CHAPTER 9 PLANT AND INTANGIBLE ASSETS

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1. Coca-Colas trademark name was not purchased from another company, but rather was developed internally. Thus, the development costs probably were not material and were treated as revenue expenditures. Even if these costs had been capitalized, they would be amortized over a period of 40 years or less. Thus, any costs associated with this trademark now would be fully amortized, leaving a zero book value. 2. There are three basic accountable events in the life of a plant asset: (1) acquisition, (2) allocation of the acquisition cost to expense, and (3) disposal. The second event, allocation of the acquisition cost to expense, typically has the greatest effect upon net income. However, any gain or loss on disposal also affects net income. The allocation of acquisition cost to expense has no effect upon cash flows (other than income taxes). However, the acquisition of plant assets requires cash outlays, and disposals often result in cash receipts. 3. (d) Held for sale in the regular course of business and (e) not capable of rendering benefits to the business in the future. 4. (a) Freight charges, (b) sales taxes on the machine, and (d) wages of employees for time spent in installing and testing the machine before it was placed in service. 5. A capital expenditure is one that is material in amount and will benefit several accounting periods and is therefore charged to an asset account. A revenue expenditure is assumed to benefit only the current period (or is not material in amount) and is charged to an expense account so that it will be deducted from revenue of the current period in the determination of net income. 6. If a capital expenditure (acquisition of an asset) is erroneously treated as a revenue expenditure (an expense), expenses of the current year will be overstated and net income, therefore, will be understated. Since this error also results in the failure to record an asset, net income will be overstated in all future periods in which depreciation should have been recognized on this asset. 7. The entire $245,000 cost should be charged to the land account. The existing structures are of no value to Shoppers Market, and soon will be torn down. Thus, the only asset being acquired by Shoppers is the building site, which is classified as land. 8. (d) Allocation of the cost of a plant asset to the periods in which benefits are received. 9. Yes, depreciation of the building should be continued regardless of rising market value. The building will render useful services for only a limited number of years and its cost should be recognized as expense of those years regardless of fluctuations in market value. 10. An accelerated depreciation method is one that recognizes greater amounts of depreciation expense in the early years of an assets life, and less in the later years. These methods are most widely used in income tax returns, as larger deductions for depreciation will reduce both taxable income and the income tax payments due in the immediate future. 11. Under the fixed-percentage-of-declining-balance depreciation method, a fixed depreciation rate is applied to the assets undepreciated cost. The fixed-percentage is a percentage of the straight-line depreciation rate. This percentage is said to be fixed because it does not change over the life of the asset. The declining balance is the assets undepreciated cost (or book value), which gets lower every year. The declining-balance method is most widely used in income tax returns.

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12. Most companies use only the straight-line method of depreciation in their financial statements. However, these companies also may compute depreciation by several other methods for income tax purposes. For example, they may use MACRS depreciation in their federal income tax returns, and various forms of the declining-balance method in their state income tax returns. 13. The balance of the Accumulated Depreciation account does not consist of cash. It is an account with a credit balance showing how much of the original cost of the plant assets now owned has been written off as depreciation expense. Cash is required to pay for new assets, and the cash owned by the company is shown by the asset account Cash. 14. Two widely used approaches to computing depreciation for a fraction of a year are (1) to round the computation to the nearest full month and (2) the half-year convention, which takes six months of depreciation on all assets (of a given type) acquired during the year. (The half-year convention also requires that six months depreciation be recorded in the last year of the assets life or year of disposal.) 15. a. No; a company may use different depreciation methods for different assets. The principle of consistency means only that once depreciation begins on a given asset, the same method should be applied throughout its useful life. b. Yes; a corporation may use different depreciation methods in its financial statements and its income tax returns. In fact, most corporations use straight-line depreciation in their financial statements and a variety of accelerated depreciation methods in their tax returns. 16. The usual method of revising depreciation rates to reflect a changed estimate of useful life is to spread the undepreciated cost over the years of remaining useful life. This results in raising or lowering the annual depreciation charge. In this case, the undepreciated cost is $9,000, that is, cost of $15,000 less accumulated depreciation of $6,000. The revised estimate calls for 8 more years of use, so the new depreciation charge will be $9,000 8, or $1,125. It also has the theoretical merit of ensuring that depreciation expense as shown in the income statements over the life of the asset will equal the total depreciable cost of the asset. 17. Intangible assets are a subcategory of plant assets which are lacking in physical substance and are noncurrent. An account receivable of the type described is clearly a current asset and hence excluded on that ground from qualifying as an intangible asset even though it is lacking in physical substance. 18. The cost of each type of intangible asset should be amortized over the period estimated to be benefited. The straight-line method is generally used for the amortization of intangible assets. 19. Goodwill is recorded in the accounts only when purchased. The most common example is that of an ongoing business being purchased as an entity by new owners. If the purchase price is in excess of a fair value of the net identifiable assets of the business, the transaction provides objective evidence that goodwill exists and also provides a basis for objective valuation of this asset. 20. Since average annual earnings of $50,000 represent a return of only 5% on the net tangible assets of $1 million, the goodwill appears to be unsupported by operating performance. Goodwill is defined as the present value of expected excess future earnings, and Digital Products Company appears to have substandard earnings rather than excess earning power. The financial statements therefore give the impression of overstated assets and owners equity. Elimination of the item of goodwill would appear to be called for.

