.
,' . , I -r:
- .

T.:I I-
C H A P T E R 4. P R O B L E M S 199

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. purchaseda new machineat the beginningof 2006 for $6,400.The companyex-
pectsthe machineto last for 5 yearsand have a salvagevalue of $400. The estimatedpro-
=,"#;,:,i"7T.I,;f;;,
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
a. Calculatethe depreciationexpensefor eachyear ofthe 5-yearlife ofthe machine
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.

P4-5A. Accountfor intangibleassers.(LO 3)


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 re-
maining useful life of 7 years.

Patents $35,000
Copyright 21,000
Goodwill 40.000

Transactionsduring the year:


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

Required
Show each of the transactionsin the accounting equation, including any adjustmentsthat
would need to be made for the year-endfinancial statements.Then, preparethe intangible
assetssectionof the balancesheetat year-end.

P4-6A. Account for change in estimatesfor depreciation. (LO 4)


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
$ 1.000at thattime.
200 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO p E R A T T O N AALS S E T S

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 depreciationexpenserelatedto 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 estimateduseful 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


asset.(LO 2,5)
Bella Interiorspurchaseda new sewingmachineon JanuaryZ,2007,for 948,000.The com-
pany 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-decliningbalancemethod
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


asset.(LO 2,5)
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?
C H A P T E R 4. P R O B L E M S 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 informa-
tion processingand some effors were made in accountingfor certain transactions.Evaluate
the following independentsituations that occurred during the year:
a. At the beginning of 2006, a building and land were purchasedtogether for
$100,000.Even though the appraisersdeterminedthat9}Vo of the price shouldbe
allocated to the building, Umpire's decided to allocate the entire purchaseprice
to the building. The building is being depreciatedusing the straight-line method
over 40 years,with an estimatedsalvagevalue of $10,000.
b. During the year, Umpire did some R&D on a new gadget to keep track of balls
and strikes. The R&D cost $20,000, and Umpire capitalizedit. The company
intends to write it off over 5 years,using straight-line depreciationwith no
salvagevalue.
c. Near the beginning of the year, Umpire spent$ 10,000on routine maintenance
for its equipment, and the accountant decided to capitalize these costs as part
of the equipment.(Equipmentis depreciatedover 5 yearswith no salvage
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:
net income,long-termassets,and retainedearnings.If thereis no error, simply
write N/A next to the item.
b. Describethe adjustmentsthat 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
P4-18. Calculatecapitalizedcost and depreciationexpense.(LO 1,2)
The executivesfor SeaWorld bought a piece of property adjacentto the park with an old,
run-downmotel. The cost of the land with the old motel was $1,500,000.Real estatecom-
missions and fees including the title searchwere $317,850.SeaWorld paid its attorney
$15,000to review the contractand completethe purchaseofthe land on July 1, 2008.The
resortpaid $25,750for the old motel to be demolishedand an additional$17,850for sugar
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
202 CHAPTER4 . ACQ UI SI TI O NAND USEO F LON G - T E R MO P E R A T I O N A A
L SSETS

of its useful life of 4 years.A machine like this is supposedto deliver 160,000hours of ser-
vice. The actual number of hours that the machine was used per year was:
Year Hours
2005 40,000
2006 60,800
2001 39,200
2008 20,000

Required
a. Calculatethe depreciationexpensefor eachyear ofthe 4-yearlife ofthe ball
machine using
1. Straighrline method
2. Activity method
3. Double-decliningmethod
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'sCandyCompanypurchasedan automateddisplayrack on January1, 2008,at a cost
of $35,000.The companyestimatesthe displayrack has a useful life of 5 yearswith a sal-
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. purchaseda new water fllter at the beginningof 2010 for $200,000.It is
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 2011-
29,000 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.

P4-5B. Accountfor intangibleassefs.(LO 3)


Larkin Company had the following balancesin its intangible assetaccountsat the begin-
ning of the year. The trademarkshave a remaining useful life of 5 years, and the copyright
has a remaininguseful life of 10 years.

Trademarks $85,000
Copyright 50,000
Goodwill 80.000
C H A P T E R 4. P R O B L E M S 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
would need to be made for the year-endfinancial statements.Then, preparethe intangible
assetssectionof the balancesheetat year-end.

