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第11章550-570页




第11章550-570页

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Chapter 1 1 Depreciation, Impairments, and Depletion Even though the net effects are equal in amount, the deferral of income tax payments under MACRS from early in the life of the asset to later in life is desirable. The different amounts of depreciation for income tax reporting and financial GAAP reporting in each year are a matter of timing and result in temporary differences, which require interperiod tax allocation. (See Chapter 19 for an extended treatment of this topic.)

Optional Straight-Line Method
An alternate MACRS method exists for determining depreciation deductions. Based on the straight-line method, it is referred to as the optional (elective) straight-line method. This method applies to the six classes of property described earlier. The alternate MACRS applies the straight-line method to the MACRS recovery periods. It ignores salvage value. Under the optional straight-line method, in the first year in which the property is put in service, the company deducts half of the amount of depreciation that would be permitted for a full year (half-year convention). Use the half-year convention for homework problems.

International Insight In Switzerland, depreciation in the financial statements conforms to that on the tax returns. As a consequence, companies may depreciate as much as 80% of the cost of assets in the first year.

Tax versus Book Depreciation
GAAP requires that companies allocate the cost of depreciable assets to expense over the expected useful life of the asset in a systematic and rational manner. Some argue that from a cost-benefit perspective it would be better for companies to adopt the MACRS approach in order to eliminate the necessity of maintaining two different sets of records. However, the tax laws and financial reporting have different objectives: The purpose of taxation is to raise revenue from constituents in an equitable manner. The purpose of financial reporting is to reflect the economic substance of a transaction as closely as possible and to help predict the amounts, timing, and uncertainty of future cash flows. Because these objectives differ, the adoption of one method for both tax and book purposes in all cases would be unfortunate.

KEY TERM
Modified Accelerated Cost Recovery System (MACRS), 547

SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 11A
8. Describe income tax methods of depreciation. Congress enacted a Modified Accelerated Cost Recovery System (MACRS) in the Tax Reform Act of 1986. It applies to depreciable assets placed in service in 1987 and later. The computation of depreciation under MACRS differs from the computation under GAAP in three respects: (1) a mandated tax life, which is generally shorter than the economic life; (2) cost recovery on an accelerated basis; and (3) an assigned salvage value of zero. Note: All asterisked Questions, Exercises, Problems, and Concepts for Analysis relate to material contained in the appendix to the chapter.

QUESTIONS
1. Distinguish between depreciation, depletion, and amortization. 2. Identify the factors that are relevant in determining the annual depreciation charge, and explain whether these factors are determined objectively or whether they are based on judgment. 3. Some believe that accounting depreciation measures the decline in the value of fixed assets. Do you agree? Explain. 4. Explain how estimation of service lives can result in unrealistically high valuations of fixed assets. 5. The plant manager of a manufacturing firm suggested in a conference of the company’s executives that accountants should speed up depreciation on the machinery in the finishing department because improvements were rapidly making those machines obsolete and a depreciation fund big enough to cover their replacement is needed. Discuss

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the accounting concept of depreciation and the effect on a business concern of the depreciation recorded for plant assets, paying particular attention to the issues raised by the plant manager. 6. For what reasons are plant assets retired? Define inadequacy, supersession, and obsolescence. 7. What basic questions must be answered before the amount of the depreciation charge can be computed? 8. Elizabeth Ashley Company purchased a machine on January 2, 2006, for $600,000. The machine has an estimated useful life of 5 years and a salvage value of $100,000. Depreciation was computed by the 150% declining-balance method. What is the amount of accumulated depreciation at the end of December 31, 2007? 9. Linda Blair Company purchased machinery for $120,000 on January 1, 2007. It is estimated that the machinery will have a useful life of 20 years, salvage value of $15,000, production of 84,000 units, and working hours of 42,000. During 2007 the company uses the machinery for 14,300 hours, and the machinery produces 20,000 units. Compute depreciation under the straightline, units-of-output, working hours, sum-of-the-years’digits, and declining-balance (use 10% as the annual rate) methods. 10. What are the major factors considered in determining what depreciation method to use? 11. Under what conditions is it appropriate for a business to use the composite method of depreciation for its plant assets? What are the advantages and disadvantages of this method? 12. If Brad Pitt, Inc. uses the composite method and its composite rate is 7.5% per year, what entry should it make when plant assets that originally cost $50,000 and have been used for 10 years are sold for $16,000? 13. A building that was purchased December 31, 1982, for $2,400,000 was originally estimated to have a life of 50 years with no salvage value at the end of that time. Depreciation has been recorded through 2006. During 2007 an examination of the building by an engineering firm discloses that its estimated useful life is 15 years after 2006. What should be the amount of depreciation for 2007? 14. Armand Assante, president of Flatbush Company, has recently noted that depreciation increases cash provided by operations and therefore depreciation is a good source of funds. Do you agree? Discuss. 15. Melanie Mayron purchased a computer for $6,000 on July 1, 2007. She intends to depreciate it over 4 years using the double-declining balance method. Salvage value is $1,000. Compute depreciation for 2008. 16. Astaire Inc. is considering the write-down of its longterm plant because of a lack of profitability. Explain to the management of Astaire how to determine whether a write-off is permitted.

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17. Last year Wilde Company recorded an impairment on an asset held for use. Recent appraisals indicate that the asset has increased in value. Should Wilde record this recovery in value? 18. Kuga Co. has equipment with a carrying amount of $700,000. The expected future net cash flows from the equipment are $705,000, and its fair value is $590,000. The equipment is expected to be used in operations in the future. What amount (if any) should Kuga report as an impairment to its equipment? 19. Explain how gains or losses on impaired assets should be reported in income. 20. It has been suggested that plant and equipment could be replaced more quickly if depreciation rates for income tax and accounting purposes were substantially increased. As a result, business operations would receive the benefit of more modern and more efficient plant facilities. Discuss the merits of this proposition. 21. Neither depreciation on replacement cost nor depreciation adjusted for changes in the purchasing power of the dollar has been recognized as generally accepted accounting principles for inclusion in the primary financial statements. Briefly present the accounting treatment that might be used to assist in the maintenance of the ability of a company to replace its productive capacity. 22. List (a) the similarities and (b) the differences in the accounting treatments of depreciation and cost depletion. 23. Describe cost depletion and percentage depletion. Why is the percentage depletion method permitted? 24. In what way may the use of percentage depletion violate sound accounting theory? 25. In the extractive industries, businesses may pay dividends in excess of net income. What is the maximum permissible? How can this practice be justified? 26. The following statement appeared in a financial magazine: “RRA—or Rah-Rah, as it’s sometimes dubbed—has kicked up quite a storm. Oil companies, for example, are convinced that the approach is misleading. Major accounting firms agree.” What is RRA? Why might oil companies believe that this approach is misleading? 27. Adriana Oil uses successful efforts accounting and also provides full-cost results as well. Under full-cost, Adriana Oil would have reported retained earnings of $42 million and net income of $4 million. Under successful efforts, retained earnings were $29 million, and net income was $3 million. Explain the difference between full costing and successful efforts accounting. 28. Target Corporation in 2004 reported net income of $3.2 billion, net sales of $45.7 billion, and average total assets of $29.8 billion. What is Target’s asset turnover ratio? What is Target’s rate of return on assets?

*29. What is a modified accelerated cost recovery system
(MACRS)? Speculate as to why this system is now required for tax purposes.

