8Challenging Issues Under
Accrual Accounting:
Long-Lived Depreciable Assets –
A Closer Look
Discussion Questions
8-1.Some factors determining the estimated useful life of assets might include:
a. prior experience the company
b. industry norms
c. anticipated technological advancements
d. the way the asset will be used
e. anticipated company growth
An important point that needs to be made during the discussion of this question is that companies are considering the useful life of the asset and not the life of the asset. Companies rarely, if ever, intend to use any asset until it is literally worthless. Usually, the estimated useful life is somewhat shorter than the actual life.
8-2.The definition of residual value or Awhat is left over@ implies that the asset will be scrapped or traded-in for a newer asset once its estimated life is over. In trying to estimate an asset=s residual value, a company actually tries to look into the future and determine what the company will receive for an asset when it is disposed of or traded in on a new purchase.If the company believes there will be a market for the used asset, the company might find out what used assets, like the one being depreciated, are selling for today.That amount could be used as a starting point in the development of the estimate of its asset=s residual value.
If a large piece of machinery is expected to be totally obsolete when the company is finished using it, the estimated residual value may be based on how much the company could expect to get from the scrap metal in the asset.Expected technological advances may lead management to anticipate that machinery may become nothing more than scrap metal well before the asset actually wears out. In this case, the residual value may be estimated as a dollar amount per ton that the company can expect to get when the machinery is replaced.
8-3.The first alternative starts with a depreciable base of $24,000 to allocate over the estimated useful life of 6 years. The cost is allocated to expense at the rate of $4,000 per year. The second case starts with a depreciable base of $25,000 allocated over 4 years. This scenario allocates the depreciable amount at a rate of $6,250 per year. Because the expense is higher, the net income is lower.
Chapter 8 – Challenging Issues under Accrual Accounting: Long-Lived Depreciable Assets – F8- 1
A Closer Look
However, the second scenario calls for depreciation expense to be recorded for only 4 years. After that, net income is not impacted by depreciation related to this asset. The second scenario would record more depreciation expense per year, but only 4 years of net income will be affected.
8-4.Units-of-production may be established for each item in the following manner:
- Long-distance truck - based on mileage or based on number of hours of engine time
- Commercial airliner - based on number of hours of engine running time or based on number of air miles flown
c.Milling machine - based on number of parts produced or based on number of machine hours used
d.Cruise ship - based on number of engine hours
Students may come up with some other useful measurements.
8-5.Answers may vary but some suggestions might include:
a. Furniture and fixtures
b. Buildings
c. Office machinery
d. Computers
e. Automotive equipment
8-6.The book value is computed by subtracting the accumulated depreciation from the original cost. The book value at the end of three years for each scenario is as follows:
Decision 1:Book Value = [$40,000 B ($9,000 x 3)] = $13,000
Decision 2:Book Value = [$40,000 B ($7,200 x 3)] = $18,400
Decision 3:Book Value = [$40,000 B ($9,500 x 3)] = $11,500
Decision 4:Book Value = [$40,000 B ($7,600 x 3)] = $17,200
8-7.This question is designed as a review for your students about the meaning of retained earnings and how yearly net income (or loss) will affect it. Beavers had a $23,000 loss in 2007, which lowered retained earnings by that amount. Since the company had a $27,000 retained earnings balance at the end of 2007 (after taking into account the $23,000 loss), the retained earnings balance at the beginning of the year must have been $50,000. This can be demonstrated by constructing a statement of retained earnings for 2007:
Retained Earnings at January 1, 2007$50,000
LESS: Net Loss (23,000)
LESS: Dividends -0-
Retained Earnings at December 31, 2007$27,000
Chapter 8 – Challenging Issues under Accrual Accounting: Long-Lived Depreciable Assets – F8- 1
A Closer Look
8-8.This question demonstrates the effect depreciation expense has on periodic earnings (and, therefore, retained earnings). To get the full benefit of this question, your students need to have worked their way through Discussion Question 8-7. From that work, they would know retained earnings at January 1, 2007 was $50,000. The statement of retained earnings for 2007 if Beavers had not recorded any depreciation is:
Retained Earnings at January 1, 2007 $ 50,000
ADD: Net Income 97,000*
LESS: Dividends -0-
Retained Earnings at December 31, 2007$147,000
*This is most easily calculated by reconstructing the 2007 income statement and simply omitting the depreciation expense:
Sales$755,000
Cost of Goods Sold 422,000
Gross Margin$333,000
Operating Expenses
Other than Depreciation (236,000)
Net Income$ 97,000
8-9.The key concept for students to grasp is that over time (at the end of the life of the asset) any method of calculating depreciation will yield the same final result. This is because depreciation is a cost allocation method and since the cost is a fixed amount, the net result of depreciation expense must be the same regardless of the way the amount is calculated during the life of the asset. The differences are in the reported depreciation expense (and net income) for individual years over the life of the asset, not the total depreciation expense.
