To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 10 QUESTIONS a The cost of land includes the original purchase price; brokers’ commissions; legal fees; title, recording, and escrow fees; surveying costs; local government special assessment taxes; cost of clearing or grading; and other costs that permanently improve the land or prepare it for use Expenditures for land improvements that have a limited life, such as paving, fencing, and landscaping, may be separately summarized as land improvements and depreciated over their estimated useful lives b The cost of buildings includes the original purchase price, brokers’ commissions, legal fees, title and escrow fees, reconditioning costs, alteration and improvement costs, and any other costs that improve the buildings and hence benefit future periods c The cost of equipment includes the original purchase price, taxes and duties on purchases, freight charges, insurance while in transit, installation charges and other costs in preparing the asset for use, subsequent improvements or additions, and any other expenditures that will improve the equipment and thus benefit more than one period a A copyright, when purchased, is recorded at its purchase price When internally developed, all costs of legally establishing the copyright are included as costs of the copyright b The cost of purchasing a franchise and all other sums paid specifically for a franchise including legal fees are considered the franchise cost Property improvements required under the franchise also are recorded as part of the franchise cost c The cost of a trademark includes all expenditures required to establish the trademark, such as filing and registration fees, as well as legal expenses for the defense of the trademark Pur- 381 chased trademarks are recorded at the purchase price Accountants frequently are required to allocate costs among two or more accounts The principal method of allocation is based on relative fair values of the individual assets, if they can be determined A ratio of each individual asset’s fair value to the sum of the fair values for all assets involved in the purchase is used to determine cost for each individual asset If fair values, or some approximation of fair values, cannot be obtained for all assets in the basket purchase, allocation can be made to those assets where fair values are available, and any remaining balance can be allocated, on some systematic basis, to remaining assets When equipment is purchased on a deferred payment contract, care must be taken to exclude the stated or implicit interest from the purchase price The asset should be recorded at its equivalent cash price Interest on the unpaid contract balance should be recognized as interest expense over the life of the contract a Sales practice for some products consistently inflates the list price that is initially assigned Because most buyers are aware of this practice, considerable negotiations take place between buyers and sellers before a market price is established If accountants use the list price without careful evaluation, values could be inflated b The goal of accounting for the acquisition of property and equipment is to record the acquisition at the equivalent cash price or the closest approximation to cash that can be obtained This is especially important when trade-ins are involved a In constructing a new building for its own use, Gaylen Corp will charge the building with all costs incurred in connection with the construction activities These costs will include building costs in the form of direct labor, direct mate- To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 382 Chapter 10 rials, factory overhead, and any other expenditures that can be identified with the construction of the asset b When a company constructs its own assets, there are two positions that may be taken in assigning general overhead to the cost of the asset: (1) Overhead may be assigned to special construction just as it is assigned to normal activities on the grounds that both activities benefit from the overhead; this would mean that construction would be charged with the increase in overhead arising from construction activities as well as a pro rata share of the company’s fixed overhead (2) Only the increase in overhead may be charged to construction on the grounds that management decides to construct its own assets after giving due consideration to the differential or additional costs involved An equitable allocation of the fixed overhead between regular operations and construction affords no special favor to construction activities; on the other hand, a charge to construction for only the increase in total overhead grants no special concessions to regular activities during the construction period Before interest charges are capitalized, a construction project should be a discrete project Interest should not be capitalized for inventories manufactured or produced on a repetitive basis, for assets that are currently being used, or for assets that are idle and not undergoing activities to prepare them for use understated Furthermore, subsequent income will be overstated through the failure to recognize depreciation, and this misstatement will be accompanied by misrepresentations of earnings-toassets and earnings-to-owners’-equity relationships reflected on the financial statements Properties unconditionally transferred should be recognized by debits to asset accounts and a credit to a revenue account in terms of the fair market values of the properties acquired, and depreciation should be recognized in using such properties b If the donation of the property is contingent upon certain conditions, the president’s position relative to the nonrecognition of the asset is proper until the time the conditions are met Until the conditions are met, the fair value of the conditional gift, along with a description of the conditions, should be disclosed in the notes to the financial statements 10 Under IAS 41, biological assets, such as cattle, fruit trees, and lumber forests, are recorded in the balance sheet at their fair value (less estimated selling costs) as of the balance sheet date Increases in this fair value are recognized as gains, and decreases are recognized as losses 11 An asset retirement obligation is a legal obligation a company