Solution manual intermediate accounting 15e by stice ch12

CHAPTER 12 QUESTIONS a The cost of land includes the original purchase price; brokers’ commissions; legal fees; title, recording, and escrow fees; surveying costs; local government special assessment taxes; cost of clearing or grading; and other costs that permanently improve the land or prepare it for use Expenditures for land improvements that have a limited life, such as paving, fencing, and landscaping, may be separately summarized as land improvements and depreciated over their estimated useful lives b The cost of buildings includes the original purchase price, brokers’ commissions, legal fees, title and escrow fees, reconditioning costs, alteration and improvement costs, and any other costs that improve the buildings and hence benefit future periods c The cost of equipment includes the original purchase price, taxes and duties on purchases, freight charges, insurance while in transit, installation charges and other costs in preparing the asset for use, subsequent improvements or additions, and any other expenditures that will improve the equipment and thus benefit more than one period a A copyright, when purchased, is recorded at its purchase price When internally developed, all costs of legally establishing the copyright are included as costs of the copyright b The cost of purchasing a franchise and all other sums paid specifically for a franchise including legal fees are considered the franchise cost Property improvements required under the franchise also are recorded as part of the franchise cost c The cost of a trademark includes all expenditures required to establish the trademark, such as filing and registration fees, as well as legal expenses for the defense of the 63 trademark Purchased trademarks are recorded at the purchase price Accountants frequently are required to allocate costs among two or more accounts The principal method of allocation is based on relative market values of the individual assets, if they can be determined A ratio of each individual asset’s market value to the sum of the market values for all assets involved in the purchase is used to determine cost for each individual asset If market values, or some approximation of market values, cannot be obtained for all assets in the basket purchase, allocation can be made to those assets where market values are available, and any remaining balance can be allocated, on some systematic basis, to remaining assets When equipment is purchased on a deferred payment contract, care must be taken to exclude the stated or implicit interest from the purchase price The asset should be recorded at its equivalent cash price Interest on the unpaid contract balance should be recognized as interest expense over the life of the contract a Sales practice for some products consistently inflates the list price that is initially assigned Because most buyers are aware of this practice, considerable negotiations take place between buyers and sellers before a market price is established If accountants use the list price without careful evaluation, values could be inflated b The goal of accounting for the acquisition of property and equipment is to record the acquisition at the equivalent cash price or the closest approximation to cash that can be obtained This is especially important when trade-ins are involved a In constructing a new building for its own use, Gaylen Corp will charge the building with all costs incurred in connection with the construction activities These costs will include building costs in the form of direct labor, direct materials, factory overhead, and any other expenditures that can be identified with the construction of the asset b When a company constructs its own assets, there are two positions that may be taken in assigning general overhead to the cost of the asset: (1) Overhead may be assigned to special construction just as it is assigned to normal activities on the grounds that both activities benefit from the overhead; this would mean that construction would be charged with the increase in overhead arising from construction activities as well as a pro rata share of the company’s fixed overhead (2) Only the increase in overhead may be charged to construction on the grounds that management decides to construct its own assets after giving due consideration to the differential or additional costs involved An equitable allocation of the fixed overhead between regular operations and construction affords no special favor to construction activities; on the other hand, a charge to construction for only the increase in total overhead grants no special concessions to regular activities during the construction period statements Properties unconditionally transferred should be recognized by debits to asset accounts and a credit to a revenue account in terms of the fair Before interest