Question 10-1

The term operational asset is used to describe the broad category of long-lived assets that are used in the production of goods and services. The difference between tangible and intangible assets is that intangible assets lack physical substance and they primarily refer to the ownership of rights.

Question 10-2
The cost of an operational asset includes the purchase price (less any discounts received from the seller), transportation costs paid by the buyer to transport the asset to the location in which it will be used, expenditures for installation, testing, legal fees to establish title, and any other costs of bringing the asset to its condition and location for use.

Question 10-3
The cost of a developed natural resource includes the acquisition costs for the use of land, the exploration and development costs incurred before production begins, and the restoration costs incurred during or at the end of extraction.

Question 10-4
Purchased intangibles are valued at their original cost to include the purchase price and all other necessary costs to bring the asset to condition and location for use. Research and development costs incurred to internally develop an intangible asset are expensed in the period incurred. Filing and legal costs for both purchased and developed intangibles are capitalized.

Question 10-5
Goodwill represents the unique value of the company as a whole over and above all identifiable tangible and intangible assets. This value results from a companys clientele and reputation, its trained employees and management team, its unique business location, and any other unique features of the company that cant be associated with a specific asset. Because goodwill cant be separated from a company, it is not possible for a buyer to acquire it without also acquiring the whole company or a substantial portion of it. Goodwill will appear as an asset in a balance sheet only when it was paid for in connection with the acquisition of another company. The capitalized cost of goodwill equals the purchase price of the acquired company less the fair value of the net assets acquired. The fair value of the net assets equals the fair value of all identifiable tangible and intangible assets less the fair value of any liabilities of the selling company assumed by the buyer.

Question 10-6
A lump-sum purchase price generally is allocated based on the relative fair values of the individual assets. The relative fair value percentages are multiplied by the lumpsum purchase price to arrive at the initial valuation of each of the separate assets.

Question 10-7
Assets acquired in exchange for deferred payment contracts are valued at their fair value or the present value of payments using a realistic interest rate. Theoretically, both alternatives should lead to the same valuation.

Question 10-8
Assets acquired through the issuance of equity securities are valued at the fair value of the securities if known; if not known, the fair value of the assets received is used.

Question 10-9
Donated assets are valued at their fair values.

Question 10-10
When an operational asset is sold, a gain or loss is recognized for the difference between the consideration received and the assets book value. Retirements and abandonments are handled in a similar fashion. The only difference is that there will be no monetary consideration received. A loss is recorded for the remaining book value of the asset.

Question 10-11
The basic principle used to value assets acquired in a nonmonetary exchange is to use the fair value of asset(s) given up plus (minus) monetary consideration - cash - paid (received).

Question 10-12
The two exceptions are (1) when fair value is not determinable and (2) when the exchange lacks commercial substance.

Question 10-13
GAAP require the capitalization of interest incurred during the construction of assets for a companys own use as well as for assets constructed for sale or lease. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Only assets that are constructed as discrete projects qualify for interest capitalization.

Question 10-14
Average accumulated expenditures for a period is an approximation of the average amount of debt the company would have had outstanding if it borrowed all of the funds necessary for construction. If construction expenditures are incurred equally throughout the period, the average accumulated expenditures for the period can be estimated by adding the accumulated expenditures at the beginning of the period to the accumulated expenditures at the end of the period and dividing by two. If expenditures on the project are unequal throughout the period, individual expenditures, perhaps expenditures grouped by month, should be weighted by the amount of time outstanding until the end of the construction period or the end of the companys fiscal year, whichever comes first.

Question 10-15
Applying the specific interest method, the interest rate on any construction related debt is used up to the amount of the construction debt and any excess average accumulated expenditures is multiplied by a weighted-average interest rate of all other debt. The weighted-average method multiplies average accumulated expenditures by the weighted-average interest rate of all debt, including any construction-related debt.

Question 10-16
SFAS No. 2 defines research and development as follows: Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process. Development is the translation of research findings or other 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.

Question 10-17
SFAS No. 2 specifically excludes from current R&D expense the cost of operational assets that have alternative future uses beyond the current R&D project. However, the depreciation or amortization of these assets will be included as R&D expenses in the future periods the assets are used for R&D activities. If the equipment has no alternative future use, its cost is expensed as R&D immediately.

Question 10-18
GAAP require the capitalization of software development costs incurred after technological feasibility is established. Technological feasibility is established when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements. Costs incurred after technological feasibility but before the product is available for general release to customers are capitalized as an intangible asset. These costs include coding and testing costs and the production of product masters. Similar to SFAS No. 2, costs incurred after commercial production begins usually are not R&D expenditures.

