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Question box p. 371 • The importance of fixed asset accounting to the financial statements of the companies mentioned would be ranked in the order the companies were named: Chevron, Yahoo, and the Bank of New York. A natural resources company such as Chevron is highly capital intensive, with large investments in property, plant, and equipment. An Internet company such as Yahoo has electronic equipment, as opposed to extensive properties or heavy equipment. Banks such as the Bank of New York have large financial assets on their balance sheets which far outweigh fixed assets.
Question box p. 378 • Renewals and improvements are betterments and are capitalized, because they improve the asset by extending its useful life, improving the quantity or quality of its output, or reducing the cost of operating the asset. Repairs are considered part of maintenance and are expensed as incurred, because they do not improve the asset
E9-9 a. (1) Straight-line depreciation: Depreciation per Year = (Cost - Salvage Value) ÷ Useful Life = ($300,000 - $60,000) ÷ 4 years = $60,000 per year for 2002, 2003, 2004, and 2005
E9-9 (2) Double-declining-balance depreciation: Depreciation Depreciation Accumulated Book Date Factor Expense CostDepreciation Value 1/1/02 $300,000 $ 0 $300,000 12/31/02 50% $150,000a 300,000 150,000 150,000 12/31/03 50% 75,000 300,000 225,000 75,000 12/31/04 50% 15,000b 300,000 240,000 60,000 12/31/05 50% 0 300,000 240,000 60,000 a Depreciation Expense = Book Value at Beginning of the Period x Depreciation Factor bBook Value ´ Depreciation Factor = $75,000 ´ 50% = $37,500. If Benick Industries depreciated $37,500 in 2001, the asset's book value would drop below its salvage value. To prevent this from happening, depreciation expense for 2001 can be only $15,000.
E9-9 • A manager should consider the costs and benefits associated with each depreciation method. The most likely benefit is the impact of depreciation methods on income taxes. An accelerated method decreases the present value of tax payments. However, since there is no requirement that a company use the same depreciation method for financial reporting purposes as it does for tax reporting, tax considerations are not an issue for financial reporting. A manager should also consider the bookkeeping costs associated with each method. However, with computers the bookkeeping costs should be relatively consistent across methods. Finally, since the choice of depreciation methods affects net income, managers might consider the impact of the different depreciation methods on contracts such as debt covenants and incentive compensation contracts. Comparability with other in the same industry may also be a factor.
Question box p. 385 • If everything about each company was exactly the same except for the method each used for depreciation, reported income would differ, as would related balance sheet amounts. Accordingly, financial statement ratios used as performance measures for each company would differ. Analysts must consider these differences when making comparisons within the industry, either qualitatively, or by attempting to make computational adjustments to make each company comparable. When such differences exist, analysts may wish to focus more on performance measures not dependent on the amount of depreciation, such as cash flow from operations, or earnings before interest, taxes, depreciation and amortization (EBITDA).
Question box p. 386 • The activity (units-of-production) method would be used to deplete the oil reserves, which has the effect of assigning more costs to expense in proportion to the asset's level of activity. This method achieves the best application of the matching principle, because the more active an asset is, the more revenue it should produce. This is particularly true in the case of natural resources. The straight-line method would be used for other property, plant, and equipment. The benefits from those assets are less directly related to activity, and more likely constant across time, so an even amount of expense each year is appropriate.
Question box p. 389 • By using accelerated, instead of straight-line, depreciation PepsiCo save taxes of 40% of the excess of accelerated depreciation over straight-line ($1.5 billion - $1 billion), or $200 million.
E9-15 Assuming that Paris Company kept the equipment for its entire five-year estimated useful life, the depreciation schedule on the equipment would be as follows. Depreciation Depreciation Accumulated Book Date Factor Expense Cost Depreciation Value 1/1/00 40% $ 25,000 0 $25,000 12/31/00 40% $10,000 25,000 10,000 15,000 12/31/01 40% 6,000 25,000 16,000 9,000 12/31/02 40% 3,600 25,000 19,600 5,400 12/31/03 40% 400* 25,000 20,000 5,000 12/31/04 40% 0 25,000 20,000 5,000 _____________ *Because the equipment's book value cannot drop below its estimated salvage value, depreciation expense for 2000 cannot exceed $400.