charges are capitalized, a construction project should be a discrete project Interest should not be capitalized for inventories manufactured or produced on a repetitive basis, for assets that are currently being used, or for assets that are idle and not undergoing activities to prepare them for use a If the donation of the property by the philanthropist is unconditional, the president’s position cannot be defended If the donation is not recognized, both assets and income will be understated Furthermore, subsequent income will be overstated through the failure to recognize depreciation, and this misstatement will be accompanied by misrepresentations of earnings-toassets and earnings-to-owners’-equity relationships reflected on the financial 64 market values of the properties acquired, and depreciation should be recognized in using such properties b If the donation of the property is contingent upon certain conditions, the president’s position relative to the nonrecognition of the asset is proper until the time the conditions are met Until the conditions are met, the fair value of the conditional gift, along with a description of the conditions, should be disclosed in the notes to the financial statements for succeeding years, but by successively decreasing amounts until the charge has been fully written off Net income will be overstated for the first year by the difference between the An asset retirement obligation is a legal obligation a company has to restore the site of a piece of property or equipment when the asset is retired The estimated fair value of the asset retirement obligation is recognized as a liability and is added to the cost of the asset when it is acquired 10 Many companies establish a minimum monetary amount for recording expenditures as assets, even though the item purchased meets the definition of an asset The principal reasons for this are materiality and the cost involved in recording an asset and depreciating it over its estimated life It is more expedient to expense these smaller capital expenditures immediately, thus avoiding the recordkeeping associated with assets 11 a The cost of a depreciable asset incorrectly recorded as an expense will understate assets and owners’ equity for the current year and for succeeding years, but by successively decreasing amounts until the asset no longer makes a contribution to periodic revenue Net income will be understated in the first year by the excess of the expenditure over depreciation for the current period; net income in succeeding years will be overstated by the amount of depreciation charges applicable to the asset that should be charged off as expense b An expense expenditure incorrectly recorded as an addition to the cost of a depreciable asset will overstate assets and owners’ equity for the first year and 65 recognized depreciation for the current period and the amount of the expenditure; net income for 12 succeeding years will be understated by the depreciation charges recognized in such periods a b c d e f Expenditure Cost of installing machinery Cost of unsuccessful litigation to protect patent Extensive repairs as a result of fire Cost of grading land Insurance on machinery in transit Interest incurred during construction period g h i j k Cost of replacing a major machinery component New safety guards on machinery Commission on purchase of real estate Special tax assessment for street improvements Cost of repainting offices 13 The remaining net book value of a component that is replaced is added to depreciation expense for the period Classification Asset Expense Expense Asset Asset Asset (if interest added to construction cost) Expense (if interest charged to expense) Asset Asset Asset Asset Expense 15 With the full cost method of accounting for oil and gas exploration costs, the cost of drilling dry holes is capitalized and amortized With the successful efforts method, only the exploratory costs associated with successful wells are capitalized; the cost of dry holes is expensed as incurred 14 a Research activities are those used to discover new knowledge that will be useful in developing new products, services, or processes, or significantly improve an existing product or process Development activities seek to apply research findings to develop a plan or design for new or improved products and processes Development activities include the formulation, design, and testing of products, construction of prototypes, and operation of pilot plants 16 In general, the cost of internally generated intangibles is expensed as incurred 17 The five general categories of intangible assets are as follows: Marketing related Customer related Artistic related Contract based Technology based b Research and development costs are generally expensed in the period incurred An exception is when the expenditure is for equipment and facilities that have alternate