Each of the five income statements tell the story of an individual year, and are affected by the differences. The balance sheets reflect the accumulated impact of the differences. Only four of five are different.
The reason the 2011 balance sheet is the same under either depreciation method is that once all the depreciation has been taken on Beaver=s machine (over its life), the accumulated depreciation is the same regardless of the method used in calculating depreciation. Additionally, since total net income over the life of the asset is the same regardless of the depreciation method, retained earnings will be the same. These are the two items on the balance sheet that were different in the previous years.
8-10.Cash is not part of the depreciation process, so the cash balances are the same under both methods. The cash paid for the machine is recorded whenever payment is made. The depreciation process has no influence on when that is.
Chapter 8 – Challenging Issues under Accrual Accounting: Long-Lived Depreciable Assets – F8- 1
A Closer Look
NOTE TO INSTRUCTOR: Students may raise the issue of net income differences impacting taxes and, therefore, cash. Be prepared to explain that our focus is on financial reporting, which is separate and distinct from tax law. Differences in methods used for financial reporting do not directly affect a company=s taxes because MACRS is used for tax purposes regardless of the financial method used.
8-11.The short answer is that the 2007 figures in Exhibit 8-8 are not enough. It is, however, important for students to see what we can and cannot learn from the limited information. The company using straight-line depreciation appears to have been more profitable. In fact, the company using double-declining-balance reported a $23,000 loss. If you were making an investment decision based on this information, the natural tendency would be to select the company that uses straight-line. The difference, however, between the two companies= figures is a result of the way depreciation was calculated.
Even if only the 2007 figures from Exhibit 8-8 were available, we could determine the difference in the amount of depreciation expanse recorded by the two companies. ($120,000 - $55,000 = $65,000). This difference fully explains the differences between the net incomes and the book values reported by the two companies.
If the company using straight-line had recorded $120,000 of depreciation expense, it, too, would have shown a $23,000 loss. In this case, the entire difference in the companies= net incomes is a result of differences in depreciation expense. Since this expense is a cost allocation, its impact on net income should not affect a decision maker=s evaluation of company performance.
Does one company have more assets than the other? We can=t tell for sure from the limited information, but the difference in the book value of their assets is a result of the depreciation expense difference. If the company using straight-line had recorded $120,000 of depreciation expense, its book value would be $65,000 lower ($180,000--just like the other company).
8-12.This question asks students to apply knowledge presented earlier about the income statement to help them realize that they are building an integrated set of skills which can enable them to read and use accounting information. The specific items appearing on Beaver=s multi-step income statement that would not appear on a single-step statement are Gross Margin and Operating Income.
NOTE TO INSTRUCTOR: Discussion Questions 8-13 through 8-19 are actually more like traditional homework exercises than most of the Discussion Questions found in this text. We have chosen to include them here because an understanding of the items covered in them is critical to your students= grasp of the effects of different depreciation methods and what gains and losses really mean. If you choose not to use them in your class work with the material, they make good homework problems.
