Chapter 11 Intermediate Accounting: Questions

12. If Remmers, 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 $14,000?

12. Cash 14,000 Accumulated Depreciation—Plant Assets 36,000 Plant Assets 50,000 No gain or loss is recognized under the composite method.

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

*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.

1. Distinguish among depreciation, depletion, and amortization.

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.

10. What are the major factors considered in determining what depreciation method to use?

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.

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?

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.

13. A building that was purchased on December 31, 2000, for $2,500,000 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 2014. During 2015, an examination of the building by an engineering firm discloses that its estimated useful life is 15 years after 2014. What should be the amount of depreciation for 2015?

13. Original estimate: $2,500,000 ÷ 50 = $50,000 per year Depreciation to January 1, 2015: $50,000 X 14 = $700,000 Depreciation in 2015 ($2,500,000 - $700,000) ÷ 15 years = $120,000

14. Charlie Parker, president of Spinners Company, has recently noted that depreciation increases cash provided by operations and therefore depreciation is a good source of funds. Do you agree? Discuss.

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 replace-ment 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.

15. Andrea Torbert purchased a computer for $8,000 on July 1, 2014. She intends to depreciate it over 4 years using the double-declining-balance method. Salvage value is $1,000. Compute depreciation for 2015.

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), 2014. $6,000 X 50% = $3,000 Depreciation for 2015.

16. Walkin Inc. is considering the write-down of its long-term plant because of a lack of profitability. Explain to the management of Walkin how to determine whether a write-down is permitted.

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.

17. Last year, Wyeth Company recorded an impairment on an asset held for use. Recent appraisals indicate that the asset has increased in value. Should Wyeth record this recovery in value?

17. Under U.S. GAAP, impairment losses on assets held for use may not be restored.

18. Toro 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 Toro report as an impairment to its equipment?

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.

19. Explain how gains or losses on impaired assets should be reported in income.

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.

24. In what way may the use of percentage depletion violate sound accounting theory?

24. Percentage depletion does not necessarily measure the proper share of the cost of land to be charged to expense for depletion and, in fact, may ultimately exceed the actual cost of the property.

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?

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.

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.

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 an estimate of an amount potentially realizable 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. 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.

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.

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. 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 to the extent that increased depreciation causes management to alter its decision about replacement, and to the extent it results in capital gains at the time of disposition, it is not matching costs and revenues in the closest possible manner.

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.

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.)

22. List (a) the similarities and (b) the differences in the accounting treatments of depreciation and cost depletion.

22. (a) Depreciation and cost depletion are similar in the accounting sense 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. Residual value is properly recognized in computing the charge to operations. 9. They 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 in the accounting sense 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. 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.

23. Describe cost depletion and percentage depletion. Why is the percentage depletion method permitted?

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.

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?

26. Reserve recognition accounting (RRA) is the method 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." The costs of exploration incurred each year are deducted from the estimated reserves discovered during the same period with the difference probably being reported as income. 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

27. Shumway Oil uses successful-efforts accounting and also provides full-cost results as well. Under full-cost, Shumway Oil would have reported retained earnings of $42 million and net income of $4 million. Under successfulefforts, retained earnings were $29 million, and net income was $3 million. Explain the difference between full-costing and successful-efforts accounting.

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.

28. Target in 2012 reported net income of $2.9 billion, net sales of $69.8 billion, and average total assets of $45.2 billion. What is Target's asset turnover? What is Target's return on assets?

28. Asset turnover: $69.8/$45.2 = 1.54 times Return on assets: $2.9/$45.2 = 6.4%

3. Some believe that accounting depreciation measures the decline in the value of fixed assets. Do you agree? Explain.

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.

4. Explain how estimation of service lives can result in unrealistically high carrying values for fixed assets.

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, periodic depreciation charges, and hence accumulated depreciation, will be lower. As a result the carrying value of the asset will be higher.

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 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.

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. 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.

6. For what reasons are plant assets retired? Define inadequacy, supersession, and obsolescence.

6. Assets are retired for one of three 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 increased. 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.

7. What basic questions must be answered before the amount of the depreciation charge can be computed?

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?

8. Workman Company purchased a machine on January 2, 2014, for $800,000. 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, 2015?

8. Cost $800,000 Cost $800,000 Depreciation rate X 30%* Depreciation for 2014 (240,000) Depreciation for 2014 $240,000 Undepreciated cost in 2015 560,000 Depreciation rate X 30% 2014 Depreciation $240,000 Depreciation for 2015 $168,000 2015 Depreciation 168,000 Accumulated depreciation at December 31, 2015 $408,000 *(1 ÷ 5) X 150%

9. Silverman Company purchased machinery for $162,000 on January 1, 2014. 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 2014, the company uses the machinery for 14,300 hours, and the machinery produces 20,000 units. Compute depreciation under the straight-line, units-of-output, working hours, sum-of-the-years'-digits, and doubledeclining- balance methods.

9. Depreciation base: Cost $162,000 Salvage (15,000) $147,000 Straight-line, $147,000 ÷ 20 = $ 7,350 Units-of-output, $147,000 X 20,000 = $35,000 84,000 Working hours, $147,000 X 14,300 = $50,050 42,000 Sum-of-the-years'-digits, $147,000 X 20/210* = $14,000 Double-declining-balance, $162,000 X 10% = $16,200 20(20+1)/2=210