has to restore the site of a piece of property or equipment when the asset is retired The estimated fair value of the asset retirement obligation is recognized as a liability and is added to the cost of the asset when it is acquired Under IAS 23, a company capitalizes the net amount of interest which is the gross amount of interest, computed as under U.S GAAP, less the amount of investment income generated by borrowed construction funds that are temporarily invested before they are needed to pay for construction expenditures Accordingly, the amount of interest capitalized under the international standard is generally less than the amount that would be capitalized under the U.S standard 12 Many companies establish a minimum monetary amount for recording expenditures as assets, even though the item purchased meets the definition of an asset The principal reasons for this are materiality and the cost involved in recording an asset and depreciating it over its estimated life It is more expedient to expense these smaller capital expenditures immediately, thus avoiding the recordkeeping associated with assets a If the donation of the property by the philanthropist is unconditional, the president’s position cannot be defended If the donation is not recognized, both assets and income will be 13 a The cost of a depreciable asset incorrectly recorded as an expense will understate assets and owners’ equity for the current year and for succeeding years, but by successively decreasing amounts until the asset no longer To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 makes a contribution to periodic revenue Net income will be understated in the first year by the excess of the expenditure over depreciation for the current period; net income in succeeding years will be overstated by the amount of depreciation charges applicable to the asset that should be charged off as expense b An expense expenditure incorrectly recorded as an addition to the cost of a depreciable asset will overstate assets 14 383 and owners’ equity for the first year and for succeeding years, but by successively decreasing amounts until the charge has been fully written off Net income will be overstated for the first year by the difference between the recognized depreciation for the current period and the amount of the expenditure; net income for succeeding years will be understated by the depreciation charges recognized in such periods Expenditure Classification Cost of installing machinery Asset Cost of unsuccessful litigation to protect patent Expense Extensive repairs as a result of a fire Expense Cost of grading land Asset Insurance on machinery in transit Asset Interest incurred during construction period Asset (if interest added to construction cost) Expense (if interest charged to expense) g Cost of replacing a major machinery component Asset h New safety guards on machinery Asset i Commission on purchase of real estate Asset j Special tax assessment for street improvements Asset k Cost of repainting offices Expense a b c d e f 15 The remaining net book value of a component that is replaced is added to depreciation expense for the period 16 a Research activities are those used to discover new knowledge that will be useful in developing new products, services, or processes, or significantly improve an existing product or process Development activities seek to apply research findings to develop a plan or design for new or improved products and processes Development activities include the formulation, design, and testing of products, construction of prototypes, and operation of pilot plants b Research and development costs are generally expensed in the period incurred An exception is when the expenditure is for equipment and facilities that have alternate future uses beyond the specific current research project This exception permits the deferral of costs incurred for materials, equipment, facilities, and intangibles purchased, but only if the alternative future use can be specifically identified In addition, software development costs are capi- talized if they are incurred after technological feasibility has been established 17 With the full cost method of accounting for oil and gas exploration costs, the cost of drilling dry holes is capitalized and amortized With the successful efforts method, only the exploratory costs associated with successful wells are capitalized; the cost of dry holes is expensed as incurred 18 In general, the cost of internally generated intangibles is expensed as incurred 19 The five general categories of intangible assets are as follows: Marketing related Customer related Artistic related Contract based Technology based 20 The two approaches used in estimating fair values using present value computations are the traditional approach and the expected cash flow approach In the traditional approach, which is often used in situations in which the amount and timing of the future cash flows is determined by contract, the present value is computed To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 384 Chapter 10 using a risk-adjusted interest rate that incorporates expectations about the uncertainty of receipt of the future contractual cash flows In the expected cash flow approach, a range of possible outcomes is identified, the present value of the cash flows in each possible outcome is computed (using the risk-free interest rate), and a weightedaverage present value is computed by summing the present value of the cash flows in each outcome, multiplied by the estimated probability of that outcome 21 a Goodwill may be reported properly as an asset only when it is purchased or otherwise established by a transaction between independent parties b Expenditures for advertising should not be capitalized as goodwill Some advertising expenditures may be deferred if the costs applicable to future benefits from such advertising can be determined objectively Normally, however, it is advisable to expense such expenditures because of the short-lived nature of the benefits and because future benefits may be difficult to estimate 22 The fair value of acquired in-process research and development is recognized as an asset when acquired as part of a business combination but as an expense when acquired as a basket purchase outside a business combination 23 Recording noncurrent operating assets at their current values represents a trade-off between relevance and reliability In the United States, reliability concerns have resulted in the prohibition of asset write-ups In many countries around the world, accountants have learned to rely on the judgment of professional appraisers who estimate the current value of long-term assets 24 Under the provisions of IAS 16, the credit entry is to a revaluation equity account when noncurrent operating assets are written up to reflect an increase in market value (The important point is that the revaluation amount is not to be reported as a gain in the income statement.) 