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ILLUSTRATION 10-19 Fair value of new machine $90,000 Book value of old machine $60,000 Computation of Basis Less: Gain deferred 36,000 OR Less: Portion of book value presumed sold 6,000* Basis of new machine $54,000 Basis of new machine $54,000 * $10,000 3$60,0005$6,000 $100,000 Queenan records the transaction with the following entry. Cash 10,000 Machinery (new) 54,000 Accumulated Depreciation—Machinery 50,000 Machinery (old) 110,000 Gain on Disposal of Machinery 4,000 The rationale for the treatment of a partial gain is as follows. Before a nonmonetary exchange that includes some cash, a company has an unrecognized gain, which is the difference between the book value and the fair value of the old asset. When the exchange occurs, a portion of the fair value is converted to a more liquid asset. The ratio of this liquid asset to the total consideration received is the portion of the total gain that the company realizes. Thus, the company recognizes and records that amount. Illustration 10-20 presents in summary form the accounting requirements for recog- nizing gains and losses on exchanges of nonmonetary assets.10 ILLUSTRATION 10-20 1. Compute the total gain or loss on the transaction. This amount is equal to the difference between the Summary of Gain and fair value of the asset given up and the book value of the asset given up. Loss Recognition on 2. If a loss is computed in step 1, always recognize the entire loss. Exchanges of 3. If a gain is computed in step 1, Nonmonetary Assets (a) and the exchange has commercial substance, recognize the entire gain. (b) and the exchange lacks commercial substance, (1) and no cash is involved, no gain is recognized. (2) and some cash is given, no gain is recognized. (3) and some cash is received, the following portion of the gain is recognized: Cash Received (Boot) 3Total Gain* Cash Received (Boot)1Fair Value of Other Assets Received *If the amount of cash exchanged is 25% or more, both parties recognize entire gain or loss. Companies disclose in their financial statements nonmonetary exchanges during a period. Such disclosure indicates the nature of the transaction(s), the method of account- ing for the assets exchanged, and gains or losses recognized on the exchanges. [7] 10Adapted from an article by Robert Capettini and Thomas E. King, “Exchanges of Nonmonetary Assets: Some Changes,” The Accounting Review (January 1976). Valuation of Property, Plant, and Equipment 555 What do the numbers mean? ABOUT THOSE SWAPS In a press release, Roy Olofson, former vice president of trading a blue truck for a red truck—it shouldn’t boost a fi nance for Global Crossing, accused company executives of company’s revenue. improperly describing the company’s revenue to the public. But Global Crossing and Qwest, among others, counted as He said the company had improperly recorded long-term revenue the money received from the other company in the sales immediately rather than over the term of the contract, swap. (In general, in transactions involving leased capacity, the had improperly booked as cash transactions swaps of capac- companies booked the revenue over the life of the contract.) ity with other carriers, and had fi red him when he blew the Some of these companies then treated their own purchases as whistle. capital expenditures, which were not run through the income The accounting for the swaps involves exchanges of statement. Instead, the spending led to the addition of assets on similar network capacity. Companies have said they en- the balance sheet (and an infl ated bottom line). gage in such deals because swapping is quicker and less The SEC questioned some of these capacity exchanges, be- costly than building segments of their own networks, or cause it appeared they were a device to pad revenue. This reac- because such pacts provide redundancies to make their tion was not surprising, since revenue growth was a key factor own networks more reliable. In one expert’s view, an ex- in the valuation of companies such as Global Crossing and change of similar network capacity is the equivalent of Qwest during the craze for tech stocks in the late 1990s and 2000.

Source: Adapted from Henny Sender, “Telecoms Draw Focus for Moves in Accounting,” Wall Street Journal (March 26, 2002), p. C7. Accounting for Contributions Companies sometimes receive or make contributions (donations or gifts). Such contri- butions, nonreciprocal transfers, transfer assets in one direction. A contribution is often some type of asset (such as cash, securities, land, buildings, or use of facilities), but it also could be the forgiveness of a debt. When companies acquire assets as donations, a strict cost concept dictates that the valuation of the asset should be zero. However, a departure from the historical cost principle seems justified; the only costs incurred (legal fees and other relatively minor expenditures) are not a reasonable basis of accounting for the assets acquired. To record nothing is to ignore the economic realities of an increase in wealth and assets. Therefore, companies use the fair value of the asset to establish its value on the books. International What then is the proper accounting for the credit in this transaction? Some Perspective believe the credit should be made to Donated Capital (an additional paid-in IFRS provides detailed guidance capital account). This approach views the increase in assets from a donation as on how to account for contribu- contributed capital, rather than as earned revenue. tions and government grants. Others argue that companies should report donations as revenues from contributions. Their reasoning is that only the owners of a business contribute capital. At issue in this approach is whether the company should report revenue immediately or over the period that the asset is employed. For example, to attract new industry a city may offer land, but the receiving enterprise may incur additional costs in the future (e.g., transportation or higher state income taxes) because the location is not the most desirable. As a consequence, some argue that the company should defer the revenue and recognize it as the costs are incurred. The FASB’s position is that in general, companies should recognize contributions received as revenues in the period received. [8]11 Companies measure contributions at the fair value of the assets received. [9] To illustrate, Max Wayer Meat Packing, Inc. has 11GAAP is silent on how to account for the transfers of assets from governmental units to business enterprises. However, we believe that the basic requirements should hold also for these types of contributions. Therefore, companies should record all assets at fair value and all credits as revenue. 556 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment recently accepted a donation of land with a fair value of $150,000 from the Memphis Industrial Development Corp. In return, Max Wayer Meat Packing promises to build a packing plant in Memphis. Max Wayer’s entry is: Land 150,000 Contribution Revenue 150,000 When a company contributes a nonmonetary asset, it should record the amount of the donation as an expense at the fair value of the donated asset. If a difference exists between the fair value of the asset and its book value, the company should recognize a gain or loss. To illustrate, Kline Industries donates land to the city of Los Angeles for a city park. The land cost $80,000 and has a fair value of $110,000. Kline Industries records this donation as follows. Contribution Expense 110,000 Land 80,000 Gain on Disposal of Land 30,000 In some cases, companies promise to give (pledge) some type of asset in the future. Should companies record this promise immediately or when they give the assets? If the promise is unconditional (depends only on the passage of time or on demand by the recipient for performance), the company should report the contribution expense and related payable immediately. If the promise is conditional, the company recognizes ex- pense in the period benefited by the contribution, generally when it transfers the asset. Other Asset Valuation Methods The exception to the historical cost principle for assets acquired through donation is

based on fair value. Another exception is the prudent cost concept. This concept states that if for some reason a company ignorantly paid too much for an asset originally, it is theoretically preferable to charge a loss immediately. For example, assume that a company constructs an asset at a cost much greater than its present economic usefulness. It would be appropriate to charge these excess costs as a loss to the current period, rather than capitalize them as part of the cost of the asset. In practice, the need to use the prudent cost approach seldom develops. Companies typically either use good reasoning in paying a given price or fail to recognize that they have overpaid. What happens, on the other hand, if a company makes a bargain purchase or inter- nally constructs a piece of equipment at a cost savings? Such savings should not result in immediate recognition of a gain under any circumstances. COSTS SUBSEQUENT TO ACQUISITION After installing plant assets and readying them for use, a company incurs addi- LEARNING OBJECTIVE 6 tional costs that range from ordinary repairs to significant additions. The major Describe the accounting treatment for problem is allocating these costs to the proper time periods. In general, costs in- costs subsequent to acquisition. curred to achieve greater future benefits should be capitalized, whereas expen- ditures that simply maintain a given level of services should be expensed. In order to capitalize costs, one of three conditions must be present: 1. The useful life of the asset must be increased. 2. The quantity of units produced from the asset must be increased. 3. The quality of the units produced must be enhanced. For example, a company like Boeing should expense expenditures that do not in- crease an asset’s future benefits. That is, it expenses immediately ordinary repairs that maintain the existing condition of the asset or restore it to normal operating efficiency. Costs Subsequent to Acquisition 557 Companies expense most expenditures below an established arbitrary min- Underlying Concepts imum amount, say, $100 or $500. Although conceptually this treatment may be Expensing long-lived wastepaper incorrect, expediency demands it. Otherwise, companies would set up depre- baskets is an application of the ciation schedules for an item such as a wastepaper basket. materiality concept. The distinction between a capital expenditure (asset) and a revenue expen- diture (expense) is not always clear-cut. Yet, in most cases, consistent application of a capital/expense policy is more important than attempting to provide general theoretical guidelines for each transaction. Generally, companies incur four major types of expenditures relative to existing assets. MAJOR TYPES OF EXPENDITURES ADDITIONS. Increase or extension of existing assets. IMPROVEMENTS AND REPLACEMENTS. Substitution of an improved asset for an existing one. REARRANGEMENT AND REINSTALLATION. Movement of assets from one location to another. REPAIRS. Expenditures that maintain assets in condition for operation. What do the numbers mean? DISCONNECTED It all started with a check of the books by an internal audi- Instead of recording these charges as operating expenses, tor for WorldCom Inc. The telecom giant’s newly installed WorldCom recorded a signifi cant portion as capital expendi- chief executive had asked for a fi nancial review, and the tures. The maneuver was worth hundreds of millions of dol- auditor was spot-checking records of capital expenditures. lars to WorldCom’s bottom line. It effectively turned a loss for She found the company was using an unorthodox technique all of 2001 and the fi rst quarter of 2002 into a profi t. The graph to account for one of its biggest expenses: charges paid to below compares WorldCom’s accounting to that under GAAP. local telephone networks to complete long-distance calls. Soon after this discovery, WorldCom fi led for bankruptcy. WorldCom’s Generally accepted accounting Expense accounting principles 1 Accounted for $3.1 billion in 1 The $3.1 billion “line-cost”

“line costs,” including telecom Capital Operating expense would be booked access and transport charges, Expense Expense as an operating expense. as capital expenditures. 2 Planned to amortize $3.1 2 The entire $3.1 billion billion over a period of Cost of would have been counted Amortization time, possibly as much as Business as a cost of business for 10 years. that quarter. 3 Reported net income of $1.38 3 Net income for 2001 billion for 2001. Higher Net Lower Net would have been a loss, Income Income amount to be determined. Source: Adapted from Jared Sandberg, Deborah Solomon, and Rebecca Blumenstein, “Inside WorldCom’s Unearthing of a Vast Accounting Scandal,” Wall Street Journal (June 27, 2002), p. A1. 558 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment Additions Additions should present no major accounting problems. By definition, companies capitalize any addition to plant assets because a new asset is created. For example, the addition of a wing to a hospital, or of an air conditioning system to an office, increases the service potential of that facility. Companies should capitalize such expenditures and match them against the revenues that will result in future periods. One problem that arises in this area is the accounting for any changes related to the existing structure as a result of the addition. Is the cost incurred to tear down an old wall, to make room for the addition, a cost of the addition or an expense or loss of the period? The answer is that it depends on the original intent. If the company had antici- pated building an addition later, then this cost of removal is a proper cost of the addi- tion. But if the company had not anticipated this development, it should properly report the removal as a loss in the current period on the basis of inefficient planning. Normally, the company retains the carrying amount of the old wall in the accounts, although theo- retically the company should remove it. Improvements and Replacements Companies substitute one asset for another through improvements and replacements. What is the difference between an improvement and a replacement? An improvement (betterment) is the substitution of a better asset for the one currently used (say, a con- crete floor for a wooden floor). A replacement, on the other hand, is the substitution of a similar asset (a wooden floor for a wooden floor). Many times improvements and replacements result from a general policy to mod- ernize or rehabilitate an older building or piece of equipment. The problem is differen- tiating these types of expenditures from normal repairs. Does the expenditure increase the future service potential of the asset? Or does it merely maintain the existing level of service? Frequently, the answer is not clear-cut. Good judgment is required to cor- rectly classify these expenditures. If the expenditure increases the future service potential of the asset, a company should capitalize it. The accounting is therefore handled in one of three ways, depend- ing on the circumstances: 1. Use the substitution approach. Conceptually, the substitution approach is correct if the carrying amount of the old asset is available. It is then a simple matter to remove the cost of the old asset and replace it with the cost of the new asset. To illustrate, Instinct Enterprises decides to replace the pipes in its plumbing system. A plumber suggests that the company use plastic tubing in place of the cast iron pipes and copper tubing. The old pipe and tubing have a book value of $15,000 (cost of $150,000 less accumulated depreciation of $135,000), and a scrap value of $1,000. The plastic tubing costs $125,000. If Instinct pays $124,000 for the new tubing after exchanging the old tubing, it makes the following entry: Plant Assets (plumbing system) 125,000 Accumulated Depreciation—Plant Assets 135,000 Loss on Disposal of Plant Assets 14,000 Plant Assets 150,000 Cash ($125,000 2 $1,000) 124,000 The problem is determining the book value of the old asset. Generally, the com- ponents of a given asset depreciate at different rates. However, generally no separate

accounting is made. For example, the tires, motor, and body of a truck depreciate at different rates, but most companies use one rate for the entire truck. Companies can Costs Subsequent to Acquisition 559 set separate depreciation rates, but it is often impractical. If a company cannot deter- mine the carrying amount of the old asset, it adopts one of two other approaches. 2. Capitalize the new cost. Another approach capitalizes the improvement and keeps the carrying amount of the old asset on the books. The justifi cation for this approach is that the item is suffi ciently depreciated to reduce its carrying amount almost to zero. Although this assumption may not always be true, the differences are often insignifi cant. Companies usually handle improvements in this manner. 3. Charge to accumulated depreciation. In cases when a company does not improve the quantity or quality of the asset itself but instead extends its useful life, the com- pany debits the expenditure to Accumulated Depreciation rather than to an asset account. The theory behind this approach is that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. The net carrying amount of the asset is the same whether debiting the asset or accumulated depreciation. Rearrangement and Reinstallation Companies incur rearrangement and reinstallation costs to benefit future periods. An ex- ample is the rearrangement and reinstallation of machines to facilitate future production. If a company like The Coca-Cola Company can determine or estimate the original installation cost and the accumulated depreciation to date, it handles the rearrangement and reinstallation cost as a replacement. If not, which is generally the case, Coca-Cola should capitalize the new costs (if material in amount) as an asset to be amortized over future periods expected to benefit. If these costs are immaterial, if they cannot be sepa- rated from other operating expenses, or if their future benefit is questionable, the com- pany should immediately expense them. Repairs A company makes ordinary repairs to maintain plant assets in operating condition. It charges ordinary repairs to an expense account in the period incurred, on the basis that it is the primary period benefited. Maintenance charges that occur regularly include replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning. A company treats these as ordinary operating expenses. It is often difficult to distinguish a repair from an improvement or replacement. The major consideration is whether the expenditure benefits more than one year or one op- erating cycle, whichever is longer. If a major repair (such as an overhaul) occurs, several periods will benefit. A company should handle the cost as an addition, improvement, or replacement.12 An interesting question is whether a company can accrue planned maintenance overhaul costs before the actual costs are incurred. For example, assume that Southwest Airlines schedules major overhauls of its planes every three years. Should Southwest be permitted to accrue these costs and related liability over the three-year period? Some argue that this accrue-in-advance approach better matches expenses to revenues and reports Southwest’s obligation for these costs. However, reporting a liability is inappro- priate. To whom does Southwest owe? In other words, Southwest has no obligation to an outside party until it has to pay for the overhaul costs, and therefore it has no liability. As a result, companies are not permitted to accrue in advance for planned major over- haul costs either for interim or annual periods. [10] 12A committee of the AICPA has proposed (see footnote 2) that companies expense as incurred costs involved for planned major expenditures unless they represent an additional component or the replacement of an existing component. 560 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment Summary of Costs Subsequent to Acquisition Illustration 10-21 summarizes the accounting treatment for various costs incurred sub-

sequent to the acquisition of capitalized assets. ILLUSTRATION 10-21 Type of Expenditure Normal Accounting Treatment Summary of Costs Subsequent to Additions Capitalize cost of addition to asset account. Acquisition of Property, Improvements and (a) Carrying value known: Remove cost of and accumulated depreciation on Plant, and Equipment replacements old asset, recognizing any gain or loss. Capitalize cost of improvement/ replacement. (b) Carrying value unknown: 1. If the asset’s useful life is extended, debit accumulated depreciation for cost of improvement/replacement. 2. If the quantity or quality of the asset’s productivity is increased, capitalize cost of improvement/replacement to asset account. Rearrangement and (a) If original installation cost is known, account for cost of rearrangement/ reinstallation reinstallation as a replacement (carrying value known). (b) If original installation cost is unknown and rearrangement/reinstallation cost is material in amount and benefits future periods, capitalize as an asset. (c) If original installation cost is unknown and rearrangement/reinstallation cost is not material or future benefit is questionable, expense the cost when incurred. Repairs (a) Ordinary: Expense cost of repairs when incurred. (b) Major: As appropriate, treat as an addition, improvement, or replacement. DISPOSITION OF PROPERTY, PLANT, AND EQUIPMENT A company, like Intel, may retire plant assets voluntarily or dispose of them by sale, LEARNING OBJECTIVE 7 exchange, involuntary conversion, or abandonment. Regardless of the type of dis- Describe the accounting treatment for posal, depreciation must be taken up to the date of disposition. Then, Intel should the disposal of property, plant, and remove all accounts related to the retired asset. Generally, the book value of the spe- equipment. cific plant asset does not equal its disposal value. As a result, a gain or loss develops. The reason: Depreciation is an estimate of cost allocation and not a process of valu- ation. The gain or loss is really a correction of net income for the years during which Intel used the fixed asset. Intel should show gains or losses on the disposal of plant assets in the income state- ment along with other items from customary business activities. However, if it sold, aban- doned, spun off, or otherwise disposed of the “operations of a component of a business,” then it should report the results separately in the discontinued operations section of the income statement (as discussed in Chapter 4). That is, Intel should report any gain or loss from disposal of a business component with the related results of discontinued operations. Sale of Plant Assets Companies record depreciation for the period of time between the date of the last depre- ciation entry and the date of sale. To illustrate, assume that Barret Company recorded depreciation on a machine costing $18,000 for 9 years at the rate of $1,200 per year. If it sells the machine in the middle of the tenth year for $7,000, Barret records depreciation to the date of sale as: Depreciation Expense ($1,200 3 1) 600 2 Accumulated Depreciation—Machinery 600 Disposition of Property, Plant, and Equipment 561 The entry for the sale of the asset then is: Cash 7,000 Accumulated Depreciation—Machinery 11,400 [($1,200 3 9) 1 $600] Machinery 18,000 Gain on Disposal of Machinery 400 The book value of the machinery at the time of the sale is $6,600 ($18,000 2 $11,400). Because the machinery sold for $7,000, the amount of the gain on the sale is $400. Involuntary Conversion Sometimes an asset’s service is terminated through some type of involuntary conver- sion such as fire, flood, theft, or condemnation. Companies report the difference be- tween the amount recovered (e.g., from a condemnation award or insurance recovery), if any, and the asset’s book value as a gain or loss. They treat these gains or losses like any other type of disposition. In some cases, these gains or losses may be reported as extraordinary items in the income statement if the conditions of the disposition are

unusual and infrequent in nature. To illustrate, Camel Transport Corp. had to sell a plant located on company prop- erty that stood directly in the path of an interstate highway. For a number of years, the state had sought to purchase the land on which the plant stood, but the company re- sisted. The state ultimately exercised its right of eminent domain, which the courts up- held. In settlement, Camel received $500,000, which substantially exceeded the $200,000 book value of the plant and land (cost of $400,000 less accumulated depreciation of $200,000). Camel made the following entry. Cash 500,000 Accumulated Depreciation—Plant Assets 200,000 Plant Assets 400,000 Gain on Disposal of Plant Assets 300,000 If the conditions surrounding the condemnation are judged to be unusual and infre- quent, Camel’s gain of $300,000 is reported as an extraordinary item. Some object to the recognition of a gain or loss in certain involuntary conversions. For example, the federal government often condemns forests for national parks. The paper companies that owned these forests must report a gain or loss on the condemna- tion. However, companies such as Georgia-Pacific contend that no gain or loss should be reported because they must replace the condemned forest land immediately and so are in the same economic position as they were before. The issue is whether condemna- tion and subsequent purchase should be viewed as one or two transactions. GAAP requires “that a gain or loss be recognized when a nonmonetary asset is involuntarily converted to monetary assets even though an enterprise reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets.” [11] Miscellaneous Problems If a company scraps or abandons an asset without any cash recovery, it recognizes a loss equal to the asset’s book value. If scrap value exists, the gain or loss that occurs is the difference between the asset’s scrap value and its book value. If an asset still can be used even though it is fully depreciated, it may be kept on the books at historical cost less depreciation. Companies must disclose in notes to the financial statements the amount of fully depreciated assets in service. For example, Petroleum Equipment Tools Inc. in its an- nual report disclosed, “The amount of fully depreciated assets included in property, plant, and equipment at December 31 amounted to approximately $98,900,000.” 562 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment KEY TERMS SUMMARY OF LEARNING OBJECTIVES additions, 558 avoidable interest, 542 capital expenditure, 557 1 Describe property, plant, and equipment. The major characteristics of capitalization period, 542 property, plant, and equipment are as follows. (1) They are acquired for use in opera- commercial tions and not for resale. (2) They are long-term in nature and usually subject to depre- substance, 550 ciation. (3) They possess physical substance. fixed assets, 538 historical cost, 538 2 Identify the costs to include in initial valuation of property, plant, and improvements equipment. The costs included in initial valuation of property, plant, and equipment (betterments), 558 are as follows. involuntary Cost of land: Includes all expenditures made to acquire land and to ready it for use. conversion, 561 Land costs typically include (1) the purchase price; (2) closing costs, such as title to the lump-sum price, 548 land, attorney’s fees, and recording fees; (3) costs incurred in getting the land in condi- major repairs, 559 tion for its intended use, such as grading, filling, draining, and clearing; (4) assumption nonmonetary assets, 550 of any liens, mortgages, or encumbrances on the property; and (5) any additional land nonreciprocal improvements that have an indefinite life. transfers, 555 Cost of buildings: Includes all expenditures related directly to their acquisition or ordinary repairs, 559 construction. These costs include (1) materials, labor, and overhead costs incurred plant assets, 538 during construction, and (2) professional fees and building permits.

Cost of equipment: Includes the purchase price, freight and handling charges property, plant, and equipment, 538 incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs. prudent cost, 556 rearrangement and 3 Describe the accounting problems associated with self-constructed reinstallation costs, 559 assets. Indirect costs of manufacturing create special problems because companies replacements, 558 cannot easily trace these costs directly to work and material orders related to the con- revenue expenditure, 557 structed assets. Companies might handle these costs in one of two ways. (1) Assign no self-constructed asset, 540 fixed overhead to the cost of the constructed asset, or (2) assign a portion of all overhead weighted-average to the construction process. Companies use the second method extensively. accumulated expenditures, 543 4 Describe the accounting problems associated with interest capital- ization. Only actual interest (with modifications) should be capitalized. The ratio- nale for this approach is that during construction, the asset is not generating revenue and therefore companies should defer (capitalize) interest cost. Once construction is completed, the asset is ready for its intended use and revenues can be recognized. Any interest cost incurred in purchasing an asset that is ready for its intended use should be expensed. 5 Understand accounting issues related to acquiring and valuing plant assets. The following issues relate to acquiring and valuing plant assets. (1) Cash discounts: Whether taken or not, they are generally considered a reduction in the cost of the asset; the real cost of the asset is the cash or cash equivalent price of the asset. (2) Deferred-payment contracts: Companies account for assets purchased on long-term credit contracts at the present value of the consideration exchanged between the con- tracting parties. (3) Lump-sum purchase: Allocate the total cost among the various assets on the basis of their relative fair values. (4) Issuance of stock: If the stock is actively traded, the market price of the stock issued is a fair indication of the cost of the property acquired. If the market price of the common stock exchanged is not determinable, estab- lish the fair value of the property and use it as the basis for recording the asset and issu- ance of the common stock. (5) Exchanges of nonmonetary assets: The accounting for ex- changes of nonmonetary assets depends on whether the exchange has commercial substance. See Illustrations 10-10 (page 551) and 10-20 (page 554) for summaries of how to account for exchanges. (6) Contributions: Record at the fair value of the asset received, and credit revenue for the same amount. Demonstration Problem 563 6 Describe the accounting treatment for costs subsequent to acquisi- tion. Illustration 10-21 (page 560) summarizes how to account for costs subsequent to acquisition. 7 Describe the accounting treatment for the disposal of property, plant, and equipment. Regardless of the time of disposal, companies take depreciation up to the date of disposition and then remove all accounts related to the retired asset. Gains or losses on the retirement of plant assets are shown in the income statement along with other items that arise from customary business activities. Gains or losses on involuntary conversions, if unusual and infrequent, may be reported as extraordinary items. DEMONSTRATION PROBLEM Columbia Company, which manufactures machine tools, had the following transactions related to plant assets in 2014. Asset A: On June 2, 2014, Columbia purchased a stamping machine at a retail price of $12,000. Columbia paid 6% sales tax on this purchase. Columbia paid a contractor $2,800 for a specially wired platform for the ma- chine, to ensure noninterrupted power to the machine. Columbia estimates the machine will have a 4-year useful life, with a salvage value of $2,000 at the end of 4 years. The machine was put into use on July 1, 2014.

Asset B: On January 1, 2014, Columbia, Inc. signed a fixed-price contract for construction of a warehouse facility at a cost of $1,000,000. It was estimated that the project will be completed by December 31, 2014. On March 1, 2014, to finance the construction cost, Columbia borrowed $1,000,000 payable April 1, 2015, plus interest at the rate of 10%. During 2014, Columbia made deposit and progress payments totaling $750,000 under the contract; the weighted-average amount of accumulated expenditures was $400,000 for the year. The excess-borrowed funds were invested in short-term securities, from which Columbia realized invest- ment revenue of $13,000. The warehouse was completed on December 1, 2014, at which time Columbia made the final payment to the contractor. Columbia estimates the warehouse will have a 25-year useful life, with a salvage value of $20,000. Columbia uses straight-line depreciation and employs the “half-year” convention in accounting for partial-year depreciation. Columbia’s fiscal year ends on December 31. Instructions (a) At what amount should Columbia record the acquisition cost of the machine? (b) What amount of capitalized interest should Columbia include in the cost of the warehouse? (c) On July 1, 2016, Columbia decides to outsource its stamping operation to Medek, Inc. As part of this plan, Columbia sells the machine (and the platform) to Medek, Inc. for $7,000. What is the impact of this disposal on Columbia’s 2016 income before taxes? Solution (a) Historical cost is measured by the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition for its intended use. For Columbia, this is: Price $12,000 Tax ($12,000 3 .06) 720 Platform 2,800 Total $15,520 (b) $40,000 ($400,000 3 .10)—Weighted-Average Accumulated Expenditures 3 Interest Rate 5 Avoidable Interest Since Columbia has outstanding debt incurred specifically for the construction project, in an amount greater than the weighted-average accumulated expenditures of $400,000, the interest rate of 10% is used for capitalization purposes. Capitalization stops upon completion of the project at Decem- ber 31, 2014. Therefore, the avoidable interest is $40,000, which is less than the actual interest. The investment revenue of $13,000 is irrelevant to the question addressed in this problem because such interest 564 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment earned on the unexpended portion of the loan is not to be offset against the amount eligible for capitalization. (c) The income effect is a gain or loss, determined by comparing the book value of the asset to the disposal value: Cost $15,520 Less: Accumulated depreciation ($1,690 1 $3,380 1 $1,690) 6,760* Book value of machine and platform 8,760 Less: Cash received for machine and platform 7,000 Loss before income taxes $ 1,760 *Depreciable base: $15,520 2 $2,000 5 $13,520. Depreciation expense: $13,520 4 4 5 $3,380 per year. 2014: ½ year ($3,380 3 .50) $1,690 2015: full year 3,380 2016: ½ year 1,690 Total $6,760 FASB CODIFICATION FASB Codification References [1] FASB ASC 360-10-35-43. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-lived Assets,” State- ment of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 34.] [2] FASB ASC 835-20-05. [Predecessor literature: “Capitalization of Interest Cost,” Statement of Financial Accounting Standards No. 34 (Stamford, Conn.: FASB, 1979).] [3] FASB ASC 835-20-15-4. [Predecessor literature: “Determining Materiality for Capitalization of Interest Cost,” Statement of Financial Accounting Standards No. 42 (Stamford, Conn.: FASB, 1980), par. 10.] [4] FASB ASC 820-10-35. [Predecessor literature: “(Predecessor literature: “Fair Value Measurement,” Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006), paras. 13–18.] [5] FASB ASC 845-10-30. [Predecessor literature: “Accounting for Nonmonetary Transactions,” Opinions of the Accounting Principles Board No. 29 (New York: AICPA, 1973), par. 18, and “Exchanges of Nonmonetary Assets, an Amendment of APB

Opinion No. 29,” Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).] [6] FASB ASC 845-10-25-6. [Predecessor literature: “Interpretations of APB Opinion No. 29,” EITF Abstracts No. 01-02 (Norwalk, Conn.: FASB, 2002).] [7] FASB ASC 845-10-50-1. [Predecessor literature: “Accounting for Nonmonetary Transactions,” Opinions of the Accounting Principles Board No. 29 (New York: AICPA, 1973), par. 28, and “Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29,” Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).] [8] FASB ASC 958-605-25-2. [Predecessor literature: “Accounting for Contributions Received and Contributions Made,” Statement of Financial Accounting Standards No. 116 (Norwalk, Conn.: FASB, 1993).] [9] FASB ASC 845-10-30. [Predecessor literature: “Accounting for Nonmonetary Transactions,” Opinions of the Accounting Prin- ciples Board No. 29 (New York: AICPA, 1973), par. 18, and “Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29,” Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).] [10] FASB ASC 360-10-25-5. [Predecessor literature: “Accounting for Planned Major Maintenance Activities,” FASB Staff Position AUG-AIR-1 (Norwalk, Conn.: FASB, September 2006), par. 5.] [11] FASB ASC 605-40-25-2. [Predecessor literature: “Accounting for Involuntary Conversions of Nonmonetary Assets to Monetary Assets,” FASB Interpretation No. 30 (Stamford, Conn.: FASB, 1979), summary paragraph.] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE10-1 Access the glossary (“Master Glossary”) to answer the following. (a) What does it mean to “capitalize” an item? (b) What is the definition of a nonmonetary asset? Questions 565 (c) What is a nonreciprocal transfer? (d) What is the definition of “contribution”? CE10-2 Herb Scholl, the owner of Scholl’s Company, wonders whether interest costs associated with developing land can ever be capitalized. What does the Codification say on this matter? CE10-3 What guidance does the Codification provide on the accrual of costs associated with planned major maintenance activities? CE10-4 Briefly describe how the purchases and sales of inventory with the same counterparty are similar to the accounting for other nonmonetary exchanges. An additional Codification case can be found in the Using Your Judgment section, on page 586. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. QUESTIONS 1. What are the major characteristics of plant assets? (i) The cost of demolishing an old building that was on the land when purchased. 2. Mickelson Inc. owns land that it purchased on January 1, 2000, for $450,000. At December 31, 2014, its current value 5. Two positions have normally been taken with respect to is $770,000 as determined by appraisal. At what amount the recording of fixed manufacturing overhead as an ele- should Mickelson report this asset on its December 31, ment of the cost of plant assets constructed by a company 2014, balance sheet? Explain. for its own use: 3. Name the items, in addition to the amount paid to the for- (a) It should be excluded completely. mer owner or contractor, that may properly be included (b) It should be included at the same rate as is charged to as part of the acquisition cost of the following plant assets. normal operations. (a) Land. What are the circumstances or rationale that support or (b) Machinery and equipment. deny the application of these methods? (c) Buildings. 6. The Buildings account of Postera Inc. includes the follow- ing items that were used in determining the basis for 4. Indicate where the following items would be shown on a depreciating the cost of a building. balance sheet.

(a) Organization and promotion expenses. (a) A lien that was attached to the land when purchased. (b) Architect’s fees. (b) Landscaping costs. (c) Interest and taxes during construction. (c) Attorney’s fees and recording fees related to purchas- (d) Interest revenue on investments held to fund con- ing land. struction of a building. (d) Variable overhead related to construction of machinery. Do you agree with these charges? If not, how would you (e) A parking lot servicing employees in the building. deal with each of the items above in the corporation’s (f) Cost of temporary building for workers during con- books and in its annual financial statements? struction of building. 7. Burke Company has purchased two tracts of land. One (g) Interest expense on bonds payable incurred during tract will be the site of its new manufacturing plant, while construction of a building. the other is being purchased with the hope that it will be (h) Assessments for sidewalks that are maintained by sold in the next year at a profit. How should these two the city. tracts of land be reported in the balance sheet? 566 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment 8. One financial accounting issue encountered when a value of $6,000. The company uses the straight-line company constructs its own plant is whether the interest method. It was traded on August 1, 2015, for a similar cost on funds borrowed to finance construction should truck costing $42,000; $16,000 was allowed as trade-in be capitalized and then amortized over the life of the as- value (also fair value) on the old truck and $26,000 was sets constructed. What is the justification for capitalizing paid in cash. A comparison of expected cash flows for the such interest? trucks indicates the exchange lacks commercial substance. 9. Provide examples of assets that do not qualify for interest What is the entry to record the trade-in? capitalization. 18. Once equipment has been installed and placed in opera- 10. What interest rates should be used in determining the tion, subsequent expenditures relating to this equipment amount of interest to be capitalized? How should the are frequently thought of as repairs or general mainte- amount of interest to be capitalized be determined? nance and, hence, chargeable to operations in the period in which the expenditure is made. Actually, determina- 11. How should the amount of interest capitalized be dis- tion of whether such an expenditure should be charged to closed in the notes to the financial statements? How operations or capitalized involves a much more careful should interest revenue from temporarily invested excess analysis of the character of the expenditure. What are funds borrowed to finance the construction of assets be the factors that should be considered in making such a accounted for? decision? Discuss fully. 12. Discuss the basic accounting problem that arises in 19. What accounting treatment is normally given to the handling each of the following situations. following items in accounting for plant assets? (a) Assets purchased by issuance of common stock. (a) Additions. (b) Acquisition of plant assets by gift or donation. (b) Major repairs. (c) Purchase of a plant asset subject to a cash discount. (c) Improvements and replacements. (d) Assets purchased on a long-term credit basis. 20. New machinery, which replaced a number of employees, (e) A group of assets acquired for a lump sum. was installed and put in operation in the last month of (f) An asset traded in or exchanged for another asset. the fiscal year. The employees had been dismissed after 13. Magilke Industries acquired equipment this year to be payment of an extra month’s wages, and this amount used in its operations. The equipment was delivered by the was added to the cost of the machinery. Discuss the pro- suppliers, installed by Magilke, and placed into operation. priety of the charge. If it was improper, describe the Some of it was purchased for cash with discounts available proper treatment. for prompt payment. Some of it was purchased under long- 21. To what extent do you consider the following items to be

term payment plans for which the interest charges approx- proper costs of the fixed asset? Give reasons for your imated prevailing rates. What costs should Magilke capi- opinions. talize for the new equipment purchased this year? Explain. (a) Overhead of a business that builds its own equipment. 14. Schwartzkopf Co. purchased for $2,200,000 property that (b) Cash discounts on purchases of equipment. included both land and a building to be used in opera- (c) Interest paid during construction of a building. tions. The seller’s book value was $300,000 for the land and $900,000 for the building. By appraisal, the fair value (d) Cost of a safety device installed on a machine. was estimated to be $500,000 for the land and $2,000,000 (e) Freight on equipment returned before installation, for for the building. At what amount should Schwartzkopf replacement by other equipment of greater capacity. report the land and the building at the end of the year? (f) Cost of moving machinery to a new location. 15. Pueblo Co. acquires machinery by paying $10,000 cash (g) Cost of plywood partitions erected as part of the re- and signing a $5,000, 2-year, zero-interest-bearing note modeling of the office. payable. The note has a present value of $4,208, and Pueblo (h) Replastering of a section of the building. purchased a similar machine last month for $13,500. At what cost should the new equipment be recorded? (i) Cost of a new motor for one of the trucks. 16. Stan Ott is evaluating two recent transactions involving 22. Neville Enterprises has a number of fully depreciated as- exchanges of equipment. In one case, the exchange has sets that are still being used in the main operations of the commercial substance. In the second situation, the ex- business. Because the assets are fully depreciated, the change lacks commercial substance. Explain to Stan the president of the company decides not to show them on differences in accounting for these two situations. the balance sheet or disclose this information in the notes. 17. Crowe Company purchased a heavy-duty truck on July 1, Evaluate this procedure. 2011, for $30,000. It was estimated that it would have a 23. What are the general rules for how gains or losses on re- useful life of 10 years and then would have a trade-in tirement of plant assets should be reported in income? Brief Exercises 567 BRIEF EXERCISES 2 BE10-1 Previn Brothers Inc. purchased land at a price of $27,000. Closing costs were $1,400. An old build- ing was removed at a cost of $10,200. What amount should be recorded as the cost of the land? 4 BE10-2 Hanson Company is constructing a building. Construction began on February 1 and was com- pleted on December 31. Expenditures were $1,800,000 on March 1, $1,200,000 on June 1, and $3,000,000 on December 31. Compute Hanson’s weighted-average accumulated expenditures for interest capitalization purposes. 4 BE10-3 Hanson Company (see BE10-2) borrowed $1,000,000 on March 1 on a 5-year, 12% note to help fi- nance construction of the building. In addition, the company had outstanding all year a 10%, 5-year, $2,000,000 note payable and an 11%, 4-year, $3,500,000 note payable. Compute the weighted-average inter- est rate used for interest capitalization purposes. 4 BE10-4 Use the information for Hanson Company from BE10-2 and BE10-3. Compute avoidable interest for Hanson Company. 5 BE10-5 Garcia Corporation purchased a truck by issuing an $80,000, 4-year, zero-interest-bearing note to Equinox Inc. The market rate of interest for obligations of this nature is 10%. Prepare the journal entry to record the purchase of this truck. 5 BE10-6 Mohave Inc. purchased land, building, and equipment from Laguna Corporation for a cash pay- ment of $315,000. The estimated fair values of the assets are land $60,000, building $220,000, and equip- ment $80,000. At what amounts should each of the three assets be recorded? 5 BE10-7 Fielder Company obtained land by issuing 2,000 shares of its $10 par value common stock. The land was recently appraised at $85,000. The common stock is actively traded at $40 per share. Prepare the

journal entry to record the acquisition of the land. 5 BE10-8 Navajo Corporation traded a used truck (cost $20,000, accumulated depreciation $18,000) for a small computer worth $3,300. Navajo also paid $500 in the transaction. Prepare the journal entry to record the exchange. (The exchange has commercial substance.) 5 BE10-9 Use the information for Navajo Corporation from BE10-8. Prepare the journal entry to record the exchange, assuming the exchange lacks commercial substance. 5 BE10-10 Mehta Company traded a used welding machine (cost $9,000, accumulated depreciation $3,000) for office equipment with an estimated fair value of $5,000. Mehta also paid $3,000 cash in the transaction. Prepare the journal entry to record the exchange. (The exchange has commercial substance.) 5 BE10-11 Cheng Company traded a used truck for a new truck. The used truck cost $30,000 and has accu- mulated depreciation of $27,000. The new truck is worth $37,000. Cheng also made a cash payment of $36,000. Prepare Cheng’s entry to record the exchange. (The exchange lacks commercial substance.) 5 BE10-12 Slaton Corporation traded a used truck for a new truck. The used truck cost $20,000 and has ac- cumulated depreciation of $17,000. The new truck is worth $35,000. Slaton also made a cash payment of $33,000. Prepare Slaton’s entry to record the exchange. (The exchange has commercial substance.) 6 BE10-13 Indicate which of the following costs should be expensed when incurred. (a) $13,000 paid to rearrange and reinstall machinery. (b) $200,000 paid for addition to building. (c) $200 paid for tune-up and oil change on delivery truck. (d) $7,000 paid to replace a wooden floor with a concrete floor. (e) $2,000 paid for a major overhaul on a truck, which extends the useful life. 7 BE10-14 Ottawa Corporation owns machinery that cost $20,000 when purchased on July 1, 2011. Deprecia- tion has been recorded at a rate of $2,400 per year, resulting in a balance in accumulated depreciation of $8,400 at December 31, 2014. The machinery is sold on September 1, 2015, for $10,500. Prepare journal en- tries to (a) update depreciation for 2015 and (b) record the sale. 7 BE10-15 Use the information presented for Ottawa Corporation in BE10-14, but assume the machinery is sold for $5,200 instead of $10,500. Prepare journal entries to (a) update depreciation for 2015 and (b) record the sale. 568 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment EXERCISES 2 E10-1 (Acquisition Costs of Realty) The following expenditures and receipts are related to land, land im- provements, and buildings acquired for use in a business enterprise. The receipts are enclosed in parentheses. (a) Money borrowed to pay building contractor (signed a note) $(275,000) (b) Payment for construction from note proceeds 275,000 (c) Cost of land fill and clearing 8,000 (d) Delinquent real estate taxes on property assumed by purchaser 7,000 (e) Premium on 6-month insurance policy during construction 6,000 (f) Refund of 1-month insurance premium because construction completed early (1,000) (g) Architect’s fee on building 22,000 (h) Cost of real estate purchased as a plant site (land $200,000 and building $50,000) 250,000 (i) Commission fee paid to real estate agency 9,000 (j) Installation of fences around property 4,000 (k) Cost of razing and removing building 11,000 (l) Proceeds from salvage of demolished building (5,000) (m) Interest paid during construction on money borrowed for construction 13,000 (n) Cost of parking lots and driveways 19,000 (o) Cost of trees and shrubbery planted (permanent in nature) 14,000 (p) Excavation costs for new building 3,000 Instructions Identify each item by letter and list the items in columnar form, using the headings shown below. All receipt amounts should be reported in parentheses. For any amounts entered in the Other Accounts column, also indicate the account title. Other Item Land Land Improvements Buildings Accounts 2 E10-2 (Acquisition Costs of Realty) Martin Buber Co. purchased land as a factory site for $400,000. The

process of tearing down two old buildings on the site and constructing the factory required 6 months. The company paid $42,000 to raze the old buildings and sold salvaged lumber and brick for $6,300. Legal fees of $1,850 were paid for title investigation and drawing the purchase contract. Martin Buber paid $2,200 to an engineering firm for a land survey, and $68,000 for drawing the factory plans. The land survey had to be made before definitive plans could be drawn. Title insurance on the property cost $1,500, and a liability insurance premium paid during construction was $900. The contractor’s charge for construction was $2,740,000. The company paid the contractor in two installments: $1,200,000 at the end of 3 months and $1,540,000 upon completion. Interest costs of $170,000 were incurred to finance the construction. Instructions Determine the cost of the land and the cost of the building as they should be recorded on the books of Martin Buber Co. Assume that the land survey was for the building. 2 E10-3 (Acquisition Costs of Trucks) Kelly Clarkson Corporation operates a retail computer store. To im- prove delivery services to customers, the company purchases four new trucks on April 1, 2014. The terms of acquisition for each truck are described below. 1. Truck #1 has a list price of $15,000 and is acquired for a cash payment of $13,900. 2. Truck #2 has a list price of $16,000 and is acquired for a down payment of $2,000 cash and a zero- interest-bearing note with a face amount of $14,000. The note is due April 1, 2015. Clarkson would normally have to pay interest at a rate of 10% for such a borrowing, and the dealership has an incre- mental borrowing rate of 8%. 3. Truck #3 has a list price of $16,000. It is acquired in exchange for a computer system that Clarkson carries in inventory. The computer system cost $12,000 and is normally sold by Clarkson for $15,200. Clarkson uses a perpetual inventory system. 4. Truck #4 has a list price of $14,000. It is acquired in exchange for 1,000 shares of common stock in Clarkson Corporation. The stock has a par value per share of $10 and a market price of $13 per share. Instructions Prepare the appropriate journal entries for the above transactions for Clarkson Corporation. Exercises 569 2 3 E10-4 (Purchase and Self-Constructed Cost of Assets) Worf Co. both purchases and constructs various equipment it uses in its operations. The following items for two different types of equipment were recorded in random order during the calendar year 2014. Purchase Cash paid for equipment, including sales tax of $5,000 $105,000 Freight and insurance cost while in transit 2,000 Cost of moving equipment into place at factory 3,100 Wage cost for technicians to test equipment 4,000 Insurance premium paid during fi rst year of operation on this equipment 1,500 Special plumbing fi xtures required for new equipment 8,000 Repair cost incurred in fi rst year of operations related to this equipment 1,300 Construction Material and purchased parts (gross cost $200,000; failed to take 2% cash discount) $200,000 Imputed interest on funds used during construction (stock fi nancing) 14,000 Labor costs 190,000 Allocated overhead costs (fi xed—$20,000; variable—$30,000) 50,000 Profi t on self-construction 30,000 Cost of installing equipment 4,400 Instructions Compute the total cost for each of these two pieces of equipment. If an item is not capitalized as a cost of the equipment, indicate how it should be reported. 2 3 E10-5 (Treatment of Various Costs) Ben Sisko Supply Company, a newly formed corporation, incurred the following expenditures related to Land, to Buildings, and to Machinery and Equipment. 4 Abstract company’s fee for title search $ 520 Architect’s fees 3,170 Cash paid for land and dilapidated building thereon 87,000 Removal of old building $20,000 Less: Salvage 5,500 14,500 Interest on short-term loans during construction 7,400 Excavation before construction for basement 19,000 Machinery purchased (subject to 2% cash discount, which was not taken) 55,000 Freight on machinery purchased 1,340