future uses beyond the specific current research project This exception permits the deferral of costs incurred for materials, equipment, facilities, and intangibles purchased, but only if the alternative future use can be specifically identified In addition, software development costs are capitalized if they are incurred after technological feasibility has been established 18 The two approaches used in estimating fair values using present value computations are the traditional approach and the expected cash flow approach In the traditional approach, which is often used in situations in which the amount and timing of the future cash flows is determined by contract, the present value is computed using a risk-adjusted interest rate that incorporates expectations about the uncertainty of receipt of the future contractual cash flows 66 In the expected cash flow approach, a range of possible outcomes is identified, the present value of the cash flows in each possible outcome is computed (using the risk-free interest rate), and a weighted-average present value is computed by summing the present value of the cash flows in each outcome, multiplied by the estimated probability of that outcome judgment of professional appraisers who estimate the current value of long-term assets 22 Under the provisions of IFRS 16, the credit entry is to a revaluation equity account when noncurrent operating assets are written up to reflect an increase in market value (The important point is that the revaluation amount is not to be reported as a gain in the income statement.) 19 a Goodwill may be reported properly as an asset only when it is purchased or otherwise established by a transaction between independent parties b Expenditures for advertising should not be capitalized as goodwill Some advertising expenditures may be deferred if the costs applicable to future benefits from such advertising can be determined objectively Normally, however, it is advisable to expense such expenditures because of the short-lived nature of the benefits and because future benefits may be difficult to estimate 23 The fixed asset turnover ratio is computed as sales divided by average property, plant, and equipment (fixed assets); it is interpreted as the number of dollars in sales generated by each dollar of fixed assets 24 As with all ratios, the fixed asset turnover ratio must be used carefully to ensure that erroneous conclusions are not made For example, fixed asset turnover ratio values for two companies in different industries cannot be meaningfully compared Another difficulty in comparing values for the fixed asset turnover ratio among different companies is that the reported amount for property, plant, and equipment can be a poor indicator of the actual fair value of the fixed assets being used by a company Another complication with the fixed asset turnover ratio is caused by leasing Many companies lease the bulk of their fixed assets in such a way that the assets are not included in the balance sheet This practice biases the fixed asset turnover ratio for these companies upward because the sales generated by the leased assets are included in the numerator of the ratio but the leased assets generating the sales are not included in the 20 Contract-based and separately tradable intangibles are recognized in both a basket purchase and in a business combination Intangibles that are neither of these, but that are still relevant and reliably measurable, are recognized in a basket purchase but are not separately recognized when acquired as part of a business combination 21 Recording noncurrent operating assets at their current values represents a trade-off between relevance and reliability In the United States, reliability concerns have resulted in the prohibition of asset writeups In many countries around the world, accountants have learned to rely on the denominator 67 PRACTICE EXERCISES PRACTICE 12–1 CATEGORIES OF TANGIBLE NONCURRENT OPERATING ASSETS Land Cost to purchase land Cost to purchase land Cost to prepare land for use Total $100,000 50,000 10,000 $160,000 Cost to construct building $125,000 Buildings Equipment Land Improvements Cost to construct parking lot and sidewalks $10,000 Cost to purchase equipment Cost to ship and install equipment Cost of testing Total PRACTICE 12–2 Equipment Building Land Total $20,000 1,000 1,750 $22,750 BASKET PURCHASE $120,000 300,000 100,000 $520,000 (120,000/520,000)  500,000 (300,000/520,000)  500,000 (100,000/520,000)  500,000 Allocated Cost $115,385 288,461 96,154 $500,000 (Note: Some rounding is necessary to ensure that the total allocated cost is $500,000.) PRACTICE 12–3 DEFERRED PAYMENT Equipment Discount on Notes Payable Cash Notes Payable 120,696 49,304 Business calculator keystrokes: N = years I = 9% PMT = $20,000 FV = (There is no balloon payment associated with the note.) PV = $110,696 68 10,000 160,000 