Chapter 11 HW Solutions

CHAPTER 11

Investing Activities

THINKING BEYOND THE QUESTION

How do we account for investing activities?

Investing is necessary for a company to grow. Good investments provide resources that a company can use to produce and sell additional prod-ucts. These sales lead to higher revenues. Good investments produce profits because the company produces and sells products that are de-manded by customers and produces the products efficiently. Higher profits result in higher value for a company and its stockholders.

Bad investments result when a company acquires assets that it does not need or is not capable of managing effectively. A company can expand into new product or customer markets that it does not understand, or it can grow more rapidly than demand for its products. Assets acquired from these investments may not result in additional revenues or may re-sult in additional expenses that are higher than additional revenues.

QUESTIONS

Q11-1 The primary types of assets Archer would include in its accounting system are:a. Current assets: those assets management expects to convert to

cash or consume during the next fiscal year.i. Cash and short-term marketable securities: highly liquid re-

sources that are ready sources of cash and that management ex-pects to convert to cash during the next year.

ii. Accounts and notes receivable: amounts due from customers that the company expects to collect in the next year.

iii. Inventories: materials used in production and goods the com-pany expects to sell in the next year.

iv. Prepaid expenses: amounts paid for insurance, taxes, and other items that will be consumed during the coming year.

b. Long-term assets: those assets that management does not expect to convert to cash or consume during the next fiscal year.i. Property, plant, and equipment: physical assets used by the com-

pany in the production, distribution, and sale of goods and in the general management of the company.

(continued)

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304 Chapter 11

ii. Long-term investments: bonds, stocks, and other securities of other companies that management does not plan to sell during the next year.

iii. Intangible assets: legal rights and other nonphysical assets ac-quired by a company that are assumed to have long-term bene-fits.

Q11-2 The gross amount of property, plant, and equipment is the original cost paid to acquire those assets. The net amount of property, plant, and equipment is the amount remaining after accumulated depreciation has been subtracted from original cost. Another term for net property, plant, and equipment is book value.

Q11-3 Student responses will vary. Some students will note that interest is the cost of renting money. It is a period cost that is traceable to a given period and should be expensed on the income statement during that period. Others will observe that if interest isn’t always part of the cost of obtaining an asset, it shouldn’t ever be. To do so would be inconsistent. Many students, however, will observe that the cost of a self-constructed asset includes the cost of all resources consumed in building it. This includes labor, materials, and financing. If the services of financing are consumed in building an asset, the cost of the asset should include the cost of financing.

Q11-4 This statement is not true. Sometimes the units-of-production method will lead to faster depreciation than straight-line and sometimes it will lead to slower depreciation. It all depends on the usage of the asset. If usage of the asset is greater than average early in its life, the depreciation will be greater in the early years than it would be under the straight-line method. On the other hand, if usage is less than average in the early years, the depreciation will be less than under the straight-line method.

Q11-5 A capital expenditure is one in which new plant assets are acquired or in which the expected useful life or value of a plant asset is enhanced. Capital expenditures are recorded as assets because they create future economic benefits. An operating expenditure is a cost to repair or maintain a plant asset; one that does not enhance either the expected useful life or value of the asset. Operating expenditures are recorded as expenses because they are associated with the use or consumption of an asset.

Q11-6 In a way the friend is correct. The terms depletion and depreciation both describe the process of allocating a portion of an asset’s cost to expense each period of the asset’s useful life. In this way, both terms describe the same process. What differentiates the terms, however, is

Investing Activities 305

that they are used to describe this process for different classes of assets. Depletion is the term used to describe the consumption (or using up) of natural resource assets. Depreciation is the term used to describe the consumption (or using up) of plant assets.

Q11-7 Depletion arises when a natural resource is consumed or used up. In most cases, it arises when the natural resource is harvested. For example, ore is taken from a mine, oil is pumped from a well, or gravel is taken from a gravel pit. In all of these cases, the cost of depletion becomes part of the cost of the product. In effect, the cost of depletion becomes part of the cost of inventory: be it ore, oil, or gravel. The cost of depletion is stored on the balance sheet as part of the cost of inventory until the inventory is sold. At that point, the depletion cost (and all other costs of production) are released to the income statement and reported under the category of Cost of Goods Sold.

Q11-8 The problem with using market value (for most classes of assets) is obtaining a reasonable estimate of market value at each balance sheet date. For example, what is the market value on a given balance sheet date for the Empire State Building? Or for a patent, or machinery in the factory? At best, the estimates of market value would have to be educated guesses: either because the asset is one of a kind, or because there is no active market for assets of that type. It’s not that these assets couldn’t be sold. It’s that the price they would sell for is anybody’s guess. The case of marketable securities is very different. These securities trade every day on U.S. and foreign exchanges. The items are homogeneous (every share is exactly the same as every other share) and there are many buyers and many sellers. Therefore, the price at which securities sell on a given day is a reasonable and reliable estimate of what they are worth. There is an active market for these assets. For other assets this is not always the case.

Q11-9 Investments in the securities of other firms (e.g., stocks, bonds, certificates of deposit, notes) are classified on a balance sheet according to management’s intention for holding the item. If the investment was made to earn a return on a temporary surplus of cash, the investment is reported as a current asset. This is because management expects to turn the investment back into cash as soon as the cash is needed. If the investment was made for a long-term purpose, such as to establish a long-term relationship with the other firm, the investment is reported as a long-term asset. In this case, management intends to hold the investment indefinitely. Using this classification approach helps users of financial statements better understand which resources are available for immediate conversion to cash and which are not.

306 Chapter 11

Q11-10 When marketable securities are held as trading securities it means that the company routinely sells securities as part of its primary business. In fact, they are more like inventory than investments. The securities are a current asset and expected to be sold soon. Therefore, it is appropriate that the unrealized gain or loss be reported as part of net income because it is a useful estimate of what will occur when the securities are actually sold. In this way, users of the financial statements are given early notification of likely future events. When marketable securities are held as available-for-sale securities, there is no specific plan of disposal. The securities might be sold soon or it might be years before sale. In this case, it is appropriate that the unrealized gain or loss not flow through the income statement. This avoids having net income bounce up and down in reaction to stock market swings during the period that available-for-sale securities are held. Instead, holding gains or losses are stored on the balance sheet as part of stockholders’ equity until the securities are sold. At the date of sale, the net unrealized holding gain or loss is canceled and the actual realized gain or loss is reported.

Q11-11 Marketable securities and intangible assets have very different characteristics. It is these differences that cause them to be reported using different valuation methods. First, marketable securities are homogeneous in that every share of XYZ Corp.’s common stock is an exact duplicate of every other share of XYZ common stock. By their very nature, intangible assets are heterogeneous or unique. For example, patents, copyrights, and trademarks are all unique. Each has a different value from all other patents or copyrights or trademarks. Clearly goodwill (and its value) is an asset that is unique to the company reporting it. Second, there is an active market for the sale of marketable securities that is much broader and deeper than any such market for intangible assets. For some intangibles, such as goodwill, there is no market at all. For these reasons, any attempt to use market value as the reporting basis for intangible assets would have to rely on estimates, assumptions, and guesses rather than actual market transactions. This would make the numbers unreliable.

Q11-12 Goodwill arises when one company buys another at a price in excess of the market value of the second company’s identifiable net assets. The amount of goodwill recorded is equal to the difference between the price paid and fair value of identifiable net assets acquired. Goodwill represents the “extra value” or extra earning power that is acquired over and above the value of the net assets. Payment for goodwill presumes that the acquired company is worth more than the mere sum of its net assets. It presumes that the company name, reputation, employees, loyal customers, etc., will allow the acquiring firm to earn a greater return than if it simply went out and reproduced the individual assets it is acquiring. It is the extra value obtained by acquiring an intact, operating firm. One


caution: sometimes companies get into bidding wars for a given target company and the winner ends up paying more than is reasonable. The entire “premium” paid by the buyer gets recorded as goodwill.

Q11-13 The effects of this transaction will show up in two places on the next statement of cash flows. First, the gain on sale ($25,800) will be reported in the operating activities section as a deduction from net income. The $25,800 gain was included as part of net income but was not the result of an operating activity. Instead, the $25,800 gain is related to an investing activity, the disposal of the land. Therefore, all cash received from the disposal of land (recovery of $40,000 cost + $25,800 gain = $65,800) must be reported in the investing activities section. If the gain is not deducted from net income in the operating activities section, it will be double counted.

Q11-14 Accounting information identifies the amounts of assets that a company has recorded. These amounts and other records about a company’s assets provide a benchmark against which actual assets can be compared. For example, if accounting records indicate a cash balance of $30,000, an actual count of cash should result in $30,000. Inspection of other assets, such as inventory, investments, and plant assets, should reveal those items for which accounting records exist. Inspections and comparisons with accounting information can reveal whether a company has control over its assets. Theft and mismanagement are common problems for many assets, especially those that are easily stolen or lost, such as cash, securities, inventories, and small tools and equipment. Having good records and comparing these with actual assets on a regular basis can reveal security problems and help identify those responsible for these problems. Accounting controls should be used along with physical controls to safeguard assets.

