Topic 7 Part 2 Long-lived assets Spring 2022 Professor Xi Wu Today’s Agenda Class Announcements HW 4 posted Review and practice Disposal of fixed assets Lots of real world examples 2 Depreciation is a process that systematically allocates acquisition costs (less its salvage value) of long-term assets with the periods benefited by their use. Cost Allocation(Unused) Balance Sheet (Used) Income Statement Depreciation Expense Depreciation (Key Concept) Acquisition Cost The remaining balance sheet amount probably does not represent market value. Accounting in the news …and question the status quo …and confidence without attitude Sen. Elizabeth Warren: lengthening the depreciation period for industrial equipment “I’m a former CEO and president of a tier-one automotive supplier. I want to shorten the depreciation time” Why Depreciation averaged 10 years => tax saving each year => after 10 years, buy new machine but only for major automotive companies 10-year old machinery purchased by tier-one suppliers, and use for another 10 years Tier-two suppliers would then purchase 20-year-old machines Results: many of the parts made for the auto industry were produced on 30-year-old machinery Germany and Japan: 6 years; hard to compete 4 1. Straight-line Depreciation (Cost – Residual Value) X 1/Useful Life Depreciation Expense = Depreciation (Cost – Residual Value) Actual Expense Estimated Total Production Production = X 2. Units-of-Production Method 3. Accelerated Depreciation Depreciation Expense (Cost – Accumulated Depreciation) Useful Life 2 ×= Depreciation Methods Joel Harvey Florists acquired a truck on January 1, 2017. The company paid $11,000 for the truck, $500 for destination charges, and $250 to paint the company name on the side of the truck. The company’s accounting manager estimates the truck to have a five-year useful life and a residual value of $1,750. The truck is expected to be driven 100,000 miles in five years. It is actually driven 15,000 miles in 2017, 25,000 miles in 2018, 30,000 miles in 2019, 25,000 miles in 2020, and 5,000 miles in 2021. Class Problem 7-1: Depreciation Methods Part 1 On January 1, 2017, how much should Joel Harvey Florist capitalize for the cost of the truck 11,000 + 500 + 250 = $11,750. Part 1 – Journal Entry Problem 7-1: Depreciation Methods Truck Fixed Asset Bal. XXX Jan 1 11,750 Jan 1 Truck Asset (+A) 11,750 Cash ( –A) 11,750 Record the purchase of truck Cash 11,750 Jan 1 Part 2: How much depreciation expense will be recorded for the years 2017 through 2021 using each of the following methods a. Straight-line Accum Deprec-Truck Bal. 2,000 2,000 12/31/17 Dec. 31 Depreciation Expense (+E, -SE) 2,000 Accumulated Depreciation (+XA, -A) 2,000 Recognize depreciation for the truck asset Truck Asset 11,750 Net Truck Balance: 11,750 – 2,000= 9,750 on the Balance Sheet as the Truck Value 11,750 Depreciation Expense 2,000 2,000 2017 Income Statement (11,750 – 1,750) ÷ 5 = $2,000 per year Part 2: If straight-line was used for the life of the truck, what would the J/E be for the following years a. Straight-line Accum Deprec-Truck Bal. 10,000 2,000 12/31/17 2,000 12/31/18 2,000 12/31/19 2,000 12/31/20 2,000 12/31/21 Dec. 31 Depreciation Expense 2,000 Accumulated Depreciation 2,000 Recognize depreciation for the truck asset Truck Asset 11,750 Net Balance at the end of 2021: 11,750 – 10,000= 1,750 on the Balance Sheet as the Truck Value at 12/31/21 11,750 Depreciation Expense 2,000 2,000 $2,000 on each year’s Income Statement Accum Deprec-Truck Bal. 1,500 1,500 12/31/17 Truck Asset 11,750 Net Balance: 11,750 – 1,500= 10,250 on the Balance Sheet as the Truck Value 11,750 Depreciation Expense 1,500 1,500 2017 Income Statement b. Unit-of-production: First, calculate the rate: 12/31/17 Depreciation Expense 1,500 Accumulated Depreciation 1,500 Recognize depreciation for the truck asset 2017: 15,000 x 0.10 = $1,500; (11,750 – 1,750) ÷ 100,000 = 10 cents/mile b. Unit-of-production cont’d Accum Deprec-Truck Bal. 10,000 1,500 12/31/17 2,500 12/31/18 3,000 12/31/19 2,500 12/31/20 500 12/31/21 Truck Asset 11,750 Net Balance at the end of 2021: 11,750 – 10,000= 1,750 on the Balance Sheet as the Truck Value 11,750 Depreciation Expense 500 500 $500 on 2021 Income Statement (11,750 – 1,750) ÷ 100,000 = 10 cents/mile 2017: 15,000 x 0.10 = $1,500; 2018: 25,000 x 0.10 = $2,500; 2019: 30,000 x 0.10 = $3,000; 2020: 25,000 x 0.10 = $2,500; 2021: 5,000 x 0.10 = $500. Year Computation Deprec Expense Accum Deprec Bal Net Book Value Acquisition 11,750 2017 2018 2019 2020 2021 c. Double-Declining Balance (11,750-0) * 2/5 (11,750-4,700)*2/5 0 $4,700 $2,820 $1,692 $1,015 $0 $788 $4,700 $7,520 $9,212 $10,227 $10,000 $4,230 $2,538 $1,750 11,750-4,700= $7,050 12/31/17 Depreciation Expense 4,700 Accumulated Depreciation 4,700 Recognize depreciation for the truck asset $1,750$10,000 (11,750-7,520)*2/5 (11,750-9,212)*2/5 (11,750-9,212)–1,750 $1,523 c. Declining Balance cont’d Accum Deprec-Truck Bal. 10,000 4,700 12/31/17 2,820 12/31/18 1,692 12/31/19 788 12/31/20 0 12/31/21 Truck Asset 11,750 Net Balance at the end of 2021: 11,750 – 10,000 = 1,750 on the Balance Sheet as the Truck Value 11,750 Depreciation Expense 0 0 $0 on 2021 Income Statement b/c fully depreciated Comparing Depreciation Methods The straight-line method best meets the matching principle for an asset that generates revenue evenly over time The units (activity) method best fits those assets that wear out because of physical use rather than obsolescence The accelerated method applies best to those assets that generate greater revenue earlier in their useful lives Most companies use straight-line What if we change useful life estimate Change in Useful Life Estimate (Key Concept) Prospective method Revise depreciation expense going forward. Do not retro-actively adjust for the past years of financial statements. What effect does increasing the useful life have on the financial statements What effect does increasing the useful life have on the financial statements In 2001, Singapore Airlines disclosed in its annual report that it had increased the estimated useful life of its aircraft from 10 to 15 years to reflect a change in its aircraft replacement policy. The change reduced depreciation expense by $265 million each year. Book problem: P8-11 Rungano Corp is a global publisher of magazines books, and music and video collections and is a leading direct mail marketer. Many direct mail marketers use high-speed Didde press equipment to print their ads. These presses can cost more than $1 million. Assume that the co. owns a press acquired at an original cost of $400,000. It is being depreciated on a straight-line basis over a 20-year estimated useful life and has a $50,000 estimated residual value. At the end of 2013, the press has been depreciated for a full 6 years. In Jan 2014, a decision was made, on the basis of
improved maintenance procedures, that a total estimated useful life of 25 years and a residual value of $73,000 would be more realistic. The accounting period ends Dec 31. 1. Compute (a) the amount of depreciation expense recorded in 2013 and (b) the book value of the press at the end of 2013 2. Compute the amount of depreciation that should be recorded in 2014. 3. Give the adjusting journal entry for depreciation at Dec 31, 2014. Req 1: (a) Cost of press $400,000 Residual value (50,000) Amount to depreciate over 20 years $350,000 Annual depreciation expense recorded in 2013 ($350,000 20 years) = $17,500 (b) Cost of press $400,000 Less: Accumulated depreciation for 6 years ($17,500 x 6 years) (105,000) Net book (carrying) value at end of 2013 $295,000 Req 2: Cost of press $400,000 Accumulated depreciation at end of 2013 (from Req. 1) (105,000) Net book value (undepreciated amount at the beginning of 2014) 295,000 Less: Revised residual value (73,000) Remaining balance to depreciate $222,000 Annual depreciation for 2014 [$222,000 (25 years – 6 years = 19 years)] = $11,684 Req. 3: December 31, 2014—Adjusting entry: Depreciation expense (+E, SE) 11,684 Accumulated depreciation (+XA, A) 11,684 Remaining Life (New) Remaining depreciable BV ÷ (New) Estimated useful life remaining = (New) Annual depreciation Accounting in the news Fixed assets, depreciation expense, salvage value & fraud at Waste Management Waste Management, Inc. is the leading provider of comprehensive waste and environmental services in North America. In 1998, Waste Management found itself facing scrutiny (and ultimately a scandal) because of the way in which they handled the accounting for their fixed assets. Much of the scandal stemmed from the topics we’re currently studying in Topic 7. What did WM’s executives do wrong They inflated the useful lives of the garbage trucks and dumpsters. Specifically, they estimated useful lives of 12- 14 years for their garbage trucks and useful lives for dumpsters of 15-20, while others in the industry estimated those to be 8-10 years and 12 years, respectively. They assigned a salvage value to dumpsters that all others in the industry assumed had $0 residual value. They didn’t depreciate their landfills as they filled them with waste. What effect did this behavior have on the financial statements It caused them to avoid