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Q11-8
timber grower, mine owner, or owner of oil wells. If the cost of natural resources “harvested”
Obj. 3
never shows up on the income statement under depletion expense, how is this cost accounted
for? Explain your answer.
Generally, under GAAP, market value is not used as the valuation basis for assets. Cost is used
Q11-9
instead. For marketable securities, however, market value is frequently used. What™s different
Obj. 4
about marketable securities that makes it reasonable for this class of asset to be reported at
market value when most other assets are reported at cost?
Barbara is studying the annual reports of three different companies that her accounting group
Q11-10
will use for its term project. She sees that two of the companies have made investments in the
Obj. 4
common stock of Microsoft, Inc. What bothers her is that one company has reported the in-
vestment as a current asset, while the other company has reported its investment as a long-
term asset. Explain to Barbara why it is permissible, and preferable in certain circumstances,
for the exact same type of asset to be reported differently.
Sometimes unrealized holding gains and losses are reported on the income statement. At other
Q11-11
times they are reported on the balance sheet under stockholders™ equity. What causes this dif-
Obj. 4
ference in treatment? Does this different treatment make sense to you? Why or why not?
If market value is such a good basis for reporting certain marketable securities on the balance
Q11-12
sheet, why not use market value as the basis for reporting intangible assets?
Obj. 5

How does goodwill arise and come to be reported on a balance sheet? How is the amount cal-
Q11-13
culated? What does goodwill represent?
Obj. 5

Five years ago, Reeco Company paid $40,000 to acquire a building site. Since then the com-
Q11-14
pany has abandoned its expansion plans and yesterday sold the site for $65,800 in cash. How
Obj. 6
will this transaction be reported on the company™s next cash flow statement? (Assume the in-
direct format is used.)
Explain how a manager can use accounting information as a means of controlling assets and
Q11-15
ensuring their security.
Obj. 6



If your instructor is using Personal Trainer in this course, you may complete online the assign-
EXERCISES ments identified by .
Write a short definition for each of the terms listed in the Terms and Concepts Defined in this
E11-1
Chapter section.
Below is a list of accounts and year-end balances taken from the general ledger of Deep
E11-2
Drillers, Inc.
Obj. 1

Treasury stock $ 3,000 Accumulated depreciation $ 40,000
Building 160,000 Goodwill 10,000
Land 120,000 Storage tanks 90,000
Drilling equipment 230,000 Trademark 4,000
Accounts receivable 25,000 Oil wells 500,500
Dividend income 6,600 Investment in Susanna Co.* 195,600
Accounts payable 5,400 Construction in process 56,300
Common stock 250,000 Inventory of tools 36,000
Accumulated depletion 15,000
*Deep Drillers owns 42% of Susanna™s common stock.
F429
CHAPTER F11: Investing Activities
432 Investing Activities

Prepare the long-term asset section of the balance sheet in good form. (Hint: Not all of the
accounts need to be used.)

You are reviewing the balance sheet of Worldwide Technology, a manufacturer of assorted
E11-3
electronic components. You observe the following account classifications.
Obj. 1

a. Intangible assets
b. Inventories
c. Investment in marketable securities
d. Property, plant, and equipment
e. Accounts receivable
For each of the classifications listed above, indicate whether it probably involves current as-
sets or long-term assets. For each classification, give two examples of assets that might be re-
ported there. Also indicate what attribute is being reported for each example you give (e.g.,
original cost, depreciated cost, market value, and so on).

The poorly trained bookkeeper at Flowing Water Company has shown you the long-term as-
E11-4
set section of the company™s balance sheet that he will soon distribute to stockholders. For
Obj. 1
your convenience, each item is identified with a letter. These letters will not appear in the fin-
ished document.

Long-term investments:
(a) Machinery, net $181,600
(b) Office supplies 8,710
(c) Land 78,000
Property, plant, and equipment:
(d) Patents 27,000
(e) Processing plant, net 206,960
(f) Obsolete equipment awaiting sale, net 16,800
Intangible assets:
(g) Prepaid insurance (for next three years) 21,000
(h) Common stock of Flower Corporation 83,000
Other long-term assets:
(i) Cash 4,722
(j) Standby equipment, net (used only during peak production) 21,000
(k) Goodwill 14,000
(l) Investment in bonds of Beech Brothers, Inc. 46,000

Write down each of the four category headings above. After each heading, list the letters of
the items you believe should be reported under that heading.

Camey Corporation purchased delivery equipment on January 1 at a cost of $300,000. The
E11-5
equipment is expected to have a useful life of seven years or 250,000 miles, and to have no
Obj. 2
salvage value. How much depreciation expense should be recorded during the first year using
the straight-line, double-declining-balance, and units-of-production methods? During the
year, the equipment was used for 80,000 miles. The company™s fiscal year-end is December
31. Assume that revenue for the year is $376,300 and that all expenses, other than for depre-
ciation, total $225,492. Would the use of one depreciation method instead of another have a
material effect on the income statement? Discuss. (Ignore taxes.)

Asia Company purchased a building on March 1, 1985 at a cost of $4 million. For financial
E11-6
reporting purposes, the building was being depreciated over 372 months at $10,000 per
Obj. 2
month. The remaining $28,000 of the cost was the estimated salvage value. The building
was sold on October 31, 2004 for $7.2 million. An accelerated depreciation method allowed
by the tax code was used to record depreciation for the tax return. As of October 31, 2004,
the company had recorded $3.3 million of depreciation for tax purposes using an acceler-
ated basis. Determine (a) the amount of gain or loss that should be reported on the income
statement regarding the sale of the building, (b) the amount of gain or loss that should be
reported on the tax return regarding the sale of the building, and (c) why a company would
use straight-line depreciation for financial reporting purposes and accelerated depreciation
for tax purposes.
F430 SECTION F2: Analysis and Interpretation of Financial Accounting Information
433
Investing Activities

E11-7 Lincoln Hospital, Inc., acquired new specialized diagnostic equipment at a cost of $430,000.
The equipment had an estimated useful life of eight years and an estimated residual value of
Obj. 2
$30,000. Lincoln uses the straight-line depreciation method. After five years, management de-
termined that the equipment was in danger of becoming obsolete. During year 6, the esti-
mated useful life of the equipment was revised to a total of seven years with a new estimated
residual value of $20,000. Determine (a) the book value of the equipment that would be re-
ported on the balance sheet at the end of year 5, and (b) the new amount of depreciation ex-
pense that would be reported on the year 6 and year 7 income statements. (c) Does the need
for revision of the depreciation estimates indicate that a poor job of estimating was originally
done? Discuss.
Franchesca Company recorded the following transactions during its 2004 fiscal year:
E11-8
Obj. 2
a. Costs incurred for buildings under construction but not completed by year-end:
Labor $350,000
Materials 675,000
Utilities 87,000
Special tools and equipment 22,000
Interest on construction loan 94,000
b. The cost of an addition to an existing building was $840,000.
c. The cost of repairs to equipment was $90,000. These repairs are required on a regular
basis and do not affect the estimated useful life of the equipment.
How would each of these transactions affect Franchesca™s financial statements for 2004? As-
sume cash had been paid for all costs by the end of the fiscal year.
Leslie Company sells business stationery, imprinted with a customer™s business name and ad-
E11-9
dress. To do this, it purchased a printing machine costing $48,000 on January 1, 2001. The
Obj. 2
machine has an expected useful life of five years and an estimated salvage value of $3,000.
Leslie Company uses straight-line depreciation for all of its depreciable assets.
On August 1, 2004, the manager of the print shop was persuaded to purchase a new ma-
chine that operated more efficiently. The old machine was sold at that time for $5,000.
a. Calculate the depreciation expense recorded on the old machine for each year of use.
b. Calculate any gain or loss on disposal of the old machine.
c. Show how information about the printing machine transactions would be reported on
the statement of cash flows for years 2001 through 2004. Assume the indirect format is
used.
d. How would the information about the printing machine affect the income statement
for years 2001 through 2004?
Energy Company owns rights to coal reserves in several states. The rights cost the company
E11-10
$140 million. The reserves were expected to produce a total of 50 billion tons of coal. During
Obj. 3
the company™s 2004 fiscal year, five billion tons of coal were mined from the reserves. Prior
to 2004, 30 billion tons of coal had been mined. How much depletion expense should the
company record in 2004? At what amount should the company report the coal reserves on its
balance sheet at the end of 2004? What effect would the depletion expense have on the com-
pany™s cash flows in 2004?
In 1975, the Big Tree Timber Company purchased 1,000 acres of recently cut forest land for
E11-11
$4,500,000. It planted new seedling trees at a cost of $1,200,000. Over the years, an additional
Obj. 3
$450,000 was spent thinning and monitoring the rapidly growing forest. Commercial harvest
operations began on this property in 2004. During the year, 10% of the harvestable timber
was cut and sold. Near year-end, a rival firm offered to purchase the remaining uncut timber
(but not the land it is on) for a price of $30 million. Big Tree Timber turned down the offer
and will harvest the remaining trees over the next four years. At that time, the acreage will be
replanted with new seedlings. (a) What total amount of cost should be subject to depletion
expense in this problem? Why? (b) What amount of depletion expense should be reported on
the 2004 income statement? (c) What information discussed above should be reported on the
year-end 2004 balance sheet? (d) What important information about Big Tree Timber Com-
pany will not be reported on the income statement or balance sheet? If it is not reported on
the financial statements, how might this important information be communicated to inter-
ested parties?
F431
CHAPTER F11: Investing Activities
434 Investing Activities