308 Chapter 11

EXERCISES

E11-1 Definitions of all terms are listed in the glossary.

E11-2 Deep Drillers, Inc.Long-Term Assets Section of Balance Sheet

At Year-End

Investments:Investment in Susanna Company $ 195,600

Property, Plant, and Equipment:Building $160,000Drilling Equipment 230,000Storage Tanks 90,000Accumulated Depreciation (40,000 ) 440,000

Oil Wells $500,500Accumulated Depletion (15,000 ) 485,500Construction in Process 56,300Land 120,000

Intangible Assets:Trademark 4,000Goodwill 10,000

Total Long-Term Assets $1,311,400

E11-3 a. Intangible assets: A long-term asset category including items such as patents, copyrights, trademarks, and goodwill

These assets are reported at their original cost less the cumula-tive amount of amortization to date, except goodwill, which is re-ported at cost or lower if impaired.

b. Inventories: A current asset composed of items that are being held for sale to customers

The inventory of a grocery store would include bread and cheese. The inventory of a car manufacturer would include tires, radiators, and seats. Inventories are reported at their cost.*

*In Chapter 13 there is coverage of valuing inventory at lower of cost or market.

c. Investment in marketable securities: a current or long-term asset, depending on the holding period intended by management

This classification includes holdings of preferred stock, common stock, bonds, or notes of other corporations. In general, such in-vestments are reported at fair market value. Special reporting rules apply when debt securities are expected to be held to their maturity or if a large portion of a company’s common stock is held.


d. Property, plant, and equipment: A long-term asset including such items as trucks, buildings, machinery, and equipment

These items are reported at cost minus accumulated deprecia-tion. This amount is called book value.

e. Accounts receivable: A current asset comprised of the amount owed to the firm by all customers

Accounts receivable is reported at the amount expected to be collected, which recognizes that some customers will refuse, or be unable, to pay.

E11-4 Long-term investments: (h) Common stock of Flower Corporation(l) Investment in bonds of Beech Brothers, Inc.

Property, plant, andequipment: (a) Machinery, net

(c) Land(e) Processing plant, net(j) Standby equipment, net

Intangible assets: (d) Patents(k) Goodwill

Other long-term assets: (f) Obsolete equipment awaiting sale, net(g) Prepaid insurance (the portion not expir-

ing within the next year)

Note: (b) Office supplies and (i) Cash are not part of long-term assets.

E11-5

DepreciationMethod

DepreciationExpense Computations

Straight-line $42,857 ($300,000 ÷ 7 years = $42,857)Double-decliningbalance $85,714 ($300,000 × 2/7 = $85,714)Units-of-produc-tion $96,000

($300,000 × [80,000 units ÷ 250,000 units] = $96,000)

The choice of one depreciation method over another can have a signifi -cant effect on the financial statements, particularly the income state-ment. Net income is computed below under each of the three deprecia-tion methods that might have been used.

Income StatementsStraight-

Line MethodDDB

Method

Units-of-Production

MethodRevenuesAll expenses (except for depreciation)Depreciation expenseNet income

$ 376,300(225,492)

(42,857 ) $ 107,951

$ 376,300 (225,492) (85,714 )

$ 65,094

$376,300 (225,492)

(96,000 ) $ 54,808

(continued)

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Depending on the depreciation method chosen, the net income re-ported for the period would vary widely.

E11-6

Calculation of Gain on Sale

Financial Reporting Purposes

TaxPurposes

Original costLess: Straight-line depreciation to date

($10,500 @ 236 months)Accelerated depreciation to date

Book value at date of saleSelling priceLess: Book valueGain on sale of building (a, b)

$4,186,0002,478,000

$1,708,000$7,200,000 1,708,000 $5,492,000

$4,186,000

3,500,000 $ 686,000 $7,200,000 686,000 $6,514,000

Companies typically use straight-line depreciation for financial reporting purposes to minimize the effect of depreciation on net income. Acceler-ated methods result in larger amounts of depreciation expense for tax purposes in the early years of asset lives. Therefore, cash outflow for taxes is reduced because of the lower amount of taxable income than if straight-line depreciation were used. In later years, a company incurs higher cash outflows for taxes because accelerated methods produce lower depreciation expense than the straight-line method. If an asset is sold, a larger amount of taxable profit will be reported than the profit re-ported for financial reporting purposes. If tax rates remain constant, the effect on cash outflow for taxes over the life of an asset will be the same regardless of which method is used. The timing of the cash flows is af-fected, however. By delaying the outflows, a company can invest the cash it saves in other productive assets and earn a return on this invest-ment until the cash is needed to pay taxes. Thus, a company is better off if it can delay tax payments by recording higher amounts of depreciation in the early years of an asset’s life.

E11-7 a. Cost of equipment $ 480,000Less: Depreciation per year

[($480,000 − $30,000) ÷ 8 years = $56,250]Accumulated depreciation total over 5 years 281,250

Book value on year 5 balance sheet $ 198,750

b. Remaining undepreciated cost $ 198,750Less: New estimated residual value 20,000 New depreciable amount $ 178,750Divide by number of years remaining ÷ 2 Depreciation expense per remaining year $ 89,375


c. The nature of estimates is that they are not expected to be realized exactly. Even high-quality estimates made by highly qualified people usually will not turn out exactly. Some revision is to be expected. Over time, circumstances change. Therefore, we cannot conclude that a poor job was done initially.

E11-8 a. The total construction costs, $1,228,000, would be recorded as an asset, construction work-in-process. Special tools and equipment necessary for the construction and interest for financing the construction would be included as part of the asset. The cost would be transferred to the building’s account once the construction was completed and would be depreciated over the useful life of the asset.

b. The cost of an addition to a building would be recorded as an asset and would be depreciated over the useful life of the asset.

c. The cost of ordinary repairs would be recorded as an expense because the cost does not result in future benefits to the company.

Cash payments for (a) and (b) would be included under the investing ac-tivities section of the statement of cash flows. The cash payment for (c) would be included as part of net income in the operating section (indirect method) of the statement of cash flows.

E11-9 a. 2004 = $9,000 ($48,000 − $3,000) ÷ 5 years = $9,0002005 = $9,0002006 = $9,0002007 = $5,250 ($9,000 × 7/12 of a year = $5,250)

b. $10,750 loss Original cost $48,000Less: depreciation (3 years @ $9,000) 27,000

depreciation (part year) 5,250 Book value at date of sale $15,750Less: disposal price 5,000 Loss on disposal $ 10,750

c. 2004 2005 2006 2007Operating activities:

Depreciation expense $ 9,000 $9,000 $9,000 $ 5,250Loss on sale 10,750

Investing activities:Sale (Purchase)of machine (48,000) 0 0 5,000

Financing activities: 0 0 0 0 Totals $(39,000) $9,000 $9,000 $21,000

312 Chapter 11

(continued)

d. For the income statement, depreciation expense of $9,000 would be subtracted for each of the years 2004–2007. For the year 2007, the amount of $5,250 would be subtracted as depreciation expense. In 2007, a loss on disposal of the machine, $10,750, would be subtracted.

E11-10 Depletion expense: $16.8 million ($140 million × 6 ÷ 50)Book value of reserves: $39.2 million ($140 million − $100.8 million*)

* Accumulated depletion = $140 million × 36 ÷ 50 = $100.8 million

Depletion expense does not have a direct effect on cash flows. Cash is paid out when depletable assets are acquired, not when depletion is recorded. Like depreciation and most other expenses, depletion affects cash flow indirectly through taxes. Depletion expense reduces taxable in-come and cash outflow for tax payments.

E11-11 a. $1,650,000 The cost of the land ($4,500,000) should be recorded in an account separate from the cost of the trees growing on the land. The cost to be depleted includes the cost of planting the trees and the cost of thinning and monitoring the timber growth ($1,200,000 + $450,000).

b. $165,000 10% × $1,650,000

c. The cost of the land should be reported at $4,500,000 as a long-term asset. The timber should be reported at $1,485,000 ($1,650,000 − $165,000) as a long-term asset.

d. The current value of the uncut timber, which is apparently at least $30 million, will not be reported on any financial statement. Because this can be very important information, an estimate of the current value of a natural resource asset is frequently disclosed in the notes to the financial statements. Another key piece of information that is not reported is the fair value of the land on which the timber sits. Its value in 1975 ($4,500,000) probably bears little resemblance to its value in 2007.


E11-12Journal Effect on Accounting Equation

Accounts Debits Credits A = L +OE

CC + REa. Long-Term Investment 30,000 +30,000

Cash 30,000 –30,000

b. Long-Term Investment 3,500 +3,500

Unrealized Holding Gain* 3,500 +3,500*

c. Cash 35,000 +35,000

Unrealized Holding Gain* 3,500 –3,500*

Long-Term Investment 33,500 –33,500

Gain on Sale of Stock 5,000 +5,000

* This is included as Other Comprehensive Income in the stockholders’ equity section of the balance sheet.



