ñòð. 20 |

Value Value

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 30,000

Accounts receivable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 300,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350,000 600,000

Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 900,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,180,000 $1,830,000

In addition, Stansbury Island had liabilities totaling $400,000 at the time of the acquisition.

1. At what amounts will the individual assets of Stansbury Island be recorded on the books

of Stringtown, the acquiring company?

2. How will Stringtown account for the liabilities of Stansbury Island?

3. How much goodwill will be recorded as part of this acquisition?

EXERCISE 9-18 FIXED ASSET TURNOVER

Handy Corner Stores reported the following asset values in 2002 and 2003:

2003 2002

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 30,000 $ 20,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 300,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 350,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200,000 150,000

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000 500,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 200,000

In addition, Handy Corner had sales of $2,000,000 in 2003. Cost of goods sold for the year

was $1,500,000.

Compute Handy Corner s fixed asset turnover ratio for 2003.

EXERCISE 9-19 ACQUISITION AND DEPRECIATION OF ASSETS

Montana Oil Company, which prepares financial statements on a calendar-year basis, pur-

chased new drilling equipment on July 1, 2003. A breakdown of the cost follows:

Cost of drilling equipment . . . . . . . . . . . . . . . $ 75,000

Cost of cement platform. . . . . . . . . . . . . . . . . 25,000

Installation charges . . . . . . . . . . . . . . . . . . . . 13,000

Freight costs for drilling equipment . . . . . . . . 2,000

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $115,000

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Assuming that the estimated life of the drilling equipment is 10 years and its salvage value is

$5,000:

1. Record the purchase on July 1, 2003.

2. Assume that the drilling equipment was recorded at a total cost of $95,000. Calculate the

depreciation expense for 2003 using the following methods:

a. Sum-of-the-years -digits.

b. Double-declining-balance.

c. 150% declining-balance.

3. Prepare the journal entry to record the depreciation for 2003 in accordance with 2(a).

EXERCISE 9-20 ACQUISITION AND DEPRECIATION

At the beginning of 2003, Lowham s Guest Ranch constructed a new walk-in freezer that had

a useful life of 10 years. At the end of 10 years, the motor could be salvaged for $2,000. In

addition to construction costs that totaled $10,000, the following costs were incurred:

Sales taxes on components. . . . . . . . . . . . . . . . . . . . . . $1,250

Delivery costs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800

Installation of motor . . . . . . . . . . . . . . . . . . . . . . . . . . . 200

Painting of both interior and exterior of freezer . . . . . . . 100

1. What is the cost of the walk-in freezer to Lowham s Guest Ranch?

2. Compute the amount of depreciation to be taken in the first year assuming Lowham s

Guest Ranch uses the

a. Double-declining-balance method.

b. Sum-of-the-years -digits method.

EXERCISE 9-21 DEPRECIATION COMPUTATIONS

Techno Company purchases a $400,000 piece of equipment on January 2, 2001, for use in

its manufacturing process. The equipment s estimated useful life is 10 years with no salvage

value. Techno uses 150% declining-balance depreciation for all its equipment.

1. Compute the depreciation expense for 2001, 2002, and 2003.

2. Compute the book value of the equipment on December 31, 2003.

DEPRECIATION CALCULATIONS

EXERCISE 9-22

The University of Northern Utah purchased a new van on January 1, 2002, for $30,000. The

estimated life of the van was five years or 95,000 miles, and its salvage value was estimated to

be $2,000. Compute the amount of depreciation expense for 2002, 2003, and 2004 using the

following methods:

1. Double-declining-balance.

2. 175% declining-balance.

3. Sum-of-the-years -digits.

EXERCISE 9-23 DEPRECIATION CALCULATIONS

On January 1, 2002, MAC Corporation purchased a machine for $60,000. The machine cost

$800 to deliver and $2,000 to install. At the end of 10 years, MAC expects to sell the ma-

chine for $2,000. Compute depreciation expense for 2002 and 2003 using the following

methods:

1. Double-declining-balance.

2. 150% declining-balance.

3. Sum-of-the-years -digits.

EXERCISE 9-24 ACCOUNTING FOR NATURAL RESOURCES

On January 1, 2002, Castle Investment Corporation purchased a coal mine for cash, having

taken into consideration the favorable tax consequences and the inevitable energy crunch in

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the future. Castle paid $800,000 for the mine. Shortly before the purchase, an engineer esti-

mated that there were 80,000 tons of coal in the mine.

1. Record the purchase of the mine on January 1, 2002.

2. Record the depletion expense for 2002, assuming that 20,000 tons of coal were mined

during the year.

3. Assume that on January 1, 2003, the company received a new estimate that the mine

now contained 120,000 tons of coal. Record the entry (if any) to show the change in es-

timate.

4. Record the depletion expense for 2003, assuming that another 20,000 tons of coal were

mined.

CHANGE IN ESTIMATED USEFUL LIFE

EXERCISE 9-25

On January 1, 2001, Landon Excavation Company purchased a new bulldozer for $120,000.

The equipment had an estimated useful life of 10 years and an estimated residual value of

$10,000. On January 1, 2003, Landon determined that the bulldozer would have a total use-

ful life of only 8 years instead of 10 years with no change in residual value. Landon uses

straight-line depreciation.

Compute depreciation expense on this bulldozer for 2001, 2002, and 2003.

problems

PROBLEM 9-1 ACQUISITION, DEPRECIATION, AND DISPOSAL OF ASSETS

On January 2, 2003, Scott Company purchased a building and land for $440,000. The most

recent appraisal values for the building and the land are $360,000 and $120,000, respectively.

The building has an estimated useful life of 20 years and a salvage value of $10,000.

1. Assuming cash transactions and straight-line depreciation, prepare journal entries to

Required:

record:

a. Purchase of the building and land on January 2, 2003.

b. Depreciation expense on December 31, 2003.

2. Assume that after three years the property (land and building) was sold for $350,000.

Prepare the journal entry to record the sale.

PROBLEM 9-2 PURCHASING PROPERTY, PLANT, AND EQUIPMENT

Jordon Company is considering replacing its automated stamping machine. The machine is spe-

cialized and very expensive. Jordon is considering three acquisition alternatives. The first is to

lease a machine for 10 years at $1 million per year, after which time Jordon can buy the ma-

chine for $1 million. The second alternative is to pay cash for the machine at a cost of $7 mil-

lion. The third alternative is to make a down payment of $3 million, followed by 10 annual

payments of $550,000. The company is trying to decide which alternative to select.

Required: 1. Assuming the present value of the lease payments is $7.2 million and the present value of

the 10 loan payments of $550,000 is $4.1 million, determine which alternative Jordon

should choose.

2. Interpretive Question: Your decision in part (1) was based only on financial factors.

What other qualitative issues might influence your decision?

PROBLEM 9-3 ACQUISITION OF AN ASSET

Pacific Printing Company purchased a new printing press. The invoice price was $158,500. The

company paid for the press within 30 days, so it was allowed a 3% discount. The freight cost

for delivering the press was $2,500. A premium of $900 was paid for a special insurance policy

to cover the transportation of the press. The company spent $2,800 to install the press and an

additional $400 in start-up costs to get the press ready for regular production.

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1. At what amount should the press be recorded as an asset?

Required:

2. What additional information must be known before the depreciation expense for the first

year of operation of the new press can be computed?

3. Interpretive Question: What criterion is used to determine whether the start-up costs of

$400 are included in the cost of the asset? Explain.

