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3310-Ch 8-End of Chapter solutions-ST
3310-Ch 8-End of Chapter solutions-ST
L. Problems
Include in
Item cost of lathe Expense Justification
Lathe $5,300,000 Record amount paid as actual amount.
1% discount (53,000) Choice; could deduct from cost of machine or
record as contra expense or revenue on income
statement.
Freight in 75,000 Cost essential to put machine in working order.
Insurance 15,000 Cost essential to put machine in working order.
Voucher Ignore. Reduce cost of next machine if/when
acquired.
Installation 60,000 Cost essential to put machine in working order.
Testing 35,000 Cost essential to put machine in working order.
Damages 40,000 Expense as has no future benefit. Only restores
asset to original working condition
Sales tax 500,000 Cost essential to put machine in working order.
(45,000) Subtract rebate as part of same event.
Shutdown Ignore opportunity costs.
Total cost $5,887,000 40,000
Site
develop
Item ($000’s) Land ment Expense Justification
Land $10,000 Clearly cost of land.
Agent fee 50 Essential cost to acquire land.
Title search 40 Essential cost to acquire land.
Rezoning fee $100 Rezoning creates value and consistent with
corporate strategy.
Unexpired $30 Expense as there is no clearly defined plan
property taxes to actually build warehouse. Could be a
matter for professional judgment.
Additional 70 Same reason as unexpired taxes.
property taxes
Demolition 90 Part of cost of getting land ready for
intended use.
Salvage (15) Offset/recovery of demolition costs.
proceeds
Landscaping 200 Part of rezoning plan.
Entertainment 10 Benefit too remote and indirect relative to
potential warehouse.
Management 5 Benefit too remote and indirect.
salaries
Advertising 35 General operating cost, part of normal
operations
Field 20 Maintenance cost. Possible to argue for
maintenance capitalization. Matter for professional
judgment.
Consulting fee 25 General operating expense, part of normal
operations
Fence 55
Total $10,165 $355 $195
Debit Credit
Dr. Building (50K + 50K + 70K) 170,000
Dr. Land (initial purchase cost) 220,000
Dr. Land (cost of demolition) 9,000
Cr. Land (proceeds of demolition) 3,000
Dr. Land (for legal costs) 1,300
Dr. Building (legal costs) 1,500
Dr. Building (insurance: 3/12 months × $2,700) 675
Dr. Building (plant superintendent) 4,400
Dr. Land improvement (a depreciable asset) 5,500
Dr. Organization costs (an intangible asset) 700
Dr. Prepaid insurance (3/12 months × $2,700) 675
Dr. Insurance expense (6/12 months × $2,700) 1,350
Dr. Salaries expense (president) 20,000
Dr. Retained earnings (reversal of write-up) 23,500
Cr. Depreciation expense (reversal) 18,224
Cr. Land and factory building 437,376
Depreciation should also be recorded for the land improvements but there is insufficient
information available for the computation.
a. The relevant costs would be the cost of the additional materials of $1,000,000 and
$300,000 in incremental hiring costs ($700,000 – $400,000), for a total of $1,300,000.
b. Additional materials ($1,000,000), salaries paid to workers ($700,000), plus allocated
fixed costs ($75,000) for a total cost of $1,775,000.
c. Net income will increase by $475,000 ($400,000+ $75,000).
a. $45,000,000/2 × 6% = $1,350,000.
The question says the company financed Building B by borrowing the $45,000,000
evenly over the year (i.e., zero at the beginning of the year and increasing to $45,000,000
by the end of the year). Since the total amount $45,000,000 was not borrowed at the
beginning of the year, we cannot apply the annual interest rate to the total amount to get
the interest cost on the loan. Instead, the solution takes the average of the loan [ (Beg.
Balance + End. Balance)/2 = (0+45,000,000)/2] and use the average loan throughout the
year to calculate the interest cost.
b. Annual depreciation expense—Building A: $45,000,000 / 20 = $2,250,000.