recording depreciation expense, which overstates their earnings and their assets. In other words, it made it look better to investors. What method might they have used to depreciate their landfills The “activity” (i.e., units of production/activity) method would work well in this case. What ultimately happened to the company They incurred $3.5 billion in pretax charges and earnings restatements. They settled a lawsuit with their shareholders for nearly $0.5 billion. They faced SEC investigations, fines and sanctions. Their auditor, Arthur Andersen LLP, paid $220 million to settle a shareholder lawsuit, faced SEC fines of $7 million, and paid a heavy reputational price. (Note the close timing to the Enron scandal.) What happened to their CEO What’s he up to now In March of 2002, the SEC indicted Dean Buntrock, the founder and CEO of Waste Management, Inc. The SEC charged him (and five other former top officers) with perpetrating a massive financial fraud from 1992 through 1997. Buntrock (and others) settled the matter out of court in 2005 for $2.3 million with no admission of wrongdoing. What happens when we sell a tangible asset Disposal of Property, Plant and Equipment (Key Concept) Assets are often sold before the end of their useful lives Difference between cash received and the net book value of the asset = gain or loss Update depreciation to the date of disposal Journalize disposal: DEBIT: Any cash or other asset received DEBIT: Updated balance in acc. dep. that relates to the asset DEBIT: LOSS — if needed to make the entry balance CREDIT: Asset at its capitalized value CREDIT: GAIN — if needed to make entry balance Disposal of Property, Plant and Equipment Disposal of Property, Plant, and Equipment 1. Update depreciation expense and accumulated depreciation. Annual Depreciation: ($30,000,000 – $0) ÷ 25 years = $1,200,000 Southwest Airlines sold flight equipment for $11 million cash at the end of its 17th year of use. The flight equipment originally cost $30 million and was depreciated using the straight-line method with zero residual value and a useful life of 25 years. Depreciation expense ……………………… 1,200,000 Accumulated Depreciation…………… 1,200,000 Disposal of Property, Plant, and Equipment Southwest Airlines sold flight equipment for $11 million cash at the end of its 17th year of use. The flight equipment originally cost $30 million and was depreciated using the straight-line method with zero residual value and a useful life of 25 years. 2. Record the Disposal Have to eliminate PPE, here: flight equipment 30,000,000 Accumulated Depreciation = (17yrs. × $1,200,000) = $20,400,000 Cash (+A) ….….………………………………… 11,000,000 Accumulated Depreciation (-XA, +A) ……… 20,400,000 Flight Equipment (-A) ………………………. 30,000,000 Gain on Sale of Assets (+Gain, +SE) .……. 1,400,000 How about T-accounts In-class example Disposal of PPE Renaissance Incorporated is a worldwide operator and franchiser of hotels and has over $750 million in property and equipment. Assume that Renaissance replaced furniture that had been used in the business for five years. The records of the company reflected the following regarding the sale of the existing furniture: Furniture (cost) $3,000,000 Accumulated depreciation 2,750,000 Required: 1.Give the journal entry for the disposal of the furniture, assuming that it was sold for a. $250,000 cash b. $800,000 cash c. $200,000 cash 2.Based on the three preceding situations, explain the effects of the disposal of an asset. Cash (+A) 250,000 Accumulated Depreciation ( XA, +A) 2,750,000 Furniture ( A) 3,000,000 (Sale of an asset at book value; the result is no loss or gain.) Requirement 1a Furniture (cost) Less: Accumulated depreciation Net book value Debit Credit $3,000,000 2,750,000 $ 250,000 In-class example Disposal of PPE Cash (+A) 800,000 Accumulated Depreciation ( XA, +A) 2,750,000 Gain on Sale of Long-lived Asset (+Gain, +SE) 550,000 Furniture ( A) 3,000,000 (Sale of an asset above book value; the result is a gain.) Requirement 1b Cash (+A) 200,000 Accumulated Depreciation ( XA, +A) 2,750,000 Loss on Sale of Long-lived Asset (+Loss, -SE) 50,000 Furniture ( A) 3,000,000 (Sale of an asset below book value; the result is a loss.) Requirement 1c Debit Credit In-class example Disposal of PPE Effects of Depreciation on Cash Depreciation is a noncash expense. Before taxes, changes in the depreciation method affect only the Accumulated Depreciation and Retained Earnings accounts. Quick Question 39 Summary 40 Key Take-Aways 1. Practice of depreciation methods 2. Disposal of fixed assets 3. Have a great time during Spring Break! 42