ACCOUNTING FOR LEASED ASSETS

PROBLEM 9-4

On January 2, 2003, Cameron Company contracted to lease a computer on a noncancelable ba-

sis for five years at an annual rental of $63,000, payable at the end of each year. The computer

has an estimated economic life of six years. There is no bargain purchase option, and the com-

puter will be returned to the lessor at the end of the five-year term of the lease. At the begin-

ning of the lease, the computer has a fair market value of $240,000, and the present value of

the lease payments equals $238,820.

Required: 1. Is this a capital lease or an operating lease? Explain.

2. Assuming that the lease is an operating lease, prepare the journal entries for Cameron

Company for 2003.

3. Assuming that the lease is a capital lease, prepare the journal entries for Cameron Com-

pany for 2003. Assume the lease payment at the end of 2003 includes interest of

$23,882.

PROBLEM 9-5 ACCOUNTING FOR LEASED ASSETS

The board of directors of Swogen Company authorized the president to lease a corporate jet to

facilitate her travels to domestic and international subsidiaries of the company. After extensive

investigation of the alternatives, the company agreed to lease a jet for $300,548 each year for

five years, payable at the end of each year. Title to the jet will pass to Swogen Company at the

end of five years with no further payments required. The lease agreement starts on January 2,

2003. The jet has an economic life of eight years. The lease contract is noncancelable and con-

tains an interest rate of 8%, resulting in a present value of the lease payments of $1,200,000 as

of January 2, 2003.

Required: 1. Does this lease contract meet the requirements to be accounted for as a capital lease?

Why or why not?

2. Assuming that the lease contract is to be accounted for as a capital lease, prepare the

journal entries for Swogen Company for 2003. Interest included in the first payment is

$96,000.

PROBLEM 9-6 INTEREST CAPITALIZATION

Jennifer Cosmetics wants to construct a new building. It has three building options, as follows:

a. Hire a contractor to do all the work. Jennifer has a bid of $850,000 from a reputable

contractor to complete the project.

b. Construct the building itself by taking out a construction loan of $800,000. Using this

alternative, Jennifer believes materials and labor will cost $800,000, and interest on the

construction loan will be calculated as follows:

$200,000 @ 12% for 9 months

$300,000 @ 12% for 6 months

$200,000 @ 12% for 3 months

$100,000 @ 12% for 1 month

Required: 1. What will be the recorded cost of the building under each alternative?

2. Assuming the building is depreciated over a 20-year period using straight-line deprecia-

tion with no salvage value, how much is the annual depreciation expense under each al-

ternative?

PROBLEM 9-7 DEPRECIATION CALCULATIONS

On January 1, VICOM Company purchased a $68,000 machine. The estimated life of the ma-

chine was five years, and the estimated salvage value was $5,000. The machine had an estimated

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useful life in productive output of 75,000 units. Actual output for the first two years was: year

1, 20,000 units; year 2, 15,000 units.

Required: 1. Compute the amount of depreciation expense for the first year, using each of the follow-

ing methods:

a. Straight-line.

b. Units-of-production.

2. What was the book value of the machine at the end of the first year, assuming that

straight-line depreciation was used?

3. If the machine is sold at the end of the fourth year for $15,000, how much should the

company report as a gain or loss (assuming straight-line depreciation)?

PROBLEM 9-8 PURCHASE OF MULTIPLE ASSETS FOR A SINGLE SUM

On April 1, 2003, Mission Company paid $360,000 in cash to purchase land, a building, and

equipment. The appraised fair market values of the assets were as follows: land, $90,000; build-

ing, $260,000; and equipment, $50,000. The company incurred legal fees of $3,000 to deter-

mine that it would have a clear title to the land. Before the facilities could be used, Mission had

to spend $2,500 to grade and landscape the land, $4,000 to put the equipment in working or-

der, and $15,000 to renovate the building. The equipment was then estimated to have a useful

life of six years with no salvage value, and the building would have a useful life of 20 years with

a net salvage value of $15,000. Both the equipment and the building are to be depreciated on

a straight-line basis. The company is on a calendar-year reporting basis.

1. Allocate the single purchase price to the individual assets acquired.

Required:

2. Prepare the journal entry to acquire the land, building, and equipment.

3. Prepare the journal entry to record the title search, landscape, put the equipment in

working order, and renovate the building.

4. Prepare the journal entries on December 31, 2003, to record the depreciation on the

building and the equipment.

PROBLEM 9-9 BASKET PURCHASE AND PARTIAL-YEAR DEPRECIATION

On April 1, 2003, Rosenberg Company purchased for $200,000 a tract of land on which was lo-

cated a fully equipped factory. The following information was compiled regarding this purchase:

Market Seller s

Value Book Value

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 75,000 $ 30,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100,000 75,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 60,000

Totals . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $225,000 $165,000

1. Prepare the journal entry to record the purchase of these assets.

Required:

2. Assume that the building is depreciated on a straight-line basis over a remaining life of

20 years and the equipment is depreciated on a straight-line basis over five years. Neither

the building nor the equipment is expected to have any salvage value. Compute the de-

preciation expense for 2003 assuming the assets were placed in service immediately upon

acquisition.

PROBLEM 9-10 ACQUISITION, DEPRECIATION, AND SALE OF AN ASSET

On January 2, 2001, Union Oil Company purchased a new airplane. The following costs are

related to the purchase:

Airplane, base price . . . . . . . . . . . . . $112,000

Cash discount . . . . . . . . . . . . . . . . . 3,000

Sales tax . . . . . . . . . . . . . . . . . . . . . 4,000

Delivery charges . . . . . . . . . . . . . . . 1,000

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1. Prepare the journal entry to record the payment of these items on January 2, 2001.

Required:

2. Ignore your answer to part 1 and assume that the airplane cost $90,000 and has an ex-

pected useful life of five years or 1,500 hours. The estimated salvage value is $3,000. Us-

ing units-of-production depreciation and assuming that 300 hours are flown in 2002, cal-

culate the amount of depreciation expense to be recorded for the second year.

3. Ignore the information in parts 1 and 2 and assume that the airplane costs $90,000, that

its expected useful life is five years, and that its estimated salvage value is $5,000. The

company now uses the straight-line depreciation method. On January 1, 2004, the fol-

lowing balances are in the related accounts:

Airplane . . . . . . . . . . . . . . . . . . . . . . . . . . $90,000

Accumulated Depreciation, Airplane . . . . . 51,000

Prepare the necessary journal entries to record the sale of this airplane on July 1, 2004, for

$40,000.

PROBLEM 9-11 ACQUISITION, DEPRECIATION, AND SALE OF AN ASSET

On July 1, 2003, Philip Ward bought a used pickup truck at a cost of $5,300 for use in his

business. On the same day, Ward had the truck painted blue and white (his company s colors)

at a cost of $800. Mr. Ward estimates the life of the truck to be three years or 40,000 miles.

He further estimates that the truck will have a $450 scrap value at the end of its life, but that

it will also cost him $50 to transfer the truck to the junkyard.

1. Record the following journal entries:

Required:

a. July 1, 2003: Paid all bills pertaining to the truck. (No previous entries have been

recorded concerning these bills.)

b. December 31, 2003: The depreciation expense for the year, using the straight-line

method.

c. December 31, 2004: The depreciation expense for 2004, again using the straight-line

method.

d. January 2, 2005: Sold the truck for $2,600 cash.