Annual depreciation expense—Building B: $46,350,000 / 20 = $2,317,500.
c. Conceptually, interest cost is as much an essential cost of a self-constructed asset as the
concrete and steel. Without the financing, the construction would not have occurred. The
benefit of the interest expenditure on the debt used to finance the asset is realized over the
period of time when the completed asset is used. Expensing immediately results in poor
matching of expense with the realization of the benefit of the expenditure (which is the
finished self-constructed asset). Therefore, this cost should be added to the cost of the
self-constructed asset and expensed via an increased depreciation expense. Further, there
is a cost of funds regardless of whether those funds derive from debt or equity--if the
construction of the asset were outsourced, the contractor would have included its cost of
financing the project as part of the contracted price. Requiring the capitalization of only
debt financing cost reduces management discretion, but leads to results that differ
depending on a company’s capital structure and method of PPE acquisition (self-
construction vs. contracting out), so the effect on comparability is unclear. ASPE’s
approach of allowing different interest capitalization policies recognizes the difficulty in
specifying a uniform requirement.
d. Interest costs may be capitalized only during the construction period because once
construction is completed there is no logistical reason why the owner of the asset cannot
start to generate revenues or cost savings from the use of the asset. While under
construction it is impossible to generate a benefit from the asset, and this is the condition
that permits capitalization. Once construction is completed there is no impediment to
delay the matching of expense to revenues as the item is available for use. Therefore,
after completion of the construction process, interest is a period cost, not a product cost.
a. Although the expenditures for the construction project came from the company’s internal
funds, the company had significant debt outstanding, so there is interest attributable to the
construction project. The warehouse was ready for its intended use on the completion
date of October 31, 2015, so interest capitalization ceases at that date (not the later date of
January 1, 2016 when the company started using the facility). The amount of debt
exceeds the cost of the project, so we need not be concerned about the cap on the amount
of interest capitalized.
× length of = Interest
time to directly
× annual completion attributable to
Payment date Amount interest rate date construction
May 31, 2014 $ 900,000 8% 17/12 years $102,000
July 31, 2014 700,000 8% 15/12 years 70,000
Sep. 30, 2014 700,000 8% 13/12 years 60,667
Nov 30, 2015 700,000 8% 11/12 years 51,333
Jun. 30, 2015 800,000 8% 4/12 years 21,333
Aug. 31, 2015 800,000 8% 2/12 years 10,667
Oct. 31, 2015 400,000 8% 0/12 years 0
Total $5,000,000 $316,000
b. Under ASPE, the company can choose any interest capitalization policy as long as it
discloses that policy. Therefore, the amount of interest capitalized can be as low as zero
or as much as $316,000 as computed in part (a).
The borrowing cost attributable to the renovation project comes from two sources: the $500,000
short-term loan obtained specifically for the project and the $300,000 from existing debt. For the
project-specific debt, the borrowing costs begin accumulating on May 1, 2014, when the bank
advanced the funds and renovations started, reduced by investment income. Interest
capitalization ceases when the renovations were complete on October 31, 2014.
= Interest
× length of directly
× annual time to attributable
interest completio to
Financing source Payment date Amount rate n date construction
Renovation loan May 1, 2014 $ 500,000 6% 6/12 years $15,000
Less investment (6,000)
income
Existing debt Sep. 30, 2014 200,000 9% 1/12 years 1,500
Existing debt Oct. 31, 2014 100,000 9% 0/12 years 0
Total $800,000 $10,500
Case A: As this expenditure is a regular and recurring cost associated with this asset lasting its
full useful life of 15 years, it should be expensed. Further, this cost is anticipated and expected
as the asset is being depreciated over 15 years, which assumes regular replacement of this part.
Dr. Maintenance expense 750,000
Cr. Cash 750,000
Case B: This expenditure is anticipated and considered essential for the machine to last 15 years.
However, as Part #45 is set up separately as a PPE asset and depreciated over the part’s useful life
of three years, a new Part #45 may be capitalized and the older part removed from the accounts.
To derecognize old part
Dr. Accumulated depreciation – Part #45 650,000
Cr. PPE – Part #45 650,000
Case C: That portion of the expenditure that increases the service potential of the PPE can be
capitalized. The first $100,000 is recurring maintenance. Note that for the current and future
years a remaining useful life of five years should be used to determine depreciation expense.
Dr. PPE – new part 75,000
Dr. Maintenance expense 100,000
Cr. Cash 175,000
Case D: The self-unloading feature is an asset as it will save the company money in the future.
However, the value of the asset cannot exceed the amount of this future benefit (which is
$300,000, 6 × $50,000). Any amount spent above this amount must be expensed.
Dr. PPE – unloader for earth mover 300,000
Dr. Maintenance expense 100,000
Cr. Cash 400,000
Case E: The entire cost of the energy-efficiency engine is an asset. However, the old engine
must be removed from the accounts. The old motor is one-third of the cost of the truck (1/3 of
$300,000 = $100,000) and 40% depreciated (40% × $100,000 = $40,000). The disposal of the
old engine gives rise to a $60,000 loss, but the new engine can be entirely capitalized.
