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Q8-1. Routine maintenance costs that are necessary to realize the full benefits of ownership
of the asset should be expensed. However, betterment or improvement costs should
be capitalized if the outlay enhances the usefulness of the asset or extends the assets
useful life beyond original expectations. As would be the case with any cost, an
immaterial amount should be expensed as incurred.
Q8-2. Capitalizing interest costs as part of the cost of constructing an asset reduces interest
expense, and increases net income during the construction period. In subsequent
periods, the interest costs that were capitalized as part of the cost of the asset will
increase the periodic depreciation expense and reduce net income.
Q8-3. As any asset is used up, its cost is removed from the balance sheet and transferred
into the income statement as an expense. Capitalization of costs onto the balance
sheet and subsequent removal as expense is the essence of accrual accounting. If the
cost of a depreciable asset is recognized in full upon purchase, profit would be
inaccurately measured: it would be too low in the year of purchase when the asset is
expensed and too high in later years as revenues earned by the asset are not matched
with a corresponding cost. The proper matching of costs (expenses) and revenues is
essential for the proper recognition of profit.
Q8-4. The primary benefit of accelerated depreciation for tax reporting is that the higher
depreciation deductions in early periods reduce taxable income and income taxes.
Cash flow is, therefore, increased, and this additional cash can be invested to yield
additional cash inflows (e.g., an "interest-free loan" that can be used to generate
additional income). We would generally prefer to receive cash inflows sooner rather
than later in order to maximize this investment potential.
Q8-5. When a change occurs in the estimate of an asset's useful life or its salvage value, the
revision of depreciation expense is handled by depreciating the current undepreciated
cost of the asset (original cost accumulated depreciation) using the revised
assumptions of remaining useful life and salvage value.
Present and future periods are affected by such revisions. Depreciation expense
calculated and reported in past periods is not revised.
Q8-7. A PPE asset is considered to be impaired when the sum of the undiscounted expected
cash flows to be derived from the asset is less than its current book value.
An impairment loss is calculated as the difference between the asset's book value and
its current fair market value.
Q8-8. Research and development costs must be expensed under GAAP unless they have
alternative future uses. Equipment relating to a specific research project with no
alternative use would, therefore, be expensed rather than capitalized and
subsequently depreciated.
Q8-9. The difficulty with amortizing intangible assets is estimating the useful life. For some
intangibles, the useful life is limited and can be easily estimated. However, some
intangibles have an indefinite life. This means that the useful life of the intangible is
long and cannot be determined with any reasonable degree of accuracy. Under these
circumstances, it is not appropriate to amortize the asset until the useful life can be
determined.
Q8-10. Goodwill arises whenever a company acquires another company and the purchase
price is greater than the fair value of the identifiable assets acquired. The amount of
goodwill is the difference between the purchase price and the value assigned to the
net assets of the acquired company. It is recorded as a long-term asset in the balance
sheet.
Since goodwill is assumed to have an indefinite life, it is not amortized. The only time
that goodwill might affect the income statement is if it is determined that its value is
impaired. In that case, an impairment loss is recorded in the income statement and
the value of the goodwill asset on the balance sheet is reduced.
a. Expense
b. Capitalize
c. Capitalize (the new equipment enhances the assembly line)
d. Expense this is routine maintenance of the building, unless it extends the buildings useful
life
e. Capitalize the useful life is extended
f. Capitalize this is a purchased intangible asset
a. Straight-line: ($18,000 - $1,500)/ 5 years = $3,300 for both 2013 and 2014.
Notice that, over the first two years, the company reports $6,600 of depreciation expense under
the straight-line method and $11,520 of depreciation expense under the double-declining-
balance method.
a. Straight-line: ($130,000 - $10,000)/ 6 years = $20,000 for both 2013 and 2014.
b.
b.
a. Straight-line depreciation
2013: ($145,800 - $5,400)/3 = $46,800; (8/12) x $46,800 = $31,200
2014: $46,800
b. Double-declining-balance depreciation
Preliminary computation: Twice straight-line rate = 2 x 100%/3 = 66%
($145,800 x 66%) = $97,200
2013: (8/12) x $97,200 = $64,800
2014: ($145,800 - $64,800) x 66% = $54,000
a. Under U.S. GAAP, capitalization of development costs is not allowed and all R&D costs must
be expensed. Under IFRS, development costs are capitalized if there is the intention, feasibility
and resources to bring the asset to completion, there exists the ability to use or sell the asset to
generate an economic benefit. Otherwise the costs must be expensed.
a.