Question 10-19
The cost of developed technology is capitalized and expensed over its expected useful life. Developed technology relates to those projects that have reached technological feasibility. Before 2009, the cost of in-process R&D was expensed in the period of the acquisition. Now, the cost of in-process R&D is capitalized and treated as an indefinite life intangible asset and not amortized. If the R&D project is completed successfully, we switch to the way we account for developed technology and amortize the capitalized amount over the estimated period the product or process developed will provide benefits. If the project instead is abandoned, we expense the entire balance immediately. Research and development costs incurred after the acquisition to complete the project are expensed

as incurred, consistent with the treatment of any other R&D not acquired in an acquisition.

Question 10-20
The successful efforts method allows companies to capitalize only exploration costs resulting in successful wells. The full-cost method allows companies to capitalize all exploration costs incurred within a geographical area.

Question 11-1
The terms depreciation, depletion, and amortization all refer to the process of allocating the cost of an operational asset to periods of use. The only difference between the terms is that they refer to different types of operational assets; depreciation for plant and equipment, depletion for natural resources, and amortization for intangibles.

Question 11-2
The term depreciation often is confused with a decline in value or worth of an asset. Depreciation is not measured as decline in value from one period to the next. Instead, it involves the distribution of the cost of an asset, less any anticipated residual value, over the asset's estimated useful life in a systematic and rational manner that attempts to match revenues with the use of the asset.

Question 11-3
The process of cost allocation for operational assets requires that three factors be established at the time the asset is put into use. These factors are: 1. Service (useful) life The estimated use that the company expects to receive from the asset. 2. Allocation base The value of the usefulness that is expected to be consumed. 3. Allocation method The pattern in which the usefulness is expected to be consumed.

Question 11-4
Physical life provides the upper bound for service life. Physical life will vary according to the purpose for which the asset is acquired and the environment in which it is operated. Service life may be less than physical life for several reasons. For example, the expected rate of technological changes may shorten service life. Management intent also may shorten the period of an assets usefulness below its physical life. For instance, a company may have a policy of using its delivery trucks for a three-year period before trading the trucks for new models.

Question 11-5
The total amount of depreciation to be recorded during an assets service life is called its depreciable base. This amount is the difference between the initial value of the asset at its acquisition (its cost) and its residual value. Residual or salvage value is the

amount the company expects to receive for the asset at the end of its service life less any anticipated disposal costs.

Question 11-6
Activity-based allocation methods estimate service life in terms of some measure of productivity. Periodic depreciation or depletion is then determined based on the actual productivity generated by the asset during the period. Time-based allocation methods estimate service life in years. Periodic depreciation or amortization is then determined based on the passage of time.

Question 11-7
The straight-line depreciation method allocates an equal amount of depreciable base to each year of an assets service life. Accelerated depreciation methods allocate higher portions of depreciable base to the early years of the assets life and lower amounts of depreciable base to later years. Total depreciation is the same by either approach.

Question 11-8
Theoretically, the use of activity-based depreciation methods would provide a better matching of revenues and expenses. Clearly, the productivity of a plant asset is more closely associated with the benefits provided by that asset than the mere passage of time. However, activity-based methods quite often are either infeasible or too costly to use. For example, buildings do not have an identifiable measure of productivity. For assets such as machinery, there may be an identifiable measure of productivity, such as machine hours or units produced, but it is more costly to determine the amount each period than it is to simply measure the passage of time. For these reasons, most companies use timebased depreciation methods.

Question 11-9
Companies might use the straight-line method because they consider that the benefits derived from the majority of plant assets are realized approximately evenly over these assets useful lives. It also is the easiest method to understand and apply. The effect on net income also could explain why so many companies prefer the straight-line method to the accelerated methods. Straight line produces a higher net income in the early years of an assets life. Net income can affect bonuses paid to management, or debt agreements with lenders. Income taxes are not a factor in determining the depreciation method because a company is not required to use the same depreciation method for both financial reporting and income tax purposes.

Question 11-10
The group approach to aggregation is applied to a collection of depreciable assets that share similar service lives and other attributes. For example, group depreciation could be used for fleets of vehicles or collections of machinery. The composite approach to aggregation is applied to dissimilar operating assets, such as all of the depreciable assets in one manufacturing plant. Individual assets in the composite may have diverse

service lives. Both approaches are similar in that they involve applying a single straightline rate based on the average service lives of the assets in the group or composite.