Storage charges on machinery, necessitated by noncompletion of building when machinery was delivered 2,180 New building constructed (building construction took 6 months from date of purchase of land and old building) 485,000 Assessment by city for drainage project 1,600 Hauling charges for delivery of machinery from storage to new building 620 Installation of machinery 2,000 Trees, shrubs, and other landscaping after completion of building (permanent in nature) 5,400 Instructions Determine the amounts that should be debited to Land, to Buildings, and to Machinery and Equipment. Assume the benefits of capitalizing interest during construction exceed the cost of implementation. Indi- cate how any costs not debited to these accounts should be recorded. 3 4 E10-6 (Correction of Improper Cost Entries) Plant acquisitions for selected companies are as follows. 1. Belanna Industries Inc. acquired land, buildings, and equipment from a bankrupt company, Torres Co., for a lump-sum price of $700,000. At the time of purchase, Torres’s assets had the following book and appraisal values. Book Values Appraisal Values Land $200,000 $150,000 Buildings 250,000 350,000 Equipment 300,000 300,000 To be conservative, the company decided to take the lower of the two values for each asset acquired. The following entry was made. Land 150,000 Buildings 250,000 Equipment 300,000 Cash 700,000 570 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment 2. Harry Enterprises purchased store equipment by making a $2,000 cash down payment and signing a 1-year, $23,000, 10% note payable. The purchase was recorded as follows. Equipment 27,300 Cash 2,000 Notes Payable 23,000 Interest Payable 2,300 3. Kim Company purchased office equipment for $20,000, terms 2/10, n/30. Because the company intended to take the discount, it made no entry until it paid for the acquisition. The entry was: Equipment 20,000 Cash 19,600 Purchase Discounts 400 4. Kaisson Inc. recently received at zero cost land from the Village of Cardassia as an inducement to locate its business in the Village. The appraised value of the land is $27,000. The company made no entry to record the land because it had no cost basis. 5. Zimmerman Company built a warehouse for $600,000. It could have purchased the building for $740,000. The controller made the following entry. Buildings 740,000 Cash 600,000 Profit on Construction 140,000 Instructions Prepare the entry that should have been made at the date of each acquisition. 4 E10-7 (Capitalization of Interest) Harrisburg Furniture Company started construction of a combination office and warehouse building for its own use at an estimated cost of $5,000,000 on January 1, 2014. Harrisburg expected to complete the building by December 31, 2014. Harrisburg has the following debt obligations outstanding during the construction period. Construction loan—12% interest, payable semiannually, issued December 31, 2013 $2,000,000 Short-term loan—10% interest, payable monthly, and principal payable at maturity on May 30, 2015 1,400,000 Long-term loan—11% interest, payable on January 1 of each year. Principal payable on January 1, 2018 1,000,000 Instructions (Carry all computations to two decimal places.) (a) Assume that Harrisburg completed the office and warehouse building on December 31, 2014, as planned at a total cost of $5,200,000, and the weighted-average amount of accumulated expendi- tures was $3,600,000. Compute the avoidable interest on this project. (b) Compute the depreciation expense for the year ended December 31, 2015. Harrisburg elected to depreciate the building on a straight-line basis and determined that the asset has a useful life of 30 years and a salvage value of $300,000. 4 E10-8 (Capitalization of Interest) On December 31, 2013, Main Inc. borrowed $3,000,000 at 12% payable annually to finance the construction of a new building. In 2014, the company made the following expendi- tures related to this building: March 1, $360,000; June 1, $600,000; July 1, $1,500,000; December 1, $1,500,000. The building was completed in February 2015. Additional information is provided as follows.

1. Other debt outstanding 10-year, 13% bond, December 31, 2007, interest payable annually $4,000,000 6-year, 10% note, dated December 31, 2011, interest payable annually $1,600,000 2. March 1, 2014, expenditure included land costs of $150,000 3. Interest revenue earned in 2014 $49,000 Instructions (a) Determine the amount of interest to be capitalized in 2014 in relation to the construction of the building. (b) Prepare the journal entry to record the capitalization of interest and the recognition of interest expense, if any, at December 31, 2014. 4 E10-9 (Capitalization of Interest) On July 31, 2014, Amsterdam Company engaged Minsk Tooling Company to construct a special-purpose piece of factory machinery. Construction was begun immediately Exercises 571 and was completed on November 1, 2014. To help finance construction, on July 31 Amsterdam issued a $300,000, 3-year, 12% note payable at Netherlands National Bank, on which interest is payable each July 31. $200,000 of the proceeds of the note was paid to Minsk on July 31. The remainder of the proceeds was tem- porarily invested in short-term marketable securities (trading securities) at 10% until November 1. On November 1, Amsterdam made a final $100,000 payment to Minsk. Other than the note to Netherlands, Amsterdam’s only outstanding liability at December 31, 2014, is a $30,000, 8%, 6-year note payable, dated January 1, 2011, on which interest is payable each December 31. Instructions (a) Calculate the interest revenue, weighted-average accumulated expenditures, avoidable interest, and total interest cost to be capitalized during 2014. (Round all computations to the nearest dollar.) (b) Prepare the journal entries needed on the books of Amsterdam Company at each of the following dates. (1) July 31, 2014. (2) November 1, 2014. (3) December 31, 2014. 4 E10-10 (Capitalization of Interest) The following three situations involve the capitalization of interest. Situation I: On January 1, 2014, Oksana Baiul, Inc. signed a fixed-price contract to have Builder Associates construct a major plant facility at a cost of $4,000,000. It was estimated that it would take 3 years to complete the project. Also on January 1, 2014, to finance the construction cost, Oksana Baiul borrowed $4,000,000 payable in 10 annual installments of $400,000, plus interest at the rate of 10%. During 2014, Oksana Baiul made deposit and progress payments totaling $1,500,000 under the contract; the weighted- average amount of accumulated expenditures was $800,000 for the year. The excess borrowed funds were invested in short-term securities, from which Oksana Baiul realized investment income of $250,000. Instructions What amount should Oksana Baiul report as capitalized interest at December 31, 2014? Situation II: During 2014, Midori Ito Corporation constructed and manufactured certain assets and incurred the following interest costs in connection with those activities. Interest Costs Incurred Warehouse constructed for Ito’s own use $30,000 Special-order machine for sale to unrelated customer, produced according to customer’s specifi cations 9,000 Inventories routinely manufactured, produced on a repetitive basis 8,000 All of these assets required an extended period of time for completion. Instructions Assuming the effect of interest capitalization is material, what is the total amount of interest costs to be capitalized? Situation III: Peggy Fleming, Inc. has a fiscal year ending April 30. On May 1, 2014, Peggy Fleming borrowed $10,000,000 at 11% to finance construction of its own building. Repayments of the loan are to commence the month following completion of the building. During the year ended April 30, 2015, expen- ditures for the partially completed structure totaled $7,000,000. These expenditures were incurred evenly throughout the year. Interest earned on the unexpended portion of the loan amounted to $650,000 for the year. Instructions How much should be shown as capitalized interest on Peggy Fleming’s financial statements at April 30, 2015? (CPA adapted) 2 3 E10-11 (Entries for Equipment Acquisitions) Jane Geddes Engineering Corporation purchased conveyor

equipment with a list price of $10,000. Presented below are three independent cases related to the equip- 5 ment. (Round to the nearest dollar.) (a) Geddes paid cash for the equipment 8 days after the purchase. The vendor’s credit terms are 2/10, n/30. Assume that equipment purchases are initially recorded gross. (b) Geddes traded in equipment with a book value of $2,000 (initial cost $8,000), and paid $9,500 in cash one month after the purchase. The old equipment could have been sold for $400 at the date of trade. (The exchange has commercial substance.) (c) Geddes gave the vendor a $10,800 zero-interest-bearing note for the equipment on the date of pur- chase. The note was due in one year and was paid on time. Assume that the effective-interest rate in the market was 9%. 572 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment Instructions Prepare the general journal entries required to record the acquisition and payment in each of the independent cases above. 2 3 E10-12 (Entries for Asset Acquisition, Including Self-Construction) Below are transactions related to 5 Duffner Company. (a) The City of Pebble Beach gives the company 5 acres of land as a plant site. The fair value of this land is determined to be $81,000. (b) 13,000 shares of common stock with a par value of $50 per share are issued in exchange for land and buildings. The property has been appraised at a fair value of $810,000, of which $180,000 has been allocated to land and $630,000 to buildings. The stock of Duffner Company is not listed on any ex- change, but a block of 100 shares was sold by a stockholder 12 months ago at $65 per share, and a block of 200 shares was sold by another stockholder 18 months ago at $58 per share. (c) No entry has been made to remove from the accounts for Materials, Direct Labor, and Overhead the amounts properly chargeable to plant asset accounts for machinery constructed during the year. The following information is given relative to costs of the machinery constructed. Materials used $12,500 Factory supplies used 900 Direct labor incurred 15,000 Additional overhead (over regular) caused by construction 2,700 of machinery, excluding factory supplies used Fixed overhead rate applied to regular manufacturing operations 60% of direct labor cost Cost of similar machinery if it had been purchased from outside suppliers 44,000 Instructions Prepare journal entries on the books of Duffner Company to record these transactions. 2 5 E10-13 (Entries for Acquisition of Assets) Presented below is information related to Zonker Company. 1. On July 6, Zonker Company acquired the plant assets of Doonesbury Company, which had discon- tinued operations. The appraised value of the property is: Land $ 400,000 Buildings 1,200,000 Equipment 800,000 Total $2,400,000 Zonker Company gave 12,500 shares of its $100 par value common stock in exchange. The stock had a market price of $168 per share on the date of the purchase of the property. 2. Zonker Company expended the following amounts in cash between July 6 and December 15, the date when it first occupied the building. Repairs to building $105,000 Construction of bases for equipment to be installed later 135,000 Driveways and parking lots 122,000 Remodeling of offi ce space in building, including new partitions and walls 161,000 Special assessment by city on land 18,000 3. On December 20, the company paid cash for equipment, $260,000, subject to a 2% cash discount, and freight on equipment of $10,500. Instructions Prepare entries on the books of Zonker Company for these transactions. 5 E10-14 (Purchase of Equipment with Zero-Interest-Bearing Debt) Chippewas Inc. has decided to pur- chase equipment from Central Michigan Industries on January 2, 2014, to expand its production capacity to meet customers’ demand for its product. Chippewas issues an $800,000, 5-year, zero-interest-bearing note to Central Michigan for the new equipment when the prevailing market rate of interest for obligations of this nature is 12%. The company will pay off the note in five $160,000 installments due at the end of each

year over the life of the note. Instructions (Round to nearest dollar in all computations.) (a) Prepare the journal entry(ies) at the date of purchase. (b) Prepare the journal entry(ies) at the end of the first year to record the payment and interest, assuming that the company employs the effective-interest method. Exercises 573 (c) Prepare the journal entry(ies) at the end of the second year to record the payment and interest. (d) Assuming that the equipment had a 10-year life and no salvage value, prepare the journal entry necessary to record depreciation in the first year. (Straight-line depreciation is employed.) 5 E10-15 (Purchase of Computer with Zero-Interest-Bearing Debt) Cardinals Corporation purchased a computer on December 31, 2013, for $105,000, paying $30,000 down and agreeing to pay the balance in five equal installments of $15,000 payable each December 31 beginning in 2014. An assumed interest rate of 10% is implicit in the purchase price. Instructions (Round to two decimal places.) (a) Prepare the journal entry(ies) at the date of purchase. (b) Prepare the journal entry(ies) at December 31, 2014, to record the payment and interest (effective- interest method employed). (c) Prepare the journal entry(ies) at December 31, 2015, to record the payment and interest (effective- interest method employed). 5 E10-16 (Asset Acquisition) Hayes Industries purchased the following assets and constructed a building as well. All this was done during the current year. Assets 1 and 2: These assets were purchased as a lump sum for $100,000 cash. The following information was gathered. Depreciation to Initial Cost on Date on Seller’s Book Value on Description Seller’s Books Books Seller’s Books Appraised Value Machinery $100,000 $50,000 $50,000 $90,000 Equipment 60,000 10,000 50,000 30,000 Asset 3: This machine was acquired by making a $10,000 down payment and issuing a $30,000, 2-year, zero-interest-bearing note. The note is to be paid off in two $15,000 installments made at the end of the first and second years. It was estimated that the asset could have been purchased outright for $35,900. Asset 4: This machinery was acquired by trading in used machinery. (The exchange lacks commercial sub- stance.) Facts concerning the trade-in are as follows. Cost of machinery traded $100,000 Accumulated depreciation to date of sale 40,000 Fair value of machinery traded 80,000 Cash received 10,000 Fair value of machinery acquired 70,000 Asset 5: Equipment was acquired by issuing 100 shares of $8 par value common stock. The stock had a market price of $11 per share. Construction of Building: A building was constructed on land purchased last year at a cost of $150,000. Construction began on February 1 and was completed on November 1. The payments to the contractor were as follows. Date Payment 2/1 $120,000 6/1 360,000 9/1 480,000 11/1 100,000 To finance construction of the building, a $600,000, 12% construction loan was taken out on February 1. The loan was repaid on November 1. The firm had $200,000 of other outstanding debt during the year at a borrowing rate of 8%. Instructions Record the acquisition of each of these assets. 5 E10-17 (Nonmonetary Exchange) Busytown Corporation, which manufactures shoes, hired a recent college graduate to work in its accounting department. On the first day of work, the accountant was assigned to total a batch of invoices with the use of an adding machine. Before long, the accountant, who had never before seen such a machine, managed to break the machine. Busytown Corporation gave the machine plus $340 to Dick Tracy Business Machine Company (dealer) in exchange for a new machine. Assume the following information about the machines. 574 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment Busytown Corp. Dick Tracy Co. (Old Machine) (New Machine) Machine cost $290 $270 Accumulated depreciation 140 –0– Fair value 85 425 Instructions For each company, prepare the necessary journal entry to record the exchange. (The exchange has com- mercial substance.) 5 E10-18 (Nonmonetary Exchange) Cannondale Company purchased an electric wax melter on April 30,

2014, by trading in its old gas model and paying the balance in cash. The following data relate to the purchase. List price of new melter $15,800 Cash paid 10,000 Cost of old melter (5-year life, $700 salvage value) 11,200 Accumulated depreciation—old melter (straight-line) 6,300 Secondhand fair value of old melter 5,200 Instructions Prepare the journal entry(ies) necessary to record this exchange, assuming that the exchange (a) has commercial substance, and (b) lacks commercial substance. Cannondale’s fiscal year ends on December 31, and depreciation has been recorded through December 31, 2013. 5 E10-19 (Nonmonetary Exchange) Carlos Arruza Company exchanged equipment used in its manufactur- ing operations plus $3,000 in cash for similar equipment used in the operations of Tony LoBianco Company. The following information pertains to the exchange. Carlos Arruza Co. Tony LoBianco Co. Equipment (cost) $28,000 $28,000 Accumulated depreciation 19,000 10,000 Fair value of equipment 12,500 15,500 Cash given up 3,000 Instructions (a) Prepare the journal entries to record the exchange on the books of both companies. Assume that the exchange lacks commercial substance. (b) Prepare the journal entries to record the exchange on the books of both companies. Assume that the exchange has commercial substance. 5 E10-20 (Nonmonetary Exchange) Dana Ashbrook Inc. has negotiated the purchase of a new piece of automatic equipment at a price of $8,000 plus trade-in, f.o.b. factory. Dana Ashbrook Inc. paid $8,000 cash and traded in used equipment. The used equipment had originally cost $62,000; it had a book value of $42,000 and a secondhand fair value of $47,800, as indicated by recent transactions involving similar equipment. Freight and installation charges for the new equipment required a cash payment of $1,100. Instructions (a) Prepare the general journal entry to record this transaction, assuming that the exchange has com- mercial substance. (b) Assuming the same facts as in (a) except that fair value information for the assets exchanged is not determinable, prepare the general journal entry to record this transaction. 6 E10-21 (Analysis of Subsequent Expenditures) King Donovan Resources Group has been in its plant facility for 15 years. Although the plant is quite functional, numerous repair costs are incurred to main- tain it in sound working order. The company’s plant asset book value is currently $800,000, as indicated below. Original cost $1,200,000 Accumulated depreciation 400,000 Book value $ 800,000 During the current year, the following expenditures were made to the plant facility. (a) Because of increased demands for its product, the company increased its plant capacity by building a new addition at a cost of $270,000. (b) The entire plant was repainted at a cost of $23,000. (c) The roof was an asbestos cement slate. For safety purposes, it was removed and replaced with a wood shingle roof at a cost of $61,000. Book value of the old roof was $41,000. Exercises 575 (d) The electrical system was completely updated at a cost of $22,000. The cost of the old electrical system was not known. It is estimated that the useful life of the building will not change as a result of this updating. (e) A series of major repairs were made at a cost of $47,000, because parts of the wood structure were rotting. The cost of the old wood structure was not known. These extensive repairs are estimated to increase the useful life of the building. Instructions Indicate how each of these transactions would be recorded in the accounting records. 6 E10-22 (Analysis of Subsequent Expenditures) The following transactions occurred during 2014. Assume that depreciation of 10% per year is charged on all machinery and 5% per year on buildings, on a straight-line basis, with no estimated salvage value. Depreciation is charged for a full year on all fixed assets acquired during the year, and no depreciation is charged on fixed assets disposed of during the year. Jan. 30 A building that cost $132,000 in 1997 is torn down to make room for a new building. The wrecking

contractor was paid $5,100 and was permitted to keep all materials salvaged. Mar. 10 Machinery that was purchased in 2007 for $16,000 is sold for $2,900 cash, f.o.b. purchaser’s plant. Freight of $300 is paid on the sale of this machinery. Mar. 20 A gear breaks on a machine that cost $9,000 in 2009. The gear is replaced at a cost of $2,000. The replacement does not extend the useful life of the machine but does make the machine more effi cient. May 18 A special base installed for a machine in 2008 when the machine was purchased has to be replaced at a cost of $5,500 because of defective workmanship on the original base. The cost of the machinery was $14,200 in 2008. The cost of the base was $3,500, and this amount was charged to the Machinery account in 2008. June 23 One of the buildings is repainted at a cost of $6,900. It had not been painted since it was constructed in 2010. Instructions (Round to the nearest dollar.) Prepare general journal entries for the transactions. 6 E10-23 (Analysis of Subsequent Expenditures) Plant assets often require expenditures subsequent to acquisition. It is important that they be accounted for properly. Any errors will affect both the balance sheets and income statements for a number of years. Instructions For each of the following items, indicate whether the expenditure should be capitalized (C) or expensed (E) in the period incurred. (a) __________ Improvement. (b) __________ Replacement of a minor broken part on a machine. (c) __________ Expenditure that increases the useful life of an existing asset. (d) __________ Expenditure that increases the efficiency and effectiveness of a productive asset but does not increase its salvage value. (e) __________ Expenditure that increases the efficiency and effectiveness of a productive asset and increases the asset’s salvage value. (f) __________ Expenditure that increases the quality of the output of the productive asset. (g) __________ Improvement to a machine that increased its fair market value and its production capacity by 30% without extending the machine’s useful life. (h) __________ Ordinary repairs. 7 E10-24 (Entries for Disposition of Assets) On December 31, 2014, Travis Tritt Inc. has a machine with a book value of $940,000. The original cost and related accumulated depreciation at this date are as follows. Machine $1,300,000 Less: Accumulated depreciation 360,000 Book value $ 940,000 Depreciation is computed at $60,000 per year on a straight-line basis. Instructions Presented below is a set of independent situations. For each independent situation, indicate the journal entry to be made to record the transaction. Make sure that depreciation entries are made to update the book value of the machine prior to its disposal. (a) A fire completely destroys the machine on August 31, 2015. An insurance settlement of $430,000 was received for this casualty. Assume the settlement was received immediately. (b) On April 1, 2015, Tritt sold the machine for $1,040,000 to Dwight Yoakam Company. 576 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment (c) On July 31, 2015, the company donated this machine to the Mountain King City Council. The fair value of the machine at the time of the donation was estimated to be $1,100,000. 7 E10-25 (Disposition of Assets) On April 1, 2014, Gloria Estefan Company received a condemnation award of $430,000 cash as compensation for the forced sale of the company’s land and building, which stood in the path of a new state highway. The land and building cost $60,000 and $280,000, respectively, when they were acquired. At April 1, 2014, the accumulated depreciation relating to the building amounted to $160,000. On August 1, 2014, Estafan purchased a piece of replacement property for cash. The new land cost $90,000, and the new building cost $400,000. Instructions Prepare the journal entries to record the transactions on April 1 and August 1, 2014. EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS

2 P10-1 (Classification of Acquisition and Other Asset Costs) At December 31, 2013, certain accounts in- cluded in the property, plant, and equipment section of Reagan Company’s balance sheet had the follow- ing balances. Land $230,000 Buildings 890,000 Leasehold improvements 660,000 Equipment 875,000 During 2014, the following transactions occurred. 1. Land site number 621 was acquired for $850,000. In addition, to acquire the land Reagan paid a $51,000 commission to a real estate agent. Costs of $35,000 were incurred to clear the land. During the course of clearing the land, timber and gravel were recovered and sold for $13,000. 2. A second tract of land (site number 622) with a building was acquired for $420,000. The closing statement indicated that the land value was $300,000 and the building value was $120,000. Shortly after acquisition, the building was demolished at a cost of $41,000. A new building was constructed for $330,000 plus the following costs. Excavation fees $38,000 Architectural design fees 11,000 Building permit fee 2,500 Imputed interest on funds used during construction (stock fi nancing) 8,500 The building was completed and occupied on September 30, 2014. 3. A third tract of land (site number 623) was acquired for $650,000 and was put on the market for resale. 4. During December 2014, costs of $89,000 were incurred to improve leased office space. The related lease will terminate on December 31, 2016, and is not expected to be renewed. (Hint: Leasehold improvements should be handled in the same manner as land improvements.) 5. A group of new machines was purchased under a royalty agreement that provides for payment of royalties based on units of production for the machines. The invoice price of the machines was $87,000, freight costs were $3,300, installation costs were $2,400, and royalty payments for 2014 were $17,500. Instructions (a) Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2014. Land Leasehold Improvements Buildings Equipment Disregard the related accumulated depreciation accounts. Problems 577 (b) List the items in the situation that were not used to determine the answer to (a) above, and indicate where, or if, these items should be included in Reagan’s financial statements. (AICPA adapted) 2 7 P10-2 (Classification of Acquisition Costs) Selected accounts included in the property, plant, and equip- ment section of Lobo Corporation’s balance sheet at December 31, 2013, had the following balances. Land $ 300,000 Land improvements 140,000 Buildings 1,100,000 Equipment 960,000 During 2014, the following transactions occurred. 1. A tract of land was acquired for $150,000 as a potential future building site. 2. A plant facility consisting of land and building was acquired from Mendota Company in exchange for 20,000 shares of Lobo’s common stock. On the acquisition date, Lobo’s stock had a closing market price of $37 per share on a national stock exchange. The plant facility was carried on Mendota’s books at $110,000 for land and $320,000 for the building at the exchange date. Current appraised values for the land and building, respectively, are $230,000 and $690,000. 3. Items of machinery and equipment were purchased at a total cost of $400,000. Additional costs were incurred as follows. Freight and unloading $13,000 Sales taxes 20,000 Installation 26,000 4. Expenditures totaling $95,000 were made for new parking lots, streets, and sidewalks at the corpo- ration’s various plant locations. These expenditures had an estimated useful life of 15 years. 5. A machine costing $80,000 on January 1, 2006, was scrapped on June 30, 2014. Double-declining- balance depreciation has been recorded on the basis of a 10-year life. 6. A machine was sold for $20,000 on July 1, 2014. Original cost of the machine was $44,000 on January 1, 2011, and it was depreciated on the straight-line basis over an estimated useful life of 7 years and a salvage value of $2,000. Instructions (Round to the nearest dollar.) (a) Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2014.

Land Buildings Land Improvements Equipment (Hint: Disregard the related accumulated depreciation accounts.) (b) List the items in the fact situation that were not used to determine the answer to (a), showing the pertinent amounts and supporting computations in good form for each item. In addition, indicate where, or if, these items should be included in Lobo’s financial statements. (AICPA adapted) 2 3 P10-3 (Classification of Land and Building Costs) Spitfire Company was incorporated on January 2, 5 2015, but was unable to begin manufacturing activities until July 1, 2015, because new factory facilities were not completed until that date. The Land and Buildings account reported the following items during 2015. January 31 Land and buildings $160,000 February 28 Cost of removal of building 9,800 May 1 Partial payment of new construction 60,000 May 1 Legal fees paid 3,770 June 1 Second payment on new construction 40,000 June 1 Insurance premium 2,280 June 1 Special tax assessment 4,000 June 30 General expenses 36,300 July 1 Final payment on new construction 30,000 December 31 Asset write-up 53,800 399,950 December 31 Depreciation—2015 at 1% (4,000) December 31, 2015 Account balance $395,950 578 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment The following additional information is to be considered. 1. To acquire land and building, the company paid $80,000 cash and 800 shares of its 8% cumulative preferred stock, par value $100 per share. Fair value of the stock is $117 per share. 2. Cost of removal of old buildings amounted to $9,800, and the demolition company retained all materials of the building. 3. Legal fees covered the following. Cost of organization $ 610 Examination of title covering purchase of land 1,300 Legal work in connection with construction contract 1,860 $3,770 4. Insurance premium covered the building for a 2-year term beginning May 1, 2015. 5. The special tax assessment covered street improvements that are permanent in nature. 6. General expenses covered the following for the period from January 2, 2015, to June 30, 2015. President’s salary $32,100 Plant superintendent’s salary—supervision of new building 4,200 $36,300 7. Because of a general increase in construction costs after entering into the building contract, the board of directors increased the value of the building $53,800, believing that such an increase was justified to reflect the current market at the time the building was completed. Retained earnings was credited for this amount. 8. Estimated life of building—50 years. Depreciation for 2015—1% of asset value (1% of $400,000, or $4,000). Instructions (a) Prepare entries to reflect correct land, buildings, and depreciation accounts at December 31, 2015. (b) Show the proper presentation of land, buildings, and depreciation on the balance sheet at December 31, 2015. (AICPA adapted) 2 5 P10-4 (Dispositions, Including Condemnation, Demolition, and Trade-In) Presented below is a schedule 7 of property dispositions for Hollerith Co. Schedule of Property Dispositions Accumulated Cash Fair Nature of Cost Depreciation Proceeds Value Disposition Land $40,000 — $31,000 $31,000 Condemnation Building 15,000 — 3,600 — Demolition Warehouse 70,000 $16,000 74,000 74,000 Destruction by fi re Machine 8,000 2,800 900 7,200 Trade-in Furniture 10,000 7,850 — 3,100 Contribution Automobile 9,000 3,460 2,960 2,960 Sale The following additional information is available. Land: On February 15, a condemnation award was received as consideration for unimproved land held primarily as an investment, and on March 31, another parcel of unimproved land to be held as an investment was purchased at a cost of $35,000. Building: On April 2, land and building were purchased at a total cost of $75,000, of which 20% was allocated to the building on the corporate books. The real estate was acquired with the intention of demolishing the building, and this was accomplished during the month of November. Cash proceeds received in November represent the net proceeds from demolition of the building.

Warehouse: On June 30, the warehouse was destroyed by fire. The warehouse was purchased January 2, 2011, and had depreciated $16,000. On December 27, the insurance proceeds and other funds were used to purchase a replacement warehouse at a cost of $90,000. Machine: On December 26, the machine was exchanged for another machine having a fair value of $6,300 and cash of $900 was received. (The exchange lacks commercial substance.) Problems 579 Furniture: On August 15, furniture was contributed to a qualified charitable organization. No other contributions were made or pledged during the year. Automobile: On November 3, the automobile was sold to Jared Winger, a stockholder. Instructions Indicate how these items would be reported on the income statement of Hollerith Co. (AICPA adapted) 2 4 P10-5 (Classification of Costs and Interest Capitalization) On January 1, 2014, Blair Corporation pur- chased for $500,000 a tract of land (site number 101) with a building. Blair paid a real estate broker’s commission of $36,000, legal fees of $6,000, and title guarantee insurance of $18,000. The closing statement indicated that the land value was $500,000 and the building value was $100,000. Shortly after acquisition, the building was razed at a cost of $54,000. Blair entered into a $3,000,000 fixed-price contract with Slatkin Builders, Inc. on March 1, 2014, for the construction of an office building on land site number 101. The building was completed and occupied on September 30, 2015. Additional construction costs were incurred as follows. Plans, specifi cations, and blueprints $21,000 Architects’ fees for design and supervision 82,000 The building is estimated to have a 40-year life from date of completion and will be depreciated using the 150% declining-balance method. To finance construction costs, Blair borrowed $3,000,000 on March 1, 2014. The loan is payable in 10 annual installments of $300,000 starting on March 1, 2015, plus interest at the rate of 10%. Blair’s weighted-average amounts of accumulated building construction expenditures were as follows. For the period March 1 to December 31, 2014 $1,300,000 For the period January 1 to September 30, 2015 1,900,000 Instructions (a) Prepare a schedule that discloses the individual costs making up the balance in the land account in respect of land site number 101 as of September 30, 2015. (b) Prepare a schedule that discloses the individual costs that should be capitalized in the office build- ing account as of September 30, 2015. Show supporting computations in good form. (AICPA adapted) 2 4 P10-6 (Interest During Construction) Grieg Landscaping began construction of a new plant on December 1, 2014. On this date, the company purchased a parcel of land for $139,000 in cash. In addition, it paid $2,000 in surveying costs and $4,000 for a title insurance policy. An old dwelling on the premises was demolished at a cost of $3,000, with $1,000 being received from the sale of materials. Architectural plans were also formalized on December 1, 2014, when the architect was paid $30,000. The necessary building permits costing $3,000 were obtained from the city and paid for on December 1 as well. The excavation work began during the first week in December with payments made to the contractor as follows. Date of Payment Amount of Payment March 1 $240,000 May 1 330,000 July 1 60,000 The building was completed on July 1, 2015. To finance construction of this plant, Grieg borrowed $600,000 from the bank on December 1, 2014. Grieg had no other borrowings. The $600,000 was a 10-year loan bearing interest at 8%. Instructions Compute the balance in each of the following accounts at December 31, 2014, and December 31, 2015. (Round amounts to the nearest dollar.) (a) Land. (b) Buildings. (c) Interest Expense. 4 P10-7 (Capitalization of Interest) Laserwords Inc. is a book distributor that had been operating in its original facility since 1987. The increase in certification programs and continuing education requirements in several professions has contributed to an annual growth rate of 15% for Laserwords since 2009. Laser-

words’ original facility became obsolete by early 2014 because of the increased sales volume and the fact that Laserwords now carries CDs in addition to books. 580 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment On June 1, 2014, Laserwords contracted with Black Construction to have a new building constructed for $4,000,000 on land owned by Laserwords. The payments made by Laserwords to Black Construction are shown in the schedule below. Date Amount July 30, 2014 $ 900,000 January 30, 2015 1,500,000 May 30, 2015 1,600,000 Total payments $4,000,000 Construction was completed and the building was ready for occupancy on May 27, 2015. Laserwords had no new borrowings directly associated with the new building but had the following debt outstanding at May 31, 2015, the end of its fiscal year. 10%, 5-year note payable of $2,000,000, dated April 1, 2011, with interest payable annually on April 1. 12%, 10-year bond issue of $3,000,000 sold at par on June 30, 2007, with interest payable annually on June 30. The new building qualifies for interest capitalization. The effect of capitalizing the interest on the new building, compared with the effect of expensing the interest, is material. Instructions (a) Compute the weighted-average accumulated expenditures on Laserwords’ new building during the capitalization period. (b) Compute the avoidable interest on Laserwords’ new building. (Round to one decimal place.) (c) Some interest cost of Laserwords Inc. is capitalized for the year ended May 31, 2015. (1) I dentify the items relating to interest costs that must be disclosed in Laserwords’ financial statements. (2) Compute the amount of each of the items that must be disclosed. (CMA adapted) 5 P10-8 (Nonmonetary Exchanges) Holyfield Corporation wishes to exchange a machine used in its opera- tions. Holyfield has received the following offers from other companies in the industry. 1. Dorsett Company offered to exchange a similar machine plus $23,000. (The exchange has commer- cial substance for both parties.) 2. Winston Company offered to exchange a similar machine. (The exchange lacks commercial substance for both parties.) 3. Liston Company offered to exchange a similar machine, but wanted $3,000 in addition to Holyfield’s machine. (The exchange has commercial substance for both parties.) In addition, Holyfield contacted Greeley Corporation, a dealer in machines. To obtain a new machine, Holyfield must pay $93,000 in addition to trading in its old machine. Holyfield Dorsett Winston Liston Greeley Machine cost $160,000 $120,000 $152,000 $160,000 $130,000 Accumulated depreciation 60,000 45,000 71,000 75,000 –0– Fair value 92,000 69,000 92,000 95,000 185,000 Instructions For each of the four independent situations, prepare the journal entries to record the exchange on the books of each company. 5 P10-9 (Nonmonetary Exchanges) On August 1, Hyde, Inc. exchanged productive assets with Wiggins, Inc. Hyde’s asset is referred to below as “Asset A,” and Wiggins’ is referred to as “Asset B.” The following facts pertain to these assets. Asset A Asset B Original cost $96,000 $110,000 Accumulated depreciation (to date of exchange) 40,000 47,000 Fair value at date of exchange 60,000 75,000 Cash paid by Hyde, Inc. 15,000 Cash received by Wiggins, Inc. 15,000 Problems 581 Instructions (a) Assuming that the exchange of Assets A and B has commercial substance, record the exchange for both Hyde, Inc. and Wiggins, Inc. in accordance with generally accepted accounting principles. (b) Assuming that the exchange of Assets A and B lacks commercial substance, record the exchange for both Hyde, Inc. and Wiggins, Inc. in accordance with generally accepted accounting principles. 5 P10-10 (Nonmonetary Exchanges) During the current year, Marshall Construction trades an old crane that has a book value of $90,000 (original cost $140,000 less accumulated depreciation $50,000) for a new crane from Brigham Manufacturing Co. The new crane cost Brigham $165,000 to manufacture and is clas- sified as inventory. The following information is also available.

Marshall Const. Brigham Mfg. Co. Fair value of old crane $ 82,000 Fair value of new crane $200,000 Cash paid 118,000 Cash received 118,000 Instructions (a) Assuming that this exchange is considered to have commercial substance, prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing. (b) Assuming that this exchange lacks commercial substance for Marshall, prepare the journal entries on the books of Marshall Construction. (c) Assuming the same facts as those in (a), except that the fair value of the old crane is $98,000 and the cash paid is $102,000, prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing. (d) Assuming the same facts as those in (b), except that the fair value of the old crane is $97,000 and the cash paid $103,000, prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing. 2 5 P10-11 (Purchases by Deferred Payment, Lump-Sum, and Nonmonetary Exchanges) Klamath Com- pany, a manufacturer of ballet shoes, is experiencing a period of sustained growth. In an effort to expand its production capacity to meet the increased demand for its product, the company recently made several acquisitions of plant and equipment. Rob Joffrey, newly hired in the position of fixed-asset accountant, requested that Danny Nolte, Klamath’s controller, review the following transactions. Transaction 1: On June 1, 2014, Klamath Company purchased equipment from Wyandot Corporation. Klamath issued a $28,000, 4-year, zero-interest-bearing note to Wyandot for the new equipment. Klamath will pay off the note in four equal installments due at the end of each of the next 4 years. At the date of the transaction, the prevailing market rate of interest for obligations of this nature was 10%. Freight costs of $425 and installation costs of $500 were incurred in completing this transaction. The appropriate factors for the time value of money at a 10% rate of interest are given below. Future value of $1 for 4 periods 1.46 Future value of an ordinary annuity for 4 periods 4.64 Present value of $1 for 4 periods 0.68 Present value of an ordinary annuity for 4 periods 3.17 Transaction 2: On December 1, 2014, Klamath Company purchased several assets of Yakima Shoes Inc., a small shoe manufacturer whose owner was retiring. The purchase amounted to $220,000 and included the assets listed below. Klamath Company engaged the services of Tennyson Appraisal Inc., an independent appraiser, to determine the fair values of the assets which are also presented below. Yakima Book Value Fair Value Inventory $ 60,000 $ 50,000 Land 40,000 80,000 Buildings 70,000 120,000 $170,000 $250,000 During its fiscal year ended May 31, 2015, Klamath incurred $8,000 for interest expense in connection with the financing of these assets. Transaction 3: On March 1, 2015, Klamath Company exchanged a number of used trucks plus cash for vacant land adjacent to its plant site. (The exchange has commercial substance.) Klamath intends to use the land for a parking lot. The trucks had a combined book value of $35,000, as Klamath had recorded $20,000 582 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment of accumulated depreciation against these assets. Klamath’s purchasing agent, who has had previous deal- ings in the secondhand market, indicated that the trucks had a fair value of $46,000 at the time of the trans- action. In addition to the trucks, Klamath Company paid $19,000 cash for the land. Instructions (a) Plant assets such as land, buildings, and equipment receive special accounting treatment. Describe the major characteristics of these assets that differentiate them from other types of assets. (b) For each of the three transactions described above, determine the value at which Klamath Company should record the acquired assets. Support your calculations with an explanation of the underlying rationale. (c) The books of Klamath Company show the following additional transactions for the fiscal year ended May 31, 2015.