E11-12 Hot Water Company purchased 1,000 shares of Big Pipe Company™s common stock for $24
each. It was a small investment, but Hot Water intended to hold the investment for the long
Obj. 4
term. At year-end, the total market value of the shares had increased to $27,500. Six months
into the following year, Hot Water decided to sell the investment at its then-current market
price of $30 per share. (a) Show how the initial purchase of the shares would be recorded in
Hot Water™s accounting system. (b) Show any entry to the accounting system that should be
made at the end of the first year. (c) Show how the sale of the investment would be recorded
in the accounting system.
Julie McBeth Company made two short-term investments in marketable securities during the
E11-13
current fiscal year. At year-end, the following summary information was available.
Obj. 4

a. Purchased 5% of the outstanding common shares of Duncan Company for $300,000
plus brokerage fees of $30,000.
b. Purchased 2% of the outstanding common shares of Macduff Company for $400,000
plus brokerage fees of $40,000.
c. At year-end, the Duncan shares had a market value of $350,000. The Macduff shares
had a market value of $360,000. McBeth owned no other investments in common
stock.
Show how the two purchases of stock and the year-end information would be entered into
McBeth™s accounting system. What information regarding these investments will you expect
to see reported on the year-end balance sheet? Be specific as to account names, their location
on the balance sheet, and dollar amounts.
Isabella Company made small investments in the common stock of two companies during the
E11-14
current year. Isabella wishes to establish a long-term business relationship with each firm and
Obj. 4
purchased the shares as a good faith gesture. Each of the firms had millions of shares out-
standing at the time.
a. Purchased 20,000 shares of Othello Company at $15 per share and paid a brokerage fee
of $14,000.
b. Purchased 25,000 of the outstanding shares of Ferdinand Company for $16 per share
and paid a brokerage fee of $18,000.
c. At year-end, the Othello shares had a market value of $350,000. The Ferdinand shares
had a market value of $395,000.
At year-end, Isabella owned no other investments in common stock. Show how the two pur-
chases of stock and the year-end information would be entered into Isabella™s accounting sys-
tem. What information regarding these investments will you expect to see reported on the
year-end balance sheet? Be specific as to account names, their location on the balance sheet,
and dollar amounts.
Manatee Company purchased $800,000 of long-term bonds on January 1, 2004 at face value.
E11-15
The bonds pay interest at an 8% annual rate on each June 30 and December 31. Semiannual
Obj. 4
payments were received, as promised, on June 30, 2004, and December 31, 2004. Manatee™s
fiscal year ends December 31. At December 31, 2004, the market value of the bonds was
$786,000. The bonds were sold on July 1, 2005 for $820,000. (a) Show how the purchase of
the bonds and the receipt of the first interest payment would be entered into the accounting
system. Indicate how information about this bond investment will be reported on Manatee™s
December 31, 2004, balance sheet if (b) management intends (and is able) to hold the bonds
until maturity, or (c) management intends to hold the bonds for a few years and then sell
them. Be sure to include the dollar amounts of any information that you suggest should be
reported.
Arkansas Company purchased 20,000 shares of Mena Company™s common stock on May 15,
E11-16
2002. Arkansas paid $380,000 for the stock. On September 12, 2002, Arkansas received a divi-
Obj. 4
dend check from Mena for $12,000. The market value of Mena™s stock on December 31, 2002
was $24 per share. On September 12, 2003, Arkansas received a dividend check from Mena for
$14,400. The market value of Mena™s stock on December 31, 2003 was $22 per share. Arkansas
sold its investment in Mena™s stock on April 6, 2004, for $400,000. Throughout this period,
Arkansas Company owned 8% of Mena™s stock and intended for it to be a long-term investment.
(Continued)
F432 SECTION F2: Analysis and Interpretation of Financial Accounting Information
435
Investing Activities

1. Using the format presented in this chapter, record all transactions for Arkansas Com-
pany involving its investment in Mena and explain the purpose of each transaction.
2. Determine the amounts Arkansas Company would report on its 2002 and 2003 balance
sheets (or notes) for its investment in Mena.
Dundee Enterprises purchased 100% of Newberg Company™s common stock for $200 million
E11-17
in cash. At the time of the purchase, the fair market value of Newberg™s assets was $350 million.
Obj. 5
The fair market value of its liabilities was $180 million. (a) Explain the meaning of goodwill. (b)
Why might a rational decision maker pay more than the fair market value of the assets acquired?
(c) How does goodwill affect a company™s financial reports? (d) What amount of goodwill should
be recorded by Dundee? (e) What reason other than goodwill can you think of that might ex-
plain why a company would pay more than fair value when acquiring the assets of another firm?
Joyful Sound Music Company purchased the net assets (i.e., assets minus liabilities) of
E11-18
Metrodome Company for $845,000. Metrodome is a retailer of music, instruments, and re-
Obj. 5
lated items. Its net assets have been carried on its own books at a total of $530,000. An ap-
praisal of all of Metrodome™s assets and liabilities revealed a net fair market value of $783,000.
Joyful is willing to pay extra because of Metrodome™s very loyal retail customers, most of whom
have dealt exclusively with the company for more than 30 years. (a) What is the amount of
goodwill that Joyful should record at acquisition of Metrodome? (b) What might cause the
purchased goodwill in this situation to become impaired?
Use the straight-line (SLN) and double-declining-balance (DDB) functions in Excel or an-
E11-19
other spreadsheet program to calculate the required amounts in the following situations.
Objs. 2, 5
a. Machinery was purchased at its invoice price of $296,016. This amount did not include
sales tax of 6.15%. The estimated useful life was 13 years and residual value was esti-
mated at $15,000. Use the straight-line depreciation method. (1) Determine the
amount of depreciation for the first year of the machinery™s use. (2) Determine the
amount of depreciation for the eighth year of the machinery™s use. (3) Determine the
book value of the machinery at the end of the 12th year of use.
SPREADSHEET
b. Computer equipment having an expected life of five years was purchased at a cost of
$112,316. Because the new equipment differed from the old, minor remodeling of the
office space was necessary at a cost of $6,152 before installation could occur. The com-
puter equipment is expected to have a $5,000 residual value. Use the double-declining-
balance method. (1) Determine the amount of depreciation for the first year of the
equipment™s life. (2) Determine the amount of depreciation for the fourth year of the
equipment™s life.
c. A patent was acquired at a cost of $1.3 million. The patent has a remaining legal life of
13 years, but technology is changing so rapidly in this industry that management be-
lieves the patent rights will be worthless at the end of six years. Straight-line amortiza-
tion is used. (1) Determine the amount of amortization for the fourth year of the
patent™s life. (2) Determine the book value of the patent at the end of six years.
You are reviewing the balance sheet, income statement, and statement of cash flows of a large,
E11-20
well-known company. It has operations in several different lines of business and in several
Obj. 6
countries. As you inspect these financial statements, you are searching for information about
the company™s investing activities. First, define the term investing activities. Second, make a
list, one for each of the three financial statements, of the information about investing activi-
ties that might be found on that statement. Carefully specify the information you might ex-
pect to see reported and indicate exactly where it would be found on the statement.
Zirconium Graphics Company reported the following information for the year ended De-
E11-21
cember 31:
Obj. 6
a. Sale of plant assets having a book value of $30,000 for $22,000 cash
b. Sale of securities with a book value of $26,000 for $28,000 cash
c. Depreciation and amortization expense of $7,500
d. Interest and dividends received from investments totaling $4,000 in cash
e. Acquisitions of plant assets for $50,000 in cash
f. Acquisitions of long-term investments for $16,000 in cash
g. Net income of $60,000
Prepare the operating and investing sections of Zirconium™s cash flow statement, assuming
that no other activities affected those sections.
F433
CHAPTER F11: Investing Activities
436 Investing Activities

E11-22 (Based on the Other Investment Issues section) On January 1, Baruti Company acquired 4,000
shares of Biltmore Company™s common stock at a price of $9 per share. Baruti did so to es-
tablish a long-term working relationship with Biltmore Company. At December 31, Biltmore
reported net income of $30,000 and paid a $0.50 cash dividend on each of its 16,000 common
shares. On that same date, the market value of Biltmore common stock was $11 per share.
(a) Which accounting method should be used to account for this investment? Why? (b) Record
all entries that should be made to the accounting system during the year as a result of this in-
vestment. (c) At what amount should the investment be reported on Baruti™s end-of-year bal-
ance sheet? Show how you arrived at your solution.