Notes Payable Cash 20,000 Interest Expense Discount on Notes Payable 20,000 9,963 9,963 Interest expense: ($160,000 – $49,304)  0.09 = $9,963 PRACTICE 12–4 EXCHANGE OF NONMONETARY ASSETS Equipment Gain on Asset Exchange Land PRACTICE 12–5 93,000 58,000 35,000 COST OF A SELF-CONSTRUCTED ASSET Cost of materials Labor cost Allocated overhead cost ($6,000,000/$3,000,000)  $500,000 Interest cost Total PRACTICE 12–6 January May November Total $ 300,000 500,000 1,000,000 80,000 $1,880,000 CAPITALIZED INTEREST: SINGLE-YEAR COMPUTATION Amount $100,000 200,000 300,000 $600,000 Applicable Interest Rate 10% 12 12 Months of Avoidable Interest 12/12 8/12 2/12 Capitalized Amount of capitalized interest = $32,000 Cost of building = $600,000 + $32,000 = $632,000 PRACTICE 12–7 CAPITALIZED INTEREST: JOURNAL ENTRY Building Interest Expense ($250,000  $32,000) Cash 32,000 218,000 250,000 Total interest: ($100,000  0.10) + ($2,000,000  0.12) = $250,000 69 $10,000 16,000 6,000 $32,000 Interest PRACTICE 12–8 CAPITALIZED INTEREST: MULTIPLE-YEAR COMPUTATION From Year Amount $ 100,000 532,000 July Total 500,000 $1,132,000 Applicable Interest Rate 10% 12 Months of Avoidable Interest 12/12 12/12 12 6/12 Capitalized Interest $ 10,000 63,840 30,000 $103,840 Amount of capitalized interest = $103,840 Cost of building = $1,132,000 + $103,840 = $1,235,840 PRACTICE 12–9 Land ACQUISITION BY DONATION 100,000 Revenue (or Gain) 100,000 PRACTICE 12–10 ACCOUNTING FOR AN ASSET RETIREMENT OBLIGATION Mining Site Cash 800,000 800,000 Mining Site Asset Retirement Obligation 72,489 72,489 FV = $200,000; I = 7%; N = 15 years  $72,489 PRACTICE 12–11 RENEWALS AND REPLACEMENTS Heating/Cooling System 180,000 Accumulated DepreciationBuildings (old system) 60,000 Depreciation Expense 40,000 Buildings (old system) 100,000 Cash 180,000 PRACTICE 12–12 RESEARCH AND DEVELOPMENT (1) (2) (3) Normal: Expense all$100,000 + $120,000 = $220,000 Software: Expense amounts before technological feasibility: $100,000 International: Expense amounts before technological feasibility: $100,000 PRACTICE 12–13 OIL AND GAS EXPLORATION COSTS (1) (2) Successful efforts: Expense all costs of dry holes = $400,000 Full cost: Capitalize all costs, and amortize the amount to expense in subsequent years Accordingly, expense for this year is $0 (Note: Because all costs were incurred on the last day of the year, there is no amortization this year.) PRACTICE 12–14 ACCOUNTING FOR THE ACQUISITION OF AN ENTIRE COMPANY 70 Cash price Fair value of net assets ($1,060,000  $400,000) Goodwill $1,000,000 660,000 $ 340,000 Cash Accounts Receivable Inventory Patent Property, Plant, and Equipment Goodwill Liabilities Cash 10,000 100,000 300,000 50,000 600,000 340,000 400,000 1,000,000 PRACTICE 12–15 ACCOUNTING FOR NEGATIVE GOODWILL Cash price $ 500,000 Market value of net assets ($1,060,000  $400,000) 660,000 Negative goodwill $(160,000) The $160,000 in negative goodwill is allocated proportionately to the $50,000 patent and the $600,000 property, plant, and equipment: Patent: $50,000 – {$160,000  [$50,000/($50,000 + $600,000)]} = $37,692 PPE: $600,000 – {$160,000  [$600,000/($50,000 + $600,000)]} = $452,308 Cash Accounts Receivable Inventory Patent Property, Plant, and Equipment Liabilities Cash 10,000 100,000 300,000 37,692 452,308 400,000 500,000 PRACTICE 12–16 INTANGIBLES AND A BASKET PURCHASE Building Operating Permit In-Process R&D Assembled Workforce Estimated Cost Allocation According to Cost Assigned to Fair Values Relative Estimated Values Individual Items $200,000 100,000 150,000 100,000 $550,000 200,000/550,000  $500,000 100,000/550,000 × $500,000 150,000/550,000 × $500,000 100,000/550,000 × $500,000 $181,818 90,909 136,364 90,909 $500,000 Building Operating Permit R&D Expense Assembled Workforce Cash 500,000 PRACTICE 12–17 INTANGIBLES AND A BUSINESS ACQUISITION 71 181,818 90,909 136,364 90,909 Cash Inventory R&D Expense Goodwill (includes fair value of assembled workforce) Liabilities 300,000 Cash 800,000 100,000 50,000 500,000 450,000 PRACTICE 12–18 FIXED ASSET TURNOVER RATIO Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $300,000/[($100,000 + $120,000)/2] = 2.73 PRACTICE 12–19 DANGER IN USING FIXED ASSET TURNOVER RATIO Company B Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $200,000/[($130,000 + $150,000)/2] = 1.43 Company A using historical cost of fixed assets Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $300,000/[($100,000 + $120,000)/2] = 2.73 Company A using market value of fixed assets Fixed asset turnover ratio = Sales/Average net property, plant, and equipment = $300,000/[($210,000 + $240,000)/2] = 1.33 Company A is more efficient (i.e., has a higher fixed asset turnover ratio) if one uses historical cost of fixed assets (2.73 compared to 1.43) However, Company B’s fixed assets are younger and are therefore reported at amounts close to their market values If we assume that