Year Book value Depreciation rate Depreciation expense
1 $50,000 2 x = 0.5 $25,000
2 25,000 2 x = 0.5 12,500
3 12,500 4,500
4 8,000 0*
*No depreciation is recorded in Year 4 because the asset is depreciated to its residual value of $8,000.
b.
Year Book value Depreciation rate Depreciation expense
1 $50,000 2 x 1/5 = 0.4 $20,000
2 30,000 2 x 1/5 = 0.4 12,000
3 18,000 2 x 1/5 = 0.4 7,200
4 10,800 2 x 1/5 = 0.4 4,320
5 6,480 3,480*
*$3,480 of depreciation is required in Year 5 to depreciate the asset to its residual value of $3,000.
c.
Year Book value Depreciation rate Depreciation expense
1 $50,000 2 x 1/10 = 0.2 $10,000
2 40,000 2 x 1/10 = 0.2 8,000
3 32,000 2 x 1/10 = 0.2 6,400
4 25,600 2 x 1/10 = 0.2 5,120
5 20,480 2 x 1/10 = 0.2 4,096
6 16,384 2 x 1/10 = 0.2 3,277
7 13,107 2 x 1/10 = 0.2 2,621
8 10,486 2 x 1/10 = 0.2 2,097
9 8,389 2 x 1/10 = 0.2 1,678
10 6,711 5,711*
* $5,711 of depreciation is required in Year 10 to depreciate the remaining value of the asset. Alternatively, DeFond
could switch to straight-line depreciation in Year 7, recording $3,027 of depreciation in Years 7 through 10.
a.
Year Barrels extracted Depletion per barrel Depletion
2013 300,000 $32,000,000 / 4,000,000 = $8 $2,400,000
2014 500,000 $32,000,000 / 4,000,000 = $8 $4,000,000
2015 600,000 $32,000,000 / 4,000,000 = $8 $4,800,000
b.
i. Oil reserve (+A) ................................................................ 32,000,000
Cash (-A) .................................................................... 32,000,000
c.
+ Oil Reserve (A) - + Oil Inventory (A) -
i. 32,000,000 ii. 2,400,000
2,400,000 ii.
Balance 29,600,000 Balance 2,400,000
+ Cash (A) -
32,000,000 i.
Balance -3,200,000
a.
PPE turnover rates for 2007
Texas Instruments $13,735 / [($4,428 + $3,680) / 2] = 3.39
Intel Corp. $53,999 / [($23,627 + $17,899) / 2] = 2.60
Texas Instruments turns its PPE more quickly than does Intel.
b. PPE turnover rates increase with increases in sales volume relative to the dollar amount of
PPE on the balance sheet. The PPE turnover rate is often a very difficult turnover rate to
change, and typically requires creative thinking. Many companies are outsourcing the
manufacturing process in whole or in part to others in the supply chain. This is beneficial so
long as the savings realized by the reduction of manufacturing assets more than offset the
higher cost of the goods as these are now purchased rather than manufactured. Another
approach is to utilize long-term operating assets in partnership with another firm, say in a joint
venture.
Abbotts R&D expenditure level could be compared to the R&D expenditure level for its
competitors to gain a sense of the appropriateness of its R&D expenditures. The median value
of R&D intensity for pharmaceutical companies is 19.6% in Exhibit 5.13 in Chapter 5. Abbott is
one of the larger, more established firms in this industry and may have an R&D program that is
more stable and less intensive than the median.
b. R&D costs must be expensed when incurred unless they are expenditures for depreciable
assets that have alternative future uses (in which case the depreciation is expensed as
recognized). As a result, the balance sheet does not reflect the costs incurred for long-term
R&D assets. In addition, operating expenses are increased, thus reducing retained earnings.
a. Straight line:
($80,000 - $5,000)/5 years = $15,000 per year
b. 1. $ 0
Cash (+A) ..................................................................................................