If your instructor is using Personal Trainer in this course, you may complete online the assign-
PROBLEMS ments identified by .

Comparing Depreciation Methods
P11-1
Obj. 2 Clary Jensen Farms purchased power equipment with an expected useful life of four years or
1,000 hours of usage. The equipment was purchased on January 1, 2004, for $125,000. It is
expected to have a salvage value of $5,000 at the end of four years. During 2004, the equip-
ment was used for 260 hours. Assume that usage for the next three years will be 220 hours,
313 hours, and 207 hours, respectively.

Required
A. Prepare a depreciation schedule for the asset showing the book value and depreciation
expense on the asset each year using the straight-line, double-declining-balance, and
units-of-production methods.
B. Which method would you prefer to use for financial reporting purposes if you were
general manager of the company? Which method would you prefer to use for tax pur-
poses? Explain.
C. Which method has the greatest effect on cash flow each year? Why?

Comparing Depreciation Methods and Cash Flow
P11-2
Obj. 2 U.S. income tax law permits some assets to be depreciated using an accelerated method dur-
ing the early years of an asset™s life. In later years, a switch to the straight-line depreciation
method is allowed if it produces more favorable tax results. (More favorable tax results occur
when application of the straight-line method to the remaining book value of the asset pro-
duces a depreciation amount greater than that scheduled to be taken under the usual double-
declining-balance method.) Pandora Company purchased equipment on March 1, 2004, at a
cost of $2,100,000. The equipment was depreciated for a full year in 2004. It was expected to
have a useful life of six years and no residual value.

Required
A. Prepare a schedule that shows the amount of depreciation that Pandora Company
would take on the asset each year for tax purposes if it applied the usual double-declin-
ing-balance method over the asset™s six-year life.
B. Prepare a similar schedule using the modified double-declining-balance method de-
scribed above.
C. Show how the cash flow for taxes paid would differ under the straight-line method and
the modified double-declining-balance method over the six-year period. The tax rate is
35%.
D. Summarize how the choice of a depreciation method affects cash flows for taxes.

Determining Acquisition Cost and First-Year Depreciation
P11-3
Obj. 2 Matta Company has just acquired two assets:
1. New diagnostic equipment for the medical services division was acquired at an in-
voice price of $93,000. This did not include the 8.7% sales tax. Transportation cost
of $2,650 was incurred to ship the equipment from the factory to Matta™s medical
(Continued)
F434 SECTION F2: Analysis and Interpretation of Financial Accounting Information
437
Investing Activities

center. During transit, the driver “forgot” to acquire a special required permit, and
Matta was fined $425. When the equipment was unloaded at the medical center,
eight feet of wall on the right side of the entry door had to be dismantled (and then
rebuilt) to provide a larger opening to get the equipment into the building. The cost
of labor and materials was $750. In addition, while the equipment was being moved
through the opening, the left side of the doorway was inadvertently damaged. Fortu-
nately, this cost only an additional $300 because workers were already on site. Setup
and testing costs to calibrate the equipment properly before it could be used on pa-
tients cost another $2,700.
2. Manufacturing equipment was acquired by the semiconductor electronics division. The
supplier of the equipment agreed to deliver the equipment, install it, and calibrate it to
Matta™s specifications, all as part of the negotiated selling price. Sales tax of 7.5% was
not included in the selling price and was paid separately. Matta and the supplier agreed
on the following terms: a $77,000 down payment, followed by three equal annual in-
stallment payments of $85,000 that include 8% interest on the unpaid balance. (Hint:
Calculate the present value of the installment payments.)

Required
A. Matta™s accounting staff has requested your advice and counsel as to the cost at which
each of these assets should be entered into Matta™s accounting records. Provide that ad-
vice, carefully specifying exactly how you came to each judgment you made.
B. Determine the amount by which net income would differ in the first year if Matta
chose to use the straight-line depreciation method instead of double-declining-bal-
ance. Both assets have estimated useful lives of six years and zero estimated residual
value.

Purchase versus Self-Construction of an Asset
P11-4
Obj. 2 Texas Company has outgrown its current office building and is considering a replacement.
There are two options available.
1. An existing building and its land can be purchased for $6,000,000. The market value of
the land alone is $100,000. The building can be renovated for $500,000. The estimated
life of the building would be 20 years with no salvage value. Texas can borrow the
money needed for the purchase at an interest rate of 8%. The loan will be repaid in 14
equal annual payments, made at the end of each year.
2. A new building can be constructed by the company for its own use. The following costs
would be incurred:

Architect™s plans $ 100,000
Materials 1,750,000
Labor costs 3,675,000
Other fees and permits 200,000

The company already owns and has paid for the land, which cost $100,000. To help finance
construction of the building, Texas can obtain a one-year loan for $4,500,000 at an interest
rate of 7%. The loan would be repaid in one year just as construction of the building was com-
pleted. The estimated life of the new building would be 25 years.

Required
A. Determine the equal annual payments to be made under the first option. What would
be the interest expense incurred during the first year of the loan?
B. Calculate the projected yearly depreciation expense for the building under each option.
Use the straight-line method.
C. What effects, arising from either of the two options, would appear on the statement of
cash flows?
D. Mr. L. Horn, the controller, points out that the company can save money if it con-
structs its own building. He compared the cost of the existing building and land of
$6,500,000 to the cost of the constructed building and land of $6,140,000. He wants to
show the difference in the two amounts on the income statement as Gain on Construc-
tion. Do you support this idea? Why or why not?
F435
CHAPTER F11: Investing Activities
438 Investing Activities

P11-5 Depreciation and Disposal of Assets
Obj. 2
Diamondback Mfg. is buying a new grinding machine. The machine costs $124,000 and is as-
sumed to have a salvage value of $4,000 in five years. The manufacturer™s description of the
machine indicates that it should operate for 30,000 hours. The company™s accountant is try-
ing to decide whether to depreciate the machine by the straight-line method, the double-de-
clining-balance method, or the units-of-production method. The machine will be purchased
on January 1 of the coming year.
SPREADSHEET Required
A. Set up depreciation schedules for the straight-line and double-declining-balance meth-
ods. (Hint: You may wish to use the SLN and DDB functions in an Excel spreadsheet.)
B. Using the units-of-production method, calculate the hourly rate and yearly deprecia-
tion, assuming the machine is used evenly throughout its life. Comment on the reason-
ableness of this assumption.
C. Assume that after using the machine for three-and-a-half years, a new and improved
machine is purchased. The old machine is then sold for $25,000. Calculate any gain or
loss on the sale of the machine under each of the three depreciation methods. (Note:
When calculating the gain or loss for the units-of-production method, assume that the
machine was not used equally each year. Instead, assume the actual hours used each
year were 6,000, 7,000, 8,000, and 4,000. Discuss any differences found in the gain or
loss.)
D. With regard to the year of disposal of the machine, indicate what would appear on the
income statement and the statement of cash flows for each method. Assume the indi-
rect method is used for the statement of cash flows.