E9-15 a. Accumulated Depreciation—Equipment (+A) 19,600 Loss on Disposal of Equipment (Lo, –SE) 5,400 Equipment (–A) 25,000 Disposed of equipment. b. Accumulated Depreciation—Equipment (+A) 20,000 Loss on Disposal of Equipment (Lo, –SE) 5,000 Equipment (-A) 25,000 Disposed of equipment.
E9-15 • Cash (+A) 8,000 Accumulated Depreciation—Equipment (+A) 19,600 Equipment (–A) 25,000 Gain on Sale of Fixed Assets (Ga, +SE) 2,600 Sold equipment. • We will not cover part d.
ID 9-10 • Property, plant and equipment make up 58.3% ($20,063/$34,437) of total assets Other long-lived assets make up 3% ($1,046/$34,437) of total assets. • Buildings is the largest category within property, plant and equipment. • Depreciation and amortization expense (from the Statement of Cash Flow) is 1.7% ($1,076/$64,816). • Per footnote #1 Home Depot depreciates its assets using the straight-line method. The company uses 10-45 years for buildings, 5-20 years for furniture and fixtures, 5-30 years for leasehold improvements, and 3-5 years for computer equipment. • The company’s largest intangible asset is Goodwill (which Home Depot labels Cost in Excess of the Fair Value of Net Assets Acquired).
ID 9-10 • Per footnote #1 Home Depot evaluates the carrying value of its long-lived assets when it closes or moves a store, as well as when it determines that a carrying value might be excessive. Home Depot books an impairment loss when it makes this determination. • Home Depot capitalizes the software costs and amortizes the costs over three years. • The production costs for advertising are expensed when the ad first runs. Until the ad appears, the expenditures are carried as current assets under prepaid advertising costs. • During 2003 (the year ending 2/1/2004) Home Depot spent $3,555 million ($3,508 in cash and $47 non-cash) for capital expenditures. The same year the company spent $215 million in cash for new businesses. • Footnote #9 indicates that the company recorded $231 million of goodwill in 2003.
Question box p. 421 • Whirlpool may have engaged in a strategy of reporting additional liabilities, and thereby prematurely recognizing related expenses, in 1997 in order to be able to report higher earnings in future years. The fact that two years after 1997, Whirlpool still had not paid all of the liabilities recognized in 1997, may indicate that Whirlpool purposely "built hidden reserves." Investors should be concerned because they are not being provided a true picture of the earnings pattern of the company. Auditors usually are faced with the possibility of understated liabilities, but must also be concerned with overstated liabilities, especially where they are part of a strategy of earnings management.
Question box p. 423 • Airlines adopted programs of giving away free flights to frequent flyers as an incentive to build customer loyalty. The awards were expected to be accommodated with otherwise-empty seats. The incremental cost to the airlines of a free flight was minimal, so liabilities were not recorded or recorded at only a small amount. The frequent-flyer programs have become so successful, that in some cases free-flight awards have to be satisfied by using seats that otherwise would have generated revenue. The immateriality of incremental costs is a less persuasive argument than it once was. Airlines already have high liabilities, with associated debt covenants, and also experience fluctuating profitability, so they have a strong incentive to minimize recorded liabilities, or to postpone liabilities whenever possible. The accounting for these programs remains a controversial subject.
E10-8 • Since Zeus Power brought the lawsuit, Zeus Power is facing a gain contingency. Gain contingencies are ordinarily not disclosed in the financial statements or in the footnotes to the financial statements due to conservatism. However, if it is probable that Zeus Power will realize the gain contingency, then it may be acceptable to disclose the contingency in the footnotes to the financial statements to avoid misleading financial statement users.
