Chapter 11 Solutions to Concepts for Analysis

SOLUTIONS TO CONCEPTS FOR ANALYSIS CA 11-1 (a) The purpose of depreciation is to distribute the cost (or other book value) of tangible plant assets, less salvage, over their useful lives in a systematic and rational manner. Under generally accepted accounting principles, depreciation accounting is a process of allocation, not of valuation, through which the productive effort (cost) in alignment of the use of the asset (expense recognition principle) is to be matched with productive accomplishment (revenue) for the period. Depreciation accounting, therefore, is concerned with the timing of the expiration of the cost of tangible plant assets. (b) The proposed depreciation method is, of course, systematic. Whether it is rational in terms of cost allocation depends on the facts of the case. It produces an increasing depreciation charge, which is usually not justifiable in terms of the benefit from the use of the asset because manufacturers typically prefer to use their new equipment as much as possible and their old equipment only as needed to meet production quotas during periods of peak demand. As a general rule, then, the benefit declines with age. Assuming that the actual operations (including equipment usage) of each year are identical, maintenance and repair costs are likely to be higher in the later years of usage than in the earlier years. Hence the proposed method would couple light depreciation and repair charges in the early years. Reported net income in the early years would be much higher than reported net income in the later years of asset life, an unreasonable and undesirable variation during periods of identical operation. On the other hand, if the expected level of operations (including equipment usage) in the early years of asset life is expected to be low as compared to that of later years because of slack demand or production policies, the pattern of the depreciation charges of the proposed method approximately parallels expected benefits (and revenues) and hence is reasonable. Although the units-of-production depreciation method is the usual selection to fit this case, the proposed method also conforms to generally accepted accounting principles in this case provided that proper justification is given. (c) (1) (2) Depreciation charges neither recover nor create funds. Revenue-producing activities are the sources of funds from operations: if revenues exceed out-of-pocket costs during a fiscal period, funds are available to cover other than out-of-pocket costs; if revenues do not exceed out-ofpocket costs, no funds are made available no matter how much, or little, depreciation is charged. Depreciation may affect funds in two ways. First, depreciation charges affect reported income and hence may affect managerial decisions such as those regarding pricing, product selection, and dividends. For example, the proposed method would result initially in higher reported income than would the straight-line method, consequently stockholders might demand higher dividends in the earlier years than they would otherwise expect. The straight-line method, by causing a lower reported income during the early years of asset life and thereby reducing the amount of possible dividends in early years as compared with the proposed method, could encourage earlier reinvestments in other profit-earning assets in order to meet increasing demand. Second, depreciation charges affect reported taxable income and hence affect directly the amount of income taxes payable in the year of deduction. Using the proposed method for tax purposes would reduce the total tax bill over the life of the assets (1) if the tax rates were increased in future years or (2) if the business were doing poorly now but were to do significantly better in the future. The first condition is political and speculative but the second condition may be applicable to Burnitz Manufacturing Company in view of its recent origin and its rapid expansion program. Consequently, more funds might be available for reinvestment in plant assets in years of large deductions if one of the above assumptions were true. 11-59 CA 11-1 (Continued) If Burnitz is not profitable now, it would not benefit from higher deductions now and should consider an increasing charge method for tax purposes, such as the one proposed. If Burnitz is quite profitable now, the president should reconsider his proposal because it will delay the availability of the tax shield provided by depreciation. However, this decision should not affect the decision to use a depreciation method for stockholders’ reporting that is systematic and rational in terms of cost allocation under generally accepted accounting principles as presently understood. LO: 1, Bloom: C, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication CA 11-2 (a) (1) The unit method of recording depreciation involves the treatment of plant assets or substantial additions thereto as individual items. The method entails maintaining detailed records of the costs of specific assets and related accumulated depreciation. Computation of depreciation is based on the estimated useful life of the individual asset. The method is distinguished from group and composite-life methods under which the cost and estimated life of the assets are commingled. Depreciation may be recorded by straight-line, accelerated, or other accepted computation methods. (2) Under the group or composite-life methods, assets are aggregated into accounting units. Such grouping might be horizontal, vertical, or geographical. Horizontal grouping assembles together all assets of similar physical characteristics, such as trucks, presses, returnable containers, etc. A vertical or functional grouping comprises all assets contributing to a common economic function, such as a sugar refinery, a service station, etc. The geographical grouping includes all assets in a district or region, such as telephone poles. Depreciation under these methods requires development of a weighted-average rate from the assets’ depreciable costs and estimated lives. Separate accounts are established for the total cost of each asset grouping and its related accumulated depreciation. The asset grouping should be composed of a large number of units to obtain a reliable average life. (b) 1. Arguments for the use of the unit method are: i. The method is simple in that it does not require