Using Spreadsheet Functions in Depreciation Calculations
P11-6
Obj. 2 Rodriguez Company acquired sophisticated production equipment at a cost of $450,000. In
addition, the firm paid $7,540 to have the equipment delivered and another $11,435 was spent
on installation and testing. The annual cost paid to insure the equipment while used in pro-
duction is $3,000. The expected life of the new equipment is six years, and the estimated sal-
vage value is $40,000. Management, however, is concerned about changing technology in the
industry. With each year that passes, it will become more and more likely that new produc-
tion technology will render this equipment obsolete. Management needs to choose between
SPREADSHEET use of straight-line depreciation and double-declining-balance. The company expects that in-
come before depreciation expense and income taxes will be approximately $160,000 per year.
The firm™s corporate tax rate is 35%.

Required
A. Determine the cost of the equipment that should be recorded in the accounting system.
B. Use the straight-line (SLN) and double-declining-balance (DDB) functions from Excel
or another spreadsheet program as an aid to constructing a schedule that shows (1) de-
preciation expense each year under each alternative, and (2) ending book value each
year under each alternative.
C. Prepare a projected income statement for the six years assuming straight-line deprecia-
tion is used. (You need to prepare only one projected income statement because all
years yield exactly the same result.) Start with Income Before Depreciation and Taxes
and conclude with Net Income.
D. Prepare projected income statements for all six years assuming double-declining-bal-
ance depreciation is used. Start with Income Before Depreciation and Taxes and con-
clude with Net Income.
E. Compare your results from parts C and D. Why is it important that a reader of finan-
cial statements consult the notes to the financial statements to determine the deprecia-
tion method in use?

Depreciation Policy and Moral Hazard
P11-7
Obj. 2 Clemson Manufacturing Company produces specialty textiles. On January 1, it purchased a
new weaving machine at a cost of $600,000. The machine has an expected life of five years
(Continued)
F436 SECTION F2: Analysis and Interpretation of Financial Accounting Information
439
Investing Activities

and an estimated salvage value of $40,000. The company manager thinks the machine can be
used to weave 4.0 million yards of fabric. The net income before depreciation and taxes in the
first year was $3,600,000. The company™s tax rate is 30%.

Required
SPREADSHEET
A. Prepare a five-year depreciation schedule for the machinery under both straight-line
and double-declining-balance methods. (Hint: You may wish to use the SLN and DDB
functions in an Excel spreadsheet.)
B. Determine the amount of depreciation expense the company would incur during the
first year if the units-of-production method were used and 1.2 million yards of fabric
were produced.
C. Which of the three methods would result in the lowest income tax expense for the first
year?
D. Which of the three methods would result in the highest net income for the first year?
E. Assume the income tax must be paid immediately at year-end. Assume also you are the
chief executive officer (CEO) of the corporation and are paid a significant bonus based
on reported profit for the year. Which accounting method would you recommend be
used regarding this new equipment? Why?

The Effect of Depreciation on Net Income and Taxes
P11-8
Obj. 2 McGuire Batt Company produces a wide line of insulation materials. On January 1, it acquired
new production equipment at a cost of $1,200,000. The machine has an expected life of four
years and an estimated salvage value of $80,000. The engineering specifications of this new
equipment state that it will produce two million units of product over its useful life. For the
first year, the company™s net income before considering depreciation and taxes was $7.2 mil-
lion. The company™s tax rate was 35%.

Required
SPREADSHEET

A. Prepare a four-year depreciation schedule for the machinery under both straight-line
and double-declining-balance methods. (Hint: You may wish to use the SLN and DDB
functions in an Excel spreadsheet.)
B. Determine the amount of depreciation expense the company would record on its in-
come statement for the first year if the units-of-production method were used and
400,000 units were produced.
C. Which of the three methods would result in the lowest income tax expense for the first
year?
D. Which of the three methods would result in the highest net income for the first year?

Choices in Depletion and Depreciation Methods
P11-9
Objs. 2, 3 Sioux City Minerals acquired a copper mine, paying $40,000,000. The mine is expected to be
productive for 10 years and yield 500,000 tons of copper ore. At the end of that time, the prop-
erty will be donated to the state. To produce the ore, the company purchased mining equip-
ment at a cost of $4,800,000, which is expected to have a useful life of 12 years with no salvage.

Required
A. Assuming that 30,000 tons of ore were produced and sold in the first year of opera-
tions, calculate the depletion for the mine and the depreciation of the machinery.
B. Assume the same facts as in part A above, except that the machinery can be used only
for this copper mine and will not be moved once the mine is abandoned. How do you
believe the equipment should be depreciated in this case? Explain why. What would be
the depletion and depreciation for the first year under your approach?
C. If the ore is sold for $120 per ton, calculate the profit under parts A and B above. If
there is a difference in the two amounts, explain why.
D. Assume that after the first year, when 30,000 tons were produced, a mining engineer esti-
mates that a total of 570,000 additional tons of ore can still be recovered from the mine.
What would be the depletion of the mine and the depreciation of the machinery if 25,000
tons of copper were produced in the second year? (Assume straight-line depreciation.)
E. What would be the book values of the mine and the machinery at the end of the sec-
ond year?
F437
CHAPTER F11: Investing Activities
440 Investing Activities

Reporting Investments
P11-10
Obj. 4 Portia Enterprises manufactures automobiles and occasionally makes small investments in
other corporations for long-term purposes. During its 2003 fiscal year, Portia purchased
100,000 common shares (10%) of Leonardo Company for $3,470,000. Also, it purchased 5%
of the common stock of Shylock Company for $2,690,000. During 2003, Portia received
$500,000 of dividends from Leonardo. At the end of the fiscal year, the investment in Leonardo
had a market value of $3,100,000. The investment in Shylock had a market value of $2,800,000.
Portia owned no other stock investments during 2003. During its 2004 fiscal year, Portia sold
the Shylock investment for $2,900,000 and made a small investment in Balthasar Company
for $1,930,000. During 2004, Portia received $500,000 of dividends from Leonardo. At the end
of 2004, the Leonardo investment had a market value of $3,350,000 and the Balthasar invest-
ment had a market value of $1,940,000. Portia owned no other stock investments during 2004.
All of Portia™s investments were properly accounted for as long-term investments.

Required
A. At year-end 2004, should these investments be classified as held-to-maturity, trading,
or available-for-sale? Why?
B. Prepare a schedule calculating the amount Portia would report for long-term invest-
ments on its balance sheet at the end of 2003 and 2004.
C. Prepare a schedule calculating the effect of Portia™s investment activities on its income
for 2003 and 2004.

Accounting for Investments in Securities
P11-11
Obj. 4 At December 31, 2004, Optimax Medical Company owned small investments in the common
stock of other firms as follows:


Number of Purchase Price
Company Shares Owned per Share

1. Fleet Company 1,000 $37.50
2. Regency, Inc. 2,200 $10.40
3. Demetri Products 700 $52.00
4. Paxton Technology 1,500 $22.50




Optimax management expects to sell its investments in Fleet and Paxton during the 2005 fis-
cal year. It does not, however, expect to sell its investments in Regency or Demetri at any time
in the foreseeable future. The market value of each investment at the end of the 2004 fiscal
year was as follows:

Fleet $39,000
Regency 24,000
Demetri 34,940
Paxton 33,020

During 2004, Optimax received $3,900 of dividends from Fleet and $1,700 of dividends from
Demetri. Optimax Company owned no other stock investments during 2004.

Required
A. Determine the amounts that should be reported on the December 31, 2004 balance
sheet under the following classifications. Show how you determined each amount.
1. Short-term investments
2. Long-term investments
3. Stockholders™ equity
B. What information about these investments should appear on 2004™s income statement?
Be specific.
(Continued)
F438 SECTION F2: Analysis and Interpretation of Financial Accounting Information
441
Investing Activities

C. How is it helpful to readers of the financial statements to see information about the
market value of common stock investments when Optimax didn™t pay those amounts
to obtain the shares? Explain.

Accounting for Investments in Bonds
P11-12
Obj. 4 Nilani Company purchased 100 Arapaho Company bonds on April 1, 2004. The bonds pay
interest semiannually on March 31 and September 30 at an annual coupon rate of 9%. The
bonds sold at an effective yield of 8%. The effect of brokerage fees is included in computing
the effective yield. The bonds mature on March 31, 2006, at their face value of $1,000 per
bond. Nilani™s fiscal year ends on September 30.