25 Under the provisions of IAS 40, a company can elect to use a fair value approach in which the investment property is reported in the balance sheet at its fair value, and any resulting gains or losses are reported in the income statement 26 The fixed asset turnover ratio is computed as sales divided by average property, plant, and equipment (fixed assets); it is interpreted as the number of dollars in sales generated by each dollar of fixed assets 27 As with all ratios, the fixed asset turnover ratio must be used carefully to ensure that erroneous conclusions are not made For example, fixed asset turnover ratio values for two companies in different industries cannot be meaningfully compared Another difficulty in comparing values for the fixed asset turnover ratio among different companies is that the reported amount for property, plant, and equipment can be a poor indicator of the actual fair value of the fixed assets being used by a company Another complication with the fixed asset turnover ratio is caused by leasing Many companies lease the bulk of their fixed assets in such a way that the assets are not included in the balance sheet This practice biases the fixed asset turnover ratio for these companies upward because the sales generated by the leased assets are included in the numerator of the ratio but the leased assets generating the sales are not included in the denominator To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 385 PRACTICE EXERCISES PRACTICE 10–1 CATEGORIES OF TANGIBLE NONCURRENT OPERATING ASSETS Land Cost to purchase land Cost to purchase land Cost to prepare land for use Total $ 85,000 50,000 10,000 $145,000 Buildings Cost to construct building $132,000 Equipment Cost to purchase equipment Cost to ship and install equipment Cost of testing Total $ 30,000 1,000 1,750 $ 32,750 Land Improvements Cost to construct parking lot and sidewalks $ 10,000 PRACTICE 10–2 Equipment Building Land Total BASKET PURCHASE $250,000 425,000 125,000 $800,000 (250,000/800,000) × $750,000 (425,000/800,000) × $750,000 (125,000/800,000) × $750,000 Allocated Cost $234,375 398,438 117,187 $750,000 (Note: Some rounding is necessary to ensure that the total allocated cost is $750,000.) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 386 Chapter 10 PRACTICE 10–3 DEFERRED PAYMENT Equipment Discount on Notes Payable Cash Notes Payable 120,696 49,304 10,000 160,000 Business calculator keystrokes: N = years I = 9% PMT = $20,000 FV = (There is no balloon payment associated with the note.) PV = $110,696 Notes Payable Cash 20,000 Interest Expense Discount on Notes Payable 9,963 20,000 9,963 Interest expense: ($160,000 – $49,304) × 0.09 = $9,963 PRACTICE 10–4 EXCHANGE OF NONMONETARY ASSETS Equipment Gain on Asset Exchange Land PRACTICE 10–5 97,300 62,300 35,000 COST OF A SELF-CONSTRUCTED ASSET Cost of materials Labor cost Allocated overhead cost ($8,000,000/$4,000,000) × $600,000 Interest cost Total $ 400,000 600,000 1,200,000 140,000 $2,340,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 387 PRACTICE 10–6 CAPITALIZED INTEREST: SINGLE-YEAR COMPUTATION January May November Total Amount $100,000 200,000 300,000 $600,000 Applicable Interest Rate 10% 13 13 Amount of capitalized interest = $33,833 Cost of building = $600,000 + $33,833 = $633,833 PRACTICE 10–7 Months of Avoidable Interest 12/12 8/12 2/12 Capitalized Interest $10,000 17,333 6,500 $33,833 CAPITALIZED INTEREST: JOURNAL ENTRY Building Interest Expense ($270,000 – $33,833) Cash 33,833 236,167 270,000 Total interest: ($100,000 × 0.10) + ($2,000,000 × 0.13) = $270,000 PRACTICE 10–8 CAPITALIZED INTEREST: MULTIPLE-YEAR COMPUTATION From Year July Total Amount $ 100,000 533,833 500,000 $1,133,833 Applicable Interest Rate 10% 13 13 Months of Avoidable Interest 12/12 12/12 6/12 Amount of capitalized interest = $111,898 Cost of building = $1,133,833 + $111,898 = $1,245,731 PRACTICE 10–9 Capitalized Interest $ 10,000 69,398 32,500 $111,898 ACQUISITION BY DONATION Land Revenue (or Gain) 111,000 111,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 388 Chapter 10 PRACTICE 10–10 ACCOUNTING FOR AN ASSET RETIREMENT OBLIGATION Mining Site Cash 800,000 Mining Site Asset Retirement Obligation 72,489 800,000 72,489 Business Calculator Keystrokes: FV = $200,000; I = 7%; N = 15 years → $72,489 PRACTICE 10–11 RENEWALS AND REPLACEMENTS Heating/Cooling System Accumulated Depreciation—Buildings (old system) Depreciation Expense Buildings (old system) Cash PRACTICE 10–12 (1) (2) (3) 160,000 210,000 RESEARCH AND DEVELOPMENT Normal: Expense all—$120,000 + $100,000 = $220,000 Software: Expense amounts before technological feasibility: $120,000 International: Expense amounts before technological feasibility: $120,000 PRACTICE 10–13 (1) (2) 210,000 128,000 32,000 OIL AND GAS EXPLORATION COSTS Successful efforts: Expense all costs of dry holes = $400,000 Full cost: Capitalize all costs, and amortize the amount to expense in subsequent years Accordingly, expense for this year is $0 (Note: Because all costs were incurred on the last day of the year, there is no amortization this year.) PRACTICE 10–14 ACCOUNTING FOR THE ACQUISITION OF AN ENTIRE COMPANY Cash price Fair value of net assets ($1,360,000 – $500,000) Goodwill Cash Accounts Receivable Inventory Patent Property, Plant, and Equipment Goodwill Liabilities Cash $1,400,000 860,000 $ 540,000 20,000 190,000 320,000 80,000 750,000 540,000 500,000 1,400,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 PRACTICE 10–15 389 ACCOUNTING FOR A BARGAIN PURCHASE Cash price Market value of net assets ($1,360,000 – $500,000) Bargain purchase amount Cash Accounts Receivable Inventory Patent Property, Plant, and