the reported amounts of Company B’s fixed asset are a fair approximation of their market values, then it appears that Company B is more efficient than is Company A (1.43 compared to 1.33) 72 Note that none of the assets acquired is a current asset Current assets would be recorded at their fair values, even with the existence of negative goodwill Discussion Case 12–64 Generally accepted accounting principles not specify exactly what costs should be included in selfconstructed assets Direct charges are clearly capital items, as are incremental overhead charges FASB Statement No 34 requires interest to be capitalized during the construction period Practice varies as to normal overhead items, with the theoretical arguments favoring a charge for all overhead This case provides an excellent vehicle for considering both general and specific problems related to accounting for self-constructed assets The specific issues of the case are discussed here (a) Overtime premium payments should be spread to all work of the maintenance department, not just to the construction of the machinery Overtime hours are necessary because of the total workload in a department, and the choice of which work is done in the overtime is purely arbitrary To avoid manipulating charges to specific jobs, overtime premium payments should be considered part of general overhead (b) Any intracompany profit should be eliminated in the cost assigned to the machinery Many companies organize their operations so that different operational centers can earn a profit Care must be exercised to be sure remaining asset values exclude these profits (c) Although it is fairly well accepted that incremental overhead should be recognized as part of the self-constructed machinery cost, there is no definite position on how the normal overhead should be charged A common practice is to allocate normal overhead to self-construction projects using the same basis as is used for regular operations (d) The cost of machinery should include charges for testing and pilot production runs Because the work will be done by the production department, a charge for material, labor, and overhead should be made by the production department to the machinery account (e) Because the construction time period is year, the interest on money being used to construct the machinery is a cost that should be recognized Although the FASB has not recommended including imputed interest on equity capital as an interest cost, including interest on outstanding debt is required (f) Although the company saves money by constructing its assets, no revenue should be recognized for this savings under the historical cost basis of accounting It could be noted, however, that if current cost valuation were to be adopted, the machinery might be valued at a higher market value that would reflect the savings due to self-construction Discussion Case 12–65 This case addresses the problems associated with accounting for software development costs Strategy wants its financial statements to present a favorable picture of the company’s financial condition and operating performance If the owner is correct in predicting that this year’s research and development costs will be recovered through sales in the following year, a strong argument could be made to defer the costs incurred this year and match them against next year’s revenues The central issue, however, is whether the sales will actually materialize next year The uncertainty of predicting future sales led the FASB to conclude that until technological feasibility has been established, costs to develop software should be expensed It is unclear from this case how much of the $45,000 was related to products for which technological feasibility had been established and how much related to new products still in the preliminary design and testing stages To the extent that the costs were incurred for new products for which technological feasibility had not been established, the CPA is correct in insisting that these costs be expensed as required by the FASB 103 Discussion Case 12–66 Generally accepted accounting principles not permit increasing the value of assets for discovery value or for changes in values It is true that users of the financial statements need to know this type of information But it is not necessary that the financial statements reflect everything that users should know This case demonstrates a set of circumstances that needs to be disclosed, probably by a note to the financial statements Information regarding the current value of assets in a case such as this could have a significant impact on stock prices and investment decisions To emphasize that the financial statements report mainly cost data, a reference to the note should be inserted in the statements There is a wide spectrum of reporting options available to investors and creditors beyond the traditional