Question 11-11
The allocation of the cost of a natural resource to periods of use is called depletion. The process otherwise is identical to depreciation. The activity-based units-of-production method is the predominant method used to calculate depletion, not the time-based straight-line method.

Question 11-12
The amortization of intangible assets is based on the same concepts as depreciation and depletion. The capitalized cost of an intangible asset that has a finite useful life must be allocated to the periods the company expects the asset to contribute to its revenue generating activities. Intangibles, though, generally have no residual values, so the amortizable base is simply cost. Also, intangibles possess no physical life to provide an upper bound to service life. However, most intangibles have a legal or contractual life that limits useful life. Intangible assets that have indefinite useful lives, including goodwill, are not amortized.

Question 11-13
A company can calculate depreciation based on the actual number of days or months the asset was used during the year. A common simplifying convention is to record one-half of a full years expense in the years of acquisition and disposal. This is known as the half-year convention. The modified half-year convention records a full years expense when the asset is acquired in the first half of the year or sold in the second half. No expense is recorded when the asset is acquired in the second half of the year or sold in the first half.

Question 11-14
A change in the service life of an operational asset is accounted for as a change in an estimate. The change is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life.

Question 11-15
A change in depreciation method is accounted for prospectively by simply depreciating the remaining depreciable base of the asset (book value at date of change less estimated residual value) over the revised remaining service life using the new depreciation method, exactly as we would account for a change in estimate. One difference is that most changes in estimate do not require a company to justify the change. However, this change in estimate is a result of changing an accounting principle

and therefore requires a clear justification as to why the new method is preferable. A disclosure note reports the effect of the change on net income and earnings per share along with clear justification for changing depreciation methods.

Question 11-16
If a material error is discovered in an accounting period subsequent to the period in which the error is made, previous years financial statements that were incorrect as a result of the error are retrospectively restated to reflect the correction. Any account balances that are incorrect as a result of the error are corrected by journal entry. If retained earnings is one of the incorrect accounts, the correction is reported as a prior period adjustment to the beginning balance in the statement of shareholders equity. In addition, a disclosure note is needed to describe the nature of the error and the impact of its correction on net income, income before extraordinary item, and earnings per share.

Question 11-17
An impairment in the value of an operational asset results when there has been a significant decline in value below carrying value (book value). For tangible operational assets and intangibles with finite useful lives, GAAP require an entity to recognize an impairment loss only when the undiscounted sum of estimated future cash flows from an asset is less than the assets book value. The loss recognized is the amount by which the book value exceeds the fair value of the asset or group of assets when the fair value is readily determinable. If fair value is not determinable, it must be estimated. One method of estimating fair value is to compute the present value of estimated future cash flows from the asset or group of assets. For intangible operational assets other than goodwill, if book value exceeds fair value, an impairment loss is recognized for the differences. For goodwill, an impairment loss is indicated if the fair value of the reporting unit is less than its book value. A goodwill impairment loss is measured as the excess of book value of goodwill over its implied fair value. For operational assets held for sale, if book value exceeds fair value, an impairment loss is recognized for the difference.

Question 11-18
Repairs and maintenance are expenditures made to maintain a given level of benefits provided by the asset and do not increase future benefits. Expenditures for these activities should be expensed in the period incurred. Additions involve adding a new major component to an existing asset. These expenditures usually are capitalized. Improvements are expenditures for the replacement of a major component of an operational asset. The costs of improvements usually are capitalized. Rearrangements are expenditures to restructure an operational asset without addition, replacement, or improvement. The objective is to create a new capability for the asset and not necessarily to extend useful life. The costs of material rearrangements should be capitalized if they clearly increase future benefits.

Question 12-1
Investment securities are classified as held-to-maturity, trading, or available-forsale securities.

Question 12-2
Increases and decreases in the market value between the time a debt security is acquired and the day it matures to a prearranged maturity value are ignored for securities classified as held-to-maturity. These changes arent important if sale before maturity isnt an alternative, which is the case if an investor has the positive intent and ability to hold the securities to maturity.

Question 12-3
SFAS No. 157 governs determination of fair value. That Standard distinguishes between three levels of inputs to fair value determination, with level 1 being readily observable fair values (for example, from a securities exchange), level 2 inputs are other observable amounts (for example, quoted values for similar items, or important inputs like interest rates), and level 3 inputs are unobservable, like the companys own assumptions. SFAS No. 157 requires disclosure of the amount of fair values based on each of these three classes of inputs.