Equipment Gain Liabilities Cash PRACTICE 10–16 $ 720,000 860,000 $(140,000) 20,000 190,000 320,000 80,000 750,000 140,000 500,000 720,000 INTANGIBLES AND A BASKET PURCHASE Building Operating permit In-process R&D Order backlog Estimated Fair Values $200,000 100,000 150,000 120,000 $570,000 Cost Allocation Cost According to Assigned to Relative Estimated Values Individual Items 200,000/570,000 × $500,000 $175,439 100,000/570,000 × $500,000 87,719 150,000/570,000 × $500,000 131,579 120,000/570,000 × $500,000 105,263 $500,000 Building Operating Permit R&D Expense* Order Backlog Cash 175,439 87,719 131,579 105,263 500,000 *The acquired in-process R&D is recognized as an expense because it has been acquired in a basket purchase outside a business combination PRACTICE 10–17 INTANGIBLES AND A BUSINESS ACQUISITION Cash Inventory In-Process R&D Asset Goodwill Liabilities Cash 100,000 50,000 500,000 450,000 300,000 800,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 390 PRACTICE 10–18 Chapter 10 FIXED ASSET TURNOVER RATIO Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $480,000/[($160,000 + $200,000)/2] = 2.67 PRACTICE 10–19 DANGER IN USING FIXED ASSET TURNOVER RATIO Company B Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $360,000/[($200,000 + $220,000)/2] = 1.71 Company A⎯using historical cost of fixed assets Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $480,000/[($160,000 + $200,000)/2] = 2.67 Company A⎯using market value of fixed assets Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $480,000/[($290,000 + $310,000)/2] = 1.60 Company A is more efficient (i.e., has a higher fixed asset turnover ratio) if one uses historical cost of fixed assets (2.67 compared to 1.71) However, Company B’s fixed assets are younger and are therefore reported at amounts close to their market values If we assume that the reported amounts of Company B’s fixed asset are a fair approximation of their market values, then it appears that Company B is more efficient than is Company A (1.71 compared to 1.60) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 410 Chapter 10 10–54 2013 interest accrued: 12%, 5-year note ($2,000,000 × 0.12) 10%, 10-year bonds ($8,000,000 × 0.10) 13%, 3-year loan ($2,000,000 × 0.13) Total interest accrued—2013* *Maximum that can be capitalized $ 240,000 800,000 260,000 $1,300,000 Weighted-average interest rate, general liabilities: Loan Amount Rate Interest Expense × 12% = $ 240,000 $ 2,000,000 × 10 = 800,000 8,000,000 $10,000,000 $1,040,000 Weighted-average interest rate ($1,040,000 ÷ $10,000,000) = 10.4% Ship 340: Completed in October 2012 No capitalized interest in 2013 Interest Fraction Capitalization of the Year Amount Rate Outstanding Capitalized Interest Expenditures Ship 341: Accum expenditure $1,150,000 April 1, 2013 1,200,000 10.4% 10.4 6/12 3/12 $ 59,800 31,200 Ship 342: Accum expenditure May 1, 2013 1,200,000 1,600,000 10.4 10.4 9/12 5/12 93,600 69,333 750,000 1,250,000 950,000 13.0 13.0 10.4 12/12 6/12 6/12 97,500 81,250 49,400 810,000 10.4 4/12 28,080 Ship 343: Accum expenditure July 1, 2013 Ship 344: Sept 1, 2013 Ship 345: Nov 1, 2013 360,000 10.4 2/12 Total capitalized interest for 2013 6,240 $516,403 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 411 10–55 Self-Constructed Equipment Cost Stated at Full Cost Services of consulting engineer Work subcontracted Materials Production labor Maintenance labor used on self-construction Payroll taxes and employee fringe benefits for indirect labor (30%) Manufacturing overhead Allocated executive salaries Postage, telephone, supplies, and miscellaneous expenses Total $ 10,000 20,000 200,000 65,000 100,000 30,000 52,000* 22,500 10,500 $510,000 *Manufacturing overhead cost: Total manufacturing overhead $5,630,000 Less: Maintenance labor used on self-construction $100,000 Payroll taxes and employee fringe benefits for maintenance labor (30%) to be charged directly to equipment 30,000 130,000 Balance to be allocated $5,500,000 Production labor for normal products $6,810,000 Add: Production labor used on self-construction 65,000 Total production labor $6,875,000 Manufacturing overhead = 80% ($5,500,000 ÷ $6,875,000) of production labor = 0.80 × $65,000 = $52,000 Self-Constructed Equipment Cost Stated at Incremental Cost Services of consulting engineer Work subcontracted Materials Production labor Variable manufacturing overhead (50% of $52,000) Postage, telephone, supplies, and miscellaneous expenses Total $ 10,000 20,000 200,000 65,000 26,000 10,500 $331,500 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 412 Chapter 10 10–55 (Concluded) The greatest amount that should be capitalized as the cost of equipment is $400,000—the low bid from a reputable manufacturer This includes at least a part of the overhead incurred other than the strictly variable overhead Most accounting authorities recommend that for self-constructed assets, overhead should be allocated on the same basis as other production when a plant is not operating at capacity This has the effect, however, of increasing net income because of the reduced overhead allocation to normal production Any cost incurred from the self-construction of an asset computed on a full cost basis that is in excess of the cost of a comparable asset from a reputable supplier might be considered a loss and thus charged against revenues of the current period 10–56 Business Calculator Keystrokes: Approach 1: FV = $10,000; I = 6%; N = 20 years → Approach 2: FV = $250,000; I = 6%; N = 20 years → Approach 3: FV = $1,200,000; I = 6%; N = 20 years → Present Value Approach $ 3,118 Approach 77,951 Approach 374,166 Total estimated fair value $3,118 $77,951 $374,166 Probability 0.15 0.25 0.60 Probability-Weighted Present Value $ 468 19,488 224,500 $244,456 Nuclear Waste Repository Site Cash 700,000 Nuclear Waste Repository Site Asset Retirement Obligation 244,456 700,000 244,456 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 413 10–57 Current Assets Land, Buildings, and Equipment (net) Goodwill Current Liabilities Long-Term Liabilities Cash 340,000 260,000 1,085,000 25,000 160,000 1,500,000 The possible reasons Aurora was willing to pay an extra $1,085,000 for Payette include • • Payette has a strong organization with trained staff already in place Payette has an efficient production and distribution