(1) Acquisition of a building for speculative purposes. (2) Purchase of a 2-year insurance policy covering plant equipment. (3) Purchase of the rights for the exclusive use of a process used in the manufacture of ballet shoes. For each of these transactions, indicate whether the asset should be classified as a plant asset. If it is a plant asset, explain why it is. If it is not a plant asset, explain why not, and identify the proper classification. (CMA adapted) PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA10-1 (Acquisition, Improvements, and Sale of Realty) Tonkawa Company purchased land for use as its corporate headquarters. A small factory that was on the land when it was purchased was torn down before construction of the office building began. Furthermore, a substantial amount of rock blasting and removal had to be done to the site before construction of the building foundation began. Because the office building was set back on the land far from the public road, Tonkawa Company had the contractor construct a paved road that led from the public road to the parking lot of the office building. Three years after the office building was occupied, Tonkawa Company added four stories to the office building. The four stories had an estimated useful life of 5 years more than the remaining estimated useful life of the original office building. Ten years later, the land and building were sold at an amount more than their net book value, and Tonkawa Company had a new office building constructed in another state for use as its new corporate headquarters. Instructions (a) Which of the expenditures above should be capitalized? How should each be depreciated or amor- tized? Discuss the rationale for your answers. (b) How would the sale of the land and building be accounted for? Include in your answer an explana- tion of how to determine the net book value at the date of sale. Discuss the rationale for your answer. CA10-2 (Accounting for Self-Constructed Assets) Troopers Medical Labs, Inc., began operations 5 years ago producing stetrics, a new type of instrument it hoped to sell to doctors, dentists, and hospitals. The demand for stetrics far exceeded initial expectations, and the company was unable to produce enough stetrics to meet demand. The company was manufacturing its product on equipment that it built at the start of its operations. To meet demand, more efficient equipment was needed. The company decided to design and build the equipment, because the equipment currently available on the market was unsuitable for producing stetrics. In 2014, a section of the plant was devoted to development of the new equipment and a special staff was hired. Within 6 months, a machine developed at a cost of $714,000 increased production dramatically and reduced labor costs substantially. Elated by the success of the new machine, the company built three more machines of the same type at a cost of $441,000 each. Concepts for Analysis 583 Instructions (a) In general, what costs should be capitalized for self-constructed equipment? (b) Discuss the propriety of including in the capitalized cost of self-constructed assets: (1) The increase in overhead caused by the self-construction of fixed assets. (2) A proportionate share of overhead on the same basis as that applied to goods manufactured for sale. (c) Discuss the proper accounting treatment of the $273,000 ($714,000 2 $441,000) by which the cost of the first machine exceeded the cost of the subsequent machines. This additional cost should not be considered research and development costs. CA10-3 (Capitalization of Interest) Vania Magazine Company started construction of a warehouse build- ing for its own use at an estimated cost of $5,000,000 on January 1, 2013, and completed the building on December 31, 2013. During the construction period, Vania has the following debt obligations outstanding. Construction loan—12% interest, payable semiannually, issued December 31, 2012 $2,000,000

Short-term loan—10% interest, payable monthly, and principal payable at maturity, on May 30, 2014 1,400,000 Long-term loan—11% interest, payable on January 1 of each year; principal payable on January 1, 2016 1,000,000 Total cost amounted to $5,200,000, and the weighted average of accumulated expenditures was $3,500,000. Jane Esplanade, the president of the company, has been shown the costs associated with this construction project and capitalized on the balance sheet. She is bothered by the “avoidable interest” included in the cost. She argues that, first, all the interest is unavoidable—no one lends money without expecting to be compensated for it. Second, why can’t the company use all the interest on all the loans when computing this avoidable interest? Finally, why can’t her company capitalize all the annual interest that accrued over the period of construction? Instructions (Round the weighted-average interest rate to two decimal places.) You are the manager of accounting for the company. In a memo, explain what avoidable interest is, how you computed it (being especially careful to explain why you used the interest rates that you did), and why the com- pany cannot capitalize all its interest for the year. Attach a schedule supporting any computations that you use. CA10-4 (Nonmonetary Exchanges) You have two clients that are considering trading machinery with each other. Although the machines are different from each other, you believe that an assessment of ex- pected cash flows on the exchanged assets will indicate the exchange lacks commercial substance. Your clients would prefer that the exchange be deemed to have commercial substance, to allow them to record gains. Here are the facts: Client A Client B Original cost $100,000 $150,000 Accumulated depreciation 40,000 80,000 Fair value 80,000 100,000 Cash received (paid) (20,000) 20,000 Instructions (a) Record the trade-in on Client A’s books assuming the exchange has commercial substance. (b) Record the trade-in on Client A’s books assuming the exchange lacks commercial substance. (c) Write a memo to the controller of Company A indicating and explaining the dollar impact on current and future statements of treating the exchange as having, versus lacking, commercial substance. (d) Record the entry on Client B’s books assuming the exchange has commercial substance. (e) Record the entry on Client B’s books assuming the exchange lacks commercial substance. (f) Write a memo to the controller of Company B indicating and explaining the dollar impact on current and future statements of treating the exchange as having, versus lacking, commercial substance. CA10-5 (Costs of Acquisition) The invoice price of a machine is $50,000. Various other costs relating to the acquisition and installation of the machine including transportation, electrical wiring, special base, and so on amount to $7,500. The machine has an estimated life of 10 years, with no salvage value at the end of that period. The owner of the business suggests that the incidental costs of $7,500 be charged to expense immedi- ately for the following reasons. 1. If the machine should be sold, these costs cannot be recovered in the sales price. 2. The inclusion of the $7,500 in the machinery account on the books will not necessarily result in a closer approximation of the market price of this asset over the years, because of the possibility of changing demand and supply levels. 3. Charging the $7,500 to expense immediately will reduce federal income taxes. 584 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment Instructions Discuss each of the points raised by the owner of the business. (AICPA adapted) CA10-6 (Cost of Land vs. Building—Ethics) Tones Company purchased a warehouse in a downtown district where land values are rapidly increasing. Gerald Carter, controller, and Wilma Ankara, financial vice president, are trying to allocate the cost of the purchase between the land and the building. Noting that depreciation can be taken only on the building, Carter favors placing a very high proportion of the cost on

the warehouse itself, thus reducing taxable income and income taxes. Ankara, his supervisor, argues that the allocation should recognize the increasing value of the land, regardless of the depreciation potential of the warehouse. Besides, she says, net income is negatively impacted by additional depreciation and will cause the company’s stock price to go down. Instructions Answer the following questions. (a) What stakeholder interests are in conflict? (b) What ethical issues does Carter face? (c) How should these costs be allocated? USING YOUR JUDGMENT FINANCIAL REPORTING Financial Statement Analysis Case Johnson & Johnson Johnson & Johnson, the world’s leading and most diversified health-care corporation, serves its customers through specialized worldwide franchises. Each of its franchises consists of a number of companies throughout the world that focus on a particular health-care market, such as surgical sutures, consumer pharmaceuticals, or contact lenses. Information related to its property, plant, and equipment in its 2011 annual report is shown in the notes to the financial statements below. 1. Property, Plant and Equipment and Depreciation Property, plant and equipment are stated at cost. The Company utilizes the straight-line method of depreciation over the estimated useful lives of the assets: Building and building equipment 20–40 years Land and leasehold improvements 10–20 years Machinery and equipment 2–13 years 4. Property, Plant and Equipment At the end of 2011 and 2010, property, plant and equipment at cost and accumulated depreciation were: (dollars in millions) 2011 2010 Land and land improvements $ 754 $ 738 Buildings and building equipment 9,389 9,079 Machinery and equipment 19,182 18,032 Construction in progress 2,504 2,577 31,829 30,426 Less accumulated depreciation 17,090 15,873 $14,739 $14,553 The Company capitalizes interest expense as part of the cost of construction of facilities and equipment. Interest expense capitalized in 2011, 2010 and 2009 was $84 million, $73 million and $101 million, respectively. Depreciation expense, including the amortization of capitalized interest in 2011, 2010 and 2009 was $2.3 billion, $2.2 billion and $2.1 billion, respectively. Using Your Judgment 585 Johnson & Johnson’s provided the following selected information in its 2011 cash flow statement. Johnson & Johnson 2011 Annual Report Consolidated Financial Statements (excerpts) Net cash fl ows from operating activities $14,298 Cash fl ows from investing activities Additions to property, plant and equipment (2,893) Proceeds from the disposal of assets 1,342 Acquisitions, net of cash acquired (2,797) Purchases of investments (29,882) Sales of investments 30,396 Other (primarily intangibles) (778) Net cash used by investing activities (4,612) Cash fl ows from fi nancing activities Dividends to shareholders (6,156) Repurchase of common stock (2,525) Proceeds from short-term debt 9,729 Retirement of short-term debt (11,200) Proceeds from long-term debt 4,470 Retirement of long-term debt (16) Proceeds from the exercise of stock options/excess tax benefi ts 1,246 Net cash used by fi nancing activities (4,452) Effect of exchange rate changes on cash and cash equivalents (47) Increase in cash and cash equivalents 5,187 Cash and cash equivalents, beginning of year (Note 1) 19,355 Cash and cash equivalents, end of year (Note 1) $24,542 Supplemental cash fl ow data Cash paid during the year for: Interest $ 576 Income taxes 2,970 Instructions (a) What was the cost of buildings and building equipment at the end of 2011? (b) Does Johnson & Johnson use a conservative or liberal method to depreciate its property, plant, and equipment? (c) What was the actual interest expense paid by the company in 2011? (d) What is Johnson & Johnson’s free cash flow? From the information provided, comment on Johnson & Johnson’s financial flexibility. Accounting, Analysis, and Principles Durler Company purchased equipment on January 2, 2010, for $112,000. The equipment had an estimated useful life of 5 years with an estimated salvage value of $12,000. Durler uses straight-line depreciation on

all assets. On January 2, 2014, Durler exchanged this equipment plus $12,000 in cash for newer equipment. The old equipment has a fair value of $50,000. Accounting Prepare the journal entry to record the exchange on the books of Durler Company. Assume that the exchange has commercial substance. Analysis How will this exchange affect comparisons of the return on asset ratio for Durler in the year of the exchange compared to prior years? 586 Chapter 10 Acquisition and Disposition of Property, Plant, and Equipment Principles How does the concept of commercial substance affect the accounting and analysis of this exchange? BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Your client is in the planning phase for a major plant expansion, which will involve the construction of a new warehouse. The assistant controller does not believe that interest cost can be included in the cost of the warehouse, because it is a financing expense. Others on the planning team believe that some interest cost can be included in the cost of the warehouse, but no one could identify the specific authoritative guidance for this issue. Your supervisor asks you to research this issue. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) Is it permissible to capitalize interest into the cost of assets? Provide authoritative support for your answer. (b) What are the objectives for capitalizing interest? (c) Discuss which assets qualify for interest capitalization. (d) Is there a limit to the amount of interest that may be capitalized in a period? (e) If interest capitalization is allowed, what disclosures are required? Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. Remember to check the book’s companion website to fi nd additional resources for this chapter. This page is intentionally left blank Depreciation, Impairments, and Depletion 1 Explain the concept of depreciation. 5 Explain the accounting issues related to asset impairment. 2 Identify the factors involved in the depreciation process. 6 Explain the accounting procedures for depletion of natural resources. 3 Compare activity, straight-line, and decreasing- charge methods of depreciation. 7 Explain how to report and analyze property, plant, equipment, and natural resources. 4 Explain special depreciation methods. Here Come the Write-Offs The credit crisis starting in late 2008 affected many financial and nonfinancial institutions. Many of the statistics related to this crisis are sobering, as noted below. • In October 2008, the FTSE 100 in the United Kingdom suffered its biggest one-day fall since October 1987. The index closed at its lowest level since October 2004. • The Dow Jones Industrial Average fell below the 8,000 level for the first time since 2003. • Germany’s benchmark DAX tumbled after the collapse of the proposed rescue plan for Hypo Real Estate. • Tightening credit and less disposable income led to Japanese electronic groups losing value. The Nikkei fell to its lowest point since February 2004. • The Hong Kong Hang Seng dropped in line with the rest of Asia, closing below 17,000 points for the first time in two years in October 2008 and below 11,000 by November of that year. • Governments spent billions of dollars bailing out financial institutions. Although some financial rebound has occurred since October 2008, it is clear that most economies of the world are now in a slower growth pattern. This slowdown raises many questions related to the proper accounting for many long-term assets, such as property, plant, and equipment; intangible assets; and many types of financial assets. One of the most difficult issues relates to the possibility of higher impairment charges related to these assets and the related disclosures that may be needed. The following is an example of a recent impairment charge taken by Fujitsu Limited.

RETPAHC 11 LEARNING OBJECTIVES After studying this chapter, you should be able to: Impairment Losses (in part) Due to the worsening of the global business environment, Fujitsu recognized consolidated impairment losses of 58.9 billion yen in relation to property, plant, and equipment of businesses with decreased profitability. The main losses are as follows: (1) Property, Plant, and Equipment of LSI Business Impairment losses related to the property, plant, and equipment of the LSI business of Fujitsu Microelectronics Limited totaled 49.9 billion yen. In January, Fujitsu Microelectronics announced business reforms in response to a sharp downturn in customer demand that began last autumn. (2) Property, Plant, and Equipment of Optical Transmission Systems and Other Businesses Consolidated impairment losses of 8.9 billion yen were recognized in relation to the property, plant, and equipment of the optical transmission systems business, the electronic components business and other businesses due to their decreased profitability. (3) Property, Plant, and Equipment of HDD Business (included in business restructuring expenses) Impairment losses of 16.2 billion yen have been recognized in relation to the property, plant, and equipment of the reorganized HDD business. These losses are included in business restructuring expenses. The impairment loss includes 5.3 billion yen recognized in the third quarter for the discontinuation of the HDD head business. CONCEPTUAL FOCUS > See the Underlying Concepts on pages 592, 593, 594, and 601. > Read the Evolving Issue on page 609 for Impairment losses for property, plant, and equipment for a discussion of using the full-cost versus many companies in the next few years will be substantial. Here successful-efforts method for accounting for are some of the questions that will need to be addressed regard- exploration costs. ing possible impairments. 1. How often should a company test for impairment? INTERNATIONAL FOCUS 2. What are key impairment indicators? > See the International Perspectives 3. What disclosures are necessary for impairments? on pages 597, 602, 603, and 609. 4. How do companies match their cash flows to the asset that > Read the IFRS Insights on is potentially impaired? pages 637–646 for a discussion of: Assessing whether a company has impaired assets is —Component depreciation difficult. For example, in addition to the technical accounting —Impairments issues, the environment can change quickly. Reduced spending —Revaluations by consumers, lack of confidence in global economic decisions, and higher volatility in both stock and commodity markets are factors to consider. Nevertheless, for investors and creditors to have assurance that the amounts reported on the balance sheet for property, plant, and equipment are relevant and representationally faithful, appropriate impairment charges must be reported on a timely basis. Source: A portion of this discussion is taken from “Top 10 Tips for Impairment Testing,” PricewaterhouseCoopers (December 2008). As noted in the opening story, both U.S. and foreign companies PREVIEW OF CHAPTER 11 are affected by impairment rules. These rules recognize that when economic conditions deteriorate, companies may need to write off an asset’s cost to indicate the decline in its usefulness. The purpose of this chapter is to examine the depreciation process and the methods of writing off the cost of property, plant, and equipment and natural resources. The content and organization of the chapter are as follows. Depreciation, Impairments, and Depletion Presentation Depreciation Impairments Depletion and Analysis • Factors involved • Recognizing impairments • Establishing a base • Presentation • Methods of depreciation • Measuring impairments • Write-off of resource cost • Analysis • Special methods • Restoration of loss • Estimating reserves • Special issues • Assets to be disposed of • Liquidating dividends • Continuing controversy 589 590 Chapter 11 Depreciation, Impairments, and Depletion DEPRECIATION—A METHOD OF COST ALLOCATION

Most individuals at one time or another purchase and trade in an automobile. The LEARNING OBJECTIVE 1 automobile dealer and the buyer typically discuss what the trade-in value of the Explain the concept of depreciation. old car is. Also, they may talk about what the trade-in value of the new car will be in several years. In both cases, a decline in value is considered to be an example of depreciation. To accountants, however, depreciation is not a matter of valuation. Rather, deprecia- tion is a means of cost allocation. Depreciation is the accounting process of allocating the cost of tangible assets to expense in a systematic and rational manner to those periods expected to benefit from the use of the asset. For example, a company like Goodyear (one of the world’s largest tire manufacturers) does not depreciate assets on the basis of a decline in their fair value. Instead, it depreciates through systematic charges to expense. T his approach is employed because the value of the asset may fluctuate between the time the asset is purchased and the time it is sold or junked. Attempts to measure these interim value changes have not been well received because values are difficult to measure objectively. Therefore, Goodyear charges the asset’s cost to depreciation expense over its estimated life. It makes no attempt to value the asset at fair value between acquisition and disposition. Companies use the cost allocation approach because it recognizes the expense in the periods expected to benefit and because fluctuations in fair value are uncertain and difficult to measure. When companies write off the cost of long-lived assets over a number of periods, they typically use the term depreciation. They use the term depletion to describe the reduction in the cost of natural resources (such as timber, gravel, oil, and coal) over a period of time. The expiration of intangible assets, such as patents or copyrights, is called amortization. Factors Involved in the Depreciation Process Before establishing a pattern of charges to revenue, a company must answer three LEARNING OBJECTIVE 2 basic questions: Identify the factors involved in the depreciation process. 1. What depreciable base is 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? The answers to these questions involve combining several estimates into one single figure. Note the calculations assume perfect knowledge of the future, which is never attainable. Depreciable Base for the Asset Gateway to The base established for depreciation is a function of two factors: the original cost, and the Profession salvage or disposal value. We discussed historical cost in Chapter 10. Salvage value is Tutorial on Depreciation the estimated amount that a company will receive when it sells the asset or removes it Methods from service. It is the amount to which a company writes down or depreciates the asset during its useful life. If an asset has a cost of $10,000 and a salvage value of $1,000, its depreciation base is $9,000. ILLUSTRATION 11-1 Original cost $10,000 Computation of Less: Salvage value 1,000 Depreciation Base Depreciation base $ 9,000 Depreciation—A Method of Cost Allocation 591 From a practical standpoint, companies often assign a zero salvage value. Some long-lived assets, however, have substantial salvage values. Estimation of Service Lives The service life of an asset often differs from its physical life. A piece of machinery may be physically capable of producing a given product for many years beyond its service life. But a company may not use the equipment for all that time because the cost of pro- ducing the product in later years may be too high. For example, the old Slater cotton mill in Pawtucket, Rhode Island, is preserved in remarkable physical condition as an historic landmark in U.S. industrial development, although its service life was termi- nated many years ago.1 Companies retire assets for two reasons: physical factors (such as casualty or expiration of physical life) and economic factors (obsolescence). Physical factors are

the wear and tear, decay, and casualties that make it difficult for the asset to perform indefinitely. These physical factors set the outside limit for the service life of an asset. We can classify the economic or functional factors into three categories: 1. Inadequacy results when an asset ceases to be useful to a company because the demands of the fi rm have changed. An example would be the need for a larger building to handle increased production. Although the old building may still be sound, it may have become inadequate for the company’s purpose. 2. Supersession is the replacement of one asset with another more effi cient and eco- nomical asset. Examples would be the replacement of the mainframe computer with a PC network, or the replacement of the Boeing 767 with the Boeing 787. 3. Obsolescence is the catchall for situations not involving inadequacy and super- session. Because the distinction between these categories appears artificial, it is probably best to consider economic factors collectively instead of trying to make distinctions that are not clear-cut. To illustrate the concepts of physical and economic factors, consider a new nuclear power plant. Which is more important in determining the useful life of a nuclear power plant—physical factors or economic factors? The limiting factors seem to be (1) ecologi- cal considerations, (2) competition from other power sources, and (3) safety concerns. Physical life does not appear to be the primary factor affecting useful life. Although the plant’s physical life may be far from over, the plant may become obsolete in 10 years. For a house, physical factors undoubtedly are more important than the economic or functional factors relative to useful life. Whenever the physical nature of the asset pri- marily determines useful life, maintenance plays an extremely vital role. The better the maintenance, the longer the life of the asset.2 In most cases, a company estimates the useful life of an asset based on its past expe- rience with the same or similar assets. Others use sophisticated statistical methods to establish a useful life for accounting purposes. And in some cases, companies select arbitrary service lives. In a highly industrial economy such as that of the United States, where research and innovation are so prominent, technological factors have as much effect, if not more, on service lives of tangible plant assets as physical factors do. 1Taken from J. D. Coughlan and W. K. Strand, Depreciation Accounting, Taxes and Business Decisions (New York: The Ronald Press, 1969), pp. 10–12. 2The airline industry also illustrates the type of problem involved in estimation. In the past, aircraft were assumed not to wear out—they just became obsolete. However, some jets have been in service as long as 20 years, and maintenance of these aircraft has become increasingly expensive. As a result, some airlines now replace aircraft not because of obsolescence but because of physical deterioration. 592 Chapter 11 Depreciation, Impairments, and Depletion What do the numbers mean? ALPHABET DUPE Some companies try to imply that depreciation is not a cost. its rides and attractions current. Those expenses are not For example, in their press releases they will often make a optional—let the rides get a little rusty, and ticket sales start bigger deal over earnings before interest, taxes, deprecia- to tail off. That means analysts really should view deprecia- tion, and amortization (often referred to as EBITDA) than tion associated with the costs of maintaining the rides (or net income under GAAP. They like it because it “dresses up” buying new ones) as an everyday expense. It also means their earnings numbers. Some on Wall Street buy this hype investors in those companies should have strong stomachs. because they don’t like the allocations that are required to What’s the risk of trusting a fad accounting measure? Just determine net income. Some banks, without batting an look at one year’s bankruptcy numbers. Of the 147 compa- eyelash, even let companies base their loan covenants on nies tracked by Moody’s that defaulted on their debt, most

EBITDA. borrowed money based on EBITDA performance. The For example, look at Premier Parks, which operates the bankers in those deals probably wish they had looked at a Six Flags chain of amusement parks. Premier touts its few other factors. On the other hand, nonfi nancial companies EBITDA performance. But that number masks a big part of in the S&P 500 generated a substantial EBITDA margin of how the company operates—and how it spends its money. 20.9 percent in 2011. Some analysts are concerned that such a Premier argues that analysts should ignore depreciation for high number suggests that companies are reluctant to incur big-ticket items like roller coasters because the rides have a costs and want to stockpile cash. The lesson? Investors will long life. Critics, however, say that the amusement industry do well to avoid focus on any single accounting measure. has to spend as much as 50 percent of its EBITDA just to keep Sources: Adapted from Herb Greenberg, “Alphabet Dupe: Why EBITDA Falls Short,” Fortune (July 10, 2000), p. 240; and V. Monga, “Operating Effi ciency Runs High at U.S. Firms,” Wall Street Journal (February 28, 2012), p. B7. Methods of Depreciation The third factor involved in the depreciation process is the method of cost apportion- LEARNING OBJECTIVE 3 ment. The profession requires that the depreciation method employed be “systematic Compare activity, straight-line, and and rational.” Companies may use a number of depreciation methods, as follows. decreasing-charge methods of depreciation. 1. Activity method (units of use or production). 2. Straight-line method. Underlying Concepts 3. Decreasing-charge methods (accelerated): Depreciation attempts to recog- (a) Sum-of-the-years’-digits. nize the cost of an asset to the (b) Declining-balance method. periods that benefi t from the 4. Special depreciation methods: use of that asset. (a) Group and composite methods. (b) Hybrid or combination methods.3 To illustrate these depreciation methods, assume that Stanley Coal Mines recently purchased an additional crane for digging purposes. Illustration 11-2 contains the perti- nent data concerning this purchase. ILLUSTRATION 11-2 Cost of crane $500,000 Data Used to Illustrate Estimated useful life 5 years Depreciation Methods Estimated salvage value $ 50,000 Productive life in hours 30,000 hours 3Accounting Trends and Techniques—2012 reports that of its 500 surveyed companies, for reporting purposes, 490 used straight-line, 9 used declining-balance, 2 used sum-of-the-years’-digits, 9 used an accelerated method (not specified), 12 used units-of-production, and 17 used group/composite. Depreciation—A Method of Cost Allocation 593 Activity Method The activity method (also called the variable-charge or units-of-production approach) assumes that depreciation is a function of use or productivity, instead of the passage of time. A company considers the life of the asset in terms of either the output it provides (units it produces) or an input measure such as the number of hours it works. Conceptually, the proper cost association relies on output instead of hours used, but often the output is not easily measurable. In such cases, an input measure such as machine hours is a more appropriate method of measuring the dollar amount of depreciation charges for a given accounting period. The crane poses no particular depreciation problem. Stanley can measure the usage (hours) relatively easily. If Stanley uses the crane for 4,000 hours the first year, the depre- ciation charge is: ILLUSTRATION 11-3 (Cost less salvage value)3Hours this year 5Depreciation charge Depreciation Calculation, Total estimated hours Activity Method—Crane ($500,0002$50,000)34,000 Example 5$60,000 30,000 The major limitation of this method is that it is inappropriate in situations in which depreciation is a function of time instead of activity. For example, a building steadily deteriorates due to the elements (time) regardless of its use. In addition, where eco- nomic or functional factors affect an asset, independent of its use, the activity method

loses much of its significance. For example, if a company is expanding rapidly, a par- ticular building may soon become obsolete for its intended purposes. In both cases, activity is irrelevant. Another problem in using an activity method is the difficulty of estimating units of output or service hours received. In cases where loss of services results from activity or productivity, the activity method does the best to record expenses in the same period as associated revenues. Companies that desire low depreciation during periods of low productivity, and high depreciation during high productivity, either adopt or switch to an activity method. In this way, a plant running at 40 percent of capacity generates 60 percent lower deprecia- tion charges. Inland Steel, for example, switched to units-of-production depreciation at one time and reduced its losses by $43 million, or $1.20 per share. Straight-Line Method Underlying Concepts The straight-line method considers depreciation as a function of time rather than a function of usage. Companies widely use this method because of its If benefi ts fl ow on a “straight- line” basis, then justifi cation simplicity. The straight-line procedure is often the most conceptually appropri- exists for recording the cost of ate, too. When creeping obsolescence is the primary reason for a limited service the asset on a straight-line basis life, the decline in usefulness may be constant from period to period. Stanley with these benefi ts. computes the depreciation charge for the crane as follows. ILLUSTRATION 11-4 Cost less salvage value 5Depreciation charge Depreciation Calculation, Estimated service life Straight-Line Method— $500,0002$50,000 Crane Example 5$90,000 5 The major objection to the straight-line method is that it rests on two tenuous a ssumptions. (1) The asset’s economic usefulness is the same each year, and (2) the maintenance and repair expense is essentially the same each period. One additional problem that occurs in using straight-line—as well as some others—is that distortions in the rate of return analysis (income/assets) develop. 594 Chapter 11 Depreciation, Impairments, and Depletion Illustration 11-5 indicates how the rate of return increases, given constant revenue flows, because the asset’s book value decreases. ILLUSTRATION 11-5 Undepreciated Income (after Rate of Return Depreciation and Rate of Depreciation Asset Balance depreciation (Income 4 Return Analysis—Crane Year Expense (book value) expense) Assets) Example 0 $500,000 1 $90,000 410,000 $100,000 24.4% 2 90,000 320,000 100,000 31.2% 3 90,000 230,000 100,000 43.5% 4 90,000 140,000 100,000 71.4% 5 90,000 50,000 100,000 200.0% Decreasing-Charge Methods The decreasing-charge methods provide for a higher depreciation cost in the Underlying Concepts earlier years and lower charges in later periods. Because these methods allow The expense recognition for higher early-year charges than in the straight-line method, they are often principle does not justify a called accelerated depreciation methods. constant charge to income. If What is the main justification for this approach? The rationale is that com- the benefi ts from the asset panies should charge more depreciation in earlier years because the asset is decline as the asset ages, then most productive in its earlier years. Furthermore, the accelerated methods a decreasing charge to income provide a constant cost because the depreciation charge is lower in the later better matches cost to benefi ts. periods, at the time when the repair and maintenance costs are often higher. Generally, companies use one of two decreasing-charge methods: the sum-of-the-years’- digits method or the declining-balance method. Sum-of-the-Years’-Digits. The sum-of-the-years’-digits method results in a decreasing depreciation charge based on a decreasing fraction of depreciable cost (original cost less salvage value). Each fraction uses the sum of the years as a denominator (5 1 4 1 3 1 2 1 1 5 15). The numerator is the number of years of estimated life remaining as of the

beginning of the year. In this method, the numerator decreases year by year, and the denominator remains constant (5/15, 4/15, 3/15, 2/15, and 1/15). At the end of the asset’s useful life, the balance remaining should equal the salvage value. Illustration 11-6 shows this method of computation.4 ILLUSTRATION 11-6 Remaining Book Sum-of-the-Years’-Digits Depreciation Life in Depreciation Depreciation Value, End Depreciation Schedule— Year Base Years Fraction Expense of Year Crane Example 1 $450,000 5 5/15 $150,000 $350,000 2 450,000 4 4/15 120,000 230,000 3 450,000 3 3/15 90,000 140,000 4 450,000 2 2/15 60,000 80,000 5 450,000 1 1/15 30,000 50,000a 15 15/15 $450,000 aSalvage value. 4What happens if the estimated service life of the asset is, let us say, 51 years? How would we calculate the sum-of-the-years’-digits? Fortunately mathematicians have developed the following formula that permits easy computation: n(n11) 51(5111) 5 51,326 2 2 Depreciation—A Method of Cost Allocation 595 Declining-Balance Method. The declining-balance method utilizes a depreciation rate (expressed as a percentage) that is some multiple of the straight-line method. For exam- ple, the double-declining rate for a 10-year asset is 20 percent (double the straight-line rate, which is 1/10 or 10 percent). Companies apply the constant rate to the declining book value each year. Unlike other methods, the declining-balance method does not deduct the salvage value in computing the depreciation base. The declining-balance rate is multiplied by the book value of the asset at the beginning of each period. Since the depreciation charge reduces the book value of the asset each period, applying the constant-declining- balance rate to a successively lower book value results in lower depreciation charges each year. This process continues until the book value of the asset equals its estimated salvage value. At that time, the company discontinues depreciation. Companies use various multiples in practice. For example, the double-declining- balance method depreciates assets at twice (200 percent) the straight-line rate. Illustra- tion 11-7 shows Stanley’s depreciation charges if using the double-declining approach. ILLUSTRATION 11-7 Book Value Rate on Balance Book Double-Declining of Asset First Declining Depreciation Accumulated Value, End Year of Year Balancea Expense Depreciation of Year Depreciation Schedule— Crane Example 1 $500,000 40% $200,000 $200,000 $300,000 2 300,000 40% 120,000 320,000 180,000 3 180,000 40% 72,000 392,000 108,000 4 108,000 40% 43,200 435,200 64,800 5 64,800 40% 14,800b 450,000 50,000 aBased on twice the straight-line rate of 20% ($90,000/$450,000 5 20%; 20% 3 2 5 40%). bLimited to $14,800 because book value should not be less than salvage value. Companies often switch from the declining-balance method to the straight-line method near the end of the asset’s useful life to ensure that they depreciate the asset only to its salvage value.5 Special Depreciation Methods Sometimes companies adopt special depreciation methods. Reasons for doing so 4 LEARNING OBJECTIVE might be that a company’s assets have unique characteristics, or the nature of the Explain special depreciation methods. industry. Two of these special methods are: 1. Group and composite methods. 2. Hybrid or combination methods. Group and Composite Methods Companies often depreciate multiple-asset accounts using one rate. For example, AT&T might depreciate telephone poles, microwave systems, or switchboards by groups. Two methods of depreciating multiple-asset accounts exist: the group method and the composite method. The choice of method depends on the nature of the assets involved. Companies frequently use the group method when the assets are similar in nature and 5A pure form of the declining-balance method (sometimes appropriately called the “fixed percentage of book value method”) has also been suggested as a possibility. This approach finds a rate that depreciates the asset exactly to salvage value at the end of its expected useful life. The formula for determination of this rate is as follows.

Salvage value Depreciation rate512 n BAcquisition cost The life in years is n. After computing the depreciation rate, a company applies it on the declining book value of the asset from period to period, which means that depreciation expense will be successively lower. This method is not used extensively in practice due to cumbersome computations. Further, it is not permitted for tax purposes. 596 Chapter 11 Depreciation, Impairments, and Depletion have approximately the same useful lives. They use the composite approach when the assets are dissimilar and have different lives. The group method more closely approxi- mates a single-unit cost procedure because the dispersion from the average is not as great. The computation for group or composite methods is essentially the same: find an average and depreciate on that basis. Companies determine the composite depreciation rate by dividing the depreciation per year by the total cost of the assets. To illustrate, Mooney Motors establishes the compos- ite depreciation rate for its fleet of cars, trucks, and campers as shown in Illustration 11-8. ILLUSTRATION 11-8 Depreciation Depreciation Calculation, Original Salvage Depreciation Estimated per Year Composite Basis Asset Cost Value Cost Life (yrs.) (straight-line) Cars $145,000 $25,000 $120,000 3 $40,000 Trucks 44,000 4,000 40,000 4 10,000 Campers 35,000 5,000 30,000 5 6,000 $224,000 $34,000 $190,000 $56,000 $56,000 Composite depreciation rate5 525% $224,000 Composite life 5 3.39 years ($190,000 4 $56,000) If there are no changes in the asset account, Mooney will depreciate the group of a ssets to the residual or salvage value at the rate of $56,000 ($224,000 3 25%) a year. As a result, it will take Mooney 3.39 years to depreciate these assets. The length of time it takes a company to depreciate its assets on a composite basis is called the composite life. We can highlight the differences between the group or composite method and the single-unit depreciation method by looking at asset retirements. If Mooney retires an as- set before or after the average service life of the group is reached, it buries the resulting gain or loss in the Accumulated Depreciation account. This practice is justified because Mooney will retire some assets before the average service life and others after the average life. For this reason, the debit to Accumulated Depreciation is the difference between original cost and cash received. Mooney does not record a gain or loss on disposition. To illustrate, suppose that Mooney Motors sold one of the campers with a cost of $5,000 for $2,600 at the end of the third year. The entry is: Accumulated Depreciation—Plant Assets 2,400 Cash 2,600 Cars, Trucks, and Campers 5,000 If Mooney purchases a new type of asset (mopeds, for example), it must compute a new depreciation rate and apply this rate in subsequent periods. Illustration 11-9 presents a typical financial statement disclosure of the group depre- ciation method for Ampco-Pittsburgh Corporation. ILLUSTRATION 11-9 Ampco-Pittsburgh Corporation Disclosure of Group Depreciation Method Depreciation rates are based on estimated useful lives of the asset groups. Gains or losses on normal retirements or replacements of depreciable assets, subject to composite depreciation methods, are not recognized; the difference between the cost of the assets retired or replaced and the related salvage value is charged or credited to the accumulated depreciation. The group or composite method simplifies the bookkeeping process and tends to average out errors caused by over- or underdepreciation. As a result, gains or losses on disposals of assets do not distort periodic income. On the other hand, the unit method (depreciation of single assets) has several a dvantages over the group or composite methods. (1) It simplifies the computation Depreciation—A Method of Cost Allocation 597 mathematically. (2) It identifies gains and losses on disposal. (3) It isolates depreciation on idle equipment. (4) It represents the best estimate of the depreciation of each asset,

not the result of averaging the cost over a longer period of time. As a consequence, com- panies generally use the unit method.6 Unless stated otherwise, you should use the unit method in homework problems. Hybrid or Combination Methods Gateway to In addition to the depreciation methods already discussed, companies are free to de- the Profession velop their own special or tailor-made depreciation methods. GAAP requires only that Expanded Discussion— the method result in the allocation of an asset’s cost over the asset’s life in a systematic Special Depreciation Methods and rational manner. For example, the steel industry widely uses a hybrid depreciation method, called the production variable method, that is a combination straight-line/activity approach. The following note from WHX Corporation’s annual report explains one variation of this method. ILLUSTRATION 11-10 WHX Corporation Disclosure of Hybrid Depreciation Method The Company utilizes the modified units of production method of depreciation which recognizes that the depreciation of steelmaking machinery is related to the physical wear of the equipment as well as a time factor. The modified units of production method provides for straight-line depreciation charges modified (adjusted) by the level of raw steel production. In the prior year, depreciation under the modified units of production method was $21.6 million or 40% less than straight-line depreciation, and in the current year it was $1.1 million or 2% more than straight-line depreciation. What do the numbers mean? DECELERATING DEPRECIATION Which depreciation method should management select? Many estate managers object to traditional depreciation methods believe that the method that best matches revenues with ex- because in their view, real estate often does not decline in penses should be used. For example, if revenues generated by value. In addition, because real estate is highly debt- the asset are constant over its useful life, select straight-line fi nanced, most real estate concerns report losses in earlier depreciation. On the other hand, if revenues are higher (or years of operations when the sum of depreciation and inter- lower) at the beginning of the asset’s life, then use a decreasing est exceeds the revenue from the real estate project. As a (or increasing) method. Thus, if a company can reliably esti- result, real estate companies, like Kimco Realty, argue for mate revenues from the asset, selecting a depreciation method some form of increasing-charge method of depreciation that best matches costs with those revenues would seem to (lower depreciation at the beginning and higher deprecia- provide the most useful information to investors and creditors tion at the end). With such a method, companies would for assessing the future cash fl ows from the asset. report higher total assets and net income in the earlier years Managers in the real estate industry face a different of the project.7 challenge when considering depreciation choices. Real 6A committee of the AICPA has indicated in an exposure draft that companies should International use the unit approach whenever feasible. In fact, it indicates that an even better way Perspective to depreciate property, plant, and equipment is to use component depreciation. Under component depreciation, a company should depreciate over its expected useful life any IFRS requires use of component part or portion of property, plant, and equipment that can be separately identified as an depreciation. asset. For example, a company could separate the various components of a building (e.g., roof, heating and cooling system, elevator, leasehold improvements) and depreciate each component over its useful life. 7In this regard, real estate investment trusts (REITs) often report (in addition to net income) an earnings measure, funds from operations (FFO), that adjusts income for depreciation expense and other noncash expenses. This method is not GAAP. There is mixed empirical evidence about whether FFO or GAAP income is more useful to real estate investment trust investors. See, for

example, Richard Gore and David Stott, “Toward a More Informative Measure of Operating Performance in the REIT Industry: Net Income vs. FFO,” Accounting Horizons (December 1998); and Linda Vincent, “The Information Content of FFO for REITs,” Journal of Accounting and Economics (January 1999). 598 Chapter 11 Depreciation, Impairments, and Depletion Special Depreciation Issues We still need to discuss several special issues related to depreciation: 1. How should companies compute depreciation for partial periods? 2. Does depreciation provide for the replacement of assets? 3. How should companies handle revisions in depreciation rates? Depreciation and Partial Periods Companies seldom purchase plant assets on the first day of a fiscal period or dispose of them on the last day of a fiscal period. A practical question is: How much depreciation should a company charge for the partial periods involved? In computing depreciation expense for partial periods, companies must determine the depreciation expense for the full year and then prorate this depreciation expense between the two periods involved. This process should continue throughout the useful life of the asset. Assume, for example, that Steeltex Company purchases an automated drill machine with a five-year life for $45,000 (no salvage value) on June 10, 2013. The company’s fiscal year ends December 31. Steeltex therefore charges depreciation for only 62/ months 3 during that year. The total depreciation for a full year (assuming straight-line deprecia- tion) is $9,000 ($45,000/5). The depreciation for the first, partial year is therefore: 62/ 3 3$9,0005$5,000 12 The partial-period calculation is relatively simple when Steeltex uses straight-line depreciation. But how is partial-period depreciation handled when it uses an acceler- ated method such as sum-of-the-years’-digits or double-declining-balance? As an illus- tration, assume that Steeltex purchased another machine for $10,000 on July 1, 2013, with an estimated useful life of five years and no salvage value. Illustration 11-11 shows the depreciation figures for 2013, 2014, and 2015. ILLUSTRATION 11-11 Sum-of-the-Years’-Digits Double-Declining-Balance Calculation of Partial- 1st full year (5/15 3 $10,000) 5 $3,333.33 (40% 3 $10,000) 5 $4,000 Period Depreciation, Two 2nd full year (4/15 3 10,000) 5 2,666.67 (40% 3 6,000) 5 2,400 Accelerated Methods 3rd full year (3/15 3 10,000) 5 2,000.00 (40% 3 3,600) 5 1,440 Depreciation from July 1, 2013, to December 31, 2013 6/12 3 $3,333.33 5 $1,666.67 6/12 3 $4,000 5 $2,000 Depreciation for 2014 6/12 3 $3,333.33 5 $1,666.67 6/12 3 $4,000 5 $2,000 6/12 3 2,666.67 5 1,333.33 6/12 3 2,400 5 1,200 $3,000.00 $3,200 or ($10,000 2 $2,000) 3 40% 5 $3,200 Depreciation for 2015 6/12 3 $2,666.67 5 $1,333.33 6/12 3 $2,400 5 $1,200 6/12 3 2,000.00 5 1,000.00 6/12 3 1,440 5 720 $2,333.33 $1,920 or ($10,000 2 $5,200) 3 40% 5 $1,920 Sometimes a company like Steeltex modifies the process of allocating costs to a partial period to handle acquisitions and disposals of plant assets more simply. One variation is to take no depreciation in the year of acquisition and a full year’s depreciation in the Depreciation—A Method of Cost Allocation 599 year of disposal. Other variations charge one-half year’s depreciation both in the year of acquisition and in the year of disposal (referred to as the half-year convention), or charge a full year in the year of acquisition and none in the year of disposal. In fact, Steeltex may adopt any one of these fractional-year policies in allocating cost to the first and last years of an asset’s life so long as it applies the method consistently. However, unless otherwise stipulated, companies normally compute depreciation on the basis of the nearest full month. Illustration 11-12 shows depreciation allocated under five different fractional-year policies using the straight-line method on the $45,000 automated drill machine pur- chased by Steeltex Company on June 10, 2013, discussed earlier. ILLUSTRATION 11-12 Machine Cost 5 $45,000 Depreciation Allocated per Period Over 5-Year Life*