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BRIEF EXERCISES
(L0 4)

BE11-1 Castlevania Corporation purchased a truck at the beginning of 2007 for $42,000. The truck is estimated to have a salvage value of $2,000 and a useful life of 160,000 miles. It was driven 23,000 miles in 2007 and 31,000 miles in 2008. Compute depreciation expense for 2007 and 2008. BE11-2 Cheetah Company purchased machinery on January 1, 2007, for $60,000. The machinery is estimated to have a salvage value of $6,000 after a useful life of 8 years. (a) Compute 2007 depreciation expense using the straight-line method. (b) Compute 2007 depreciation expense using the straight-line method assuming the machinery was purchased on September 1, 2007. BE11-3 Use the information for Cheetah Company given in BE11-2. (a) Compute 2007 depreciation expense using the sum-of-the-years’-digits method. (b) Compute 2007 depreciation expense using the sumof-the-years’-digits method assuming the machinery was purchased on April 1, 2007. BE11-4 Use the information for Cheetah Company given in BE11-2. (a) Compute 2007 depreciation expense using the double-declining balance method. (b) Compute 2007 depreciation expense using the double-declining balance method assuming the machinery was purchased on October 1, 2007. BE11-5 Garfield Company purchased a machine on July 1, 2008, for $25,000. Garfield paid $200 in title fees and county property tax of $125 on the machine. In addition, Garfield paid $500 shipping charges for delivery, and $475 was paid to a local contractor to build and wire a platform for the machine on the plant floor. The machine has an estimated useful life of 6 years with a salvage value of $3,000. Determine the depreciation base of Garfield’s new machine. Garfield uses straight-line depreciation. BE11-6 Battlesport Inc. owns the following assets.
Asset A B C Cost $70,000 50,000 82,000 Salvage $ 7,000 10,000 14,000 Estimated Useful Life 10 years 5 years 12 years

(L0 2, 3)

(L0 2, 3)

(L0 2, 3)

(L0 2, 3)

(L0 4)

Compute the composite depreciation rate and the composite life of Battlesport’s assets.
(L0 2)

BE11-7 Myst Company purchased a computer for $7,000 on January 1, 2006. Straight-line depreciation is used, based on a 5-year life and a $1,000 salvage value. In 2008, the estimates are revised. Myst now feels the computer will be used until December 31, 2009, when it can be sold for $500. Compute the 2008 depreciation. BE11-8 Dinoland Company owns machinery that cost $900,000 and has accumulated depreciation of $360,000. The expected future net cash flows from the use of the asset are expected to be $500,000. The fair value of the equipment is $400,000. Prepare the journal entry, if any, to record the impairment loss. BE11-9 Genghis Khan Corporation acquires a coal mine at a cost of $400,000. Intangible development costs total $100,000. After extraction has occurred, Khan must restore the property (estimated fair value of the obligation is $75,000), after which it can be sold for $160,000. Khan estimates that 4,000 tons of coal can be extracted. If 700 tons are extracted the first year, prepare the journal entry to record depletion. BE11-10 In its 2004 annual report Campbell Soup Company reports beginning-of-the-year total assets of $6,205 million, end-of-the-year total assets of $6,675 million, total sales of $7,109 million, and net income of $647 million. (a) Compute Campbell’s asset turnover ratio. (b) Compute Campbell’s profit margin on sales. (c) Compute Campbell’s rate of return on assets (1) using asset turnover and profit margin and (2) using net income.

(L0 5)

(L0 6)

(L0 7)

(L0 8)

*BE11-11 Timecap Corporation purchased an asset at a cost of $40,000 on March 1, 2008. The asset has a
useful life of 8 years and a salvage value of $4,000. For tax purposes, the MACRS class life is 5 years. Compute tax depreciation for each year 2008–2013.

EXERCISES
(L0 2, 3)

E11-1 (Depreciation Computations—SL, SYD, DDB) Deluxe Ezra Company purchases equipment on January 1, Year 1, at a cost of $469,000. The asset is expected to have a service life of 12 years and a salvage value of $40,000. Instructions (a) Compute the amount of depreciation for each of Years 1 through 3 using the straight-line depreciation method.

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(b) Compute the amount of depreciation for each of Years 1 through 3 using the sum-of-the-years’digits method. (c) Compute the amount of depreciation for each of Years 1 through 3 using the double-declining balance method. (In performing your calculations, round constant percentage to the nearest onehundredth of a point and round answers to the nearest dollar.)
(L0 2, 3)

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E11-2 (Depreciation—Conceptual Understanding) Rembrandt Company acquired a plant asset at the beginning of Year 1. The asset has an estimated service life of 5 years. An employee has prepared depreciation schedules for this asset using three different methods to compare the results of using one method with the results of using other methods. You are to assume that the following schedules have been correctly prepared for this asset using (1) the straight-line method, (2) the sum-of-the-years’-digits method, and (3) the double-declining balance method.
Year 1 2 3 4 5 Total Straight-Line $ 9,000 9,000 9,000 9,000 9,000 $45,000 Sum-of-theYears’-Digits $15,000 12,000 9,000 6,000 3,000 $45,000 Double-Declining Balance $20,000 12,000 7,200 4,320 1,480 $45,000

Instructions Answer the following questions. (a) (b) (c) (d) (e) (f)
(L0 2, 3)

What is the cost of the asset being depreciated? What amount, if any, was used in the depreciation calculations for the salvage value for this asset? Which method will produce the highest charge to income in Year 1? Which method will produce the highest charge to income in Year 4? Which method will produce the highest book value for the asset at the end of Year 3? If the asset is sold at the end of Year 3, which method would yield the highest gain (or lowest loss) on disposal of the asset?

E11-3 (Depreciation Computations—SYD, DDB—Partial Periods) Judds Company purchased a new plant asset on April 1, 2007, at a cost of $711,000. It was estimated to have a service life of 20 years and a salvage value of $60,000. Judds’ accounting period is the calendar year. Instructions (a) Compute the depreciation for this asset for 2007 and 2008 using the sum-of-the-years’-digits method. (b) Compute the depreciation for this asset for 2007 and 2008 using the double-declining balance method.

(L0 2, 3)

E11-4 (Depreciation Computations—Five Methods) Jon Seceda Furnace Corp. purchased machinery for $315,000 on May 1, 2007. It is estimated that it will have a useful life of 10 years, salvage value of $15,000, production of 240,000 units, and working hours of 25,000. During 2008 Seceda Corp. uses the machinery for 2,650 hours, and the machinery produces 25,500 units. Instructions From the information given, compute the depreciation charge for 2008 under each of the following methods. (Round to the nearest dollar.) (a) (b) (c) (d) (e) Straight-line. Units-of-output. Working hours. Sum-of-the-years’-digits. Declining-balance (use 20% as the annual rate).

(L0 2, 3)

E11-5 (Depreciation Computations—Four Methods) Robert Parish Corporation purchased a new machine for its assembly process on August 1, 2007. The cost of this machine was $117,900. The company estimated that the machine would have a salvage value of $12,900 at the end of its service life. Its life is estimated at 5 years and its working hours are estimated at 21,000 hours. Year-end is December 31. Instructions Compute the depreciation expense under the following methods. Each of the following should be considered unrelated. (a) Straight-line depreciation for 2007. (b) Activity method for 2007, assuming that machine usage was 800 hours.

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(c) Sum-of-the-years’-digits for 2008. (d) Double-declining balance for 2008.

(L0 2, 3)

E11-6 (Depreciation Computations—Five Methods, Partial Periods) Muggsy Bogues Company purchased equipment for $212,000 on October 1, 2006. It is estimated that the equipment will have a useful life of 8 years and a salvage value of $12,000. Estimated production is 40,000 units and estimated working hours are 20,000. During 2006, Bogues uses the equipment for 525 hours and the equipment produces 1,000 units. Instructions Compute depreciation expense under each of the following methods. Bogues is on a calendar-year basis ending December 31. (a) (b) (c) (d) (e) Straight-line method for 2006. Activity method (units of output) for 2006. Activity method (working hours) for 2006. Sum-of-the-years’-digits method for 2008. Double-declining balance method for 2007.