network that is up and running Payette has good relationships with its banks and suppliers Payette sells a superior product that has a well-established market niche • • Current Assets Land, Buildings, and Equipment (net) Gain Current Liabilities Long-Term Liabilities Cash 340,000 260,000 Current Assets Land, Buildings, and Equipment (net) Gain Current Liabilities Long-Term Liabilities Cash 340,000 260,000 65,000 25,000 160,000 350,000 265,000 25,000 160,000 150,000 10–58 2013: Interest Expense Construction in Progress Accrued Interest Payable Cash 2012: Interest Expense Construction in Progress Accrued Interest Payable Cash 470,000 350,000 8,000 828,000 410,000 260,000 13,000 657,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 414 Chapter 10 10–58 (Concluded) 2013 Statement of Cash Flows: In the Cash Flows from Operating Activities section: Decrease in accrued interest payable $ (8,000) In the Cash Flows from Investing Activities section: Increase in construction in progress (350,000) Supplemental Disclosure: Cash paid during the year for interest (amount of interest paid net of the amount capitalized) 478,000 2012 Statement of Cash Flows: In the Cash Flows from Operating Activities section: Increase in accrued interest payable $ 13,000 In the Cash Flows from Investing Activities section: Increase in construction in progress (260,000) Supplemental Disclosure: Cash paid during the year for interest (amount of interest paid net of the amount capitalized) 397,000 10–59 Return on equity = Net income ÷ Stockholders’ equity = $38 million ÷ ($325 million – $180 million) = 26.2% Yes, Cole exceeded its profitability goal of 25% ROE The following adjustments are necessary (a) Decrease net income and total assets by $15 million capitalized R&D (b) Decrease paid-in capital and total assets by $12 million to reflect market value of the stock (c) The equipment should be recorded at the present value of the payment stream Present value = $1,000,000 + [$3,000,000 × (PVAF, n = 8, i = 12%)] = $1,000,000 + [$3,000,000 × (4.9676)] = $15,902,800 or with a business calculator: PMT = $3,000,000; N = 8; I = 12% → PV = $14,902,919 $1,000,000 + $14,902,919 = $15,902,919 $25,000,000 – $15,902,800 = $9,097,200 Decrease total liabilities and total assets by $9,097,200 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 415 10–59 (Concluded) (d) Decrease net income and total assets by $7 million After the adjustments, net income is $16 million ($38 million – $15 million – $7 million); total assets are $281.9028 million ($325 million – $15 million – $12 million – $9.0972 million – $7 million); total liabilities are $170.9028 million ($180 million – $9.0972 million); total equity is $111 million ($145 million – $15 million – $12 million – $7 million) Return on equity = $16 million ÷ $111 million = 14.4% After the adjustments, Cole does not meet its profitability goal Note that item (c) does not affect the value of ROE and that item (b) actually has the effect of increasing ROE (by decreasing equity) The auditors should catch this kind of accounting abuse However, even a good audit may fail to detect such abuses when employees collude in order to bias the accounting numbers in some way 10–60 (a) Buildings 462,000 Cash 462,000 To record cost of addition to building (Expenditures for additions are capitalized and are depreciated over the life of the asset.) (b) Loss on Removal of Wall (or Operating Expense) 26,020 Cash 26,020 To record cost of removal of plant wall—$23,410 + $2,610 (Cost to tear down old wall not considered part of new wall cost No benefit to future periods from old wall.) (c) Accumulated Depreciation—Buildings 17,300 Cash 6,570 Depreciation Expense 10,030 Buildings 33,900 To cancel book value identified with plant wall and to record amount received from salvage (The removed wall will not benefit future operations and therefore should be eliminated from the books.) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 416 Chapter 10 10–60 (Concluded) (d) Accumulated Depreciation—Buildings Depreciation Expense Buildings To remove cost of old floor covering 6,250 6,750 Floor Covering Cash To record cost to replace flooring 9,190 (e) Painting Expense Cash To record maintenance charge for repainting 12,420 (f) Accumulated Depreciation—Buildings Depreciation Expense Buildings To remove cost of old shelving 990 1,210 Shelving Cash To record cost of new shelving 4,180 (g) Buildings Cash To record cost of new wiring (Wiring has same remaining useful life as the building.) 13,440 Accumulated Depreciation—Buildings Depreciation Expense Buildings To record the removal of old wiring 1,900 3,210 (h) Buildings Discount on Notes Payable Notes Payable To record cost of new fixtures (Electrical fixtures have the same remaining useful life as the building.) 9,440 800 Accumulated Depreciation—Buildings Depreciation Expense Buildings To record the removal of old fixtures 1,410 1,890 13,000 9,190 12,420 2,200 4,180 13,440 5,110 10,240 3,300 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 417 10–61 Business Calculator Keystrokes: Customer List Outcome 1: PMT = $40,000; I = 7%; N = years → Outcome 2: PMT = 18,000; I = 7%; N = years → Outcome 3: PMT = 9,000; I = 7%; N = years → Present Value Outcome $164,008 Outcome 60,970 Outcome 23,619 Total estimated fair value Probability 0.20 0.30 0.50 $164,008 60,970 23,619 Probability-Weighted Present Value $32,802 18,291 11,810 $62,903 Business Calculator Keystrokes: Ongoing Research Project Outcome 1: PMT = $450,000; I = 7%; N = 10 years → $3,160,612 Outcome 2: PMT = 12,000; I = 7%; N = years → 40,647 Outcome 3: PMT = 500; I = 7%; N = years → 1,312 Present Value Outcome $3,160,612 Outcome 40,647 Outcome 1,312 Total estimated fair value Customer list Ongoing research Probability-Weighted Probability Present Value 0.10 $316,061 0.20 8,129 0.70 918 $325,108 Cost Allocation Estimated According to Fair Values Relative Estimated Values $ 62,903 $62,903/$388,011 × $300,000 325,108 $325,108/$388,011 × $300,000 $388,011 Customer List R&D Expense* Cash Cost Assigned to Individual Items $ 48,635 251,365 $300,000 48,635 251,365 300,000 *The acquired in-process R&D is recognized as an expense because it has been acquired in a basket purchase outside a business combination To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 