Chapter 7

Time Value of Money

Money earns interest over time - interest is the cost of using money - To borrowers, interest is a fee - To lenders, interest is revenue earned

Present Value = ? Future Value = 10,000 (at the end of 1 year) Interest Rate = 5%

PV X (1 + int. Rate) = FV ___ X (1 + .05) = 10,000 So, 10,000 divided by 1.05 = 9,523

A recent grad student needs to accumulate 100,000 to go to medical school in 3 years. Assuming he earns 10% interest at the end of each year how much must he save each year?

WORK IT OUT

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Double Declining Depreciation Method(2 Steps)

1. Straight line rate X 200% (2) = Double Declining Rate 2. DDR % X Book Value = Depreciation per period

To calculate the future value of an investment, you need:

1. The amount of initial payment (or Receipt) 2. The length of time between investment and future receipt (or payment) 3. The interest rate

Cost: 170,000 Useful life: 5 years What is the amortization?

170,000/5= 34,000

Impairment Loss

= Net book value - Fair Value

The net book value (or carrying value) of an asset is ________. A. the original cost of the asset minus its accumulated depreciation B. the original cost of the asset minus its salvage value minus its accumulated depreciation C. the amount for which the asset could be sold D. increased when the market value of the asset increases

A

What effect does recording a capital expenditure as repairs and maintenance expense have on the financial statements of the current period? A. It overstates expenses and understates net income. B. It understates expenses and understates assets. C. It overstates assets and overstates owners' equity. D. It understates expenses and overstates owners' equity.

A Capital expenditures should be recorded as an increase in the cost of the asset and depreciated over the remaining useful life of the asset. If the expenditure is all expensed in the current period, it will overstate the expenses and understate net income in the current period.

A customer deposits 5,000 in a savings account on Jan. 1st, 2016, that will accumulate at the end of each year. a) what will be the balance at the end of year 10? b) how much interest will be earned in year 3?

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Report on Long-Term Assets

1. Recorded at cost 2. Accumulated Depreciation: added during each accounting period Formula: Cost - Accumulated Depreciation = Book Value

Amortization

(cost - salvage value)/ useful life

Before accounting for *disposal*, the business should bring depreciation up to date to:

- Measure the asset's final book value - Record the expense up to the date of disposal

Goodwill

- The excess cost of purchasing another company over the sum of the market values of the acquired company's net assets - Only recorded when it is purchased, never when it is created - Perform Impairment tests - "how much you overpaid"

Units of Production Deprecation Method

1. Calculate depreciation per unit (eg. miles) Depreciation per unit = (cost - residual value)/(Useful life or units of production) 2. Apply the depreciation per unit to level of production = Depreciation per unit X Number of units in current period

Fathom Company acquired a $50,000 machine on January 1, 2016. The machine is estimated to have a useful life of 5 years, and a residual value of $5,000. For unit depreciation purposes, the machine is expected to produce 500,000 units. What is the depreciable value of the machine acquired by Fathom Company? A. $45,000 B. $50,000 C. $10,000 D. $5,000

A Depreciable cost is calculated by reducing the cost of the asset by any residual value (i.e., $50,000 - $5,000 = $45,000).

The process of expensing the cost of a natural resource over its useful life is called ________. A. Depletion B. Depreciation C. Amortization D. Accumulated Depreciation

A Land is not a depreciable fixed / plant asset. However, sometimes land may be purchased for the natural resources that are available from the land. As these resources are extracted, portions of the cost of the land can be expensed (similar to the units of production method of depreciation). This is called depletion as the land is being depleted of the natural resource.