(L0 2, 3)

E11-7 (Different Methods of Depreciation) Jackel Industries presents you with the following information.
Description Machine Machine Machine Machine A B C D Date Purchased 2/12/06 8/15/05 7/21/04 10/12/(g) Cost $142,500 (c) 75,400 219,000 Salvage Value $16,000 21,000 23,500 69,000 Life in Years 10 5 8 5 Depreciation Method (a) SL DDB SYD Accumulated Depreciation to 12/31/07 $33,350 29,000 (e) 70,000 Depreciation for 2008 (b) (d) (f) (h)

Instructions Complete the table for the year ended December 31, 2008. The company depreciates all assets using the half-year convention.
(L0 2, 3)

E11-8 (Depreciation Computation—Replacement, Nonmonetary Exchange) George Zidek Corporation bought a machine on June 1, 2005, for $31,000, f.o.b. the place of manufacture. Freight to the point where it was set up was $200, and $500 was expended to install it. The machine’s useful life was estimated at 10 years, with a salvage value of $2,500. On June 1, 2006, an essential part of the machine is replaced, at a cost of $1,980, with one designed to reduce the cost of operating the machine. The cost of the old part and related depreciation cannot be determined with any accuracy. On June 1, 2009, the company buys a new machine of greater capacity for $35,000, delivered, trading in the old machine which has a fair market value and trade-in allowance of $20,000. To prepare the old machine for removal from the plant cost $75, and expenditures to install the new one were $1,500. It is estimated that the new machine has a useful life of 10 years, with a salvage value of $4,000 at the end of that time. (The exchange has commercial substance.) Instructions Assuming that depreciation is to be computed on the straight-line basis, compute the annual depreciation on the new equipment that should be provided for the fiscal year beginning June 1, 2009. (Round to the nearest dollar.)

(L0 2, 3)

E11-9 (Composite Depreciation) Presented below is information related to LeBron James Manufacturing Corporation.
Asset A B C D E Cost $40,500 33,600 36,000 19,000 23,500 Estimated Salvage $5,500 4,800 3,600 1,500 2,500 Estimated Life (in years) 10 9 9 7 6

Instructions (a) Compute the rate of depreciation per year to be applied to the plant assets under the composite method. (b) Prepare the adjusting entry necessary at the end of the year to record depreciation for the year. (c) Prepare the entry to record the sale of asset D for cash of $4,800. It was used for 6 years, and depreciation was entered under the composite method.
(L0 2, 3)

E11-10 (Depreciation Computations, SYD) Five Satins Company purchased a piece of equipment at the beginning of 2004. The equipment cost $430,000. It has an estimated service life of 8 years and an

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expected salvage value of $70,000. The sum-of-the-years’-digits method of depreciation is being used. Someone has already correctly prepared a depreciation schedule for this asset. This schedule shows that $60,000 will be depreciated for a particular calendar year. Instructions Show calculations to determine for what particular year the depreciation amount for this asset will be $60,000.
(L0 2, 3)

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E11-11 (Depreciation—Change in Estimate) Machinery purchased for $60,000 by Tom Brady Co. in 2003 was originally estimated to have a life of 8 years with a salvage value of $4,000 at the end of that time. Depreciation has been entered for 5 years on this basis. In 2008, it is determined that the total estimated life should be 10 years with a salvage value of $4,500 at the end of that time. Assume straight-line depreciation. Instructions (a) Prepare the entry to correct the prior years’ depreciation, if necessary. (b) Prepare the entry to record depreciation for 2008.

(L0 2, 3)

E11-12 (Depreciation Computation—Addition, Change in Estimate) In 1980, Herman Moore Company completed the construction of a building at a cost of $2,000,000 and first occupied it in January 1981. It was estimated that the building will have a useful life of 40 years and a salvage value of $60,000 at the end of that time. Early in 1991, an addition to the building was constructed at a cost of $500,000. At that time it was estimated that the remaining life of the building would be, as originally estimated, an additional 30 years, and that the addition would have a life of 30 years, and a salvage value of $20,000. In 2009, it is determined that the probable life of the building and addition will extend to the end of 2040 or 20 years beyond the original estimate. Instructions (a) Using the straight-line method, compute the annual depreciation that would have been charged from 1981 through 1990. (b) Compute the annual depreciation that would have been charged from 1991 through 2008. (c) Prepare the entry, if necessary, to adjust the account balances because of the revision of the estimated life in 2009. (d) Compute the annual depreciation to be charged beginning with 2009.

(L0 2, 3)

E11-13 (Depreciation—Replacement, Change in Estimate) Greg Maddox Company constructed a building at a cost of $2,200,000 and occupied it beginning in January 1988. It was estimated at that time that its life would be 40 years, with no salvage value. In January 2008, a new roof was installed at a cost of $300,000, and it was estimated then that the building would have a useful life of 25 years from that date. The cost of the old roof was $160,000. Instructions (a) What amount of depreciation should have been charged annually from the years 1988 to 2007? (Assume straight-line depreciation.) (b) What entry should be made in 2008 to record the replacement of the roof? (c) Prepare the entry in January 2008, to record the revision in the estimated life of the building, if necessary. (d) What amount of depreciation should be charged for the year 2008?

(L0 2, 3)

E11-14 (Error Analysis and Depreciation, SL and SYD) Mike Devereaux Company shows the following entries in its Equipment account for 2008. All amounts are based on historical cost.
Equipment 2008 Jan. 1 Aug. 10 12 25 Nov. 10 Balance Purchases Freight on equipment purchased Installation costs Repairs 134,750 32,000 700 2,700 500 2008 June 30 Cost of equipment sold (purchased prior to 2008)

23,000

Instructions (a) Prepare any correcting entries necessary. (b) Assuming that depreciation is to be charged for a full year on the ending balance in the asset account, compute the proper depreciation charge for 2008 under each of the methods listed

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below. Assume an estimated life of 10 years, with no salvage value. The machinery included in the January 1, 2008, balance was purchased in 2006. (1) Straight-line. (2) Sum-of-the-years’-digits.

(L0 2, 3)

E11-15 (Depreciation for Fractional Periods) On March 10, 2009, Lost World Company sells equipment that it purchased for $192,000 on August 20, 2002. It was originally estimated that the equipment would have a life of 12 years and a salvage value of $16,800 at the end of that time, and depreciation has been computed on that basis. The company uses the straight-line method of depreciation. Instructions (a) Compute the depreciation charge on this equipment for 2002, for 2009, and the total charge for the period from 2003 to 2008, inclusive, under each of the six following assumptions with respect to partial periods. (1) Depreciation is computed for the exact period of time during which the asset is owned. (Use 365 days for base.) (2) Depreciation is computed for the full year on the January 1 balance in the asset account. (3) Depreciation is computed for the full year on the December 31 balance in the asset account. (4) Depreciation for one-half year is charged on plant assets acquired or disposed of during the year. (5) Depreciation is computed on additions from the beginning of the month following acquisition and on disposals to the beginning of the month following disposal. (6) Depreciation is computed for a full period on all assets in use for over one-half year, and no depreciation is charged on assets in use for less than one-half year. (Use 365 days for base.) (b) Briefly evaluate the methods above, considering them from the point of view of basic accounting theory as well as simplicity of application.

(L0 5)

E11-16 (Impairment) Presented below is information related to equipment owned by Suarez Company at December 31, 2007.
Cost Accumulated depreciation to date Expected future net cash flows Fair value $9,000,000 1,000,000 7,000,000 4,800,000

Assume that Suarez will continue to use this asset in the future. As of December 31, 2007, the equipment has a remaining useful life of 4 years. Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2007. (b) Prepare the journal entry to record depreciation expense for 2008. (c) The fair value of the equipment at December 31, 2008, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value.
(L0 5)

E11-17 (Impairment) Assume the same information as E11-16, except that Suarez intends to dispose of the equipment in the coming year. It is expected that the cost of disposal will be $20,000. Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2007. (b) Prepare the journal entry (if any) to record depreciation expense for 2008. (c) The asset was not sold by December 31, 2008. The fair value of the equipment on that date is $5,300,000. Prepare the journal entry (if any) necessary to record this increase in fair value. It is expected that the cost of disposal is still $20,000.