financial statements Some accountants feel the profession is leaning too much toward disclosure outside the basic financial statements, thereby failing to record events that really should be part of the formal accounting reports Uncertainty affects the decision of information placement Users generally perceive information in financial statements differently from information found in notes and supplementary reports Discussion Case 12–67 From the brief description of Arnold, it is reasonable to assume that Arnold spends a lot for research and development (R&D) and for advertising On theoretical grounds, both of these can be argued to be capital expenditures However, R&D must be expensed as incurred and advertising expenditures are usually treated in the same way This can result in a substantial amount of real economic assets that are not recorded on the balance sheet For example, assume that Arnold spends an average of $300,000 per year on R&D and $400,000 per year on advertising and that the average economic life of the assets created is years for the R&D expenditures and years for the advertising This means that Arnold has unrecorded assets of $2,700,000 If these assets were reported on the balance sheet, Arnold’s ROA would be about the same as that for Baker Other assets that are not shown on companies’ balance sheets include the value of asset appreciation, key employees, favorable market position, and good reputation with suppliers, creditors, and employees The lack of comparability is an issue because some companies have large amounts of unrecorded assets and others not For example, two companies may both have pieces of land with a current market value of $500,000 However, one company may show the land at $100,000 because it was purchased years ago while the other may have purchased it just recently and thus will show it at $500,000 A comparison of the book values of companies (total assets – total liabilities) and the market values of those companies as measured by total market value of shares outstanding illustrates that there is considerable variability among companies, a fact that suggests companies often have large amounts of unrecorded assets Discussion Case 12–68 It can be argued that the asbestos removal costs are no different from any other costs incurred in getting a building ready for use Also, it is reasonable to think that the purchase price of the building incorporated an adjustment for the estimated removal costs and thus was lower than it otherwise would have been Capitalizing the costs would cause the building to be shown at what it would really cost to acquire it and put it into service Those who think the removal costs should be expensed argue that they are more like repairs, which simply return the building to its normal state The EITF concluded that the asbestos removal costs for buildings acquired with a known problem should be capitalized if they are incurred within a reasonable time after the acquisition Because the building cannot be properly used without removing the asbestos, it can be argued that the removal costs enhance the building Also, the asbestos removal can be thought of as extending the useful life of the building If this is true, the costs should be capitalized However, it can also be argued that the removal costs nothing to enhance the building or extend its useful life but are more on the order of maintenance or repairs, which are typically expensed 104 105 The ElTF’s decision was that the asbestos removal costs for an already owned building may be capitalized; the removal costs are essentially treated as a betterment For both situations (1) and (2), the EITF emphasized that any capitalization should be subject to a test for impaired asset value to ensure that capitalizing the removal costs would not result in reporting the building at more than its current market value Answers will vary This solution is adapted from “Recent EITF Actions,” Journal of Accountancy, February 1990, p 93 Discussion Case 12–69 The students’ reports should include the following points: Company A will capitalize the interest on the construction loan and report total building cost of $21,400,000 [($20,000,000  0.14  6/12) + $20,000,000] Company B has no interest payments to capitalize, so reported total building cost is $20,000,000 The contractor would also need financing during the construction period and would certainly add that cost to the price of the building Assuming that Companies A and B were as efficient at construction as the contractor, a reasonable price would be $21,400,000 Some might argue that the contractor, being a specialist and thus more efficient, would be able to charge a lower price The important point is that the contractor’s price would include a charge for the interest during the period of construction Just as borrowing has a cost, called interest, using invested funds