CC + REa. S-Term Investment in Duncan 330,000 +330,000

Cash 330,000 –330,000

b. S-Term Investment in Macduff 440,000 +440,000

Cash 440,000 –440,000

c. S-Term Investment in Duncan 20,000 +20,000


Unrealized Holding Loss* 80,000 –80,000*

S-Term Investment in Mac-

duff 80,000 –80,000


At year-end, the two investments should be combined and reported in the asset section as short-term investments, $710,000 ($330,000 + $440,000 + $20,000 − $80,000). In addition, the net holding loss of $60,000 ($20,000 − $80,000) will be reported as a deduction in the stockholders’ equity section. If the Macduff investment was a trading security, the $20,000 gain would be an addition to stockholders’ equity, and the $80,000 loss would be reported on the income statement.

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CC + REa. Long-Term Investment in Othello 314,000 +314,000

Cash 314,000 –314,000

b. Long-Term Investment in

Ferdinand 418,000 +418,000

Cash 418,000 –418,000

c. Long-Term Investment in Othello 36,000 +36,000


Unrealized Holding Loss* 23,000 –23,000*

Long-Term Investment in

Ferdinand 23,000

–23,000


At year-end, the two investments should be combined and reported in the asset section as noncurrent available-for-sale investments, $745,000 ($314,000 + 418,000 + $36,000 − $23,000). In addition, the net holding gain of $13,000 ($36,000 − $23,000) will be reported as an addition in the stockholders’ equity section.

E11-15 a.Journal Effect on Accounting Equation


CC + REInvestment in Bonds 800,000 +800,000

Cash 800,000 –800,000

Cash 32,000 +32,000

Interest Income 32,000 +32,000

b. Assets:Long-term investments:Investment in bonds(at cost) 800,000

c. Assets:Long-term investments:Investment in bonds(at market) 786,000

Stockholders’ equity:Unrealized holding loss 14,000


E11-16 1.Journal Effect on Accounting Equation

Date Accounts Debits Credits A = L +OE

CC + REMay 15, 2005 Long-Term Investment 380,000 +380,000

Cash 380,000 –380,000

Sept. 12, 2005 Cash 12,000 +12,000

Investment Income 12,000 +12,000

Dec. 31, 2005 Long-Term Investment 100,000 +100,000

Unrealized Holding

Gain* 100,000

+100,000

*

Sept. 12, 2006 Cash 14,400 +14,400

Investment Income 14,400 +14,400

Dec. 31, 2006

Unrealized Holding

Loss* 40,000 –40,000*

Long-Term

Investment 40,000 –40,000

Apr. 6, 2007 Cash 400,000 +400,000

Unrealized Holding

Loss* 60,000 –60,000*

Long-Term

Investment 440,000 –440,000

Realized Gain on

Sale 20,000 +20,000


Explanations:

May 15, 2005: Investment recorded at cost.

September 12, 2005: Dividends reported as realized income; reported in the income statement in computing net income for the year.

December 31, 2005: Increase in the market value of the investment; not included as part of net income because it is an unrealized holding gain; added to owners' equity.

September 12, 2006: Dividends reported as realized income; reported in the income statement in computing net income for the year.

December 31, 2006: Decrease in the market value of the investment; not included as part of net income because it is an unrealized holding loss; subtracted from owners' equity.

April 6, 2007: Recognized a gain on sale of the investment; reported as part of net income because the investment was sold. Realized gains and losses are recorded when investments are sold.

(continued)

316 Chapter 11

2. 2005 2006Cost of investment $380,000 $380,000Holding gain 100,000 100,000Holding loss (40,000 )Market value of investment $ 480,000 $ 440,000

E11-17 a. Goodwill arises when one firm buys another. It is the difference between the purchase price and the fair market value of the purchased company’s identifiable net assets. It represents the intangible value of a company that exceeds the value of its identifiable assets and liabilities.

b. The key to understanding goodwill is that certain valuable aspects of a company cannot be recorded on its balance sheet. The value of highly trained employees, high employee morale, high customer loyalty, or supplier loyalty is not captured and reported in the financial statements. Goodwill is the amount paid to acquire these nonrecorded “assets.”

c. Goodwill is reported as an intangible asset on the balance sheet of a company that has purchased another company. If management successfully maintains (or enhances) the value of goodwill, it stays on the balance sheet at original cost. If the value of goodwill decreases (is impaired), it is written down on the balance sheet and a loss is recorded in the income statement.

d. $30 million. The fair market value of the acquired company’s net assets was $170 million ($350 million fair value of assets − $180 million fair value of liabilities). In exchange for $170 million of net assets, the buying firm paid $200 million. The difference is recorded as goodwill.

e. Sometimes, management of the acquiring firm simply makes a mistake by offering more for a company than it is worth. The estimated value of a company’s identifiable assets (trucks, buildings, etc.) is difficult enough to estimate. The estimated value of unrecorded assets (employee morale, loyal customers, etc.) is even more difficult. Sometimes, poor estimates are made, higher prices than appropriate are offered, and management later wishes it had not acquired the second company after all.

E11-18 a. Amount paid to acquire 100% of Metrodome’s net assets $845,000Fair market value of Metrodome’s net assets 783,000 Goodwill $ 62,000

b. In general, goodwill becomes impaired when the activities that created it cease. For instance, in this case the goodwill was generated by activities that created “very loyal retail customers.” Perhaps these activities included convenient hours or after-hour


services, an extensive product line, special discounts for long-time customers, personal first-name service, or visible community support activities. If those activities were to cease under the new owners it is understandable that the customers might become less loyal and the goodwill would dissipate. In this specific case, there is another probable reason that goodwill could become impaired. It exists because of loyal customers who have been so “for more than 30 years.” These folks can’t last much longer. Unless new loyal customers can be created, the existing goodwill is likely to die off eventually.

E11-19 a. 1. $23,017 1st year depreciation: SLN(314221,15000,13)

Invoice price of machinery $296,016Add: 6.15% sales tax 18,205 Cost of machinery $314,221

2. $23,017 (same amount for each year)

3. $38,017 Cost of machinery $314,221Less: 12 year @ $23,017 276,204 Book value $ 38,017

b. 1. $47,387 1st year depreciation: DDB(118468,5000,5,1)

Invoice price of equipment $112,316Add: remodeling cost/installation 6,152 Cost of equipment $118,468

2. $10,236 4th year depreciation: DDB(118468,5000,5,4)

c. 1. $216,667 All years are the same: SLN(1300000,0,6)

2. zero $1.3 million cost − $1.3 million amortization

E11-20 Investing activities are those that involve acquisition, use, and disposal of long-term assets. Short-term investments in marketable securities are also part of investing activities.

Balance sheet:1. Most noncurrent asset accounts involve investing activities. In-

creases or decreases in long-term investments; property, plant, and equipment; and intangible assets are all the result of investing activi-ties.

2. Short-term investments in marketable securities are reported in the current asset section.

3. Holding gains or losses are reported in the stockholders’ equity sec-tion.

Income statement:

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1. Depreciation, amortization, and depletion are reported as part of oper-ating expenses.

(continued)


2. Dividends and interest earned from investments are reported after op-erating expenses as nonoperating revenue.

3. Gains or losses from disposing of long-term assets are reported as nonoperating items after operating expenses.

Statement of cash flows:1. Depreciation, amortization, and depletion expense are added to net in-

come (under the indirect method) in the operating activities section.2. Gains (losses) are subtracted (added) in the operating activities sec-

tion of an indirect method statement.3. Every item listed under the investing activities section involves in-

vesting activities (under both the direct and indirect methods). These include all cash purchases and cash sales of property, plant, and equipment; intangibles; and long-term investments. Interest and divi-dends received from investments in securities are part of net income. Thus, they are part of the operating activities section, not the invest-ing activities section.

E11-21 Zirconium Graphics CompanyPartial Statement of Cash FlowsFor the Year Ended December 31

Cash Flow from Operating ActivitiesNet income $ 60,000Adjustments for noncash items:

Depreciation and amortization expense $ 7,500Loss on sale of plant assets 8,000Gain on sale of investments (2,000 )

Net cash flow from operating activities $ 73,500Cash Flow from Investing ActivitiesCapital expenditures $(50,000)Sale of plant assets 22,000Purchase of investment (16,000)Sales of investment* 28,000

Net cash flow for investing activities $(16,000)

Interest and dividend income is part of net income. Since cash was re-ceived for the interest and dividends, no adjustment is necessary.

*Note: While the assignment says nothing about these securities be-ing “trading securities,” if they were, the impact of the cash sale would be shown in the operating section, since trading securities are part of the primary operations.