418 Chapter 10 10–62 Land Buildings Equipment Total fixed assets 2013 $ 600,000 900,000 350,000 $1,850,000 2012 $ 400,000 800,000 250,000 $1,450,000 Fixed asset turnover: $4,800,000/[($1,850,000 + $1,450,000)/2] = 2.91 (Note: The LIFO reserves are fair value adjustments that relate to current assets instead of long-term assets Also, it is reasonable to assume that the fair values of cash and accounts receivable are close to their book values.) Fair value of fixed assets: Fair value of total assets – Cash – Accounts receivable – Inventory – LIFO reserve 2013: 2012: $3,800,000 – $50,000 – $300,000 – $650,000 – $150,000 = $2,650,000 $3,000,000 – $45,000 – $220,000 – $510,000 – $100,000 = $2,125,000 Fixed asset turnover: $4,800,000/[($2,650,000 + $2,125,000)/2] = 2.01 It is difficult to tell whether Progressive is more or less efficient at using its fixed assets than is Steady State Based on the reported financial numbers, Progressive’s fixed asset turnover is 2.91, whereas the ratio for Steady State is only 2.5 However, as shown in (2), this difference may result from a difference between book value and fair value of reported long-term assets If Steady State has relatively new fixed assets, for which the book value is quite close to the fair value, then Progressive’s 2.01 fixed asset turnover ratio (based on fair values) is worse than the 2.5 ratio value for Steady State 10–63 The correct answer is b Capitalized interest will be based on the amount of avoidable interest caused by the building construction When that amount exceeds the specific funds borrowed, interest on unrelated liabilities will be capitalized When that amount is lower than the funds borrowed, as is the case here, the amount to be capitalized will be the lower amount of $40,000 The correct answer is b The only time costs are capitalized as goodwill is when a business combination occurs and the cost of the acquisition exceeds the fair market value of the underlying net identifiable assets acquired Neither the cost of developing nor of maintaining goodwill is capitalized To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 419 CASES Discussion Case 10–64 Each of the five items introduced in the case is discussed (a) Recorded book values on the books of the seller are irrelevant to the buyer Fair values of all identifiable assets, both tangible and intangible, should be used to make the entry to record the purchase Appraisal values are one source of estimated fair values Other possible sources include recent sales of similar assets and engineers’ estimates of building costs In this instance, the appraisal for fire insurance purposes is recent enough that it probably could be used for purposes of recording the purchase The land value would be $35,000, or 1/5 of the building value One could object to the values in the appraisal for fire insurance coverage because of its potential bias toward higher values to sell more insurance coverage Evaluation of the reputation of the fire insurance company and its appraisers would be required to determine the extent of such bias (b) Replacement costs of equipment can be used as a basis for determining the fair value of such assets Because it is easier to obtain replacement costs on new equipment than it is to determine the market value for used equipment that exactly matches the age and condition of the assets owned, it is common practice to use the new market price and then depreciate it to the estimated age of the used equipment In this instance, the new cost is estimated to be $450,000, and the depreciated value of 50% of the cost new, $225,000, would be a reasonable estimate of the market price of the old equipment (c) Franchises can be very valuable assets As with tangible assets, the value recorded on the seller’s books is irrelevant to the buyer Because the franchise is for an unlimited time, its value to the buyer is unaffected by the time the seller used it The current purchase price of similar franchises, $120,000, can be used to record the purchase (d) The two research scientists who will transfer employment to Fugate represent a value to Fugate However, this human resource value is generally not recognized as an asset in our historical cost system Fugate would not “own” the scientists, and they could leave the company with no contract penalties Only in a few types of activities, such as professional sports, are contracts for human resources capitalized and carried on the books as assets In a business acquisition, the intangible value of “at-will” employees is not recognized but is included as part of goodwill In this case, the researchers’ salaries will be charged to expense as they are paid The accounting for human resources is one accounting area that is certain to develop in the future (e) Patents are valuable assets that can be owned and transferred The fair value of the patent is the appropriate measure of the asset value at the transaction date and the zero book balance on Gleave’s books is not relevant to Fugate The total fair value of the assets acquired would be as follows: Land $ 35,000 Building 175,000 Equipment 225,000 Franchise 120,000 Patents 150,000 Total $705,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 420 Chapter 10 Discussion Case 10–64 (Concluded) Because only $556,950 was paid for these assets, this was a bargain purchase The journal entry would be as follows: Land Building Equipment Franchise Patents Gain Cash 35,000 175,000 225,000 120,000 150,000 148,050 556,950 Discussion Case 10–65 This case addresses the problems associated with accounting for software development costs Strategy wants its financial statements to present a favorable picture of the company’s financial condition and operating performance If the owner is correct in predicting that this year’s research and development costs will be recovered through sales in the following year, a strong argument could be made to defer the costs incurred this year and match them against next year’s revenues The central issue, however, is whether the sales will actually materialize next year The uncertainty of predicting future sales led the FASB to conclude that until technological feasibility has been established, costs to develop software should be expensed It is unclear from this case how much of the $45,000 was related to products