To derecognize old engine
Dr. Loss on engine disposal 60,000
Dr. Accumulated depreciation – truck (engine) 40,000
Cr. PPE – truck (engine) 100,000
Case F: The oil change and tire rotation are considered regular repairs and maintenance. The
satellite receiver can be classified as an asset as it is expected to generate additional rentals of the
vehicle. The advertising to promote the satellite feature is a normal operating cost and should be
expensed.
Dr. PPE – satellite radio 1,500,000
Dr. Maintenance expense 6,000,000
Dr. Advertising expense 2,500,000
Cr. Cash 10,000,000
Case A: As this expenditure is a regular and recurring cost associated with this asset lasting its
full useful life of 15 years, it should be expensed. Further, this cost does not improve the
quantity or quality of the machine or its output, so it is not a betterment.
Dr. Maintenance expense 750,000
Cr. Cash 750,000
Case B: Since this part was initially recognized as a separate asset, when it is replaced, the old
asset must be derecognized and a new asset established.
To derecognize old part
Dr. Accumulated depreciation – Part #45 650,000
Cr. PPE – Part #45 650,000
Case C: This expenditure would be considered to be a betterment because it extends the useful
life of the machine by two years. As a betterment, the expenditure can be capitalized.
Dr. PPE – betterment 175,000
Cr. Cash 175,000
Case D: The self-unloading feature can be either recorded as a separate asset or as a betterment
as it will save the company money in the future. However, the value of the asset cannot exceed
the amount of this future benefit (which is $300,000, 6 × $50,000). Any amount spent above this
amount must be expensed.
Dr. PPE – unloader for earth mover or betterment 300,000
Dr. Maintenance expense 100,000
Cr. Cash 400,000
Case E: The energy-efficient engine is a betterment and should be capitalized. While the old
engine had not been identified as a separate component, it should still be derecognized by using
management’s best estimate. The old motor is one-third of the cost of the truck (1/3 of $300,000
= $100,000) and 40% depreciated (40% × $100,000 = $40,000). The disposal of the old engine
gives rise to a $60,000 loss, but the new engine can be entirely capitalized.
To derecognize old engine
Dr. Loss on engine disposal 60,000
Dr. Accumulated depreciation – truck (engine) 40,000
Cr. PPE – truck (engine) 100,000
Case F: The oil change and tire rotation are considered regular repairs and maintenance. The
satellite receiver can be classified as an asset as it is expected to generate additional rentals of the
vehicle. The advertising to promote the satellite feature is a normal operating cost and should be
expensed.
Dr. PPE – satellite radio 1,500,000
Dr. Maintenance expense 6,000,000
Dr. Advertising expense 2,500,000
Cr. Cash 10,000,000
b. The rust-proofing has future benefits and therefore the cost can be capitalized into PPE.
Note that the opportunity cost of lost revenue is not recorded:
Dr. PPE - Trucks 3,500,000
Cr. Cash 3,500,000
c. The parcel tracking system has future benefits and therefore it can be capitalized into
PPE:
Dr. PPE – Parcel tracking system 5,000,000
Cr. Cash 5,000,000
d. All of these costs can be capitalized with the exception of interest, which can be partially
capitalized to the date of construction completion:
Dr. Land 5,000,000
Dr. Building (for materials) 15,000,000
Dr. Building (for labour) 20,000,000
Dr. Building (for project supervision) 1,200,000
Dr. Building (for construction insurance) 400,000
Dr. Building (interest capitalized) 1,400,000
May to Nov: 7/8 × 1.6m
Dr. Interest expense (December: 1/8× 1.6m) 200,000
Cr. Cash 43,200,000
b. The rust-proofing has future benefits and therefore the cost can be capitalized into PPE.