320 Chapter 11

E11-22 a. Equity method. This investment was large enough to acquire significant influence over the investee firm (4,800 of the firm’s 16,000 shares).

b.Journal Effect on Accounting Equation


CC + REJan. 1 Long-Term Investment 43,200 +43,200

Cash 43,200 –43,200

Dec. 31 Long-Term Investment 9,000 +9,000

Investment Income 9,000 −9,000

Dec. 31 Cash 2,400 +2,400

Long-Term Invest-

ment 2,400 –2,400

c. $49,800 Original cost $43,200Add: 30% of Biltmore’s net income 9,000Less: dividends received (2,400 )Ending balance of investment account $49,800

PROBLEMS

P11-1 A. Depreciation ScheduleStraight-Line

MethodDeclining-Balance

MethodUnits-of-Production

Method

YearDepreciation

ExpenseBookValue

DepreciationExpense

BookValue

DepreciationExpense

BookValue

0

1

2

3

4

$ 30,000

30,000

30,000

30,000

$125,000

95,000

65,000

35,000

5,000

$ 62,500

31,250

15,625

10,625*

$125,000

62,500

31,250

15,625

5,000

$ 31,200

26,400

37,560

24,840

$125,000

93,800

67,400

29,840

5,000

Totals $120,000 $120,000 $120,000

Double-declining-balance:Year 1 = $125,000 (2/4) = $62,500Year 2 = $62,500 (2/4) = $31,250Year 3 = $31,250 (2/4) = $15,625

*Year 4 = $15,625 − $5,00 = $10,625 (amount needed to reduce book value to estimated residual value of $5,000)

Units-of-production (unit depreciation rate is $120,000 1,000 hours $120 per hour):

Year 1 $120 per hour 260 hours = $31,200Year 2 $120 per hour 220 hours = $26,400Year 3 $120 per hour 313 hours = $37,560Year 4 $120 per hour 207 hours = $24,840


(continued)

B. The straight-line method generally has the advantage of creating the smallest amount of depreciation expense in the early years of the asset’s life. Therefore, it would usually result in higher reported net income in years 1 and 2 than other methods. This is not the case, however, if the units-of-production method is used and less-than-average use is made of the asset. In that case, a small amount of usage results in a small amount of depreciation expense and correspondingly higher net income. The double-declining-balance method generally creates the largest amount of depreciation expense in years 1 and 2, as it did for this asset. Therefore, the method generally results in lower reported net income than the other methods. Because most managers want to report high net incomes for financial reporting purposes but low net incomes for tax purposes, they generally use straight-line depreciation for financial reporting and an accelerated method for tax purposes.

C. Depreciation expense reduces the book value of an asset but does not require cash outflow. Cash flow is affected indirectly by depreciation expense through income tax. A higher amount of expense results in a lower amount of taxable income and in lower tax payments. Therefore, the depreciation method that produces the highest depreciation expense each year produces the highest net cash inflow (lowest cash outflow). For the asset in this problem, double-declining-balance would result in the lowest tax payment in years 1 and 2, units-of-production in year 3, and straight-line in year 4.

P11-2 A. B.

Year

Book Valueat

Beginningof Year

Usual Double-Declining-Bal-ance Method(2/6 × Book

Value)

Book Value at Beginning

of Year

Modified Double-Declin-

ing-Balance Method

200720082009201020112012

$2,100,0001,400,000

933,333622,222414,815276,543

$ 700,000466,667311,111207,407138,272276,543

$2,100,0001,400,000

933,333622,222414,815207,408

$ 700,000466,667311,111207,407207,407207,408*

Total $2,100,000 $2,100,000

*$1 rounding adjustmentUnder the modified approach, depreciation for tax purposes in 2007, 2008, and 2009 uses the standard double-declining-balance method (2/6 × book value at beginning of period). In 2010, the straight-line method is applied to the remaining book value ($2,100,000 − $700,000 − $466,667 − $311,111 = $622,222). This results in the same amount of depreciation ($207,407) for

322 Chapter 11

each of the last three years. In 2011 and 2012, the straight-line deprecia-tion of $207,407 is higher than double-declining-balance depreciation.Note: Under the tax code version of double-declining balance, residual values are not recognized and book value never reaches zero. In effect, part of the asset’s cost is never deductible as depreciation expense. The modified double-declining-balance method is designed to allow 100% of the asset’s cost to be recovered via depreciation expense.

C.

Year

1Modified Dou-ble-Declining-

Balance Method

2Straight-Line Depreciation

(Cost ÷ 6 years)

3Differencein Income

(Column 1 − Column 2)

4Difference in Taxes

(Column 3 × 35%)

200720082009201020112012

$ 700,000466,667311,111207,407207,407207,408

$ 350,000350,000350,000350,000350,000350,000

$ 350,000116,667(38,889)

(142,593)(142,593)(142,592)

$122,50040,833

(13,611)(49,908)(49,908)(49,906)*

Total $2,100,000 $2,100,000 $ 0

*$1 rounding adjustment

D. The higher the depreciation, the lower is taxable income and the lower is the amount of cash paid out for taxes. Choosing an accelerated depreciation method raises depreciation in the earlier years of the asset’s life, which reduces taxable income and decreases cash paid out for taxes. This benefit is reversed, however, in the later years when depreciation is lower, income is higher, and higher taxes must be paid. The company saves taxes in the first years of the asset’s life but pays higher taxes in the remaining years. On a present value basis, the company is better off by deferring taxes during the early years until the later years.

P11-3 A. Cost of diagnostic equipment = $107,191

(The cost of an asset includes all expenditures necessary and rea-sonable to get the asset to the location needed in the condition needed.)

Item Amount Include? Reason

1. Invoice cost $93,000 Yes Necessary and reasonable2. Sales tax 8,091 Yes Necessary and reasonable3. Transportation cost 2,650 Yes Necessary and reasonable4. Special permit fine 425 No Not necessary to incur this cost5. Right-side wall cost 750 Yes Necessary and reasonable6. Left-side wall cost 300 No Carelessness not an asset7. Setup and testing 2,700 Yes Necessary and reasonable


(continued)

Cost of manufacturing equipment = $318,258

The cost of the equipment is the present value of the cash flows neces-sary to acquire it.

Present value of down payment $ 77,000Present value of installment payments ($85,000 2.57710) 219,054 Total purchase price before sales tax $ 296,054Sales tax (@ 7.5%) 22,204 Cost of the manufacturing equipment $ 318,258

B.

Asset

DDB Depreciationfor the

First Year

SL Depreciationfor the

First Year

Difference in First-Year Depreciation Expense and Net

IncomeDiagnostic Equipment

$35,730($107,191 × 2/6)

$17,865($107,191 ÷ 6 yrs)

$17,865

Manufacturing Equipment

$106,086($318,258 × 2/6)

$53,043($318,258 ÷ 6 yrs)

$53,043

Totals $141,816 $70,908 $70,908

First-year net income would be $70,908 higher if straight-line were used instead of double-declining-balance.

P11-4 A. Equal annual payment = $727,781 PV of an annuity = Amount × IF(Table 4)$6,000,000 = Amount × 8.24424$727,781 = $6,000,000 ÷ 8.24424

First year interest = $480,000 ($6,000,000 × 0.08 = $480,000)

B. Existing building = $295,000 Cost ($5,500,000 + $500,000per year − $100,000) $5,900,000

Life ÷ 20 yearsDepreciation per year $

295,000New building = $229,600 per year

For the new building, the total cost must be determined. It is the sum of the costs given in the problem plus interest on the one-year construction loan:

Architect's plans $ 120,000Materials 1,700,000Labor costs 3,500,000Other fees and permits 150,000Interest on loan 270,000 ($4,500,000 × 6%)

324 Chapter 11

Total cost $5,740,000Useful life ÷ 25 years Depreciation per year $ 229,600

C. If the firm purchases the existing building and land, there would be an outflow in the investing section for the cost of the building and land, $6,000,000. Also, assuming the indirect method is used to prepare the statement of cash flows, depreciation expense of $295,000 would be added to net income in the operating section. There also would be an inflow of $6,000,000 in the financing section.

If the firm constructs its own building, there would be an outflow in the investing section for the cost of the building, $5,740,000. Again, assuming the indirect method, depreciation expense of $229,600 would be added to net income in the operating section. There would be an inflow and an outflow (when repaid) of $4,500,000 in the financing section.

D. The difference that the controller wishes to recognize as a Gain on Construction is $160,000. It would not be appropriate to include such an item on the income statement because the gain itself did not arise from an exchange with an external party. Only the actual cost of acquiring either of the two assets should be included in the long-term asset section of the balance sheet.