Which financial statement shows how much cash was paid for newly acquired property, plant and equipment? A. statement of cash flows B. statement of financial position C. statement of operations D. statement of changes in shareholders' equity

A The statement of cash flows shows the cash inflows and outflows for the period covered by the statement (i.e., cash paid for newly acquired fixed assets). The statement of financial position (balance sheet) would show the total amount of fixed assets, but not the amount spent on newly acquired assets for the period. The statement of operations would show only the depreciation expense recorded on the plant assets, as well as any repairs expense related to them but not the amount that was acquired over the period

Equipment costing $55,000 with a book value of $24,500 is sold for $21,000. What is the gain or loss on sale and how is it recorded for this transaction? A. debit to Loss on Sale for $3,500 B. credit to Gain on Sale for $51,500 C. credit to Loss on Sale for $3,500 D. debit to Gain on Sale for $51,500

A To record the sale of this plant asset, four accounts have to be effected: Equipment (credited for the cost of the asset), Accumulated Depreciation (debited for the amount of depreciation recorded to date), Cash (debited for the amount received), and Gain (credit) or Loss (debit) to balance the entry.

Straight Line Depreciation Method

Cost - Residual/Salvage value (Value @ end of period) ---------------------------------- Useful life

Capitalize Expense

All costs incurred *after* acquisition After Acquisition: ---------------------- - Repairs - Maintenance - Annual Registration

Capitalize Cost

All expenses incurred to bring an asset to operation. Goes initially to the bank statement. Day 0: Acquisition ---------------------- - Purchase Price - Warranty - Taxes/Title

Changing the useful life of a depreciable asset

Asset's remaining Depreciable book value/ New est. useful life = New annual depreciation

Pittsburg Resources acquired a coalmine for $6,000,000. The company's survey estimates that 120,000 tons of coal can be extracted from the mine. In the first year of operations, 25,000 tons of coal was extracted, and the coal is considered sold immediately upon extraction. Pittsburg Resources would recognize ________. A. depreciation expense of $1,250,000 B. depletion expense of $1,250,000 C. depreciation expense of $25,000 D. depletion expense of $25,000

B Depletion expense is calculated similarly to the units of production method for depreciation. To calculate depletion, you must first determine the depletion expense per unit extracted, or per ton in this problem. This is determined by subtracting the residual value (if applicable) from the cost, then dividing by the total units expected to be extracted from the asset. Next, annual depletion expense is determined by multiplying the depletion rate per unit by the actual amount of units extracted in the period. For Pittsburg, this is calculated as: ($6,000,000 - $0) / 120,000 = $50 per ton $50 × 25,000 tons = $1,250,000

Fathom Company acquired a $50,000 machine on January 1, 2016. The machine is estimated to have a useful life of 5 years and a residual value of $5,000. For unit depreciation purposes, the machine is expected to produce 500,000 units. If Fathom Company uses double-declining-balance depreciation, what is the depreciation expense in 2017? A. $7,200 B. $12,000 C. $20,000 D. $9,000

B Double-declining balance ignores residual value when computing depreciation expense. When computing double-declining balance, we first calculate the straight-line rate of depreciation, calculated as 1 / useful life, or 1 / 5, which is 20%. Then we multiply the straight-line rate by 2 to determine the double-declining balance rate of depreciation, resulting in a double-declining balance rate of 40% (20% x 2). Annual depreciation expense is then determined each year as the double-declining balance rate of depreciation (40%) multiplied by the beginning period book value of the asset (Cost - Accumulated Depreciation), resulting in depreciation expense in 2016 and 2017 of: 2016: 40% × $50,000 = $20,000 2017: 40% × ($50,000 - $20,000) = $12,000

Fair Market, Inc. purchased land, a warehouse, and a delivery truck for $450,000. The appraised values for the items are $300,000, $150,000, and $50,000, respectively. Fair Market should record this purchase ________. A. as an expense of $450,000 on the income statement B. as assets on the balance sheet: $270,000 for the land, $135,000 for the building, and $45,000 for the delivery truck C. as assets on the balance sheet: $300,000 for the land, $150,000 for the building and $50,000 for the delivery truck D. as assets on the balance sheet: $500,000 for the basket purchase minus $50,000 accumulated depreciation