(L0 5)

E11-18 (Impairment) The management of Petro Garcia Inc. was discussing whether certain equipment should be written off as a charge to current operations because of obsolescence. This equipment has a cost of $900,000 with depreciation to date of $400,000 as of December 31, 2007. On December 31, 2007, management projected its future net cash flows from this equipment to be $300,000 and its fair value to be $230,000. The company intends to use this equipment in the future. Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2007. (b) Where should the gain or loss (if any) on the write-down be reported in the income statement? (c) At December 31, 2008, the equipment’s fair value increased to $260,000. Prepare the journal entry (if any) to record this increase in fair value. (d) What accounting issues did management face in accounting for this impairment?

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(L0 6)

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E11-19 (Depletion Computations—Timber) Stanislaw Timber Company owns 9,000 acres of timberland purchased in 1996 at a cost of $1,400 per acre. At the time of purchase the land without the timber was valued at $400 per acre. In 1997, Stanislaw built fire lanes and roads, with a life of 30 years, at a cost of $84,000. Every year Stanislaw sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 1998, Stanislaw selectively logged and sold 700,000 board feet of timber, of the estimated 3,500,000 board feet. In 1999, Stanislaw planted new seedlings to replace the trees cut at a cost of $100,000. Instructions (a) Determine the depreciation expense and the cost of timber sold related to depletion for 1998. (b) Stanislaw has not logged since 1998. If Stanislaw logged and sold 900,000 board feet of timber in 2009, when the timber cruise (appraiser) estimated 5,000,000 board feet, determine the cost of timber sold related to depletion for 2009.

(L0 6)

E11-20 (Depletion Computations—Oil) Diderot Drilling Company has leased property on which oil has been discovered. Wells on this property produced 18,000 barrels of oil during the past year that sold at an average sales price of $55 per barrel. Total oil resources of this property are estimated to be 250,000 barrels. The lease provided for an outright payment of $500,000 to the lessor (owner) before drilling could be commenced and an annual rental of $31,500. A premium of 5% of the sales price of every barrel of oil removed is to be paid annually to the lessor. In addition, Diderot (lessee) is to clean up all the waste and debris from drilling and to bear the costs of reconditioning the land for farming when the wells are abandoned. The estimated fair value, at the time of the lease, of this clean-up and reconditioning is $30,000. Instructions From the provisions of the lease agreement, you are to compute the cost per barrel for the past year, exclusive of operating costs, to Diderot Drilling Company.

(L0 6)

E11-21 (Depletion Computations—Timber) Forda Lumber Company owns a 7,000-acre tract of timber purchased in 2000 at a cost of $1,300 per acre. At the time of purchase the land was estimated to have a value of $300 per acre without the timber. Forda Lumber Company has not logged this tract since it was purchased. In 2007, Forda had the timber cruised. The cruise (appraiser) estimated that each acre contained 8,000 board feet of timber. In 2007, Forda built 10 miles of roads at a cost of $7,840 per mile. After the roads were completed, Forda logged and sold 3,500 trees containing 850,000 board feet. Instructions (a) Determine the cost of timber sold related to depletion for 2007. (b) If Forda depreciates the logging roads on the basis of timber cut, determine the depreciation expense for 2007. (c) If Forda plants five seedlings at a cost of $4 per seedling for each tree cut, how should Forda treat the reforestation?

(L0 6)

E11-22 (Depletion Computations—Mining) Alcide Mining Company purchased land on February 1, 2007, at a cost of $1,190,000. It estimated that a total of 60,000 tons of mineral was available for mining. After it has removed all the natural resources, the company will be required to restore the property to its previous state because of strict environmental protection laws. It estimates the fair value of this restoration obligation at $90,000. It believes it will be able to sell the property afterwards for $100,000. It incurred developmental costs of $200,000 before it was able to do any mining. In 2007 resources removed totaled 30,000 tons. The company sold 22,000 tons. Instructions Compute the following information for 2007. (a) Per unit material cost. (b) Total material cost of December 31, 2007, inventory. (c) Total materials cost in cost of goods sold at December 31, 2007.

(L0 6)

E11-23 (Depletion Computations—Minerals) At the beginning of 2007, Aristotle Company acquired a mine for $970,000. Of this amount, $100,000 was ascribed to the land value and the remaining portion to the minerals in the mine. Surveys conducted by geologists have indicated that approximately 12,000,000 units of the ore appear to be in the mine. Aristotle incurred $170,000 of development costs associated with this mine prior to any extraction of minerals. It also determined that the fair value of its obligation to prepare the land for an alternative use when all of the mineral has been removed was $40,000. During 2007, 2,500,000 units of ore were extracted and 2,100,000 of these units were sold.

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Instructions Compute the following. (a) The total amount of depletion for 2007. (b) The amount that is charged as an expense for 2007 for the cost of the minerals sold during 2007.

(L0 7)

E11-24

(Ratio Analysis)

The 2004 Annual Report of Eastman Kodak contains the following information.
December 31, 2004 $14,737 10,926 13,516 556 December 31, 2003 $14,846 11,601 12,909 253

(in millions) Total assets Total liabilities Net sales Net income

Instructions Compute the following ratios for Eastman Kodak for 2004. (a) (b) (c) (d)
(L0 8)

Asset turnover ratio. Rate of return on assets. Profit margin on sales. How can the asset turnover ratio be used to compute the rate of return on assets?

*E11-25 (Book vs. Tax (MACRS) Depreciation) Futabatei Enterprises purchased a delivery truck on
January 1, 2007, at a cost of $27,000. The truck has a useful life of 7 years with an estimated salvage value of $6,000. The straight-line method is used for book purposes. For tax purposes the truck, having an MACRS class life of 7 years, is classified as 5-year property; the optional MACRS tax rate tables are used to compute depreciation. In addition, assume that for 2007 and 2008 the company has revenues of $200,000 and operating expenses (excluding depreciation) of $130,000. Instructions (a) Prepare income statements for 2007 and 2008. (The final amount reported on the income statement should be income before income taxes.) (b) Compute taxable income for 2007 and 2008. (c) Determine the total depreciation to be taken over the useful life of the delivery truck for both book and tax purposes. (d) Explain why depreciation for book and tax purposes will generally be different over the useful life of a depreciable asset.

(L0 8)

* E11-26 (Book vs. Tax (MACRS) Depreciation) Shimei Inc. purchased computer equipment on March 1,
2007, for $31,000. The computer equipment has a useful life of 10 years and a salvage value of $1,000. For tax purposes, the MACRS class life is 5 years. Instructions (a) Assuming that the company uses the straight-line method for book and tax purposes, what is the depreciation expense reported in (1) the financial statements for 2007 and (2) the tax return for 2007? (b) Assuming that the company uses the double-declining balance method for both book and tax purposes, what is the depreciation expense reported in (1) the financial statements for 2007 and (2) the tax return for 2007? (c) Why is depreciation for tax purposes different from depreciation for book purposes even if the company uses the same depreciation method to compute them both? See the book’s website, www.wiley.com/college/kieso, for Additional Exercises.
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PROBLEMS
(L0 2, 3)

P11-1 (Depreciation for Partial Period—SL, SYD, and DDB) Onassis Company purchased Machine #201 on May 1, 2007. The following information relating to Machine #201 was gathered at the end of May.
Price Credit terms Freight-in costs Preparation and installation costs Labor costs during regular production operations $73,500 2/10, n/30 $ 970 $ 3,800 $10,500

ile

y. c o m /

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It was expected that the machine could be used for 10 years, after which the salvage value would be zero. Onassis intends to use the machine for only 8 years, however, after which it expects to be able to sell it for $1,200. The invoice for Machine #201 was paid May 5, 2007. Onassis uses the calendar year as the basis for the preparation of financial statements. Instructions (a) Compute the depreciation expense for the years indicated using the following methods. (Round to the nearest dollar.) (1) Straight-line method for 2007. (2) Sum-of-the-years’-digits method for 2008. (3) Double-declining balance method for 2007. (b) Suppose Jackie Ari, the president of Onassis, tells you that because the company is a new organization, she expects it will be several years before production and sales reach optimum levels. She asks you to recommend a depreciation method that will allocate less of the company’s depreciation expense to the early years and more to later years of the assets’ lives. What method would you recommend?
(L0 2, 3)

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P11-2 (Depreciation for Partial Periods—SL, Act., SYD, and DDB) The cost of equipment purchased by Boris Becker, Inc., on June 1, 2007 is $67,000. It is estimated that the machine will have a $4,000 salvage value at the end of its service life. Its service life is estimated at 7 years; its total working hours are estimated at 42,000 and its total production is estimated at 525,000 units. During 2007 the machine was operated 6,000 hours and produced 55,000 units. During 2008 the machine was operated 5,500 hours and produced 48,000 units. Instructions Compute depreciation expense on the machine for the year ending December 31, 2007, and the year ending December 31, 2008, using the following methods. (a) (b) (c) (d) (e) Straight-line. Units-of-output. Working hours. Sum-of-the-years’-digits. Declining balance (twice the straight-line rate).