P11-5 A.Straight-Line Depreciation

YearBeginning Book Value

Depreciation Expense

Accumulated Depreciation

Ending Book Value

1 $124,000 $ 24,000* $ 24,000 $100,0002 100,000 24,000 48,000 76,0003 76,000 24,000 72,000 52,0004 52,000 24,000 96,000 28,0005 28,000 24,000 120,000 4,000

Total $120,000*($124,000 − $4,000) ÷ 5 years

Double-Declining-Balance Depreciation

Year

Beginning Book Value

(BBV)


(BBV × 0.4)Accumulated Depreciation

Ending Book Value

1 $124,000 $ 49,600 $ 49,600 $74,4002 74,400 29,760 79,360 44,6403 44,640 17,856 97,216 26,7844 26,784 10,714* 107,930 16,0705 16,070 12,070** 120,000 4,000

Total $120,000


* Rounded to nearest whole number.** Note that in year 5, an additional amount of depreciation expense is-

recorded so that the ending book value is the salvage amount of $4,000.

(continued)B.

Units-of-Production Depreciation


Depreciation Expense*


Ending Book Value

1 $124,000 $ 24,000 $ 24,000 $100,0002 100,000 24,000 48,000 76,0003 76,000 24,000 72,000 52,0004 52,000 24,000 96,000 28,0005 28,000 24,000 120,000 4,000

Total $120,000

*Based on $4 per hour ($124,000 − $4,000) ÷ 30,000 hours. If used evenly, the annual usage is 6,000 hours (30,000 hours ÷ 5 years). 6,000 hours × $4 = $24,000 per year.

It is probably not reasonable to expect that actual usage would be even. Variations in usage could be the result of shutdowns for main-tenance, employee vacations, layoffs, strikes, changing economic conditions (changes in customer orders), or shortage of raw materi-als, to mention a few possibilities.

C. Using the answers from parts A and B, the book value at the time of the sale must be calculated for each depreciation method. For the straight-line and double-declining-balance methods, one-half of the depreciation expense from year 5 is added to the amount of accumulated depreciation for year 4.

Straight-Line

Double-Declining-Balance

Units-of-Production

Original cost $124,000 $124,000 $124,000Year 1 depreciation (24,000) (49,600) (24,000)Year 2 depreciation (24,000) (29,760) (28,000)Year 3 depreciation (24,000) (17,856) (32,000)Year 4 partial

depreciation (12,000 ) (5,357 )* (16,000 )Book value at date of

sale $ 40,000 $ 21,427 $ 24,000

Selling price $ 25,000 $ 25,000 $ 25,000Book value at date of 40,000 21,427 24,000

326 Chapter 11

saleGain (loss) on sale $(15,000) $ 3,573 $ 1,000

* $10,714 ÷ 2 = $5,357

The straight-line method yields a loss on sale, while the double-de-clining-balance and units-of-production methods show a gain on sale. This results from the rapidity of depreciation; straight-line is slower (less depreciation per year) than the other two. The acceler-ated depreciation methods drove the book value down below what the asset could sell for. Therefore, there was a gain on sale. In essence, the accelerated depreciation methods depreciated the asset too rapidly and some of that depreciation expense was recovered when sold. Straight-line depreciation had the opposite effect. Book value was not driven down fast enough and a loss was incurred at the date of sale.

D.

Straight-line


Units-of-Production

Income statement:Depreciation expense $12,000 $5,357 $16,000Effect of sale $15,000 loss $3,573 gain $1,000 gain

Statement of cash flows:Operating activities

Add: depreciation expenseAdd (deduct) loss or gain on sale

$12,000

15,000

$5,357

(3,573)

$16,000

(1,000)Investing activities:

Add: Sale of machine $25,000 $25,000 $25,000

P11-6 A. $468,975 Invoice $450,000Delivery 7,540Installation and testing 11,435 Total cost $468,975

The annual insurance cost is not part of the cost of equipment.B.

Straight-Line MethodDouble-Declining-Balance

Method

YearDepreciation

ExpenseEnd-of-Year Book Value


End-of-Year Book Value

0 468,975 468,9751 71,496 397,479 156,325 312,6502 71,496 325,983 104,217 208,4333 71,496 254,487 69,478 138,9554 71,496 182,991 46,319 92,6365 71,496 111,495 30,879 61,757


6 71,496 40,000* 21,757** 40,000* Ignore $1 rounding error.** Amount necessary to reduce ending book value to residual value.

(continued)C.

Income statements:Straight-line depreciation

All years arethe same

Income before depreciation and taxes $160,000Depreciation 71,496Income before taxes 88,504Income taxes (35%) 30,976Net income 57,528

D.

Income statements:Double-declining-balance Year 1 Year 2 Year 3 Year 4 Year 5 Year 6Income beforedepreciation and taxes $160,000 $160,000 $160,000 $160,000 $160,000 $160,000Depreciation 156,325 104,217 69,478 46,319 30,879 21,757Income before taxes 3,675 55,783 90,522 113,681 129,121 138,243Income taxes (35%) 1,286 19,524 31,683 39,788 45,192 48,385Net income 2,389 36,259 58,839 73,893 83,929 89,858

E. A very different pattern of net income is reported over the six years depending on which depreciation method is used. Because double-declining-balance depreciation “front-loads” the depreciation expense into the early years, net income is smaller in the early years and larger in the latter years as compared to use of the straight-line method. The depreciation method being used is not reported on the face of the income statement or balance sheet. Instead, the reader of the financial statements must consult the notes to the financial statements to determine this. With knowledge of the depreciation method in use, the reader is better able to interpret the significance of the reported numbers. This is especially true when companies in similar businesses use different accounting methods.





Ending Book Value

1 $600,000 $112,000 $112,000 488,0002 488,000 112,000 224,000 376,0003 376,000 112,000 336,000 264,0004 264,000 112,000 448,000 152,000

328 Chapter 11

5 152,000 112,000 560,000 40,000 Total $560,000

The straight-line depreciation schedule is based on $112,000 depreci-ation expense per year.($600,000 cost − $40,000 residual value) ÷ 5 years = $112,000 per year






Ending Book Value

1 $600,000 $240,000 $240,000 $360,0002 360,000 144,000 384,000 216,0003 216,000 86,400 470,400 129,6004 129,600 51,840 522,240 77,7605 77,760 37,760 560,000 40,000

Total $560,000

The double-declining-balance depreciation schedule is based on these computations:($600,000 × 2/5 = $240,000)($360,000 × 2/5 = $144,000)($216,000 × 2/5 = $86,400)($129,600 × 2/5 = $51,840)($77,760 × 2/5 = $31,104*)

*Note that in year 5, an additional amount of depreciation expense is recorded so that the ending book value is reduced to the salvage amount of $40,000.

B. $168,000

Units-of-production rate = ($600,000 – $40,000) ÷ 4,000,000 units = $0.14 per yard. Depreciation expense = 1,200,000 million yards × $0.14 = $168,000.

C. Double-declining-balance method

Straight-Line


Units-of-Production

Net income before depreciation and taxes $3,600,000 $3,600,000 $3,600,000

Depreciation expense 112,000 240,000 168,000 Income before tax $3,488,000 $3,360,000 $3,432,000Income tax (30%) 1,046,400 1,008,000 1,029,600 Net income $2,441,600 $2,352,000 $2,402,400

D. Straight-line method (see schedule above)

E. This is an example of moral hazard. The CEO must make a decision on behalf of the stockholders, but the interests of the CEO and the interests of the stockholders are different. The CEO’s interest is to maximize net income because that maximizes the CEO’s bonus. Under this guideline, the straight-line method would be chosen. The stockholders’ interest is to minimize the cash outflow for taxes.

330 Chapter 11

(continued)


(When given the choice of paying taxes now or paying taxes later, stockholders would prefer to pay later given the time value of money.) Under this guideline, the double-declining-balance method would be chosen. Would you be willing to put the interests of the stockholders (for whom you work) before your own?





Ending Book Value

1 $1,200,000 $ 280,000 $ 280,000 $920,0002 920,000 280,000 560,000 640,0003 640,000 280,000 840,000 360,0004 360,000 280,000 1,120,000 80,000

Total $1,120,000

Straight-line depreciation schedule based on $280,000 depreciation expense per year. ($1,200,000 cost − $80,000 residual value) ÷ 4 years = $280,000 per year





Ending Book Value

1 $1,200,000 $ 600,000 $ 600,000 $600,0002 600,000 300,000 900,000 300,0003 300,000 150,000 1,050,000 150,0004 150,000 70,000* 1,120,000 80,000

Total $1,120,000

Double-declining-balance depreciation schedule is based on these computations:

($1,200,000 × 2/4 = $600,000)($600,000 × 2/4 = $300,000)($300,000 × 2/4 = $150,000)($150,000 × 2/4 = $75,000)

*Since recording $75,000 of depreciation expense would decrease book value below salvage value, only $70,000 of depreciation ex-pense is recorded in the last period.

B. $224,000

Units-of-production rate = ($1,200,000 − $80,000) ÷ 2,000,000 units = $0.56 per unit. Depreciation expense = 400,000 units × $0.56 = $224,000.

