Chapter 11 Answers to Questions

ANSWERS TO QUESTIONS 1. The differences among the terms depreciation, depletion, and amortization are that they imply a cost allocation of different types of assets. Depreciation is employed to indicate that tangible plant assets have decreased in carrying value. Where natural resources (wasting assets) such as timber, oil, coal, and lead are involved, the term depletion is used. The expiration of intangible assets such as patents or copyrights is referred to as amortization. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 2. The factors relevant in determining the annual depreciation for a depreciable asset are the initial recorded amount (cost), estimated salvage value, estimated useful life, and depreciation method. Assets are typically recorded at their acquisition cost, which is in most cases objectively determinable. But cost assignment in other cases—“basket purchases” and the selection of an implicit interest rate in asset acquisitions under deferred-payment plans—may be quite subjective, involving considerable judgment. The salvage value is the estimated amount that a company will receive when the asset is sold or when the asset is retired from service. The estimate is based on judgment and is affected by the length of the useful life of the asset. The useful life is also based on judgment. It involves selecting the “unit” of measure of service life and estimating the number of such units embodied in the asset based on the company’s experience with such assets. Such units may be measured in terms of time periods or in terms of activity (for example, years or machine hours). When selecting the life, one should select the lower (shorter) of the physical life or the economic life. Physical life involves wear and tear and casualties; economic life involves such things as technological obsolescence and inadequacy. Selecting the depreciation method is generally a judgment decision, but a method may be inherent in the definition adopted for the units of service life, as discussed earlier. For example, if such units are machine hours, the method is a function of the number of machine hours used during each period. A method should be selected that will best measure the portion of services expiring each period. Once a method is selected, it may be objectively applied by using a predetermined, objectively derived formula. LO: 1, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: Communication 3. Disagree. Accounting depreciation is defined as an accounting process of allocating the costs of tangible assets to expense in a systematic and rational manner to the periods expected to benefit from the use of the asset. Thus, depreciation is not a matter of valuation but a means of cost allocation. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 4. The carrying value of a fixed asset is its cost less accumulated depreciation. If the company estimates that the asset will have an unrealistically long life, the result will be to lower periodic depreciation charges, and hence accumulated depreciation. As a result the carrying value of the asset will be higher. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None 5. A change in the amount of annual depreciation recorded does not change the facts about the decline in economic usefulness. It merely changes reported figures. Depreciation in accounting consists of allocating the cost of an asset over its useful life in a systematic and rational manner. Abnormal obsolescence, as suggested by the plant manager, would justify more rapid depreciation, but increasing the depreciation charge would not necessarily result in funds for replacement. It would not increase revenue but simply make reported income lower than it would have been, thus preventing overstatement of net income. 11-5 Questions Chapter 11 (Continued) Recording depreciation on the books does not set aside any assets for eventual replacement of the depreciated assets. Fund segregation can be accomplished but it requires additional managerial action. Unless an increase in depreciation is accompanied by an increase in sales price of the product, or unless it affects management’s decision on dividend policy, it does not affect funds. Ordinarily higher depreciation will not lead to higher sales prices and thus to more rapid “recovery” of the cost of the asset, and the economic factors present would have permitted this higher price regardless of the excuse given or the particular rationalization used. The price could have been increased without a higher depreciation charge. The funds of a firm operating profitably do increase, but these may be used as working capital policy may dictate. The measure of the increase in these funds from operations is not merely net income, but that figure plus charges to operations which did not require working capital, less credits to operations which did not create working capital. The fact that net income alone does not measure the increase in funds from profitable operations leads some non-accountants to the erroneous conclusion that a fund is being created and that the amount of depreciation recorded affects the fund accumulation. Acceleration of depreciation for purposes of income tax calculation stands in a slightly different category, since this is not merely a matter of recordkeeping. Increased depreciation will tend to postpone tax payments, and thus temporarily increase funds (although the liability for taxes may be the same or even greater in the long run than it would have been) and generate gain to the firm to the extent of the value of use of the extra funds. LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 6. Assets are retired for one of two reasons: physical factors or economic factors—or a combination of both. Physical factors are the wear and tear, decay, and casualty factors which hinder the asset from performing indefinitely. Economic factors can be interpreted to mean any other constraint that develops to hinder the service life of an asset. Some accountants attempt to classify the economic factors into three groups: inadequacy, supersession, and obsolescence. Inadequacy is defined as a situation where an asset is no longer useful to a given enterprise because the demands of the firm have changed. Supersession is defined as a situation where the replacement of an asset occurs because another asset is more efficient and economical. Obsolescence is the catchall term that encompasses all other situations and is sometimes referred to as the major concept when economic factors are considered. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 7. Before the amount of the depreciation charge can be computed, three basic questions must be answered: (1) What is the depreciation base to be used for the asset? (2) What is the asset’s useful life? (3) What method of cost apportionment is best for this asset? LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Measurement, Reporting, AICPA PC: None 8. Cost Depreciation rate Depreciation for 2017 2017 Depreciation 2018 Depreciation Accumulated depreciation at December 31, 2018 *(1 ÷ 5) X 150% $800,000 X 30%* $240,000 $240,000 168,000 Cost Depreciation for 2017 Undepreciated cost in 2018 Depreciation rate Depreciation for 2018 $408,000 LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None 11-6 $800,000 (240,000) 560,000 X 30% $168,000 Questions Chapter 11 (Continued) 9. Depreciation base: Cost Salvage $162,000 (15,000) $147,000 Straight-line, $147,000 ÷ 20 = Units-of-output, $147,000 X $ 7,350 20,000 = 84,000 14,300 $35,000 = 42,000 Sum-of-the-years’-digits, $147,000 X 20/210* = $14,000 Double-declining-balance, $162,000 X 10% = $16,200 Working hours, *2020+(1) 2 $147,000 X $50,050 =210 LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None 10. From a conceptual point of view, the method which best matches revenue and expenses should be used; in other words, the answer depends on the decline in the service potential of the asset. If the service potential decline is faster in the earlier years, an accelerated method would seem to be more desirable. On the other hand, if the decline is more uniform, perhaps a straight-line approach should be used. Many firms adopt depreciation methods for more pragmatic reasons. Some companies use accelerated methods for tax purposes but straight-line for book purposes because a higher net income figure is shown on the books in the earlier years, but a lower tax is paid to the government. Others attempt to use the same method for tax and accounting purposes because it eliminates some recordkeeping costs. Tax policy sometimes also plays a role. LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 11. The composite method is appropriate for a company which owns a large number of heterogeneous plant assets and which would find it impractical to keep detailed records for them. The principal advantage is that it is not necessary to keep detailed records for each plant asset in the group. The principal disadvantage is that after a period of time the book value of the plant assets may not reflect the proper carrying value of the assets. Inasmuch as the Accumulated Depreciation account is debited or credited for the difference between the cost of the asset and the cash received from the retirement of the asset (i.e., no gain or loss on disposal is recognized), the Accumulated Depreciation account is self-correcting over time. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 12. Cash.................................................................................................... Accumulated Depreciation—Plant Assets........................................... Plant Assets....................................................................... No gain or loss is recognized under the composite method. 14,000 36,000 50,000 LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-10, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None 13. Original estimate: $2,500,000 ÷ 50 = $50,000 per year Depreciation to January 1, 2018: $50,000 X 14 = $700,000 Depreciation in 2018 ($2,500,000 – $700,000) ÷ 15 years = $120,000 LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 11-7 Questions Chapter 11 (Continued) 14. No, depreciation does not provide cash; revenues do. The funds for the replacement of the assets come from the revenues; without the revenues no income materializes and no cash inflow results. A separate decision must be made by management to set aside cash to accumulate asset replacement funds. Depreciation is added to net income on the statement of cash flows (indirect method) because it is a noncash expense, not because it is a cash inflow. LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None 15. 25% straight-line rate X 2 = 50% double-declining rate $8,000 X 50% = $4,000 Depreciation for first full year. $4,000 X 6/12 = $2,000 Depreciation for half a year (first year), 2017. $6,000 ($8,000-$2,000) X 50% = $3,000 Depreciation for 2018. LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: None, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None 16. The accounting standards require that if events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable, then the carrying amount of the asset should be assessed. The assessment or review takes the form of a recoverability test that compares the sum of the expected future cash flows from the asset (undiscounted) to the carrying amount. If the cash flows are less than the carrying amount, the asset has been impaired. The impairment loss is measured as the amount by which the carrying amount exceeds the fair value of the asset. The fair value of assets is measured by their market value if an active market for them exists. If no market price is available, the present value of the expected future net cash flows from the asset may be used. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 17. Under U.S. GAAP, impairment losses on assets held for use may not be restored. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 18. An impairment is deemed to have occurred if, in applying the recoverability test, the carrying amount of the asset exceeds the expected future net cash flows from the asset. In this case, the expected future net cash flows of $705,000 exceed the carrying amount of the equipment of $700,000 so no impairment is assumed to have occurred; thus no measurement of the loss is made or recognized even though the fair value is $590,000. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 19. Impairment losses are reported as part of income from continuing operations, generally in the “Other expenses and losses” section. Impairment losses (and recovery of losses for assets to be disposed of) are similar to other costs that would flow through operations. Thus, gains (recoveries of losses) on assets to be disposed of should be reported as part of income from continuing operations in the “Other revenues and gains” section. LO: 3, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 20. In a decision to replace or not to replace an asset, the undepreciated cost of the old asset is not a factor to be considered. Therefore, the decision to replace plant assets should not be affected by the amount of depreciation that has been recorded. The relative efficiency of new equipment as compared with that presently in use, the cost of the new facilities, the availability of capital for the new asset, etc., are the factors entering into the decision. Normally, the fact that the asset had been fully depreciated through the use of some accelerated depreciation method, although the asset was still in use, should not cause management to decide to replace the asset. If the new asset under consideration for replacement was not any more efficient than the old, or if it cost a good deal more in relationship to its efficiency, it is illogical for management to replace it merely because all or the major portion of the cost had been charged off for tax and accounting purposes. 11-8 Questions Chapter 11 (Continued) If depreciation rates were higher it might be true that a business would be financially more able to replace assets, since during the earlier years of the asset’s use a larger portion of its cost would have been charged to expense, and hence during this period a smaller amount of income tax paid. By selling the old asset, which might result in a capital gain, and purchasing a new asset, the higher depreciation charge might be continued for tax purposes. However, if the asset were traded in, having taken higher depreciation would result in a lower basis for the new asset. It should be noted that expansion (not merely replacement) might be encouraged by increased depreciation rates. Management might be encouraged to expand, believing that in the first few years when they are reasonably sure that the expanded facilities will be profitable, they can charge off a substantial portion of the cost as depreciation for tax purposes. Similarly, since a replacement involves additional capital outlays, the tax treatment may have some influence. Also, because of the inducement to expand or to start new businesses, there may be a tendency in the economy as a whole for the accounting and tax treatment of the cost of plant assets to influence the retirement of old plant assets. It should be noted that increased depreciation may cause management to alter its decision about replacement. LO: 2, Bloom: K, Difficulty: Moderate, Time: 5-10, AACSB: Communication, Reflective Thinking, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 21. In lieu of recording depreciation on replacement costs, management might elect to make annual appropriations of retained earnings in contemplation of replacing certain facilities at higher price levels. Such appropriations might help to eliminate misunderstandings as to amounts available for distribution as dividends, higher wages, bonuses, or lower sales prices. The need for these appropriations can be explained by supplementary financial schedules, explanations, and footnotes accompanying the financial statements. (However, neither depreciation charges nor appropriations of retained earnings result in the accumulation of funds for asset replacement. Fund accumulation is a result of profitable operations and appropriate funds management.) LO: 2, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 22. (a) Depreciation and cost depletion are similar accounting concepts in that: 1. The cost of the asset is the starting point from which computation of the amount of the periodic charge to operations is made. 2. The estimated life is based on economic or productive life. 3. The accumulated total of past charges to operations is deducted from the original cost of the asset on the balance sheet. 4. When output methods of computing depreciation charges are used, the formulas are essentially the same as those used in computing depletion charges. 5. Both represent an apportionment of cost under the process of matching costs with revenue. 6. Assets subject to either are reported in the same classification on the balance sheet. 7. Appraisal values are sometimes used for depreciation while discovery values are sometimes used for depletion. 8. Salvage value is properly recognized in computing the charge to operations. 9. Depreciation and depletion may be included in inventory if the related asset contributed to the production of the inventory. 10. The rates may be changed upon revision of the estimated productive life used in the original rate computations. (b) Depreciation and cost depletion are dissimilar accounting concepts in that: 1. Depletion is almost always based on output whereas depreciation is usually based on time. 2. Many formulas are used in computing depreciation but only one is used to any extent in computing depletion. 3. Depletion applies to natural resources while depreciation applies to plant and equipment. 11-9 4. Depletion refers to the physical exhaustion or consumption of the asset while depreciation refers to the wear, tear, and obsolescence of the asset. 