(L0 2, 3)

P11-3 (Depreciation—SYD, Act., SL, and DDB) The following data relate to the Plant Assets account of Arthur Fiedler, Inc. at December 31, 2007.
Plant Assets A Original cost Year purchased Useful life Salvage value Depreciation method Accum. Depr. through 2007* $35,000 2002 10 years $ 3,100 Sum-of-theyears’-digits $23,200 B $51,000 2003 15,000 hours $ 3,000 Activity $35,200 C $80,000 2004 15 years $ 5,000 Straight-line $15,000 D $80,000 2006 10 years $35,000 Double-declining balance $16,000

*In the year an asset is purchased, Fiedler, Inc. does not record any depreciation expense on the asset. In the year an asset is retired or traded in, Fiedler, Inc. takes a full year’s depreciation on the asset.

The following transactions occurred during 2008. (a) On May 5, Asset A was sold for $13,000 cash. The company’s bookkeeper recorded this retirement in the following manner in the cash receipts journal.
Cash Asset A 13,000 13,000

(b) On December 31, it was determined that Asset B had been used 2,100 hours during 2008. (c) On December 31, before computing depreciation expense on Asset C, the management of Fiedler, Inc. decided the useful life remaining from January 1, 2008, was 10 years. (d) On December 31, it was discovered that a plant asset purchased in 2007 had been expensed completely in that year. This asset cost $22,000 and has a useful life of 10 years and no salvage value. Management has decided to use the double-declining balance method for this asset, which can be referred to as “Asset E.”

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Instructions Prepare the necessary correcting entries for the year 2008. Record the appropriate depreciation expense on the above-mentioned assets.

(L0 2, 3)

P11-4 (Depreciation and Error Analysis) A depreciation schedule for semitrucks of Oglala Manufacturing Company was requested by your auditor soon after December 31, 2008, showing the additions, retirements, depreciation, and other data affecting the income of the company in the 4-year period 2005 to 2008, inclusive. The following data were ascertained.
Balance of Semitrucks account, Jan. 1, 2005 Truck No. 1 purchased Jan. 1, 2002, cost Truck No. 2 purchased July 1, 2002, cost Truck No. 3 purchased Jan. 1, 2004, cost Truck No. 4 purchased July 1, 2004, cost Balance, Jan. 1, 2005 $18,000 22,000 30,000 24,000 $94,000

The Semitrucks—Accumulated Depreciation account previously adjusted to January 1, 2005, and duly entered in the ledger, had a balance on that date of $30,200 (depreciation on the four trucks from the respective dates of purchase, based on a 5-year life, no salvage value). No charges had been made against the account before January 1, 2005. Transactions between January 1, 2005, and December 31, 2008, and their record in the ledger were as follows.
July 1, 2005 Truck No. 3 was traded for a larger one (No. 5), the agreed purchase price of which was $34,000. Oglala Mfg. Co. paid the automobile dealer $15,000 cash on the transaction. The entry was a debit to Semitrucks and a credit to Cash, $15,000. The transaction has commercial substance. Truck No. 1 was sold for $3,500 cash; entry debited Cash and credited Semitrucks, $3,500. A new truck (No. 6) was acquired for $36,000 cash and was charged at that amount to the Semitrucks account. (Assume truck No. 2 was not retired.) Truck No. 4 was damaged in a wreck to such an extent that it was sold as junk for $700 cash. Oglala Mfg. Co. received $2,500 from the insurance company. The entry made by the bookkeeper was a debit to Cash, $3,200, and credits to Miscellaneous Income, $700, and Semitrucks, $2,500.

Jan. 1, 2006 July 1, 2007 July 1, 2007

Entries for depreciation had been made at the close of each year as follows: 2005, $20,300; 2006, $21,100; 2007, $24,450; 2008, $27,800. Instructions (a) For each of the 4 years compute separately the increase or decrease in net income arising from the company’s errors in determining or entering depreciation or in recording transactions affecting trucks, ignoring income tax considerations. (b) Prepare one compound journal entry as of December 31, 2008, for adjustment of the Semitrucks account to reflect the correct balances as revealed by your schedule, assuming that the books have not been closed for 2008.
(L0 3, 6)

P11-5 (Depletion and Depreciation—Mining) Richard Wright Mining Company has purchased a tract of mineral land for $600,000. It is estimated that this tract will yield 120,000 tons of ore with sufficient mineral content to make mining and processing profitable. It is further estimated that 6,000 tons of ore will be mined the first and last year and 12,000 tons every year in between. The land will have a residual value of $30,000. The company builds necessary structures and sheds on the site at a cost of $36,000. It is estimated that these structures can serve 15 years but, because they must be dismantled if they are to be moved, they have no salvage value. The company does not intend to use the buildings elsewhere. Mining machinery installed at the mine was purchased second-hand at a cost of $48,000. This machinery cost the former owner $100,000 and was 50% depreciated when purchased. Richard Wright Mining estimates that about half of this machinery will still be useful when the present mineral resources have been exhausted but that dismantling and removal costs will just about offset its value at that time. The company does not intend to use the machinery elsewhere. The remaining machinery will last until about one-half the present estimated mineral ore has been removed and will then be worthless. Cost is to be allocated equally between these two classes of machinery. Instructions (a) As chief accountant for the company, you are to prepare a schedule showing estimated depletion and depreciation costs for each year of the expected life of the mine. (b) Also compute the depreciation and depletion for the first year assuming actual production of 7,000 tons. Nothing occurred during the year to cause the company engineers to change their estimates of either the mineral resources or the life of the structures and equipment.

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(L0 6)

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P11-6 (Depletion, Timber, and Extraordinary Loss) Conan O’Brien Logging and Lumber Company owns 3,000 acres of timberland on the north side of Mount St. Helens, which was purchased in 1968 at a cost of $550 per acre. In 1980, O’Brien began selectively logging this timber tract. In May of 1980, Mount St. Helens erupted, burying the timberland of O’Brien under a foot of ash. All of the timber on the O’Brien tract was downed. In addition, the logging roads, built at a cost of $150,000, were destroyed, as well as the logging equipment, with a net book value of $300,000. At the time of the eruption, O’Brien had logged 20% of the estimated 500,000 board feet of timber. Prior to the eruption, O’Brien estimated the land to have a value of $200 per acre after the timber was harvested. O’Brien includes the logging roads in the depletion base. O’Brien estimates it will take 3 years to salvage the downed timber at a cost of $700,000. The timber can be sold for pulp wood at an estimated price of $3 per board foot. The value of the land is unknown, but must be considered nominal due to future uncertainties. Instructions (a) Determine the depletion cost per board foot for the timber harvested prior to the eruption of Mount St. Helens. (b) Prepare the journal entry to record the depletion prior to the eruption. (c) If this tract represents approximately half of the timber holdings of O’Brien, determine the amount of the estimated loss and show how the losses of roads, machinery, and timber and the salvage of the timber should be reported in the financial statements of O’Brien for the year ended December 31, 1980.