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21. Depletion in the amount of $10,000,000 should be deducted from revenue in the current year. The other $2,000,000 of depletion applicable to the current years operations will be included in the valuation of the ending inventory. Depletion is a cost of producing inventory. Costs assigned to inventory represent current assets until the goods are sold, at which time the costs are transferred to the Cost of Goods Sold account. 22. An asset is impaired when the owner cannot recover the undepreciated cost either through use or sale. In such situations, the carrying value of the asset should be reduced (written down) to net realizable value, which results in the recognition of a loss. 23. The owner of March Metals is in error. When the company discontinued use of the trademark, the unamortized cost of this asset should have been written off immediately. A trademark or other intangible should not be carried as an asset after its usefulness has ended.

Ex. 91

a. Two factors have caused the truck to depreciate: (1) physical deterioration and (2) obsolescence. The miles driven during the past six years have caused wear and tear on all of the trucks major components, including its engine, transmission, brakes, and tires. As these components deteriorate, their fair market values, in turn, depreciate. Furthermore, during the time that you have owned the truck, innovations have been developed leading to improved fuel economy, higher horsepower, better handling, and more corrosion-resistant materials. These innovations have made the truck obsolete in many respects. As the design and engineering technologies associated with the truck become more and more outdated, its fair market value will continue to depreciate. b. No. It is not likely that the bank will lend you an additional $5,000, even if you agree to pledge your truck as collateral. Your truck will continue to depreciate in value each year. By the time you begin repayment of your loan, it will be worth less to the bank than its current fair market value. c. Depreciation is a process of cost allocation, not a process of valuation. As such, accounting records do not attempt to show the current fair market values of business assets. Only by coincidence would the balance sheet show $10,000 in accumulated depreciation on this truck.

Ex. 92

a. b. c. d. e. f.

Capital expenditure Revenue expenditure Revenue expenditure Capital expenditure Revenue expenditure (too small in amount to capitalize regardless of length of useful life) Capital expenditure

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Ex. 94 a. (1) Straight-Line Schedule Year 1 2 3 4 5 Computation $35,000 15 35,000 15 35,000 15 35,000 15 35,000 15 Depreciation Expense $7,000 7,000 7,000 7,000 7,000 Depreciation Expense $16,000 9,600 5,760 3,456 184 Depreciation Expense $12,000 8,400 5,880 4,360 4,360 Accumulated Depreciation $ 7,000 14,000 21,000 28,000 35,000 Accumulated Depreciation $16,000 25,600 31,360 34,816 35,000 Accumulated Depreciation $12,000 20,400 26,280 30,640 35,000 Book Value $33,000 26,000 19,000 12,000 5,000 Book Value $24,000 14,400 8,640 5,184 5,000 Book Value $28,000 19,600 13,720 9,360 5,000

(2) 200% Declining-Balance Schedule Year 1 2 3 4 5 Computation $40,000 40% 24,000 40% 14,400 40% 8,640 40% $5,184 $5,000

(3) 150% Declining-Balance Schedule Year Computation 1 $40,000 30% 2 28,000 30% 3 19,600 30% 4* ($13,720 $5,000) 2 yrs. 5* ($13,720 $5,000) 2 yrs. * Switch to straight-line

b. Both accelerated methods result in a higher depreciation expense than the straight-line method in the first two years of the assets life. This pattern reverses in years 3 through 5. After four years, 99% of the assets total depreciation expense has been recorded under the 200% declining-balance method, as compared to only 88% under the 150% declining-balance method.