2. What would the depreciation expense for 2003 have been if the truck had been driven

8,000 miles and the units-of-production method of depreciation had been used?

3. Interpretive Question: In part 1(d), there is a loss of $650. Why did this loss occur?

PROBLEM 9-12 ACCOUNTING FOR NATURAL RESOURCES

On April 30, 2001, Lindon Oil Company purchased an oil well, with estimated reserves of

100,000 barrels of oil, for $1 million cash.

Prepare journal entries for the following:

Required:

1. Record the purchase of the oil well.

2. During 2001, 10,000 barrels of oil were extracted from the well. Record the depletion

expense for 2001.

3. During 2002, 18,000 barrels of oil were extracted from the well. Record the depletion

expense for 2002.

PROBLEM 9-13 ASSET IMPAIRMENT

Delta Company owns plant and equipment on the island of Lagos. The cost and book value of

the building are $2,800,000 and $2,400,000, respectively. Until this year, the market value of

the factory was $7 million. However, a new dictator just came to power and declared martial

law. As a result of the changed political status, the future cash inflows from the use of the fac-

tory are expected to be greatly reduced. Delta now believes that the output from the factory will

generate cash inflows of $100,000 per year for the next 20 years. In addition, the market value

of the factory building is now just $1,300,000. Delta is not sure how to account for the sud-

den impairment in value.

1. Explain how to decide whether an impairment loss is to be recognized.

Required:

2. Prepare the necessary journal entry, if any, to account for an impairment in the value of

the factory.

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PROBLEM 9-14 ACCOUNTING FOR INTANGIBLE ASSETS (GOODWILL)

On January 1, 2003, Universal Company purchased the following assets and liabilities from

Grand Company for $250,000:

Book Fair Market

Value Value

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,000 $ 50,000

Building . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000 100,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 60,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 20,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (10,000) (10,000)

Required: 1. Prepare a journal entry to record the purchase of Grand by Universal.

2. Record amortization of goodwill as of December 31, 2003. (Assume a 40-year amortiza-

tion period for the goodwill.)

PROBLEM 9-15 ACCOUNTING FOR GOODWILL

On January 1, 2003, Fishing Creek Company purchased Skull Valley Technologies for

$8,800,000 cash. The book value and fair value of Skull Valley s assets as of the date of the ac-

quisition are listed below:

Book Market

Value Value

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100,000 $ 100,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 500,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000 1,200,000

Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500,000 1,900,000

Trademark . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0 2,000,000

Totals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,050,000 $5,700,000

In addition, Skull Valley had liabilities totaling $4,000,000 at the time of the acquisition.

1. At what amount will Skull Valley s trademark be recorded on the books of Fishing

Required:

Creek, the acquiring company?

2. How much goodwill will be recorded as part of this acquisition?

3. How much goodwill amortization expense will Fishing Creek recognize in 2003? What

assumptions are necessary to answer this question?

4. Interpretive Question: What was Skull Valley s recorded stockholders equity immedi-

ately before the acquisition? Under what circumstances does stockholders equity yield a

poor measure of the fair value of a company?

PROBLEM 9-16 FIXED ASSET TURNOVER RATIO

Waystation Company reported the following asset values in 2002 and 2003:

2003 2002

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000 $ 30,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 400,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000 500,000

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 200,000

Buildings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000 600,000

Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000 300,000

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In addition, Waystation had sales of $4,000,000 in 2003. Cost of goods sold for the year was

$2,500,000.

As of the end of 2002, the fair value of Waystation s total assets was $2,500,000. Of the

excess of fair value over book value, $50,000 resulted because the fair value of Waystation s in-

ventory was greater than its recorded book value. As of the end of 2003, the fair value of Waysta-

tion s total assets was $3,500,000. As of December 31, 2003, the fair value of Waystation s in-

ventory was $100,000 greater than the inventory s recorded book value.

1. Compute Waystation s fixed asset turnover ratio for 2003.

Required:

2. Using the fair value of fixed assets instead of the book value of fixed assets, recompute

Waystation s fixed asset turnover ratio for 2003. State any assumptions that you make.

3. Interpretive Question: Waystation s primary competitor is Handy Corner. Handy Cor-

ner s fixed asset turnover ratio for 2003, based on publicly available information, is 2.8

times. Is Waystation more or less efficient at using its fixed assets than is Handy Corner?

Explain your answer.

PROBLEM 9-17 DEPRECIATION CALCULATIONS

Springs Hardware Company has a giant paint mixer that cost $31,500 plus $400 to install. The

estimated salvage value of the paint mixer at the end of its useful life in 15 years is estimated to

be $1,900. Springs estimates that the machine can mix 850,000 cans of paint during its life-

time.

Required: Compute the second full year s depreciation expense, using the following methods:

1. Double-declining-balance.

2. Sum-of-the-years -digits.

PROBLEM 9-18 DEPRECIATION CALCULATIONS

On January 1, Top Flight Company purchased a $68,000 machine. The estimated life of the

machine was five years, and the estimated salvage value was $5,000. The machine had an esti-

mated useful life in productive output of 75,000 units. Actual output for the first two years was:

year 1, 20,000 units; year 2, 15,000 units.

Required: 1. Compute the amount of depreciation expense for the first year, using each of the follow-

ing methods:

a. Straight-line.

b. Units-of-production.

c. Sum-of-the-years -digits.

d. Double-declining-balance.

2. What was the book value of the machine at the end of the first year, assuming that

straight-line depreciation was used?

3. If the machine is sold at the end of the fourth year for $15,000, how much should the

company report as a gain or loss (assuming straight-line depreciation)?

PROBLEM 9-19 FINANCIAL STATEMENT EFFECTS OF DEPRECIATION

METHODS

On July 1, 2002, the consulting firm of Little, Smart, and Quick bought a new computer for

$120,000 to help it service its clients more efficiently. The new computer was estimated to have

a useful life of five years with an estimated salvage value of $20,000 at the end of five years. It

was further estimated that the computer would be in operation about 1,500 hours in each of

the five years with some variation of use from year to year. Janet Little, who manages the firm s

internal operations, has asked you to help her decide which depreciation method should be se-

lected for the new computer. The methods being considered are straight-line, double-declining-

balance, and sum-of-the-years -digits.

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1. Prepare a schedule showing depreciation for 2002, 2003, and 2004 for each of the three

Required:

methods being considered.

2. For each of the three methods, compute the asset book value that would be reported on

the balance sheet at December 31, 2004.

3. Interpretive Question: Which method would maximize income for the three years

(2002 2004), and which would minimize income for the same period?

PROBLEM 9-20 DEPRECIATION CALCULATIONS

Curtis, Inc., a firm that makes oversized boots, purchased a machine for its factory. The fol-

lowing data relate to the machine:

Price . . . . . . . . . . . . . . . . . . . . . $16,000

Delivery charges . . . . . . . . . . . . $200

Installation charges. . . . . . . . . . $600

Date purchased. . . . . . . . . . . . . May 1, 2002

Estimated useful life:

In years . . . . . . . . . . . . . . . . . 8 years

In hours of production. . . . . . 30,000 hours of

operating time

Salvage value . . . . . . . . . . . . . . $1,800

During 2002, the machine was used 4,400 hours. During 2003, the machine was used 3,200

hours.

