Chapter 8 Homework For Individuals The Most Familiar Type Replacement

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INSTRUCTOR’S MANUAL

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Lecture Suggestions

Module 1

LO 2

Discuss examples of acquisition costs. Note, some instructors prefer to discuss the topic of capital

versus revenue expenditures (LO 7) at this point in time.

A manufacturing company produces wicker furniture. It is running short of cash and borrows

money from the bank to purchase raw materials. Is the interest on the loan included in the cost of

the inventory or is it shown on the income statement as an expense?

Students tend to believe that salvage value and estimated lives are insignificant to the overall

financial statements. They should understand that by changing these estimates, the financial

statements can be significantly impacted. It is one of the ways the management tends to “cook the

books.” An excellent example is the Waste Management fraud. In 2002, the SEC filed a complaint

against the company alleging that management fraudulently manipulated the company’s financial

results to meet predetermined earnings targets. They employed a multitude of improper accounting

practices:

CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES

Module 2

LO 6

Define residual value. Explain that residual value is called salvage value and/or scrap value.

Discuss how a business would choose which depreciation method to use, as well as the advantages

and disadvantages of each. The text uses the same information for all illustrations. This gives the

instructor an opportunity to compare the advantages and disadvantages of each type of

depreciation method. Give an example of how an asset is depreciated when sold during the middle

of the year. Remind students that this is an estimate and if it is later discovered that the estimate

must be changed, it does not mean that a mistake was made in the past. This is a good time to

discuss changes in estimates and the manipulation of income.

example of those situations.

students if a business is only worth the amount of the net current value of its assets.

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Projects and Activities

Module 1

LO 1

Balance Sheet Presentation

Outside assignment: Your personal balance sheet

Did you do a personal balance sheet in Chapter 1? If so, review this assignment now. Concentrate on the

assets section.

◼ Which of your assets are long-lived assets? Can you assign these a useful life and a residual value?

List the factors you considered in assigning these values.

◼ Are your personal assets depreciating? Explain.

◼ Do you have any intangible assets? What are they?

◼ What portion of your total assets are long-lived assets? You may now want to rearrange your

balance sheet to conform to the proper presentation format, separating your current and long-lived

assets.

Solution

Of course there is no “right” answer to this. The question helps the students to think of assets in real terms,

as “their” assets.

◼ Personal assets do have lives. The lives depend not on how long the item could possibly last,

Module 1

LO 3

Acquisition Cost of Assets

In-class discussion: What does it cost to acquire an asset?

Prepare a list of assets that require more than a simple purchase to be put to use. Ask students, perhaps in

teams, to list the costs that would be involved in preparing one of these assets for use. Some possible

examples are a mainframe computer system; a delivery truck; purchase of land and a building with the

intent of building the company’s new corporate headquarters on the cleared site; land holding a former

manufacturing building to be converted to an office building.

Solution

The items that students will list depend on the asset chosen (you probably have your own favorites) and the

CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES

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Module 2

LO 5

Depreciation of assets

In–class discussion: Nike’s asset lives

Nike included the following in a footnote to their 2015 annual report2:

Property, Plant and Equipment and Depreciation

Property, plant, and equipment are recorded at cost. Depreciation is determined on a

straight-line basis for buildings and leasehold improvements over 2 to 40 years and for

machinery and equipment over 2 to 15 years. Computer software (including in some

cases, the cost of internal labor) is depreciated on a straight–line basis over 3 to 10 years.

Software Development Costs

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◼ By using the straight-line method of depreciation for reporting buildings and improvements, what

assumption about the usefulness of assets is the company making? Do you think this was the

primary consideration in choosing the straight-line method?

◼ What is the impact on the income statement of using accelerated methods of depreciation for tax

purposes? What is the impact on the balance sheet? What is the impact on cash?