Chapter 8 – Challenging Issues under Accrual Accounting: Long-Lived Depreciable Assets – F8- 1
A Closer Look
8-13.Two items would be different on the income statement. The first is the loss on the sale of the machine (reported as $6,000), which would become a loss on the abandonment of the machine equal to the book value of the machine ($25,000). The difference is caused by the fact that Beavers did not receive the $19,000 cash as reported in the financial statements in Exhibit 8-12. The other item affected on the income statement is net income, which would be $72,000 instead of $91,000 reported in the exhibit. This difference is caused by the loss being $19,000 higher.
Two specific items would be different on the balance sheet. The first is cash (reported as $212,000), which would now be $193,000. The difference is caused by the fact that Beavers did not receive the $19,000 cash as reported in the financial statement in Exhibit 8-11. This difference in cash would, of course, cause a difference in total assets, as well. The other item affected on the balance sheet is retained earnings, which would be $332,000 instead of $351,000. This difference is caused by net income (this period=s addition to retained earnings) being $19,000 lower. The difference in retained earnings would, of course, cause a difference in total liabilities and stockholders= equity.
8-14. Straight Arrow Automotive:
$228,000 - $92,000 /4 years=$34,000 per year.
Accelerated Movers:
1.Figure the straight-line rate in percentages.
100% / 4 = 25% (per year)
2.Double the straight-line percentage.
25% x 2 = 50% (per year)
3.Apply that percentage to the book value of the asset.
50% x $228,000 = $114,000 (depreciation expense for the first year)
8-15.This question helps your students understand how the one difference in depreciation flows through other related items on the two financial statements.
Income Statement Items:
Depreciation Expense: Higher for Accelerated Automotive because the company is using double-declining-balance depreciation.
Total Operating expenses: Higher for Accelerated Automotive because Depreciation Expense is higher.
Operating Income: Lower for Accelerated Automotive due to higher Total Operating Expenses.
Net Income: Lower for Accelerated Automotive due to higher Total Operating Expenses.
Balance Sheet Items:
Accumulated Depreciation:Higher for Accelerated Automotive due to higher Depreciation Expense.
Trucks, Net. Lower for Accelerated Automotive due to higher Accumulated Depreciation.
Total Assets: Lower for Accelerated Automotive due to lower book value of trucks.
Retained Earnings: Lower for Accelerated Automotive due to lower Net Income.
Total Shareholders= Equity: Lower for Accelerated Automotive due to lower Retained Earnings.
Total Liabilities and Owner=s Equity: Lower for Accelerated Automotive due to lower Total Shareholders= Equity.
8-16.Straight-Line Automotive and Accelerated Automotive both had beginning retained earnings balances of $143,000. This can best be determined by creating a 2007 statement of retained earnings for each company from the information provided in the income statements and balance sheets and then filling in the unknown beginning balances of retained earnings:
Straight-Line Automotive:
Retained Earnings, January 1, 2007$143,000 (determined)
ADD: Net Income for 2007 221,000 (given)
LESS: Dividends -0- (given)
Retained Earnings, December 31, 2007$364,000 (given)
Accelerated Automotive:
Retained Earnings, January 1, 2007$143,000 (determined)
ADD: Net Income for2007 141,000 (given)
LESS: Dividends -0- (given)
Retained Earnings, December 31, 2007 $284,000
8-17.Depreciation expense on the income statement of Straight-Line Automotive was $34,000 in 2008 and accumulated depreciation on its balance sheet at the end of 2008 is also $34,000. Depreciation expense for Accelerated Automotive was $114,000 and accumulated depreciation is also $114,000. In both cases the reason the depreciation expense are the same is because 2008 is the first year the assets are being depreciated. Accumulated depreciation is the sum of all the prior years= depreciation expense plus the depreciation expense for the current year. Since each company purchased its fleet of trucks in 2008, there was no prior depreciation. Therefore, the Accumulated Depreciation shown on the 2008 balance sheet and the Depreciation Expense reported on the 2008 income statement are the same. In all years subsequent to 2008, Accumulated Depreciation and Depreciation Expense related to this asset will be different amounts.