Determine the depreciation expense and the year-end book values for the machine for the years

Required:

2002 and 2003, assuming that:

1. The straight-line method is used.

2. The double-declining-balance method is used.

3. The units-of-production method is used.

4. The sum-of-the-years -digits method is used.

5. Interpretive Question: If you were Curtis, which method would you use in order to re-

port the highest profits in 2002 and 2003 combined?

PROBLEM 9-21 CHANGES IN DEPRECIATION ESTIMATES AND

CAPITALIZATION OF EXPENDITURES

Ironic Metal Products, Inc., acquired a machine on January 2, 2001, for $76,600. The useful

life of the machine was estimated to be eight years with a salvage value of $4,600. Depreciation

is recorded on December 31 of each year using the sum-of-the-years -digits method.

At the beginning of 2003, the company estimated the remaining useful life of the machine

to be four years and changed the estimated salvage value from $4,600 to $2,600. On January

2, 2004, major repairs on the machine cost the company $34,000. The repairs added two years

to the machine s useful life and increased the salvage value to $3,000.

Required: 1. Prepare journal entries to record:

a. The purchase of the machine.

b. Annual depreciation expense for the years 2001 and 2002.

c. Depreciation in 2003 under the revised estimates of useful life and salvage value.

d. The expenditure for major repairs in 2004.

e. Depreciation expense for 2004.

2. Compute the book value of the machine at the end of 2004.

PROBLEM 9-22 UNIFYING CONCEPTS: ACCOUNTING FOR NATURAL

RESOURCES

Forest Products, Inc., buys and develops natural resources for profit. Since 2000, it has had the

following activities:

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1/1/00 Purchased for $800,000 a tract of timber estimated to contain 1,600,000 board feet of

lumber.

1/1/01 Purchased for $600,000 a silver mine estimated to contain 30,000 tons of silver ore.

7/1/01 Purchased for $60,000 a uranium mine estimated to contain 5,000 tons of uranium ore.

1/1/02 Purchased for $500,000 an oil well estimated to contain 100,000 barrels of oil.

1. Provide the necessary journal entries to account for the following:

Required:

a. The purchase of these assets.

b. The depletion expense for 2002 on all four assets, assuming that the following were

extracted:

(1) 200,000 board feet of lumber.

(2) 5,000 tons of silver.

(3) 1,000 tons of uranium.

(4) 10,000 barrels of oil.

2. Assume that on January 1, 2003, after 20,000 tons of silver had been mined, engineers

estimates revealed that only 4,000 tons of silver remained. Record the depletion expense

for 2003, assuming that 2,000 tons were mined.

3. Compute the book values of all four assets as of December 31, 2003, assuming that the

total extracted to date is:

a. Timber tract, 800,000 board feet.

b. Silver mine, 22,000 tons [only 2,000 tons are left per (2)].

c. Uranium mine, 3,000 tons.

d. Oil well, 80,000 barrels.

PROBLEM 9-23 UNIFYING CONCEPTS: PROPERTY, PLANT, AND EQUIPMENT

Smithfield Corportation owns and operates three sawmills that make lumber for building homes.

The operations consist of cutting logs in the forest, hauling them to the various sawmills, saw-

ing the lumber, and shipping it to building supply warehouses throughout the western part of

the United States. To haul the logs, Smithfield has several trucks. Relevant data pertaining to

one truck are:

a. Date of purchase, July 1, 2001.

b. Cost:

Truck . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000

Trailer . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Paint job (to match company colors) . . . . . 1,500

Sales tax . . . . . . . . . . . . . . . . . . . . . . . . . . 3,500

c. Estimated useful life of the truck, 150,000 miles.

d. Estimated salvage value, zero.

e. 2002 expenditures on truck:

(1) Spent $5,000 on tires, oil changes, greasing, and other miscellaneous items.

(2) Spent $22,000 to overhaul the engine and replace the transmission on January 1,

2002. This expenditure increased the life of the truck by 135,000 miles.

Record journal entries to account for:

Required:

1. The purchase of the truck.

2. The 2001 depreciation expense using units-of-production depreciation and assuming the

truck was driven 45,000 miles.

3. The expenditures relating to the truck during 2002.

4. The 2002 depreciation expense using the units-of-production method and assuming the

truck was driven 60,000 miles.

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Part 3 CEO Financing Activities

competency enhancement opportunities

LLL

LLLL

Analyzing Real Company Information The Debate

International Case Cumulative Spreadsheet Project

Ethics Case Internet Search

Writing Assignment

The following additional assignments provide opportunities for students to de-

velop critical thinking, ethical perspectives, oral and written communication

skills, experience with electronic research, and teamwork through group and

business activities.

L

ANALYZING REAL COMPANY INFORMATION

Analyzing 9-1 (Microsoft)

Using MICROSOFT s 1999 annual report contained in Appendix A, answer the

following questions:

1. As a percentage of total assets, is Microsoft s investment in property, plant,

and equipment increasing or decreasing over time? Which of Microsoft s

assets is increasing the fastest as a percentage of total assets? What does

that indicate Microsoft is doing?

2. Reference the notes to the financial statements. Which depreciation method

does Microsoft use? Estimate the average useful life of Microsoft s depre-

ciable assets (i.e., not including land) by dividing the ending balance in the

depreciable asset accounts by the depreciation expense for the year. Does

the resulting estimated useful life seem reasonable?

3. Microsoft notes in its statement of cash flows that $583 million of prop-

erty, plant, and equipment was purchased in 1999. Using that informa-

tion along with the detailed information from the notes, compute (a) the

original cost of the equipment disposed of during 1999 and (b) the ac-

cumulated depreciation associated with that equipment. (HINT: For prop-

erty, plant, and equipment, beginning balance purchases disposals

ending balance; a similar calculation is used for accumulated depre-

ciation.)

Analyzing 9-2 (FedEx)

FEDEX delivers packages around the world. To accomplish this task, FedEx has

made huge investments in long-term assets.

1. Identify what you consider to be the major long-term assets of FedEx. Re-

view the information shown at the top of the next page from FedEx s bal-

ance sheet (numbers are in thousands) to see how well you did.

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Investments And Equipment And In Intangible Assets CEO Chapter 9

2000 1999

Property and Equipment, at Cost (Notes 1, 3, 4 and 12):

Flight equipment $ 4,960,204 $ 4,556,747

Package handling and ground support equipment 3,430,316 3,193,620

Computer and electronic equipment 2,088,510 2,114,492

Other 2,479,540 2,332,227

$12,958,570 $12,197,086

Less accumulated depreciation and amortization 6,846,647 6,454,579

Net property and equipment $ 6,111,923 $ 5,742,507

2. FedEx uses the straight-line depreciation method in depreciating most of

its assets. For each major category flight equipment, package handling

and ground support equipment (mainly trucks and buildings), and com-

puter and electronic equipment provide an estimate (or a range) as to

what you would deem a reasonable useful life for each category.

3. Using the information above, compute the accumulated depreciation as-

sociated with the property and equipment sold during 2000 given that de-

preciation for the year was $997,735,000.

4. FedEx reports a balance of $328 million in its goodwill account at the end

of 2000. In the notes to its annual report, the company reported amortiza-

tion for the period of $11.7 million. Given that the company uses the

straight-line method for amortizing its intangible assets, compute the ap-

proximate number of years left for amortizing goodwill.

Analyzing 9-3 (U.S. Steel)

1. U.S. STEEL provides the following information in the notes to its financial

statements relating to its use of the straight-line method of depreciation.