Note that the opportunity cost of lost revenue is not recorded:
Dr. PPE – Trucks (betterment) 3,500,000
Cr. Cash 3,500,000
c. The parcel tracking system has future benefits and therefore it can be capitalized into
PPE:
Dr. PPE – Parcel tracking system 5,000,000
Cr. Cash 5,000,000
d. All of these costs can be capitalized with the exception of interest, which can be partially
capitalized to the date of construction completion:
Dr. Land 5,000,000
Dr. Building (for materials) 15,000,000
Dr. Building (for labour) 20,000,000
Dr. Building (for project supervision) 1,200,000
Dr. Building (for construction insurance) 400,000
Dr. Building (interest capitalized) 1,400,000
May to Nov: 7/8 × 1.6m
Dr. Interest expense (December: 1/8× 1.6m) 200,000
Cr. Cash 43,200,000
d. Journal entries for fiscal years ending 2015, 2016, and 2017:
2014 Apr Dr. Mine site restoration cost 2,462,847
Cr. Obligation for future site restoration cost 2,462,847
2015 Mar Dr. Interest expense 246,285
Cr. Obligation for future site restoration 246,285
2016 Mar Dr. Interest expense 270,193
Cr. Obligation for future site restoration 270,913
d. The only entries that would differ for the second and third year would be the Interest Expense
accrual. Where the straight-line method is used, the depreciation charge would remain the same.
Year 2
Dr. Interest expense (12,160,384 + 729,623) × 6% 773,400
Cr. Obligation for future site restoration 773,400
Year 3
Dr. Interest expense (12,160,384 × 1.062) × 6% 819,804
Cr. Obligation for future site restoration 819,804
Long-term liabilities
Obligation for future site restoration $14,483,212*
g. The total expense relating to site restoration is the sum of depreciation and interest on the
site restoration costs, as follows:
Interest expense accrual
Depreciation of site on obligation for future Total expense relating to
Year restoration costs site restoration site restoration
1 $608,019 729,623 $1,337,642
2 608,019 773,400 1,381,419
20 608,019 2,207,547* 2,815,566
* Obligation for site restoration at beginning of Year 20 = $39,000,000 / 1.06 = $36,792,452
Interest on obligation = $36,792,452 × 6% = $2,207,547
Fraction of total
PPE category Appraised value appraised value ×Total price = Allocated price
Land $28,000,000 28/56 50,000,000 $25,000,000
Building 21,000,000 21/56 50,000,000 18,750,000
Moving equipment 4,000,000 4/56 50,000,000 3,571,429
HVAC system 3,000,000 3/56 50,000,000 2,678,571
Total $56,000,000 $50,000,000
Fraction of
Appraised total
value in appraised Allocated
PPE category Intended use optimal use value Total price price
Machine A Operate $3,000,000 3.0/10.5 $10,000,000 $2,857,143
Machine B Spare parts 5,000,000 5.0/10.5 10,000,000 4,761,905
Machine C Scrap 2,500,000 2.5/10.5 10,000,000 2,380,952
Total $10,500,000 $10,000,000
Costs to be allocated
Cost of purchase excluding taxes $7,000,000
Refundable taxes Exclude
Non-refundable taxes 220,000
Legal fees 50,000
Freight 20,000
$7,290,000
* First, PPE are assets. All assets have three qualities: (1) future benefits; (2) controlled by
the entity; and (3) the result of past transactions or events. The first, most important, and
most challenging of these qualities for PPE is to establish that the expenditure (outflow of
cash) does cause the entity to experience a benefit or reward that will occur in later
periods. These future economic benefits are realized in three different ways: (1) by
directly causing or enhancing a revenue inflow—for example, buying a machine which
makes a product that can be sold; (2) by directly allowing the entity to avoid a future
expense or cash outflow—for example, buying a head office building so the company
does not have to rent a premises; (3) by indirectly assisting the firm in generating revenue
or a cash inflow—for example, buying a warehouse or retail outlet to store or display
goods from which they are subsequently sold. The difficulty is to objectively and
logically prove there is a connection behind the expenditure and a later future economic
benefit.
* Second, the delay in the realization of the future benefit is over several fiscal periods. As
PPE are non-current assets, it must be shown that several periods enjoy the reward of this
expenditure by increased cash inflows or reduced cash outflows.
* Third is the matching concept. This perspective is the reverse of the first point. A future
economic benefit implies that at some later point in time the benefit will be experienced.
When this occurs, the expenditure should be expensed to merge or match the recognition
of the benefit such that the appropriate income is determined. The method of subsequent
allocation of the PPE to expense must be systematic, logical, and supportable by
objective evidence and estimates.
* Fourth, if the expenditure relates to PPE, the object of the cash outflow must be tangible
and have physical substance. You must be able to touch whatever was purchased (in
contrast to intangible assets).
* Finally, the estimation of the future economic benefit must be reasonably assured.