Ex. 98

Average earnings ...................................................................................................... $ 540,000 Normal earnings, 15% of $3,000,000 ....................................................................... 450,000 Excess earnings ......................................................................................................... $ 90,000 Goodwill ($90,000 x 5)............................................................................................. $ 450,000 Fair market value of net identifiable assets............................................................... 3,000,000 Price to be offered for Goldtone Appliance Co. ....................................................... $3,450,000

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Ex. 911 a. Inventory ...................................................................................... Accumulated Depletion: Northern Tier Mine .................. To record depletion on the Northern Tier Mine: 50,000 tons mined $8 per ton [($21,000,000 $1,000,000) 2,500,000 tons = $8 per ton].

400,000 400,000

b. Property, plant, & equipment: Mining property: Northern Tier Mine...................................... $21,000,000 Less: Accumulated depletion ................................................... 400,000 $20,600,000 c. No; the $400,000 of depletion of the mine should not all be deducted from revenue during the first year of operations. Since only 40,000 of the 50,000 tons of ore mined were sold, only 80% of the depletion cost ($320,000) should be deducted from revenue as part of the cost of goods sold. The remaining 20% of this amount ($80,000) relates to the 10,000 tons of ore still on hand and remains in the inventory account. d. The journal entry in part a increases the current ratio, because it reclassifies an amount of plant assets as inventory, which is a current asset. Thus, current assets are increased. Extracting ore from the ground does make the company more liquid. Mined ore is a more liquid asset than ore that is still in the ground.

Ex. 913 a.

$8,000 $13,000 $5,000 50,000 miles = 50,000 miles = $0.16 per mile

b. 1,670,000 miles $0.16 per mile = $267,200 c. Yes. The units-of-output method recognizes more depreciation in periods in which the cars are driven morewhich means that the cars are generating more revenue. The straight-line method would recognize the same amount of depreciation expense regardless of how much the automobiles were used (driven).

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50 Minutes, Strong

PROBLEM 93 SMART HARDWARE

$12,000 520 780 2,700 $16,000

a. Costs to be depreciated include: Cost of shelving Freight charges Sales taxes Installation Total cost to be depreciated (1) Straight-Line (nearest whole month): Year 2002 2003 2004 2005 Computation $16,000 120 912 16,000 120 16,000 120 16,000 120

Depreciation Expense $600 800 800 800

Accumulated Depreciation $ 600 1,400 2,200 3,000 Accumulated Depreciation $ 800 2,320 3,688 4,919 Accumulated Depreciation $ 600 1,755 2,823 3,811

Book Value $15,400 14,600 13,800 13,000 Book Value $15,200 13,680 12,312 11,081 Book Value $15,400 14,245 13,177 12,189

(2) 200% Declining-Balance (half-year convention): Depreciation Year Computation Expense $ 800 2002 $16,000 10% 12 2003 1,520 15,200 10% 2004 1,368 13,680 10% 2005 1,231 $12,312 10% (3) 150% Declining-Balance (half-year convention): Depreciation Year Computation Expense $ 600 2002 $16,000 7.5% 12 2003 1,155 15,400 7.5% 2004 1,068 14,245 7.5% 2005 988 13,177 7.5%

b. Smart may use the straight-line method in its financial statements to achieve the least amount of depreciation expense in the early years of the shelvings useful life. In its federal income tax return, Smart may use an accelerated method (called MACRS). The use of MACRS will reduce Coles income as much as possible in the early years of the shelvings useful life. Thus, managements goals are really not in conflict. c. The 200% declining-balance method results in the lowest reported book value at the end of 2005 ($11,081). Depreciation, however, is not a process of valuation. Thus, the $11,081 book value is not an estimate of the shelvings fair market value at the end of 2005.

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PROBLEM 93 SMART HARDWARE (concluded)

d. A book value of $400 means that accumulated depreciation at the time of the disposal was $8,600. 1. Journal entries assuming that the shelving was sold for $1,200: Cash Accumulated Depreciation: Shelving Shelving Gain on Disposal of Assets To record sale of shelving for $1,200 cash. 2. Journal entries assuming that the shelving was sold for $200: Cash Accumulated Depreciation: Shelving Loss on Sale of Asset Shelving To record sale of shelving for $200 cash. 200 8,600 200 9,000

1,200 8,600 9,000 800

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25 Minutes, Medium

PROBLEM 94 ESCOLA DEVELOPERS

General Journal

a.