Can you interpret the information contained in the note?

Long-lived assets Depreciation is generally computed us-

ing a modified straight-line method based upon estimated

lives of assets and production levels. The modification fac-

tors range from a minimum of 85% at a production level

below 81% of capability, to a maximum of 105% for a 100%

production level. No modification is made at the 95% pro-

duction level, considered the normal long-range level.

2. U.S. Steel also provides information relating to the balances in its individ-

ual property, plant and equipment accounts, as shown at the top of the

next page. In very general terms, how old is the company s property, plant,

and equipment? Provide support for your answer.

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Part 3 CEO Financing Activities

18. Property, Plant and Equipment

December 31

(In millions) 1999 1998

Land and depletable property . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 152 $ 151

Buildings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 484 469

Machinery and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,007 7,711

Leased assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 105 108

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,748 $8,439

Less accumulated depreciation,

depletion and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,232 5,939

Net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,516 $2,500

L

INTERNATIONAL CASE

Cadbury Schweppes

CADBURY SCHWEPPES is a company based in the United Kingdom. You can

probably guess some of the company s products from its name. The company

produces Cadbury chocolates and Schweppes tonic water, among other things.

But the company also owns the brands Dr. Pepper, A&W, 7 Up, and Crush. The

company licenses these brands to distributors around the world.

Although most accounting rules in the United Kingdom are similar to those

used in the United States, there are some differences. For example, companies

in the United Kingdom are allowed to revalue their property, plant, and equip-

ment upward based on the appraisals of experts. Cadbury Schweppes notes

in its 1996 annual report that assets are revalued every five years and that,

The Group properties were professionally revalued at 30 September 1995.

Information contained in the company s notes indicates that the company s

land and buildings had an appraised value of 392 million British pounds and

a book value of 314 million British pounds.

1. Can you compose the journal entry made by Cadbury Schweppes accoun-

tants to write the assets up in value? What would be the credit portion of

the journal entry? (HINT: Although you may not know the exact answer,

think about it and make an educated guess. Would the credit be to another

asset account? Would it be to a liability account?)

2. Suppose that in the next year, the assets were again revalued and it was

determined that a difference existed between market value and book value

of only 70 million British pounds. How would this year s journal entry dif-

fer from the previous year s?

L

ETHICS CASE

Strategic Accounting Method Choices

You saw in Chapter 6 that a company s management selects the percentage

to be used when computing bad debt expense. You noted in Chapter 7 that

management is allowed to choose the method for valuing inventory. In this

chapter you found that management gets to choose the method used for de-

preciating assets, the estimated salvage value, and the estimated useful life.

Suppose that you are involved in negotiations with the local labor union

regarding wages for your company s employees. Labor leaders are asking that

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Investments And Equipment And In Intangible Assets CEO Chapter 9

their members be given an average annual raise of 12%. The company presi-

dent has asked you to prepare a set of financial statements that portrays the

company s performance as being mediocre at best. The president also makes

it clear that she does not want you to prepare fraudulent financial statements.

All estimates must be within the bounds of reason.

So you come up with the following:

Change the percentage used for estimating bad debts from 1.5% to 2%.

Elect to use the LIFO method for valuing inventory because the prices as-

sociated with inventory have been rising.

Change the average estimated salvage value of long-term assets from 15%

to 10% of historical cost.

Change the depreciation method from straight-line to an accelerated

method.

Change the average estimated useful life of long-term assets from 10 years

to 7 years.

As you know, each of these changes will result in net income being lower.

Each of these changes is also still within the bounds of reason required by the

company president.

1. Would it be appropriate to make the changes described above in order to

obtain favorable terms from the labor union negotiators?

2. If the above changes are made, what sort of disclosure do you think should

be required?

L

WRITING ASSIGNMENT

Gains Are Good, Losses Are Bad Right?

When a long-term asset is sold for more than its book value, we record a gain.

When a long-term asset is sold for less than its book value, we record a loss.

Your assignment is to write a two-page memo addressing the following

questions:

1. What factors affect a long-term asset s book value?

2. What factors affect a long-term asset s fair value?

3. Should financial statement users expect an asset s book value to equal its

fair value?

4. In the case of an asset sold for a loss, if we knew when we purchased the

asset what we know at the point of sale, how would depreciation expense

have differed if our objective was to ensure that book value equaled fair

value when the asset was sold?

5. Is recognizing a loss on the sale of a long-term asset a bad thing? Is a gain

good?

L

THE DEBATE

Depreciating an Asset with an Increasing Value

Paul Didericksen owns and operates a limousine service. He purchases luxury

cars and hires drivers to transport people from place to place. Last year, Paul

expanded his operations by renting out luxury vehicles on a daily basis for such

events as weddings, proms, etc. One car Paul purchased for rental is a 1957

FORD Thunderbird. He paid $45,000 for the car and rents it for $250 per day.

Paul s accountant recently provided financial information indicating that the

Thunderbird has a book value of $36,000. Paul questions this figure because

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he recently received an offer of $53,000 for the Thunderbird. Paul thinks that

the car should not be depreciated because its value is increasing. In fact, Paul

argues that the asset should be written up in value rather than down.

Divide your group into two teams and prepare to represent the following

positions:

The first team supports the position that the Thunderbird should be de-

preciated because it is used in generating revenues. You are also to pro-

vide support against writing the asset up to its fair market value.

The second team argues that the Thunderbird should not be depreciated

because its value is increasing rather than decreasing. Also, your group is

to argue that the car should be written up to its fair value on the company s

books.

L

CUMULATIVE SPREADSHEET PROJECT

This spreadsheet project is a continuation of the spreadsheet projects in ear-

lier chapters. If you completed those spreadsheets, you have a head start on

this one.

1. Handyman wishes to prepare a forecasted balance sheet and income state-

ment for 2004. Use the original financial statement numbers for 2003 [given

in part (1) of the Cumulative Spreadsheet Project assignment in Chapter 2]

as the basis for the forecast, along with the following additional informa-

tion:

a. Sales in 2004 are expected to increase by 40% over 2003 sales of $700.

b. Cash will increase at the same rate as sales.

c. The forecasted amount of accounts receivable in 2004 is determined

using the forecasted value for the average collection period. For sim-

plicity, do the computations using the end-of-period accounts receiv-

able balance instead of the average balance. The average collection pe-

riod for 2004 is expected to be 14.08 days.

d. The forecasted amount of inventory in 2004 is determined using the

forecasted value for the number of days sales in inventory (computed

using the end-of-period inventory balance). The number of days sales

in inventory for 2004 is expected to be 107.6 days.

e. The forecasted amount of accounts payable in 2004 is determined us-

ing the forecasted value for the number of days purchases in accounts

payable (computed using the end-of-period accounts payable balance).

The number of days purchases in accounts payable for 2004 is ex-

pected to be 48.34 days.

f. The $160 in operating expenses reported in 2003 breaks down as fol-

lows: $5 depreciation expense, $155 other operating expenses.

g. No new long-term debt will be acquired in 2004.

h. No cash dividends will be paid in 2004.

i. New short-term loans payable will be acquired in an amount sufficient

to make Handyman s current ratio in 2004 exactly equal to 2.0.

Note: These statements were constructed as part of the spreadsheet as-

signment in Chapter 7; you can use that spreadsheet as a starting point if

you have completed that assignment. Clearly state any additional as-

sumptions that you make.