Fractional-Year Fractional-Year Policy 2013 2014 2015 2016 2017 2018 Depreciation Policies 1. Nearest fraction of a year. $5,000a $9,000 $9,000 $9,000 $9,000 $4,000b 2. Nearest full month. 5,250c 9,000 9,000 9,000 9,000 3,750d 3. Half year in period of acquisition and disposal. 4,500 9,000 9,000 9,000 9,000 4,500 4. Full year in period of acquisition, none in period of disposal. 9,000 9,000 9,000 9,000 9,000 –0– 5. None in period of acquisition, full year in period of disposal. –0– 9,000 9,000 9,000 9,000 9,000 a6.667/12 ($9,000) b5.333/12 ($9,000) c7/12 ($9,000) d5/12 ($9,000) *Rounded to nearest dollar. Depreciation and Replacement of Property, Plant, and Equipment A common misconception about depreciation is that it provides funds for the replace- ment of fixed assets. Depreciation is like other expenses in that it reduces net income. It differs, though, in that it does not involve a current cash outflow. To illustrate why depreciation does not provide funds for replacement of plant assets, assume that a business starts operating with plant assets of $500,000 that have a useful life of five years. The company’s balance sheet at the beginning of the period is: Plant assets $500,000 Stockholders’ equity $500,000 If we assume that the company earns no revenue over the five years, the income statements are: Year 1 Year 2 Year 3 Year 4 Year 5 Revenue $ –0– $ –0– $ –0– $ –0– $ –0– Depreciation (100,000) (100,000) (100,000) (100,000) (100,000) Loss $(100,000) $(100,000) $(100,000) $(100,000) $(100,000) Total depreciation of the plant assets over the five years is $500,000. The balance sheet at the end of the five years therefore is: Plant assets –0– Stockholders’ equity –0– This extreme example illustrates that depreciation in no way provides funds for the replacement of assets. The funds for the replacement of the assets come from the revenues (generated through use of the asset). Without the revenues, no income materi- alizes and no cash inflow results. 600 Chapter 11 Depreciation, Impairments, and Depletion Revision of Depreciation Rates When purchasing a plant asset, companies carefully determine depreciation rates based on past experience with similar assets and other pertinent information. The provisions for depreciation are only estimates, however. Companies may need to revise them during the life of the asset. Unexpected physical deterioration or unforeseen obsoles- cence may decrease the estimated useful life of the asset. Improved maintenance proce- dures, revision of operating procedures, or similar developments may prolong the life of the asset beyond the expected period.8 For example, assume that International Paper Co. purchased machinery with an original cost of $90,000. It estimates a 20-year life with no salvage value. However, during year 6, International Paper estimates that it will use the machine for an addi- tional 25 years. Its total life, therefore, will be 30 years instead of 20. Depreciation has been recorded at the rate of 1/20 of $90,000, or $4,500 per year by the straight-line method. On the basis of a 30-year life, International Paper should have recorded depre- ciation as 1/30 of $90,000, or $3,000 per year. It has therefore overstated depreciation, and understated net income, by $1,500 for each of the past five years, or a total amount of $7,500. Illustration 11-13 shows this computation. ILLUSTRATION 11-13 Per For 5 Computation of Year Years Accumulated Difference Depreciation charged per books (1/20 3 $90,000) $4,500 $22,500 Due to Revisions Depreciation based on a 30-year life (1/30 3 $90,000) (3,000) (15,000) Excess depreciation charged $1,500 $ 7,500 International Paper should report this change in estimate in the current and pro- spective periods (prospectively): It should not make any changes in previously re- ported results. And it does not adjust opening balances nor attempt to “catch up” for prior periods. The reason? Changes in estimates are a continual and inherent part of any estimation process. Continual restatement of prior periods would occur for revisions of

estimates unless handled prospectively. Therefore, no entry is made at the time the change in estimate occurs. Charges for depreciation in subsequent periods (assuming use of the straight-line method) are determined by dividing the remaining book value less any salvage value by the remaining estimated life. ILLUSTRATION 11-14 Machinery $90,000 Computing Depreciation Less: Accumulated depreciation 22,500 after Revision of Book value of machinery at end of 5th year $67,500 Estimated Life Depreciation (future periods) 5 $67,500 book value 4 25 years remaining life 5 $2,700 The entry to record depreciation for each of the remaining 25 years is: Depreciation Expense 2,700 Accumulated Depreciation—Machinery 2,700 8As an example of a change in operating procedures, General Motors (GM) used to write off its tools—such as dies and equipment used to manufacture car bodies—over the life of the body type. Through this procedure, it expensed tools twice as fast as Ford and three times as fast as Chrysler. However, it slowed the depreciation process on these tools and lengthened the lives on its plant and equipment. These revisions reduced depreciation and amortization charges by approximately $1.23 billion, or $2.55 per share, in the year of the change. In Chapter 22, we provide a more complete discussion of changes in estimates. Impairments 601 What do the numbers mean? DEPRECIATION CHOICES The amount of depreciation expense recorded depends on Note 4: Property, Plant, and Equipment (partial) both the depreciation method used and estimates of service Range of lives and salvage values of the assets. Differences in these Useful Lives choices and estimates can signifi cantly impact a company’s Land — reported results and can make it diffi cult to compare the Buildings 15–35 depreciation numbers of different companies. Machinery & equipment 5–25 For example, when Willamette Industries extended Furniture & fi xtures 3–15 the estimated service lives of its machinery and equipment During the year, the estimated service lives for most machinery by five years, it increased income by nearly $54 million and equipment were extended fi ve years. The change was based (see Note 4 to the right). upon a study performed by the company’s engineering department, An analyst determines the impact of these management comparisons to typical industry practices, and the effect of the choices and judgments on the amount of depreciation company’s extensive capital investments which have resulted in expense by examining the notes to fi nancial statements. For a mix of assets with longer productive lives due to technological advances. As a result of the change, net income was increased example, Willamette Industries provided the following note by $54,000,000. to its fi nancial statements. IMPAIRMENTS The general accounting standard of lower-of-cost-or-market for inventories does 5 LEARNING OBJECTIVE not apply to property, plant, and equipment. Even when property, plant, and Explain the accounting issues related equipment has suffered partial obsolescence, accountants have been reluctant to asset impairment. to reduce the asset’s carrying amount. Why? Because, unlike inventories, it is difficult to arrive at a fair value for property, plant, and equipment that is not subjective and arbitrary. For example, Falconbridge Ltd. Nickel Mines had to decide whether to Underlying Concepts write off all or a part of its property, plant, and equipment in a nickel-mining The going concern concept operation in the Dominican Republic. The project had been incurring losses assumes that the company can because nickel prices were low and operating costs were high. Only if nickel recover the investment in its prices increased by approximately 33 percent would the project be reasonably assets. Under GAAP, companies profitable. Whether a write-off was appropriate depended on the future price of do not report the fair value of nickel. Even if the company decided to write off the asset, how much should be long-lived assets because a written off? going concern does not plan to

sell such assets. However, if the assumption of being able to Recognizing Impairments recover the cost of the investment is not valid, then a company As discussed in the opening story, the credit crisis starting in late 2008 has should report a reduction in affected many financial and nonfinancial institutions. As a result of the global value. slump, many companies are considering write-offs of some of their long-lived assets. These write-offs are referred to as impairments. Various events and changes in circumstances might lead to an impairment. Exam- ples are: • A significant decrease in the fair value of an asset. • A significant change in the extent or manner in which an asset is used. • A significant adverse change in legal factors or in the business climate that affects the value of an asset. 602 Chapter 11 Depreciation, Impairments, and Depletion • An accumulation of costs significantly in excess of the amount originally expected to acquire or construct an asset. • A projection or forecast that demonstrates continuing losses associated with an asset. See the FASB These events or changes in circumstances indicate that the company may not be able to Codification section recover the carrying amount of the asset. In that case, a recoverability test is used to (page 618). determine whether an impairment has occurred. [1] To apply the first step of the recoverability test, a company like UPS estimates the future net cash flows expected from the use of that asset and its eventual disposition. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, UPS considers the asset impaired. Conversely, if the sum of the expected future net cash flows (undiscounted) is equal to or greater than the carrying amount of the asset, no impairment has occurred. The recoverability test therefore screens for asset impairment. For example, if the expected future net cash flows from an asset are $400,000 and its carrying amount is $350,000, no impairment has occurred. However, if the expected future net cash flows are $300,000, an impairment has occurred. The rationale for the recoverability test relies on a basic presumption: A balance sheet should report long-lived assets at no more than the carrying amounts that are recoverable. Measuring Impairments If the recoverability test indicates an impairment, UPS computes a loss. The impairment loss is the amount by which the carrying amount of the asset exceeds its fair value. International How does UPS determine the fair value of an asset? It is measured based on the Perspective market price if an active market for the asset exists. If no active market exists, UPS uses the present value of expected future net cash flows to determine fair IFRS also uses a fair value test value. to measure the impairment loss. To summarize, the process of determining an impairment loss is as follows. However, IFRS does not use the fi rst-stage recoverability test 1. Review events or changes in circumstances for possible impairment. used under GAAP—comparing the undiscounted cash fl ows to 2. I f the review indicates a possible impairment, apply the recoverability test. the carrying amount. As a result, If the sum of the expected future net cash fl ows from the long-lived asset is the IFRS test is more strict than less than the carrying amount of the asset, an impairment has occurred. GAAP. 3. A ssuming an impairment, the impairment loss is the amount by which the carrying amount of the asset exceeds the fair value of the asset. The fair value is the market price of the asset or the present value of expected future net cash fl ows. Impairment—Example 1 M. Alou Inc. has equipment that, due to changes in its use, it reviews for possible impairment. The equipment’s carrying amount is $600,000 ($800,000 cost less $200,000 accumulated depreciation). Alou determines the expected future net cash flows (undis- counted) from the use of the equipment and its eventual disposal to be $650,000. The recoverability test indicates that the $650,000 of expected future net cash flows

from the equipment’s use exceed the carrying amount of $600,000. As a result, no impairment occurred. (Recall that the undiscounted future net cash flows must be less than the carrying amount for Alou to deem an asset to be impaired and to measure the impairment loss.) Therefore, M. Alou Inc. does not recognize an impairment loss in this case. Impairments 603 Impairment—Example 2 Assume the same facts as in Example 1, except that the expected future net cash flows from Alou’s equipment are $580,000 (instead of $650,000). The recoverability test indi- cates that the expected future net cash flows of $580,000 from the use of the asset are less than its carrying amount of $600,000. Therefore, an impairment has occurred. The difference between the carrying amount of Alou’s asset and its fair value is the impairment loss. Assuming this asset has a fair value of $525,000, Illustration 11-15 shows the loss computation. ILLUSTRATION 11-15 Carrying amount of the equipment $600,000 Computation of Fair value of equipment (525,000) Impairment Loss Loss on impairment $ 75,000 M. Alou records the impairment loss as follows. Loss on Impairment 75,000 Accumulated Depreciation—Equipment 75,000 M. Alou Inc. reports the impairment loss as part of income from continuing operations, in the “Other expenses and losses” section. Generally, Alou should not report this loss as an extraordinary item. Costs associated with an impairment loss are the same costs that would flow through operations and that it would report as part of continuing op- erations. Alou will continue to use these assets in operations. Therefore, it should not report the loss below “Income from continuing operations.” A company that recognizes an impairment loss should disclose the asset(s) im- paired, the events leading to the impairment, the amount of the loss, and how it deter- mined fair value (disclosing the interest rate used, if appropriate). Restoration of Impairment Loss After recording an impairment loss, the reduced carrying amount of an asset held for use becomes its new cost basis. A company does not change the new cost basis except for depreciation or amortization in future periods or for additional impairments. To illustrate, assume that Damon Company at December 31, 2013, has International equipment with a carrying amount of $500,000. Damon determines this asset is Perspective impaired and writes it down to its fair value of $400,000. At the end of 2014, IFRS permits write-ups for Damon determines that the fair value of the asset is $480,000. The carrying subsequent recoveries of amount of the equipment should not change in 2014 except for the depreciation impairment, back up to the taken in 2014. Damon may not restore an impairment loss for an asset held for original amount before the use. The rationale for not writing the asset up in value is that the new cost basis impairment. GAAP prohibits puts the impaired asset on an equal basis with other assets that are unimpaired. those write-ups, except for assets to be disposed of. Impairment of Assets to Be Disposed Of What happens if a company intends to dispose of the impaired asset, instead of holding it for use? At one time, Kroger recorded an impairment loss of $54 million on property, plant, and equipment it no longer needed due to store closures. In this case, Kroger re- ports the impaired asset at the lower-of-cost-or-net realizable value (fair value less costs to sell). Because Kroger intends to dispose of the assets in a short period of time, it uses net realizable value in order to provide a better measure of the net cash flows that it will receive from these assets. Kroger does not depreciate or amortize assets held for disposal during the period it holds them. The rationale is that depreciation is inconsistent with the notion of assets to 604 Chapter 11 Depreciation, Impairments, and Depletion be disposed of and with the use of the lower-of-cost-or-net realizable value. In other words, assets held for disposal are like inventory; companies should report them at the lower-of-cost-or-net realizable value.

Because Kroger will recover assets held for disposal through sale rather than through operations, it continually revalues them. Each period, the assets are reported at the lower-of-cost-or-net realizable value. Thus, Kroger can write up or down an asset held for disposal in future periods, as long as the carrying value after the write-up never exceeds the carrying amount of the asset before the impairment. Companies should report losses or gains related to these impaired assets as part of income from continuing operations. Illustration 11-16 summarizes the key concepts in accounting for impairments. ILLUSTRATION 11-16 Graphic of Accounting Measurement of Recoverability Test Impairment Loss for Impairments Expected future net cash flows Yes Impairment less than carrying amount? No Assets held Assets held for use for disposal No impairment 1. Impairment loss: excess 1. Impairment loss: excess of of carrying amount over carrying amount over fair fair value. value less cost of disposal. 2. Depreciate on new 2. No depreciation taken. cost basis. 3. Restoration of impairment 3. Restoration of impairment loss not permitted. loss permitted. DEPLETION Natural resources, often called wasting assets, include petroleum, minerals, and LEARNING OBJECTIVE 6 timber. They have two main features: (1) the complete removal (consumption) of Explain the accounting procedures the asset, and (2) replacement of the asset only by an act of nature. Unlike plant for depletion of natural resources. and equipment, natural resources are consumed physically over the period of use and do not maintain their physical characteristics. Still, the accounting problems associ- ated with natural resources are similar to those encountered with fixed assets. The ques- tions to be answered are: 1. How do companies establish the cost basis for write-off? 2. What pattern of allocation should companies employ? Recall that the accounting profession uses the term depletion for the process of allocating the cost of natural resources. Depletion 605 Establishing a Depletion Base How do we determine the depletion base for natural resources? For example, a com- pany like ExxonMobil makes sizable expenditures to find natural resources. And for every successful discovery, there are many failures. Furthermore, the company encoun- ters long delays between the time it incurs costs and the time it obtains the benefits from the extracted resources. As a result, a company in the extractive industries, like ExxonMobil, frequently adopts a conservative policy in accounting for the expenditures related to finding and extracting natural resources. Computation of the depletion base involves four factors: (1) acquisition cost of the deposit, (2) exploration costs, (3) development costs, and (4) restoration costs. Acquisition Costs Acquisition cost is the price ExxonMobil pays to obtain the property right to search and find an undiscovered natural resource. It also can be the price paid for an already- discovered resource. A third type of acquisition cost can be lease payments for property containing a productive natural resource. Included in these acquisition costs are royalty payments to the owner of the property. Generally, the acquisition cost of natural resources is recorded in an account titled Undeveloped Property. ExxonMobil later assigns that cost to the natural resource if exploration efforts are successful. If the efforts are unsuccessful, it writes off the acquisi- tion cost as a loss. Exploration Costs As soon as a company has the right to use the property, it often incurs exploration costs needed to find the resource. When exploration costs are substantial, some companies capitalize them into the depletion base. In the oil and gas industry, where the costs of finding the resource are significant and the risks of finding the resource are very uncer- tain, most large companies expense these costs. Smaller oil and gas companies often capitalize these exploration costs. We examine the unique issues related to the oil and gas industry on pages 608–609 (see “Continuing Controversy”).

Development Costs Companies divide development costs into two parts: (1) tangible equipment costs and (2) intangible development costs. Tangible equipment costs include all of the transporta- tion and other heavy equipment needed to extract the resource and get it ready for market. Because companies can move the heavy equipment from one extracting site to another, companies do not normally include tangible equipment costs in the depletion base. Instead, they use separate depreciation charges to allocate the costs of such equip- ment. However, some tangible assets (e.g., a drilling rig foundation) cannot be moved. Companies depreciate these assets over their useful life or the life of the resource, which- ever is shorter. Intangible development costs, on the other hand, are such items as drilling costs, tunnels, shafts, and wells. These costs have no tangible characteristics but are needed for the production of the natural resource. Intangible development costs are considered part of the depletion base. Restoration Costs Companies sometimes incur substantial costs to restore property to its natural state after extraction has occurred. These are restoration costs. Companies consider restoration costs part of the depletion base. The amount included in the depletion base is the fair value of the obligation to restore the property after extraction. A more complete discussion 606 Chapter 11 Depreciation, Impairments, and Depletion of the accounting for restoration costs and related liabilities (sometimes referred to as asset retirement obligations) is provided in Chapter 13. Similar to other long-lived assets, companies deduct from the depletion base any salvage value to be received on the property. Write-Off of Resource Cost Once the company establishes the depletion base, the next problem is determining how to allocate the cost of the natural resource to accounting periods. Normally, companies compute depletion (often referred to as cost depletion) on a units-of-production method (an activity approach). Thus, depletion is a function of the number of units extracted during the period. In this approach, the total cost of the natu- ral resource less salvage value is divided by the number of units estimated to be in the resource deposit, to obtain a cost per unit of product. To compute depletion, the cost per unit is then multiplied by the number of units extracted. For example, MaClede Co. acquired the right to use 1,000 acres of land in Alaska to mine for gold. The lease cost is $50,000, and the related exploration costs on the property are $100,000. Intangible development costs incurred in opening the mine are $850,000. Total costs related to the mine before the first ounce of gold is extracted are, therefore, $1,000,000. MaClede estimates that the mine will provide approximately 100,000 ounces of gold. Illustration 11-17 shows computation of the depletion cost per unit (depletion rate). ILLUSTRATION 11-17 Total cost2Salvage value Computation of 5Depletion cost per unit Total estimated units available Depletion Rate $1,000,000 5$10 per ounce 100,000 If MaClede extracts 25,000 ounces in the first year, then the depletion for the year is $250,000 (25,000 ounces 3 $10). It records the depletion as follows. Inventory (gold) 250,000 Gold Mine 250,000 MaClede debits Inventory for the total depletion for the year and credits Gold Mine to reduce the carrying value of the natural resource. MaClede credits Inventory when it sells the inventory and debits Cost of Goods Sold. The amount not sold remains in in- ventory and is reported in the current assets section of the balance sheet.9 Sometimes companies use an Accumulated Depletion account. In that case, MaClede’s balance sheet would present the cost of the natural resource and the amount of accumu- lated depletion entered to date as follows. ILLUSTRATION 11-18 Gold mine (at cost) $1,000,000 Balance Sheet Less: Accumulated depletion 250,000 $750,000 Presentation of Natural Resource For purposes of homework, credit depletion to the asset account. 9 The tax law has long provided a deduction against revenue from oil, gas, and most minerals for

the greater of cost or percentage depletion. The percentage (statutory) depletion allows some companies a write-off ranging from 5 percent to 22 percent (depending on the natural resource) of gross revenue received. As a result of this tax benefit, the amount of depletion may exceed the cost assigned to a given natural resource. An asset’s carrying amount may be zero, but the company may take a depletion deduction if it has gross revenue. The significance of the percentage depletion allowance is now greatly reduced since Congress repealed it for most oil and gas companies. Depletion 607 MaClede may also depreciate on a units-of-production basis the tangible equipment used in extracting the gold. This approach is appropriate if it can directly assign the estimated lives of the equipment to one given resource deposit. If MaClede uses the equipment on more than one job, other cost allocation methods such as straight-line or accelerated depreciation methods would be more appropriate. Estimating Recoverable Reserves Sometimes companies need to change the estimate of recoverable reserves. They do so either because they have new information or because more sophisticated production processes are available. Natural resources such as oil and gas deposits and some rare metals have recently provided the greatest challenges. Estimates of these reserves are in large measure merely “knowledgeable guesses.” This problem is the same as accounting for changes in estimates for the useful lives of plant and equipment. The procedure is to revise the depletion rate on a pro- spective basis: A company divides the remaining cost by the new estimate of the recov- erable reserves. This approach has much merit because the required estimates are so uncertain. What do the numbers mean? RESERVE SURPRISE Cuts in the estimates of oil and natural gas reserves at Royal be shown “with reasonable certainty to be recoverable in Dutch Shell, El Paso Corporation, and other energy compa- future years. . . .” The phrase “reasonable certainty” is crucial nies at one time highlighted the importance of reserve disclo- to this guidance, but differences in interpretation of what is sures. Investors appeared to believe that these disclosures reasonably certain can result in a wide range of estimates. provide useful information for assessing the future cash In one case, for example, ExxonMobil’s estimate was fl ows from a company’s oil and gas reserves. For example, 29 percent higher than an estimate the SEC developed. Exxon- when Shell’s estimates turned out to be overly optimistic Mobil was more optimistic about the effects of new technol- (to the tune of 3.9 billion barrels or 20 percent of reserves), ogy that enables the industry to retrieve more of the oil and Shell’s stock price fell. gas it fi nds. Thus, to ensure the continued usefulness of The experience at Shell and other companies has led the r eserve information disclosures, the SEC continues to work on SEC to look at how companies are estimating their “proved” a measurement methodology that keeps up with technology reserves. Proved reserves are quantities of oil and gas that can changes in the oil and gas industry. Sources: S. Labaton and J. Gerth, “At Shell, New Accounting and Rosier Outlook,” New York Times (nytimes.com) (March 12, 2004); and J. Ball, C. Cummins, and B. Bahree, “Big Oil Differs with SEC on Methods to Calculate the Industry’s Reserves,” Wall Street Journal (February 24, 2005), p. C1. Liquidating Dividends A company often owns as its only major asset a property from which it intends to extract natural resources. If the company does not expect to purchase additional properties, it may gradually distribute to stockholders their capital investments by paying liquidating dividends, which are dividends greater than the amount of accumulated net income. The major accounting problem is to distinguish between dividends that are a return of capital and those that are not. Because the dividend is a return of the investor’s origi- nal contribution, the company issuing a liquidating dividend should debit Paid-in

Capital in Excess of Par for that portion related to the original investment, instead of debiting Retained Earnings. To illustrate, at year-end, Callahan Mining had a retained earnings balance of $1,650,000, accumulated depletion on mineral properties of $2,100,000, and paid-in capital 608 Chapter 11 Depreciation, Impairments, and Depletion in excess of par of $5,435,493. Callahan’s board declared a dividend of $3 per share on the 1,000,000 shares outstanding. It records the $3,000,000 cash dividend as follows. Retained Earnings 1,650,000 Paid-in Capital in Excess of Par—Common Stock 1,350,000 Cash 3,000,000 Callahan must inform stockholders that the $3 dividend per share represents a $1.65 ($1,650,000 4 1,000,000 shares) per share return on investment and a $1.35 ($1,350,000 4 1,000,000 shares) per share liquidating dividend. Continuing Controversy A major controversy relates to the accounting for exploration costs in the oil and gas industry. Conceptually, the question is whether unsuccessful ventures are a cost of those that are successful. Those who hold the full-cost concept argue that the cost of drilling a dry hole is a cost needed to find the commercially profitable wells. Others believe that companies should capitalize only the costs of successful projects. This is the successful- efforts concept. Its proponents believe that the only relevant measure for a project is the cost directly related to that project, and that companies should report any remaining costs as period charges. In addition, they argue that an unsuccessful company will end up capitalizing many costs that will make it, over a short period of time, show no less income than does one that is successful.10 The FASB has attempted to narrow the available alternatives, with little success. Here is a brief history of the debate. 1. 1977—The FASB required oil and gas companies to follow successful-efforts accounting. Small oil and gas producers, voicing strong opposition, lobbied extensively in Congress. Governmental agencies assessed the implications of this standard from a public interest perspective and reacted contrary to the FASB’s position.11 2. 1978—In response to criticisms of the FASB’s actions, the SEC reexamined the issue and found both the successful-efforts and full-cost approaches inadequate. Neither method, said the SEC, refl ects the economic substance of oil and gas exploration. As a substitute, the SEC argued in favor of a yet-to-be developed method, reserve recognition accounting (RRA), which it believed would provide more useful infor- mation. Under RRA, as soon as a company discovers oil, it reports the value of the oil on the balance sheet and in the income statement. Thus, RRA is a fair value approach, in contrast to full-costing and successful-efforts, which are historical cost approaches. The use of RRA would make a substantial difference in the balance sheets and income statements of oil companies. For example, Atlantic Richfi eld Co. at one time reported net producing property of $2.6 billion. Under RRA, the same properties would be valued at $11.8 billion. 3. 1979–1981—As a result of the SEC’s actions, the FASB issued another standard that suspended the requirement that companies follow successful-efforts accounting. 10Large international oil companies such as ExxonMobil use the successful-efforts approach. Most of the smaller, exploration-oriented companies use the full-cost approach. The differences in net income figures under the two methods can be staggering. Analysts estimated that the difference between full-cost and successful-efforts for ChevronTexaco would be $500 million over a 10-year period (income lower under successful-efforts). 11The Department of Energy indicated that companies using the full-cost method at that time would reduce their exploration activities because of the unfavorable earnings impact associated with successful-efforts accounting. The Justice Department asked the SEC to postpone adoption of one uniform method of accounting in the oil and gas industry until the SEC could determine

whether the information reported to investors would be enhanced and competition constrained by adoption of the successful-efforts method. Presentation and Analysis 609 Therefore, full-costing was again permissible. In attempting to implement RRA, however, the SEC encountered practical problems in estimating (1) the amount of the reserves, (2) the future production costs, (3) the periods of expected disposal, (4) the discount rate, and (5) the selling price. Companies needed an estimate for each of these to arrive at an accurate valuation of existing reserves. Estimating the future selling price, appropriate discount rate, and future extraction and delivery costs of reserves that are years away from realization can be a formidable task. 4. 1981—The SEC abandoned RRA in the primary fi nancial statements of oil and gas producers. The SEC decided that RRA did not possess the required degree of reliabil- ity for use as a primary method of fi nancial reporting. However, it continued to stress the need for some form of fair-value-based disclosure for oil and gas reserves. As a result, the profession now requires fair value disclosures for those natural resources. Currently, companies can use either the full-cost approach or the successful- International efforts approach. It does seem ironic that Congress directed the FASB to develop Perspective one method of accounting for the oil and gas industry, and when the FASB did so, IFRS also permits companies to the government chose not to accept it. Subsequently, the SEC attempted to de- use either full-cost or successful- velop a new approach, failed, and then urged the FASB to develop the disclosure efforts approaches. requirements in this area. After all these changes, the two alternatives still exist.12 Evolving Issue FULL-COST OR SUCCESSFUL-EFFORTS? The controversy in the oil and gas industry provides a Indeed, failure to consider the economic consequences of number of lessons. First, it demonstrates the strong influence accounting principles is a frequent criticism of the profes- that the federal government has in financial reporting sion. However, the neutrality concept requires that the state- matters. Second, the concern for economic consequences ments be free from bias. Freedom from bias requires that places pressure on the FASB to weigh the economic effects of the statements reflect economic reality, even if undesirable any required standard. Third, the experience with RRA high- effects occur. Finally, the debate over oil and gas accounting lights the problems that accompany any proposed change reinforces the need for a conceptual framework with care- from an historical cost to a fair value approach. Fourth, this fully developed guidelines for recognition, measurement, controversy illustrates the difficulty of establishing stan- and reporting, so that interested parties can more easily dards when affected groups have differing viewpoints. resolve issues of this nature in the future. PRESENTATION AND ANALYSIS Presentation of Property, Plant, Equipment, and Natural Resources A company should disclose the basis of valuation—usually historical cost—for 7 LEARNING OBJECTIVE property, plant, equipment, and natural resources along with pledges, liens, and Explain how to report and analyze other commitments related to these assets. It should not offset any liability secured property, plant, equipment, and natural by property, plant, equipment, and natural resources against these assets. Instead, resources. this obligation should be reported in the liabilities section. The company should 12One requirement of the full-cost approach is that companies can capitalize costs only up to a ceiling, which is the present value of company reserves. Companies must expense costs above that ceiling. When the price of oil fell in the mid-1980s, so did the present value of companies’ reserves, which forced expensing of costs beyond the ceiling. Companies lobbied for leniency, but the SEC decided that the write-offs had to be taken. Mesa Limited Partnerships restated its

$31 million profit to a $169 million loss, and Pacific Lighting restated its $44.5 million profit to a $70.5 million loss. 610 Chapter 11 Depreciation, Impairments, and Depletion segregate property, plant, and equipment not currently employed as producing assets in the business (such as idle facilities or land held as an investment) from assets used in operations. When depreciating assets, a company credits a valuation account such as Accumu- lated Depreciation—Equipment. Using an accumulated depreciation account permits the user of the financial statements to see the original cost of the asset and the amount of depreciation that the company charged to expense in past years. When depleting natural resources, some companies use an accumulated depletion account. Many, however, simply credit the natural resource account directly. The ratio- nale for this approach is that the natural resources are physically consumed, making direct reduction of the cost of the natural resources appropriate. Because of the significant impact on the financial statements of the depreciation method(s) used, companies should disclose the following. 1. Depreciation expense for the period. 2. Balances of major classes of depreciable assets, by nature and function. 3. Accumulated depreciation, either by major classes of depreciable assets or in total. 4. A general description of the method or methods used in computing depreciation with respect to major classes of depreciable assets. [2]13 Special disclosure requirements relate to the oil and gas industry. Companies engaged in these activities must disclose the following in their financial statements: (1) the basic method of accounting for those costs incurred in oil and gas producing activities (e.g., full-cost versus successful-efforts), and (2) how the company disposes of costs relating to extractive activities (e.g., dispensing immediately versus depreciation and depletion). [3]14 The 2011 annual report of International Paper Company in Illustration 11-19 shows an acceptable disclosure. It uses condensed balance sheet data supplemented with details and policies in notes to the financial statements. ILLUSTRATION 11-19 International Paper Company Disclosures for Property, Plant, Equipment, and Consolidated Balance Sheet (partial) Natural Resources In millions at December 31 2011 2010 Assets Total current assets $10,456 $ 8,028 Plants, properties and equipment, net 11,817 12,002 Forestlands 660 747 Investments 632 1,092 Goodwill 2,346 2,308 Deferred charges and other assets 1,082 1,191 Total assets $26,993 $25,368 13Some believe that companies should disclose the average useful life of the assets or the range of years of asset life to help users understand the age and life of property, plant, and equipment. 14Public companies, in addition to these two required disclosures, must include as supplemen- tary information numerous schedules reporting reserve quantities; capitalized costs; acquisition, exploration, and development activities; and a standardized measure of discounted future net cash flows related to proved oil and gas reserve quantities. Given the importance of these disclosures, the SEC has issued rules for disclosures to help investors better understand the nature of oil and gas company operations. These rules provide updated guidance on (1) estimates of quantities of proved reserves, (2) estimates of future net revenues, and (3) disclo- sure of reserve information. See “Modernization of Oil and Gas Reporting,” SEC Financial Reporting Release No. 78 (Release No. 33-8995) (December 31, 2008). Presentation and Analysis 611 ILLUSTRATION 11-19 Note 1 (partial) (continued) Plants, Properties and Equipment. Plants, properties and equipment are stated at cost, less accumulated depreciation. Expenditures for betterments are capitalized, whereas normal repairs and maintenance are expensed as incurred. The units-of-production method of depreciation is used for major pulp and paper mills, and the straight-line method is used for other plants and equipment. Annual straight-line depreciation

rates are, for buildings—2 1/2% to 8 1/2%, and for machinery and equipment—5% to 33%. Forestlands. At December 31, 2011, International Paper and its subsidiaries owned or managed approximately 325,000 acres of forestlands in Brazil, and through licenses and forest management agreements, had harvesting rights on government-owned forestlands in Russia. Costs attributable to timber are charged against income as trees are cut. The rate charged is determined annually based on the relationship of incurred costs to estimated current merchantable volume. Note 7 (partial) Plants, properties and equipment by major classification were: In millions at December 31 2011 2010 Pulp, paper and packaging facilities Mills $22,494 $22,935 Packaging plants 6,358 6,534 Other plants, properties and equipment 1,556 1,524 Gross cost 30,408 30,993 Less: Accumulated depreciation 18,591 18,991 Plants, properties and equipment, net $11,817 $12,002 In millions 2011 2010 2009 Depreciation expense $1,263 $1,396 $1,416 Analysis of Property, Plant, and Equipment Analysts evaluate assets relative to activity (turnover) and profitability. Asset Turnover How efficiently a company uses its assets to generate sales is measured by the asset turnover. This ratio divides net sales by average total assets for the period. The resulting number is the dollars of sales produced by each dollar invested in assets. To illustrate, we use the following data from the Johnson & Johnson 2011 annual report. Illustration 11-20 shows computation of the asset turnover. Johnson & Johnson (in millions) Net sales $ 65,030 Total assets, 1/2/12 113,644 Total assets, 1/2/11 102,908 Net income 9,672 ILLUSTRATION 11-20 Net sales Asset turnover5 Asset Turnover Average total assets $65,030 5 ($113,6441$102,908)/2 5.60 The asset turnover shows that Johnson & Johnson generated sales of $0.60 per dollar of assets in the year ended January 2, 2012. Asset turnovers vary considerably among industries. For example, a large utility like Ameren has a ratio of 0.32 times. A large grocery chain like Kroger has a ratio of 2.73 times. Thus, in comparing performance among companies based on the asset turn- over ratio, you need to consider the ratio within the context of the industry in which a company operates. 612 Chapter 11 Depreciation, Impairments, and Depletion Profi t Margin on Sales Another measure for analyzing the use of property, plant, and equipment is the profit margin on sales (return on sales). Calculated as net income divided by net sales, this profitability ratio does not, by itself, answer the question of how profitably a company uses its assets. But by relating the profit margin on sales to the asset turnover during a period of time, we can ascertain how profitably the company used assets during that period of time in a measure of the return on assets. Using the Johnson & Johnson data shown on page 611, we compute the profit margin on sales and the return on assets as follows. ILLUSTRATION 11-21 Net income Profi t Margin on Sales Profit margin on sales5 Net sales $9,672 5 $65,030 514.87% Return on assets5Profit margin on sales3Asset turnover 514.87%3.6006 58.93% Return on Assets The return on assets (ROA) is computed directly by dividing net income by average total assets. Using Johnson & Johnson’s data, we compute the ratio as follows. ILLUSTRATION 11-22 Net income Return on Assets Return on assets5 Average total assets $9,672 5 ($113,6441$102,908)/2 58.93% You will want to read the The 8.93 percent return on assets computed in this manner equals the 8.93 percent IFRS INSIGHTS rate computed by multiplying the profit margin on sales by the asset turnover. The rate on pages 637–646 of return on assets measures profitability well because it combines the effects of profit for discussion of margin and asset turnover. IFRS related to property, plant, and equipment. KEY TERMS SUMMARY OF LEARNING OBJECTIVES accelerated depreciation methods, 594 activity method, 593 1 Explain the concept of depreciation. Depreciation allocates the cost of amortization, 590 tangible assets to expense in a systematic and rational manner to those periods expected

asset turnover, 611 to benefit from the use of the asset. composite approach, 596 composite depreciation 2 Identify the factors involved in the depreciation process. Three factors rate, 596 involved in the depreciation process are (1) determining the depreciation base for the cost depletion, 606 asset, (2) estimating service lives, and (3) selecting a method of cost apportionment (depreciation). Summary of Learning Objectives 613 3 Compare activity, straight-line, and decreasing-charge methods of declining-balance depreciation. (1) Activity method: Assumes that depreciation is a function of use or method, 595 decreasing-charge productivity instead of the passage of time. The life of the asset is considered in terms of methods, 594 either the output it provides, or an input measure such as the number of hours it works. depletion, 590, 604 (2) Straight-line method: Considers depreciation a function of time instead of a function of usage. The straight-line procedure is often the most conceptually appropriate when depreciation, 590 the decline in usefulness is constant from period to period. (3) Decreasing-charge methods: depreciation base, 590 Provide for a higher depreciation cost in the earlier years and lower charges in later development costs, 605 periods. The main justification for this approach is that the asset is the most productive double-declining-balance in its early years. method, 595 exploration costs, 605 4 Explain special depreciation methods. Two special depreciation methods full-cost concept, 608 are as follows. (1) Group and composite methods: The group method is frequently used group method, 595 when the assets are fairly similar in nature and have approximately the same useful impairment, 601 lives. The composite method may be used when the assets are dissimilar and have dif- inadequacy, 591 ferent lives. (2) Hybrid or combination methods: These methods may combine straight- liquidating dividends, 607 line/activity approaches. natural resources, 604 obsolescence, 591 5 Explain the accounting issues related to asset impairment. The process percentage depletion, to determine an impairment loss is as follows. (1) Review events and changes in circum- 606(n) stances for possible impairment. (2) If events or changes suggest impairment, determine profit margin on sales, 612 if the sum of the expected future net cash flows from the long-lived asset is less than the recoverability test, 602 carrying amount of the asset. If less, measure the impairment loss. (3) The impairment reserve recognition loss is the amount by which the carrying amount of the asset exceeds the fair value of accounting (RRA), 608 the asset. restoration costs, 605 After a company records an impairment loss, the reduced carrying amount of the return on assets long-lived asset is its new cost basis. Impairment losses may not be restored for assets (ROA), 612 held for use. If the company expects to dispose of the asset, it should report the impaired salvage value, 590 asset at the lower-of-cost-or-net realizable value. It is not depreciated. It can be continu- straight-line method, 593 ously revalued, as long as the write-up is never to an amount greater than the carrying amount before impairment. successful-efforts concept, 608 6 Explain the accounting procedures for depletion of natural resources. sum-of-the-years’-digits method, 594 To account for depletion of natural resources, companies (1) establish the depletion base supersession, 591 and (2) write off resource cost. Four factors are part of establishing the depletion base: (a) acquisition costs, (b) exploration costs, (c) development costs, and (d) restoration costs. To write off resource cost, companies normally compute depletion on the units-of- production method. Thus, depletion is a function of the number of units withdrawn during the period. To obtain a cost per unit of product, the total cost of the natural resource less salvage value is divided by the number of units estimated to be in the resource deposit, to obtain a cost per unit of product. To compute depletion, this cost per

unit is multiplied by the number of units withdrawn. 7 Explain how to report and analyze property, plant, equipment, and natural resources. The basis of valuation for property, plant, and equipment and for natural resources should be disclosed along with pledges, liens, and other commitments related to these assets. Companies should not offset any liability secured by property, plant, and equipment or by natural resources against these assets, but should report it in the liabilities section. When depreciating assets, credit a valuation account normally called Accumulated Depreciation. When depleting assets, use an accumulated depletion account, or credit the depletion directly to the natural resource account. Companies engaged in significant oil and gas producing activities must provide additional disclosures about these activities. Analysis may be performed to evaluate the asset turnover, profit margin on sales, and return on assets. 614 Chapter 11 Depreciation, Impairments, and Depletion APPENDIX 11A INCOME TAX DEPRECIATION For the most part, a financial accounting course does not address issues related to LEARNING OBJECTIVE 8 the computation of income taxes. However, because the concepts of tax depreciation Describe income tax methods are similar to those of book depreciation and because tax depreciation methods are of depreciation. sometimes adopted for book purposes, we present an overview of this subject. Congress passed the Accelerated Cost Recovery System (ACRS) as part of the Eco- nomic Recovery Tax Act of 1981. The goal was to stimulate capital investment through faster write-offs and to bring more uniformity to the write-off period. For assets pur- chased in the years 1981 through 1986, companies use ACRS and its preestablished “cost recovery periods” for various classes of assets. In the Tax Reform Act of 1986 Congress enacted a Modified Accelerated Cost Recovery System, known as MACRS. It applies to depreciable assets placed in service in 1987 and later. The following discussion is based on these MACRS rules. Realize that tax depreciation rules are subject to change annually.15 MODIFIED ACCELERATED COST RECOVERY SYSTEM The computation of depreciation under MACRS differs from the computation under GAAP in three respects: (1) a mandated tax life, which is generally shorter than the economic life; (2) cost recovery on an accelerated basis; and (3) an assigned salvage value of zero. Tax Lives (Recovery Periods) Each item of depreciable property belongs to a property class. The recovery period (depreciable tax life) of an asset depends on its property class. Illustration 11A-1 presents the MACRS property classes. ILLUSTRATION 11A-1 3-year property I ncludes small tools, horses, and assets used in research and development activities MACRS Property Classes 5-year property I ncludes automobiles, trucks, computers and peripheral equipment, and office machines 7-year property I ncludes office furniture and fixtures, agriculture equipment, oil exploration and development equipment, railroad track, manufacturing equipment, and any property not designated by law as being in any other class 10-year property I ncludes railroad tank cars, mobile homes, boilers, and certain public utility property 15-year property I ncludes roads, shrubbery, and certain low-income housing 20-year property I ncludes waste-water treatment plants and sewer systems 27.5-year property I ncludes residential rental property 39-year property I ncludes nonresidential real property 15For example, in an effort to jump-start the economy following the September 11, 2001, terrorist attacks, Congress passed the Job Creation and Worker Assistance Act of 2002 (the Act). The Act allows a 30 percent first-year bonus depreciation for assets placed into service after September 11, 2001, but before September 11, 2004. A follow-up provision enacted in 2003 extended the tax savings to assets placed in service before January 1, 2005. And in 2010, Congress extended bonus depreciation for smaller companies. These laws encourage companies to invest in fixed assets

because they can front-load depreciation expense, which lowers taxable income and amount of taxes companies pay in the early years of an asset’s life. Although the Act may be a good thing for the economy, it can distort cash flow measures—making them look artificially strong when the allowances are in place but reversing once the bonus depreciation expires. See D. Zion and B. Carcache, “Bonus Depreciation Boomerang,” Credit Suisse First Boston Equity Research (February 19, 2004). Appendix 11A: Income Tax Depreciation 615 Tax Depreciation Methods Companies compute depreciation expense using the tax basis—usually the cost—of the asset. The depreciation method depends on the MACRS property class, as shown below. ILLUSTRATION 11A-2 MACRS Depreciation Method for Property Class Depreciation Method Various MACRS Property 3-, 5-, 7-, and 10-year property Double-declining-balance Classes 15- and 20-year property 150% declining-balance 27.5- and 39-year property Straight-line Depreciation computations for income tax purposes are based on the half-year convention. That is, a half year of depreciation is allowable in the year of acquisition and in the year of disposition.16 A company depreciates an asset to a zero value so that there is no salvage value at the end of its MACRS life. Use of IRS-published tables, shown in Illustration 11A-3, simplifies application of these depreciation methods. ILLUSTRATION 11A-3 MACRS Depreciation Rates by Class of Property IRS Table of MACRS Recovery 3-year 5-year 7-year 10-year 15-year 20-year Depreciation Rates, by Year (200% DB) (200% DB) (200% DB) (200% DB) (150% DB) (150% DB) Property Class 1 33.33 20.00 14.29 10.00 5.00 3.750 2 44.45 32.00 24.49 18.00 9.50 7.219 3 14.81* 19.20 17.49 14.40 8.55 6.677 4 7.41 11.52* 12.49 11.52 7.70 6.177 5 11.52 8.93* 9.22 6.93 5.713 6 5.76 8.92 7.37 6.23 5.285 7 8.93 6.55* 5.90* 4.888 8 4.46 6.55 5.90 4.522 9 6.56 5.91 4.462* 10 6.55 5.90 4.461 11 3.28 5.91 4.462 12 5.90 4.461 13 5.91 4.462 14 5.90 4.461 15 5.91 4.462 16 2.95 4.461 17 4.462 18 4.461 19 4.462 20 4.461 21 2.231 *Switchover to straight-line depreciation. Example of MACRS To illustrate depreciation computations under both MACRS and GAAP straight-line accounting, assume the following facts for a computer and peripheral equipment pur- chased by Denise Rode Company on January 1, 2013. 16The tax law requires mid-quarter and mid-month conventions for MACRS purposes in certain circumstances. 616 Chapter 11 Depreciation, Impairments, and Depletion Acquisition Date January 1, 2013 Cost $100,000 Estimated useful life 7 years Estimated salvage value $16,000 MACRS class life 5 years MACRS method 200% declining-balance GAAP method Straight-line Disposal proceeds—January 2, 2020 $11,000 Using the rates from the MACRS depreciation rate schedule for a 5-year class of prop- erty, Rode computes depreciation as follows for tax purposes. ILLUSTRATION 11A-4 MACRS Depreciation Computation of MACRS 2013 $100,000 3 .20 5 $ 20,000 Depreciation 2014 $100,000 3 .32 5 32,000 2015 $100,000 3 .192 5 19,200 2016 $100,000 3 .1152 5 11,520 2017 $100,000 3 .1152 5 11,520 2018 $100,000 3 .0576 5 5,760 Total depreciation $100,000 Rode computes the depreciation under GAAP straight-line method, with $16,000 of estimated salvage value and an estimated useful life of 7 years, as shown in Illustration 11A-5. ILLUSTRATION 11A-5 GAAP Depreciation Computation of GAAP ($100,000 2 $16,000) 4 7 5 $12,000 annual depreciation Depreciation 3 7 years 1/1/13–1/2/20 $84,000 total depreciation The MACRS depreciation recovers the total cost of the asset on an accelerated basis. But, a taxable gain of $11,000 results from the sale of the asset at January 2, 2020. There- fore, the net effect on taxable income for the years 2013 through 2020 is $89,000 ($100,000 depreciation 2 $11,000 gain). Under GAAP, the company recognizes a loss on disposal of $5,000 ($16,000 book value 2 $11,000 disposal proceeds). The net effect on income before income taxes for the years 2013 through 2020 is $89,000 ($84,000 depreciation 1 $5,000 loss), the same as the net effect of MACRS on taxable income.