Required
SPREADSHEET
A. Compute the price Nilani paid for Arapaho™s bonds. (Hint: Determine the present
value of the interest payments and principal repayment as demonstrated in Chapter
F8.)
B. Prepare an amortization schedule for Nilani™s investment.
C. Assume that the bonds are classified as held-to-maturity securities. Use the format pre-
sented in this chapter to show how the bond transactions would be entered into Ni-
lani™s accounting system in 2004, 2005, and 2006.
D. What is the total interest revenue from these bonds that Nilani will report on its 2004,
2005, and 2006 income statements? How does total interest revenue compare to Ni-
lani™s net cash flow from this bond investment during those same three years? Show
your computations.
E. What does the result in part D suggest to you regarding the similarities and differences
between accrual and cash-based measures?

Accounting for Investments in Bonds
P11-13
Obj. 4 On January 1, the Cheng Corporation purchased $10,000 of 5%, five-year bonds as a long-
term investment. Interest is paid annually. The company is not involved in active trading of
securities.

Required Using the format presented in the chapter, record each of the following trans-
actions.
A. Record the purchase of the bonds for $10,000.
B. Record the receipt of the first interest payment on the bonds in part A.
C. Assuming the company intends to hold the bonds to maturity, what entry is necessary
at the end of the first year if the market value of the bonds is $10,400 at that time?
D. Show how the answer to part C would differ if the company does not intend to hold
the bonds to maturity.
E. Assume that the company purchased these bonds at a cost of $10,445. This price yields
an effective rate of 4%.
F. Record the receipt of the first interest payment on the bonds purchased in part E.
G. Assuming the company intends to hold the bonds to maturity, prepare the necessary
entry at the end of the first year to reflect the $10,400 market value of the bonds.
H. Show how the answer to part G would differ if the company does not intend to hold
the bonds to maturity.
I. Report the carrying value (book value) of the bonds at the end of the first year in parts
C, D, G, and H. Explain how the amounts have been calculated.
J. Prepare an amortization table for the bonds purchased in E, assuming the company
holds the bonds to maturity. What is the total amount of cash received? What is the to-
tal amount of interest revenue? What is the difference between the two?

Investments in Debt Securities
P11-14
Obj. 4 On January 1, Gandini Company purchased $300,000 face value of Battaglia™s 8.4% bonds at
a price of $283,439. At this price, the bonds yielded 9% annually. At December 31, Gandini
received an interest check on these bonds of $25,200. The market price of these bonds that
day was $282,000.
F439
CHAPTER F11: Investing Activities
442 Investing Activities

Required
A. Using the format presented in this chapter, show the entries that would be made to the
accounting system to record the purchase of this investment and receipt of the interest
check. Assume this is a long-term investment.
B. Show how this investment should be reported in the year-end financial statements by
completing the table of information that follows.

If the bonds are . . .
Held-to- Available-
maturity Trading for-sale
securities securities securities
Accounting method to be used

Amount of unrealized holding gain (loss)
to be reported on income statement
Amount of unrealized holding gain (loss)
to be reported on balance sheet
Amount of discount amortized during
first year
Balance of investment account on balance sheet
at end of the first year


Investments in Equity Securities
P11-15
Obj. 4 On August 22, 2004, Burgess Company purchased 20,000 common shares of Radius Mea-
surement, Inc. at a price of $8 per share. Brokerage commissions, taxes, and transfer fees to-
taled an additional $800. At December 31, 2004, Burgess still owned the securities but the
aggregate market value had declined to $148,000. This is a long-term investment.

Required
A. Using the format presented in this chapter, show the entries that would be made to the
accounting system to record the purchase of these securities.
B. Show how this investment should be reported in the year-end 2004 financial statements
by completing the table of information below.

If the total number of Radius
common shares outstanding totals
1 million 80,000 30,000
Accounting method to be used

Amount of unrealized holding gain (loss)
to be reported on income statement
Amount of unrealized holding gain (loss)
to be reported on balance sheet
Balance of investment account on balance sheet


C. Assume the investment in common stock was sold on January 23, 2005 at a price of
$171,400. Use the format presented in this chapter to show the entry to record this event.
Assume the investment has always been on the books as available-for-sale securities.

Depreciation, Amortization, and Depletion
P11-16
Objs. 2, 3, 5 The accounting staff at Golden Mining Company will soon prepare year-end entries to the
accounting system to record the partial consumption of certain long-term assets. Your advice
is sought regarding each of the following situations.
1. A mining site was acquired 10 years ago at a cost of $4,900,000. This included $700,000
to prepare an environmental impact statement, conduct a required survey, and build
(Continued)
F440 SECTION F2: Analysis and Interpretation of Financial Accounting Information
443
Investing Activities

road access. The mine was expected to produce approximately 20 million tons of high-
grade ore, after which the site could be sold for $500,000. This past year, 3.0 million
tons were produced, processed, and sold.
2. Trucks and machinery having an estimated useful life of five years are being depreci-
ated by the double-declining-balance method. These assets were purchased for
$152,000 and have an estimated residual value of $22,000. This is the end of their third
year in use.
3. A patent relating to the ore-refining process was purchased three years ago at a cost of
$57,000. At the time of purchase, the patent had a remaining legal life of eight years.
Management wants the required write-off of the patent™s cost to have the minimum ef-
fect on net income that is allowed under the circumstances.

Required
A. Assist the accounting staff by suggesting the year-end entries that should be made to
the accounting system for each of the situations above.
B. Assume the trucks and machinery have always been depreciated using the straight-line
method. Assume further that it was determined during the current year that the esti-
mated useful life would actually be a total of 10 years with a residual value of $2,000.
What amount of depreciation expense would have been reported during each of the
first two years under the straight-line method? What amount of depreciation expense
will be reported for the current year and the years that follow under the straight-line
method?


Accounting for Fixed, Natural, and Intangible Assets
P11-17
Objs. 2, 3, 5 On the last day of the fiscal year, the chief financial officer of MultiPlex Industries is review-
ing several accounting matters. They are as follows:
1. Equipment purchased seven years ago at a cost of $450,000 was sold yesterday as scrap
metal at a price of $3,000. It had originally been estimated to have a 10-year life with a
$50,000 residual value. The straight-line method has been used.
2. Early in the current year, the mineral rights to a bauxite mine were acquired at a cost
of $5.5 million. Mining consultants have estimated there are about 350,000 tons of re-
coverable ore that can be removed and processed.
3. Just yesterday, the company purchased a subsidiary company by paying the $2.8 million
purchase price. Investigation prior to the acquisition reveals the market value of the
subsidiary™s identifiable assets totals $1.9 million.

Required Use the format presented in this chapter for parts A, B, C, and E.
A. Prepare the entry to record the current year™s depreciation expense.
B. Prepare the entry to record yesterday™s sale of old machinery. Also show how you ar-
rived at the amounts you entered.
C. During the year just ended, 77,000 tons of bauxite ore was removed, processed, and
sold from the mine. Prepare the appropriate entry to record the expense.
D. Explain what goodwill represents.
E. Prepare the entry to record the purchase of the subsidiary.


Accounting for Plant Assets
P11-18
Objs. 2, 6 Garland Company purchased construction equipment on July 1, 2001, for $800,000. The
equipment was expected to have a useful life of five years and a residual value of $50,000. On
June 30, 2004, Garland no longer needed the equipment and sold it for $311,000. Garland™s
accounting year ends on December 31. The company uses the straight-line depreciation
method.

Required
A. Information about this equipment must be entered into the accounting system on July
1, 2001; December 31, 2001; December 31, 2002; December 31, 2003; and June 30,
2004. Show how that information should be entered, using the format shown in this
chapter. (Hint: On June 30, 2004, be sure to record depreciation expense for the six
months immediately preceding sale of the equipment.)
F441
CHAPTER F11: Investing Activities
444 Investing Activities

B. Why was a gain (or loss) recorded at the date of disposal? What caused this to occur?
Does a loss mean that the company has been negligent in selling the asset? Does a gain
on sale mean that the company has been skillful in selling the asset? Explain.
C. Calculate the cumulative net effect that all transactions involving the equipment had on
Garland™s pretax income from 2001 through 2004. Also, calculate the cumulative net effect
that all transactions involving the equipment had on cash flows for this period. Explain the
relationship between (1) the effect on pretax income and (2) the effect on cash flows.