For this exercise, add the following additional assumptions:

j. The forecasted amount of property, plant, and equipment (PP&E) in

2004 is determined using the forecasted value for the fixed asset

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Investments And Equipment And In Intangible Assets CEO Chapter 9

turnover ratio. For simplicity, compute the fixed asset turnover ratio us-

ing the end-of-period gross PP&E balance. The fixed asset turnover ra-

tio for 2004 is expected to be 3.518 times.

k. In computing depreciation expense for 2004, use straight-line depreci-

ation and assume a 30-year useful life with no residual value. Gross

PP&E acquired during the year is only depreciated for half the year. In

other words, depreciation expense for 2004 is the sum of two parts: (1)

a full year of depreciation on the beginning balance in PP&E, assum-

ing a 30-year life and no residual value, and (2) a half-year of depreci-

ation on any new PP&E acquired during the year, based on the change

in the Gross PP&E balance.

Clearly state any additional assumptions that you make.

2. Repeat (1), with the following changes in assumptions:

a. Fixed asset turnover ratio is expected to be 6.000 times.

b. Fixed asset turnover ratio is expected to be 2.000 times.

3. Comment on the differences in the forecasted values of the following items

in 2004 under each of the following assumptions about the fixed asset

turnover ratio: 3.518 times, 6.000 times, and 2.000 times:

a. Property, plant, and equipment.

b. Depreciation expense.

c. Income tax expense.

d. Paid-in capital.

4. Return the fixed asset turnover ratio to 3.518 times. Now, repeat (1), with

the following changes in assumptions:

a. Estimated useful life is expected to be 15 years.

b. Estimated useful life is expected to be 60 years.

5. Comment on the differences in the forecasted values of the following items

in 2004 under each of the following assumptions about the estimated use-

ful life of property, plant, and equipment: 30 years, 15 years, and 60 years.

a. Depreciation expense.

b. Income tax expense.

L

INTERNET SEARCH

General Electric

We began this chapter with a review of the history of GENERAL ELECTRIC.

Let s go to GE s Web site at http://www.ge.com and learn a little more about

the company and its financial position. Sometimes Web addresses change, so

if this address doesn t work, access the Web site for this textbook (http://

albrecht.swcollege.com) for an updated link to GE.

Once you have gained access to General Electric s Web site, answer the

following questions:

1. General Electric was formed in 1892 and constructed the nation s first in-

dustrial research laboratory In 1900. Can you identify where this laboratory

was located?

2. Locate the company s most recent balance sheet. What percentage of to-

tal assets does property, plant, and equipment represent for General Elec-

tric? Is that percentage increasing, decreasing, or remaining constant?

3. Access the notes to the financial statements. What depreciation method does

General Electric use for most of its manufacturing plant and equipment?

4. Find the note relating specifically to property, plant, and equipment. What

types of property, plant, and equipment does General Electric own? Is GE

involved strictly in producing light bulbs?

Long-Term

Debt Financing

chapter

10

f10

learning objectives After studying this chapter, you should be able to:

leases being excluded from

1 Use present value concepts the balance sheet.

to measure long-term

liabilities.

4 Account for bonds, including

6 Amortize bond discounts

the original issuance, the

2 Account for long-term

and bond premiums using

payment of interest, and the

liabilities, including notes

either the straight-line

retirement of bonds.

payable and mortgages

method or the effective-

payable.

5 Use debt-related financial interest method.

ratios to determine the

3 Account for capital lease degree of a company s

obligations and understand

financial leverage and its

the significance of operating

ability to repay loans.

454 chapter f10

Long-Term Debt Financing

In 1923, two brothers, Walt and Roy Dis- Disneylands in Anaheim, California; Paris;

ney, founded the DISNEY BROTHERS STU- and Tokyo. In November 2000, Disney was

DIO as a partnership to produce animated even scheduled to open an indoor theme

features for film. Five years later, the Dis- park, DisneyQuest, in Chicago.

ney Brothers Studio released its first ani- Disney s company has expanded far

mated film with sound effects and dia- beyond what even he could have foreseen.

logue, Steamboat Willie, featuring a THE WALT DISNEY COMPANY is now in-

soon-to-become-famous mouse, Mickey. volved in television and radio stations; in-

Pluto was introduced to American audi- ternational film distribution; home video

ences in 1930, and Goofy was created just production; live theatrical entertainment;

two years later. Walt Disney earned his online computer programs; interactive

first Academy Award in 1932 with the re- computer games; telephone company

lease of Flowers and Trees, the first full- partnerships; cruise lines; Disney Stores;

color animated film. Donald Duck ap- newspaper, magazine, and book publish-

setting the stage

peared on the scene in 1934, and in 1937 ing; Internet marketing; and the conven-

Snow White and the Seven Dwarfs was re- tion business. In the past decade, The Walt

leased, accompanied by the first compre- Disney Company has grown over 600%.

hensive merchandising campaign. How has the company financed this

But Walt Disney s vision encompassed growth? In part through very successful

more than animated films. In 1952, Disney operations, but these have not been

began designing and creating Disneyland, enough. The company has also borrowed

which opened on July 17, 1955. Beginning to finance its expansion. As of September

in the late 1950s, the television shows Dis- 30, 1999, The Walt Disney Company had

neyland (which ran for 29 seasons under long-term debt totaling over $9 billion.

various names) and The Mickey Mouse This long-term financing includes lines of

Club were also successful Disney ventures. credits with U.S. banks as well as loans de-

Though Walt Disney passed away in 1966, nominated (or made) in Japanese yen and

his influence is still felt around the world. Italian lira. The effective interest rates on

Disney s loans range from 2.7 to 6.4%.1

We have Walt Disney World in Florida and

How does the market determine the appropriate rate of interest that Disney, or any company, must

pay when it borrows money? What factors affect interest rates, and how do interest rate changes in-

fluence the value of a liability? What other types of liabilities are affected by interest rates? In this

net work chapter, we will introduce various types of long-term liabilities. We will explain a concept used in

measuring the present value of an obligation due in the future. This concept the time value of

Speaking of debt, let s take

a look at our government s money is useful for computing the value of bonds and notes, as in the Disney example, as well as

debt situation. To see what

for computing mortgage payments and pension obligations. In the main part of this chapter, we dis-

the national debt is to the

cuss the measurement of long-term liabilities and introduce numerous types of long-term liabilities

penny, go to

http://www.publicdebt. notes, mortgages, leases, and bonds. The basic accounting procedures associated with several of these

treas.gov/opd/opd.htm.

liabilities are also discussed. In the expanded material, the complexities associated with the amorti-

What was the national debt

zation of a bond issued at a premium or discount are discussed. Exhibit 10-1 highlights the finan-

100 years ago? 200 years

ago? cial statement accounts discussed in this chapter.

MEASURING LONG-TERM LIABILITIES

Conceptually, the value of a liability is the cash that would be required to pay the liability in

1 full today. Because money has a time value, most people are willing to accept less money today

Use present value concepts

than they would if a liability were paid in the future. Therefore, with the exception of Accounts

to measure long-term

Payable, liabilities to be paid in the future usually involve interest.

liabilities.