for which technological feasibility had been established and how much related to new products still in the preliminary design and testing stages To the extent that the costs were incurred for new products for which technological feasibility had not been established, the CPA is correct in insisting that these costs be expensed as required by the FASB Discussion Case 10–66 From the brief description of Arnold, it is reasonable to assume that Arnold spends a lot for research and development (R&D) and for advertising On theoretical grounds, both of these can be argued to be capital expenditures However, R&D must be expensed as incurred and advertising expenditures are usually treated in the same way This can result in a substantial amount of real economic assets that are not recorded on the balance sheet For example, assume that Arnold spends an average of $300,000 per year on R&D and $400,000 per year on advertising and that the average economic life of the assets created is five years for the R&D expenditures and three years for the advertising This means that Arnold has unrecorded assets of $2,700,000 If these assets were reported on the balance sheet, Arnold’s ROA would be about the same as that for Baker Other assets that are not shown on companies’ balance sheets include the value of asset appreciation, key employees, favorable market position, and good reputation with suppliers, creditors, and employees The lack of comparability is an issue because some companies have large amounts of unrecorded assets and others not For example, two companies may both have pieces of land with a current market value of $500,000 However, one company may show the land at $100,000 because it was purchased years ago while the other may have purchased it just recently and thus will show it at $500,000 A comparison of the book values of companies (total assets – total liabilities) and the market values of those companies as measured by total market value of shares outstanding illustrates that there is considerable variability among companies, a fact that suggests companies often have large amounts of unrecorded assets To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 421 Discussion Case 10–67 The rule requiring firms to expense R&D outlays results in a decrease in net income for most firms A decrease in reported net income can impact a firm in several ways: • Managers’ bonuses are frequently based on reported earnings • Loan covenants are often written in terms of reported earnings • Some investors seem to rely on the naive use of reported earnings in picking stocks Accordingly, managers’ compensation may suffer when R&D expenditures are expensed, and those managers may be less willing to authorize R&D projects This is in spite of the fact that the R&D might be beneficial for the firm’s long-run profitability It might be expected that in response to an accounting standard change, management bonus plans, loan covenants, and investors’ decision rules would be adapted to allow for the change in reported earnings brought about solely because of the accounting change However, there is evidence that such adjustments are not always made Discussion Case 10–68 The estimated Gillette brand value is relevant both to outsiders who wish to value Gillette stock and to Gillette’s management who wish to monitor the impact of their actions on Gillette’s most valuable asset— the brand name However, reading the description of the 4-stage estimation process casts doubt on the reliability of the estimate The valuation estimate requires assumptions about the following quantities: • An appropriate sales-to-asset ratio • The baseline return on sales of a generic brand in Gillette’s industry • Gillette’s marginal tax rate • The brand strength multiple Given the assumptions made by Financial World magazine, the computed brand value is $10.3 billion, but slightly different estimates could result in numbers anywhere from $5 billion to $15 billion This may be a good example of a situation in which disclosure is better than recognition Recognizing a point estimate of the brand value gives an illusion of precision Disclosing the brand value in the notes, along with the assumptions underlying the computation, gives financial statement users a more realistic impression of the estimated value Discussion Case 10–69 Appreciation in asset values is a large part of the business of a real estate firm Because of this and because generally accepted accounting rules require long-term assets to be depreciated, many users of financial statements think that historical cost financial statements for real estate companies can be particularly uninformative For a further discussion, see Edward P Swanson and Frederick Niswander, “Voluntary Current Value Disclosures in the Real Estate Industry,” Accounting Horizons, December 1992, p 49 Daimler-Benz was willing to reveal the magnitude of its hidden reserves in order to comply with U.S GAAP as a prerequisite to listing its shares on the New York Stock Exchange Hidden reserves are a result of the “prudence principle”: the primary goal of current management is to make sure that the firm survives into the future to the benefit of stockholders, creditors, employees, local economies, and so on One way to build up a financial cushion to increase the probability of survival is to pay out small cash dividends In many jurisdictions, the amount of cash dividends is tied to the amount of reported income Accordingly, the prudence principle dictates the recording of accelerated depreciation in order to lower reported income and reduce the payment of cash dividends To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 422 Chapter 10 Discussion Case 10–69 (Concluded) SEC dissatisfaction with asset revaluations in the 1920s and 1930s was mainly a result of unease about the methods used to compute the revaluations, not about the notion of revaluation per se When there is an established market for an asset, revaluation to market value is almost as objective and verifiable as using historical cost An auditor is understandably wary about appraisals and estimates; however, market values from an active market are not as subjective Case 10–70 Because Disney has developed its brand name itself instead of purchasing it from another company, no value is recognized in