B Recall that assets are recorded on the balance sheet at cost. However, when purchasing a group of assets for one lump sum, it requires allocating the total cost of the group of assets to each individual asset in the group by using the fair market value of the individual assets: *Land* 300,000 / 500,000 = 60% x $450,000 = $270,000 *Warehouse* 150,000 / 500,000 = 30% x $450,000 = $135,000 *Delivery Truck* 50,000 / 500,000 = 10% x $450,000 = $45,000 *Total* 450,000

Steeler Manufacturers reported the following information from its income statement and balance sheet: Income Statement: Net Sales - $2,500,000; Gross Profit - $1,200,000; Net Income - $750,000 Balance Sheet - Total Assets, beginning and ending, respectively - $10,500,000 & $13,500,000. What is Steeler's Return on Assets? A. 20.83% B. 6.25% C. 5.56% D. 10%

B Return on Assets is calculated as Net Income / Average Total Assets. Average Total Assets is calculated as (Beginning Total Assets + Ending Total Assets) / 2. For Steeler, Return on Assets is calculated as: $750,000 ((10,500,000 + 13,500,000) / 2) This results in Return on Assets of 6.25%.

A bookkeeper did not record depreciation expense for a period. As a result ________. A. There is no effect on the accounting equation because accumulated depreciation is a contra asset account that offsets depreciation expense. B. shareholders' equity will be overstated C. liabilities will be understated D. assets will be understated

B The omitted journal entry would include a debit to depreciation expense and a credit to accumulated deprecation. If this entry was not recorded, assets would be overstated because the accumulated depreciation being a contra asset reducing overall assets would be omitted and depreciation expense reducing net income would be omitted. As net income affects retained earnings and retained earnings affect shareholders' equity, shareholders' equity would be overstated due to this omission.

Cardinal Construction has a long-term asset with the following year-end information: Net book Value = $475,000 Estimated future cash flows = $$425,000 Fair Value = $410,000 Is Cardinal required to impair this asset? If so, what amount of loss will be recorded? A. Yes, Cardinal will record an impairment loss of $50,000. B. Yes, Cardinal will record an impairment loss of $65,000. C. No, an impairment of this asset is not required because the future net cash flows are greater than the fair value of the asset. D. No, an impairment of this asset is not required because the net book value is less than the future cash flows.

B To determine if an impairment has occurred and the amount of impairment loss to record, Cardinal must use the following test of impairment: Step 1: Impairment Test - Is the book value > future cash flows (Yes, $475,000 > $425,000) Step 2: Impairment Loss = Net Book Value - Fair Value = $475,000 - $410,000 = $65,000 Impairment Loss.

Which of the following should be recorded as an intangible asset? A. The cost of advertising a new product B. Research and development costs on a new project C. The cost to obtain exclusive rights to manufacture a unique product D. The cost of employee education

C An intangible asset is a copyright, patent, etc. that is amortized (expensed) over its useful life (similar to depreciation of a fixed asset). Research and development costs are expensed when incurred because the benefits from this cost are uncertain.

A bookkeeper recorded a capital expenditure as an asset. As a result ________. A. liabilities will be understated B. assets will be understated C. the books are correct as capital expenditures should be recorded as assets, not expenses D. shareholders' equity will be overstated

C Capital expenditures typically extend the useful life of a fixed asset and, therefore, should be expensed over the remaining useful life of the asset. This is called capitalization. As these capital expenditures are expected to benefit future periods, they must be recorded as part of the cost and depreciated over the periods that will be benefited from the costs.

The process of expensing the cost of an intangible asset over its useful life is called ________. A. Accumulated Depreciation B. Depletion C. Amortization D. Depreciation

C Intangibles, although not a visible unit producing asset like many fixed / plant assets, are still expensed over their "useful" lives. For example, a patent on an invention may be good for 40 years and is, therefore, expensed via amortization over its useful life.