also has a cost Shareholders invest in a company and allow the board of directors to retain profits in the company because the shareholders expect a return on their investment in the form of dividends or of an increase in the value of their shares (capital gain) Conceptually, this return expected by shareholders is exactly analogous to the interest expected by debt holders The difference lies in the fact that this “equity interest” is implicit, whereas the debt interest is explicit Some have argued that the implicit interest cost associated with the use of equity should be capitalized in the same way that debt interest is now capitalized in accordance with SFAS No 34 See Robert Anthony, “The Accounting Concepts We Need,” Accounting Horizons, December 1988, p 128 Discussion Case 12–70 The rule requiring firms to expense R&D outlays results in a decrease in net income for most firms A decrease in reported net income can impact a firm in several ways:  Managers’ bonuses are frequently based on reported earnings  Loan covenants are often written in terms of reported earnings  Some investors seem to rely on the naive use of reported earnings in picking stocks Accordingly, managers’ compensation may suffer when R&D expenditures are expensed, and those managers may be less willing to authorize R&D projects This is in spite of the fact that the R&D might be beneficial for the firm’s long-run profitability It might be expected that in response to an accounting standard change, management bonus plans, loan covenants, and investors’ decision rules would be adapted to allow for the change in reported earnings brought about solely because of the accounting change However, there is evidence that such adjustments are not always made 106 Discussion Case 12–71 The estimated Gillette brand value is relevant both to outsiders who wish to value Gillette stock and to Gillette’s management who wish to monitor the impact of their actions on Gillette’s most valuable asset —the brand name However, reading the description of the four-stage estimation process casts doubt on the reliability of the estimate The valuation estimate requires assumptions about the following quantities:  An appropriate sales-to-asset ratio  The baseline return on sales of a generic brand in Gillette’s industry  Gillette’s marginal tax rate  The brand strength multiple Given the assumptions made by Financial World magazine, the computed brand value is $10.3 billion, but slightly different estimates could result in numbers anywhere from $5 billion to $15 billion This may be a good example of a situation in which disclosure is better than recognition Recognizing a point estimate of the brand value gives an illusion of precision Disclosing the brand value in the notes, along with the assumptions underlying the computation, gives financial statement users a more realistic impression of the estimated value Discussion Case 12–72 Appreciation in asset values is a large part of the business of a real estate firm Because of this and because generally accepted accounting rules require long-term assets to be depreciated, many users of financial statements think that historical cost financial statements for real estate companies can be particularly uninformative For a further discussion, see Edward P Swanson and Frederick Niswander, “Voluntary Current Value Disclosures in the Real Estate Industry,” Accounting Horizons, December 1992, p 49 Daimler-Benz was willing to reveal the magnitude of its hidden reserves in order to comply with U.S GAAP as a prerequisite to listing its shares on the New York Stock Exchange Hidden reserves are a result of the “prudence principle”: the primary goal of current management is to make sure that the firm survives into the future to the benefit of stockholders, creditors, employees, local economies, and so on One way to build up a financial cushion to increase the probability of survival is to pay out small cash dividends In many jurisdictions, the amount of cash dividends is tied to the amount of reported income Accordingly, the prudence principle dictates the recording of accelerated depreciation in order to lower reported income and reduce the payment of cash dividends SEC dissatisfaction with asset revaluations in the 1920s and 1930s was mainly a result of unease about the methods used to compute the revaluations, not about the notion of revaluation per se When there is an established market for an asset, revaluation to market value is almost as objective and verifiable as using historical cost An auditor is understandably wary about appraisals and estimates; however, market values from an active market are not as subjective 107 SOLUTIONS TO STOP & THINK Stop & Think (p 722): Is capitalized interest extra interest that the company has to pay? How would the financial statements be impacted if a company were to forget to capitalize