Hoping for a future economic benefit is not a sufficient or useful justification for
capitalizing expenditure. The facts and circumstances surrounding the expenditure must
afford management a reasonable basis to justify and quantify that the corporation will
receive a future cash inflow or avoid a cash outflow that exceeds the cost being
capitalized. The presumption is that the expenditure is an expense unless justification to
the contrary can be supplied by management, and the auditor convinced of the soundness
of management’s arguments.
Second reason: Depreciation expense is the matching of the cost of the asset (future benefit)
with the period when the future benefit is realized. Plant and equipment are classified as assets as
they represent future service potential, when that service potential is utilized in the process of
generating income. The depreciation process seeks to match the cost of the asset with the benefit
realized in the form of revenue or cost savings. As such it is consistent with the underlying
economic logic of the investment process. Few would argue that when a long-lived asset is
acquired, that the asset’s cost should be immediately expensed. Most would suggest that the cost
of the asset should be spread over the period when the asset is used, and this is what the
depreciation process does.
Third reason: One must be cautious in identifying which component of PPE increases in value.
In real estate, it is usually the value of land that is increasing, not the value of the building.
Financial accounting does not depreciate land. This raises another question as to whether
increases in the value of land should be recognized, but this is different from the process of
recording depreciation.
Fourth reason: As we learned all too painfully, what goes up often comes down. Run-ups in
asset prices often reverse, as they did in 2008 in spectacular fashion. Those who advocate not
recording depreciation are suggesting that when PPE goes up in value, this increase should be
recorded as income. Following this logic, when asset prices fall this decline should also be
recorded. By not recording depreciation and rather recognizing the appreciation or depreciation
of an asset’s fair market or current value, net income will become more volatile. Increased
earnings volatility can increase a user’s risk perceptions, and likely result in lower firm
valuations. (Chapter 10 will visit this interesting issue on revaluations in greater detail.)
Building: The straight-line method most closely matches the loss in benefit as it is weather and
the passage of time that causes buildings to lose usefulness.
Factory equipment: The units-of-production method most closely matches the realization of the
future benefit of these assets, as it is in their use that they create value. The machine produces
goods which are sold for a profit, so it seems reasonable that an essential cost incurred in the
production of the item, the depreciation of the cost of the machine used to make the product,
should be included in its cost. Further, if no goods or more or fewer goods are produced it would
be appropriate to adjust the aggregate depreciation charge in that period to match production
levels. In this way the per unit depreciation charge would remain stable.
Computers: The declining balance method is most appropriate as this method charges more
depreciation expense in the earlier periods, with the charge declining over time. This resembles
the realization of the benefit of the computer (or other higher technology items) in that its
competitive advantage and novelty is most beneficial in the earlier periods of its adoption. As we
know all too well with personal computers, what was fast and state-of-the-art a year ago may
now be outdated or obsolete. Computers and other technology-related products lose their value
quickly. While depreciation does not seek to value items, it should not be blind or indifferent to
what is actually happening.
The office should be depreciated for six months. On June 30, the building had remaining useful
life of 9.5 years. Therefore, depreciation = $50,000 / 9.5 years × 6/12 = $2,632, so income before
tax would decrease by this amount.
Since the company uses the straight-line method and there are no changes in assumptions, the
depreciation is the same for each year of the assets’ useful lives.
Annual
Item depreciation Calculation
Lathe $542,857 (4,000,000 – 200,000) / 7
Building $1,225,000 (25,000,000 – 500,000) / 20
Earth-moving truck $105,000 (700,000 – 70,000) / 6
Electric turbine $620,000 (7,000,000 – 800,000) / 10
Stamping machine $777,778 (10,000,000 – 3,000,000) / 9
The straight-line rate would be 1/10 = 10%, so the double declining balance rate is 20%.
Depreciation = $30,000 × 20% × 9/12 = $4,500.
a. To facilitate calculation, you should note that the carrying amount at the end of a year
equals Cost × (1 – DB rate)t. For example, with cost of $100 and a DB rate of 10%, the
carrying amount at the end of Year 1 is $100 × 0.9 = $90. At the end of Year 2, it is $100
× 0.92 = $81.