5. Under statutes which base the legality of dividends on accumulated earnings, depreciation is usually a required deduction but depletion is usually not a required deduction. 6. The computation of the depletion rate is usually much less precise than the computation of depreciation rates because of the greater uncertainty in estimating the productive life. 7. A difference that is temporary in nature arises from the timing of the recognition of depreciation under conventional accounting and under the Internal Revenue Code, and it results in the recording of deferred income taxes. On the other hand, the difference between cost depletion under conventional accounting and its counterpart, percentage depletion, under the Internal Revenue Code is permanent and does not require the recording of deferred income taxes. LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 23. Cost depletion is the procedure by which the capitalized costs, less residual land values, of a natural resource are systematically charged to operations. The purpose of this procedure is to match the cost of the resource with the revenue it generates. The usual method is to divide the total cost less residual value by the estimated number of recoverable units to arrive at a depletion charge for each unit removed. A change in the estimate of recoverable units will necessitate a revision of the unit charge. Percentage depletion is the procedure, authorized by the Internal Revenue Code, by which a certain percentage of gross income is charged to operations in arriving at taxable income. Percentage depletion is not considered to be a generally accepted accounting principle because it is not related to the cost of the asset and is allowed even though the property is fully depleted under cost depletion accounting. Applicable rates, ranging from 5% to 22% of gross income, are specified for nearly all natural resources. The total amount deductible in a given year may not be less than the amount computed under cost depletion procedures, and it may not exceed 50% of taxable income from the property before the depletion deduction. Cost depletion differs from percentage depletion in that cost depletion is a function of production whereas percentage depletion is a function of income. Percentage depletion has arisen, in part, from the difficulty of valuing the natural resource or determining the discovery value of the asset and of determining the recoverable units. Although other arguments have been advanced for maintaining percentage depletion, a primary argument is its value in encouraging the search for additional resources. It is deemed to be in the national interest to provide an incentive to the continuing search for natural resources. As noted in the textbook, percentage depletion is no longer permitted for many enterprises. LO: 4, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 24. Percentage depletion does not necessarily measure the proper share of the cost of a natural resource to be charged to expense for depletion and, in fact, may ultimately exceed the actual cost of the property. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 25. The maximum dividend permissible is the amount of accumulated net income (after depletion) plus the amount of depletion charged. This practice can be justified for companies that expect to extract natural resources and not purchase additional properties. In effect, such companies are distributing gradually to stockholders their original investments. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 26. Reserve recognition accounting (RRA) is the method (a fair value approach) that was proposed by the SEC to account for oil and gas resources. Proponents of this approach argue that oil and gas should be valued at the date of discovery. The value of the reserve still in the ground is estimated and this amount, appropriately discounted, is reported on the balance sheet as “oil deposits.” 11-10 Questions Chapter 11 (Continued) The oil companies are concerned because the valuation issue is extremely tenuous. For example, to properly value the reserves, the following must be estimated: (1) amount of the reserves, (2) future production costs, (3) periods of expected disposal, (4) discount rate, and (5) the selling price. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Measurement Reporting, AICPA PC: Communication 27. Using full-cost accounting, the cost of unsuccessful ventures as well as those that are successful is capitalized, because a cost of drilling a dry hole is a cost that is needed to find the commercially profitable wells. Successful efforts accounting capitalizes only those costs related to successful projects. They contend that to measure cost and effort accurately for a single property unit, the only measure is in terms of the cost directly related to that unit. In addition, it is argued that full-cost is misleading because capitalizing all costs will make an unsuccessful company over a short period of time show no less income than does one that is successful. LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 28. Asset turnover: $482.2 = 2.36 times $204.2 Return on assets: $16.4 = 8% $204.2 LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None *29. The modified accelerated cost recovery system (MACRS) has been adopted by the Internal Revenue Service. It applies to depreciable assets acquired in 1987 and later. MACRS eliminates the need to determine each asset’s useful life. The selection of a depreciation method and a salvage value is also unnecessary under MACRS. The taxpayer determines the recovery deduction for an asset by applying a statutory percentage to the historical cost of the property. MACRS was adopted to permit a faster write-off of tangible assets so as to provide additional tax incentives and to simplify the depreciation process. The simplification should end disputes related to estimated useful life, salvage value, and so on. LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication 11-11