Question 12-4
For investments to be held for an unspecified period of time, fair value information is more relevant than for investments to be held to maturity. Changes in fair values are less relevant if the investment is to be held to maturity because sale at that fair value is not an option. The investor receives the same contracted interest payments for the period held to maturity and the stated principal at maturity, regardless of movements in market values. However, when the investment is of unspecified length, changes in fair values indicate managements success in deciding when to acquire the investment and when to sell it, as well as the propriety of investing in fixed-rate or variable-rate securities and long-term or short-term securities.

Question 12-5
The way unrealized holding gains and losses are reported in the financial statements depends on whether the investments are classified as securities available-for-sale or as trading securities. Securities available-for-sale are reported at fair value, and resulting holding gains and losses are not included in the determination of income for the period. Rather, they are reported as a separate component of shareholders equity, as part of Other comprehensive income. (Available-for-sale securities for which the investor has chosen the fair value option are reclassified as trading securities.)

Question 12-6
Comprehensive income is a more expansive view of the change in shareholders equity than traditional net income. It encompasses all changes in equity from nonowner transactions. The non-income part of comprehensive income is called Other comprehensive income. Other comprehensive income includes net unrealized holding gains (losses) on investments.

Question 12-7
Unrealized holding gains or losses on trading securities are reported in the income statement as if they actually had been realized. Trading securities are actively managed in a trading account with the express intent of profiting from short-term market price changes. So, any gains and losses that result from holding securities during market price changes are suitable measures of success or lack of success in achieving that goal. On the other hand, unrealized holding gains or losses on securities available-for-sale are not reported in the income statement. By definition, these securities are not acquired for the purpose of profiting from short-term market price changes, so gains and losses from holding these securities while prices change are less relevant performance measures to be included in earnings.

Question 12-8
Apparently, the drop in the market price of the stock is an other-than-temporary impairment. So, when the investment is written down to its fair value, the amount of the write-down should be treated as if it were a realized loss, meaning the loss is included in income for the period. Subsequent to the other-than-temporary write-down, the usual treatment of unrealized gains or losses should be resumed. Therefore, later changes in fair value will be reported as a separate component of shareholders equity, accumulated other comprehensive income.

Question 12-9
When acquired, debt and equity securities are assigned to one of the three reporting classifications held-to-maturity, trading, or available-for-sale. The appropriateness of the classification is reassessed at each reporting date. A reclassification should be accounted for as though the security had been sold and immediately reacquired at its fair value. Any unrealized holding gain or loss should be accounted for in a manner consistent with the classification into which the security is being transferred. Specifically, when a security is transferred:

1. Into the trading category, any unrealized holding gain or loss should be recognized in earnings of the reclassification period. 2. Into the available-for-sale category, any unrealized holding gain or loss should be recorded in Other Comprehensive Income, which will then increase Accumulated Other Comprehensive Income in shareholders equity. 3. Into the held-to-maturity category, any unrealized holding gain or loss should be amortized over the remaining time to maturity. This would be the case for Western Die-Castings investment in the LGB Heating Equipment bonds. Question 12-10
Yes. Although a company is not required to report individual amounts for the three categories of investments held-to-maturity, available-for-sale, or trading on the face of the balance sheet, that information should be presented in the disclosure notes. The following also should be disclosed for each year presented: aggregate fair value, gross realized and unrealized holding gains, gross realized and unrealized holding losses, the change in net unrealized holding gains and losses, and amortized cost basis by major security type. Information about the level of the fair value hierarchy upon which fair values are based should be provided, and more disclosure is necessary with respect to amounts based on level 3 of the fair value hierarchy. In addition, information about maturities should be reported for debt securities, by disclosing the fair value and cost for at least 4 maturity groupings: (a) within 1 year, (b) after 1 year through 5 years, (c) after 5 years through 10 years, and (d) after 10 years.

Question 12-11
When a company elects the fair value option for held-to-maturity or available-for-sale investments, it simply reclassifies those investments as trading securities and accounts for them in that fashion.

Question 12-12
U.S. GAAP allows companies complete discretion in electing the fair value option when an investment is made. The only constraint is that the election is irrevocable. IFRS

only allows companies to elect the fair value option in specific circumstances, e.g., when a group of financial assets or liabilities are managed on a fair value basis, or to allow more consistent accounting of a hedging arrangement.

Question 12-13
The equity method is used when an investor cant control but can significantly influence the investee. For example, if effective control is absent, the investor still might be able to exercise significant influence over the operating and financial policies of the investee if the investor owns a large percentage of the outstanding shares relative to other shareholders. By voting those shares as a block, the investor often can sway decisions in the direction desired. We presume, in the absence of evidence to the contrary, that the investor exercises significant influence over the investee when it owns between 20% and 50% of the investee's voting shares.