1 The information for this scenario was obtained from Disney s Web site at http://www.disney.com.

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f456 Part 3 Long-Term Debt Financing

Investing and Financing Activities

Financial Statement Items Discussed in This Chapter

exhibit 10-1

Statement of

Balance Sheet Cash Flows

Operating activities

Long-term liabilities

Payments for

Long-term debt

interest

Financing activities

Proceeds from

borrowing

Repayments of

borrowing

Income

Statement

Other revenues

and expenses

Interest expense

Accounting for long-term liabilities is complex because usually payments of interest, or in

long-term liabilities Debts

or other obligations that some cases principal and interest, are made periodically over the period in which the liability is

will not be paid within one

outstanding. Further, in some cases the amount of the liability in a noncash transaction may

year.

not be readily apparent. The time value of money concept is used in measuring and recording

these liabilities.

Present Value and Future Value Concepts

The concepts of present value and future value are used to measure the effect of time on the

value of money. To illustrate, if you are to receive $100 one year from today, is it worth $100

today? Obviously not, because if you had the $100 today you could either use it now or invest

it and earn interest. If the $100 isn t to be received for one year, those options are not available.

The present value of $1 is the value today of $1 to be received or paid in the future, given a

present value of $1 The

value today of $1 to be re- specified interest rate. To determine the value today of money to be received or paid in the fu-

ceived or paid at some fu-

ture, we must discount the future amount (reduce the amount to its present value) by an ap-

ture date, given a specified

propriate interest rate. For example, if money can earn 10% per year, $100 to be received one

interest rate.

year from now is approximately equal to $90.91 received today.

Putting it another way, if $90.91 is invested today in an account that earns 10% interest

for one year, the interest earned will be $9.09 ($90.91 10% 1 year $9.09). The sum of

the $90.91 principal and the $9.09 interest will equal $100 at the end of one year. Thus, the

present value of $100 to be received (or paid) in one year with 10% interest is $90.91. This

present value relationship can be diagrammed as follows:

Present Value Future Amount

(Computed) (Known)

$90.91 $100

(One-Year Period @ 10%)

$90.91 is the present value of the $100 future amount.

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The relationships in this diagram can be described in two ways. We have just seen that the

$90.91 is the present value of $100 to be received one year from now when interest is 10%. In

this example, the $100 to be received one year from now is known, and the present value of

$90.91 must be computed. We are computing a present value amount from a known future

value amount.

Another way to look at the relationship is on a future value basis. Future values apply when

the amount today ($90.91) is known, and the future amount must be calculated. Future values

are exactly the opposite of present values. Thinking in terms of future values, $100 is the future

amount we can expect to receive in one year, given a present known amount of $90.91 when

the interest rate is 10%. We can diagram this relationship as follows:

Present Value Future Amount

(Known) (Computed)

$90.91 $100

(One-Year Period @ 10%)

$100 is the future value of the $90.91 present value.

Present and future values can be calculated using formulas. If more than one period is in-

volved, however, the formula is exponential, and the calculations become rather complicated.

Therefore, it is more convenient to use either a present value table or a calculator that gives the

present value of $1 for various numbers of periods and interest rates (see Table I, page 483) or

a future value table that gives the future value of $1 for various numbers of periods and inter-

est rates (see Table III, page 485). We will illustrate the use of both a present value table and a

future value table as well as the keystrokes needed when using a standard business calculator.

To use a present value

COMPUTING THE PRESENT VALUE OF A SINGLE AMOUNT

table, you simply locate the appropriate number of periods in the leftmost column and the inter-

est rate in the row at the top of the table. The intersection of the row and column is the factor

representing the present value of $1 for the number of periods and the relevant interest rate. To

find the present value of an amount other than $1, multiply the factor in the table by that amount.

To illustrate the use of a present value table (Table I) to find the present value of a known

future amount, assume that $10,000 is to be paid four years from today when the interest rate

is 10%. What is the present value of the $10,000 payment?

Amount of payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Present value factor of $1 to be paid in 4 periods

at 10% interest (from Table I) . . . . . . . . . . . . . . . . . . . . . . . . . . 0.6830

Present value of payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,830

This present value amount, $6,830, is the amount that could be paid today to satisfy the

obligation that is due four years from now. As indicated, this procedure is sometimes referred

to as discounting. Thus, we say that $10,000 discounted for four years at 10% is $6,830.

Stated another way, if $6,830 is invested today in an account that pays 10% interest, in four

years the balance in that account will be $10,000.

Another way to compute this same amount is to use a business calculator. The keystrokes

described below are for a Hewlett-Packard 10B business calculator; similar keystrokes are used

with other business calculators. To compute the present value of $10,000 to be received four

years from today, with a prevailing interest rate of 10%, make the following keystrokes:

Hewlett-Packard Keystrokes:

a. Always CLEAR ALL before doing anything else. With a Hewlett-Packard 10B, one

does this by pressing the yellow key, then pressing Input. This has the effect of

clearing out any information left over from a prior computation.

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b. Always set P/YR (payments per year) to the correct number 1 in this case. With

a Hewlett-Packard 10B, one does this by pressing 1, then pressing the yellow key,

then pressing PMT. This has the effect of telling the calculator that each year is be-

ing viewed as a separate period. As described later in this chapter, interest can be com-

pounded over different periods, such as monthly, quarterly, daily, or even continu-

ously. Setting P/YR equal to 1 means that the interest rate is compounded annually.

Sometimes, the default for this amount is 12 because the calculator is set to com-

pute monthly payments. Until you are comfortable using your calculator, your best

strategy is to set this amount to 1 to avoid having the calculator doing too many

mysterious things automatically.

1. 10,000 Press FV.

2. 4 Press N.

3. 10 Press I/YR.

4. Press PV for the answer of $6,830.13.

COMPUTING THE FUTURE VALUE OF A SINGLE AMOUNT To find the future value

of an amount that is known today, use a future value table. When using a future value table,

simply locate the appropriate number of periods in the leftmost column and the interest rate

in the row at the top of the table. The intersection of the row and column is the factor rep-

resenting the future value of $1 for the number of periods and the relevant interest rate. To

find the future value of an amount other than $1, multiply the factor in the table by that

amount.

To illustrate the use of a future value table (Table III), we will use the same information as

before, except that we will now assume that the present value of $6,830 is known, not the fu-

ture amount of $10,000. Assume that we have a savings account with a current balance of $6,830

that earns interest of 10%. What will be the balance in that account in four years?

Present value in savings account . . . . . . . . . . . . . . . . . . . . . . . . $ 6,830*

Future value factor of $1 in 4 periods

at 10% interest (from Table III) . . . . . . . . . . . . . . . . . . . . . . . . . 1.4641*

Future value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000*

*Rounded; other calculations in chapter will also be rounded.

Hewlett-Packard Keystrokes:

a. CLEAR ALL.

b. Set P/YR to 1.

1. 6,830 Press PV.

2. 4 Press N.

3. 10 Press I/YR.

4. Press FV for the answer of $9,999.80.

When computing future values, we often use the term compounding to mean the frequency

with which interest is added to the principal. Thus, we say that interest of 10% has been com-

pounded once a year (annually) to arrive at a future value at the end of four years of $10,000.

If the interest is added more or less frequently than once a year, the future amount will be

different.

The preceding example assumed an annual compounding period for interest. If the 10%

compounding period The

period of time for which in- interest had been compounded semiannually (twice a year) for four years, the calculation would

terest is computed.

have used a 5% (one-half of the 10%) rate for eight periods (4 years 2 periods per year) in-

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stead of 10% for four periods. To illustrate, what is the present value of $10,000 to be paid in

four years if interest of 10% is compounded semiannually?