P4-6B. Accountfor changein estimatesfor depreciation.(LO 4)


In July 2006, Hallmark Company purchaseda computer systemthat cost $7,000.The com-
pany estimatesthat the systemwill last for 5 yearsand will havea salvagevalue of $2,000.
The company usesthe straightline method of depreciation and has a June 30 fiscal year-
end.Analyze eachof the following independentscenarios.
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 depreciationexpenseis recordedfor the fiscal year endedJune 30,2009,
Hallmark decidesthat the computersystemwill last until June30,201I but that
it will be worth only $1,500at that time.
d. Before depreciationexpenseis recordedfor the fiscal year endedJune 30,2009,
Hallmark's computerexpertsdecidethat the systemcan be useduntil June30,
2013 if the companyspends$1,000on upgrades.However,the estimatedsalvage
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.
b. A copy machinethat cost $35,000had an estimateduseful life of 5 yearsand a
salvagevalue of $5,000. After 2 yearsof using double-decliningbalance
depreciation,the companysold the copy machinefor $10,000.
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.
204 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A L
ASSETS

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


asset.(LO 2,5)
The Queen GrandeView Hotel purchaseda van 3 years ago for $62,000.The company ex-
pects 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 statementsfor the year?
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 statementsfor the year?
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 capitalizedowas $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.
C H A P T E4R . F I N A N C I A LS T A T E M E N T
ANALYSIS 205

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-termassetson the balancesheet.(LO 6)
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 BalanceSheetof The Home Depot, at
( dollar sin m ill i o n s ) January 29 January
30
2006 2005
Propertyand Equipmentat cost:
Land 7,924 6,932
B uildings 14,056 12,325
F ur nit ur e,F ix tu re sa n d Eq u i p m e n t 7,073 6,195
Leaseholdlmprovements 1,207 1,191
Constructionin Progress 843 1,404
CapitalLeases 427 390
31,s30 28,437
LessAccumulatedDeoreciationand Amortization 6,629 5,711
Net P r oper tya n d E q u i p me n t 24,901 22,726

FSA4-2.Analyzelong-termassetson the balancesheet.(LO 6)


Information from the 2005 Sony Annual Report is given here.
Fromthe Sony CorporationBalanceSheetsat March 31
D ol l arsi n mi l l i ons
Ye n in mi l l i ons (Note 3)
2004 2005 200s
P r oper t yplan
, tand equipment
( Not es9 and 1 2 ):
Land 189,785 182,900 1,709
B uildings 930,983 925,796 8,652
M ac hiner yand e q u i p me n t 2,0s3,08s 2,192,038 20,486
Constructionin progress 98,480 92,611 866
3,272,333 3,393,345 31,713
Less-Accumu lated depreciation 1,907,289 2,020,946 18,887
1,365,044 1,372,399 12,826
I nt angibleas se ts
G oodwill,net 299,024 283,923
I nt angiblesne
, t 307,O34 187,024
206 CHAPTER4 . ACQ UI SI TI O NAND USEO F L O N G - T E R MO P E R A T I O N A A
L ssETS

From the Notes to the Financial Statements


Property, Plant and Equipment and Deprecintion
Property,plant and equipmentare statedat cost.Depreciation ofproperty, plant and equip-
ment is primarily computed on the declining-balance methodfor Sony Corporation and
Japanesesubsidiaries,exceptfor certain semiconductormanufacturingfacilities whosede-
preciation is computedon the straight-line method,and on the straight-Iine methodfor for-
eign 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 ma-
chinery and equipment.Significant renewalsand additions are capitalized at cost. Mainte-
nance 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 other-
wise 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?
c. Are any ofthe assetslisted as property,plant, and equipmentnot being
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 accumulateddepreciationrepresents.
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.

FSA4-3.Analyzelong-termassetson the balancesheet.(LO 2,3,5,6)


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?

CriticalThinkingProblems
Riskand Control
Whatkindsof risksdoesa firm like OfficeDepotfacewith respectto safeguarding its as-
sets?Whattypesof controlsdoyou thinkit alreadyhasin placeto minimizetheserisks?Are
anyspecificcontrolsmentionedin the 10-Kreportprovidedon thewebsitefor thisbook?
C H A P T E4R . I N T E R N E TE X E R C I S EB:E S TB U Y 207

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 of-
ten 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 be-
havior 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.

BestBuy
lnternetExercise:
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?
d. Are any ofthe assetslisted not being depreciated?
lE4-2. Use the notes to financial statementsto 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?
b. Find the headingGoodwill. What type of an assetis goodwill? Does Best Buy
write off this asset?Explain what the company does.
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
fiscal year did the company make best use of its assets?How can you tell?
Appendix
4
Depreciation
andTaxes

I.$ " 9 Depreciation and Tbxes


Ex plainhow depr e c i a ti o n
for financialstatements The accounting information a company presents on its flnancial statements is not the same
differsfrom depreciation information the company reports to the IRS on its federal income tax retum. The company
for taxes. 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).
With a tax rate of 25o/o, the 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