Ethics in Financial Reporting
P11-19
Obj. 6 Show-Me-the-Money, Inc. is a medium-sized bank. The bank™s stock is owned primarily by
residents in the city where the bank operates. During the last decade, the bank lent money for
numerous real estate developments. Most of the loans went to developers who constructed of-
fice space and expected to repay the loans from office rent. Aggressive lending and building
practices resulted in overbuilding. A downturn in the local economy drastically reduced de-
mand for office space. As a result, many of the buildings are now largely empty. Rent from the
facilities is insufficient to pay interest on several of the bank™s larger loans. The bank has per-
mitted several borrowers to restructure their loans, providing a longer period of repayment and
lower interest rates. The market value of the property backing these loans has decreased ap-
proximately 40% since its construction. The bank™s proposed year-end balance sheet reports
loans in the bank™s long-term investment portfolio at $43 million. This amount is net of a loan
loss reserve of $5 million. The balance sheet also includes $18 million of property among the
bank™s assets. This property was acquired through foreclosures on several loans. The property
is valued at the present value of the original loan payments, including interest the bank ex-
pected from the original borrowers. The bank is collecting rent from tenants and expects to sell
the property when real estate values return to higher levels. The bank™s total assets are $80 mil-
lion, and total stockholders™ equity is $10 million. The bank™s proposed income statement for
the year reports profits of $6 million. The year-end audit is now underway, and the bank™s au-
ditors are reviewing the proposed financial statements. They have questioned management
about its loans and property values. The auditors believe that the current market value of the
loan portfolio is about $35 million. They are less sure about the value of the property. The
bank™s managers are arguing that the current market value of the loans is not relevant because
they do not expect to sell the loans. Instead, they expect to hold the loans until they mature.
Also, they do not plan to sell the property until they can recover the amount the bank invested.

Required Do you believe the investors and creditors of the bank will be well served by the
financial statements that the bank™s management proposes to report? Explain. Do you see any
ethical problems with the way the bank™s managers want to report its assets? Why? What prob-
lems may arise for the bank if it reports its loans at current market value?

The Equity Method
P11-20
(Based on the Other Investment Issues section) On January 1, Schuster Company bought 2,400
of Helio Corporation™s 10,000 outstanding shares of common stock as a long-term invest-
ment. The stock was acquired at a cost of $24,000. On December 31, Helio reported net in-
come of $38,000 and paid dividends totaling $6,000. On the same date, the market value of
Helio™s common stock was $15 per share.

Required
A. Use the format presented in this chapter to show how the events described above
would be entered into Schuster™s accounting system.
B. Describe how this would be reported on Schuster™s year-end financial statements by
completing the table that follows.

Question Solution
1. In which section of the balance sheet
will this investment be reported?
Be specific.
2. What amount will be reported on the
balance sheet for this investment?
Show your work.
(Continued)
F442 SECTION F2: Analysis and Interpretation of Financial Accounting Information
445
Investing Activities

Question Solution
3. What amount of income will be
reported on the income statement
related to this investment? Explain.
4. What information will be reported
about any unrealized holding gain or
loss? Explain.


Excel in Action
P11-21
The Book Wermz expanded its operations in March 2005 by purchasing an existing chain of
bookstores. The total cost of the purchase was $5 million. Of this amount, $2.2 million was
allocated to the cost of buildings, $1.0 million to the cost of store equipment, and $275,000
to the cost of transportation equipment. The buildings have an estimated useful life of 30 years
(360 months) and a salvage value of $100,000. The store equipment has an estimated useful
life of five years (60 months) and a salvage value of $50,000. The transportation equipment
SPREADSHEET has an estimated useful life of three years (36 months) or 90,000 miles and a salvage value of
$75,000. The Book Wermz uses straight-line depreciation for financial reporting purposes. For
income tax purposes, it uses double-declining-balance depreciation for buildings and store
equipment and units-of-production depreciation for transportation equipment.

Required Use a spreadsheet to prepare a depreciation schedule for The Book Wermz for
the assets described. The depreciation schedule will contain data for April through December
2005. Rows 1 through 3 should contain “The Book Wermz”, “Depreciation Schedule”, and
“April-December 2005”. Beginning in cell A5, list the following captions in column A: Asset,
Cost, Salvage, Life (months), and Method. In column B, provide the data for Buildings that
correspond to the captions in column A. Repeat the process for Store Equipment in column
D and for Transportation Equipment in column F.
In cell A10 enter “Month”, followed by the numbers 1 through 9 (corresponding to April
through December) in cells A11 through A19. In cell B9, enter “Straight-Line”. In cell C9, en-
ter “Declining-Balance”.
In cell B11, enter a function to calculate the straight-line depreciation for April for Build-
ings. Click on the Function button, select the Financial category, and select SLN from the
Function name list. In the dialog box, enter the appropriate cell addresses for each of the val-
ues requested to complete the function. For example, enter $B$6 for cost. Make sure you in-
clude the $ sign in front of the cell references for cost, salvage, and life because the references
are to fixed locations (cells B6 to B8). Once the calculation is completed for April, copy cell
B11 to cells B12 to B19 to provide calculations for May through December. The amount of
depreciation in each cell should be the same. In cell B20, calculate the total depreciation for
2002 using the Summation button.
In cell C11, enter a function to calculate the double-declining-balance depreciation for
April for Buildings. Repeat the process used for straight-line depreciation, except use the DDB
function in the Financial category. The references in the dialog box will be the same as those
for straight-line depreciation. You will need to include a reference for Period. The reference
is A11 for April. Do not enter $ signs for this reference because the reference will change for
months May through December. You may leave the Factor reference blank. The factor is 2 for
double-declining-balance, and 2 is the default for the DDB method. Once the calculation is
made for April, copy cell C11 to cells C12 to C19. The amount of depreciation should be less
each month than the preceding month (declining balance). Total the column of depreciation
amounts in cell C20.
In columns D and E, repeat the processes described above for Store Equipment.
In column F, enter data for Transportation Equipment and calculate straight-line depre-
ciation. In column G enter data for the units-of-production method. In cell G10, enter the
caption “Miles”. In cells G11 through G19 enter the miles the equipment was used each month,
as follows: 1500, 1800, 2000, 2800, 3000, 2500, 2700, 2600, and 2200. In cell H10, enter the
caption “Expense”. In cell H11, calculate the amount of depreciation for April using the equa-
tion $F$6*(G11/90000). Copy cell H11 to cells H12 through H19. Calculate totals for each
column in row 20.
In columns I and J, calculate the total straight-line and accelerated depreciation amounts
for each month. Total each column in row 20.
F443
CHAPTER F11: Investing Activities
446 Investing Activities

Calculate the tax savings to The Book Wermz of using accelerated depreciation for tax
purposes. In column A, enter captions for “Total Accelerated”, “Total Straight-line”, “Differ-
ence”, “Tax rate”, and “Tax savings”, beginning in cell A22. In column B, enter the amounts
(cell references) that correspond with the total amounts. Use an equation to calculate the dif-
ference and assume a tax rate of 35%.
Format cells to provide a business appearance to the spreadsheet.
Suppose the life of the buildings was 380 months and the life of the store equipment was 72
months. How much depreciation would the company report and how much tax would it save?

Multiple-Choice Overview of the Chapter
P11-22
1. Which of the following is (are) used to determine how a given asset will be reported on
the balance sheet?
The Expected Period of Time Until the The Source of Financing That
Asset Will be Converted to Cash or Used Up Was Used to Acquire the Asset
a. Yes Yes
b. Yes No
c. No Yes
d. No No
2. Belly-Acres Land Company made capital expenditures during the current year. At year-
end, these expenditures should be reported on the
a. income statement as expenses.
b. balance sheet under current assets.
c. balance sheet under long-term assets.
d. statement of cash flows under operating activities.
3. The Song-in-My-Heart Record Store reported $20,000 of depreciation expense on as-
sets acquired at the beginning of the current year. The assets™ original cost was $50,000
with an estimated useful life of five years. The method used by Song-in-My-Heart for
depreciating the assets was the
a. straight-line method.
b. cost recovery method.
c. units-of-production method.
d. double-declining-balance method.
4. The Shiny Metal Mining Company acquired mineral rights for $3,100,000. Geological
studies indicate that two million tons of economically recoverable ore are likely to be
present on the site. Subsequently, the rights to remaining minerals can be sold for ap-
proximately $300,000. The firm estimates that it will take about five years to mine the
ore. In the first year, 600,000 tons of ore were recovered, processed, and sold. What is
the amount of depletion for the first year?
a. $930,000
b. $840,000
c. $620,000
d. $560,000
5. Assuming an estimated useful life of three years and zero residual value, which of the
following depreciation methods will always result in the least depreciation expense in
the first year?
a. Straight-line
b. Double-declining-balance
c. Units-of-production
d. Cannot be determined from the information given
6. Boswell Company purchased its first investment in available-for-sale securities during
the current year. At year-end, the current market value of the marketable securities is
greater than the price paid to acquire them. As a result of this information, the com-
pany should report an unrealized holding
a. loss on its income statement.
b. gain on its income statement.
c. loss on the balance sheet.
(Continued)
d. gain on the balance sheet.
F444 SECTION F2: Analysis and Interpretation of Financial Accounting Information
447
Investing Activities