If equipment is purchased for $200,000, freight costs are $3,800, sales tax amounts to $2,000, and maintenance during the first year of use is $7,000, what is the cost of the equipment? A. $212,800 B. $200,000 C. $205,800 D. $203,800

C The "purchase price" or "cost" of a plant asset includes anything that gets the asset ready for its intended use. In this case, without the payment of the freight and sales tax, we would not have the asset and it would not be ready for its intended use. The maintenance cost for the year would be a period cost and expensed as incurred, not included as part of the cost of the asset.

Equipment costing $20,000 with $17,800 of accumulated depreciation is sold for $2,500 cash. The journal entry will involve a ________. A. debit to depreciation expense for $17,800 B. credit to depreciation expense for $17,800 C. debit to accumulated depreciation for $17,800 D. credit to accumulated depreciation for $17,800

C When an asset is sold, it must be taken off the books with a credit for the cost (which is still reported in the books in the asset account); in addition, its associated contra asset account, accumulated depreciation (carries a normal credit balance) must also be taken off the books with a debit. If the asset is sold above the book value, there is a gain (credit). If the asset is sold below the book value, there is a loss (debit). The entry for the sale of equipment in this problem would be: Cash 2,500 Accumulated Depreciation 17,800 Equipment 20,000 Gain on Sale of Equipment 300

Capitalize Expenditure vs Expensing

Capitalize: - Add to the asset --> Balance Sheet - Adds useful life = future benefit - Extra ordinary Maintenance = New Engine Expense: - Benefit in the current period only. - Immediate expense to the income statement - i.e. Oil Changes - Maintenance = ordinary

Fathom Company acquired a $50,000 machine on January 1, 2016. The machine is estimated to have a useful life of 5 years and a residual value of $5,000. For unit depreciation purposes, the machine is expected to produce 500,000 units. If Fathom Company uses straight-line depreciation, what is the depreciation expense in 2017? A. $4,500 B. $5,000 C. $10,000 D. $9,000

D Straight line depreciation spreads the cost of the asset equally over the assets useful life and is calculated by dividing the depreciable cost by the useful life: (Cost - Residual Value) / Useful life ($50,000 - $5,000) / 5 years = $9,000 per year

A major expenditure made to equipment that extends its useful life beyond the original estimate is journalized by ________. A. debiting repairs expense B. debiting depreciation expense C. crediting depreciation expense D. debiting equipment

D If a cost is associated with an asset that extends its useful life, it is capitalized as part of the cost of the asset and, therefore, debited to the asset account. This cost will be expensed but over the useful life of the asset as depreciation.

Cash inflows and outflows relating to plant assets, natural resources, and intangibles are reported in which section of the statement of cash flows? A. Financing Activities B. Operating Activities C. Operating and Investing D. Investing Activities

D Operating activities in the statement of cash flows relate to transactions that make up net income. Financing activities deal with cash-related increases in long-term liability and shareholder's equity accounts. Transactions involving cash related to long-term asset accounts are reported in the investing activities section of the statement of cash flows. Although depreciation and amortization are seen in the operating section, it's because these are non-cash items that are being added back to net income, not cash inflows or outflows related to long-term assets.

Which of the following is not a plant asset? A. Equipment B. Land C. Building D. Copyright

D Plant assets (also called fixed assets or property, plant and equipment) are long-term assets that will be used for many years to generate revenues. Therefore, these assets are not expensed when purchased but expensed over their useful lives by one of the approved methods of depreciation. Copyrights are considered to be intangible assets that are also long-term. The method of spreading out their cost over their useful life is called amortization.