8-18.Accelerated Automotive shows accumulated depreciation of $114,000 and book value of $114,000. To understand these two amounts are the same, you must remember.
1.Double-declining balance depreciation is calculated using twice the straight-line rate.
2.The estimated useful life of the trucks is four years, which is 25% each year using straight-line depreciation. This means that double-declining balance depreciation use 50% (twice the straight-line rate).
3.The 50% rate is applied to the book value each year, and in the first year (before any depreciation has been recorded) the book value equals the cost. (The estimated residual value of $92,000 is ignored in the initial calculation of depreciation using the double declining-balance method.)
Given the facts of this case for Accelerated Automotive, the depreciation calculation for the first year (2008) is:
Book Value
At The 2008
Beginning Depreciation Depreciation
Year Of The Year Percentage Expense 2008 $228,000 X 50% = $114,000
The amount of depreciation expense for the first year is exactly half of the original cost of the trucks. Book value is defined as the original cost of an asset less the accumulated depreciation. Since accumulated depreciation is equal to 50% of the cost of the trucks ($114,000), the book value of the trucks is also 50% of the original cost of the trucks ($114,000).
Straight-Line Automotive shows accumulated depreciation of $34,000 and book value of $194,000. The amounts are different because only $34,000 of depreciation expense was recognized. The book value is calculated by subtracting the accumulated depreciation from the cost of the trucks ($228,000 - $34,000 = $194,000).
8-19.Depreciation expense under the double-declining-balance method is based on the book value at the beginning of any given year during an asset=s estimated useful life. The fleet of trucks had a book value at the beginning of 2009of $114,000 ($228,000 cost - $114,000 accumulated depreciation). Therefore, it would seem reasonable to calculate depreciation expense of $57,000 ($114,000 X 50%).
Companies, however, are not allowed to depreciate assets beyond the point at which the book value of the assets is equal to the assets= estimated residual value. The maximum amount of depreciation expense recorded over the life of the asset is the asset=s depreciable base (cost - residual value). In this case, accumulated depreciation cannot exceed $136,000, the depreciable base. At this point, the book value will equal the residual value ($228,000 - $136,000 = $92,000). With this limit in mind, and $114,000 in accumulated depreciation already, the amount of depreciation expense for 2009 is limited to $22,000.
8-20.There is no way to tell from the information provided in the text whether the companies were wise to sell their trucks or whether they got a Agood deal@. The purpose of this question is to drive home to the students that an informed user of accounting information needs more than just numbers to successfully evaluate a decision.
Also, this question Asets up@ the examination of Exhibit 8-15. Both companies sell their trucks for $150,000. The evaluation of whether or not the move is wise should be the same for both companies at this point because what limited information we have is the same for both. Students will soon see that one company will show a gain and one will incur a loss, but those results are not evidence of whether or not selling these assets is a smart move.
Before we could evaluate whether selling the trucks at this time for $150,000 was a smart move, we would need to know more, including information about:
--why the companies sold the trucks.
--whether the companies planned or needed to replace the trucks.
--what the cost of replacement trucks would be.
--how the sale of the trucks will affect each company=s operations.
--the market for used trucks (could the companies get more for them in a different season?)
--what the companies planned to so with the $150,000.
Review the Facts
A.Examples of long-lived assets would include furniture, office equipment, automobiles, trucks and real estate.
B.The depreciation process is the systematic allocation of the historical cost of long-lived assets.
C.The computation of depreciation requires management to estimate the useful life of the equipment and the expected salvage value at the end of the life of the equipment.
D.The depreciable base of an asset is the cost of the asset minus the residual or salvage value. The depreciable base of the asset is the maximum amount of the asset that may be depreciated.