Question 12-14
The equity method, like consolidation, views the investor and investee as a special type of single entity. By the equity method, though, the investor doesnt include separate financial statement items of the investee on an item-by-item basis as in consolidation. Rather, by the equity method, the investor reports its equity interest in the investee as a single investment account. That single investment account is periodically adjusted to reflect the effects of consolidation, without actually consolidating financial statements.

Question 12-15
The investor should account for dividends from the investee as a reduction in the investment account. Since investment revenue is recognized as the investee earns it, it would be inappropriate to again recognize revenue when earnings are distributed as dividends. Rather, the dividend distribution is considered to be a reduction of the investees net assets, indicating that the investors ownership interest in those net assets declines proportionately.

Question 12-16
The equity method attempts to approximate the effects of accounting for the purchase of the investee as a consolidation. Consolidated financial statements report acquired net assets at their fair values as of the date the investor acquired the investee. The accounting in the consolidated financial statements subsequent to the acquisition date is based on those fair values. So, if Finest had consolidated its acquisition of Penner, Penners depreciable assets would have been put on Finests balance sheet in their respective asset accounts at their fair value on the date of acquisition and then depreciated over 10 years. Under the equity method, Finests investment in Penner is shown in a single investment account. Therefore, for the equity method to approximate consolidation, it would reduce both investment revenue (as if depreciation expense were being recognized) and the investment (as if the book value of the asset were being reduced) by the negative income

effect of the extra depreciation the higher fair value would cause. This would equal 40% x $12 million 10 years = $480,000 each year for ten years.

Question 12-17
The investment account was decreased by $40,000 (40% x $100,000). increased by the same amount. There is no effect on the income statement. Cash

Question 12-18
When it becomes necessary to change from the equity method to another method, no adjustment is made to the carrying amount of the investment. The equity method is simply discontinued and the new method is applied from then on. The investment account balance when the equity method is discontinued would serve as the new cost basis for writing the investment up or down to fair value in the next set of financial statements.

Question 12-19
IFRS require that accounting policies of investees be adjusted to correspond to those of the investor when applying the equity method. U.S. GAAP has no such requirement. Also, IFRS allow investors to account for a joint venture using either the equity method or proportionate consolidation, whereby the investor combines its proportionate share of the investees accounts with its own accounts on an item-by-item basis. U.S. GAAP generally requires that the equity method be used to account for joint ventures.

Question 12-20
When a company elects the fair value option for a significant-influence investment, that investment is not reclassified as a trading security. Rather, the investment still appears on the balance sheet as a significant-influence investment, but the amount that is accounted for at fair value is indicated on the balance sheet either parenthetically on a single line that includes the total amount of significant-influence investment or on a separate line. As with trading securities, unrealized gains and losses are included in earnings in the period in which they occur.

Question 12-21
A financial instrument is: (a) cash, (b) evidence of an ownership interest in an entity, (c) a contract that (1) imposes on one entity an obligation to deliver cash or another financial instrument and (2) conveys to a second entity a right to receive cash or another financial instrument, or (d) a contract that (1) imposes on one entity an obligation to exchange financial instruments on potentially unfavorable terms and (2) conveys to a second entity a right to exchange other financial instruments on potentially favorable terms. Accounts payable, bank loans, and investments in securities are examples.

Question 12-22
These instruments derive their values or contractually required cash flows from some other security or index.

Question 12-23
Since this fund wont be used within the upcoming operating cycle, it is a noncurrent asset. It should be reported as part of Investments and funds.

Question 12-24
Part of each premium payment the company makes is not used by the insurance company to pay for life insurance coverage, but rather is invested on behalf of the insured company in a fixed-income investment. As a result, the periodic insurance premium should not be expensed in its entirety; an appropriate portion should be recorded instead as a noncurrent asset cash surrender value.

Question 12-25
When a creditors investment in a receivable becomes impaired, due to a troubled debt restructuring or for any other reason, the receivable is re-measured based on the discounted present value of currently expected cash flows at the loans original effective rate (regardless of the extent to which expected cash receipts have been reduced). The extent of the impairment is the difference between the carrying amount of the receivable (the present value of the receivables cash flows prior to the restructuring) and the present value of the revised cash flows discounted at the loans original effective rate. This difference is recorded as a loss at the time the receivable is reduced.