332 Chapter 11

C. Double-declining-balance method

Straight-Line


Units-of-Production

Income before depreciation and taxes $7,200,000 $7,200,000 $7,200,000

Depreciation expense 280,000 600,000 224,000 Income before tax $6,920,000 $6,600,000 $6,976,000Income tax (35%) 2,422,000 2,310,000 2,441,600 Net income $4,498,000 $4,290,000 $4,534,400

D. Units-of-production method (see part C solution)

P11-9 A. First year depletion = $2,400,000 Cost of mine $40,000,000Estimated tons of ore ÷ 500,000 Depletion per ton $ 80Tons produced 1st year × 30,000 First year depletion $ 2,400,000

First year depreciation = $400,000 Cost of machinery $ 4,800,000Expected life in years ÷ 12 Depreciation per year $ 400,000

B. First year depletion = $2,400,000 No change from part A

First year depreciation = $288,000*

*Student responses will vary. One reasonable approach is as follows. If the machinery can be used only for this mine, it is reasonable to base depreciation on the output of the mine; that is, use units-of-production depreciation, rather than straight-line based on the estimated life of the machinery.

Cost of machinery $4,800,000Expected life (tons of ore) ÷ 500,000 Depreciation per ton $ 9.60Tons produced first year × 30,000 Depreciation expense $ 288,000

C. Profit under part A = $800,000

Profit under part B = $912,000Part A Part B

Revenue ($120 × 30,000 tons) $3,600,000 $3,600,000Less: Depletion (cost of goods sold) 2,400,000 2,400,000

Depreciation 400,000 288,000 Profit $ 800,000 $ 912,000

(continued)


The profit differs only because of the choices made regarding ac-counting for depreciation. The difference between depreciation ex-pense is $112,000, which is the entire difference in profit.

D. Second year depletion = $1,649,000Cost of mine $40,000,000First year depletion 2,400,000 Remaining cost $37,600,000Remaining tons of ore ÷ 570,000 Cost per remaining ton $ 65.96Tons in second year × 25,000 Second year depletion $ 1,649,000

Second year depreciation = $400,000 Same amount every year.

E. Book value of mine = $35,951,000 Cost $40,000,000Year 1 depletion 2,400,000Year 2 depletion 1,649,000 Ending book value $35,951,000

Book value of machinery = $4,000,000 Cost $4,800,000Year 1 depreciation 400,000Year 2 depreciation 400,000 Ending book value $4,000,000

P11-10 A. Available-for-sale: Because these are investments in equity securities, they cannot qualify for held-to-maturity treatment. They could only be trading securities if they were held for resale in the normal course of business. Nothing in this problem suggests that is the purpose of these investments. In fact, the problem expressly notes the long-term nature of its occasional investments. Accordingly, the proper classification is available-for-sale.

B.

2006 Milton Holmes TotalYear-end market valueHistorical costNet unrealized holding

loss

$3,100,0003,500,000

$2,800,0002,690,000

$5,900,000 6,190,000

$ (290,000)

For year-end 2006, Keelson would report $5,900,000 in long-term in-vestments and $290,000 in net unrealized holding loss.

2007 Milton Balthasar TotalYear-end market valueHistorical costNet unrealized holding

loss

$3,350,0003,500,000

$1,940,0001,930,000

$5,290,000 5,430,000

$ (140,000)

334 Chapter 11

For year-end 2007, Keelson would report $5,290,000 in long-term in-vestments and $140,000 in net unrealized holding loss.

In both years, the net unrealized holding loss would be reported as a deduction from stockholders’ equity.

C. Effect on income in 2006:Dividends received from Milton $500,000

Effect on income in 2007:Dividends received from Milton $500,000Realized gain on sale of Holmes stock 210,000 *Net effect on income $710,000

*$2,900,000 − $2,690,000 historical cost = $210,000

P11-11 A. 1. Short-term investments (at market value):Harbor Company $41,000Paxton 32,540 Total $ 73,540

2. Long-term investments (at market value):Regency $25,000Hilton 34,200 Total $ 59,200

3. Stockholders’ equity:Net unrealized holding gain $2,210

Proof:Market Cost Gain (Loss)

Harbor $41,000 $37,500 $ 3,500Regency 25,000 22,880 2,120Hilton 34,200 36,400 (2,200)Paxton 32,540 33,750 (1,210 )Net unrealized holding gain $ 2,210

B. Dividend revenue (or investment revenue) $5,600[Harbor dividends ($3,900) + Hilton dividends ($1,700)]

C. Companies hold assets because of the future economic benefits that can be derived from them. In the case of buildings and equipment, for example, future benefits are obtained by using the assets in the production of goods and services. In the case of small investments in common stock, however, future economic benefits are derived from their sale. That is, this class of asset is not used in the business to produce goods and services. The benefits of this asset come only from receipt of periodic dividends and eventual sale. The current market value of an investment is likely to be a better estimate of the future economic benefit to be obtained upon sale than is the price originally paid to acquire it.


P11-12 A. $101,815. The price of the bonds would be computed as the present value of four semiannual payments of $4,500 each ($100,000 × 9% × 1/2 year) discounted at 4% plus the present value of a single payment of $100,000 at the end of four periods discounted at 4%: ($4,500 × 3.62990) + ($100,000 × 0.85480) = $16,335 + $85,480 = $101,815.

B.

1 2 3 4 5 6

Period

Present Valueat Beginning

of Period

InterestRevenue (Col-umn 2 × 4%)

CashInterest

Received

Amort. of Premium

(Column 4 − Column 3)

Value at End of Period

1 101,815 4,073 4,500 427 101,3882 101,388 4,056 4,500 444 100,9443 100,944 4,038 4,500 462 100,4824 100,482 4,018* 4,500 482 100,000

*$1 adjustment for roundingC.

Journal Effect on Accounting Equation


CC + RE2007

Apr. 1 Investment in Bonds 101,815 +101,815

Cash 101,815 –101,815

Sept. 30 Cash 4,500 +4,500

Interest Revenue 4,073 +4,073

Investment in Bonds 427 –427

2008

Mar. 31 Cash 4,500 +4,500



Sept. 30 Cash 4,500 +4,500



2009

Mar. 31 Cash 4,500 +4,500



Mar. 31 Cash 100,000 +100,000

Investment in Bonds 100,000 –100,000

336 Chapter 11

D. Interest CashYear Revenue Flows 2007 $ 4,073 $−101,815

4,5002008 8,094 9,0002009 4,018 4,500

+100,000 $ 16,185 $ 16,185

The total interest revenue reported on the three year-end income statements (2007 = $4,073; 2008 = $8,094; 2009 = $4,018) is $16,185. This is exactly equal to the net cash inflow over the same years from the investment in bonds.

E. When considering a completed transformation cycle, accrual basis and cash basis measures yield the same results. Here the entire transformation has taken place. The bonds were purchased, cash interest payments were received, and the principal recovered. It is only when a transformation cycle is incomplete that accrual and cash-based measures yield different results. This is seen in the solution to part D where the information at each of the five important dates is very different between the two measures. Overall, however, they both report that the firm earned $16,185 from the investment in bonds.


P11-13Journal Effect on Accounting Equation


CC + REA. Long-Term Investments 10,000 +10,000

Cash 10,000 –10,000

B. Cash 500 +500

Interest Revenue 500 +500

C. No entry necessary

D. Long-Term Investments 400 +400

Unrealized Holding Gain* 400 +400*

E. Long-Term Investments 10,445 +10,445

Cash 10,445 –10,445

F. Cash 500 +500

Long-Term Investment1 82 –82

Interest Revenue 418 +418

G. No entry necessary

H. Long-Term Investment 37 +37

Unrealized Holding Gain2* 37 +37*

1 A portion of the premium must be amortized. Cash interest received equals $500 ($10,000 × 5%) while interest revenue is $418 ($10,445 × 4%). This yields $82 of premium amortization.

2 Amortization of premium brings the carrying value of the bonds down to $10,363 ($10,445 – $82). The market value, however, is $10,400. Therefore, an unrealized holding gain of $37 must be recog-nized ($10,400 – $10,363).

* This is included as Other Comprehensive Income in the stockhold-ers’ equity section of the balance sheet.

I. The carrying values to be reported on the balance sheet at the end of year one in parts C, D, G, and H would be:

Part

Original

CostAmortization of Premium

Market ValueAdjustment

Carrying Value(Book Value) at

End of Year 1C $10,000 None None $10,000D 10,000 None + $400 $10,400G 10,445 − $82 None $10,363H 10,445 − $82 + $37 $10,400

338 Chapter 11

J. Amortization table

1 2 3 4 5 6

Year

Present Value at

Beginning of Year

Interest Revenue

(Column 2 × Interest

Rate)Cash

Received

Amortization of Premium (Column 3 − Column 4)

Value at End of Year (Column 2 − Column 5)

1 $10,445 $ 418 $ 500 −82 $10,3632 10,363 415 500 −85 10,2783 10,278 411 500 −89 10,1894 10,189 408 500 −92 10,0975 10,097 404 500 −96 10,001*

Totals $2,056 $2,500 −444*

*Ignore the $1 rounding error.