◼ If Nike switched to accelerated depreciation on buildings and improvements for reporting

purposes, how would net income change? Would you recommend that they make this switch in

order to bring the book and tax expenses “in line?” Do you think this is a change in principle or a

change in estimate?

◼ What is the difference between a “major renewal” and a “repair”? Why is the former capitalized

and the latter expensed?

◼ How might an asset become “impaired”? Explain, citing specific examples.

Solution

◼ Straight-line depreciation assumes the asset is equally useful throughout its life. The primary

consideration in selecting a depreciation method was probably the simplicity of straight–line.

Module 2

LO 7

Capital versus Revenue Expenditures

In-class discussion: Capitalization versus expense

WorldCom was a major global communications provider, which operated in more than 65 countries.

According to a civil action brought against WorldCom by the SEC:

CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES

◼ What effect did WorldCom’s action have on the income statement and balance sheet? Is this effect

permanent, or a timing difference? If the effect is only a timing difference, does that make it less

of a problem?

Solution

◼ Under GAAP (Generally Accepted Accounting Principles), line fees cannot be capitalized. They

Module 2

LO 8

Disposal of Operating Assets

Outside assignment: Impact of disposals

Suppose that Time Warner owns a piece of cable television equipment with an original cost of $450,000.

Accumulated depreciation is $390,000. Consider each of the following cases separately:

◼ Time Warner sells the asset for $75,000. What is the gain or loss?

◼ Time Warner sells the asset for $50,000. What is the gain or loss?

◼ Time Warner cannot find a buyer for the asset, and pays $5,000 to have it removed. What is the

gain or loss?

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Solution

The journal entries: (gains and losses are highlighted)

◼ To sell the asset for $75,000:

◼ This exercise demonstrates that a disposal always involves (1) removing the asset from the

balance sheet and (2) removing the related accumulated depreciation. No matter what else

happens, those two lines will be the same. The only lines in the entry that are different are the

proceeds (which may not exist, or may be a receivable, or may actually be a payment), and the

gain or loss.

◼ Most students are reluctant to accept recording a gain from a disaster. An accounting entry only

records the transaction. Obviously the follow-up will be the purchase of a new machine, using the

cash settlement. No moral or ethical problem is involved here, only the recording of an expected

cash receipt.

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the item insured. Companies insure for the same reason that individuals do—for protection.

Companies want to protect their assets from a catastrophic loss that might seriously impair their

ability to continue in business. For this reason, insuring for replacement cost makes good business

sense.

Outside assignment: Ethical decision: Is residual value important?

You are an assistant controller for a company with a number of operating segments. Each division has a

divisional controller who reports to the division director. These controller/director teams make many

financial decisions for their divisions, but are expected to adhere to guidelines set forth by the corporate

accounting department. Your duties include working closely with all the division controllers in gathering

and analyzing monthly operating results.

Back in your office you think over what you have found. The division is a large and very powerful one in

the company, with substantial dollars invested in equipment. Communicating this discovery to your boss,

the corporate controller, is going to put you in the middle of a politically volatile situation. You are also

concerned about how the resolution will be handled by the controller, because the success of your job has

been greatly influenced by your ability to maintain good relationships with divisional personnel, while

carrying out corporate policy.

What should you do? Consider the following items in your answer:

◼ What is a residual value? How is it determined? Why is it subtracted from cost before depreciation

expense is calculated?

◼ What impact does the choice (or lack) of a residual value have on the income statement and

balance sheet of an entity in the year the asset is purchased? During the asset’s life? In the year of

disposal of the asset?

◼ Which fundamental accounting principle(s) govern(s) this situation?

Solution

◼ A residual value is the amount the company expects to realize from the sale of an asset when it is

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Module 3

LO 9

Intangibles

Outside assignment: Are customers a depreciable asset?

In 1987, The Herald Co., a Michigan company, merged with the Newark Morning Ledger Co., a New

◼ Are customers an asset? Do not view this from a tax perspective, where IRS rules govern, but

from what you have learned about what is or is not an asset. Are they an asset whose cost can be

reasonably estimated and recorded? If you think so, how would you value this asset? What life

would you give it?