7. Hwan Manufacturing Company owns held-to-maturity bonds that were acquired at a
premium. Each period that Hwan holds the investment, amortization of the premium
will have which one of the following effects?
a. The amount of interest revenue reported on the income statement will increase.
b. The amount of cash received will decrease.
c. The book value of the investment will decrease.
d. The rate of return earned on the investment will decrease.
8. The excess of cost over the market value of identifiable net assets acquired in a pur-
chase of another company should be reported in the financial statements as
a. a current asset.
b. an intangible asset.
c. an expense of the period in which the acquisition occurs.
d. a revenue of the period in which the acquisition occurs.
9. Which of the following is a false statement about intangible assets, other than goodwill?
a. They have no physical substance.
b. They have no real economic value.
c. They can often be purchased or sold.
d. They are amortized over their useful lives.
10. Khim Singer Company sold obsolete machinery that was no longer used in its factory.
The transaction resulted in a loss being recorded in the company™s accounting system.
Information about this event will appear on which of the company™s year-end financial
statements?
Income Statement of Cash Flows
Statement (Indirect Format)
a. Yes Yes
b. Yes No
c. No Yes
d. No No
11. (Based on the Other Investment Issues section) Farma Pharmaceutical Company has in-
vested in the common stock of Bailey Biotech. The primary factor that will determine
whether the equity method or the consolidation method is used to account for this is
size of the
a. investment.
b. industry.
c. parent company.
d. total assets.
12. (Based on the Other Investment Issues section) On January 1 of the current year, Nancy
Enterprises acquired 14,000 shares of the 40,000 outstanding shares of Tang Toys for
$100,000. During the year, Tang Toys had net income of $50,000 and paid $10,000 in
dividends. At December 31 of the current year, Nancy Enterprises should report what
amount as its investment in Tang Toys?
a. $96,500
b. $103,500
c. $114,000
d. $117,500



Projects
CASES
Comparison of Purchase and Leasing of Plant Assets
C11-1
Objs. 2, 6 Swenson Company plans to acquire new chemical processing equipment on January 1, the
beginning of the company™s fiscal year. The equipment costs $2 million. Swenson can either
borrow $2 million from a bank or lease the equipment. Both the bank and the leasing com-
pany believe that a 10% interest rate is appropriate, given Swenson™s credit history. A lease
would be accounted for as a capital lease (as discussed in Chapter F8). The equipment is ex-
F445
CHAPTER F11: Investing Activities
448 Investing Activities

pected to have a useful life of four years, which would be the same as the lease period. The
equipment is expected to have zero residual value. Swenson normally uses the straight-line
method to depreciate its equipment. The lease alternative would require year-end payments
of $635,000 each year. If money is borrowed from a bank, four year-end payments would be
required. Each payment would include one-fourth of the principal amount borrowed plus all
of the interest expense that had been incurred on the unpaid balance during the year.

Required As the Chemical Division manager, you have been asked to evaluate the alterna-
tives and to recommend the best choice for acquiring the equipment. Determine the com-
parative effects of purchasing versus leasing the equipment on Swenson™s income statement,
balance sheet, and statement of cash flows over the four-year period. Evaluate the alternatives
and make a recommendation to top management.

Analysis of Investment Activities
C11-2
Objs. 2, 4, 6
Appendix B of this book contains a copy of the 2002 annual report of General Mills, Inc.

Required Review the annual report and write a short report in which you respond to each
of the issues raised below.
A. Identify the accounting methods used by the company to account for plant assets, in-
tangible assets, research and development costs, and advertising costs. (Hint: This in-
formation is disclosed in the notes to the financial statements.)
B. Identify the cost of each of the company™s types of plant assets and the total amount of
accumulated depreciation on these assets at the end of the most recent period reported.
C. Explain how the company reports its holdings of marketable securities in the financial
statements. What percentage of its marketable securities (based on market value) are
expected to be liquidated within one year? What percentage over more than one year
and up to seven years? What amount over more than seven years? (Hint: This informa-
tion is in the notes.)
D. Explain the change in the company™s plant asset accounts during the most recent year
reported by an analysis of its investment activities and depreciation. (Hint: Because of
certain accounting complexities, you won™t be able to prove the change exactly. But see
how much of the change you can explain.)
F12 12
ANALYSIS OF INVESTING
ACTIVITIES
How do assets create value for our business?

C hapter F11 discussed investing activities, including accounting for the acquisition,
use, and disposal of long-term assets. Decisions about long-term assets affect the
profitability and value of a company. Property and equipment are necessary to support
operating activities. Manufacturing companies require equipment and facilities to pro-
duce goods, and all companies require equipment and facilities to support administrative
and sales functions. The amounts and types of assets a company acquires affect a company™s
expenses and cash flows. Good asset investments support additional sales and profits. Poor in-
vestments lead to higher expenses and reduced profits.

Maria and Stan have decided that, for Mom™s Cookie Company to grow and become more valu-
able, it will need to produce its own goods. The company will need to invest in production equip-
ment and facilities. They have to make decisions about the types and amounts of assets to acquire.


FOOD FOR THOUGHT
If you are managing Mom™s Cookie Company, what issues should you consider when deciding on the
amounts and types of assets to use in the company? How should investors analyze the company™s
financial statements to assess management™s investing decisions and the effects of these decisions on
profits and company value?


Maria, president, Stan, vice president of operations, and Ellen, vice president of finance of Mom™s Cookie Company, met
to discuss investing plans for their company.

We need to identify the equipment and facilities required for Mom™s Cookie Company to become a
Maria:
manufacturing company. Is there anything special we need to consider?
First, make sure the assets we acquire will permit us to produce the amount of goods we need and keep
Ellen:
our production costs low enough so that we can make a profit.
Also, it™s important for us to make sure the facilities and processes we use permit us to produce high-
Stan:
quality goods.
Do we have to trade off quality for cost? Are there other issues that affect our decision?
Maria:
We should consider how the assets we acquire will affect our cost structure. Some costs don™t increase as
Ellen:
sales increase, and other costs do. Cost structure can have an important effect on the profitability of
Mom™s Cookie Company.
F447
CHAPTER F12: Analysis of Investing Activities
450 Analysis of Investing Activities


OBJECTIVES

Once you have completed this chapter, you 4 Explain how investing activities affect
should be able to: company value, and use accounting
information to measure value-increasing
1 Explain why investing decisions are
activities.
important to a company and how they can
affect its profits. 5 Identify ways in which a company can use
its assets to improve effectiveness and
2 Explain how operating leverage affects a
efficiency.
company™s risk and profits.
6 Explain why accounting information about
3 Use financial statements to evaluate
long-term assets is useful for creditors.
investing activities for various companies.




INVESTING DECISIONS
Maria, Stan, and Ellen continue to discuss investing activities for their new company.
OBJECTIVE 1
The three managers had decided earlier to finance their company primarily by issuing
Explain why investing common stock. Their decisions now involve the types of long-term assets the company
decisions are important to needs.
a company and how they Maria observed: “We decided last week that we probably will need $5 million to
can affect its profits. fund production facilities and production and marketing costs. We assumed that we
will require $4 million for plant assets. Now we should decide on the specific types of
assets we™ll need. We want to be sure that $5 million will be adequate.”
“I have looked at various alternatives,” Stan remarked, “and I have some estimates
for us to consider. Our production process involves mixing ingredients to make cookie
dough, shaping or forming the cookies, baking the cookies, examining the finished
product for quality, and packaging the cookies for sale. Exhibit 1 illustrates the pro-
duction process.