(L0 6)

P11-7 (Natural Resources—Timber) Western Paper Products purchased 10,000 acres of forested timberland in March 2008. The company paid $1,700 per acre for this land, which was above the $800 per acre most farmers were paying for cleared land. During April, May, June, and July 2008, Western cut enough timber to build roads using moveable equipment purchased on April 1, 2008. The cost of the roads was $195,000, and the cost of the equipment was $189,000; this equipment was expected to have a $9,000 salvage value and would be used for the next 15 years. Western selected the straight-line method of depreciation for the moveable equipment. Western began actively harvesting timber in August and by December had harvested and sold 472,500 board feet of timber of the estimated 6,750,000 board feet available for cutting. In March 2009, Western planted new seedlings in the area harvested during the winter. Cost of planting these seedlings was $120,000. In addition, Western spent $8,000 in road maintenance and $6,000 for pest spraying during calendar-year 2009. The road maintenance and spraying are annual costs. During 2009 Western harvested and sold 774,000 board feet of timber of the estimated 6,450,000 board feet available for cutting. In March 2010, Western again planted new seedlings at a cost of $150,000, and also spent $15,000 on road maintenance and pest spraying. During 2010, the company harvested and sold 650,000 board feet of timber of the estimated 6,500,000 board feet available for cutting. Instructions Compute the amount of depreciation and depletion expense for each of the 3 years (2008, 2009, 2010). Assume that the roads are usable only for logging and therefore are included in the depletion base.

(L0 2, 3)

P11-8 (Comprehensive Fixed Asset Problem) Selig Sporting Goods Inc. has been experiencing growth in the demand for its products over the last several years. The last two Olympic Games greatly increased the popularity of basketball around the world. As a result, a European sports retailing consortium entered into an agreement with Selig’s Roundball Division to purchase basketballs and other accessories on an increasing basis over the next 5 years. To be able to meet the quantity commitments of this agreement, Selig had to obtain additional manufacturing capacity. A real estate firm located an available factory in close proximity to Selig’s Roundball manufacturing facility, and Selig agreed to purchase the factory and used machinery from Starks Athletic Equipment Company on October 1, 2005. Renovations were necessary to convert the factory for Selig’s manufacturing use. The terms of the agreement required Selig to pay Starks $50,000 when renovations started on January 1, 2006, with the balance to be paid as renovations were completed. The overall purchase price for the factory and machinery was $400,000. The building renovations were contracted to Malone Construction at $100,000. The payments made, as renovations progressed during 2006, are shown below. The factory was placed in service on January 1, 2007.
1/1 Starks Malone $50,000 4/1 $100,000 30,000 10/1 $100,000 30,000 12/31 $150,000 40,000

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On January 1, 2006, Selig secured a $500,000 line-of-credit with a 12% interest rate to finance the purchase cost of the factory and machinery, and the renovation costs. Selig drew down on the line-of-credit to meet the payment schedule shown above; this was Selig’s only outstanding loan during 2006. Rob Stewart, Selig’s controller, will capitalize the maximum allowable interest costs for this project. Selig’s policy regarding purchases of this nature is to use the appraisal value of the land for book purposes and prorate the balance of the purchase price over the remaining items. The building had originally cost Starks $300,000 and had a net book value of $50,000, while the machinery originally cost $125,000 and had a net book value of $40,000 on the date of sale. The land was recorded on Starks’ books at $40,000. An appraisal, conducted by independent appraisers at the time of acquisition, valued the land at $280,000, the building at $105,000, and the machinery at $45,000. Linda Safford, chief engineer, estimated that the renovated plant would be used for 15 years, with an estimated salvage value of $30,000. Safford estimated that the productive machinery would have a remaining useful life of 5 years and a salvage value of $3,000. Selig’s depreciation policy specifies the 200% declining-balance method for machinery and the 150% declining-balance method for the plant. One-half year’s depreciation is taken in the year the plant is placed in service and one-half year is allowed when the property is disposed of or retired. Selig uses a 360-day year for calculating interest costs. Instructions (a) Determine the amounts to be recorded on the books of Selig Sporting Goods Inc. as of December 31, 2006, for each of the following properties acquired from Starks Athletic Equipment Company. (1) Land. (2) Building. (3) Machinery. (b) Calculate Selig Sporting Goods Inc.’s 2007 depreciation expense, for book purposes, for each of the properties acquired from Starks Athletic Equipment Company. (c) Discuss the arguments for and against the capitalization of interest costs. (CMA adapted)

(L0 5)

P11-9 (Impairment) Olsson Company uses special strapping equipment in its packaging business. The equipment was purchased in January 2007 for $8,000,000 and had an estimated useful life of 8 years with no salvage value. At December 31, 2008, new technology was introduced that would accelerate the obsolescence of Olsson’s equipment. Olsson’s controller estimates that expected future net cash flows on the equipment will be $5,300,000 and that the fair value of the equipment is $4,400,000. Olsson intends to continue using the equipment, but it is estimated that the remaining useful life is 4 years. Olsson uses straightline depreciation. Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2008. (b) Prepare any journal entries for the equipment at December 31, 2009. The fair value of the equipment at December 31, 2009, is estimated to be $4,600,000. (c) Repeat the requirements for (a) and (b), assuming that Olsson intends to dispose of the equipment and that it has not been disposed of as of December 31, 2009.

(L0 2, 3)

P11-10 (Comprehensive Depreciation Computations) Sheryl Crow Corporation, a manufacturer of steel products, began operations on October 1, 2006. The accounting department of Crow has started the fixed-asset and depreciation schedule presented on page 563. You have been asked to assist in completing this schedule. In addition to ascertaining that the data already on the schedule are correct, you have obtained the following information from the company’s records and personnel. 1. Depreciation is computed from the first of the month of acquisition to the first of the month of disposition. 2. Land A and Building A were acquired from a predecessor corporation. Crow paid $820,000 for the land and building together. At the time of acquisition, the land had an appraised value of $90,000, and the building had an appraised value of $810,000. 3. Land B was acquired on October 2, 2006, in exchange for 2,500 newly issued shares of Crow’s common stock. At the date of acquisition, the stock had a par value of $5 per share and a fair value of $30 per share. During October 2006, Crow paid $16,000 to demolish an existing building on this land so it could construct a new building. 4. Construction of Building B on the newly acquired land began on October 1, 2007. By September 30, 2008, Crow had paid $320,000 of the estimated total construction costs of $450,000. It is estimated that the building will be completed and occupied by July 2009. 5. Certain equipment was donated to the corporation by a local university. An independent appraisal of the equipment when donated placed the fair market value at $30,000 and the salvage value at $3,000.

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6. Machinery A’s total cost of $164,900 includes installation expense of $600 and normal repairs and maintenance of $14,900. Salvage value is estimated at $6,000. Machinery A was sold on February 1, 2008. 7. On October 1, 2007, Machinery B was acquired with a down payment of $5,740 and the remaining payments to be made in 11 annual installments of $6,000 each beginning October 1, 2007. The prevailing interest rate was 8%. The following data were abstracted from present-value tables (rounded).
Present value of $1.00 at 8% 10 years 11 years 15 years .463 .429 .315 Present value of an ordinary annuity of $1.00 at 8% 10 years 11 years 15 years 6.710 7.139 8.559

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SHERYL CROW CORPORATION Fixed Asset and Depreciation Schedule For Fiscal Years Ended September 30, 2007, and September 30, 2008 Depreciation Expense Year Ended September 30 2007 N/A $17,450 N/A — (8) (11) — 2008 N/A (4) N/A (6) (9) (12) (14)

Assets Land A Building A Land B Building B Donated Equipment Machinery A Machinery B N/A—Not applicable

Acquisition Date October 1, 2006 October 1, 2006 October 2, 2006 Under Construction October 2, 2006 October 2, 2006 October 1, 2007 $

Cost (1) (2) (5) $320,000 to date (7) (10) (13)