Item Year 1 Year 3 Year 5 Final year
Lathe 4,000,000 4,000,000 × 4,000,000 × (5/7)4 × Year 7: 4,000,000 × (5/7)6 ×
× 2/7 = (5/7)2 × 2/7 2/7 = 2/7 =
$1,142,857 = $297,495 531,241 × 2/7 =
$583,090 $151,783
Building 25,000,000 25,000,000 25,000,000 × Year 20: 25,000,000 ×
× 2/20 = × (18/20)2 × (18/20)4 × 2/20 = (18/20)19 × 2/20 =
$2,500,000 2/20 = $1,640,250 3,377,129 × 2/20 =,337,713
$2,025,000
Earth- 700,000 × 700,000 × 700,000 × (4/6)4 × Year 6: 700,000 × (4/6)5 × 2/6
2
moving 2/6 = (4/6) × 2/6 2/6 = = 92,181× 2/6 = 30,727 but
truck $233,333 = $46,091 this would reduce carrying
$103,704 amount below residual value of
$70,000; therefore, only record
22,181 (= 92,181 – 70,000)
4
Electric 7,000,000 7,000,000 × 7,000,000 × (8/10) Year 10: 7,000,000 × (8/10)9 ×
2
turbine × 2/10 = (8/10) × × 2/10 = 2/10 =
$1,400,000 2/10 = = $573,440 939,524 × 2/10 = 187,905 but
$896,000 this would reduce carrying
amount below residual value of
$800,000; therefore, only
record $139,524 (= 939,524 –
800,000)
b. If the assets are sold at their estimated residual value, the following journal entries would
be recorded. Per part (a), all except the lathe and the building have been fully depreciated
down to their residual values.
Lathe Dr. Cash 200,000
Dr. Loss on disposal [plug] 179,458
Dr. Accumulated depreciation – lathe 3,620,542
[4,000,000 – 4,000,000 × (5/7)7]
Cr. Lathe 4,000,000
Actual production – Final year 350,000 units 62,000 units 100,000 units
Depreciation rate per unit $1.40 / unit $2.62 / unit $1.50 / unit
Depreciation – Final year $490,000 $162,440 $150,000
Depreciation base
Cost $100,000
Delivery 1,000
Installation 6,000
Testing 3,000
Refundable sales taxes exclude
$110,000
a. Straight-line
Cost $110,000
Estimated residual value – 4,000
Depreciable amount 106,000
Estimated useful life ÷ 8 years
Depreciation rate per unit $13,250 / year
b. Declining balance
Months to be End-of-year
Year Depreciation rate depreciated Depreciation carrying amount
$110,000
2016 25% 10 / 12 22,917 87,083
2017 25% 12 / 12 21,771 65,312
c. Units-of-production
Cost $110,000
Estimated residual value – 4,000
Depreciable amount 106,000
Estimated total units ÷ 40,000 units
Depreciation rate per unit $2.65 / unit
Case C:
2011 June 1 Dr. Land 8,800,000
Dr. Building 7,200,000
Cr. Cash 16,000,000
End-of-year
Year # Depreciation rate Depreciation carrying amount
1,000,000
1 20% 200,000 800,000
2 20% 160,000 640,000
3 20% 128,000 512,000
4 20% 102,400 409,600
5 20% 81,920 327,680
6 20% 65,536 262,144
7 10% 26,214 235,930
8 10% 23,593 212,337
9 10% 12,337 200,000
10 10% 0 200,000
Note that in Year 9, depreciation at 10% would have resulted in depreciation of $21,234, which
would have reduced the carrying amount below the residual value of $200,000. Therefore, the
depreciation is equal to the amount that leaves the end-of-year carrying amount equal to the
residual value. For the same reason, no depreciation is recorded in Year 10.
Case A:
2017 Dec 31 Dr. Depreciation expense 437,500
Cr. Accumulated depreciation 437,500
(4,000,000 – 500,000) / 8
Case B:
2017 Dec 31 Dr. Depreciation expense 1,000,000
Cr. Accumulated depreciation 1,000,000
4,000,000 × 25%
b. Straight-line depreciation:
Building cost $440,000
Residual value 50,000
Depreciable amount $390,000
Estimated total hours 40 years
Depreciation per year $ 9,750
c.
Dr. Cash 680,000
Dr. Accumulated depreciation (9,750 × 3.5 years) 34,125
Cr. Building 440,000
Cr. Land 118,400
Cr. Gain on disposal [plug] 155,725
*Purchased Feb. 2016 and destroyed Sept. 2018 – available for use two full years
(24 months) and 8 additional months (Feb. – Sept. inclusive). Depreciation taken
in all months when available for use. Depreciation during the period between the
destruction of the equipment and receipt of the insurance settlement is not
appropriate as the equipment was not available for use.