Feb

10 Loss on Disposal of Plant Assets Accumulated Depreciation: Office Equipment Office Equipment Scrapped office equipment; received no salvage value. 1 Cash Notes Receivable Accumulated Depreciation: Building Land Building Gain on Sale of Plant Assets Sold land and building for a $100,000 cash down payment and a 5-year, 9% note for the balance.

2 0 0 2 5 8 0 0 2 6 0 0 0

Apr

1 0 0 0 0 0 8 0 0 0 0 0 2 5 0 0 0 0 5 0 0 0 0 5 5 0 0 0 0 5 5 0 0 0 0

Aug 15 Vehicles (new truck) Accumulated Depreciation: Vehicles (old truck) Vehicles (old truck) Gain on Disposal of Plant Assets Cash To record trade-in of old truck on new; trade-in allowance exceeded book value by $2,000. Oct 1 Office Equipment (new computer) Loss on Trade-in of Plant Assets Accumulated Depreciation: Office Equip. (old computer) Office Equipment (old computer) Cash Notes Payable Acquired new computer system by trading in old computer, paying part cash, and issuing a 1-year, 8% note payable. Recognized loss equal to book value of old computer ($4,000) minus trade-in allowance ($500).

3 9 0 0 0 1 8 0 0 0 2 6 0 0 0 2 0 0 0 2 9 0 0 0

8 0 0 0 3 5 0 0 1 1 0 0 0 1 5 0 0 0 1 5 0 0 6 0 0 0

b. Gains and losses on asset disposals do not affect gross profit because they are not part of the cost of goods sold. Such gains and losses do, however, affect net income reported in a firms income statement. c. Unlike realized gains and losses on asset disposals, unrealized gains and losses on marketable securities are not generally reported in a firms income statement. Instead, they are reported in the balance sheet as a component of stockholders equity.

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25 Minutes, Medium

PROBLEM 95 WHITE CORPORATION

a. Operating expense. Although the training of employees probably has some benefit extending beyond the current period, the number of periods benefited is highly uncertain. Therefore, current accounting practice is to expense routine training costs. b. Intangible asset. Goodwill represents the present value of future earnings in excess of what is considered normal. The goodwill associated with Whites purchase of the vinyl flooring company should not be amortized, but is subject to evaluation for impairment in value. c. Operating expense. Because of the great uncertainty surrounding the potential benefits of R&D programs, research and development costs should be charged to expense in the period in which these costs are incurred. Although this accounting treatment is controversial, it at least has the benefit of reducing the number of alternative accounting practices previously in use, thereby increasing the comparability of financial statements. d. Intangible asset. A patent grants its owner the exclusive right to produce a particular product. If the patent has significant cost, this cost should be regarded as an intangible asset and expensed over the period of time that ownership of the patent will contribute to revenue. In this case, revenue is expected to be earned only over the 6-year period during which the product will be produced and sold. e. Operating expense. Advertising costs are regarded as operating expense because of the difficulty in objectively determining the existence or life of any future benefit.

20 Minutes, Easy

CASE 93 INTERNATIONAL PAPER COMPANY

a. The depreciation methods used in financial statements are determined by management, not by income tax laws. b. Nodifferent depreciation methods may be used for different assets. The principle of consistency only means that a company should not change from year to year the method used to compute depreciation expense on a particular asset. This principle does not prohibit using different methods for different assets, or using different depreciation methods in income tax returns. c. (1) 20 years (a 5% straight-line depreciation rate is equivalent to writing off 1/20 of the assets cost each year, indicating a useful life of 20 years). (2) 3 years (a 33% straight-line depreciation rate is equivalent to writing off 1/3 of the assets cost each year, indicating a useful life of 3 years). The useful lives over which assets are to be depreciated are determined by management. However, if the company is audited by a CPA firm, the auditors will review these estimates of useful lives to determine that they are reasonable. d. Accelerated depreciation methods transfer the costs of plant assets to expense more quickly than does the straight-line method. These larger charges to depreciation expense reduce the amount of taxable income and, therefore, reduce the amount of income taxes currently due.

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