Salvage N/A $40,000 N/A — 3,000 6,000 —

Depreciation Method N/A Straight-line N/A Straight-line 150% declining balance Sum-of-theyears’-digits Straight-line

Estimated Life in Years N/A (3) N/A 30 10 18 20

Instructions For each numbered item on the schedule above, supply the correct amount. Round each answer to the nearest dollar.
(L0 2, 3)

P11-11 (Depreciation for Partial Periods—SL, Act., SYD, and DDB) On January 1, 2005, a machine was purchased for $77,000. The machine has an estimated salvage value of $5,000 and an estimated useful life of 5 years. The machine can operate for 100,000 hours before it needs to be replaced. The company closed its books on December 31 and operates the machine as follows: 2005, 20,000 hrs; 2006, 25,000 hrs; 2007, 15,000 hrs; 2008, 30,000 hrs; 2009, 10,000 hrs. Instructions (a) Compute the annual depreciation charges over the machine’s life assuming a December 31 yearend for each of the following depreciation methods. (1) Straight-line method. (3) Sum-of-the-years’-digits method. (2) Activity method. (4) Double-declining balance method. (b) Assume a fiscal year-end of September 30. Compute the annual depreciation charges over the asset’s life applying each of the following methods. (1) Straight-line method. (2) Sum-of-the-years’-digits method. (3) Double-declining balance method.

(L0 2, 3, 8)

*P11-12 (Depreciation—SL, DDB, SYD, Act., and MACRS) On January 1, 2005, Begen Company, a
small machine-tool manufacturer, acquired for $1,100,000 a piece of new industrial equipment. The new equipment had a useful life of 5 years, and the salvage value was estimated to be $50,000. Begen estimates that the new equipment can produce 12,000 machine tools in its first year. It estimates that production will decline by 1,000 units per year over the remaining useful life of the equipment. The following depreciation methods may be used: (1) straight-line; (2) double-declining balance; (3) sum-of-the-years’-digits; and (4) units-of-output. For tax purposes, the class life is 7 years. Use the MACRS tables for computing depreciation.

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Instructions (a) Which depreciation method would maximize net income for financial statement reporting for the 3-year period ending December 31, 2007? Prepare a schedule showing the amount of accumulated depreciation at December 31, 2007, under the method selected. Ignore present value, income tax, and deferred income tax considerations. (b) Which depreciation method (MACRS or optional straight-line) would minimize net income for income tax reporting for the 3-year period ending December 31, 2007? Determine the amount of accumulated depreciation at December 31, 2007. Ignore present value considerations. (AICPA adapted)

CONCEPTS FOR ANALYSIS
CA11-1 (Depreciation Basic Concepts) Prophet Manufacturing Company was organized January 1, 2007. During 2007, it has used in its reports to management the straight-line method of depreciating its plant assets. On November 8 you are having a conference with Prophet’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. Frank Peretti, president of Prophet, has suggested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Following is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a salvage value of approximately $8,000.
Years of Life Used 1 2 3 4 5 Accumulated Depreciation at End of Year $ 16,000 48,000 96,000 160,000 240,000 Book Value at End of Year $232,000 200,000 152,000 88,000 8,000

Year 1 2 3 4 5

Fraction Rate 1/15 2/15 3/15 4/15 5/15

Depreciation Expense $16,000 32,000 48,000 64,000 80,000

The president favors the new method because he has heard that: 1. It will increase the funds recovered during the years near the end of the assets’ useful lives when maintenance and replacement disbursements are high. 2. It will result in increased write-offs in later years and thereby will reduce taxes. Instructions (a) What is the purpose of accounting for depreciation? (b) Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision discuss the circumstances, if any, under which use of the method would be reasonable and those, if any, under which it would not be reasonable. (c) The president wants your advice on the following issues. (1) Do depreciation charges recover or create funds? Explain. (2) Assume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations? CA11-2 (Unit, Group, and Composite Depreciation) The certified public accountant is frequently called upon by management for advice regarding methods of computing depreciation. Of comparable importance, although it arises less frequently, is the question of whether the depreciation method should be based on consideration of the assets as units, as a group, or as having a composite life. Instructions (a) Briefly describe the depreciation methods based on treating assets as (1) units and (2) a group or as having a composite life. (b) Present the arguments for and against the use of each of the two methods. (c) Describe how retirements are recorded under each of the two methods. (AICPA adapted)

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CA11-3 (Depreciation—Strike, Units-of-Production, Obsolescence) Presented below are three different and unrelated situations involving depreciation accounting. Answer the question(s) at the end of each situation. Situation I Recently, Davenport Company experienced a strike that affected a number of its operating plants. The controller of this company indicated that it was not appropriate to report depreciation expense during this period because the equipment did not depreciate and an improper matching of costs and revenues would result. She based her position on the following points. 1. It is inappropriate to charge the period with costs for which there are no related revenues arising from production. 2. The basic factor of depreciation in this instance is wear and tear, and because equipment was idle, no wear and tear occurred. Instructions Comment on the appropriateness of the controller’s comments. Situation II Sharapova Company manufactures electrical appliances, most of which are used in homes. Company engineers have designed a new type of blender which, through the use of a few attachments, will perform more functions than any blender currently on the market. Demand for the new blender can be projected with reasonable probability. In order to make the blenders, Sharapova needs a specialized machine that is not available from outside sources. It has been decided to make such a machine in Sharapova’s own plant. Instructions (a) Discuss the effect of projected demand in units for the new blenders (which may be steady, decreasing, or increasing) on the determination of a depreciation method for the machine. (b) What other matters should be considered in determining the depreciation method? Ignore income tax considerations. Situation III Venus Paper Company operates a 300-ton-per-day kraft pulp mill and four sawmills in Wisconsin. The company is in the process of expanding its pulp mill facilities to a capacity of 1,000 tons per day and plans to replace three of its older, less efficient sawmills with an expanded facility. One of the mills to be replaced did not operate for most of 2007 (current year), and there are no plans to reopen it before the new sawmill facility becomes operational. In reviewing the depreciation rates and in discussing the residual values of the sawmills that were to be replaced, it was noted that if present depreciation rates were not adjusted, substantial amounts of plant costs on these three mills would not be depreciated by the time the new mill came on stream. Instructions What is the proper accounting for the four sawmills at the end of 2007?

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CA11-4 (Depreciation Concepts) As a cost accountant for San Francisco Cannery, you have been approached by Merton Miller, canning room supervisor, about the 2006 costs charged to his department. In particular, he is concerned about the line item “depreciation.” Miller is very proud of the excellent condition of his canning room equipment. He has always been vigilant about keeping all equipment serviced and well oiled. He is sure that the huge charge to depreciation is a mistake; it does not at all reflect the cost of minimal wear and tear that the machines have experienced over the last year. He believes that the charge should be considerably lower. The machines being depreciated are six automatic canning machines. All were put into use on January 1, 2006. Each cost $469,000, having a salvage value of $40,000 and a useful life of 12 years. San Francisco depreciates this and similar assets using double-declining balance depreciation. Miller has also pointed out that if you used straight-line depreciation the charge to his department would not be so great. Instructions Write a memo to Merton Miller to clear up his misunderstanding of the term “depreciation.” Also, calculate year-1 depreciation on all machines using both methods. Explain the theoretical justification for double-declining balance and why, in the long run, the aggregate charge to depreciation will be the same under both methods.

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Chapter 1 1 Depreciation, Impairments, and Depletion
CA11-5 (Depreciation Choice) Dusty Baker, Waveland Corporation’s controller, is concerned that net income may be lower this year. He is afraid upper-level management might recommend cost reductions by laying off accounting staff, including him. Baker knows that depreciation is a major expense for Waveland. The company currently uses the doubledeclining balance method for both financial reporting and tax purposes, and he’s thinking of selling equipment that, given its age, is primarily used when there are periodic spikes in demand. The equipment has a carrying value of $2,000,000 and a market value of $2,180,000. The gain on the sale would be reported in the income statement. He doesn’t want to highlight this method of increasing income. He thinks, “Why don’t I increase the estimated useful lives and the salvage values? That will decrease depreciation expense and require less extensive disclosure, since the changes are accounted for prospectively. I may be able to save my job and those of my staff.” Instructions Answer the following questions. (a) Who are the stakeholders in this situation? (b) What are the ethical issues involved? (c) What should Baker do?