*Brought into use in May 2015 and sold Aug. 2019 – owned four full years (48
months) and 3 additional months (May, June, & July). Depreciation not taken in
month of disposition (Aug.).
The net cash outflow is purchase price less the proceeds from sale, which equals $3,000,000 –
1,700,000 = $1,300,000. Is this a coincidence? No, it is by design. The logic/nature of the accrual
process is such that the cumulative consequence of the income statement adjustments equals the
net cash outflow associated with the asset. It is the purpose and goal of the allocation process to
spread the consequences of transactions to multiple periods. The overall effect will be the net
cash flow of the complete transaction cycle. Estimates are required, especially as to the useful
life and residual value of the depreciable asset at the start of the depreciation allocation process.
These estimates will cause the carrying amount to over- or understate the asset value relative to
its resale price, but the accounting gain or loss upon disposal settles up this difference.
The cumulative effect of depreciation is directly related to the amount of gain (or loss). The
higher the amount of depreciation, the larger will be the gain (or smaller the loss) on disposal. In
this case, the cumulative effect of the depreciation expense and any gain or loss is $4,000,000.
c. The gain is the consequence of overdepreciating the equipment in 2014 and 2015. The
loss is from underdepreciating the equipment in 2014 and 2015. Gains and losses do not
suggest excellent or poor management, but rather are the result of incorrect expense
allocations. At best, the relative size of the gain or loss may provide some insight into
senior management’s ability to make accurate estimates.
d. A gain on disposal tells us that prior years’ net income should have been higher as
depreciation expense was too much. A loss on disposal tells us that prior years’ net
incomes were too high as depreciation expense should have been higher. What such gains
and losses definitely do not tell us is the ability of management in the year the gain or
loss was recorded.
First reason: The most important reason for not recording depreciation expense in the year of
disposal is that this amount will exactly increase any gain on disposal or reduce any loss on
disposal by the same amount. The recording of depreciation will reduce the carrying amount of
the asset by the amount of the expense but increase the gain (reduce any loss) by the same
amount. So, by recording depreciation the net effect on net income in the year of disposal is zero;
net income stays the same.
Second reason: This policy makes the recordkeeping function simpler since there is one less
entry to derive and record.
Third reason: Many companies record a full year of depreciation expense in the year of
acquisition so that not recording depreciation expense in the year of disposal balances out this
accounting simplification.
Fourth reason: The amount of depreciation that would be recorded is immaterial. Note that the
first reason given above is exactly correct for depreciation that is expensed. There is potentially a
small income effect for PPE that is used in production, because the depreciation on such PPE
becomes part of inventory cost. Any inventory not sold at the end of the year would result in
depreciation remaining on the balance sheet rather than expensed, so that depreciation (or lack
thereof) in the year of disposal will not exactly cancel out the gain or loss on disposal. However,
this effect is likely to be immaterial.
a. The transaction appears to have commercial substance. Recall that a transaction has
commercial substance if either the assets being exchanged are dissimilar or the configuration
of the cash flows is different. Both these tests have been met. Clearly the nature of a used
forklift and cash are materially different from that of a piece of undeveloped land. Similarly,
giving up cash and an asset that is being used in production (and hence contributing to cash
flows) for a non-productive asset will impact on the configuration of QFC’s cash flows.
*The fair market value of the assets given up is used to value the transaction if
both the assets given up and received can be reliably measured.
e. In the entry to part (c) the new machine is recorded at $4,450,000, which exceeds the fair
market value of $4,250,000. This occurs because the loss on disposal has been carried
forward (capitalized) into the new machine.
f. When the transaction is considered not to have commercial substance, the gain on
disposal reduces the value of the new asset acquired. Instead of recording $4,000,000 for
the new asset as in part (b), the amount in part (a) is $3,650,000, which is $350,000
lower.
a. No commercial substance
Dr. Accumulated depreciation 35,000
Cr. PPE – old machine 195,000
Cr. Cash 15,000
Dr. PPE – new machine [plug] 175,000
c. The rationale for the accounting treatment for exchanges without commercial substance is
that such exchanges do not result in a culmination of the earnings process. Consequently, no
gains or losses are recognized on the exchange.
Transaction 3: This transaction involves an exchange of services for goods, which are then given
to employees. We separate the transaction into two parts: the exchange, and employee
compensation.