368,000
Accumulated depreciation (-XA, +A) ......................................................... 432,000
Plane (-A) ................................................................................................. 800,000
b. 1. 0
2. $400 gain ($15,000 - $14,600)
3. $2,600 loss ($12,000 - $14,600)
c. Straight line: ($110,000 $15,833x2 $10,000) / 5 = $13,667 in 2015 and each subsequent
year.
Note: We eliminate land and construction in progress from the computation because these
assets are not depreciated.
Assuming that assets are replaced evenly as they are used up, we would expect assets to be
50% depreciated, on average. Deeres 59% is higher than this level. Our concern is that it will
require higher capital expenditures in the near future to replace aging assets.
b. 3Ms Receivable and PPE turnover ratios have improved significantly while its inventory
turnover rates improved marginally. 3Ms revenues increased significantly in 2011, and that
increase is likely to account for the increase in PPET. However, PPE turns can also be
improved by off-loading manufacturing to other companies in the supply chain and acquiring
long-term operating assets in partnership with other companies, for example, in a joint
venture. The Receivable turnover improvement could be due to monitoring more closely
the quality of customers to which credit is granted, implementing better collection
procedures, and offering discounts as an incentive for early payment. Inventory turnover
rates can be improved by weeding out slowly moving product lines, by reducing the depth
and breadth of products carried, and by implementing just-in-time deliveries.
c. Adams assets are almost completely depreciated. This results in an extremely high percent
depreciated ratio and also a very high PPE turnover ratio (PPET). Adding inventories and
receivables to get all the firms net operating asset turnover (NOAT) is more reasonable
devisor. Adams outsources most of its manufacturing and, recognizing concerns that these
numbers might produce, reports in its 10K that its current facilities (PPE assets) are
adequate for the foreseeable future. Thus, although the ratios might suggest otherwise, the
company does not anticipate large capital expenditures in the near future. Indeed this has
been the case for the last several years as well.
a. The list illustrates the wide range in expenditures for R&D (as a percent of sales) across
firms. Note the large amount spent by pharmaceutical companies Pfizer (13.51%) and
Merck (17.62%), compared to the amount spent by Lenovo (1.53%). The companies in the
list are paired by industry. It is interesting to see how similar some firms in the same
industry are. For example, Callaway Golf and Adams Golf and Head N.V. spend almost the
same percentage of sales on R&D despite the fact that Callaway is several times larger than
Adams.
b. Beside industry affiliation, the differences in R&D expenditures as a percent of sales is due
to differences in markets, product mix, and other strategic considerations. As suppliers of
technology (hardware and software), Intel and Microsoft depend very heavily on their
intellectual property. As a result, their expenditures on research and development are
among the highest of established firms. Apple has established itself as an innovator in
technology and design and has spent billions of dollars developing unique products such as
the iPad. Apples research intensity for 2011 has been reduced by the tremendous
increase in the companys sales revenue. From 2009 to 2011, Apples revenues increased
by 152%, while R&D increased by 82%.
a. Yes, the equipment is impaired at July 1, 2013 because its book value is not recoverable
through future cash flows. Specifically, on July 1, 2013, its book value is $145,000
($225,000 initial cost less $80,000 accumulated depreciation*) and the estimated future
(undiscounted) cash flows are only $125,000.
b. The impairment loss in a is computed as the equipment's book value minus its current fair
value: $145,000 $90,000 = $55,000
c. Assuming that the salvage value remains the same after the impairment (this is not likely
given the decline in market value of the asset), the annual depreciation expense would be
($90,000 - $25,000) / 6 = $10,833 per year.
d.