E10-8 • Since Regional Supply is the defendant in the lawsuit, Regional Supply is facing a loss contingency. The appropriate accounting treatment for this lawsuit by Regional Supply depends upon (1) whether an adverse outcome to the lawsuit (from Regional Supply's perspective) is remote, reasonably possible, or probable and (2) whether the amount of the loss, given an adverse outcome, can be reasonably estimated and (3) if it is material to Regional Supply. To record an economic event, a company must be able to quantify the dollar amount of the event. If the company cannot quantify the dollar amount of the event, it is impossible for the company to prepare a journal entry. Thus, if Regional Supply cannot reasonably estimate the amount of the loss, it cannot accrue a contingent liability. At best, Regional Supply could disclose the loss contingency in the footnotes to its financial statements.
E10-8 • Alternatively, assume that Regional Supply can reasonably estimate how much it would lose if it lost the lawsuit. If the probability that it will lose the lawsuit is remote, Regional Supply can ignore the lawsuit for financial reporting purposes. If it is reasonably possible that Regional Supply will lose the lawsuit, it should disclose the lawsuit, and the amount of the potential loss, in the footnotes to its financial statements. Finally, if it is probable that Regional Supply will lose the lawsuit, then it should accrue a contingency liability (i.e., it should prepare a journal entry in which it recognizes a loss and related liability for the lawsuit). In this particular case, it appears that the amount of the loss can be reasonably estimated. Regional Supply must decide whether "a greater that 50% chance" of losing the lawsuit means it is reasonably possible or probable that the company will lose the lawsuit.
E10-8 • Zeus Power and Regional Supply would account for this lawsuit differently due to conservatism. Under conservatism, the basic rule is "if in doubt on how to record or report an economic event, put your worst foot forward." That is, record or report the event in the way that is least favorable to the company. Since doubt exists as to who will win the lawsuit, this event qualifies for conservatism. For Zeus Power, disclosing or recording the potential gain would put it in a better position than not disclosing or recording it. Consequently, Zeus Power should probably ignore this event for financial reporting purposes. For Regional Supply, the opposite is true. Disclosing or accruing the lawsuit presents the event in the least favorable way.
ID 10-14 • Working capital is the excess of current assets over current liabilities. It is one measure of the solvency of a company. Home Depot’s working capital was $3,882 in 2002 (ending 2/3/2003) and $3,774 in 2003, showing a slight decline. • In 2002 working capital was 12.9% of total assets, dropping to 11.0% in 2003. • Home Depot’s current ratio was 1.48 in 2002 and decreased to 1.40 in 2003. The largest increase in a current liability, causing this drop in solvency, was in Current Installments of Long-Term Debt. Evidently, Home Depot has several payments due in the coming year for its Long Term Debt. Increases to Cash and Merchandise Inventories were not enough to compensate for the increases in current obligations. • The most important current liability reported by Home Depot is accounts payable ($5,159). Accounts payable are usually the biggest current liability for any retailer. Other important current liabilities are Deferred Revenue (which could represent gift cards and other prepayments from customers) and accrued expenses.
ID 10-14 • Accounts payable turnover = COGS ÷ (Average accounts payable) 2003 X = $44,236 ÷ (($5,159 + $4,560) ÷ 2) X = 9.103* *dividing turnover into 365 days yields 40 days on hand for accounts payable 2002 2001 Accounts Payable not provided, so average cannot be calculated
ID 10-14 • Per footnote #8, Home Depot does have some contingencies related to letters of credit, but these primarily are due to the normal course of business. The company does not disclose any contingencies for litigation that it considers to be material to the financial position or operating results of the company. • Per footnote #6, Home Depot provides three defined contribution plans. Home Depot contributed $106 million, $99 million, and $97 million in the last three years, respectively.
ID 10-14 • Conservatism Ratio = Reported Income Before Taxes ÷ Taxable Income 2003 2002 2001 Reported income before tax 6,843 5,872 4,957 ÷ Taxable income 5,213 5,412 4,972 = Conservatism ratio 1.31 1.08 1.00 Current year tax liability 1,934 2,035 1,919 ÷ Effective tax rate* 37.1% 37.6% 38.6% = Taxable Income $5,213 $5,412 $4,972 *footnote #3 The tax strategy of Home Depot was slightly more aggressive in 2002 than it had been in 2001, but the company was very aggressive in 2003 (as shown by the much higher conservatism ratio of 1.31).