USING YOUR JUDGMENT
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B or can be accessed on the KWW website .
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Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What descriptions are used by P&G in its balance sheet to classify its property, plant, and equipment? (b) What method or methods of depreciation does P&G use to depreciate its property, plant, and equipment? (c) Over what estimated useful lives does P&G depreciate its property, plant, and equipment? (d) What amounts for depreciation and amortization expense did P&G charge to its income statement in 2004, 2003, and 2002? (e) What were the capital expenditures for property, plant, and equipment made by P&G in 2004, 2003, and 2002?

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Financial Statement Analysis Case
McDonald’s Corporation
McDonald’s is the largest and best-known global food service retailer, with more than 30,000 restaurants in 121 countries. On any day, McDonald’s serves approximately 1 percent of the world’s population. Presented on the next page is information related to McDonald’s property and equipment. Instructions (a) What method of depreciation does McDonald’s use? (b) Does depreciation and amortization expense cause cash flow from operations to increase? Explain. (c) What does the schedule of cash flow measures indicate?

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Using Your Judgment

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McDonald’s Corporation
Summary of Significant Accounting Policies Section Property and Equipment. Property and equipment are stated at cost, with depreciation and amortization provided on the straight-line method over the following estimated useful lives: buildings—up to 40 years; leasehold improvements—lesser of useful lives of assets or lease terms including option periods; and equipment—3 to 12 years. [In the notes to the financial statements:] Property and Equipment Net property and equipment consisted of: (in millions) Land Buildings and improvements on owned land Buildings and improvements on leased land Equipment, signs, and seating Other Accumulated depreciation and amortization Net property and equipment December 31, 2004 $ 4,661.1 10,260.3 10,520.7 4,426.1 639.6 30,507.8 (9,804.7) $20,703.1 2003 $ 4,483.0 9,693.4 9,792.1 4,090.5 681.2 28,740.2 (8,815.5) $19,924.7

Depreciation and amortization expense was (in millions): 2004–$1,138.3; 2003–$1,113.3; 2002–$971.1. [In the management discussion and analysis section, McDonald’s provides the following schedule.] Cash Provided by Operations (dollars in millions) Cash provided by operations Cash provided by operations as a percent of capital expenditures 2004 $3,904 275% 2003 $3,269 250% 2002 $2,890 144%

Comparative Analysis Case
The Coca-Cola Company and PepsiCo., Inc.
Instructions Go to the book’s website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What amount is reported in the balance sheets as property, plant, and equipment (net) of Coca-Cola at December 31, 2004, and of PepsiCo at December 25, 2004? What percentage of total assets is invested in property, plant, and equipment by each company? (b) What depreciation methods are used by Coca-Cola and PepsiCo for property, plant, and equipment? How much depreciation was reported by Coca-Cola and PepsiCo in 2004, 2003, and 2002? (c) Compute and compare the following ratios for Coca-Cola and PepsiCo for 2004. (1) Asset turnover. (2) Profit margin on sales. (3) Rate of return on assets. (d) What amount was spent in 2004 for capital expenditures by Coca-Cola and PepsiCo? What amount of interest was capitalized in 2004?

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Research Case
An article by Martin Peers and Robin Sidel, entitled “Days May Be Numbered for EBITDA’s Role,” appeared in the July 5, 2002, issue of the Wall Street Journal.

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Chapter 1 1 Depreciation, Impairments, and Depletion
Instructions Read the article and answer the following questions. (a) Explain what is meant by EBITDA and why companies are reporting this number. (b) Why has the WorldCom bankruptcy caused EBITDA to fall into disfavor as a performance metric? (c) What is wrong with performance metrics such as EBITDA, cash earnings, or other pro-forma income measures?

International Reporting Case
Companies following international accounting standards are permitted to revalue fixed assets above the assets’ historical costs. Such revaluations are allowed under various countries’ standards and the standards issued by the International Accounting Standards Board (IASB). Liberty International, a real estate company, headquartered in United Kingdom (U.K.), follows U.K. standards. In a recent year, Liberty disclosed the following information on revaluations of its tangible fixed assets. The revaluation reserve measures the amount by which tangible fixed assets are recorded above historical cost and is reported in Liberty’s stockholders’ equity.

Liberty International
Completed Investment Properties Completed investment properties are professionally valued on a market value basis by external valuers at the balance sheet date. Surpluses and deficits arising during the year are reflected in the revalution reserve.

Liberty reported the following additional data. Amounts for Kimco Realty (which follows U.S. GAAP) in the same year are provided for comparison.
Liberty (pounds sterling, in thousands) Total revenues Average total assets Net income ? 741 5,577 125 Kimco (dollars, in millions) $ 517 4,696 297

Instructions (a) Compute the following ratios for Liberty and Kimco. (1) Return on assets. (2) Profit margin. (3) Asset turnover. How do these companies compare on these performance measures? (b) Liberty reports a revaluation reserve of 1,952 pounds. Assume that 1,550 of this amount arose from an increase in the net replacement value of investment properties during the year. Prepare the journal entry to record this increase. (Hint: Credit the Revaluation Reserve account.) (c) Under U.K. (and IASB) standards, are Liberty’s assets and equity overstated? If so, why? When comparing Liberty to U.S. companies, like Kimco, what adjustments would you need to make in order to have valid comparisons of ratios such as those computed in (a) above?

Professional Research: Financial Accounting and Reporting
Nomar Garcia recently joined Hamm Company as a staff accountant in the controller’s office. Hamm Company provides warehousing services for companies in several midwestern cities. The location in Dubuque, lowa, has not been performing well due to increased competition and the loss of several customers that have recently gone out of business. Nomar’s department manager suspects that the plant and equipment may be impaired and wonders whether those assets should be written down. Given the company’s prior success, this issue has never arisen in the past, and Nomar has been asked to conduct some research on this issue.

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Using Your Judgment
Instructions Using the Financial Accounting Research System (FARS), respond to the following items. (Provide text strings used in your search.) (a) What accounting standard provides the authoritative guidance for asset impairments? Briefly discuss the scope of the standard (i.e., explain the types of transactions to which the standard applies). (b) Give several examples of events that would cause an asset to be tested for impairment. Does it appear that Hamm should perform an impairment test? Explain. (c) What is the best evidence of fair value? Describe alternate methods of estimating fair value.

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Professional Simulation
In this simulation you are asked to address questions regarding the accounting for property, plant, and equipment. Prepare responses to all parts.

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KWW_Professional _Simulation Property, Plant, and Equipment
Directions Situation Explanation Measurement

Time Remaining 1 hour 40 minutes
Journal Entry Resources

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Whitley Corporation purchased machinery on January 1, 2006, at a cost of $100,000. The estimated useful life of the machinery is 4 years, with an estimated residual value of $10,000 at the end of that period. The company is considering different depreciation methods that could be used for financial reporting purposes.
Directions Situation Explanation Measurement Journal Entry Resources

(a) What is the purpose of depreciation? (b) Identify the factors that are relevant in determining annual depreciation, and explain whether those factors are determined objectively or whether they are based on judgment.
Directions Situation Explanation Measurement Journal Entry Resources

(a) Which depreciation method would result in the highest reported 2006 income? Explain. (b) Which method would result in the highest total reported earnings over the 4-year period? Explain. (c) Which method would result in the highest 2006 cash flow? Explain.
Directions Situation Explanation Measurement Journal Entry Resources

Assume that the company sold the machinery on January 1, 2008, for $84,000 and that the company used the straight-line method. Prepare the journal entry to record the transaction.

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Remember to check the book’s companion website to find additional resources for this chapter.

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