Even though the net effects are equal in amount, the deferral of income tax payments under MACRS from early in the life of the asset to later in life is desirable. The different amounts of depreciation for income tax reporting and financial GAAP reporting in each year are a matter of timing and result in temporary differences, which require interperiod tax allocation. (See Chapter 19 for an extended treatment of this topic.) OPTIONAL STRAIGHT-LINE METHOD An alternate MACRS method exists for determining depreciation deductions. Based on the straight-line method, it is referred to as the optional (elective) straight-line method. This method applies to the six classes of property described earlier. The alternate Demonstration Problem 617 MACRS applies the straight-line method to the MACRS recovery periods. It ignores salvage value. Under the optional straight-line method, in the first year in which the property is put in service, the company deducts half of the amount of depreciation that would be permitted for a full year (half-year convention). Use the half-year convention for homework problems. TAX VERSUS BOOK DEPRECIATION GAAP requires that companies allocate the cost of depreciable assets to expense over the expected useful life of the asset in a systematic and rational manner. Some argue that from a cost-benefit perspective it would be better for companies to adopt the MACRS approach in order to eliminate the necessity of maintaining two different sets of records. However, the tax laws and financial reporting have different objectives. The pur- pose of taxation is to raise revenue from constituents in an equitable manner. The purpose of financial reporting is to reflect the economic substance of a transaction as closely as possible and to help predict the amounts, timing, and uncertainty of future cash flows. Because these objectives differ, the adoption of one method for both tax and book purposes in all cases is not in accordance with GAAP. KEY TERM SUMMARY OF LEARNING OBJECTIVE Modified Accelerated FOR APPENDIX 11A Cost Recovery System (MACRS), 614 8 Describe income tax methods of depreciation. Congress enacted a Modified Accelerated Cost Recovery System (MACRS) in the Tax Reform Act of 1986. It applies to depreciable assets placed in service in 1987 and later. The computation of depreciation under MACRS differs from the computation under GAAP in three respects: (1) a mandated tax life, which is generally shorter than the economic life; (2) cost recovery on an accelerated basis; and (3) an assigned salvage value of zero. DEMONSTRATION PROBLEM Norwel Company manufactures miniature circuit boards used in smartphones. On June 5, 2014, Norwel purchased a circuit board stamping machine at a retail price of $24,000. Norwel paid 5% sales tax on this purchase and hired a contractor to build a specially wired platform for the machine for $1,800, to meet OSHA safety requirements. Norwel estimates the machine will have a 5-year useful life, with a salvage value of $2,000 at the end of 5 years. Norwel uses straight-line depreciation and employs the “half-year” convention in accounting for partial-year depreciation. Norwel’s fiscal year ends on December 31. Instructions (a) At what amount should Norwel record the acquisition cost of the machine? (b) How much depreciation expense should Norwel record in 2014 and in 2015? (c) At what amount will the machine be reported in Norwel’s balance sheet at December 31, 2015? (d) During 2016, Norwel’s circuit board business is experiencing significant competition from compa- nies with more advanced low-heat circuit boards. As a result, at June 30, 2016, Norwel conducts an impairment evaluation of the stamping machine purchased in 2014. Norwel determines that undis- counted future cash flows for the machine are estimated to be $15,200 and the fair value of the machine, based on prices in the re-sale market, to be $13,400. Prepare the journal entry to record an impairment, if any, on the stamping machine. 618 Chapter 11 Depreciation, Impairments, and Depletion Solution

(a) Historical cost is measured by the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition for its intended use. For Norwel, this is: Price $24,000 Tax ($24,000 3 .05) 1,200 Platform 1,800 Total $27,000 (b) Depreciable base: $27,000 2 $2,000 5 $25,000 Depreciation expense: $25,000 4 5 5 $5,000 per year 2014: 1/2 year 5 $5,000 3 .50 5 $2,500 2015: full year 5 $5,000 (c) The amount reported on the balance sheet is the cost of the asset less accumulated depreciation: Machinery $27,000 Less: Accumulated depreciation 7,500 Book value $19,500 (d) Norwel first conducts the recoverability test, comparing the book value of the machine to the undis- counted future cash flows. This indicates the future cash flows ($15,200) are less than the book value ($17,000*). *Cost $27,000 Less: Accumulated depreciation ($2,500 1 $5,000 1 $2,500) 10,000 Book value of machine and platform $17,000 Thus, Norwel will record an impairment, based on comparison of the fair value of the machine and platform to the book value. The entry is as follows. Loss on Impairment ($17,000 2 $13,400) 3,600 Accumulated Depreciation—Machinery 3,600 FASB CODIFICATION FASB Codification References [1] FASB ASC 360-10-05. [Predecessor literature: “Accounting for the Impairment or Disposal of Long-lived Assets,” Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: 2001).] [2] FASB ASC 360-10-50-1. [Predecessor literature: “Omnibus Opinion—1967,” Opinions of the Accounting Principles Board No. 12 (New York: AICPA, 1967), par. 5.] [3] FASB ASC 932-235-50-1. [Predecessor literature: “Disclosures about Oil and Gas Producing Activities,” Statement of Financial Accounting Standards Board No. 69 (Stamford, Conn.: FASB, 1982).] Exercises If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. CE11-1 Access the glossary (“Master Glossary”) to answer the following. (a) What is the definition of amortization? (b) What is the definition of impairment? (c) What is the definition of recoverable amount? (d) What are activities, as they relate to the construction of an asset? Questions 619 CE11-2 Your client, Barriques Inc., is contemplating a restructuring of its operations, including the possibility of spinning off some of its assets to the original owners. However, management is unsure of the accounting for any impairment on the assets. What does the authoritative literature say about these types of impairments? CE11-3 Your great-uncle, who is a CPA, is impressed that you are majoring in accounting. But, he believes that depreciation is something that companies do based on past practice, not on the basis of any authoritative guidance. Provide the authoritative literature to support the practice of fixed-asset depreciation. CE11-4 What is the nature of SEC guidance concerning property, plant, and equipment disclosures? An additional Codification case can be found in the Using Your Judgment section, on page 637. Be sure to check the book’s companion website for a Review and Analysis Exercise, with solution. Brief Exercises, Exercises, Problems, and many more learning and assessment tools and resources are available for practice in WileyPLUS. Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter. QUESTIONS 1. Distinguish among depreciation, depletion, and amorti- 8. Workman Company purchased a machine on January 2, zation. 2014, for $800,000. The machine has an estimated useful 2. Identify the factors that are relevant in determining the life of 5 years and a salvage value of $100,000. Deprecia- tion was computed by the 150% declining-balance annual depreciation charge, and explain whether these method. What is the amount of accumulated depreciation factors are determined objectively or whether they are at the end of December 31, 2015? based on judgment. 3. Some believe that accounting depreciation measures 9. Silverman Company purchased machinery for $162,000

the decline in the value of fixed assets. Do you agree? on January 1, 2014. It is estimated that the machinery will Explain. have a useful life of 20 years, salvage value of $15,000, production of 84,000 units, and working hours of 42,000. 4. Explain how estimation of service lives can result in During 2014, the company uses the machinery for 14,300 unrealistically high carrying values for fixed assets. hours, and the machinery produces 20,000 units. Compute 5. The plant manager of a manufacturing firm suggested in depreciation under the straight-line, units-of-output, a conference of the company’s executives that accoun- working hours, sum-of-the-years’-digits, and double- tants should speed up depreciation on the machinery in declining-balance methods. the finishing department because improvements were 10. What are the major factors considered in determining rapidly making those machines obsolete, and a deprecia- what depreciation method to use? tion fund big enough to cover their replacement is needed. Discuss the accounting concept of depreciation and the 11. Under what conditions is it appropriate for a business to effect on a business concern of the depreciation recorded use the composite method of depreciation for its plant for plant assets, paying particular attention to the issues assets? What are the advantages and disadvantages of raised by the plant manager. this method? 6. For what reasons are plant assets retired? Define inade- 12. If Remmers, Inc. uses the composite method and its com- quacy, supersession, and obsolescence. posite rate is 7.5% per year, what entry should it make 7. What basic questions must be answered before the when plant assets that originally cost $50,000 and have amount of the depreciation charge can be computed? been used for 10 years are sold for $14,000? 620 Chapter 11 Depreciation, Impairments, and Depletion 13. A building that was purchased on December 31, 2000, for 21. Neither depreciation on replacement cost nor deprecia- $2,500,000 was originally estimated to have a life of 50 tion adjusted for changes in the purchasing power of the years with no salvage value at the end of that time. Depre- dollar has been recognized as generally accepted account- ciation has been recorded through 2014. During 2015, an ing principles for inclusion in the primary financial state- examination of the building by an engineering firm dis- ments. Briefly present the accounting treatment that might closes that its estimated useful life is 15 years after 2014. be used to assist in the maintenance of the ability of a What should be the amount of depreciation for 2015? company to replace its productive capacity. 14. Charlie Parker, president of Spinners Company, has 22. List (a) the similarities and (b) the differences in the ac- recently noted that depreciation increases cash provided counting treatments of depreciation and cost depletion. by operations and therefore depreciation is a good source 23. Describe cost depletion and percentage depletion. Why is of funds. Do you agree? Discuss. the percentage depletion method permitted? 15. Andrea Torbert purchased a computer for $8,000 on July 24. In what way may the use of percentage depletion violate 1, 2014. She intends to depreciate it over 4 years using the sound accounting theory? double-declining-balance method. Salvage value is $1,000. Compute depreciation for 2015. 25. In the extractive industries, businesses may pay divi- 16. Walkin Inc. is considering the write-down of its long-term dends in excess of net income. What is the maximum per- missible? How can this practice be justified? plant because of a lack of profitability. Explain to the management of Walkin how to determine whether a 26. The following statement appeared in a financial maga- write-down is permitted. zine: “RRA—or Rah-Rah, as it’s sometimes dubbed—has 17. Last year, Wyeth Company recorded an impairment on an kicked up quite a storm. Oil companies, for example, are convinced that the approach is misleading. Major ac- asset held for use. Recent appraisals indicate that the asset

counting firms agree.” What is RRA? Why might oil com- has increased in value. Should Wyeth record this recovery panies believe that this approach is misleading? in value? 18. Toro Co. has equipment with a carrying amount of 27. Shumway Oil uses successful-efforts accounting and $700,000. The expected future net cash flows from the also provides full-cost results as well. Under full-cost, equipment are $705,000, and its fair value is $590,000. The Shumway Oil would have reported retained earnings of equipment is expected to be used in operations in the $42 million and net income of $4 million. Under successful- future. What amount (if any) should Toro report as an efforts, retained earnings were $29 million, and net impairment to its equipment? income was $3 million. Explain the difference between full-costing and successful-efforts accounting. 19. Explain how gains or losses on impaired assets should be reported in income. 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. 20. It has been suggested that plant and equipment could be What is Target’s asset turnover? What is Target’s return replaced more quickly if depreciation rates for income tax on assets? and accounting purposes were substantially increased. As a result, business operations would receive the benefit of * 29. What is a modified accelerated cost recovery system more modern and more efficient plant facilities. Discuss (MACRS)? Speculate as to why this system is now required the merits of this proposition. for tax purposes. BRIEF EXERCISES 2 3 BE11-1 Fernandez Corporation purchased a truck at the beginning of 2014 for $50,000. The truck is esti- mated to have a salvage value of $2,000 and a useful life of 160,000 miles. It was driven 23,000 miles in 2014 and 31,000 miles in 2015. Compute depreciation expense for 2014 and 2015. 2 3 BE11-2 Lockard Company purchased machinery on January 1, 2014, for $80,000. The machinery is esti- mated to have a salvage value of $8,000 after a useful life of 8 years. (a) Compute 2014 depreciation expense using the straight-line method. (b) Compute 2014 depreciation expense using the straight-line method assuming the machinery was purchased on September 1, 2014. 2 3 BE11-3 Use the information for Lockard Company given in BE11-2. (a) Compute 2014 depreciation expense using the sum-of-the-years’-digits method. (b) Compute 2014 depreciation expense using the sum-of-the-years’-digits method, assuming the machinery was purchased on April 1, 2014. Exercises 621 2 3 BE11-4 Use the information for Lockard Company given in BE11-2. (a) Compute 2014 depreciation expense using the double-declining-balance method. (b) Compute 2014 depreciation expense using the double-declining-balance method, assuming the machinery was purchased on October 1, 2014. 2 3 BE11-5 Cominsky Company purchased a machine on July 1, 2015, for $28,000. Cominsky paid $200 in title fees and county property tax of $125 on the machine. In addition, Cominsky paid $500 shipping charges for delivery, and $475 was paid to a local contractor to build and wire a platform for the machine on the plant floor. The machine has an estimated useful life of 6 years with a salvage value of $3,000. Determine the depreciation base of Cominsky’s new machine. Cominsky uses straight-line depreciation. 4 BE11-6 Dickinson Inc. owns the following assets. Asset Cost Salvage Estimated Useful Life A $70,000 $7,000 10 years B 50,000 5,000 5 years C 82,000 4,000 12 years Compute the composite depreciation rate and the composite life of Dickinson’s assets. 4 BE11-7 Holt Company purchased a computer for $8,000 on January 1, 2013. Straight-line depreciation is used, based on a 5-year life and a $1,000 salvage value. In 2015, the estimates are revised. Holt now feels the computer will be used until December 31, 2016, when it can be sold for $500. Compute the 2015 depreciation. 5 BE11-8 Jurassic Company owns equipment that cost $900,000 and has accumulated depreciation of $380,000. The expected future net cash flows from the use of the asset are expected to be $500,000. The fair

value of the equipment is $400,000. Prepare the journal entry, if any, to record the impairment loss. 6 BE11-9 Everly Corporation acquires a coal mine at a cost of $400,000. Intangible development costs total $100,000. After extraction has occurred, Everly must restore the property (estimated fair value of the obli- gation is $80,000), after which it can be sold for $160,000. Everly estimates that 4,000 tons of coal can be extracted. If 700 tons are extracted the first year, prepare the journal entry to record depletion. 7 BE11-10 In its 2011 annual report, Campbell Soup Company reports beginning-of-the-year total assets of $6,276 million, end-of-the-year total assets of $6,862 million, total sales of $7,719 million, and net income of $805 million. (a) Compute Campbell’s asset turnover. (b) Compute Campbell’s profit margin on sales. (c) Compute Campbell’s return on assets using (1) asset turnover and profit margin and (2) net income. 8 *B E11-11 Francis Corporation purchased an asset at a cost of $50,000 on March 1, 2014. The asset has a useful life of 8 years and a salvage value of $4,000. For tax purposes, the MACRS class life is 5 years. Compute tax depreciation for each year 2014–2019. EXERCISES 2 3 E11-1 (Depreciation Computations—SL, SYD, DDB) Deluxe Ezra Company purchases equipment on January 1, Year 1, at a cost of $469,000. The asset is expected to have a service life of 12 years and a salvage value of $40,000. Instructions (a) Compute the amount of depreciation for each of Years 1 through 3 using the straight-line depreciation method. (b) Compute the amount of depreciation for each of Years 1 through 3 using the sum-of-the-years’- digits method. (c) Compute the amount of depreciation for each of Years 1 through 3 using the double-declining-balance method. (In performing your calculations, round constant percentage to the nearest one-hundredth of a point and round answers to the nearest dollar.) 2 3 E11-2 (Depreciation—Conceptual Understanding) Rembrandt Company acquired a plant asset at the beginning of Year 1. The asset has an estimated service life of 5 years. An employee has prepared deprecia- tion schedules for this asset using three different methods to compare the results of using one method with the results of using other methods. You are to assume that the following schedules have been correctly prepared for this asset using (1) the straight-line method, (2) the sum-of-the-years’-digits method, and (3) the double-declining-balance method. 622 Chapter 11 Depreciation, Impairments, and Depletion Sum-of-the- Double-Declining- Year Straight-Line Years’-Digits Balance 1 $ 9,000 $15,000 $20,000 2 9,000 12,000 12,000 3 9,000 9,000 7,200 4 9,000 6,000 4,320 5 9,000 3,000 1,480 Total $45,000 $45,000 $45,000 Instructions Answer the following questions. (a) What is the cost of the asset being depreciated? (b) What amount, if any, was used in the depreciation calculations for the salvage value for this asset? (c) Which method will produce the highest charge to income in Year 1? (d) Which method will produce the highest charge to income in Year 4? (e) Which method will produce the highest book value for the asset at the end of Year 3? (f) If the asset is sold at the end of Year 3, which method would yield the highest gain (or lowest loss) on disposal of the asset? 2 3 E11-3 (Depreciation Computations—SYD, DDB—Partial Periods) Judds Company purchased a new plant asset on April 1, 2014, at a cost of $711,000. It was estimated to have a service life of 20 years and a salvage value of $60,000. Judds’ accounting period is the calendar year. Instructions (a) Compute the depreciation for this asset for 2014 and 2015 using the sum-of-the-years’-digits method. (b) Compute the depreciation for this asset for 2014 and 2015 using the double-declining-balance method. 2 3 E11-4 (Depreciation Computations—Five Methods) Jon Seceda Furnace Corp. purchased machinery for $315,000 on May 1, 2014. It is estimated that it will have a useful life of 10 years, salvage value of $15,000, production of 240,000 units, and working hours of 25,000. During 2015, Seceda Corp. uses the machinery

for 2,650 hours, and the machinery produces 25,500 units. Instructions From the information given, compute the depreciation charge for 2015 under each of the following methods. (Round to the nearest dollar.) (a) Straight-line. (d) Sum-of-the-years’-digits. (b) Units-of-output. (e) Declining-balance (use 20% as the annual rate). (c) Working hours. 2 3 E11-5 (Depreciation Computations—Four Methods) Robert Parish Corporation purchased a new machine for its assembly process on August 1, 2014. The cost of this machine was $117,900. The company estimated that the machine would have a salvage value of $12,900 at the end of its service life. Its life is estimated at 5 years, and its working hours are estimated at 21,000 hours. Year-end is December 31. Instructions Compute the depreciation expense under the following methods. Each of the following should be con- sidered unrelated. (a) Straight-line depreciation for 2014. (b) Activity method for 2014, assuming that machine usage was 800 hours. (c) Sum-of-the-years’-digits for 2015. (d) Double-declining-balance for 2015. 2 3 E11-6 (Depreciation Computations—Five Methods, Partial Periods) Muggsy Bogues Company pur- chased equipment for $212,000 on October 1, 2014. It is estimated that the equipment will have a useful life of 8 years and a salvage value of $12,000. Estimated production is 40,000 units and estimated working hours are 20,000. During 2014, Bogues uses the equipment for 525 hours and the equipment produces 1,000 units. Instructions Compute depreciation expense under each of the following methods. Bogues is on a calendar-year basis ending December 31. (a) Straight-line method for 2014. (b) Activity method (units of output) for 2014. Exercises 623 (c) Activity method (working hours) for 2014. (d) Sum-of-the-years’-digits method for 2016. (e) Double-declining-balance method for 2015. 2 3 E11-7 (Different Methods of Depreciation) Jackel Industries presents you with the following information. Accumulated Date Salvage Life in Depreciation Depreciation to Depreciation Description Purchased Cost Value Years Method 12/31/15 for 2016 Machine A 2/12/14 $142,500 $16,000 10 (a) $33,350 (b) Machine B 8/15/13 (c) 21,000 5 SL 29,000 (d) Machine C 7/21/12 75,400 23,500 8 DDB (e) (f) Machine D 10/12/(g) 219,000 69,000 5 SYD 70,000 (h) Instructions Complete the table for the year ended December 31, 2016. The company depreciates all assets using the half-year convention. 2 3 E11-8 (Depreciation Computation—Replacement, Nonmonetary Exchange) George Zidek Corporation bought a machine on June 1, 2012, for $31,000, f.o.b. the place of manufacture. Freight to the point where it was set up was $200, and $500 was expended to install it. The machine’s useful life was estimated at 10 years, with a salvage value of $2,500. On June 1, 2013, an essential part of the machine is replaced, at a cost of $1,980, with one designed to reduce the cost of operating the machine. The cost of the old part and related depreciation cannot be determined with any accuracy. On June 1, 2016, the company buys a new machine of greater capacity for $35,000, delivered, trading in the old machine which has a fair value and trade-in allowance of $20,000. To prepare the old machine for removal from the plant cost $75, and expenditures to install the new one were $1,500. It is estimated that the new machine has a useful life of 10 years, with a salvage value of $4,000 at the end of that time. (The exchange has commercial substance.) Instructions Assuming that depreciation is to be computed on the straight-line basis, compute the annual depreciation on the new equipment that should be provided for the fiscal year beginning June 1, 2016. (Round to the nearest dollar.) 4 E11-9 (Composite Depreciation) Presented below is information related to LeBron James Manufacturing Corporation. Asset Cost Estimated Salvage Estimated Life (in years) A $40,500 $5,500 10 B 33,600 4,800 9 C 36,000 3,600 9 D 19,000 1,500 7 E 23,500 2,500 6 Instructions (a) Compute the rate of depreciation per year to be applied to the plant assets under the composite method.

(b) Prepare the adjusting entry necessary at the end of the year to record depreciation for the year. (c) Prepare the entry to record the sale of asset D for cash of $4,800. It was used for 6 years, and depre- ciation was entered under the composite method. 2 3 E11-10 (Depreciation Computations, SYD) Five Satins Company purchased a piece of equipment at the beginning of 2011. The equipment cost $430,000. It has an estimated service life of 8 years and an expected salvage value of $70,000. The sum-of-the-years’-digits method of depreciation is being used. Someone has already correctly prepared a depreciation schedule for this asset. This schedule shows that $60,000 will be depreciated for a particular calendar year. Instructions Show calculations to determine for what particular year the depreciation amount for this asset will be $60,000. 2 3 E11-11 (Depreciation—Change in Estimate) Machinery purchased for $60,000 by Tom Brady Co. in 4 2010 was originally estimated to have a life of 8 years with a salvage value of $4,000 at the end of that time. Depreciation has been entered for 5 years on this basis. In 2015, it is determined that the total esti- mated life should be 10 years with a salvage value of $4,500 at the end of that time. Assume straight-line depreciation. 624 Chapter 11 Depreciation, Impairments, and Depletion Instructions (a) Prepare the entry to correct the prior years’ depreciation, if necessary. (b) Prepare the entry to record depreciation for 2015. 2 3 E11-12 (Depreciation Computation—Addition, Change in Estimate) In 1987, Herman Moore Company 4 completed the construction of a building at a cost of $2,000,000 and first occupied it in January 1988. It was estimated that the building will have a useful life of 40 years and a salvage value of $60,000 at the end of that time. Early in 1998, an addition to the building was constructed at a cost of $500,000. At that time, it was estimated that the remaining life of the building would be, as originally estimated, an additional 30 years, and that the addition would have a life of 30 years and a salvage value of $20,000. In 2016, it is determined that the probable life of the building and addition will extend to the end of 2047, or 20 years beyond the original estimate. Instructions (a) Using the straight-line method, compute the annual depreciation that would have been charged from 1988 through 1997. (b) Compute the annual depreciation that would have been charged from 1998 through 2015. (c) Prepare the entry, if necessary, to adjust the account balances because of the revision of the esti- mated life in 2016. (d) Compute the annual depreciation to be charged, beginning with 2016. 2 3 E11-13 (Depreciation—Replacement, Change in Estimate) Greg Maddox Company constructed a build- 4 ing at a cost of $2,200,000 and occupied it beginning in January 1995. It was estimated at that time that its life would be 40 years, with no salvage value. In January 2015, a new roof was installed at a cost of $300,000, and it was estimated then that the build- ing would have a useful life of 25 years from that date. The cost of the old roof was $160,000. Instructions (a) What amount of depreciation should have been charged annually from the years 1995 to 2014? (Assume straight-line depreciation.) (b) What entry should be made in 2015 to record the replacement of the roof? (c) Prepare the entry in January 2015 to record the revision in the estimated life of the building, if necessary. (d) What amount of depreciation should be charged for the year 2015? 2 3 E11-14 (Error Analysis and Depreciation, SL and SYD) Mike Devereaux Company shows the following entries in its Equipment account for 2015. All amounts are based on historical cost. Equipment 2015 2015 Jan. 1 Balance 134,750 June 30 Cost of equipment sold Aug. 10 Purchases 32,000 (purchased prior 12 Freight on equipment to 2015) 23,000 purchased 700 25 Installation costs 2,700 Nov. 10 Repairs 500 Instructions (a) Prepare any correcting entries necessary. (b) Assuming that depreciation is to be charged for a full year on the ending balance in the asset

account, compute the proper depreciation charge for 2015 under each of the methods listed below. Assume an estimated life of 10 years, with no salvage value. The machinery included in the January 1, 2015, balance was purchased in 2013. (1) Straight-line. (2) Sum-of-the-years’-digits. 2 3 E11-15 (Depreciation for Fractional Periods) On March 10, 2016, Lost World Company sells equipment that it purchased for $192,000 on August 20, 2009. It was originally estimated that the equipment would have a life of 12 years and a salvage value of $16,800 at the end of that time, and depreciation has been computed on that basis. The company uses the straight-line method of depreciation. Instructions (a) Compute the depreciation charge on this equipment for 2009, for 2016, and the total charge for the period from 2010 to 2015, inclusive, under each of the six following assumptions with respect to partial periods. Exercises 625 (1) Depreciation is computed for the exact period of time during which the asset is owned. (Use 365 days for base.) (2) Depreciation is computed for the full year on the January 1 balance in the asset account. (3) Depreciation is computed for the full year on the December 31 balance in the asset account. (4) Depreciation for one-half year is charged on plant assets acquired or disposed of during the year. (5) D epreciation is computed on additions from the beginning of the month following acquisition and on disposals to the beginning of the month following disposal. (6) Depreciation is computed for a full period on all assets in use for over one-half year, and no depreciation is charged on assets in use for less than one-half year. (Use 365 days for base.) (b) Briefly evaluate the methods above, considering them from the point of view of basic accounting theory as well as simplicity of application. 5 E11-16 (Impairment) Presented below is information related to equipment owned by Suarez Company at December 31, 2014. Cost $9,000,000 Accumulated depreciation to date 1,000,000 Expected future net cash fl ows 7,000,000 Fair value 4,800,000 Assume that Suarez will continue to use this asset in the future. As of December 31, 2014, the equipment has a remaining useful life of 4 years. Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2014. (b) Prepare the journal entry to record depreciation expense for 2015. (c) The fair value of the equipment at December 31, 2015, is $5,100,000. Prepare the journal entry (if any) necessary to record this increase in fair value. 5 E11-17 (Impairment) Assume the same information as E11-16, except that Suarez intends to dispose of the equipment in the coming year. It is expected that the cost of disposal will be $20,000. Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2014. (b) Prepare the journal entry (if any) to record depreciation expense for 2015. (c) The asset was not sold by December 31, 2015. The fair value of the equipment on that date is $5,300,000. Prepare the journal entry (if any) necessary to record this increase in fair value. It is expected that the cost of disposal is still $20,000. 5 E11-18 (Impairment) The management of Petro Garcia Inc. was discussing whether certain equipment should be written off as a charge to current operations because of obsolescence. This equipment has a cost of $900,000 with depreciation to date of $400,000 as of December 31, 2014. On December 31, 2014, manage- ment projected its future net cash flows from this equipment to be $300,000 and its fair value to be $230,000. The company intends to use this equipment in the future. Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2014. (b) Where should the gain or loss (if any) on the write-down be reported in the income statement? (c) At December 31, 2015, the equipment’s fair value increased to $260,000. Prepare the journal entry (if any) to record this increase in fair value. (d) What accounting issues did management face in accounting for this impairment?

6 E11-19 (Depletion Computations—Timber) Stanislaw Timber Company owns 9,000 acres of timberland purchased in 2003 at a cost of $1,400 per acre. At the time of purchase, the land without the timber was valued at $400 per acre. In 2004, Stanislaw built fire lanes and roads, with a life of 30 years, at a cost of $84,000. Every year, Stanislaw sprays to prevent disease at a cost of $3,000 per year and spends $7,000 to maintain the fire lanes and roads. During 2005, Stanislaw selectively logged and sold 700,000 board feet of timber, of the estimated 3,500,000 board feet. In 2006, Stanislaw planted new seedlings to replace the trees cut at a cost of $100,000. Instructions (a) Determine the depreciation expense and the cost of timber sold related to depletion for 2005. (b) Stanislaw has not logged since 2005. If Stanislaw logged and sold 900,000 board feet of timber in 2016, when the timber cruise (appraiser) estimated 5,000,000 board feet, determine the cost of timber sold related to depletion for 2016. 626 Chapter 11 Depreciation, Impairments, and Depletion 6 E11-20 (Depletion Computations—Oil) Diderot Drilling Company has leased property on which oil has been discovered. Wells on this property produced 18,000 barrels of oil during the past year that sold at an average sales price of $55 per barrel. Total oil resources of this property are estimated to be 250,000 barrels. The lease provided for an outright payment of $500,000 to the lessor (owner) before drilling could be commenced and an annual rental of $31,500. A premium of 5% of the sales price of every barrel of oil removed is to be paid annually to the lessor. In addition, Diderot (lessee) is to clean up all the waste and debris from drilling and to bear the costs of reconditioning the land for farming when the wells are abandoned. The estimated fair value, at the time of the lease, of this clean-up and reconditioning is $30,000. Instructions From the provisions of the lease agreement, you are to compute the cost per barrel for the past year, exclu- sive of operating costs, to Diderot Drilling Company. 6 E11-21 (Depletion Computations—Timber) Forda Lumber Company owns a 7,000-acre tract of timber purchased in 2000 at a cost of $1,300 per acre. At the time of purchase, the land was estimated to have a value of $300 per acre without the timber. Forda Lumber Company has not logged this tract since it was purchased. In 2014, Forda had the timber cruised. The cruise (appraiser) estimated that each acre contained 8,000 board feet of timber. In 2014, Forda built 10 miles of roads at a cost of $7,840 per mile. After the roads were completed, Forda logged and sold 3,500 trees containing 850,000 board feet. Instructions (a) Determine the cost of timber sold related to depletion for 2014. (b) If Forda depreciates the logging roads on the basis of timber cut, determine the depreciation expense for 2014. (c) If Forda plants five seedlings at a cost of $4 per seedling for each tree cut, how should Forda treat the reforestation? 6 E11-22 (Depletion Computations—Mining) Alcide Mining Company purchased land on February 1, 2014, at a cost of $1,190,000. It estimated that a total of 60,000 tons of mineral was available for mining. After it has removed all the natural resources, the company will be required to restore the property to its previous state because of strict environmental protection laws. It estimates the fair value of this restoration obligation at $90,000. It believes it will be able to sell the property afterwards for $100,000. It incurred developmental costs of $200,000 before it was able to do any mining. In 2014, resources removed totaled 30,000 tons. The company sold 22,000 tons. Instructions Compute the following information for 2014. (a) Per unit material cost. (b) Total material cost of December 31, 2014, inventory. (c) Total material cost in cost of goods sold at December 31, 2014. 6 E11-23 (Depletion Computations—Minerals) At the beginning of 2014, Aristotle Company acquired a mine for $970,000. Of this amount, $100,000 was ascribed to the land value and the remaining portion to

the minerals in the mine. Surveys conducted by geologists have indicated that approximately 12,000,000 units of the ore appear to be in the mine. Aristotle incurred $170,000 of development costs associated with this mine prior to any extraction of minerals. It also determined that the fair value of its obligation to pre- pare the land for an alternative use when all of the mineral has been removed was $40,000. During 2014, 2,500,000 units of ore were extracted and 2,100,000 of these units were sold. Instructions Compute the following. (a) The total amount of depletion for 2014. (b) The amount that is charged as an expense for 2014 for the cost of the minerals sold during 2014. 7 E11-24 (Ratio Analysis) The 2011 Annual Report of Tootsie Roll Industries contains the following information. (in millions) December 31, 2011 December 31, 2010 Total assets $857.9 $858.0 Total liabilities 191.9 190.6 Net sales 528.4 517.1 Net income 43.9 53.0 Problems 627 Instructions Compute the following ratios for Tootsie Roll for 2011. (a) Asset turnover. (b) Return on assets. (c) Profit margin on sales. (d) How can the asset turnover be used to compute the return on assets? 8 * E11-25 (Book vs. Tax (MACRS) Depreciation) Futabatei Enterprises purchased a delivery truck on Janu- ary 1, 2014, at a cost of $27,000. The truck has a useful life of 7 years with an estimated salvage value of $6,000. The straight-line method is used for book purposes. For tax purposes, the truck, having an MACRS class life of 7 years, is classified as 5-year property; the optional MACRS tax rate tables are used to compute depreciation. In addition, assume that for 2014 and 2015 the company has revenues of $200,000 and operat- ing expenses (excluding depreciation) of $130,000. Instructions (a) Prepare income statements for 2014 and 2015. (The final amount reported on the income statement should be income before income taxes.) (b) Compute taxable income for 2014 and 2015. (c) Determine the total depreciation to be taken over the useful life of the delivery truck for both book and tax purposes. (d) Explain why depreciation for book and tax purposes will generally be different over the useful life of a depreciable asset. 8 * E11-26 (Book vs. Tax (MACRS) Depreciation) Shimei Inc. purchased computer equipment on March 1, 2014, for $31,000. The computer equipment has a useful life of 10 years and a salvage value of $1,000. For tax purposes, the MACRS class life is 5 years. Instructions (a) Assuming that the company uses the straight-line method for book and tax purposes, what is the depreciation expense reported in (1) the financial statements for 2014 and (2) the tax return for 2014? (b) Assuming that the company uses the double-declining-balance method for both book and tax pur- poses, what is the depreciation expense reported in (1) the financial statements for 2014 and (2) the tax return for 2014? (c) Why is depreciation for tax purposes different from depreciation for book purposes even if the company uses the same depreciation method to compute them both? EXERCISES SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of exercises. PROBLEMS 2 3 P11-1 (Depreciation for Partial Period—SL, SYD, and DDB) Alladin Company purchased Machine #201 on May 1, 2014. The following information relating to Machine #201 was gathered at the end of May. Price $85,000 Credit terms 2/10, n/30 Freight-in $ 800 Preparation and installation costs $ 3,800 Labor costs during regular production operations $10,500 It is expected that the machine could be used for 10 years, after which the salvage value would be zero. Alladin intends to use the machine for only 8 years, however, after which it expects to be able to sell it for $1,500. The invoice for Machine #201 was paid May 5, 2014. Alladin uses the calendar year as the basis for the preparation of financial statements. 628 Chapter 11 Depreciation, Impairments, and Depletion Instructions (a) Compute the depreciation expense for the years indicated using the following methods. (Round to

the nearest dollar.) (1) Straight-line method for 2014. (2) Sum-of-the-years’-digits method for 2015. (3) Double-declining-balance method for 2014. (b) Suppose Kate Crow, the president of Alladin, tells you that because the company is a new organi- zation, she expects it will be several years before production and sales reach optimum levels. She asks you to recommend a depreciation method that will allocate less of the company’s depreciation expense to the early years and more to later years of the assets’ lives. What method would you recommend? 2 3 P11-2 (Depreciation for Partial Periods—SL, Act., SYD, and Declining-Balance) The cost of equipment purchased by Charleston, Inc., on June 1, 2014, is $89,000. It is estimated that the machine will have a $5,000 salvage value at the end of its service life. Its service life is estimated at 7 years, its total working hours are estimated at 42,000, and its total production is estimated at 525,000 units. During 2014, the machine was operated 6,000 hours and produced 55,000 units. During 2015, the machine was operated 5,500 hours and produced 48,000 units. Instructions Compute depreciation expense on the machine for the year ending December 31, 2014, and the year ending December 31, 2015, using the following methods. (a) Straight-line. (d) Sum-of-the-years’-digits. (b) Units-of-output. (e) Declining-balance (twice the straight-line rate). (c) Working hours. 2 3 P11-3 (Depreciation—SYD, Act., SL, and DDB) The following data relate to the Machinery account of Eshkol, Inc. at December 31, 2014. Machinery A B C D Original cost $46,000 $51,000 $80,000 $80,000 Year purchased 2009 2010 2011 2013 Useful life 10 years 15,000 hours 15 years 10 years Salvage value $ 3,100 $ 3,000 $ 5,000 $ 5,000 Depreciation Sum-of-the- Double-declining- method years’-digits Activity Straight-line balance Accum. depr. through 2014* $31,200 $35,200 $15,000 $16,000 *In the year an asset is purchased, Eshkol, Inc. does not record any depreciation expense on the asset. In the year an asset is retired or traded in, Eshkol, Inc. takes a full year’s depreciation on the asset. The following transactions occurred during 2015. (a) On May 5, Machine A was sold for $13,000 cash. The company’s bookkeeper recorded this retire- ment in the following manner in the cash receipts journal. Cash 13,000 Machinery (Machine A) 13,000 (b) On December 31, it was determined that Machine B had been used 2,100 hours during 2015. (c) On December 31, before computing depreciation expense on Machine C, the management of Eshkol, Inc. decided the useful life remaining from January 1, 2015, was 10 years. (d) On December 31, it was discovered that a machine purchased in 2014 had been expensed com- pletely in that year. This machine cost $28,000 and has a useful life of 10 years and no salvage value. Management has decided to use the double-declining-balance method for this machine, which can be referred to as “Machine E.” Instructions Prepare the necessary correcting entries for the year 2015. Record the appropriate depreciation expense on the above-mentioned machines. 2 3 P11-4 (Depreciation and Error Analysis) A depreciation schedule for semi-trucks of Ichiro Manufacturing Company was requested by your auditor soon after December 31, 2015, showing the additions, retirements, Problems 629 depreciation, and other data affecting the income of the company in the 4-year period 2012 to 2015, inclu- sive. The following data were ascertained. Balance of Trucks account, Jan. 1, 2012 Truck No. 1 purchased Jan. 1, 2009, cost $18,000 Truck No. 2 purchased July 1, 2009, cost 22,000 Truck No. 3 purchased Jan. 1, 2011, cost 30,000 Truck No. 4 purchased July 1, 2011, cost 24,000 Balance, Jan. 1, 2012 $94,000 The Accumulated Depreciation—Trucks account previously adjusted to January 1, 2012, and entered in the ledger, had a balance on that date of $30,200 (depreciation on the four trucks from the respective dates of purchase, based on a 5-year life, no salvage value). No charges had been made against the account before January 1, 2012.