Dr. Cars (inventory) 0.3m
Cr. Transportation revenue 0.3m
Dr. Compensation expense 0.3m
Cr. Cars 0.3m
a. The costs need to be separated according to whether they relate to the factory, the mixing
machine, or the packaging machine. Since the mixing machine and packaging machine
are of a similar size, weight, and complexity, PPC should allocate equally the costs of
freight, concrete platform, and testing.
Mixing Packaging
Factory machine machine
Invoice cost of item $100,000 $20,000 $30,000
Freight cost (allocated equally) 4,000 4,000
Testing and training cost (allocated equally) 8,000 8,000
Total $100,000 $32,000 $42,000
c. The exchange involves primarily non-monetary consideration. Since the machines have
different capacities, it is reasonable to assume that the cash flow configuration of the two
machines differ from each other. Based on this assumption, this is a non-monetary
exchange with commercial substance, so fair value should be used. The only fair value
available is that of the new machine. The $25,000 is the fair value to the machine
manufacturer, but the fair value to PPC should also include the $3,000 freight and $8,000
of testing/training costs not needed.
Dr. Mixing machine (new) 36,000
($25,000 fair value to seller + $3,000 freight + $8,000
training/testing)
Dr. Accumulated depreciation – mixing machine 2,800
($32,000 / 20 × 1.75 years)
Cr. Cash ($1,000 + $3,000 freight) 4,000
Cr. Mixing machine (old) 32,000
Cr. Gain on sale of mixing machine 2,800
d. If the exchange is considered not to have commercial substance, then PPC should use the
book value of the asset given up to value the exchange, resulting in no gain or loss.
Dr. Mixing machine (new) 33,200
Dr. Accumulated depreciation – mixing machine 2,800
($32,000 / 20 × 1.75 years)
Dr. Cash ($1,000 + $3,000 freight) 4,000
Cr. Mixing machine (old) 32,000
a. As disclosed in Note 15, Thomson Reuters’ PPE consists primarily of computer hardware
(cost $2,010million) followed by land, buildings, and improvements ($1,338 million) and
furniture, fixtures, and equipment ($567 million).
b. The company uses the cost basis. Depreciation follows the straight-line method. Note 1
discloses these accounting policies, as well as the estimated useful lives:
c. Since the company uses the straight-line method, the average age can be estimated using
the amount of accumulated depreciation divided by cost, assuming that residual values are
negligible.
Land, buildings, Furniture,
Computer and building fixtures, and
hardware improvements equipment
Acc. depreciation (A) $1,605 $ 642 $358
Cost (B) 2,010 1,338 548
% Depreciated (A/B) = 79.9% 48.0% 65.3%
average age as % of
useful life
d. The average useful life for computer hardware can be estimated by dividing the cost of the
assets by the year’s depreciation, assuming that residual values are negligible.
Assume
additions occur
Include evenly through
Exclude addition additions and year (use
during year (use disposals during average of cost
cost at beginning year (use cost at at beginning and
of year) end of year) end of year)
Cost (A) $2,266 $2,010 $2,138
Depreciation for the 260 260 260
year(B)
Estimated useful life in 8.7 7.7 8.2
years (A/B)
All three estimates result in the average useful life exceeding the range of 3-5 years
indicated in the company’s accounting policy (see part b). The most likely reason is that
some of the computer hardware has been fully depreciated but remain in use, so their cost
remains on the books until they are disposed. This conjecture is consistent with the 79.9%
average age computed in part (c). If this is true, then the company has been conservative in
over-depreciating its computer hardware.
a. Canadian Tire uses the cost method to measure PPE. Disclosure of this choice appears on
page 73 (Note 3 of the financial statements). Also, Note 2 on page 65, which describes the
company’s basis of presentation, indicates that the financial statements use the historical
cost basis except for five items (and those five items do not include PPE).
b. The balance sheet reports net “Property and equipment” at $3,516.1 million at the end of
2013.
c. The income statement does not report depreciation because the company has chosen to
report operating expenses by function (i.e., use), whereas depreciation would be reported
had the company chosen to report by the nature of operating expenses.
d. Depreciation appears in three places. Note 32 on page 103 discloses operating expenses by
nature, which shows $253.8 million for “Depreciation of property and equipment and
investment property.” Second, Note 15 shows $2.7 million for depreciation on investment
property. Third, Note 16 shows $251.1 million for depreciation on property and equipment.
The amounts reconcile: $2.7m + $251.1m = $253.8m.
e. Note 3 on page 73 indicates that the company uses the declining balance method. The
depreciation rates are 4-20% for buildings and 5-40% for fixtures and equipment.