◼ Re-read the quote from the article. Do you find an item that does not seem correct to you?

◼ What argument can you make for not capitalizing customer lists?

◼ As an accountant who has to explain in the current annual report the potential results of this

litigation, draft a memo to management with your opinion as to the outcome of this case. The

memo should include your answers to the above questions.

Solution

This is an old case with some interesting theories. It is still applicable today. How does Microsoft value the

CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES

In-class discussion: Amortization versus depreciation

Depreciation of plant, property, or equipment is credited not to the asset account itself, which is maintained

at historical cost, but to a separate contra asset, Accumulated Depreciation. However, amortization of

intangibles is often credited directly to the asset. What characteristics of intangible assets versus tangible

assets can you name that would explain this difference in treatment?

Solution

Property, plant, and equipment are “things.” That is, they have physical substance. They age as you use

In-class discussion: Intangibles and research and development expenses

Merck is an international, research-based pharmaceutical company. Its annual report for 20145 contains the

following information in the footnotes:

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reflected as a reduction of research and development expenses when the specific milestone has been

achieved. Nonrefundable advance payments for goods and services that will be used in future research and

development activities are expensed when the activity has been performed or when the goods have been

received rather than when the payment is made. Research and development expenses include restructuring

costs and IPR&D impairment charges in all periods. In addition, research and development expenses in

2014 include a charge to increase the fair value of a liability for contingent consideration.

Acquired Intangibles — Acquired intangibles include products and product rights, tradenames and patents,

which are recorded at fair value, assigned an estimated useful life, and are amortized primarily on a

straight-line basis over their estimated useful lives ranging from 3 to 20 years (see Note 7). The Company

◼ Merck’s intangible assets (Goodwill and Identifiable intangible assets, less accumulated

amortization) comprises 34%6 of its total assets and research and development and amortization of

intangibles comprise 20% 7of its operating expenses. Is this what you would expect of a

pharmaceutical company?

◼ How does Merck account for R & D expenses? Is this is conformity with GAAP?

◼ What do you think they mean by a “specific Milestone”?

◼ How would Merck account for a patent that is on their books that has been unsuccessfully

defended in a lawsuit?

◼ How are R & D costs handled under IFRS?

Solution

◼ Yes, research and development costs are the lifeblood of a pharmaceutical company. It may take

CHAPTER 8 OPERATING ASSETS: PROPERTY, PLANT, AND EQUIPMENT, AND INTANGIBLES

Decision

Models Ethics Decision Making Model

You are the accountant for a small messenger/delivery service company that owns a fleet of six minivans.

Each driver is responsible for scheduling routine maintenance on his or her van, including oil changes,

tune-ups, and tires. The owner of the company learned that one of the drivers has neglected to schedule

regular maintenance. His van, which is 1.5 years old, has never had an oil change. Recently, the van came

to a sudden, permanent halt during its delivery rounds. The garage said that the damage to the engine is so

severe that the engine must be replaced. The mechanic can install a rebuilt engine for a cost of $6,000.

The company’s owner is upset about the expenditure and its potential impact on the company’s operating

results. He wants to capitalize the $6,000, and add two years to the original life of the van.

Using the Ethics Decision Making Model, determine what you should do.

1. Recognize an ethical dilemma. Should you expense or capitalize the $6,000 spent to overhaul the

engine.

2. Analyze the key elements in the situation.

• Who will benefit? The owner will benefit because the financial statements will improve

bias, and material error.

3. Determine what alternative methods are available to report the transaction, situation or

event.

• There are two alternative methods to report the transaction:

a. Report the $6,000 spent to overhaul the engine as a repair expense of the period.

b. Report the $6,000 as a capital item and depreciate it over the remaining useful life.

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