The difference between the interest revenue and the cash received for interest is (ignoring the $1 rounding error) equal to the amount of the premium.

P11-14 A.Journal Effect on Accounting Equation



Cash 283,439 –283,439

Dec 31 Cash 25,200 +25,200

Long-Term Investment 3101 +310

Investment Revenue 25,5102 +25,510

1Amortization of discount ($25,510 – $25,200 = $310)2Balance of investment account × 9% yield ($283,439 × 9% = $25,510)

(continued)


B.If the bonds are?

Held-to-Maturity

SecuritiesTrading

Securities

Available-for-Sale

Securities

Accounting method to be usedAmortized

costMark tomarket

Mark tomarket

Amount of unrealized holding gain (loss) to be reported on income statement none $(1,749)3 noneAmount of unrealized holding gain (loss) to be reported on balance sheet none none $(1,749)Amount of discount amortized during first year $3101 $310 $310Balance of investment account on balance sheet at end of first year $283,7492 $282,0004 $282,000

1 Interest earned ($283,439 × 9% = $25,510) minus interest received ($25,200)

2 Amortized cost ($283,439 + $310)3 Difference between amortized cost ($283,749) and market value

($282,000)4 Market value at balance sheet date



CC + REAug. 22 Long-Term Investment 160,800* +160,800

Cash 160,800 –160,800

*Includes commission, fees, and taxes.

340 Chapter 11

B.If the total number of Radius common

shares outstanding totals

1 million1 80,0002 30,0003

Accounting method to be usedMark tomarket Equity method

Consolidationmethod

Amount of unrealized holding gain (loss) to be reported on income statement none none noneAmount of unrealized holding gain (loss) to be reported on balance sheet $(12,800)4 none noneBalance of investment account on balance sheet $148,0005

notdeterminable none

1 A small investment (2% of outstanding shares) that does not create sig-nificant influence or control.

2 An investment comprising 25% of the outstanding shares (20,000 ÷ 80,000 shares). Large enough to assume significant influence.

3 An investment comprising 2/3 of the outstanding shares. This gives control to the acquiring firm.

4 Cost ($160,800) minus ending market value ($148,000)5 Ending market value

C.Journal Effect on Accounting Equation


CC + REJan. 23 Cash 171,400 +171,400


Unrealized Holding Loss 12,800 +12,8001

Realized Holding Gain 10,600 +10,6002

1 This is included as Other Comprehensive Income in the stockholders’ equity section of the balance sheet.

2 Selling price – original purchase price



CC + RE1. Cost of Goods Sold 660,000 –660,000

Mining Site 660,000 –660,000

(continued)


Cost of the mining site less salvage value ($4,900,000 − $500,000) divided by estimated output (20 million tons) equals depletion cost per ton of $0.22. Cost per ton ($0.22) times amount produced and sold (3 million tons) equals total depletion amount of $660,000.



CC + RE2. Depreciation Expense 21,888 –21,888

Accumulated Depreciation 21,888 –21,888

Proof:

YearBeginning Book Value Rate


Ending Book Value

1 $152,000 40% $60,800 $91,2002 91,200 40% 36,480 54,7203 54,720 40% 21,888 32,832



CC + RE3. Amortization Expense 7,125 –7,125

Patent 7,125 –7,125

The minimum effect on net income is accomplished by amortizing over the longest period allowed. The maximum period allowed is 40 years, or the economic life, whichever is shorter. In this case, the economic life is 8 years. Therefore, amortization expense is $57,000 ÷ 8 years = $7,125.

B. Straight-line depreciation expense (year 1)= $26,000 [($152,000 − $22,000) ÷ 5]

Straight-line depreciation expense (year 2)= $26,000 [($152,000 − $22,000) ÷ 5]

Revised depreciation expense (years 3–10) = $12,250

Proof:Cost of assets $152,000Depreciation taken in first two years ($26,000 each year) 52,000

$100,000Less: Estimated residual value 2,000 Remaining amount to be depreciated $ 98,000Divided by 8 years remaining ÷ 8

$ 12,250

342 Chapter 11



CC + REDepreciation Expense 42,500 –42,500

Accumulated Depreciation 42,500 –42,500

($475,000 cost − $50,000 residual value) ÷ 10 years = $42,500 depre-ciation expense

B.Journal Effect on Accounting Equation


CC + RECash1 3,000 +3,000

Accumulated Depreciation2 297,500 +297,500

Loss on Sale3 174,500 –174,500

Machinery4 475,000 –475,0001Given in the data.2$42,500 annual depreciation expense × 7 years3Book value ($475,000 – $297,500 = $177,500) minus cash received ($3,000) = $174,5004Original cost of machinery

C.Journal Effect on Accounting Equation


CC + RECost of Goods Sold 1,265,000 –1,265,000

Mineral Rights 1,265,000* –1,265,000

*(80,500 tons ÷ 350,000 tons) × $5,500,000 = $1,265,000

D. Mechanically, goodwill is the amount paid over and above the market value of a company’s net assets (assets minus liabilities). Conceptually, it is the amount paid for resources that do not appear on the balance sheet. For example, the acquired company may have extremely loyal customers, highly skilled managers, or unusually high morale among employees. Because these allow the acquired company to earn above-average profits, the buying company is willing to pay extra to obtain the extra profits. Goodwill is the amount paid to obtain the extra profits.

E.Journal Effect on Accounting Equation


CC + REInvestment in Subsidiary 2,200,000 +2,200,000

Goodwill 800,000 +800,000

Cash 3,000,000 –3,000,000


P11-18 A.



CC + REJuly 1, 2004 Equipment 800,000 +800,000

Cash 800,000 –800,000

Dec. 31, 2004 Depreciation Expense 75,000 –75,000

Accumulated

Depreciation 75,000 –75,000


Accumulated



Accumulated


June 30, 2007 Depreciation Expense 75,000 –75,000

Accumulated


June 30, 2007 Cash 311,000 +311,000

Accumulated Depreciation 450,000 +450,000

Loss on Asset Sale 39,000 –39,000

Equipment 800,000 –800,000

B. A $39,000 loss was recorded at the date of sale because the amount of cash received ($311,000) was less than the book value of the equipment (cost − accumulated depreciation = $800,000 − $450,000 = $350,000). The loss does not mean the company was negligent when selling the equipment. Instead, the loss indicates that the fair value of the asset had declined further than the amount of depreciation that had been taken to date. In a sense, the asset was underdepreciated during the three years of its use. A gain on sale of the asset does not mean the company was skillful in selling the asset. Instead, it indicates that the asset was overdepreciated during the period it was used.

C. Effect on pretax income for 2004–2007:Total depreciation expense ($75,000 + $150,000

+ $150,000 + $75,000) $450,000Loss on sale 39,000 Cumulative net decrease in pretax income for

2004 through 2007 $ 489,000

Effect on cash flows for 2004–2007:Purchase cost of the equipment (2004) $800,000Sale of the equipment (2007) 311,000 Cumulative net cash outflow $ 489,000

344 Chapter 11

Accrual and cash flow measurements usually produce the same results when all effects of a series of related transactions are considered. The life of a plant asset is a good example of these relationships. Cash flow and accrual measurements occur from the time an asset is acquired until it is disposed of. Over the life of the asset, the effects on income and cash flows are the same. The difference between the measurements is not in amount, but in timing. Cash flows are measured when they occur. Accrual accounting allocates asset cost over the life of the asset to match expenses with revenues in the periods that benefit from use of the asset.

P11-19 Asset valuation by financial institutions has been a major accounting issue in recent years. Traditional accounting rules permitted banks to report loans and other assets at historical cost. Nonperforming loans were written off. Restructured loans could be reported after adjusting for the lower expected cash receipts, resulting from changes in loan terms. An important question in this problem is whether investors are likely to be misled by the bank’s financial report. Are investors facing a risk that is not apparent? If so, some disclosure of this risk that is sufficient to permit investors to assess the risk and the effect it has on the value of their investments would appear necessary. Otherwise, an ethical problem arises because management is concealing information that has a bearing on the welfare of the bank’s investors. This information also may affect decisions of depositors, employees, and government authorities.

On the other hand, if the bank’s valuation of $43 million is a fair repre-sentation of the present value of the expected cash flows the bank ex-pects to receive from the loans, the amount may not be misleading. A rel-evant issue is whether the loan loss reserve is sufficient to cover the losses the bank should expect from nonperforming loans. If the bank writes its loans down to market value, it would recognize a loss of $8 mil -lion on the loans ($43 million at cost, adjusted for expected losses − $35 million at market). This loss would wipe out its current year profits and most of its equity. The loss could result in problems for the bank with regulatory agencies and depositors.