Transactions between January 1, 2012, and December 31, 2015, which were recorded in the ledger, are as follows. July 1, 2012 Truck No. 3 was traded for a larger one (No. 5), the agreed purchase price of which was $40,000. Ichiro Mfg. Co. paid the automobile dealer $22,000 cash on the transaction. The entry was a debit to Trucks and a credit to Cash, $22,000. The transaction has commercial substance. Jan. 1, 2013 Truck No. 1 was sold for $3,500 cash; entry debited Cash and credited Trucks, $3,500. July 1, 2014 A new truck (No. 6) was acquired for $42,000 cash and was charged at that amount to the Trucks account. (Assume truck No. 2 was not retired.) July 1, 2014 Truck No. 4 was damaged in a wreck to such an extent that it was sold as junk for $700 cash. Ichiro Mfg. Co. received $2,500 from the insurance company. The entry made by the bookkeeper was a debit to Cash, $3,200, and credits to Miscellaneous Income, $700, and Trucks, $2,500. Entries for depreciation had been made at the close of each year as follows: 2012, $21,000; 2013, $22,500; 2014, $25,050; and 2015, $30,400. Instructions (a) For each of the 4 years, compute separately the increase or decrease in net income arising from the company’s errors in determining or entering depreciation or in recording transactions affecting trucks, ignoring income tax considerations. (b) Prepare one compound journal entry as of December 31, 2015, for adjustment of the Trucks account to reflect the correct balances as revealed by your schedule, assuming that the books have not been closed for 2015. 3 6 P11-5 (Depletion and Depreciation—Mining) Khamsah Mining Company has purchased a tract of mineral land for $900,000. It is estimated that this tract will yield 120,000 tons of ore with sufficient mineral content to make mining and processing profitable. It is further estimated that 6,000 tons of ore will be mined the first and last year and 12,000 tons every year in between. (Assume 11 years of mining opera- tions.) The land will have a salvage value of $30,000. The company builds necessary structures and sheds on the site at a cost of $36,000. It is estimated that these structures can serve 15 years but, because they must be dismantled if they are to be moved, they have no salvage value. The company does not intend to use the buildings elsewhere. Mining machinery installed at the mine was purchased secondhand at a cost of $60,000. This machinery cost the former owner $150,000 and was 50% depreciated when purchased. Khamsah Mining estimates that about half of this machinery will still be useful when the present mineral resources have been exhausted, but that dismantling and removal costs will just about offset its value at that time. The company does not intend to use the machinery else- where. The remaining machinery will last until about one-half the present estimated mineral ore has been removed and will then be worthless. Cost is to be allocated equally between these two classes of machinery. Instructions (a) As chief accountant for the company, you are to prepare a schedule showing estimated depletion and depreciation costs for each year of the expected life of the mine. (b) Also compute the depreciation and depletion for the first year assuming actual production of 5,000 tons. Nothing occurred during the year to cause the company engineers to change their estimates of either the mineral resources or the life of the structures and equipment. 6 P11-6 (Depletion, Timber, and Extraordinary Loss) Conan O’Brien Logging and Lumber Company owns 3,000 acres of timberland on the north side of Mount Leno, which was purchased in 2002 at a cost of $550 per acre. In 2014, O’Brien began selectively logging this timber tract. In May 2014, Mount Leno erupted, burying the timberland of O’Brien under a foot of ash. All of the timber on the O’Brien tract was downed. In addition, the logging roads, built at a cost of $150,000, were destroyed, as well as the logging equipment, with a net book value of $300,000. 630 Chapter 11 Depreciation, Impairments, and Depletion

At the time of the eruption, O’Brien had logged 20% of the estimated 500,000 board feet of timber. Prior to the eruption, O’Brien estimated the land to have a value of $200 per acre after the timber was harvested. O’Brien includes the logging roads in the depletion base. O’Brien estimates it will take 3 years to salvage the downed timber at a cost of $700,000. The timber can be sold for pulp wood at an estimated price of $3 per board foot. The value of the land is unknown, but must be considered nominal due to future uncertainties. Instructions (a) Determine the depletion cost per board foot for the timber harvested prior to the eruption of Mount Leno. (b) Prepare the journal entry to record the depletion prior to the eruption. (c) If this tract represents approximately half of the timber holdings of O’Brien, determine the amount of the extraordinary loss due to the eruption of Mount Leno for the year ended December 31, 2014. 6 P11-7 (Natural Resources—Timber) Bronson Paper Products purchased 10,000 acres of forested timber- land in March 2014. The company paid $1,700 per acre for this land, which was above the $800 per acre most farmers were paying for cleared land. During April, May, June, and July 2014, Bronson cut enough timber to build roads using moveable equipment purchased on April 1, 2014. The cost of the roads was $250,000, and the cost of the equipment was $225,000; this equipment was expected to have a $9,000 salvage value and would be used for the next 15 years. Bronson selected the straight-line method of depreciation for the moveable equipment. Bronson began actively harvesting timber in August and by December had harvested and sold 540,000 board feet of timber of the estimated 6,750,000 board feet available for cutting. In March 2015, Bronson planted new seedlings in the area harvested during the winter. Cost of plant- ing these seedlings was $120,000. In addition, Bronson spent $8,000 in road maintenance and $6,000 for pest spraying during calendar-year 2015. The road maintenance and spraying are annual costs. During 2015, Bronson harvested and sold 774,000 board feet of timber of the estimated 6,450,000 board feet avail- able for cutting. In March 2016, Bronson again planted new seedlings at a cost of $150,000, and also spent $15,000 on road maintenance and pest spraying. During 2016, the company harvested and sold 650,000 board feet of timber of the estimated 6,500,000 board feet available for cutting. Instructions Compute the amount of depreciation and depletion expense for each of the 3 years (2014, 2015, and 2016). Assume that the roads are usable only for logging and therefore are included in the depletion base. 2 3 P11-8 (Comprehensive Fixed-Asset Problem) Darby Sporting Goods Inc. has been experiencing growth in the demand for its products over the last several years. The last two Olympic Games greatly increased the popularity of basketball around the world. As a result, a European sports retailing consortium entered into an agreement with Darby’s Roundball Division to purchase basketballs and other accessories on an increasing basis over the next 5 years. To be able to meet the quantity commitments of this agreement, Darby had to obtain additional manu- facturing capacity. A real estate firm located an available factory in close proximity to Darby’s Roundball manufacturing facility, and Darby agreed to purchase the factory and used machinery from Encino Athletic Equipment Company on October 1, 2013. Renovations were necessary to convert the factory for Darby’s manufacturing use. The terms of the agreement required Darby to pay Encino $50,000 when renovations started on Janu- ary 1, 2014, with the balance to be paid as renovations were completed. The overall purchase price for the factory and machinery was $400,000. The building renovations were contracted to Malone Construction at $100,000. The payments made, as renovations progressed during 2014, are shown below. The factory was placed in service on January 1, 2015. 1/1 4/1 10/1 12/31 Encino $50,000 $90,000 $110,000 $150,000

Malone 30,000 30,000 40,000 On January 1, 2014, Darby secured a $500,000 line-of-credit with a 12% interest rate to finance the pur- chase cost of the factory and machinery, and the renovation costs. Darby drew down on the line-of-credit to meet the payment schedule shown above; this was Darby’s only outstanding loan during 2014. Bob Sprague, Darby’s controller, will capitalize the maximum allowable interest costs for this project. Darby’s policy regarding purchases of this nature is to use the appraisal value of the land for book pur- poses and prorate the balance of the purchase price over the remaining items. The building had originally cost Encino $300,000 and had a net book value of $50,000, while the machinery originally cost $125,000 and had a net book value of $40,000 on the date of sale. The land was recorded on Encino’s books at $40,000. An appraisal, conducted by independent appraisers at the time of acquisition, valued the land at $290,000, the building at $105,000, and the machinery at $45,000. Problems 631 Angie Justice, chief engineer, estimated that the renovated plant would be used for 15 years, with an estimated salvage value of $30,000. Justice estimated that the productive machinery would have a remain- ing useful life of 5 years and a salvage value of $3,000. Darby’s depreciation policy specifies the 200% declining-balance method for machinery and the 150% declining-balance method for the plant. One-half year’s depreciation is taken in the year the plant is placed in service, and one-half year is allowed when the property is disposed of or retired. Darby uses a 360-day year for calculating interest costs. Instructions (a) Determine the amounts to be recorded on the books of Darby Sporting Goods Inc. as of December 31, 2014, for each of the following properties acquired from Encino Athletic Equipment Company. (1) Land. (2) Buildings. (3) Machinery. (b) Calculate Darby Sporting Goods Inc.’s 2015 depreciation expense, for book purposes, for each of the properties acquired from Encino Athletic Equipment Company. (c) Discuss the arguments for and against the capitalization of interest costs. (CMA adapted) 5 P11-9 (Impairment) Roland Company uses special strapping equipment in its packaging business. The equipment was purchased in January 2013 for $10,000,000 and had an estimated useful life of 8 years with no salvage value. At December 31, 2014, new technology was introduced that would accelerate the obso- lescence of Roland’s equipment. Roland’s controller estimates that expected future net cash flows on the equipment will be $6,300,000 and that the fair value of the equipment is $5,600,000. Roland intends to con- tinue using the equipment, but it is estimated that the remaining useful life is 4 years. Roland uses straight- line depreciation. Instructions (a) Prepare the journal entry (if any) to record the impairment at December 31, 2014. (b) Prepare any journal entries for the equipment at December 31, 2015. The fair value of the equipment at December 31, 2015, is estimated to be $5,900,000. (c) Repeat the requirements for (a) and (b), assuming that Roland intends to dispose of the equipment and that it has not been disposed of as of December 31, 2015. 2 3 P11-10 (Comprehensive Depreciation Computations) Kohlbeck Corporation, a manufacturer of steel products, began operations on October 1, 2013. The accounting department of Kohlbeck has started the fixed-asset and depreciation schedule presented on page 632. You have been asked to assist in completing this schedule. In addition to ascertaining that the data already on the schedule are correct, you have obtained the following information from the company’s records and personnel. 1. Depreciation is computed from the first of the month of acquisition to the first of the month of disposition. 2. Land A and Building A were acquired from a predecessor corporation. Kohlbeck paid $800,000 for the land and building together. At the time of acquisition, the land had an appraised value of $90,000, and the building had an appraised value of $810,000.

3. Land B was acquired on October 2, 2013, in exchange for 2,500 newly issued shares of Kohlbeck’s common stock. At the date of acquisition, the stock had a par value of $5 per share and a fair value of $30 per share. During October 2013, Kohlbeck paid $16,000 to demolish an existing building on this land so it could construct a new building. 4. Construction of Building B on the newly acquired land began on October 1, 2014. By September 30, 2015, Kohlbeck had paid $320,000 of the estimated total construction costs of $450,000. It is esti- mated that the building will be completed and occupied by July 2016. 5. Certain equipment was donated to the corporation by a local university. An independent appraisal of the equipment when donated placed the fair value at $40,000 and the salvage value at $3,000. 6. Machinery A’s total cost of $182,900 includes installation expense of $600 and normal repairs and maintenance of $14,900. Salvage value is estimated at $6,000. Machinery A was sold on February 1, 2015. 7. On October 1, 2014, Machinery B was acquired with a down payment of $5,740 and the remaining payments to be made in 11 annual installments of $6,000 each beginning October 1, 2014. The prevailing interest rate was 8%. The following data were abstracted from present value tables (rounded). Present value of $1.00 at 8% Present value of an ordinary annuity of $1.00 at 8% 10 years .463 10 years 6.710 11 years .429 11 years 7.139 15 years .315 15 years 8.559 632 Chapter 11 Depreciation, Impairments, and Depletion KOHLBECK CORPORATION Fixed-Asset and Depreciation Schedule For Fiscal Years Ended September 30, 2014, and September 30, 2015 Depreciation Expense Year Ended Estimated September 30 Acquisition Depreciation Life in Assets Date Cost Salvage Method Years 2014 2015 Land A October 1, 2013 $ (1) N/A* N/A N/A N/A N/A Building A October 1, 2013 (2) $40,000 Straight-line (3) $13,600 (4) Land B October 2, 2013 (5) N/A N/A N/A N/A N/A Building B Under $320,000 — Straight-line 30 — (6) Construction to date Donated Equipment October 2, 2013 (7) 3,000 150% declining- 10 (8) (9) balance Machinery A October 2, 2013 (10) 6,000 Sum-of-the- 8 (11) (12) years’-digits Machinery B October 1, 2014 (13) — Straight-line 20 — (14) *N/A—Not applicable Instructions For each numbered item on the schedule above, supply the correct amount. (Round each answer to the nearest dollar.) 2 3 P11-11 (Depreciation for Partial Periods—SL, Act., SYD, and DDB) On January 1, 2012, a machine was purchased for $90,000. The machine has an estimated salvage value of $6,000 and an estimated useful life of 5 years. The machine can operate for 100,000 hours before it needs to be replaced. The company closed its books on December 31 and operates the machine as follows: 2012, 20,000 hours; 2013, 25,000 hours; 2014, 15,000 hours; 2015, 30,000 hours; and 2016, 10,000 hours. Instructions (a) Compute the annual depreciation charges over the machine’s life assuming a December 31 year-end for each of the following depreciation methods. (1) Straight-line method. (3) Sum-of-the-years’-digits method. (2) Activity method. (4) Double-declining-balance method. (b) Assume a fiscal year-end of September 30. Compute the annual depreciation charges over the asset’s life applying each of the following methods. (1) Straight-line method. (3) Double-declining-balance method. (2) Sum-of-the-years’-digits method. 2 3 * P11-12 (Depreciation—SL, DDB, SYD, Act., and MACRS) On January 1, 2013, Locke Company, a 8 small machine-tool manufacturer, acquired for $1,260,000 a piece of new industrial equipment. The new equipment had a useful life of 5 years, and the salvage value was estimated to be $60,000. Locke estimates that the new equipment can produce 12,000 machine tools in its first year. It esti- mates that production will decline by 1,000 units per year over the remaining useful life of the equipment. The following depreciation methods may be used: (1) straight-line, (2) double-declining-balance, (3) sum-of-the-years’-digits, and (4) units-of-output. For tax purposes, the class life is 7 years. Use the

MACRS tables for computing depreciation. Instructions (a) Which depreciation method would maximize net income for financial statement reporting for the 3-year period ending December 31, 2015? Prepare a schedule showing the amount of accumulated depreciation at December 31, 2015, under the method selected. Ignore present value, income tax, and deferred income tax considerations. (b) Which depreciation method (MACRS or optional straight-line) would minimize net income for income tax reporting for the 3-year period ending December 31, 2015? Determine the amount of accumulated depreciation at December 31, 2015. Ignore present value considerations. (AICPA adapted) Concepts for Analysis 633 PROBLEMS SET B See the book’s companion website, at www.wiley.com/college/kieso, for an additional set of problems. CONCEPTS FOR ANALYSIS CA11-1 (Depreciation Basic Concepts) Burnitz Manufacturing Company was organized on January 1, 2014. During 2014, it has used in its reports to management the straight-line method of depreciating its plant assets. On November 8, you are having a conference with Burnitz’s officers to discuss the depreciation method to be used for income tax and stockholder reporting. James Bryant, president of Burnitz, has sug- gested the use of a new method, which he feels is more suitable than the straight-line method for the needs of the company during the period of rapid expansion of production and capacity that he foresees. Follow- ing is an example in which the proposed method is applied to a fixed asset with an original cost of $248,000, an estimated useful life of 5 years, and a salvage value of approximately $8,000. Accumulated Years of Depreciation Book Value Life Fraction Depreciation at End at End Year Used Rate Expense of Year of Year 1 1 1/15 $16,000 $ 16,000 $232,000 2 2 2/15 32,000 48,000 200,000 3 3 3/15 48,000 96,000 152,000 4 4 4/15 64,000 160,000 88,000 5 5 5/15 80,000 240,000 8,000 The president favors the new method because he has heard that: 1. It will increase the funds recovered during the years near the end of the assets’ useful lives when maintenance and replacement disbursements are high. 2. It will result in increased write-offs in later years and thereby will reduce taxes. Instructions (a) What is the purpose of accounting for depreciation? (b) Is the president’s proposal within the scope of generally accepted accounting principles? In making your decision, discuss the circumstances, if any, under which use of the method would be reason- able and those, if any, under which it would not be reasonable. (c) The president wants your advice on the following issues. (1) Do depreciation charges recover or create funds? Explain. (2) A ssume that the Internal Revenue Service accepts the proposed depreciation method in this case. If the proposed method were used for stockholder and tax reporting purposes, how would it affect the availability of cash flows generated by operations? CA11-2 (Unit, Group, and Composite Depreciation) The certified public accountant is frequently called upon by management for advice regarding methods of computing depreciation. Of comparable impor- tance, although it arises less frequently, is the question of whether the depreciation method should be based on consideration of the assets as units, as a group, or as having a composite life. Instructions (a) Briefly describe the depreciation methods based on treating assets as (1) units and (2) a group or as having a composite life. (b) Present the arguments for and against the use of each of the two methods. (c) Describe how retirements are recorded under each of the two methods. (AICPA adapted) CA11-3 (Depreciation—Strike, Units-of-Production, Obsolescence) Presented on page 634 are three d ifferent and unrelated situations involving depreciation accounting. Answer the question(s) at the end of each situation. 634 Chapter 11 Depreciation, Impairments, and Depletion Situation I: Recently, Broderick Company experienced a strike that affected a number of its operating plants. The controller of this company indicated that it was not appropriate to report depreciation expense

during this period because the equipment did not depreciate and an improper matching of costs and revenues would result. She based her position on the following points. 1. It is inappropriate to charge the period with costs for which there are no related revenues arising from production. 2. The basic factor of depreciation in this instance is wear and tear. Because equipment was idle, no wear and tear occurred. Instructions Comment on the appropriateness of the controller’s comments. Situation II: Etheridge Company manufactures electrical appliances, most of which are used in homes. Company engineers have designed a new type of blender which, through the use of a few attachments, will perform more functions than any blender currently on the market. Demand for the new blender can be projected with reasonable probability. In order to make the blenders, Etheridge needs a specialized ma- chine that is not available from outside sources. It has been decided to make such a machine in Etheridge’s own plant. Instructions (a) Discuss the effect of projected demand in units for the new blenders (which may be steady, decreas- ing, or increasing) on the determination of a depreciation method for the machine. (b) What other matters should be considered in determining the depreciation method? (Ignore income tax considerations.) Situation III: Haley Paper Company operates a 300-ton-per-day kraft pulp mill and four sawmills in Wisconsin. The company is in the process of expanding its pulp mill facilities to a capacity of 1,000 tons per day and plans to replace three of its older, less efficient sawmills with an expanded facility. One of the mills to be replaced did not operate for most of 2014 (current year), and there are no plans to reopen it before the new sawmill facility becomes operational. In reviewing the depreciation rates and in discussing the salvage values of the sawmills that were to be replaced, it was noted that if present depreciation rates were not adjusted, substantial amounts of plant costs on these three mills would not be depreciated by the time the new mill came on stream. Instructions What is the proper accounting for the four sawmills at the end of 2014? CA11-4 (Depreciation Concepts) As a cost accountant for San Francisco Cannery, you have been ap- proached by Phil Perriman, canning room supervisor, about the 2014 costs charged to his department. In particular, he is concerned about the line item “depreciation.” Perriman is very proud of the excellent con- dition of his canning room equipment. He has always been vigilant about keeping all equipment serviced and well oiled. He is sure that the huge charge to depreciation is a mistake; it does not at all reflect the cost of minimal wear and tear that the machines have experienced over the last year. He believes that the charge should be considerably lower. The machines being depreciated are six automatic canning machines. All were put into use on January 1, 2014. Each cost $625,000, having a salvage value of $55,000 and a useful life of 12 years. San Francisco depreciates this and similar assets using double-declining-balance depreciation. Perriman has also pointed out that if you used straight-line depreciation, the charge to his department would not be so great. Instructions Write a memo to Phil Perriman to clear up his misunderstanding of the term “depreciation.” Also, calculate year-1 depreciation on all machines using both methods. Explain the theoretical justification for double- declining-balance and why, in the long run, the aggregate charge to depreciation will be the same under both methods. CA11-5 (Depreciation Choice—Ethics) Jerry Prior, Beeler Corporation’s controller, is concerned that net income may be lower this year. He is afraid upper-level management might recommend cost reductions by laying off accounting staff, including him. Prior knows that depreciation is a major expense for Beeler. The company currently uses the double- declining-balance method for both financial reporting and tax purposes, and he’s thinking of selling equip-

ment that, given its age, is primarily used when there are periodic spikes in demand. The equipment has a carrying value of $2,000,000 and a fair value of $2,180,000. The gain on the sale would be reported in the income statement. He doesn’t want to highlight this method of increasing income. He thinks, “Why don’t I increase the estimated useful lives and the salvage values? That will decrease depreciation expense and Using Your Judgment 635 require less extensive disclosure, since the changes are accounted for prospectively. I may be able to save my job and those of my staff.” Instructions Answer the following questions. (a) Who are the stakeholders in this situation? (b) What are the ethical issues involved? (c) What should Prior do? USING YOUR JUDGMENT FINANCIAL REPORTING Financial Reporting Problem The Procter & Gamble Company (P&G) The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report, including the notes to the financial statements, can be accessed at the book’s companion website, www. wiley.com/college/kieso. Instructions Refer to P&G’s financial statements and the accompanying notes to answer the following questions. (a) What descriptions are used by P&G in its balance sheet to classify its property, plant, and equipment? (b) What method or methods of depreciation does P&G use to depreciate its property, plant, and equipment? (c) Over what estimated useful lives does P&G depreciate its property, plant, and equipment? (d) What amounts for depreciation and amortization expense did P&G charge to its income statement in 2011, 2010, and 2009? (e) What were the capital expenditures for property, plant, and equipment made by P&G in 2011, 2010, and 2009? Comparative Analysis Case The Coca-Cola Company and PepsiCo., Inc. Instructions Go to the book’s companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc. (a) What amount is reported in the balance sheets as property, plant, and equipment (net) of Coca-Cola at December 31, 2011, and of PepsiCo at December 31, 2011? What percentage of total assets is invested in property, plant, and equipment by each company? (b) What depreciation methods are used by Coca-Cola and PepsiCo for property, plant, and equipment? How much depreciation was reported by Coca-Cola and PepsiCo in 2011? In 2010? (c) Compute and compare the following ratios for Coca-Cola and PepsiCo for 2011. (1) Asset turnover. (2) Profit margin on sales. (3) Return on assets. (d) What amount was spent in 2011 for capital expenditures by Coca-Cola and PepsiCo? What amount of interest was capitalized in 2011? Financial Statement Analysis Case McDonald’s Corporation McDonald’s is the largest and best-known global food-service retailer, with more than 32,000 restaurants in 118 countries. On any day, McDonald’s serves approximately 1 percent of the world’s population. Pre- sented on the next page is information related to McDonald’s property and equipment. 636 Chapter 11 Depreciation, Impairments, and Depletion McDonald’s Corporation Summary of Significant Accounting Policies Section Property and Equipment. Property and equipment are stated at cost, with depreciation and amortization provided using the straight-line method over the following estimated useful lives: buildings—up to 40 years; leasehold improvements—the lesser of useful lives of assets or lease terms, which generally include option periods; and equipment—three to 12 years. [In the notes to the financial statements:] Property and Equipment Net property and equipment consisted of: December 31 (In millions) 2011 2010 Land $ 5,328.3 $ 5,200.5 Buildings and improvements on owned land 13,079.9 12,399.4 Buildings and improvements on leased land 12,021.8 11,732.0 Equipment, signs and seating 4,757.2 4,608.5 Other 550.4 542.0 35,737.6 34,482.4 Accumulated depreciation and amortization (12,903.1) (12,421.8) Net property and equipment $22,834.5 $22,060.6 Depreciation and amortization expense was (in millions): 2011—$1,329.6; 2010—$1,200.4;

2009—$1,160.8. [In its 6-year summary, McDonald’s provides the following information.] Cash Provided by Operations (dollars in millions) 2011 2010 2009 Cash provided by operations $7,150 $6,342 $5,751 Capital expenditures $2,730 $2,135 $1,952 Instructions (a) What method of depreciation does McDonald’s use? (b) Does depreciation and amortization expense cause cash flow from operations to increase? Explain. (c) What does the schedule of cash flow measures indicate? Accounting, Analysis, and Principles Electroboy Enterprises, Inc. operates several stores throughout the western United States. As part of an operational and financial reporting review in a response to a downturn in its markets, the company’s management has decided to perform an impairment test on five stores (combined). The five stores’ sales have declined due to aging facilities and competition from a rival that opened new stores in the same markets. Management has developed the following information concerning the five stores as of the end of fiscal 2013. Original cost $36 million Accumulated depreciation $10 million Estimated remaining useful life 4 years Estimated expected future annual cash fl ows (not discounted) $4.0 million per year Appropriate discount rate 5 percent Accounting (a) Determine the amount of impairment loss, if any, that Electroboy should report for fiscal 2013 and the book value at which Electroboy should report the five stores on its fiscal year-end 2013 balance sheet. Assume that the cash flows occur at the end of each year. (b) Repeat part (a), but instead assume that (1) the estimated remaining useful life is 10 years, (2) the estimated annual cash flows are $2,720,000 per year, and (3) the appropriate discount rate is 6 percent. IFRS Insights 637 Analysis Assume that you are a financial analyst and you participate in a conference call with Electroboy manage- ment in early 2014 (before Electroboy closes the books on fiscal 2013). During the conference call, you learn that management is considering selling the five stores, but the sale won’t likely be completed until the second quarter of fiscal 2014. Briefly discuss what implications this would have for Electroboy’s 2013 finan- cial statements. Assume the same facts as in part (b) above. Principles Electroboy management would like to know the accounting for the impaired asset in periods subsequent to the impairment. Can the assets be written back up? Briefly discuss the conceptual arguments for this accounting. BRIDGE TO THE PROFESSION Professional Research: FASB Codifi cation Matt Holmes recently joined Klax Company as a staff accountant in the controller’s office. Klax Company provides warehousing services for companies in several midwestern cities. The location in Dubuque, Iowa, has not been performing well due to increased competition and the loss of several customers that have recently gone out of business. Matt’s department manager suspects that the plant and equipment may be impaired and wonders whether those assets should be written down. Given the company’s prior success, this issue has never arisen in the past, and Matt has been asked to con- duct some research on this issue. Instructions If your school has a subscription to the FASB Codification, go to http://aaahq.org/asclogin.cfm to log in and prepare responses to the following. Provide Codification references for your responses. (a) What is the authoritative guidance for asset impairments? Briefly discuss the scope of the standard (i.e., explain the types of transactions to which the standard applies). (b) Give several examples of events that would cause an asset to be tested for impairment. Does it appear that Klax should perform an impairment test? Explain. (c) What is the best evidence of fair value? Describe alternate methods of estimating fair value. Additional Professional Resources See the book’s companion website, at www.wiley.com/college/kieso, for professional simulations as well as other study resources. IFRS INSIGHTS GAAP adheres to many of the same principles of IFRS in the accounting for prop-

9 LEARNING OBJECTIVE erty, plant, and equipment. Major differences relate to use of component deprecia- Compare the accounting for property, tion, impairments, and revaluations. plant, and equipment under GAAP and IFRS. RELEVANT FACTS Following are the key similarities and differences between GAAP and IFRS related to property, plant, and equipment. Similarities • The defi nition of property, plant, and equipment is essentially the same under GAAP and IFRS. 638 Chapter 11 Depreciation, Impairments, and Depletion • Under both GAAP and IFRS, changes in depreciation method and changes in useful life are treated in the current and future periods. Prior periods are not affected. • The accounting for plant asset disposals is the same under GAAP and IFRS. • The accounting for the initial costs to acquire natural resources is similar under GAAP and IFRS. • Under both GAAP and IFRS, interest costs incurred during construction must be capitalized. Recently, IFRS converged to GAAP. • The accounting for exchanges of non-monetary assets is essentially the same between IFRS and GAAP. GAAP requires that gains on exchanges of non-monetary assets be recognized if the exchange has commercial substance. This is the same framework used in IFRS. • GAAP and IFRS both view depreciation as allocation of cost over an asset’s life. GAAP permits the same depreciation methods (straight-line, diminishing-balance, units-of- production) as IFRS. Differences • IFRS requires component depreciation. Under GAAP, component depreciation is permitted but is rarely used. • Under IFRS, companies can use either the historical cost model or the revaluation model. GAAP does not permit revaluations of property, plant, and equipment or mineral resources. • In testing for impairments of long-lived assets, GAAP uses a different model than IFRS to test for impairments (details of the IFRS impairment test is presented in the About the Numbers discussion). As long as future undiscounted cash fl ows ex- ceed the carrying amount of the asset, no impairment is recorded. The IFRS im- pairment test is stricter. However, unlike GAAP, reversals of impairment losses are permitted. ABOUT THE NUMBERS Component Depreciation Under IFRS, companies are required to use component depreciation. IFRS requires that each part of an item of property, plant, and equipment that is significant to the total cost of the asset must be depreciated separately. Companies therefore have to exercise judg- ment to determine the proper allocations to the components. As an example, when a company like Nokia purchases a building, it must determine how the various building components (e.g., the foundation, structure, roof, heating and cooling system, and elevators) should be segregated and depreciated. To illustrate the accounting for component depreciation, assume that EuroAsia Airlines purchases an airplane for $100,000,000 on January 1, 2014. The airplane has a useful life of 20 years and a residual value of $0. EuroAsia uses the straight-line method of depreciation for all its airplanes. EuroAsia identifies the following components, amounts, and useful lives, as shown in Illustration IFRS11-1. ILLUSTRATION Components Component Amount Component Useful Life IFRS11-1 Airframe $60,000,000 20 years Airplane Components Engine components 32,000,000 8 years Other components 8,000,000 5 years IFRS Insights 639 Illustration IFRS11-2 shows the computation of depreciation expense for EuroAsia for 2014. ILLUSTRATION Components Component Amount 4 Useful Life 5 Component Depreciation IFRS11-2 Airframe $ 60,000,000 20 $3,000,000 Computation of Engine components 32,000,000 8 4,000,000 Component Depreciation Other components 8,000,000 5 1,600,000 Total $100,000,000 $8,600,000 As indicated, EuroAsia records depreciation expense of $8,600,000 in 2014 as follows. Depreciation Expense 8,600,000 Accumulated Depreciation—Airplane 8,600,000 On the statement of financial position at the end of 2014, EuroAsia reports the air- plane as a single amount. The presentation is shown in Illustration IFRS11-3. ILLUSTRATION

Non-current assets IFRS11-3 Airplane $100,000,000 Less: Accumulated depreciation—airplane 8,600,000 Presentation of Carrying Amount of Airplane $ 91,400,000 In many situations, a company may not have a good understanding of the cost of the individual components purchased. In that case, the cost of individual components should be estimated based on reference to current market prices (if available), discus- sion with experts in valuation, or use of other reasonable approaches. Recognizing Impairments As discussed in the textbook, the credit crisis starting in late 2008 has affected many financial and non-financial institutions. As a result of this global slump, many com- panies are considering write-offs of some of their long-lived assets. These write-offs are referred to as impairments. The accounting for impairments is different under GAAP and IFRS. A long-lived tangible asset is impaired when a company is not able to recover the asset’s carrying amount either through using it or by selling it. To determine whether an asset is impaired, on an annual basis, companies review the asset for indicators of impairments—that is, a decline in the asset’s cash-generating ability through use or sale. This review should consider internal sources (e.g., adverse changes in perfor- mance) and external sources (e.g., adverse changes in the business or regulatory envi- ronment) of information. If impairment indicators are present, then an impairment test must be conducted. This test compares the asset’s recoverable amount with its car- rying amount. If the carrying amount is higher than the recoverable amount, the differ- ence is an impairment loss. If the recoverable amount is greater than the carrying amount, no impairment is recorded. Recoverable amount is defined as the higher of fair value less costs to sell or value- in-use. Fair value less costs to sell means what the asset could be sold for after deduct- ing costs of disposal. Value-in-use is the present value of cash flows expected from the future use and eventual sale of the asset at the end of its useful life. Illustration IFRS11-4 (page 640) highlights the nature of the impairment test. 640 Chapter 11 Depreciation, Impairments, and Depletion ILLUSTRATION IFRS11-4 Carrying Recoverable Compared to Impairment Test Amount Amount Higher of Fair Value Less Value-in-Use Costs to Sell If either the fair value less costs to sell or value-in-use is higher than the carrying amount, there is no impairment. If both the fair value less costs to sell and value-in-use are lower than the carrying amount, a loss on impairment occurs. Example: No Impairment Assume that Cruz Company performs an impairment test for its equipment. The carrying amount of Cruz’s equipment is $200,000, its fair value less costs to sell is $180,000, and its value-in-use is $205,000. In this case, the value-in-use of Cruz’s equipment is higher than its carrying amount of $200,000. As a result, there is no impairment. (If a company can more readily determine value-in-use (or fair value less costs to sell) and it determines that no impairment is needed, it is not required to compute the other measure.) Example: Impairment Assume the same information for Cruz Company above except that the value-in-use of Cruz’s equipment is $175,000 rather than $205,000. Cruz measures the impairment loss as the difference between the carrying amount of $200,000 and the higher of fair value less costs to sell ($180,000) or value-in-use ($175,000). Cruz therefore uses the fair value less cost of disposal to record an impairment loss of $20,000 ($200,000 2 $180,000). Cruz makes the following entry to record the impairment loss. Loss on Impairment 20,000 Accumulated Depreciation—Equipment 20,000 Loss on Impairment is reported in the income statement in the “Other income and expense” section. The company then either credits Equipment or Accumulated Depreciation—Equipment to reduce the carrying amount of the equipment for the impairment. For purposes of homework, credit accumulated depreciation when recording an impairment for a depreciable asset.