In order to determine the entries for the sale of property, plant and equipment, we need to fill in
the blanks for the PPE and accumulated depreciation accounts. Once we record the
purchases and the depreciation expense, we can determine the cost and accumulated
depreciation for the assets sold.
b. R&D costs are expensed in the income statement except for the portion relating to
depreciable assets that have alternate uses. Expensing (rather than capitalizing and
depreciating) reduces assets, and the additional expense reduces profit and equity (via the
reduction in retained earnings). In addition, expensing R&D as incurred means that
potentially valuable intangible assets are omitted from the balance sheet.
c. Agilent has reduced its R&D spending as a percent of revenues in recent years and, as a
result, increased its earnings. (Agilent had a loss from operations in 2003.) This has turned
operating losses into an operating profit for the company. However, Agilent is dependent
upon technology in order to maintain its market position, and R&D is critical to its very
existence. Agilent has divested itself of some high-intensity R&D businesses over the eight
years from 2003 to 2011, and its spending on R&D has remained pretty constant in absolute
terms from 2005 to the present. The decrease in intensity is due to increased revenues, not
decreases in R&D spending. In addition, a company can maintain its investment in
intellectual capital and reduce expenses by outsourcing the activity to other countries where
the intellectual resources are less expensive.
($ millions)
a. i. Depreciation expense (+E, -SE) ................................................................
2,060
Accumulated depreciation (+XA, -A) .......................................................... 2,060
ii. Property and equipment (+A) .................................................................... 2,129
Cash (-A) ................................................................................................... 2,129
iii. Cash (+A) .................................................................................................69
b. The problem provides information directly to make entries (i), (ii), (iv) and (v) in part a. For
part (iii), we can infer the accumulated depreciation on disposed property and equipment as
being the amount ($990) that makes that account balance. Since no gain or loss was
reported on these disposals, the credit to property and equipment in part (iii) is the amount
that balances the disposal transaction ($1,059).
However, this leaves the property and equipment T-account unbalanced. A likely reason is
that Target acquires some property and equipment without an expenditure of cash.
(Chapter 10 will cover capital lease transactions, which play a role in Targets operations.)
Based on the information in the problem, we would estimate that $247 million of property
and equipment was acquired through such transactions, because that amount balances the
property and equipment T-account.
The process used in this question is to fill in the entries for property and equipment and for
accumulated depreciation in parts a, b and c, and then to use the plug figures in the T-
accounts to determine the values in part d.
($ thousands)
a. Depreciation expense (+E, -SE) ................................................................
144,630
Accumulated depreciation (+XA, -A) .......................................................... 144,630
The firm does not appear to be as capital intensive as others in the industry based on a
higher than average PPE turnover ratio than its closest competitors.
*Note: We eliminate land from the computation because land is never depreciated. We eliminate construction in
progress because these represent assets that the company is building. These assets are not yet in service and
are consequently not yet depreciable. This elimination is also used in part c.
If plant assets are replaced at a constant rate, we would expect those assets to be about
50% used up, on average. A substantially higher percentage used up indicates that the
assets are closer to the end of their useful lives and will require replacement (and usually
higher maintenance costs near the end of their useful lives). Such a situation would
negatively impact future cash flows.
1. Use of less costly components (of equal quality) and production with lower wage rates
2. Elimination of product features not valued by customers
3. Outsourcing to reduce product cost
4. Just-in-time deliveries of raw materials
5. Elimination of manufacturing bottlenecks to reduce work-in-process inventories
6. Producing to order rather than to estimated demand to reduce finished goods inventories
7. Eliminating defects
c. Reducing PPE assets is much more difficult. The benefits, however, can be substantial.
Some suggestions are the following:
d. Reducing unnecessary intangible assets that are reported on the balance sheet is the most
difficult.
a. Take-Two (TTWO) spent $159,859 in 2011 and in 2012 $196,683 on software development.
TTWOs amortization and write-downs were $143,811 in 2011 and $150,700 in 2012. Using
EAs method, the money spent on additions would be expensed, and the amortization and
write-downs would disappear. The result is that if TTWOs used EAs approach, 2011
expenses would increase by $16,048 ($159,859 143,811). Net income would decrease by
$10,431 [$16,048 X (1-0.35)] in 2011. In 2012, TTWOs expenses would increase by
$45,983 ($196,683 - $150,700) if TTWO used the same method as EA. Net income would
decrease by $29,889 [$45,983 X (1-0.35)].