A separate issue is valuation of the property held by the bank. The book value of the property appears to be less than its market value. The property should be reflected on the bank’s statements at an amount ap-proximating its value to the bank. This value could be approximated by discounting the expected cash flows the bank expects from the property.

A criticism of accounting rules is that they do not necessarily require organizations to report information about the current market value of their assets. These values may be useful to decision makers. Managers and auditors often argue against reporting these amounts because they often are subjective and may be difficult to determine.





Cash 24,000 –24,000

Dec. 31 Long-Term Investment 9,120 +9,120

Investment Revenue 9,120 +9,120

Dec. 31 Cash 1,440 +1,440


B.Question Solution

1. In which section of the balance sheet will this investment be reported? Be specific.

Long-term investment section.

2. What amount will be reported on the balance sheet for this investment? Show your work.

$31,680; Cost of $24,000 plus $9,120 earned on investment minus $1,440 received via dividends.

3. What amount of income will be reported on the income statement related to this investment? Explain.

$9,120; 24% of Helio Company’s net income. The dividends received are not income but a partial return of Schuster’s investment in Helio.

4. What information will be reported about any unrealized holding gain or loss? Explain.

None. Under the equity method, the market value of the investment is ignored. This is reasonable since there is no expectation that the investment will be sold any time soon.

346 Chapter 11

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348 Chapter 11

P11-22 A. Routine maintenance is an expense that should be recorded in the period incurred. It is not an investing activity similar to those discussed in this chapter. The president is attempting to mislead stakeholders by understating selling, general, and administrative expenses and overstating net income. Investors and creditors depend on relevant and reliable information in order to make decisions.

B.Journal Effect on Accounting Equation


CC + REa. SGA Expenses 1,000,000 –1,000,000

Investment in Fixed Assets 1,000,000 –1,000,000

C.

CMI Com WorldStatement of Income

For the Year Ended 12/31/07

(In thousands)Revenues $43,000Cost of revenues 28,000Selling, general and administration 15,750 Net income (loss) $ (750 )

Number of shares 1,000

Earnings per share ($0.75)

D. The revised income statement results in a loss of $0.75 per share rather than a profit of $0.25 per share as originally shown. The president’s misclassification misleads investors and distorts the financial condition of the company.

P11-23

1 2 3 4 5 6 7 8 9 10 11 12

b c d b d d c b b a a c


CASES

C11-1 Financial statement effects of a purchase:

On January 1, Swenson would record an increase in plant assets and long-term liabilities of $2 million. The assets would be depreciated as fol-lows:

YearBook Value at

Beginning of YearDepreciation

ExpenseBook Value at End of Year

1 $2,000,000 $ 500,000 $1,500,0002 1,500,000 500,000 1,000,0003 1,000,000 500,000 500,0004 500,000 500,000 0

Total $2,000,000

The interest expense would be computed as follows:

(a)

Year

(b)BeginningPrincipal

(c)Interestat 10%

(d)Repaymentof Principal

(c + d)Total CashPayment

(b – d)End-of-Year

Principal1 $2,000,000 $200,000 $ 500,000 $ 700,000 $1,500,0002 1,500,000 150,000 500,000 650,000 1,000,0003 1,000,000 100,000 500,000 600,000 500,0004 500,000 50,000 500,000 550,000 0

Totals $500,000 $2,000,000 $2,500,000

Summary of effects on income statement:1. Depreciation expense each year of $500,000. Total over four years =

$2,000,000.2. Interest expense each year of $200,000, $150,000, $100,000, and

$50,000, respectively. Total interest expense over four years = $500,000.

Summary of effects on the balance sheet:1. The assets are reported at book value (cost of $2,000,000 less accu-

mulated depreciation) each year. Book value at the end of each of the four years is $1,500,000, $1,000,000, $500,000, and zero, respectively.

2. The liability for borrowed money is reported at the amount of unpaid principal at the end of each year. Those amounts are $1,500,000, $1,000,000, $500,000, and zero, respectively.

Summary of effects on the statement of cash flows:1. Under the indirect format, the depreciation expense is added to net in-

come as part of computing cash provided by operations.2. The purchase of the equipment is reported at $2 million as an invest-

ing activity.

350 Chapter 11

3. The borrowing of $2 million from the bank is reported in the first year as a financing activity cash outflow.

4. The cash repayment of principal each year ($500,000) is reported un-der financing activities. The cash paid for interest expense ($200,000, $150,000, $100,000, and $50,000, respectively) is reported as part of operating activities. The total cash outflow for four years = $2,500,000.

Financial statement effects of a lease:

On January 1, Swenson would capitalize the lease at the present value of the required lease payments. $635,000 × 3.16987 (10% for 4 periods, Ta-ble 4) = $2,012,867. This amount would be recorded as a long-term asset and a long-term liability. The assets would be depreciated as follows:

Year Book Value at Be-ginning of Year


Book Value at End of Year

1 $2,012,867 $ 503,217 $1,509,6502 1,509,650 503,217 1,006,4333 1,006,433 503,217 503,2164 503,216 503,216 * 0

Total $2,012,867

(a)

Year

(b)

BeginningLease

Principal

(c)

EffectiveInterest

(B × 10%)

(d)

Lease Pay-ment

(Given)

(e)(d – c)

Reduction of LeasePrincipal

(f)(b – e)

End-of-YearLease

Principal1 $2,012,867 $201,287 $ 635,000 $ 433,713 $1,579,1542 1,579,154 157,915 635,000 477,085 1,102,0693 1,102,069 110,207 635,000 524,793 577,2764 577,276 57,724 * 635,000 577,276 0

Totals $527,133 $2,540,000 $2,012,867

Summary of effects on income statement:1. Depreciation expense each year of $503,217. Total over four years =

$2,012,867.2. Interest expense each year of $201,287, $157,915, $110,207, and

$57,724, respectively. Total interest expense over four years = $527,133.

(continued)


Summary of effects on the balance sheet:1. The assets are reported at book value (capitalized cost of $2,012,867

less accumulated depreciation) each year. Book value at the end of each of the four years is $1,509,650, $1,006,433, $503,216, and zero, respectively.

2. The liability for borrowed money is reported as the amount of unpaid lease principal at the end of each year. Those amounts are $1,579,154, $1,102,069, $577,276, and zero, respectively.

Summary of effects on the statement of cash flows:1. Under the indirect format, the depreciation expense is added to net in-

come as part of computing cash provided by operations.2. The portion of the lease payment that is repayment of principal is re-

ported each year under financing activities. Those amounts are $433,713, $477,085, $524,793, and $577,276, respectively. The cash paid for interest expense ($201,287, $157,915, $110,207, and $57,724, respectively) is reported each year as part of cash from operations. The total cash outflow for lease payments over four years = $2,540,000.

Overall, the lease would result in $40,000 more in cash outflow than the purchase over the four-year period. The present value of this difference is $12,867 at the end of the first year ($2,012,867 − $2,000,000 = $12,867). Depreciation expense would also be $12,867 higher under the lease op-tion, and interest expense would be $27,133 higher over four years ($527,133 − $500,000). Therefore, the purchase option produces slightly more favorable results.

C11-2 A. The primary method for depreciating buildings and equipment is the straight-line method. Accelerated methods are generally used for income tax purposes. Useful lives range from three to 50 years (Note 1-B). Section D (Intangible Assets) explains that on May 28, 2001, the company adopted SFAS no. 142, “Goodwill and Intangible Assets.” This statement eliminated amortization of goodwill and instead requires that goodwill is tested annually for impairment. Other intangibles are amortized evenly over their estimated useful lives (Note 1-D). All expenditures for research and development are charged against earnings (expensed) in the year incurred (Note 1-J). The production costs of advertising are expensed the first time the advertising takes place (Note 1-K).

352 Chapter 11

B. Cost of plant assets is reported in Note 5 (in millions):Land $ 53Buildings 1,290Equipment 3,419Construction-in-progress 557

Total $ 5,319Less: Accumulated depreciation (2,208 )Net plant assets $ 3,111

C. Marketable equity securities are reported in the “Other Assets” section of the consolidated balance sheet at fair market value. At May 30, 2004, the company reported marketable equity securities valued at $30 million. This represents approximately 0.1% (or 1/10 of 1%) of the company’s total assets.

D. Plant assets at end of fiscal year 2003 reportedon the balance sheet (in millions) $2,980

Purchase of plant assets (statement of cash flows) 628Disposal of plant assets (statement of cash flows) (36)Depreciation—includes amortization

(statement of cash flows or income statement) (399 )Plant assets at end of fiscal year 2004 (as calculated) $3,173Plant assets at end of fiscal year 2004 (as reported) $3,111

The difference between the calculated amount of plant assets and the reported amount is due primarily to the acquisition and disposal of other companies, whose assets are included in the total plant as-set account. Also, the depreciation expense amount ($399) used above overstates depreciation because it includes amortization of intangibles.

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