involved mathematical computations. ii. The gain or loss on the retirement of a particular asset can be computed. iii. For cost purposes, depreciation on idle equipment can be isolated. iv. The method results in a more accurately computed depreciation provision in any given year, as the total depreciation charge represents the best estimate of the depreciation of each asset and is not the result of averaging the cost over a longer period of time. Arguments against the unit method are: i. Considerable additional bookkeeping is necessary to account for each asset and its related depreciation. (Computers reduce the work burden, however.) ii. There is a point of diminishing returns in the accumulation of accounting data under this method, that is, additional accuracy may not justify the additional cost of record-keeping. iii. Under a decentralized financial control system where a measure of the division’s efficiency is the rate of return on the gross book value of the investment a division manager might scrap fully or nearly fully depreciated equipment to improve the division’s rate of return even though the equipment is still serviceable. iv. There may be reluctance on the part of a division manager to replace equipment not fully depreciated with more efficient equipment because of the effect of the loss on the division’s profits in the year of replacement. 2. 11-60 Arguments for the use of the group and composite-life methods are: i. The methods require less detailed bookkeeping. ii. The application of depreciation to the whole group tends to average out or offset errors, economic or operating, caused by under-depreciation or over-depreciation. CA 11-2 (Continued) iii. Periodic income is not distorted by gains or losses on disposal of assets. iv. A more useful charge to expense is derived from these methods because of their recognition that depreciation estimates are based on averages and that gains and losses on individual assets are of little significance. Arguments against the use of the group and composite-life methods would include: i. The methods would conceal faulty estimates for a long period of time. ii. When there is an early heavy retirement of assets a debit balance might appear in the Accumulated Depreciation account and present an accounting problem. iii. Information is not available regarding a particular machine for cost-calculation purposes. iv. Under a decentralized financial control system where a measure of the division’s efficiency is the rate of return on the gross book value of the investment, to improve the division’s financial reports a division manager might scrap idle but serviceable equipment or equipment that is not earning a satisfactory return on book value. The company would sustain an actual loss in the amount of the value of the equipment scrapped. v. Under the same situation as “iv” above, except that net book value is used, where the assets, although serviceable, are fully or almost fully depreciated, the division manager might hesitate to replace them because of the high rate of return on investment. (c) Under the unit method, retirements are recorded by removing from the accounts the cost of the asset and its related accumulated depreciation. The difference between the two accounts, adjusted for salvage and disposal costs, if any, is recognized as gain or loss. Under the group and composite-life methods the cost of the retired asset is removed from the asset account, and the Accumulated Depreciation—Plant assets account is reduced by the amount of the cost of the retired asset, adjusted for salvage, salvage costs, and removal costs. Accordingly, there is no periodic recognition of gain or loss; the Accumulated Depreciation—Plant assets account serves as a suspense account for the recognition of gain or loss until the final asset retirement. LO: 1, Bloom: C, Difficulty: Simple, Time: 20-25, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication CA 11-3 Situation I. This position relates to the omission of a provision for depreciation during a strike. The same question could be raised with respect to plant shut-downs for many reasons, such as for a lack of sales or for seasonal business. The method of depreciation used should be systematic and rational. The annual provision for depreciation should represent a fair estimate of the loss in value arising from wear and usage and also from obsolescence. Each company should analyze its own facts and establish the best method under the circumstances. If the company was employing a straight-line depreciation method, for example, it is inappropriate to stop depreciating the plant asset during the strike. If the company employs a units-of-production method, however, it would be appropriate not to depreciate the asset during this period. Even in this latter case, however, if the strike were prolonged, it might be desirable to record some depreciation because of the obsolescence factors related to the passage of time. Situation II. (a) Steady demand for the new blenders suggests use of the straight-line method or the units-of-production method, either of which will allocate cost evenly over the life of the machine. Decreasing demand indicates use of an accelerated method (declining-balance or sum-of-the-years’digits) or the units-of-production method in order to allocate more of the cost to the earlier years of the machine’s life. Increasing demand indicates the use of the units-of-production method to charge more 11-61 of the cost to the later years of the machine’s life; an increasing-charge method (annuity or sinkingfund) could be employed, though these methods are seldom used except by utilities. CA 11-3 (Continued) (b) In determining the depreciation method to be used for the machine, the objective should be to allocate the cost of the machine over its useful life in a systematic and rational manner, so that costs will be matched with the benefits expected to be obtained. In addition to demand, consideration should be given to the items discussed below, their interrelationships, the relative importance of each, and the degree of certainty with which each can be predicted: The expected pattern of costs of repairs and maintenance should be considered. Costs which vary with use of the machine may suggest the use of the units-of-production method. Costs which are expected to be equal from period to period suggest the use of the straight-line method. If