Amount of payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Present value factor of $1 to be paid in 8 periods

at 5% interest (from Table I) . . . . . . . . . . . . . . . . . . . . . . . . . . 0.6768

Present value of payment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,768

Thus, the present value of $10,000 to be paid in four years is $6,768 if interest is com-

pounded semiannually. Likewise, if semiannual compounding is used to determine the future

value of $6,768 in four years at 10% compounded semiannually, the result is as follows:

Present value in savings account . . . . . . . . . . . . . . . . . . . . . . . . $ 6,768

Future value factor of $1 in 8 periods

at 5% interest (from Table III). . . . . . . . . . . . . . . . . . . . . . . . . . 1.4775

Future value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Note that the present value ($6,768) is lower with semiannual compounding than with an-

nual compounding ($6,830). The more frequently interest is compounded, the greater the to-

tal amount of interest deducted (in computing present values) or added (in computing future

values).

For practice using semiannual compounding with a business calculator, try the following

set of keystrokes:

Hewlett-Packard Keystrokes:

a. CLEAR ALL.

b. Set P/YR to 1. There is a simple way to tell the calculator to automatically compute

the impact of semiannual compounding. Look in your calculator instruction book if

you are interested in knowing how to do this. Alternatively, you can do some of the

calculations yourself (divide the interest rate by two and double the number of peri-

ods) and use the keystrokes below.

1. 6,768 Press PV.

2. 8 Press N.

3. 5 Press I/YR.

4. Press FV for the answer of $9,999.72.

Because interest may also be compounded quarterly, monthly, or for some

Without referencing the

other period, you should learn the relationship of interest to the compounding

present value tables, answer these ques-

period. Semiannual interest means that you double the interest periods and

tions: As interest rates increase, would you

halve the annual interest rate; with quarterly interest, you quadruple the peri-

expect the present value factors to increase ods and take one-fourth of the annual interest rate. The formula for interest

or decrease? Why? rate is:

Interest rate per

Yearly interest rate

compounding period

Compounding periods per year

The number of interest periods is simply the number of periods per year times the num-

ber of years. That formula is:

Compounding Number of Number of

periods per year years interest periods

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f460 Part 3 Long-Term Debt Financing

Investing and Financing Activities

Computing the Present Value of an Annuity

In discussing present values and future values, we have assumed only a single present value or

future value with one of the amounts known and the other to be computed. With liabilities, we

generally know the future amount that must be paid and would like to compute the present

value of that future payment. Because this chapter focuses on liabilities, we will concentrate on

present value calculations.

Many long-term liabilities involve a series of payments rather than one lump-sum payment.

annuity A series of equal

amounts to be received or For example, a company might purchase equipment under an installment agreement requiring

paid at the end of equal payments of $5,000 each year for five years. Determining the value today (present value) of a

time intervals.

series of equally spaced, equal-amount payments (called an annuity) is more complicated than

determining the present value of a single future payment. If you were to try to calculate the pre-

present value of an annuity

The value today of a series sent value of an annuity by hand, you would have to discount the first payment for one pe-

of equally spaced, equal- riod, the second payment for two periods, and so on, and then add all the present values to-

amount payments to be

gether. Because such calculations are time-consuming, a table is generally used (see Table II,

made or received in the fu-

page 484). The factors in the table are the sums of the individual present values of all future

ture given a specified inter-

payments. Based on the present value of an annuity of $1, the table provides factors for various

est rate.

interest rates and number of payments.

To illustrate the use of a present value of an annuity table (Table II), we will assume

caution

that $10,000 is to be paid at the end of each of the next 10 years. This series of payments

Use care when referencing the

is illustrated below:

present value and future value

tables. You can do all your

$10,000

$10,000 $10,000

$10,000

$10,000 $10,000

computations correctly, but if

10 years

4 5

3

1

Now 2

you pull the factor from the

wrong table, your answer will

be wrong.

If the interest rate is 12% compounded annually, Table II shows a present value fac-

tor of 5.6502. This factor means that the present value of $1 paid each year for 10 years

discounted at 12% is approximately $5.65. Applying this factor to payments of $10,000 results

in the following:

Amount of the annual payment . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Present value factor of an annuity of $1

discounted for 10 payments at 12%. . . . . . . . . . . . . . . . . . . . 5.6502

Present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56,502

fyi

This amount, $56,502, is the amount (present value) that could be paid today to satisfy

The underlying mathematical the obligation if the interest rate is 12%.

formula for computing the pre- The present value of an annuity can also be computed with a business calculator as

follows:

sent value of an annuity is ac-

tually an elegant simplification

of a long series of present value

Hewlett-Packard Keystrokes:

formulas, one for each pay-

a. CLEAR ALL.

ment. Unfortunately, it is be-

b. Set P/YR to 1.

yond the scope of this text to il-

lustrate how this annuity 1. 10,000 Press PMT.

2. 10 Press N.

formula can be derived as the

3. 12 Press I/YR.

difference between two infinite

4. Press PV for the answer of $56,502.23.

sums.

With some modifications, the same calculations used

COMPUTING PERIODIC PAYMENTS

to compute the present value of an annuity can be used to compute the proper amount of a pe-

riodic loan payment. For example, consider the task of computing the appropriate monthly pay-

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Long-Term Debt Financing Chapter 10

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ment on an automobile loan of $20,000 if the interest rate is 12% compounded monthly (i.e.,

1% per month) and the loan period is 60 months. This problem can be viewed as follows:

P

P P

P

P P

$20,000

60 months

4 5

3

1 2

Now

In this case, we know the present value of the annuity it is $20,000, or the amount we would

have to pay today to pay off the entire loan. What we want to know is what series of 60 pay-

ments (P in the diagram) has a present value exactly equal to the $20,000 that we owe. The cal-

culation of the payment amount can be set up as follows:

Amount of the annual payment . . . . . . . . . . . . . . . . . . . . . . . . Payment

Present value factor of an annuity of $1

discounted for 60 payments at 1% . . . . . . . . . . . . . . . . . . . . 44.9550

Present value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000

In equation format, this can be written as follows:

$20,000 Payment 44.9550

Payment $20,000/44.9550

Payment $444.89

In other words, paying $444.89 per month for 60 months is the same as paying $20,000 right

now, if the interest rate on borrowed money is 12% compounded monthly (1% per month).

This payment amount can also be computed with a business calculator as follows:

Hewlett-Packard Keystrokes:

a. CLEAR ALL.

b. Set P/YR to 1.

1. 20,000 Press PV.

2. 60 Press N.

3. 1 Press I/YR.

4. Press PMT for the answer of $444.88895.

to summarize

Long-term liabilities are debts or other obligations that will not be paid or sat-

isfied within one year. Present value concepts, which equate the value of money

received or paid in different periods, are used to measure long-term liabilities.

Although present values can be computed using formulas, it is usually more

convenient to use a table, such as Table I or II on pages 483 484, or a busi-

ness calculator. If a future lump-sum payment is involved, Table I can be used

to determine the present value. Table II is used to compute the present value

of an annuity, which is a series of equally spaced, equal-amount payments. To

determine the value of an amount at some point in the future, future value ta-

bles can be used. Tables III and IV allow one to compute the future value of a

lump sum or an annuity, respectively. In calculating present and future values,

you must consider the compounding period and the interest rate. For other

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f462 Part 3 Long-Term Debt Financing

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than annual payments, the number of periods used is the number of periods

per year times the number of years; the interest rate used is the annual rate

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