Exhibit 1 The Production Process for Mom™s Cookie Company

Ingredients

Mixing
Rolling
& Cutting




Baking
Packaging

Inspection
F448 SECTION F2: Analysis and Interpretation of Financial Accounting Information
451
Analysis of Investing Activities

“Obviously,” continued Stan, “we need equipment such as mixers and ovens. Also,
we need equipment to move the materials between processes. We need enough build-
ing space to produce the product and provide storage for materials and finished goods.”
“That seems fairly simple,” Maria interrupted. “Can™t we just buy what we need?”
“Well, it™s not quite that simple,” Stan responded. “We have to make some choices.
For example, we have to decide how much of each type of equipment we need. We can
start small and add more equipment as demand increases, but because the equipment
has to be special-ordered, this will be a relatively expensive approach in the long run,
assuming that our demand increases as we expect. If we start with smaller mixers and
ovens, we will not be able to increase capacity very much once demand picks up.
“Perhaps the biggest decision we have to make,” Stan continued, “is how much au-
tomation we want in the production process. We can use rather simple equipment that
requires a lot of manual labor. For example, we can use pushcarts to move materials from
one process to the next. Materials can be loaded into mixers and ovens by hand. And, we
can use workers to inspect and package the finished products. These processes will re-
quire relatively large amounts of labor but will allow us to invest less in equipment.
“As an alternative, we can purchase more sophisticated equipment. Exhibit 2 shows
this alternative. This equipment completes most of the processes with little human in-
volvement. Conveyors can move materials to locations where ingredients are automat-
ically loaded. The equipment prepares the dough, forms the cookies, and transfers them
to ovens. Workers would have to make sure the equipment is functioning properly and
make changes in settings for different types of cookies. This option calls for fewer em-
ployees. However, the employees would require more skills, so we would have to pay
them more. Also, if we use automated equipment, we must acquire sufficient machin-
ery to meet expected demand for the foreseeable future. It is expensive to increase the
size of an automated production process, and therefore our initial investment will be
larger than if we start with manual equipment.


Exhibit 2 An Alternative Production Process for Mom™s Cookie Company




Ingredients Rolling & Inspecting
Baking
& Mixing Cutting & Packing




“Thus, our basic choice is manual or automated equipment. If we select manual
equipment, we can start with less investment and add equipment as demand increases.
If we select automated equipment, we must invest more initially, but we will have the
capacity we expect to need. Also, we will be able to produce a higher quality product.
An automated production process is more reliable.”
Maria observed, “This decision is more complicated than I had realized. What ef-
fect do the choices have on our expected profits?”


Investment Decisions and Profit
“The potential effects are quite large,” Ellen responded. “Exhibit 3 provides some sum-
mary information.
F449
CHAPTER F12: Analysis of Investing Activities
452 Analysis of Investing Activities

“We expect sales of $3 million next year. That is the amount I assume in Exhibit
3,” Ellen noted. “The amount we will need to invest initially in equipment differs be-
tween alternatives.”



Exhibit 3 (In thousands) Manual Automated
Expected Effects of
Assets:
Mom™s Cookie
Current assets $ 1,000 $ 1,000
Company™s Investing
Plant assets 3,500 4,000
Decisions with Sales of
Total assets $ 4,500 $ 5,000
$3 Million
Sales $ 3,000 $ 3,000
Cost of ingredients (800) (800)
Depreciation (250) (300)
Wages and benefits (780) (700)
Other operating expenses (1,000) (1,000)
Operating income 170 200
Interest expense (170) (170)
Pretax income ” 30
Income taxes ” (9)
Net income $” $ 21




“If we use manual equipment, our initial equipment investment would be $3.5 mil-
lion. The automated equipment alternative requires an initial investment of $4 million.
Consequently, the amount of capital required to finance the company will be larger if
we use automated equipment.
“The choice of equipment affects our projected income statement in two ways. The
amount of depreciation differs because of the amounts invested in equipment. Annual
depreciation expense will be lower for manual equipment. The choice also affects the
amount of labor cost we can expect. The automated equipment alternative results in
lower wages and benefits, saving us $80,000 next year. Other income statement amounts,
except taxes, do not vary between the alternatives.
“The bottom line is, we should expect profit to be zero in the first year if we choose
the manual equipment alternative. We earn a $21,000 profit if we choose automated
equipment. Keep in mind, however, that we have to invest more money if we go with
automated equipment.”
“Okay,” Stan remarked, “but what happens in the future? We expect sales to increase
each year. Can we produce enough product to meet higher demand in the future?”
“The answer depends on which alternative we choose,” Ellen answered. “Exhibit 4
provides similar information to Exhibit 3, assuming sales of $3.6 million, the amount
we expect in the second year of operations.
“If we select the manual equipment, we will have to purchase an additional $250,000
of equipment to meet the higher demand. The advantage of using manual equipment
is that we can start with less equipment and add more equipment as demand increases.
For example, we can start with five mixers and add a sixth when we need it. If we use
automated equipment, we must purchase large automated mixers and ovens to meet
our expected sales of $3 million. However, we can increase production to $3.6 million
without adding equipment. Another advantage of the automated equipment is that we
can increase production without increasing labor costs. If we use manual machines, we
will need additional employees to operate the new machinery.
“The result of these changes is that at $3.6 million of sales, depreciation and labor
costs increase for the manual equipment alternative. Also, we will use more ingredients
regardless of the type of equipment we use. Other costs do not increase, however. There-
fore, our net income is positive for each alternative. The automated equipment alter-
native provides much higher income, however, as you can see in Exhibit 4.”
F450 SECTION F2: Analysis and Interpretation of Financial Accounting Information
453
Analysis of Investing Activities

Exhibit 4 (In thousands) Manual Automated
Expected Effects of
Assets:
Mom™s Cookie
Current assets $ 1,200 $ 1,440
Company™s Investing
Plant assets 3,750 4,000
Decisions with Sales of
Total assets $ 4,950 $ 5,440
$3.6 Million
Sales $ 3,600 $ 3,600
Cost of ingredients (960) (960)
Depreciation (275) (300)
Wages and benefits (936) (700)
Other operating expenses (1,000) (1,000)
Operating income 429 640
Interest expense (170) (170)
Pretax income 259 470
Income taxes (78) (141)
Net income $ 181 $ 329




“So it looks like the choice is clear,” Maria concluded. “The automated equipment
appears to be the best choice. It results in higher net income at the $3 and $3.6 million
sales levels. Shouldn™t we select that alternative?”

Investment Decisions and Risk
“Probably,” Ellen agreed. “But we need to consider the risk associated with each alterna-
OBJECTIVE 2
tive. The automated equipment requires a larger investment. Also, we cannot reduce our
Explain how operating costs very much if our sales don™t meet expectations. Look at Exhibit 5, for example.”
leverage affects a “In this exhibit, sales for next year are assumed to be $2.8 million, less than we ex-
company™s risk and pect but still a possibility. A real advantage of using manual equipment is apparent at
profits. this level. We can buy less equipment and still produce enough cookies to meet demand.
Also, we can hire fewer employees and save some labor costs. Therefore, though we in-
cur a loss, it is less than the loss incurred with the automated alternative. Also, the cash
we save from buying less equipment will help us stay in business until demand increases.
“A disadvantage of the automated equipment is that we cannot reduce labor costs.
We will need the same number of employees to operate and maintain the equipment
whether we sell $2.8 million of product or $3.6 million. Once we have the automated
equipment, our costs would remain fairly constant regardless of how much we pro-
duce. And, we can™t downsize our operations and still stay in business. All of the equip-
ment will be needed to manufacture any reasonable amount of product.


Exhibit 5 (In thousands) Manual Automated
Expected Effects of
Assets:
Mom™s Cookie
Current assets $ 900 $ 900
Company™s Investing
Plant assets 3,400 4,000
Decisions with Sales of
Total assets $ 4,300 $ 4,900
$2.8 Million
Sales $ 2,800 $ 2,800
Cost of ingredients (747) (747)
Depreciation (233) (300)
Wages and benefits (728) (700)
Other operating expenses (1,000) (1,000)
Operating income 92 53
Interest expense (170) (170)
Pretax income (78) (117)
Income taxes 23 35
Net income $ (55) $ (82)
F451
CHAPTER F12: Analysis of Investing Activities
454 Analysis of Investing Activities

“Exhibit 6 illustrates the relation between sales and net income for each alterna-
tive. Manual equipment is the safer choice. If sales are lower than expected, we are more
likely to survive if we invest in this equipment. On the other hand, we stand to make
more money if we go with automated equipment.”


Exhibit 6 A Comparison of the Effects of Investment Decisions on Profits of Mom™s Cookie Company



350
300
Automated
250 Equipment
200
150
Net Income
100
(In thousands)
50
0
Manual
50
Equipment
100
500
3,800
3,400 3,600
3,000 3,200
2,600 2,800
Revenues (In thousands)

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