Fathom Company acquired a $50,000 machine on January 1, 2016. The machine is estimated to have a useful life of 5 years and a residual value of $5,000. For unit depreciation purposes, the machine is expected to produce 500,000 units. If Fathom Company uses unit depreciation and the company produces 75,000 units in 2017, what is depreciation expense for 2017? A. $9,000 B. $5,000 C. $7,500 D. $6,750

D The calculation for the units-of-production method of depreciation is very similar to straight-line depreciation: (Cost - Residual Value) / Total units of production = Depreciation expense per unit Depreciation expense per unit × Number of units produced in current year = Depreciation Expense ($50,000 - $5,000) / 500,000 units = $0.09 per unit $.09 x 75,000 units produced in the current year = $6,750

Equipment costing $55,000 with a book value of $24,500 is sold for $21,000. The journal entry will involve a ________. A. credit to accumulated depreciation for $34,000 B. credit to equipment for $21,000 C. debit to accumulated depreciation for $24,500 D. debit to accumulated depreciation for $30,500

D To record the sale of this plant asset, four accounts have to be effected: Equipment (credited for the cost of the asset), Accumulated Depreciation (debited for the amount of depreciation recorded to date), Cash (debited for the amount received), and Gain (credit) or Loss (debit) to balance the entry. In this example, the book value of the asset was given, not the accumulated depreciation. Book value is the cost of the asset less its accumulated depreciation, however, so since we were given the books value and the cost of the equipment, we can determine the balance of accumulated depreciation by subtraction: Accumulated Depreciation = Cost - Book Value Accumulated Depreciation = $55,000 - $24,500 = $30,500.

Which of the following accounting treatments violates the matching principle? A. A long-term asset is expensed over its useful life using one of the depreciation methods in accordance with GAAP; then these depreciation rates are revised and a new depreciation amount is recorded later in life based on new asset information. B. Repairs on a long-term asset are recorded as expenses. C. A capital expenditure is recorded as an asset when acquired and expensed as it generates revenue. D. The cost of replacing the motor for a piece of equipment that will extend the useful life of the equipment by 3 years was recorded as Repairs Expense.

D When an asset has maintenance that extends the useful life of the asset, that maintenance cost is not expensed when incurred. Instead, this cost is capitalized (i.e., depreciated) over the remaining useful life of the asset. Simple repairs and maintenance maintain the asset and do not necessarily extend the useful life or are negligible expenses and are expensed when incurred.

Long-Term Assets

I. *Plant Assets* (i.e. property, land, building, equipment) - Land: No Depreciation - Building/Building Improvements/equipment: Deprecation II. *Natural Resources* (i.e. oil, gas, minerals, etc.) - Leads to depletion III. *Intangibles* (i.e. Trademark Copyrights - Infinite Life --> EX: Good will mergers/impairment tests - Finite life --> amortize

What amount do we capitalize and as what asset? 300,000 Land 10,000 Broker Commissions 8,000 Back Property Taxes 5,000 Remove an Old Building 1,000 Survey Fee 260,000 Paving for a parking lot

Land through survey fee = Land Assets because there is no depreciation. This adds up to a $324,000 Land Asset amount. 260,000 for paving is a depreciation amount and is not calculated into the Land Asset amount. Dr. Land (324,000) Cr. Note Payable ( 300,000) Cr. Cash (24,000) Dr. Land Improvements (260,000) Cr. Cash (260,000)

Ordinary annuity Investments

Provide multiple receipts of an equal amount at fixed year end intervals over the investments duration.

Lump Sum Purchase

Purchase different types of assets, with difference useful lifes for a single amount. - EX: Buy an office building with furniture for 3 million on a one acre lot. - Use relative sales technique to estimate the value of each asset class > Land = 1.5 Million > Building = 1 Million > Furniture (bld. improv.) = .5 Million (building +furniture) = market data

Present Value

The Value on a given date of a future payment discounted to reflect the time value of money. Depends on... - The amount of the payment (receipt) - Length of time between investment and future receipt - Interest rate Often referred to as discounting. PV= Future Value/ (1 + interest rate)^n n = number of periods

Compound interest

The interest you earn on your principal amount plus the interest you have already earned.

Future Value

The sum of money that a given current investment will be "worth" at a specified time in the future.

Look at notes for Double Depreciation method example.

look at your notes mackenzie.