978-0078025679 Chapter 10 Solution Manual Part 3

10–31

Requirement 2:

ROA for Lantana Co. (000s omitted):

Jan. 1

Dec. 31

2014

2015

2016

2017

2018

Asset net book value

$20,000

$20,080*

$20,234

$20,455

$20,736

$21,071

Net operating cash

flow, increasing

2%/year

$5,000

$5,100

$5,202

$5,306

$5,412

Depreciation exp.

4,000

4,008

4,024

4,049

4,082

Pretax profit

$1,000

$1,092

$1,178

$1,257

$1,330

ROA on beginning

5%

5.4%

5.8%

6.1%

6.4%

of year assets

Average age of

assets

5 years

10–32

2014

2015

2016

2017

2018

Beginning of the

year gross assets1

$40,000

$40,080

$40,242

$40,487

$40,817

Less: retired

($4,000)

Add: new assets

4,080

4,162

4,245

4,330

4,417

End of year gross

$40,080

$40,242

$40,487

$40,817

$41,234

assets

Depreciation expense

$4,000

$4,008

$4,024

$4,049

$4,082

(Beginning of year

x 10%)

1 Assets are, on average, 5 years old, with a 10-year life = ½ depreciated. Therefore,

$20,000,000 net asset base x 2 = $40,000,000 gross asset base.

*Computed as: Beginning net book value ($20,000,000) + capital expenditures ($4,080,000) –

depreciation expense ($4,000,000). All other years computed similarly.

Requirement 3:

Gardenia’s rapidly increasing ROA gives the appearance of significant year–

to-year improvement. But this is illusory because the ROA increase is caused

primarily by the increasing average age of its asset base. This factor would

alone cause ROA to increase even in the absence of inflation. But the upward

P10–17. Accounting for asset retirement obligations

Requirement 1:

GAAP requires companies to recognize an asset retirement obligation (ARO)

when a reasonable estimate of its fair value can be made. These legal

obligations arise when a company builds or buys an asset that requires

Payment $15,000,000

x PV factor, 5 periods, at 10% .62092

= Present value of the ARO $ 9,313,800

Journal entry:

01/01/Year 1

10–34

The entry to record the interest (for example, in year 1) is:

DR Accretion expense $931,380

P10-18. Accounting for assets held for sale

Requirement 1:

Carrying value at 12/31/11:

Historical cost $12,000,000

10–35

Prescott’s income statement for the year ended December 31, 2014 should

report discontinued operations for the railroad component after income from

continuing operations and before extraordinary items.

Prescott Co.

Partial Income Statement

For the Year Ending December 31, 2014

Income from continuing operations

$7,875,000*

Discontinued operations (see Note xx)

Loss from operations of

discontinued railroad component

(Including $1,273,000 impairment

loss)

(1,748,000)+

Net income

$6,127,000

*(This is net income of $7,400,000 plus the loss of $475,000 added back

on the railroad component)

+(This is the loss on the railroad component of $475,000 plus the

impairment loss of $1,273,000)

Requirement 3:

Operating margin ROA

With DCO treatment

$7,875,000 $7,875,000

$18,200,000* = 43.3% $88,000,000+ = 8.9%

Without DCO treatment

$7,400,000 $7,400,000

10–36

Separate reporting of discontinued operations helps financial statement

readers make meaningful comparisons of year-to-year results for income from

continuing operations. For all prior years presented for comparative purposes,

P10–19. Evaluating approaches to long-lived asset valuation

Requirement 1:

Expected benefit approaches focus on the estimated value of long-term

assets in an output market, that is, a market where the assets could be sold.

10–37

example of an economic sacrifice approach is current replacement cost. This

is the amount that would be required to purchase/replace the asset today with

an “identical” or “similar” asset. A problem that arises under this approach is

estimates about the future conditions of the firm and appropriate discount

rates. Many managers believe that the necessity of these estimates will

P10–20. Weakness of the Straight-line Depreciation Method

Requirement 1:

a. Annual depreciation expense = (Cost – salvage) ÷ life

$3,962 = ($15,849 − $0) ÷ 4

End of

Depreciation

Accumulated

Book

Year

Expense

Depreciation

Value

0

15,849

1

3,962

11,887

2

3,962

7,924

7,925

3

3,962

11,886

3,963

4

3,963

15,849

–

b. If the company were to record straight–line depreciation, its four years’ income statements

would appear as follows:

1

2

3

4

Revenue

$ 5,000

Depreciation expense

3,962

3,963

Net income (A)

$ 1,038

$ 1,037

Initial investment (B)

$ 15,849

$ 11,887

$ 7,925

$ 3,963

Less: depreciation expense

3,962

3,963

Ending investment balance

$ 11,887

$ 7,925

$ 3,963

$ –

c.

Return on investment (A ÷ B) 6.5% 8.7% 13.1% 26.2%

Requirement 2:

a.

Under the present value method of depreciation, annual depreciation expense is the

difference between the present value of future cash flows at the beginning of year and end of

year.

Beginning

of year PV

Annual

of Future

Depreciation

Accumulated

Year

cash flow

cash flows

expense

Depreciation

Book Value

0

15,849

1

5,000

12,434

3,415

12,434

2

5,000

8,678

3,756

7,171

8,678

3

5,000

4,545

4,133

11,304

4,545

4

5,000

4,545

15,849

–

10–39

Revenue

$ 5,000

Depreciation expense

3,415

3,756

4,133

4,545

Net income (A)

$ 1,585

$ 1,244

$ 867

$ 455

Initial investment (B)

$ 15,849

$ 12,434

$ 8,678

$ 4,545

Less: depreciation expense

3,415

3,756

4,133

4,545

Ending investment balance

$ 12,434

$ 8,678

$ 4,545

$ 0

created by the use of an arbitrary method of depreciation. In this example, with

straight-line depreciation, a constant numerator (Net income) is divided by a

declining denominator (Initial investment) to produce a rising annual return on

investment, which is a counter-intuitive result. Why should the annual return on

investment be rising when the actual cash inflow each year was precisely as

investment would be correspondingly higher or lower. The use of this method

enables a reader of the income statement to determine whether, and to what

extent, the company achieved its required 10% return on investment. Another

way of looking at the “present value method” is that the depreciation expense

each year represents the implicit depreciation when one calculates the present

10–40

Requirement 4:

The “present value method” is not an acceptable method in U.S. financial