Reversal of Impairment Loss After recording the impairment loss, the recoverable amount becomes the basis of the impaired asset. What happens if a review in a future year indicates that the asset is no longer impaired because the recoverable amount of the asset is higher than the carrying amount? In that case, the impairment loss may be reversed. To illustrate, assume that Tan Company purchases equipment on January 1, 2014, for $300,000, with a useful life of three years, and no residual value. Its depreciation and related carrying amount over the three years is as follows. Year Depreciation Expense Carrying Amount 2014 $100,000 ($300,000/3) $200,000 2015 $100,000 ($300,000/3) $100,000 2016 $100,000 ($300,000/3) 0 IFRS Insights 641 At December 31, 2014, Tan determines it has an impairment loss of $20,000 and therefore makes the following entry. Loss on Impairment 20,000 Accumulated Depreciation—Equipment 20,000 Tan’s depreciation expense and related carrying amount after the impairment is as indicated in Illustration IFRS11-5. ILLUSTRATION Year Depreciation Expense Carrying Amount IFRS11-5 2015 $90,000 ($180,000/2) $90,000 Carrying Value of 2016 $90,000 ($180,000/2) 0 Impaired Asset At the end of 2015, Tan determines that the recoverable amount of the equipment is $96,000, which is greater than its carrying amount of $90,000. In this case, Tan reverses the previously recognized impairment loss with the following entry. Accumulated Depreciation—Equipment 6,000 Recovery of Loss from Impairment 6,000 The recovery of the impairment loss is reported in the “Other income and expense” sec- tion of the income statement. The carrying amount of Tan’s equipment is now $96,000 ($90,000 1 $6,000) at December 31, 2015. The general rule related to reversals of impair- ments is as follows. The amount of the recovery of the loss is limited to the carrying amount that would result if the impairment had not occurred. For example, the carrying amount of Tan’s equipment at the end of 2015 would be $100,000, assuming no impair- ment. The $6,000 recovery is therefore permitted because Tan’s carrying amount on the equipment is now only $96,000. However, any recovery above $10,000 is not permitted. The reason is that any recov- ery above $10,000 results in Tan carrying the asset at a value above its historical cost. Revaluations Up to this point, we have assumed that companies use the historical cost principle to value long-lived tangible assets after acquisition. However, under IFRS companies have a choice. They may value these assets at cost or at fair value. Recognizing Revaluations Network Rail (a company in Great Britain) is an example of a company that elected to use fair values to account for its railroad network. Its use of fair value led to an increase of £4,289 million to its long-lived tangible assets. When companies choose to fair value their long-lived tangible assets subsequent to acquisition, they account for the change in the fair value by adjusting the appropriate asset account and establishing an unrealized gain on the revalued long-lived tangible asset. This unrealized gain is often referred to as revaluation surplus. Revaluation—Land. To illustrate revaluation of land, assume that Siemens Group purchased land for $1,000,000 on January 5, 2014. The company elects to use revaluation accounting for the land in subsequent periods. At December 31, 2014, the land’s fair value is $1,200,000. The entry to record the land at fair value is as follows. Land 200,000 Unrealized Gain on Revaluation (land) 200,000 The land is reported on the statement of financial position at $1,200,000, and Unrealized Gain on Revaluation (land) increases other comprehensive income in the statement of 642 Chapter 11 Depreciation, Impairments, and Depletion comprehensive income. In addition, if this is the only revaluation adjustment to date, the statement of financial position reports accumulated other comprehensive income of $200,000. Revaluation—Depreciable Assets. To illustrate the accounting for revaluations of depreciable assets, assume that Lenovo Group purchases equipment for $500,000 on

January 2, 2014. The equipment has a useful life of five years, is depreciated using the straight-line method of depreciation, and its residual value is zero. Lenovo chooses to revalue its equipment to fair value over the life of the equipment. Lenovo records depreciation expense of $100,000 ($500,000 4 5) at December 31, 2014, as follows. December 31, 2014 Depreciation Expense 100,000 Accumulated Depreciation—Equipment 100,000 (To record depreciation expense in 2014) After this entry, Lenovo’s equipment has a carrying amount of $400,000 ($500,000 2 $100,000). Lenovo receives an independent appraisal for the fair value of equipment at December 31, 2014, which is $460,000. To report the equipment at fair value, Lenovo does the following. 1. Reduces the Accumulated Depreciation—Equipment account to zero. 2. Reduces the Equipment account by $40,000—it then is reported at its fair value of $460,000. 3. Records Unrealized Gain on Revaluation (equipment) for the difference between the fair value and carrying amount of the equipment, or $60,000 ($460,000 2 $400,000). The entry to record this revaluation at December 31, 2014, is as follows. December 31, 2014 Accumulated Depreciation—Equipment 100,000 Equipment 40,000 Unrealized Gain on Revaluation (equipment) 60,000 (To adjust the equipment to fair value and record revaluation increase) The equipment is now reported at its fair value of $460,000 ($500,000 2 $40,000). As an alternative to the one shown here, companies restate on a proportionate basis the cost and accumulated depreciation of the asset, such that the carrying amount of the asset after revaluation equals its revalued amount. The increase in the fair value of $60,000 is reported on the statement of comprehen- sive income as other comprehensive income. In addition, the ending balance is reported in accumulated other comprehensive income on the statement of financial position in the equity section. Illustration IFRS11-6 shows the presentation of revaluation elements. ILLUSTRATION On the statement of comprehensive income: IFRS11-6 Depreciation expense $100,000 Financial Statement Other comprehensive income Presentation— Unrealized gain on revaluation (equipment) $ 60,000 Revaluations On the statement of financial position: Non-current assets Equipment ($500,000 2 $40,000) $460,000 Accumulated depreciation—equipment ($100,000 2 $100,000) –0– Carrying amount $460,000 Equity Accumulated other comprehensive income $ 60,000 IFRS Insights 643 As indicated, at December 31, 2014, the carrying amount of the equipment is now $460,000. Lenovo reports depreciation expense of $100,000 in the income statement and Unrealized Gain on Revaluation (equipment) of $60,000 in “Other comprehensive income.” Assuming no change in the useful life of the equipment, depreciation in 2015 is $115,000 ($460,000 4 4). In summary, a revaluation increase generally goes to equity. A revaluation decrease is reported as an expense (as an impairment loss), unless it offsets previously recorded revaluation increases. If the revaluation increase offsets a revaluation decrease that went to expense, then the increase is reported in income. Under no circumstances can the Accumulated Other Comprehensive Income account related to revaluations have a negative balance. ON THE HORIZON With respect to revaluations, as part of the conceptual framework project, the Boards will examine the measurement bases used in accounting. It is too early to say whether a converged conceptual framework will recommend fair value measurement (and revalu- ation accounting) for property, plant, and equipment. However, this is likely to be one of the more contentious issues, given the long-standing use of historical cost as a mea- surement basis in GAAP. IFRS SELF-TEST QUESTIONS 1. Mandall Company constructed a warehouse for $280,000 on January 2, 2014. Mandall estimates that the warehouse has a useful life of 20 years and no residual value. Construction records indicate that $40,000 of the cost of the warehouse relates to its heating, ventilation, and air conditioning (HVAC)

system, which has an estimated useful life of only 10 years. What is the first year of depreciation expense using straight-line component depreciation under IFRS? (a) $28,000. (c) $16,000. (b) $14,000. (d) $4,000. 2. Francisco Corporation is constructing a new building at a total initial cost of $10,000,000. The build- ing is expected to have a useful life of 50 years with no residual value. The building’s finished sur- faces (e.g., roof cover and floor cover) are 5% of this cost and have a useful life of 20 years. Building services systems (e.g., electric, heating, and plumbing) are 20% of the cost and have a useful life of 25 years. The depreciation in the first year using component depreciation, assuming straight-line depreciation with no residual value, is: (a) $200,000. (c) $255,000. (b) $215,000. (d) None of the above. 3. Which of the following statements is correct? (a) Both IFRS and GAAP permit revaluation of property, plant, and equipment. (b) IFRS permits revaluation of property, plant, and equipment but not GAAP. (c) Both IFRS and GAAP do not permit revaluation of property, plant, and equipment. (d) GAAP permits revaluation of property, plant, and equipment but not IFRS. 4. Hilo Company has land that cost $350,000 but now has a fair value of $500,000. Hilo Company d ecides to use the revaluation method specified in IFRS to account for the land. Which of the following statements is correct? (a) Hilo Company must continue to report the land at $350,000. (b) Hilo Company would report a net income increase of $150,000 due to an increase in the value of the land. (c) Hilo Company would debit Revaluation Surplus for $150,000. (d) Hilo Company would credit Revaluation Surplus by $150,000. 5. Under IFRS, value-in-use is defined as: (a) net realizable value. (b) fair value. (c) future cash flows discounted to present value. (d) total future undiscounted cash flows. 644 Chapter 11 Depreciation, Impairments, and Depletion IFRS CONCEPTS AND APPLICATION IFRS11-1 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. IFRS11-2 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? IFRS11-3 Toro Co. has equipment with a carrying amount of $700,000. The value-in-use of the equipment is $705,000, and its fair value less costs of disposal 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? IFRS11-4 Explain how gains or losses on impaired assets should be reported in income. IFRS11-5 Tanaka Company has land that cost $15,000,000. Its fair value on December 31, 2014, is $20,000,000. Tanaka chooses the revaluation model to report its land. Explain how the land and its related valuation should be reported. IFRS11-6 Why might a company choose not to use revaluation accounting? IFRS11-7 Ortiz purchased a piece of equipment that cost $202,000 on January 1, 2014. The equipment has the following components. Component Cost Residual Value Estimated Useful Life A $70,000 $7,000 10 years B 50,000 5,000 5 years C 82,000 4,000 12 years Compute the depreciation expense for this equipment at December 31, 2014. IFRS11-8 Tan Chin Company purchases a building for $11,300,000 on January 2, 2014. An engineer’s report shows that of the total purchase price, $11,000,000 should be allocated to the building (with a 40-year life), $150,000 to 15-year property, and $150,000 to 5-year property. No residual (salvage) value should be considered. Compute depreciation expense for 2014 using component depreciation. IFRS11-9 Brazil Group purchases a vehicle at a cost of $50,000 on January 2, 2014. Individual components of the vehicle and useful lives are as follows. Cost Useful Lives Tires $ 6,000 2 years Transmission 10,000 5 years Trucks 34,000 10 years Instructions (Assume no residual (salvage) value.)

(a) Compute depreciation expense for 2014, assuming Brazil depreciates the vehicle as a single unit. (b) Compute depreciation expense for 2014, assuming Brazil uses component depreciation. (c) Why might a company want to use component depreciation to depreciate its assets? IFRS11-10 Jurassic Company owns machinery that cost $900,000 and has accumulated depreciation of $380,000. The present value of expected future net cash flows from the use of the asset are expected to be $500,000. The fair value less cost of disposal of the equipment is $400,000. Prepare the journal entry, if any, to record the impairment loss. IFRS11-11 Presented below is information related to equipment owned by Pujols Company at December 31, 2014. Cost (residual value $0) $9,000,000 Accumulated depreciation to date 1,000,000 Value-in-use 5,500,000 Fair value less cost of disposal 4,400,000 Assume that Pujols will continue to use this asset in the future. As of December 31, 2014, the equipment has a remaining useful life of 8 years. Pujols uses straight-line depreciation. IFRS Insights 645 Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2014. (b) Prepare the journal entry to record depreciation expense for 2015. (c) The recoverable amount of the equipment at December 31, 2015, is $6,050,000. Prepare the journal entry (if any) necessary to record this increase. IFRS11-12 Assume the same information as in IFRS11-11, except that Pujols intends to dispose of the equipment in the coming year. Instructions (a) Prepare the journal entry (if any) to record the impairment of the asset at December 31, 2014. (b) Prepare the journal entry (if any) to record depreciation expense for 2015. (c) The asset was not sold by December 31, 2015. The fair value of the equipment on that date is $5,100,000. Prepare the journal entry (if any) necessary to record this increase. It is expected that the cost of disposal is $20,000. IFRS11-13 Falcetto Company acquired equipment on January 1, 2013, for $12,000. Falcetto elects to value this class of equipment using revaluation accounting. This equipment is being depreciated on a straight- line basis over its 6-year useful life. There is no residual value at the end of the 6-year period. The appraised value of the equipment approximates the carrying amount at December 31, 2013 and 2015. On December 31, 2014, the fair value of the equipment is determined to be $7,000. Instructions (a) Prepare the journal entries for 2013 related to the equipment. (b) Prepare the journal entries for 2014 related to the equipment. (c) Determine the amount of depreciation expense that Falcetto will record on the equipment in 2015. International Reporting Case IFRS11-14 Companies following international accounting standards are permitted to revalue fixed assets above the assets’ historical costs. Such revaluations are allowed under various countries’ standards and the standards issued by the IASB. Liberty International, a real estate company headquartered in the United Kingdom (U.K.), follows U.K. standards. In a recent year, Liberty disclosed the following information on revaluations of its tangible fixed assets. The revaluation reserve measures the amount by which tangible fixed assets are recorded above historical cost and is reported in Liberty’s stockholders’ equity. Liberty International Completed Investment Properties Completed investment properties are professionally valued on a market value basis by external valuers at the balance sheet date. Surpluses and deficits arising during the year are reflected in the revalution reserve. Liberty reported the following additional data. Amounts for Kimco Realty (which follows GAAP) in the same year are provided for comparison. Liberty Kimco (pounds sterling, in thousands) (dollars, in millions) Total revenues £ 741 $ 517 Average total assets 5,577 4,696 Net income 125 297 Instructions (a) Compute the following ratios for Liberty and Kimco. (1) Return on assets. (2) Profit margin on sales. (3) Asset turnover. How do these companies compare on these performance measures?

(b) Liberty reports a revaluation surplus of £1,952. Assume that £1,550 of this amount arose from an increase in the net replacement value of investment properties during the year. Prepare the journal entry to record this increase. 646 Chapter 11 Depreciation, Impairments, and Depletion (c) Under U.K. (and IASB) standards, are Liberty’s assets and equity overstated? If so, why? When comparing Liberty to U.S. companies, like Kimco, what adjustments would you need to make in order to have valid comparisons of ratios such as those computed in (a) above? Professional Research IFRS11-15 Matt Holmes recently joined Klax Company as a staff accountant in the controller’s office. Klax Company provides warehousing services for companies in several European cities. The location in Koblenz, Germany, has not been performing well due to increased competition and the loss of several cus- tomers that have recently gone out of business. Matt’s department manager suspects that the plant and equipment may be impaired and wonders whether those assets should be written down. Given the com- pany’s prior success, this issue has never arisen in the past, and Matt has been asked to conduct some research on this issue. Instructions Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.) (a) What is the authoritative guidance for asset impairments? Briefly discuss the scope of the standard (i.e., explain the types of transactions to which the standard applies). (b) Give several examples of events that would cause an asset to be tested for impairment. Does it appear that Klax should perform an impairment test? Explain. (c) What is the best evidence of fair value? Describe alternate methods of estimating fair value. International Financial Reporting Problem Marks and Spencer plc IFRS11-16 The financial statements of Marks and Spencer plc ((MM&&SS)) are available at the book’s com- panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks-and- Spencer-Annual-report-and-financial-statements-2012.pdf. Instructions Refer to M&S’s financial statements and the accompanying notes to answer the following questions. (a) What descriptions are used by M&S in its statement of financial position to classify its property, plant, and equipment? (b) What method or methods of depreciation does M&S use to depreciate its property, plant, and equipment? (c) Over what estimated useful lives does M&S depreciate its property, plant, and equipment? (d) What amounts for depreciation and amortization expense did M&S charge to its income state- ment in 2012 and 2011? (e) What were the capital expenditures for property, plant, and equipment made by M&S in 2012 and 2011? ANSWERS TO IFRS SELF-TEST QUESTIONS 1. c 2. c 3. b 4. d 5. c Remember to check the book’s companion website to fi nd additional resources for this chapter. This page is intentionally left blank Intangible Assets 1 Describe the characteristics of intangible assets. 6 Explain the accounting issues related to intangible- asset impairments. 2 Identify the costs to include in the initial valuation of intangible assets. 7 Identify the conceptual issues related to research and development costs. 3 Explain the procedure for amortizing intangible assets. 8 Describe the accounting for research and development and similar costs. 4 Describe the types of intangible assets. 9 Indicate the presentation of intangible assets 5 Explain the accounting issues for recording and related items. goodwill. Is This Sustainable? Companies are increasing their focus on sustainability issues. Companies like Southwest Airlines, Clorox, and Northrop Grumman are executing strategic initiatives including fuel-spill control, use of recycled materials, and water conservation. Why the growing importance of responsible management of resource use? One reason is that market participants are now

more interested in investing in companies that are pursuing sustainability strategies. For example, as indicated in the following graph, sustainable investing by professional portfolio managers in the United States has increased from below $500 billion in the mid-1990s to over $2.5 trillion (or 12.5% of the total under management) in 2010. RETPAHC 12 LEARNING OBJECTIVES After studying this chapter, you should be able to: Sustainability Investing in the United States (1995–2010) $3,000 2,500 2,000 1,500 1,000 500 0 1995 1997 1999 2001 2003 2005 2007 2010 Years In light of investor focus on sustainability, it is not surprising that companies are increasing the amount of information reported to the market about their sustainability efforts. However, rather than adding a line item in the income statement or balance sheet, companies instead provide more useful information about the future cash flow consequences of sustainability strategies, which are intangible and usually “nonfinancial” in nature. )snoillib ni( Source: Social Investment Forum. CONCEPTUAL FOCUS > See the Underlying Concepts on pages 651, 659, and 662. > Read the Evolving Issue on page 673 for a Consider, for example, the disclosure of information about discussion of recognition of R&D and internally greenhouse gases. In 2010, the Securities and Exchange generated intangibles. Commission clarified the circumstances in which public compa- nies should disclose information related to climate change, as INTERNATIONAL FOCUS well as the impact on financial performance of their efforts to manage the consequences of greenhouse gas emissions. So > See the International Perspectives here’s the paradox: If nonfinancial data, such as greenhouse gas on pages 652 and 666. emissions per dollar of revenue, is included in a financial report > Read the IFRS Insights on for investors, how can it still be called nonfinancial? pages 693–699 for a discussion of: As with the reporting of research and development expen- — Development costs ditures and other intangible assets—many of which do not — Impairments of intangibles show up on a balance sheet or income statement—companies are now exploring ways to combine the nonfinancial information with mandated disclosures in what is called an integrated report. In such a report, a company might disclose data on any of dozens of metrics beyond conventional balance sheet a ccounting, whether they are “integrated” or released separately. Practitioners collectively refer sustainability reporting as ESG for the three major categories of data—environmental, social, and corporate governance. While 228 U.S. companies issued a sustainability report in 2011, there was significant variation in the content and format. Only a handful, like those prepared by Clorox, Northrop Grumman, SAS, Genentech, and Polymer Group Inc., integrated a sustainability report with the financial statements. As with accounting reports prepared under GAAP, perhaps sustainability reporting is in need of standards? Sources: S. Lopresti and P. Lilak, “Do Investors Care About Sustainability?” PwC (March 2012); and E. Rostin, “Non-Financial Data Are Material: The Sustainability Paradox,” www.bloombergnews.com (April 13, 2012). As our opening story indicates, sustainability strategies are taking PREVIEW OF CHAPTER 12 on increased importance for companies like Southwest Airlines and Clorox. Reporting challenges for effective sustainability investments are similar to those for intangible assets. In this chapter, we explain the basic conceptual and reporting issues related to intangible assets. The content and organization of the chapter are as follows. Intangible Assets Presentation of Intangible Types of Impairment of Research and Intangibles and Asset Issues Intangibles Intangibles Development Costs Related Items • Characteristics • Marketing-related • Limited-life • Identifying R&D • Intangible assets • Valuation • Customer-related intangibles • Accounting for R&D • R&D costs • Amortization • Artistic-related • Indefinite-life • Similar costs • Contract-related intangibles other

• Technology-related than goodwill • Goodwill • Goodwill • Summary 649 650 Chapter 12 Intangible Assets INTANGIBLE ASSET ISSUES Characteristics Gap Inc.’s most important asset is its brand image, not its store fixtures. The Coca- LEARNING OBJECTIVE 1 Cola Company’s success comes from its secret formula for making Coca-Cola, not Describe the characteristics of its plant facilities. America Online’s subscriber base, not its Internet connection intangible assets. equipment, provides its most important asset. The U.S. economy is dominated by information and service providers. For these companies, their major assets are often intangible in nature. See the FASB Codification section What exactly are intangible assets? Intangible assets have two main character- (page 676). istics. [1] 1. They lack physical existence. Tangible assets such as property, plant, and equip- ment have physical form. Intangible assets, in contrast, derive their value from the rights and privileges granted to the company using them. 2. They are not fi nancial instruments. Assets such as bank deposits, accounts receiv- able, and long-term investments in bonds and stocks also lack physical substance. However, fi nancial instruments derive their value from the right (claim) to receive cash or cash equivalents in the future. Financial instruments are not classifi ed as intangibles. In most cases, intangible assets provide benefits over a period of years. Therefore, companies normally classify them as long-term assets. Following a discussion of the general valuation and accounting provisions for in- tangible assets, we present a more extensive discussion of the types of intangible assets and their accounting. Valuation Purchased Intangibles Companies record at cost intangibles purchased from another party. Cost includes LEARNING OBJECTIVE 2 all acquisition costs plus expenditures to make the intangible asset ready for its Identify the costs to include in the intended use. Typical costs include purchase price, legal fees, and other incidental initial valuation of intangible assets. expenses. Sometimes companies acquire intangibles in exchange for stock or other assets. In such cases, the cost of the intangible is the fair value of the consideration given or the fair value of the intangible received, whichever is more clearly evident. What if a company buys several intangibles, or a combination of intangibles and tangibles? In such a “basket purchase,” the company should allocate the cost on the basis of fair values. Essentially, the accounting treatment for purchased intangibles closely parallels that for purchased tangible assets.1 Internally Created Intangibles Sometimes a company may incur substantial research and development (R&D) costs to create an intangible. For example, Google expensed the R&D costs incurred to develop its valuable search engine. Costs incurred internally to create intangibles are generally expensed. 1The accounting in this section relates to the acquisition of a single asset or group of assets. The accounting for intangible assets acquired in a business combination (transaction in which the purchaser obtains control of one or more businesses) is discussed later in this chapter. Intangible Asset Issues 651 How do companies justify this approach? Some argue that the costs incurred internally to create intangibles bear no relationship to their real value. Underlying Concepts Therefore, they reason, expensing these costs is appropriate. Others note that it The controversy surrounding the is difficult to associate internal costs with a specific intangible. Still others con- accounting for R&D expenditures tend that due to the underlying subjectivity related to intangibles, companies refl ects a debate about whether should follow a conservative approach—that is, expense as incurred. As a such expenditures meet the def- result, companies capitalize only direct costs incurred in developing the intan- inition of an asset. If so, then an gible, such as legal costs, and expense the rest. “expense all R&D costs” policy results in overstated expenses

and understated assets. Amortization of Intangibles The allocation of the cost of intangible assets in a systematic way is called amor- 3 LEARNING OBJECTIVE tization. Intangibles have either a limited (finite) useful life or an indefinite Explain the procedure for amortizing useful life. For example, a company like Walt Disney Company has both types intangible assets. of intangibles. Disney amortizes its limited-life intangible assets (e.g., copy- rights on its movies and licenses related to its branded products). It does not amortize indefinite-life intangible assets (e.g., the Disney trade name or its Internet domain name). Limited-Life Intangibles Companies amortize their limited-life intangibles by systematic charges to expense over their useful life. The useful life should reflect the periods over which these assets will contribute to cash flows. Disney, for example, considers these factors in determining useful life: 1. The expected use of the asset by the company. 2. The expected useful life of another asset or a group of assets to which the useful life of the intangible asset may relate (such as lease rights to a studio lot). 3. Any legal, regulatory, or contractual provisions that may limit the useful life. 4. Any provisions (legal, regulatory, or contractual) that enable renewal or extension of the asset’s legal or contractual life without substantial cost. This factor assumes that there is evidence to support renewal or extension. Disney also must be able to accomplish renewal or extension without material modifi cations of the existing terms and conditions. 5. The effects of obsolescence, demand, competition, and other economic factors. Examples include the stability of the industry, known technological advances, legis- lative action that results in an uncertain or changing regulatory environment, and expected changes in distribution channels. 6. The level of maintenance expenditure required to obtain the expected future cash fl ows from the asset. For example, a material level of required maintenance in rela- tion to the carrying amount of the asset may suggest a very limited useful life. [2] The amount of amortization expense for a limited-life intangible asset should reflect the pattern in which the company consumes or uses up the asset, if the company can reliably determine that pattern. For example, assume that Second Wave, Inc. pur- chases a license to provide a specified quantity of a gene product called Mega. Second Wave should amortize the cost of the license following the pattern of use of Mega. If Second Wave’s license calls for it to provide 30 percent of the total the first year, 20 percent the second year, and 10 percent per year until the license expires, it would amortize the license cost using that pattern. If it cannot determine the pattern of production 652 Chapter 12 Intangible Assets or consumption, Second Wave should use the straight-line method of amortization. (For homework problems, assume the use of the straight-line method unless stated otherwise.) When Second Wave amortizes these licenses, it should show the charges as expenses. It should credit either the appropriate asset accounts or separate accumulated amortiza- tion accounts. The amount of an intangible asset to be amortized should be its cost less residual value. The residual value is assumed to be zero unless at the end of its useful life the intangible asset has value to another company. For example, if Hardy Co. commits to purchasing an intangible asset from U2D Co. at the end of the asset’s useful life, U2D Co. should reduce the cost of its intangible asset by the residual value. Similarly, U2D Co. should consider fair values, if reliably determined, for residual values. What happens if the life of a limited-life intangible asset changes? In that case, the remaining carrying amount should be amortized over the revised remaining useful life. Companies should, on a regular basis, evaluate the limited-life intangibles for impair- ment. Similar to the accounting for property, plant, and equipment, an impairment loss

should be recognized if the carrying amount of the intangible is not recoverable and its carrying amount exceeds its fair value. (We will cover impairment of intangibles in more detail later in the chapter.) Indefi nite-Life Intangibles If no factors (legal, regulatory, contractual, competitive, or other) limit the useful life of an intangible asset, a company considers its useful life indefinite. An indefinite life means that there is no foreseeable limit on the period of time over which the intangible asset is expected to provide cash flows. A company does not amortize an intangible as- set with an indefinite life. To illustrate, assume that Double Clik Inc. acquired a trade- mark that it uses to distinguish a leading consumer product. It renews the trademark every 10 years. All evidence indicates that this trademarked product will generate cash flows for an indefinite period of time. In this case, the trademark has an indefinite life; Double Clik does not record any amortization. International Companies should test indefinite-life intangibles for impairment at least Perspective annually. As we will discuss in more detail later in the chapter, the impairment test for indefinite-life intangibles differs from the one for limited-life intangi- IFRS requires capitalization bles. Only the fair value test is performed for indefinite-life intangibles; there is of some development costs. no recoverability test for these intangibles. The reason? Indefinite-life intangible assets might never fail the undiscounted cash flows recoverability test because cash flows could extend indefinitely into the future. Illustration 12-1 summarizes the accounting treatment for intangible assets. ILLUSTRATION 12-1 Manner Acquired Accounting Treatment Type of Internally Impairment for Intangibles Intangible Purchased Created Amortization Test Limited-life Capitalize Expense* Over useful life Recoverability intangibles test and then fair value test Indefinite-life Capitalize Expense* Do not Fair value test intangibles amortize only *Except for direct costs, such as legal costs. Types of Intangible Assets 653 What do the numbers mean? DEFINITELY INDEFINITE The importance of intangible asset classifi cation as either to limited-life, with an expected life of 21.33 years (a fairly limited-life or indefi nite-life is illustrated in the experi- defi nite useful life) and, shortly thereafter, wrote off this ence of Outdoor Channel Holdings. Here’s what hap- intangible completely. pened. Outdoor Channel recorded an intangible asset Apparently, the company was overly optimistic about the r elated to the value of an important distributor relation- expected future cash fl ows arising from the distributor rela- ship, purchased from another company. At that time, it tionship. As a result of that optimism, income in the second classifi ed the relationship as indefi nite-life. Thus, in the year was overstated by $9.5 million, or 14 percent, and the fi rst two years of the asset’s life, Outdoor Channel re- impairment recorded in the third year amounted to 7 percent corded no amortization expense on this asset. In the third of assets. From indefi nite-life to limited-life to worthless in year, investors were surprised to fi nd that Outdoor Chan- two short years—investors were surely hurt by Outdoor’s nel changed the classifi cation of the distributor relationship aggressive intangible asset classifi cation. Source: Jack Ciesielski, The AAO Weblog, www.accountingobserver.com/blog/ (January 12, 2007). TYPES OF INTANGIBLE ASSETS As indicated, the accounting for intangible assets depends on whether the intan- 4 LEARNING OBJECTIVE gible has a limited or an indefinite life. There are many different types of intangibles, Describe the types of intangible often classified into the following six major categories. [3] assets. 1. Marketing-related intangible assets. 2. Customer-related intangible assets. 3. Artistic-related intangible assets. 4. Contract-related intangible assets. 5. Technology-related intangible assets. 6. Goodwill. Marketing-Related Intangible Assets

Companies primarily use marketing-related intangible assets in the marketing or pro- motion of products or services. Examples are trademarks or trade names, newspaper mastheads, Internet domain names, and noncompetition agreements. A trademark or trade name is a word, phrase, or symbol that distinguishes or iden- tifies a particular company or product. Trade names like Kleenex, Pepsi-Cola, Buick, Excedrin, Wheaties, and Sunkist create immediate product identification in our minds, thereby enhancing marketability. Under common law, the right to use a trademark or trade name, whether registered or not, rests exclusively with the original user as long as the original user continues to use it. Registration with the U.S. Patent and Trademark Office provides legal protection for an indefinite number of renewals for periods of 10 years each. Therefore, a company that uses an established trademark or trade name may properly consider it to have an indefinite life and does not amortize its cost. If a company buys a trademark or trade name, it capitalizes the cost at the purchase price. If a company develops a trademark or trade name, it capitalizes costs related to securing it, such as attorney fees, registration fees, design costs, consulting fees, and successful legal defense costs. However, it excludes research and development costs. When the total cost of a trademark or trade name is insignificant, a company simply expenses it. 654 Chapter 12 Intangible Assets The value of a marketing-related intangible can be substantial. Consider Internet domain names. The name Drugs.com at one time sold for $800,000. The bidding for the name Loans.com approached $500,000. An expansion of domain names will allow in- dustries to use terms like .cars or even Internet slang like lol. This expansion has led to a new wave of domain name activity. For a fee of $185,000, companies can register their own domain names. Applications received include company names (such as Microsoft, which would have the name .microsoft) and for city-based domains (such as .nyc and .berlin). Company names also identify qualities and characteristics that companies work hard and spend much to develop. In a recent year, an estimated 1,230 companies took on new names in an attempt to forge new identities and paid over $250 million to corporate-identity consultants. Among these were Primerica (formerly American Can), Navistar (formerly International Harvester), and Nissan (formerly Datsun). What do the numbers mean? KEEP YOUR HANDS OFF MY INTANGIBLE! Companies go to great extremes to protect their valuable introduced its hot new phone in 2007. Not so fast, said Cisco, intangible assets. Consider how the creators of the highly which had held the iPhone trade name since 2000 and was successful game Trivial Pursuit protected their creation. First, using it on its own Voice over Internet Protocol (VoIP) prod- they copyrighted the 6,000 questions that are at the heart of ucts. The two companies came to an agreement for joint use the game. Then they shielded the Trivial Pursuit name by ap- of the name. It was not disclosed what Apple paid for this plying for a registered trademark. As a third mode of protec- arrangement, but it is not surprising why Apple would want tion, they obtained a design patent on the playing board’s to settle—to avoid a costly delay to the launch of its highly design as a unique graphic creation. anticipated iPhone. Another example is the iPhone trade name. Cisco Systems sued Apple for using the iPhone trade name when Apple Source: Nick Wingfi eld, “Apple, Cisco Reach Accord Over iPhone,” Wall Street Journal Online (February 22, 2007). Customer-Related Intangible Assets Customer-related intangible assets result from interactions with outside parties. Examples include customer lists, order or production backlogs, and both contractual and noncontractual customer relationships. To illustrate, assume that Green Market Inc. acquires the customer list of a large newspaper for $6,000,000 on January 1, 2014. This customer database includes names,

contact information, order history, and demographic information. Green Market expects to benefit from the information evenly over a three-year period. In this case, the customer list is a limited-life intangible that Green Market should amortize on a straight-line basis. Green Market records the purchase of the customer list and the amortization of the customer list at the end of each year as follows. January 1, 2014 Customer List 6,000,000 Cash 6,000,000 (To record purchase of customer list) December 31, 2014, 2015, 2016 Amortization Expense 2,000,000 Customer List (or Accumulated Customer List Amortization) 2,000,000 (To record amortization expense) The preceding example assumed no residual value for the customer list. But what if Green Market determines that it can sell the list for $60,000 to another company at the Types of Intangible Assets 655 end of three years? In that case, Green Market should subtract this residual value from the cost in order to determine the amortization expense for each year. Amortization expense would be $1,980,000, as shown in Illustration 12-2. ILLUSTRATION 12-2 Cost $6,000,000 Calculation of Less: Residual value 60,000 Amortization Expense Amortization base $5,940,000 with Residual Value Amortization expense per period: $1,980,000 ($5,940,000 4 3) Companies should assume a zero residual value unless the asset’s useful life is less than the economic life and reliable evidence is available concerning the residual value. [4] Artistic-Related Intangible Assets Artistic-related intangible assets involve ownership rights to plays, literary works, musical works, pictures, photographs, and video and audiovisual material. Copyrights protect these ownership rights. A copyright is a federally granted right that all authors, painters, musicians, sculp- tors, and other artists have in their creations and expressions. A copyright is granted for the life of the creator plus 70 years. It gives the owner or heirs the exclusive right to reproduce and sell an artistic or published work. Copyrights are not renewable. Copyrights can be valuable. In the late 1990s, Walt Disney Company faced the loss of its copyright on Mickey Mouse, which could have affected sales of billions of dollars of Mickey-related goods and services (including theme parks). This copyright was so important that Disney and many other big entertainment companies fought all the way to the Supreme Court—and won an extension of copyright lives from 50 to 70 years. As another example, Really Useful Group owns copyrights on the musicals of Andrew Lloyd Webber—Cats, Phantom of the Opera, Jesus Christ Superstar, and others. The company has little in the way of tangible assets, yet analysts value it at over $300 million. Companies capitalize the costs of acquiring and defending a copyright. They amor- tize any capitalized costs over the useful life of the copyright if less than its legal life (life of the creator plus 70 years). For example, Really Useful Group should allocate the costs of its copyrights to the years in which it expects to receive the benefits. The difficulty of determining the number of years over which it will receive benefits typically encour- ages a company like Really Useful Group to write off these costs over a fairly short period of time. Companies must expense the research and development costs that lead to a copyright as those costs are incurred. Contract-Related Intangible Assets Contract-related intangible assets represent the value of rights that arise from contrac- tual arrangements. Examples are franchise and licensing agreements, construction permits, broadcast rights, and service or supply contracts. A franchise is a contractual arrangement under which the franchisor grants the franchisee the right to sell certain products or services, to use certain trademarks or trade names, or to perform certain functions, usually within a designated geographical area. When you purchase a Prius from a Toyota dealer, fill up your tank at the corner Shell station, eat lunch at Subway, or make reservations at a Marriott hotel, you are

dealing with franchises. 656 Chapter 12 Intangible Assets The franchisor, having developed a unique concept or product, protects its concept or product through a patent, copyright, or trademark or trade name. The franchisee acquires the right to exploit the franchisor’s idea or product by signing a franchise agreement. Another type of franchise, granted by a governmental body, permits the business to use public property in performing its services. Examples are the use of city streets for a bus line or taxi service; the use of public land for telephone, electric, and cable television lines; and the use of airwaves for radio or TV broadcasting. Such operating rights are referred to as licenses or permits. For example, Fox, CBS, and NBC recently agreed to pay $27.9 billion for the right to broadcast NFL football games over an eight-year period. Franchises and licenses may be for a definite period of time, for an indefinite period of time, or perpetual. The company securing the franchise or license carries an intangi- ble asset account (entitled Franchises or Licenses) on its books, only when it can identify costs with the acquisition of the operating right. (Such costs might be legal fees or an advance lump-sum payment, for example.) A company should amortize the cost of a franchise (or license) with a limited life as an operating expense over the life of the franchise. It should not amortize a franchise with an indefinite life nor a perpetual fran- chise; the company should instead carry such franchises at cost. Annual payments made under a franchise agreement should be entered as operat- ing expenses in the period in which they are incurred. These payments do not represent an asset since they do not relate to future rights to use the property. Technology-Related Intangible Assets Technology-related intangible assets relate to innovations or technological advances. Examples are patented technology and trade secrets granted by the U.S. Patent and Trademark Office. A patent gives the holder exclusive right to use, manufacture, and sell a product or process for a period of 20 years without interference or infringement by others. Compa- nies such as Merck, Polaroid, and Xerox were founded on patents and built on the ex- clusive rights thus granted.2 The two principal kinds of patents are product patents, which cover actual physical products, and process patents, which govern the process of making products. If a company like Qualcomm purchases a patent from an inventor, the purchase price represents its cost. Qualcomm can capitalize other costs incurred in connection with securing a patent, as well as attorneys’ fees and other unrecovered costs of a suc- cessful legal suit to protect the patent, as part of the patent cost. However, it must expense as incurred any research and development costs related to the development of the product, process, or idea that it subsequently patents. (We discuss accounting for research and development costs in more detail on pages 665–667.) Companies should amortize the cost of a patent over its legal life or its useful life (the period in which benefits are received), whichever is shorter. If Qualcomm owns a patent from the date it is granted and expects the patent to be useful during its entire legal life, the company should amortize it over 20 years. If it appears that the patent will be useful for a shorter period of time, say for five years, it should amortize its cost over five years. 2Consider the opposite result. Sir Alexander Fleming, who discovered penicillin, decided not to use a patent to protect his discovery. He hoped that foregoing a patent would help companies produce the medication more quickly. Companies, however, refused to develop it because they did not have the patent shield and, therefore, were afraid to make the investment. Types of Intangible Assets 657 Changing demand, new inventions superseding old ones, inadequacy, and other factors often limit the useful life of a patent to less than the legal life. For example, the useful life of pharmaceutical patents is frequently less than the legal life because of the

testing and approval period that follows their issuance. A typical drug patent has several years knocked off its 20-year legal life. Why? Because a drug-maker spends one to four years on animal tests, four to six years on human tests, and two to three years for the Food and Drug Administration to review the tests. All this time occurs after issuing the patent but before the product goes on pharmacists’ shelves. What do the numbers mean? PATENT BATTLES From online retailing to cell phone features, global competi- (and Apple countersued) over cell phone features such as tion is bringing to the boiling point battles over patents. For swiping gestures on touch screens and the ”app store” for example, to protect its patented “one-click” shopping tech- downloading software. Apple also targeted HTC for in- nology that saves your shipping and credit card information fringing on Apple’s patented feature that allows screens to when you shop online, Amazon.com fi led a complaint detect more than one fi nger touch at a time. This facilitates against Barnesandnoble.com, its rival in the e-tailing wars. the popular zoom-in and zoom-out capability. HTC, in turn, The smartphone industry is another patent battleground. sued Apple for infringing on patented technology that For example, Nokia fi led patent lawsuits against Apple helps extend battery life. Sources: Adapted from L. Rohde, “Amazon, Barnes and Noble Settle Patent Dispute,” CNN.com (March 8, 2002); and J. Mintz, “Smart Phone Makers in Legal Fights over Patents,” Wisconsin State Journal (December 19, 2010), p. F4. As mentioned earlier, companies capitalize the costs of defending copyrights. The accounting treatment for a patent defense is similar. A company charges all unrecov- ered legal fees and other costs incurred in successfully defending a patent suit to Patents, an asset account. Such costs should be amortized along with acquisition cost over the remaining useful life of the patent. Amortization expense should reflect the pattern, if reliably determined, in which a company uses up the patent.3 A company may credit amortization of patents directly to the Patents account or to an Accumulated Patent Amortization account. To illustrate, a ssume that Harcott Co. incurs $180,000 in legal costs on January 1, 2014, to successfully defend a patent. The patent’s useful life after defense is 12 years, amortized on a straight- line basis. Harcott records the legal fees and the amortization at the end of 2014 as follows. January 1, 2014 Patents 180,000 Cash 180,000 (To record legal fees related to patent) December 31, 2014 Amortization Expense ($180,000 4 12) 15,000 Patents (or Accumulated Patent Amortization) 15,000 (To record amortization of patent) We’ve indicated that a patent’s useful life should not extend beyond its legal life of 20 years. However, companies often make small modifications or additions that lead to a new patent. For example, Astra Zeneca plc filed for additional patents on minor mod- ifications to its heartburn drug Prilosec. The effect may be to extend the life of the old 3Companies may compute amortization on a units-of-production basis in a manner similar to that described for depreciation on property, plant, and equipment. 658 Chapter 12 Intangible Assets patent. If the new patent provides essentially the same benefits, Astra Zeneca can apply the unamortized costs of the old patent to the new patent.4 Alternatively, if a patent becomes impaired because demand drops for the product, the asset should be written down or written off immediately to expense. What do the numbers mean? THE VALUE OF A SECRET FORMULA After several espionage cases were uncovered, the secrets color and corn syrup, as well as a blend of oils known as 7X contained within the Los Alamos nuclear lab seemed easier (rumored to be a mix of orange, lemon, cinnamon, and to check out than a library book. But The Coca-Cola others). Distilling natural products like these is compli- Company has managed to keep the recipe for the world’s cated since they are made of thousands of compounds.

best-selling soft drink under wraps for more than 100 years. One ingredient you will not fi nd, by the way, is cocaine. The company offers almost no information about its life- Although the original formula did contain trace amounts, blood, and the only written copy of the formula resides in a today’s Coke doesn’t. When was it removed? That too is a bank vault in Atlanta. This handwritten sheet is available to secret. no one except by vote of Coca-Cola’s board of directors. Some experts indicate that the power of the Coca-Cola Can’t science offer some clues? Coke purportedly con- formula and related brand image account for almost $72 bil- tains 17 to 18 ingredients. That includes the usual caramel lion, or roughly 6 percent, of Coke’s $1,128 billion stock value. Sources: Adapted from Reed Tucker, “How Has Coke’s Formula Stayed a Secret?” Fortune (July 24, 2000), p. 42; and “Best Global Brands 2011,” www.interbrand.com (accessed July 5, 2012). Goodwill Although companies may capitalize certain costs incurred in developing specifi- LEARNING OBJECTIVE 5 cally identifiable assets such as patents and copyrights, the amounts capitalized Explain the accounting issues are generally insignificant. But companies do record material amounts of intangi- for recording goodwill. ble assets when purchasing them, particularly in situations involving a business combination (the purchase of another business). To illustrate, assume that Portofino Company decides to purchase Aquinas Com- pany. In this situation, Portofino measures the assets acquired and the liabilities as- sumed at fair value. In measuring these assets and liabilities, Portofino must identify all the assets and liabilities of Aquinas. As a result, Portofino may recognize some assets or liabilities not previously recognized by Aquinas. For example, Portofino may recognize intangible assets such as a brand name, patent, or customer list that were not recorded by Aquinas. In this case, Aquinas may not have recognized these assets because they were developed internally and charged to expense. In many business combinations, the purchasing company records goodwill. Goodwill is measured as the excess of the cost of the purchase over the fair value of the identifiable net assets (assets less liabilities) purchased. For example, if Portofino paid $2,000,000 to purchase Aquinas’s identifiable net assets (with a fair value of $1,500,000), Portofino records goodwill of $500,000. Goodwill is therefore measured as a residual rather than measured directly. That is why goodwill is sometimes referred to as a plug, a gap filler, or a master valuation account.5 4Another classic example is Eli Lilly’s drug Prozac (prescribed to treat depression). In 1998, this product accounted for 43 percent of Eli Lilly’s sales. The patent on Prozac expired in 2001, and the company was unable to extend its protection with a second-use patent for the use of Prozac to treat appetite disorders. Sales of the product slipped substantially as generic equivalents entered the market. 5GAAP [5] provides detailed guidance regarding the recognition of identifiable intangible assets in a business combination. With this guidance, companies should recognize more identifiable intangible assets, and less goodwill, in the financial statements as a result of business combinations. Types of Intangible Assets 659 Conceptually, goodwill represents the future economic benefits arising from the other assets acquired in a business combination that are not individually identified and separately recognized. It is often called “the most intangible of the intangible assets” because it is identified only with the business as a whole. The only way to sell goodwill is to sell the business. Recording Goodwill Internally Created Goodwill. Goodwill generated internally should not be capital- ized in the accounts. The reason? Measuring the components of goodwill is simply too complex, and associating any costs with future benefits is too difficult. The future ben- efits of goodwill may have no relationship to the costs incurred in the development of

that goodwill. To add to the mystery, goodwill may even exist in the absence of specific costs to develop it. Finally, because no objective transaction with outside parties takes place, a great deal of subjectivity—even misrepresentation—may occur. Purchased Goodwill. As indicated earlier, goodwill is recorded only when an Underlying Concepts entire business is purchased. To record goodwill, a company compares the fair Capitalizing goodwill only when value of the net tangible and identifiable intangible assets with the purchase it is purchased in an arm’s- price of the acquired business. The difference is considered goodwill. Goodwill length transaction, and not capi- is the residual—the excess of cost over fair value of the identifiable net assets talizing any goodwill generated acquired. internally, is another example of To illustrate, Multi-Diversified, Inc. decides that it needs a parts division to faithful representation winning supplement its existing tractor distributorship. The president of Multi-Diversified out over relevance. is interested in buying Tractorling Company, a small concern in Chicago. Illus- tration 12-3 presents the balance sheet of Tractorling Company. ILLUSTRATION 12-3 TRACTORLING CO. Tractorling Co. Balance BALANCE SHEET Sheet AS OF DECEMBER 31, 2014 Assets Liabilities and Equity Cash $ 25,000 Current liabilities $ 55,000 Accounts receivable 35,000 Capital stock 100,000 Inventory 42,000 Retained earnings 100,000 Property, plant, and equipment, net 153,000 Total assets $255,000 Total liabilities and equity $255,000 After considerable negotiation, Tractorling Company decides to accept Multi- Gateway to Diversified’s offer of $400,000. What, then, is the value of the goodwill, if any? the Profession The answer is not obvious. Tractorling’s historical cost-based balance sheet does not Expanded Discussion— Valuing Goodwill disclose the fair values of its identifiable assets. Suppose, though, that as the negotiations progress, Multi-Diversified investigates Tractorling’s underlying assets to determine their fair values. Such an investigation may be accomplished either through a purchase audit undertaken by Multi-Diversified or by an independent appraisal from some other source. The investigation determines the valuations shown in Illustration 12-4 (page 660). Normally, differences between current fair value and book value are more common among long-term assets than among current assets. Cash obviously poses no problems as to value. Receivables normally are fairly close to current valuation although they may at times need certain adjustments due to inadequate bad debt provisions. Liabilities usually are stated at book value. However, if interest rates have changed since the company incurred the liabilities, a different valuation (such as present value based on 660 Chapter 12 Intangible Assets ILLUSTRATION 12-4 Fair Values Fair Value of Tractorling’s Net Assets Cash $ 25,000 Accounts receivable 35,000 Inventory 122,000 Property, plant, and equipment, net 205,000 Patents 18,000 Liabilities (55,000) Fair value of net assets $350,000 expected cash flows) is appropriate. Careful analysis must be made to determine that no unrecorded liabilities are present. The $80,000 difference in Tractorling’s inventories ($122,000 2 $42,000) could result from a number of factors. The most likely is that the company uses LIFO. Recall that during periods of inflation, LIFO better matches expenses against revenues. However, it also creates a balance sheet distortion. Ending inventory consists of older layers costed at lower valuations. In many cases, the values of long-term assets such as property, plant, and equip- ment, and intangibles may have increased substantially over the years. This difference could be due to inaccurate estimates of useful lives, continual expensing of small expen- ditures (say, less than $300), inaccurate estimates of residual values, and the discovery of some unrecorded assets. (For example, in Tractorling’s case, analysis determines Patents have a fair value of $18,000.) Or, fair values may have substantially increased.