costs are expected to increase with the age of the machine, an accelerated method may be considered reasonable because it will tend to equalize total expenses from period to period. The operating efficiency of the machine may change with its age. A decrease in operating efficiency may cause increases in such costs as labor and power; if so, an accelerated method is indicated. If operating efficiency is not expected to decline, the straight-line method is indicated. Another consideration is the expiration of the physical life of the machine. If the machine wears out in relation to the passage of time, the straight-line method is indicated. Within this maximum life, if the usage per period varies, the units-of-production method may be appropriate. The machine may become obsolete because of technological innovation; it may someday be more efficient to replace the machine even though it is far from worn out. If the probability is high that such obsolescence will occur in the near future, the shortened economic life should be recognized. Within this shortened life, the depreciation method used would be determined by evaluating such consideration as the anticipated periodic usage. An example of the interrelationship of the items discussed above is the effect of the repairs and maintenance policy on operating efficiency and physical life of the machine. For instance, if only minimal repairs and maintenance are undertaken, efficiency may decrease rapidly and life may be short. It is possible that different considerations may indicate different depreciation methods for the machine. If so, a choice must be made based on the relative importance of the considerations. For instance, physical life may be less important than the strong chance of technological obsolescence which would result in a shorter economic life. Situation III. Depreciation rates should be adjusted in order that the operating sawmills which are to be replaced will be depreciated to their residual value by the time the new facility becomes available. The step-up in the depreciation rates should be considered as a change in estimate and prior years’ financial statements should not be adjusted. The idle mill should be written off immediately as it appears to have no future service potential. LO: 1, Bloom: AN, Difficulty: Simple, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 11-62 CA 11-4 To: Phil Perriman, Supervisor of Canning Room From: Your name, Accountant Date: January 22, 2017 Subject: Annual depreciation charge to the canning department This memo addresses the questions you asked about the depreciation charge against your department. Admittedly this charge of $625,000 is very high; however, it is not intended to reflect the wear and tear which the machinery has undergone over the last year. Rather, it is a portion of the machines’ cost which has been allocated to this period. Depreciation is frequently thought to reflect an asset’s loss in value over time. For financial statement purposes, however, depreciation allocates part of an asset’s cost in a systematic way to each period during its useful life. Although there will always be a decline in an asset’s value over time, the depreciation charge is not supposed to measure that decline; instead, it is a periodic “charge” for using purchased equipment during any given period. When you consider the effect which the alternative would have on your departmental costs—expensing the total cost for all six machines this year—is more equitable. You also mentioned that using straight-line depreciation would result in a smaller charge than would the current double-declining-balance method. This is true during the first years of the equipment’s life. Straight-line depreciation expenses even amounts of depreciation for each canning machine’s twelveyear life. Thus the straight-line charge for this and all subsequent years would be $47,500 per machine for total annual depreciation of $285,000. During the earlier years of an asset’s life, the double-declining-balance method results in higher depreciation charges because it doubles the straight-line rate which would have been made under the straight-line method. However, the same percentage depreciation in the first year is applied annually to the asset’s declining book value. Therefore, the double-declining-balance charge becomes lower than the straight-line charge during the last several years of the asset’s life. For this year, as mentioned above, the charge is $625,000, but in subsequent years this expense will become lower. By the end of the twelfth year, the same amount of depreciation will have been taken regardless of the method used. The straight-line method would result in fewer charges against your department this year. However, consider this: when the asset is new, additional costs for service and repairs are minimal. Thus a greater part of the asset’s cost should be allocated to this optimal portion of the asset’s life. After a few years, your department will have to absorb the additional burden of repair and maintenance costs. During that time, wouldn’t you rather have a lower depreciation charge? I hope that this explanation helps clarify any questions which you may have had about depreciation charges to your department. LO: 1, Bloom: AN, Difficulty: Moderate, Time: 25-35, AACSB: Analytic, Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication CA 11-5 (a) The stakeholders are Beeler’s employees, including Prior, current and potential investors and creditors, and upper-level management. (b) The ethical issues are honesty and integrity in financial reporting, job security, and the external users’ right to know the financial picture. 11-63 CA 11-5 (Continued) (c) Prior should review the estimated useful lives and salvage values of the depreciable assets. Since they are estimates, it is possible that some should be changed. Any changes should be based on sound, objective information without concern for the effect on the financial statements (or anyone’s job). Prior weight also consider selling assets have been depreciated at a fast rate, and which result in gains, selling assets just to increase income also raises ethical issues. (Note: This case can be used with Chapter 22, Accounting Changes and Error Analysis.) LO: 2, Bloom: AN, Difficulty: Moderate, Time: 20-25, AACSB: Analytic, Ethics, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Professional Demeanor 11-64