the financial statements However, Disney does recognize the costs of registering and successfully defending its rights and trademarks In Note 9, Disney discloses: “The Company capitalizes interest on assets constructed for its parks, resorts, and other property, and on theatrical productions In 2009, 2008 and 2007, total interest capitalized was $57 million, $62 million and $37 million, respectively.” Supplemental cash flow information at the bottom of Disney’s cash flow statement states that cash paid for interest in 2009 was $485 million This cash paid relates to interest reported as interest expense, not to the capitalized interest If it is assumed that all the capitalized interest was paid in cash in 2009, the summary journal entry to record interest for the year is as follows: Projects in Progress Interest Expense Interest Payable… Cash ($485 + $57) 57 466 19 542 Note explains Disney’s amortization policy for intangible assets The following explanation is included under the subheading “Goodwill and Other Intangible Assets”: The Company is required to test goodwill and other indefinite-lived intangible assets for impairment on an annual basis and between annual tests if current events or circumstances require an interim impairment assessment Goodwill is allocated to various reporting units, which are generally an operating segment or one reporting level below the operating segment The Company compares the fair value of each reporting unit to its carrying amount to determine if there is potential goodwill impairment If the fair value of a reporting unit is less than its carrying value, an impairment loss is recorded to the extent that the fair value of the goodwill within the reporting unit is less than the carrying value of its goodwill Amortizable intangible assets, principally copyrights, are generally amortized on a straight-line basis over periods of up to 31 years To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 10 423 Case 10–70 (Concluded) The business segment information in Note states that capital expenditures for each of Disney’s operating segments were as follows in 2009 (in millions): Media Networks Cable Networks……………………………………… 151 Broadcasting…………………………………………… 143 Parks and Resorts: Domestic 1,039 International 143 Studio Entertainment 135 Consumer Products 46 Interactive Media……………………………………… 21 Corporate 75 Total (doesn’t add exactly because of rounding) $1,753 Case 10–71 To: Controller, Hunter Company From: [Student Name] Subject: Accounting for the Finch Land Transfer The land to be transferred from Rosalyn Finch should be recorded as an asset on the books of Hunter Company The title to the land is being transferred unconditionally, so there really is no question on this issue The difficult issue here is how to value the land The two major concerns are as follows: Rosalyn Finch is an officer of the company, so this qualifies as a related-party transaction The consideration given to Finch may not be an unbiased indication of the fair value of the land It may be advisable for Hunter Company to commission an external appraisal in order to determine an independent value for the land Computing a value for the employment contract and royalty contract given to Finch in exchange for the machine will be very difficult Regarding the employment contract, unless it involves an agreement to pay Finch a salary in excess of the fair value of her services, the contract should not be accounted for any differently than any other employment contract—that is, no value should be attached to the contract The royalty provision is based on future sales, making the value of the contract difficult to estimate For the two reasons outlined above, every attempt should be made to value the land using an independent outside appraisal To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 424 Chapter 10 Case 10–72 The general outline of facts in this ethical dilemma matches the actual facts of the Chambers Development case The same audit firm had been on the Chambers engagement for a number of years, and former audit partners from the firm were employed by Chambers The heroes in this case were the members of the new team of auditors who were able to overcome the obvious pressures to cover up the wrongful capitalization of landfill costs This case illustrates a difficult conflict between doing what is best for the firm that employs you and doing what will please your immediate supervisor If the auditors on the Chambers job had just ignored the accounting irregularities they found, their audit firm could have been liable for huge damages in subsequent years when the truth was finally revealed So, it was clearly in the best interests of the audit firm for the auditors to blow the whistle However, a staff auditor would still be reluctant to raise the issue with a manager or partner who may have approved the “fishy” accounting in previous years The accounting announcement on March 17, 1992, was just the beginning of troubles for Chambers Continuing business problems eventually forced the board of directors of Chambers to put the company up for sale Chambers was acquired by USA Waste on June 30, 1995 Articles that contain more information on the interesting Chambers Development case include: Gabriella Stern and Laurie P Cohen, "Chambers Development Switches Accounting Plan," The Wall Street Journal, March 19, 1992, p B4 Roula Khalaf, "Fuzzy Accounting," Forbes, June 22, 1992, p 96 Gabriella Stern, "Audit Report Shows How Far Chambers Would Go for Profits," The Wall Street Journal, October 21, 1992, p A1 Case 10–73 Solutions to this problem can be found on the Instructor’s Resource CD-ROM or downloaded from the Web at www.cengage.com/accounting/stice ... away unwanted trees and shrubs, shaping the land for the tees and greens, building sand traps, and constructing artificial lakes To download more slides, ebook, solutions and test bank, visit... Accountancy, February 1989, p 31 (a) and (b) CN—Capitalize and don’t depreciate Costs of changing the land itself should be viewed as permanent improvements to the land and are not depreciable These... understate assets and owners’ equity for the current year and for succeeding years, but by successively decreasing amounts until the asset no longer To download more slides, ebook, solutions and test