Question box p 473 • CBS would want an option to redeem long-term debt, especially debt such as the debentures mentioned which are scheduled for repayment over 20 years from now, to protect itself in the event interest rates and other economic conditions change. For instance, if interest rates drop, CBS could lower its interest cost by redeeming the debentures and replacing them with bonds bearing a lesser interest rate.
Question box P. 483 • Georgia Pacific must have issued bonds in earlier years when interest rates were higher, and chose to retire the bonds in 1998 when financing costs were less. A loss was recorded in the financial statements because the redemption price for the bonds was greater than the book value. From an economic perspective, Georgia Pacific would be willing to incur this loss because they could issue new bonds at a lower interest cost.
Question box p. 484 • Operating leases are treated as pure leasing or rental arrangements. The property would be on the books of the lessor. J.C. Penney, as lessee, would not recognize any asset or liability on its books, but simply record rent expense on the income statement as the rent is paid or accrued.
Question box p. 485 • Property under capital leases of $2.038 billion would be shown as an asset on the balance sheet, and the capital lease obligation of $1.014 billion would be shown as a liability. The asset value represents the present value of the total of the future lease payments as of the inception of the lease, less depreciation recognized through year-end 2000. The liability represents the present value of the remaining payments under the lease as of year-end 2000, computed using the effective interest rate as of the inception of the lease. • Do ID11-9
E11-14 • Face Value $100,000 Present value (i = 3%, n = 20) PV of face value ($100,000 0.55368 from Table 4 in Appendix B) $55,368 PV of interest payments ($4,000 14.87747 from Table 5 in Appendix B) 59,510 Total present value $114,878 Premium $ 14,878 Cash (+A) 114,878 Premium on Bonds Payable (+L) 14,878 Bonds Payable (+L) 100,000 Issued bonds.
ID 11-11 • The long-term debt ratio/ total asset ratio for Home Depot was 7.2% in 2004 ($2,476/$34,437) and 7.2% in 2003 ($2,174/$30,011). The ratio did not change for Home Depot over this time period. • Total interest costs as a percentage of revenues for 2004 was 0.10% ($62/$64,816), for 2003 was 0.06% ($37/$58,247), and for 2002 was 0.05% ($28/$53,553). While the ratio has increased slightly over the years, the interest expense is very low. • The 2004 original cost of property under capital leases is $352. The straight-line method of depreciation is used for these assets. Footnote #5 indicates that total lease payments (both operating and capital) in 2004 will be $660 million, of which $608 million are for operating leases. Therefore, approximately 92% ($608/$660) of lease payments are for operating leases. • In fiscal 2002 Home Depot received proceeds from long-term debt of $532 million, while in 2003 proceeds were only $1 million. In 2004, no proceeds were received from the issuance of long term debt. The company has become less reliant on long-term debt as a source of financing.
ID 11-11 • The company has continued to grow (see Investing Activities on the Statement of Cash Flow), but as discussed in d. above, long term debt has not been the source of financing. The company, due to the strength of the stock market and the increased market price of its stock, has instead funded growth with issuances of equity. Also funding the growth, and reducing the reliance on long-term debt, has been the continued growth in cash generated from operations. • Footnote #2 indicates that the market values of the Senior Notes are $515 million and $532 million, while the book value of the two debt issuances are $500 million each. This disparity is driven by the difference between the stated rate of interest on the Notes and the company’s effective interest rate as determined by the debt markets. • Footnote #2 states that the Commercial Paper facility contains some “restrictive” covenants, but details as to specific ratios are not given. The company does state that it feels the covenants will not have a material effect on the company. • Footnote #1 describes the interest rate hedging instruments that the company uses to manage its interest rate exposure. Effectively Home Depot is able to swap fixed rates for variable rates in order to protect against fluctuations in the valuation of their obligations due to interest rate fluctuations in the marketplace.