Since the investigation now determines the fair value of net assets to be $350,000, why would Multi-Diversified pay $400,000? Undoubtedly, Tractorling points to its established reputation, good credit rating, top management team, well-trained employees, and so on. These factors make the value of the business greater than $350,000. Multi-Diversified places a premium on the future earning power of these attributes as well as on the basic asset structure of the company today. Multi-Diversified labels the difference between the purchase price of $400,000 and the fair value of net assets of $350,000 as goodwill. Goodwill is viewed as one or a group of unidentifiable values (intangible assets), the cost of which “is measured by the difference between the cost of the group of assets or enterprise acquired and the sum of the assigned costs of individual tangible and identifiable intangible assets acquired less liabilities assumed.”6 This procedure for valuation is called a master valuation approach. It assumes goodwill covers all the values that cannot be specifically identified with any identifiable tangible or intangible asset. Illustration 12-5 shows this approach. ILLUSTRATION 12-5 Cash $ 25,000 Determination of Accounts receivable 35,000 Goodwill—Master Inventory 122,000 Valuation Approach Property, plant, and equipment, net 205,000 Assigned to Patents 18,000 purchase price Liabilities (55,000) of $400,000 Fair value of net identifiable assets $350,000 Purchase price 400,000 Value assigned to goodwill $ 50,000 6The FASB expressed concern about measuring goodwill as a residual but noted that there is no real measurement alternative since goodwill is not separable from the company as a whole. [6] Types of Intangible Assets 661 Multi-Diversified records this transaction as follows. Cash 25,000 Accounts Receivable 35,000 Inventory 122,000 Property, Plant, and Equipment 205,000 Patents 18,000 Goodwill 50,000 Liabilities 55,000 Cash 400,000 Companies often identify goodwill on the balance sheet as the excess of cost over the fair value of the net assets acquired. Goodwill Write-Off Companies that recognize goodwill in a business combination consider it to have an indefinite life and therefore should not amortize it. Although goodwill may decrease in value over time, predicting the actual life of goodwill and an appropriate pattern of amortization is extremely difficult. In addition, investors find the amortization charge of little use in evaluating financial performance. Furthermore, the investment community wants to know the amount invested in goodwill, which often is the largest intangible asset on a company’s balance sheet. Therefore, companies adjust its carrying value only when goodwill is impaired. This approach significantly impacts the income statements of some companies. Some believe that goodwill’s value eventually disappears. Therefore, they argue, companies should charge goodwill to expense over the periods affected, to better match expense with revenues. Others note that the accounting treatment for purchased goodwill and goodwill created internally should be consistent. They point out that companies immediately expense goodwill created internally and should follow the same treatment for purchased goodwill. Though these arguments may have some merit, nonamortization of goodwill combined with an adequate impairment test should provide the most useful financial information to the investment community. We discuss the accounting for goodwill impairments later in the chapter. Bargain Purchase In a few cases, the purchaser in a business combination pays less than the fair value of the identifiable net assets. Such a situation is referred to as a bargain purchase. A bargain purchase results from a market imperfection. That is, the seller would have been better off to sell the assets individually than in total. However, situations do occur (e.g., a forced liquidation or distressed sale due to the death of a company founder) in which the purchase price is less than the value of the net identifiable assets. This excess

amount is recorded as a gain by the purchaser. The FASB notes that an economic gain is inherent in a bargain purchase. The pur- chaser is better off by the amount by which the fair value of what is acquired exceeds the amount paid. Some expressed concern that some companies may attempt inappro- priate gain recognition by making an intentional error in measurement of the assets or liabilities. As a result, the FASB requires companies to disclose the nature of this gain transaction. Such disclosure will help users to better evaluate the quality of the earn- ings reported.7 7This gain is not reported as an extraordinary item, [7] which is consistent with convergence in international accounting standards. IFRS does not permit extraordinary item reporting. 662 Chapter 12 Intangible Assets IMPAIRMENT OF INTANGIBLE ASSETS In some cases, the carrying amount of a long-lived asset (property, plant, and equip- LEARNING OBJECTIVE 6 ment, or intangible assets) is not recoverable. Therefore, a company needs to record a Explain the accounting issues related write-off. As discussed in Chapter 11, this write-off is referred to as an impairment. to intangible-asset impairments. Impairment of Limited-Life Intangibles The rules that apply to impairments of property, plant, and equipment also apply to limited-life intangibles. As discussed in Chapter 11, a company should review prop- erty, plant, and equipment for impairment at certain points—whenever events or changes in circumstances indicate that the carrying amount of the asset may not be re- coverable. In performing this recoverability test, the company estimates the future cash flows expected from use of the asset and its eventual disposal. If the sum of the expected future net cash flows (undiscounted) is less than the carrying amount of the asset, the com- pany would measure and recognize an impairment loss. [8] The company then uses the fair value test. This test measures the impairment loss by comparing the asset’s fair value with its carrying amount. The impairment loss is the carrying amount of the asset less the fair value of the impaired asset. As with other impair- ments, the loss on the limited-life intangible is reported as part of income from continu- ing operations. The entry generally appears in the “Other expenses and losses” section. To illustrate, assume that Lerch, Inc. has a patent on how to extract oil from shale rock. Unfortunately, several recent non-shale oil discoveries adversely affected the de- mand for shale-oil technology. Thus, the patent has provided little income to date. As a result, Lerch performs a recoverability test. It finds that the expected future net cash flows from this patent are $35 million. Lerch’s patent has a carrying amount of $60 mil- lion. Because the expected future net cash flows of $35 million are less than the carrying amount of $60 million, Lerch must determine an impairment loss. Discounting the expected future net cash flows at its market rate of interest, Lerch determines the fair value of its patent to be $20 million. Illustration 12-6 shows the impairment loss computation (based on fair value). ILLUSTRATION 12-6 Carrying amount of patent $60,000,000 Computation of Loss on Less: Fair value (based on present value computation) 20,000,000 Impairment of Patent Loss on impairment $40,000,000 Lerch records this loss as follows. Loss on Impairment 40,000,000 Underlying Concepts Patents 40,000,000 The basic attributes of intan- After recognizing the impairment, the reduced carrying amount of the pat- gibles, their uncertainty as to ents is its new cost basis. Lerch should amortize the patent’s new cost over its future benefi ts, and their unique- remaining useful life or legal life, whichever is shorter. Even if shale-oil prices ness have discouraged valuation increase in subsequent periods and the value of the patent increases, Lerch may in excess of cost. not recognize restoration of the previously recognized impairment loss. Impairment of Indefi nite-Life Intangibles Other Than Goodwill Companies should test indefinite-life intangibles other than goodwill for impairment at

least annually. The impairment test for an indefinite-life asset other than goodwill is a fair value test. This test compares the fair value of the intangible asset with the asset’s Impairment of Intangible Assets 663 carrying amount. If the fair value is less than the carrying amount, the company recog- nizes an impairment. Companies use this one-step test because many indefinite-life as- sets easily meet the recoverability test (because cash flows may extend many years into the future). Thus, companies do not use the recoverability test. To illustrate, assume that Arcon Radio purchased a broadcast license for $2,000,000. The license is renewable every 10 years if the company provides appropriate service and does not violate Federal Communications Commission (FCC) rules. Arcon Radio has renewed the license with the FCC twice, at a minimal cost. Because it expects cash flows to last indefinitely, Arcon reports the license as an indefinite-life intangible asset. Re- cently, the FCC decided to auction significantly more of these licenses. As a result, Arcon Radio expects reduced cash flows for the remaining two years of its existing license. It performs an impairment test and determines that the fair value of the intangible asset is $1,500,000. Arcon therefore reports an impairment loss of $500,000, computed as follows. ILLUSTRATION 12-7 Carrying amount of broadcast license $2,000,000 Computation of Loss on Less: Fair value of broadcast license 1,500,000 Impairment of Broadcast Loss on impairment $ 500,000 License Arcon Radio now reports the license at $1,500,000, its fair value. Even if the value of the license increases in the remaining two years, Arcon may not restore the previously recognized impairment loss. Companies have the option to perform a qualitative assessment to determine whether it is more likely than not (i.e., a likelihood of more than 50 percent) that an indefinite-life intangible asset is impaired. [9] If the qualitative assessment indicates that the fair value of the reporting unit is more likely than not to be greater than the carrying value (i.e., the asset is not impaired), the company need not continue with the fair value test. As a result, use of the qualitative assessment option should reduce both the cost and complexity of performing the impairment test.8 Impairment of Goodwill Goodwill must be tested for impairment at least annually. The impairment rule for goodwill is a two-step process. First, a company compares the fair value of the report- ing unit to its carrying amount, including goodwill. If the fair value of the reporting unit exceeds the carrying amount, goodwill is not impaired. The company does not have to do anything else. Similar to other indefinite-life intangibles, companies may instead perform an optional qualitative assessment to determine whether it is more likely than not that goodwill is impaired. If the qualitative assessment indicates that the fair value of the reporting unit is more likely than not to be greater than the carrying value, the company need not continue with the two-step impairment test.9 To illustrate, assume that Kohlbuy Corporation has three divisions. It purchased one division, Pritt Products, four years ago for $2 million. Unfortunately, Pritt experienced operating losses over the last three quarters. Kohlbuy management is now reviewing the 8 Examples of events and circumstances to be evaluated include but are not limited to (1) deteriora- tion in general economic conditions; (2) an increased competitive environment, a decline in market- dependent multiples or metrics, a change in the market for a company’s products or services, or a regulatory or political development; (3) cost factors such as increases in raw materials, labor, or other costs that have a negative effect on earnings; and (4) overall financial performance such as negative or declining cash flows or a decline in actual or planned revenue or earnings. 9The qualitative assessment examines similar factors as those used in the optional qualitative test for

other indefinite-life intangibles but are based on events and circumstances related to the reporting unit. [10] 664 Chapter 12 Intangible Assets division for purposes of recognizing an impairment. Illustration 12-8 lists the Pritt Divi- sion’s net assets, including the associated goodwill of $900,000 from the purchase. ILLUSTRATION 12-8 Cash $ 200,000 Net Assets of Pritt Accounts receivable 300,000 Division, Including Inventory 700,000 Goodwill Property, plant, and equipment (net) 800,000 Goodwill 900,000 Accounts and notes payable (500,000) Net assets $2,400,000 Kohlbuy determines that the fair value of Pritt Division is $2,800,000. Because the fair value of the division exceeds the carrying amount of the net assets, Kohlbuy does not recognize any impairment. However, if the fair value of Pritt Division were less than the carrying amount of the net assets, then Kohlbuy would perform a second step to determine possible impair- ment. In the second step, Kohlbuy determines the fair value of the goodwill (implied value of goodwill) and compares it to its carrying amount. To illustrate, assume that the fair value of the Pritt Division is $1,900,000 instead of $2,800,000. Illustration 12-9 com- putes the implied value of the goodwill in this case.10 ILLUSTRATION 12-9 Fair value of Pritt Division $1,900,000 Determination of Implied Less: Net identifiable assets (excluding goodwill) ($2,400,000 2 $900,000) 1,500,000 Value of Goodwill Implied value of goodwill $ 400,000 Kohlbuy then compares the implied value of the goodwill to the recorded goodwill to measure the impairment, as shown in Illustration 12-10. ILLUSTRATION 12-10 Carrying amount of goodwill $900,000 Measurement of Less: Implied value of goodwill 400,000 Goodwill Impairment Loss on impairment $500,000 Impairment Summary Illustration 12-11 summarizes the impairment tests for various intangible assets. ILLUSTRATION 12-11 Type of Summary of Intangible Intangible Asset Impairment Test Asset Impairment Tests Limited life Recoverability test, then fair value test Indefinite life other than goodwill Fair value test* Goodwill Fair value test on reporting unit, then fair value test on implied goodwill* *An optional qualitative assessment may be performed to determine whether the fair value test needs to be performed. 10 Illustration 12-9 assumes that the carrying amount equals the fair value of net identifiable assets (excluding goodwill). If different, companies use the fair value of the net identifiable assets (excluding goodwill) to determine the implied goodwill. Research and Development Costs 665 What do the numbers mean? IMPAIRMENT RISK As shown in the chart below, goodwill impairments spiked with book values well above market value of equity ($1.8 tril- in 2008 and 2009, coinciding with the stock market downturn lion for about 10 percent of companies in the S&P 500 at the in the wake of the fi nancial crisis. end of 2001). As one analyst noted, “Anybody looking at a A spike in impairments when the market declines is un- decline in market price could see the company was placing a derstandable because declines in stock price are indicators much higher value on its assets than the market thought they that the fair values of acquired assets have declined below were worth.” the carrying value. And while there is a declining trend in Investors need to keep watch. Such asset write-downs— impairments in 2009 and 2010, notable goodwill impair- for brand names, franchise rights, and other intangible assets ments are being reported. For example, Microsoft posted a (including goodwill)—are important because they tell inves- goodwill impairment charge of $6.3 billion in 2012. Some are tors that management have concluded their companies’ expecting more goodwill impairments for other companies future cash fl ows will not achieve previous estimates. Annual Goodwill Impairment Trend 10% 8% 6% 4% 2% 0% Years Total number impaired Percentage impaired RESEARCH AND DEVELOPMENT COSTS Research and development (R&D) costs are not in themselves intangible assets. 7 LEARNING OBJECTIVE

However, we present the accounting for R&D costs here because R&D activities Identify the conceptual issues related frequently result in the development of patents or copyrights (such as a new prod- to research and development costs. uct, process, idea, formula, composition, or literary work) that may provide future value. Many companies spend considerable sums on research and development. Illustra- tion 12-12 (page 666) shows the outlays for R&D made by selected global companies. Two difficulties arise in accounting for R&D expenditures: (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the deriapmi rebmuN noitalupop latot fo egatnecreP 350 18% 16% 300 14% 250 12% 200 150 100 50 0 2005 2006 2007 2008 2009 2010 Source: “Evaluating Impairment Risk: Goodwill Impairment Continues Downward Trend in 2010” (KPMG LLP), 2010. Sources: M. Murphy, “The Big Number,” Wall Street Journal (November 16, 2011), p. B5; and S. Thurm, “Buyers Beware: The Goodwill Games,” Wall Street Journal (August 13, 2012). 666 Chapter 12 Intangible Assets ILLUSTRATION 12-12 Sales R&D Outlays, as a Company (millions) R&D/Sales Percentage of Sales Canon $3,557,433 8.65% Daimler €106,540 3.92% GlaxoSmithKline £27,387 14.64% Johnson & Johnson $65,030 11.61% Nokia €38,659 14.52% Roche CHF42,531 19.58% Procter & Gamble $82,559 2.42% Samsung W 165,002 6.05% International Perspective IFRS requires the capitalization magnitude of the future benefits and length of time over which such benefits of appropriate development may be realized. Because of these latter uncertainties, the FASB has simplified expenditures. This confl icts the accounting practice in this area. Companies must expense all research and with GAAP. development costs when incurred. [11] Identifying R&D Activities Illustration 12-13 shows the definitions for research activities and development activi- ties. These definitions differentiate research and development costs from other similar costs. [12] ILLUSTRATION 12-13 Research Activities Research Activities Development Activities versus Development Activities Idea Planned search or critical investigation aimed Translation of research findings or other at discovery of new knowledge. knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. Examples Examples Laboratory research aimed at discovery of Conceptual formulation and design of possible new knowledge; searching for applications of product or process alternatives; construction new research findings. of prototypes and operation of pilot plants. R&D activities do not include routine or periodic alterations to existing products, production lines, manufacturing processes, and other ongoing operations, even though these alterations may represent improvements. For example, routine ongoing efforts to refine, enrich, or improve the qualities of an existing product are not considered R&D activities. Research and Development Costs 667 Accounting for R&D Activities 8 LEARNING OBJECTIVE The costs associated with R&D activities and the accounting treatments accorded Describe the accounting for research them are as follows. and development and similar costs. 1. Materials, equipment, and facilities. Expense the entire costs, unless the items have alternative future uses (in other R&D projects or otherwise). If there are alternative future uses, carry the items as inventory and allocate as consumed, or capitalize and depreciate as used. 2. Personnel. Expense as incurred salaries, wages, and other related costs of personnel engaged in R&D. 3. Purchased intangibles. Recognize and measure at fair value. After initial recogni- tion, account for in accordance with their nature (as either limited-life or indefi nite- life intangibles).11 4. Contract services. Expense the costs of services performed by others in connection with the R&D as incurred. 5. Indirect costs. Include a reasonable allocation of indirect costs in R&D costs, except for general and administrative cost, which must be clearly related in order to be

included in R&D. [14] Consistent with item 1 above, if a company owns a research facility that conducts R&D activities and that has alternative future uses (in other R&D projects or otherwise), it should capitalize the facility as an operational asset. The company accounts for depre- ciation and other costs related to such research facilities as R&D expenses.12 To illustrate, assume that Next Century Incorporated develops, produces, and markets laser machines for medical, industrial, and defense uses.13 Illustration 12-14 (on the next page) lists the types of expenditures related to its laser-machine activities, along with the recommended accounting treatment. Costs Similar to R&D Costs Many costs have characteristics similar to research and development costs. Examples are: 1. Start-up costs for a new operation. 2. Initial operating losses. 3. Advertising costs. 4. Computer software costs. 11If R&D-related intangibles (often referred to as in-process R&D) are also acquired in a business combination, they are also recognized and measured at fair value. After initial recognition, these intangible assets are accounted for in accordance with their nature (as either limited-life or indefinite-life intangibles). [13] 12Companies in the extractive industries can use the following accounting treatment for the unique costs of research, exploration, and development activities and for those costs that are similar to but not classified as R&D costs: (1) expense as incurred, (2) capitalize and either depreciate or amortize over an appropriate period of time, or (3) accumulate as part of invento- riable costs. Choice of the appropriate accounting treatment for such costs is based on the degree of certainty of future benefits and the principle of matching revenues and expenses. 13Sometimes companies conduct R&D activities for other companies under a contractual arrangement. In this case, the contract usually specifies that the company performing the R&D work be reimbursed for all direct costs and certain specific indirect costs, plus a profit element. Because reimbursement is expected, the company doing the R&D work records the R&D costs as a receivable. The company for whom the work has been performed reports these costs as R&D and expenses them as incurred. For a more complete discussion of how an enterprise should account for funding of its R&D by others, see [15]. 668 Chapter 12 Intangible Assets NEXT CENTURY INCORPORATED Type of Expenditure Accounting Treatment Rationale 1. C onstruction of long-range research facility Capitalize and depreciate as R&D expense. Has alternative future use. for use in current and future projects (three-story, 400,000-square-foot building). 2. A cquisition of R&D equipment for use on Expense immediately as R&D. Research cost. current project only. 3. Acquisition of machinery for use on current Capitalize and depreciate as R&D expense. Has alternative future use. and future R&D projects. 4. Purchase of materials for use on current Inventory and allocate to R&D projects; Has alternative future use. and future R&D projects. expense as consumed. 5. Salaries of research staff designing new laser Expense immediately as R&D. Research cost. bone scanner. 6. Research costs incurred under contract with Record as a receivable. Not R&D cost (reimbursable expense). New Horizon, Inc., and billable monthly. 7. M aterial, labor, and overhead costs of Expense immediately as R&D. Development cost. prototype laser scanner. 8. Costs of testing prototype and design Expense immediately as R&D. Development cost. modifications. 9. Legal fees to obtain patent on new laser Capitalize as patent and amortize to overhead Direct cost of patent. scanner. as part of cost of goods manufactured. 10. Executive salaries. Expense as operating expense. Not R&D cost (general and administrative expense). 11. Cost of marketing research to promote new Expense as operating expense. Not R&D cost (selling expense). laser scanner. 12. Engineering costs incurred to advance the Expense immediately as R&D. Development cost.

laser scanner to full production stage. 13. Costs of successfully defending patent on Capitalize as patent and amortize to overhead Direct cost of patent. laser scanner. as part of cost of goods manufactured. 14. Commissions to sales staff marketing new Expense as operating expense. Not R&D cost (selling expense). laser scanner. ILLUSTRATION 12-14 Sample R&D Expenditures and Their Accounting Treatment For the most part, these costs are expensed as incurred, similar to the accounting for R&D costs. We briefly explain these costs in the following sections. Start-Up Costs Start-up costs are incurred for one-time activities to start a new operation. Examples include opening a new plant, introducing a new product or service, or conducting business in a new territory. Start-up costs include organizational costs, such as legal and state fees incurred to organize a new business entity. The accounting for start-up costs is straightforward: Expense start-up costs as in- curred. The profession recognizes that companies incur start-up costs with the expecta- tion of future revenues or increased efficiencies. However, to determine the amount and timing of future benefits is so difficult that a conservative approach—expensing these costs as incurred—is required. [16] To illustrate examples of start-up costs, assume that U.S.-based Hilo Beverage Company decides to construct a new plant in Brazil. This represents Hilo’s first entry into the Brazilian market. Hilo plans to introduce the company’s major U.S. brands into Brazil on a locally produced basis. The following costs might be involved: 1. Travel-related costs; costs related to employee salaries; and costs related to feasibility studies, accounting, tax, and government affairs. Research and Development Costs 669 2. Training of local employees related to product, maintenance, computer systems, fi nance, and operations. 3. Recruiting, organizing, and training related to establishing a distribution network. Hilo Beverage should expense all these start-up costs as incurred. Start-up activities commonly occur at the same time as activities involving the acquisition of assets. For example, as it is incurring start-up costs for the new plant, Hilo probably is also buying or building property, plant, equipment, and inventory. Hilo should not immediately expense the costs of these tangible assets. Instead, it should report them on the balance sheet using appropriate GAAP reporting guidelines. Initial Operating Losses Some contend that companies should be allowed to capitalize initial operating losses incurred in the start-up of a business. They argue that such operating losses are an unavoidable cost of starting a business. For example, assume that Hilo lost money in its first year of operations and wishes to capitalize this loss. Hilo’s CEO argues that as the company becomes profitable, it will offset these losses in future periods. What do you think? We believe that this approach is unsound since losses have no future service potential and therefore cannot be considered an asset. GAAP requires that operating losses during the early years should not be capital- ized. In short, the accounting and reporting standards should be no different for an enterprise trying to establish a new business than they are for other enterprises. [17]14 Advertising Costs Over the years, PepsiCo has hired various pop stars, such as Elton John and Beyoncé, to advertise its products. How should it report such advertising costs related to its star spokespeople? Pepsi could expense the costs in various ways: 1. When the pop stars have completed their singing assignments. 2. The fi rst time the advertising runs. 3. Over the estimated useful life of the advertising. 4. In an appropriate fashion to each of the three periods identifi ed above. 5. Over the period revenues are expected to result. For the most part, Pepsi must expense advertising costs as incurred or the first time the advertising takes place. Whichever of these two approaches is followed, the results are essentially the same. On the other hand, companies record as assets any tan-

gible assets used in advertising, such as billboards or blimps. The rationale is that such assets do have alternative future uses. Again the profession has taken a conservative approach to recording advertising costs because defining and measuring the future benefits can be so difficult. [18]15 Computer Software Costs A special problem arises in distinguishing R&D costs from selling and administrative ac- Gateway to tivities. The FASB’s intent was that companies exclude from the definition of R&D activities the Profession the acquisition, development, or improvement of a product or process for use in their Expanded Discussion— selling or administrative activities. For example, the costs of software incurred by an airline Software Development Costs 14A company is considered to be in the developing stages when it is directing its efforts toward establishing a new business and either the company has not started the principal operations or it has earned no significant revenue. 15There are some exceptions for immediate expensing of advertising costs when they relate to direct-response advertising, but that subject is beyond the scope of this book. 670 Chapter 12 Intangible Assets in improving its computerized reservation system or the costs incurred in developing a company’s management information system are not research and development costs. What do the numbers mean? BRANDED For many companies, developing a strong brand image is as Occasionally you may fi nd the value of a brand included important as developing the products they sell. Now more in a company’s fi nancial statements under goodwill. But than ever, companies see the power of a strong brand, generally you will not fi nd the estimated values of brands e nhanced by signifi cant and effective advertising investments. recorded in companies’ balance sheets. The reason? The sub- As the following chart indicates, the value of brand in- jectivity that goes into estimating a brand’s value. In some vestments is substantial. Coca-Cola heads the list with an cases, analysts base an estimate of brand value on opinion estimated brand value of about $72 billion. polls or on some multiple of ad spending. For example, in estimating the brand values shown to the left, Interbrand The World’s 10 Most Valuable Brands Corp. estimates the percentage of the overall future revenues (in billions) the brand will generate and then discounts the net cash 1 Coca-Cola $71.9 fl ows, to arrive at a present value. 2 IBM 69.9 Some analysts believe that information on brand values is 3 Microsoft 59.0 4 Google 55.3 relevant. Others voice valid concerns about the reliability of 5 GE 42.8 brand value estimates due to subjectivity in the estimates 6 McDonald’s 35.6 for revenues, costs, and the risk component of the discount 7 Intel 35.2 rate. For example, another brand valuation fi rm, Millward 8 Apple 33.5 Brown, ranks Apple as number one with an estimated brand 9 Disney 29.0 10 HP 28.9 value of $183 billion (or about one-third of Apple’s market value). These data support the highly subjective nature of Source: 2011 data, from Interbrand Corp. brand valuation estimates. Sources: “Best Global Brands 2011,” www.interbrand.com (accessed July 5, 2012); and S. Vranica and J. Hansegard, “Ikea Discloses an $11 Billion Secret,” Wall Street Journal (August 9, 2012). PRESENTATION OF INTANGIBLES AND RELATED ITEMS Presentation of Intangible Assets The reporting of intangible assets is similar to the reporting of property, plant, and LEARNING OBJECTIVE 9 equipment. However, contra accounts are not normally shown for intangibles on Indicate the presentation of intangible the balance sheet. As Illustration 12-15 shows, on the balance sheet companies assets and related items. should report as a separate item all intangible assets other than goodwill. If good- will is present, companies should report it separately. The FASB concluded that since goodwill and other intangible assets differ significantly from other types of assets, such disclosure benefits users of the balance sheet. On the income statement, companies should present amortization expense and

impairment losses for intangible assets other than goodwill separately and as part of continuing operations. Again, see Illustration 12-15. Goodwill impairment losses should also be presented as a separate line item in the continuing operations section, unless the goodwill impairment is associated with a discontinued operation. The notes to the financial statements should include information about acquired in- tangible assets, including the aggregate amortization expense for each of the succeeding five years. If separate accumulated amortization accounts are not used, accumulated amor- tization should be disclosed in the notes. The notes should include information about changes in the carrying amount of goodwill during the period. Presentation of Intangibles and Related Items 671 ILLUSTRATION 12-15 HARBAUGH COMPANY Intangible Asset Balance Sheet (partial) Disclosures (in thousands) Intangible assets (Note C) $3,840 Goodwill (Note D) 2,575 Income Statement (partial) (in thousands) as part of Continuing operations Amortization expense $380 Impairment losses (goodwill) 46 Notes to the Financial Statements Note C: Acquired Intangible Assets As of December 31, 2014 Gross Carrying Accumulated Amount Amortization Amortized intangible assets Trademark $2,000 $(100) Customer list 500 (310) Types of intangibles Other 60 (10) and carrying values Total $2,560 $(420) Unamortized intangible assets Licenses $1,300 Trademark 400 Total $1,700 Aggregate Amortization Expense For year ended 12/31/14 $380 Estimated Amortization Expense For year ended 12/31/15 $200 Current and future For year ended 12/31/16 90 expense For year ended 12/31/17 70 For year ended 12/31/18 60 For year ended 12/31/19 50 Note D: Goodwill The changes in the carrying amount of goodwill for the year ended December 31, 2014, are as follows. Technology Communications ($000s) Segment Segment Total Balance as of January 1, 2014 $1,413 $904 $2,317 Goodwill by segment Goodwill acquired during year 189 115 304 and carrying values Impairment losses — (46) (46) Balance as of December 31, 2014 $1,602 $973 $2,575 The Communications segment is tested for impairment in the third quarter, after the annual forecasting process. Due to an increase in competition in the Texas and Louisiana cable industry, operating profits and cash flows were lower than expected in the fourth quarter of 2013 and the first and second Impairment quarters of 2014. Based on that trend, the earnings forecast for the next 5 years was revised. In methodology September 2014, a goodwill impairment loss of $46 was recognized in the Communications reporting unit. The fair value of that reporting unit was estimated using the expected present value of future cash flows. 672 Chapter 12 Intangible Assets Presentation of Research and Development Costs Companies should disclose in the financial statements (generally in the notes) the total R&D costs charged to expense each period for which they present an income statement. Merck & Co., Inc., a global research pharmaceutical company, reported both internal and acquired research and development in its recent income statement, as shown in Illustration 12-16. ILLUSTRATION 12-16 Income Statement Disclosure of R&D Costs In addition, Merck provides a discussion about R&D expenditures in its annual report, as shown in Illustration 12-17. Merck & Co., Inc. Research and development in the pharmaceutical industry is inherently a long-term process. The following data show the trend of the Company’s research and development spending. For the period 1998 to 2011, the compounded annual growth rate in research and development was approximately 21%. R&D Expenditures $12,000 6,000 5,000 4,200 3,150 2,100 98 99 00 01 02 03 04 05 06 07 08 )snoillim ni( Merck & Co., Inc. (in millions) Years Ended December 31 2011 2010 2009 Sales $48,047 $45,987 $27,428.3 Costs, expenses and other Materials and production 16,871 18,396 9,018.9 Marketing and administrative 13,733 13,125 8,543.2 Research and development 8,467 11,111 5,845.0 Restructuring costs 1,306 985 1,633.9 Equity income from affiliates (610) (587) (2,235.0)

Other (income) expense, net 946 1,304 (10,669.5) $40,713 $44,334 $12,136.5 ILLUSTRATION 12-17 Merck’s R&D Disclosure You will want to read the 1,050 IFRS INSIGHTS on pages 693–699 0 for discussion of 09 10 11 IFRS related to Years intangible assets. Summary of Learning Objectives 673 Evolving Issue RECOGNITION OF R&D AND INTERNALLY GENERATED INTANGIBLES The requirement that companies expense immediately all showed a significant relationship between R&D outlays and R&D costs (as well as start-up costs) incurred internally is a subsequent benefits in the form of increased productivity, practical solution. It ensures consistency in practice and uni- earnings, and shareholder value for R&D-intensive companies. formity among companies. But the practice of immediately Another study found that there was a significant decline in writing off expenditures made in the expectation of benefit- earnings usefulness for companies that were forced to switch ing future periods is conceptually incorrect. from capitalizing to expensing R&D costs, and that the Proponents of immediate expensing contend that from an decline appears to persist over time. income statement standpoint, long-run application of this The current accounting for R&D and other internally standard frequently makes little difference. They argue that generated intangible assets represents one of the many because of the ongoing nature of most companies’ R&D trade-offs made among relevance, faithful representation, a ctivities, the amount of R&D cost charged to expense each and cost-benefit considerations. The FASB and IASB have accounting period is about the same, whether there is immedi- completed some limited-scope projects on the accounting ate expensing or capitalization and subsequent amortization. for intangible assets, and the Boards have contemplated a Others criticize this practice. They believe that the balance joint project on the accounting for identifiable intangible sheet should report an intangible asset related to expendi- assets (i.e., excluding goodwill). Such a project would tures that have future benefit. To preclude capitalization of address concerns that the current accounting requirements all R&D expenditures removes from the balance sheet what lead to inconsistent treatments for some types of intangi- may be a company’s most valuable asset. ble assets depending on how they arise. (See http://www.ifrs. Indeed, research findings indicate that capitalizing R&D org/C urrent1Projects/IASB1Projects/Intangible1Assets/ costs may be helpful to investors. For example, one study Intangible1Assets.htm.) Sources for research studies: Baruch Lev and Theodore Sougiannis, “The Capitalization, Amortization, and Value-Relevance of R&D,” Journal of Accounting and Economics (February 1996); and Martha L. Loudder and Bruce K. Behn, “Alternative Income Determination Rules and Earnings Usefulness: The Case of R&D Costs,” Contemporary Accounting Research (Fall 1995). KEY TERMS SUMMARY OF LEARNING OBJECTIVES amortization, 651 bargain purchase, 661 business combination, 1 Describe the characteristics of intangible assets. Intangible assets have 650(n) two main characteristics: (1) They lack physical existence, and (2) they are not financial copyright, 655 instruments. In most cases, intangible assets provide services over a period of years and development so are normally classified as long-term assets. activities, 666 2 Identify the costs to include in the initial valuation of intangible assets. fair value test, 662 Intangibles are recorded at cost. Cost includes all acquisition costs and expenditures franchise, 655 needed to make the intangible asset ready for its intended use. If intangibles are goodwill, 658 acquired in exchange for stock or other assets, the cost of the intangible is the fair value impairment, 662 of the consideration given or the fair value of the intangible received, whichever is more indefinite-life clearly evident. When a company makes a “basket purchase” of several intangibles or a intangibles, 651 combination of intangibles and tangibles, it should allocate the cost on the basis of fair intangible assets, 650

values. license (permit), 656 limited-life 3 Explain the procedure for amortizing intangible assets. Intangibles have intangibles, 651 either a limited useful life or an indefinite useful life. Companies amortize limited-life master valuation intangibles. They do not amortize indefinite-life intangibles. Limited-life intangibles approach, 660 should be amortized by systematic charges to expense over their useful life. The useful organizational costs, 668 life should reflect the period over which these assets will contribute to cash flows. The 674 Chapter 12 Intangible Assets patent, 656 amount to report for amortization expense should reflect the pattern in which a com- recoverability test, 662 pany consumes or uses up the asset, if it can reliably determine that pattern. Otherwise, research activities, 666 use a straight-line approach. research and 4 Describe the types of intangible assets. Major types of intangibles are development (R&D) (1) marketing-related intangibles, used in the marketing or promotion of products or costs, 665 services; (2) customer-related intangibles, resulting from interactions with outside parties; start-up costs, 668 (3) artistic-related intangibles, giving ownership rights to such items as plays and literary trademark, trade works; (4) contract-related intangibles, representing the value of rights that arise from name, 653 contractual arrangements; (5) technology-related intangibles, relating to innovations or technological advances; and (6) goodwill, arising from business combinations. 5 Explain the accounting issues for recording goodwill. Unlike receiv- ables, inventories, and patents that a company can sell or exchange individually in the marketplace, goodwill can be identified only with the company as a whole. Good- will is a “going concern” valuation and is recorded only when an entire business is purchased. A company should not capitalize goodwill generated internally. The future benefits of goodwill may have no relationship to the costs incurred in the de- velopment of that goodwill. Goodwill may exist even in the absence of specific costs to develop it. To record goodwill, a company compares the fair value of the net tangible and iden- tifiable intangible assets with the purchase price of the acquired business. The difference is considered goodwill. Goodwill is the residual. Goodwill is often identified on the balance sheet as the excess of cost over the fair value of the net assets acquired. 6 Explain the accounting issues related to intangible-asset impairments. Impairment occurs when the carrying amount of the intangible asset is not recoverable. Companies use a recoverability test and a fair value test to determine impairments for limited-life intangibles. They use only a fair value test for indefinite-life intangibles. Goodwill impairments require a two-step process. First, test the fair value of the report- ing unit, then do the fair value test on implied goodwill. 7 Identify the conceptual issues related to research and development costs. R&D costs are not in themselves intangible assets, but R&D activities frequently result in the development of something a company patents or copyrights. The difficul- ties in accounting for R&D expenditures are (1) identifying the costs associated with particular activities, projects, or achievements, and (2) determining the magnitude of the future benefits and length of time over which a company may realize such benefits. Because of these latter uncertainties, companies are required to expense all research and development costs when incurred. 8 Describe the accounting for research and development and similar costs. Illustration 12-14 (page 668) shows typical costs associated with R&D activities and the accounting treatment accorded them. Many costs have characteristics similar to R&D costs. Examples are start-up costs, initial operating losses, and advertising costs. For the most part, these costs are expensed as incurred, similar to the accounting for R&D costs. 9 Indicate the presentation of intangible assets and related items. On

the balance sheet, companies should report all intangible assets other than goodwill as a separate item. Contra accounts are not normally shown. If goodwill is present, it too should be reported as a separate item. On the income statement, companies should report amortization expense and impairment losses in continuing operations. The notes to the financial statements have additional detailed information. Financial statements must disclose the total R&D costs charged to expense each period for which an income statement is presented. Demonstration Problem 675 DEMONSTRATION PROBLEM Sky Co., organized in 2014, provided you with the following information. 1. Purchased a license for $20,000 on July 1, 2014. The license gives Sky exclusive rights to sell its services in the tri-state region and will expire on July 1, 2022. 2. Purchased a patent on January 2, 2015, for $40,000. It is estimated to have a 5-year life. 3. Costs incurred to develop an exclusive Internet connection process as of June 1, 2015, were $45,000. The process has an indefinite life. 4. On April 1, 2015, Sky Co. purchased a small circuit board manufacturer for $350,000. Goodwill recorded in the transaction was $90,000. 5. On July 1, 2015, legal fees for successful defense of the patent purchased on January 2, 2015, were $11,400. 6. Research and development costs incurred as of September 1, 2015, were $75,000. Instructions (a) Prepare the journal entries to record all the entries related to the patent during 2015. (b) At December 31, 2015, an impairment test is performed on the license purchased in 2014. It is estimated that the net cash flows to be received from the license will be $13,000, and its fair value is $7,000. Compute the amount of impairment, if any, to be recorded on December 31, 2015. (c) What is the amount to be reported for intangible assets on the balance sheet at December 31, 2014? At December 31, 2015? Solution (a) January 2, 2015 Patents 40,000 Cash 40,000 July 1, 2015 Patents 11,400 Cash 11,400 December 31, 2015 Patent Amortization Expense 9,267 Patents 9,267 Computation of patent expense: $40,000 3 12/60 5 $8,000 $11,400 3 6/54 5 1,267 Total $9,267 (b) Computation of impairment loss: Cost $20,000 Less: Accumulated amortization ($20,000 3 18/96) 3,750 Book value $16,250 Book value of $16,250 is greater than net cash flows of $13,000. Therefore, the license is impaired. The impair- ment loss is computed as follows. Book value $16,250 Fair value 7,000 Loss on impairment $ 9,250 676 Chapter 12 Intangible Assets (c) Intangible assets as of December 31, 2014: License $18,750* *Cost $20,000 Less: Accumulated amortization ($20,000 3 6/96) 1,250 Total $18,750 Intangible assets as of December 31, 2015: License $ 7,000 Patents ($40,000 1 $11,400 2 $9,267) $42,133 Goodwill $90,000 All the costs to develop the Internet connection process and the research and development costs are expensed as incurred. FASB CODIFICATION FASB Codification References [1] FASB ASC 350-10-05. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001).] [2] FASB ASC 350-30-35. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. 11.] [3] FASB ASC 805-10. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No. 141R (Norwalk, Conn.: FASB, 2007).] [4] FASB ASC 350-30-35. [Predecessor literature: “Goodwill and Other Intangible Assets,” Statement of Financial Accounting Standards No. 142 (Norwalk, Conn.: FASB, 2001), par. B55.] [5] FASB ASC 805-10-20. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No. 141R (Norwalk, Conn.: FASB, 2007).] [6] FASB ASC 805-10-30. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards No. 141R (Norwalk, Conn.: FASB, 2007).] [7] FASB ASC 805-10-30. [Predecessor literature: “Business Combinations,” Statement of Financial Accounting Standards