interest? Capitalized interest is not extra interest If a company were to forget to capitalize interest that should be capitalized, interest expense would be overstated and long-term assets would be understated Total cash flow would be unaffected, but cash from operations would be understated and cash from investing activities would be overstated Stop & Think (p 745): Do you think it is likely that within the next 10 years the FASB or SEC will require companies to recognize the current value of noncurrent operating assets? Why or why not? It is unlikely that within the next 10 years U.S companies will be required to recognize the current value of property, plant, and equipment The historical cost tradition is strong in the United States, and the FASB is having enough trouble getting the business community to accept the recognition of the fair value of financial instruments Current value recognition of property, plant, and equipment is only a matter of time—the information is very relevant and can be estimated by professional appraisers, just as the pension liability is currently estimated by actuaries Stop & Think (p 747): Why did Safeway’s accumulated depreciation decrease so dramatically from 1985 to 1986? One event that reduces accumulated depreciation is the disposal of old assets This is not what happened to Safeway between 1985 and 1986 Instead, when Safeway’s assets were revalued in late 1986, the accumulated depreciation account was set to zero It was as if Safeway had disposed of all of its old assets and then repurchased them at their current market values 108 SOLUTIONS TO STOP & RESEARCH Stop & Research (p 714): Several companies in the “five largest” lists are probably unfamiliar to you Find out what business the following companies are in: Peabody Energy, AES, and Alcan Peabody Energy – the largest coal producer in the world AES – electricity generation and distribution; AES stands for Applied Energy Services Alcan – production of aluminum; original name was Aluminum Company of Canada Stop & Research (p 714): If McDonald’s requires an initial cash outlay of only $175,000 for a franchise and the value of an average McDonald’s franchise is much more than $175,000, simple economics tells us that there must be excess demand for McDonald’s franchises What additional conditions does McDonald’s impose on potential franchisees? At http:// www.mcdonalds.com, we learn the following additional requirements for McDonald’s franchisees: Q: What business qualifications does McDonald's seek in its potential franchisees? A: The following qualifications, among others, are essential to be considered for a McDonald's franchise:        High personal integrity An entrepreneurial spirit and strong desire to succeed A proven ability to motivate and train people The ability to manage finances A willingness to personally devote full time and best efforts to the day-to-day operation of the restaurant as an on-premise owner-operator A willingness to complete a comprehensive training program and become proficient in all aspects of operating a McDonald's restaurant business Financial resources Q: How much does a McDonald's franchise cost? A: Typically, new restaurant costs range from 455,000 to 768,500 USD The size of the restaurant facility, area of the country, pre-opening expenses, inventory, kitchen equipment, signage, and style of decor and landscaping will affect new restaurant costs These costs are paid to suppliers In addition, at the time of opening, an initial fee of 45,000 USD is paid to McDonald's Corporation for all new restaurants Q: How much cash (or liquid assets) is required to acquire a franchise? A: The initial cash investment is a minimum of $175,000 for a conventional purchase or $100,000 for a Business Facilities Lease Q: Will McDonald's finance the remaining balance of the cost of the franchise? A: No McDonald's does not provide any financing The remaining cost may be financed through a bank Q: May I obtain the funds to purchase a franchise from a relative, friend or associate? A: No, because this would then involve you in a type of partnership We not franchise restaurants to partners or investors An individual must personally meet the financial qualifications and be willing to devote his or her full time and best efforts to the day-to-day operation of the restaurant A franchisee must divest himself or herself of all other active business interests 109 Stop & Research (p 742): Another way to handle negative goodwill is to leave the recorded asset values unchanged and report the entire amount as an extraordinary gain In SFAS No 141, the FASB discussed and specifically rejected this approach What reason did the FASB give? ( Hint: Look in Appendix B of SFAS No 141.) In Statement No 141, paragraph B188, the FASB stated that the existence of negative goodwill is, in most cases, the result of measurement error in the estimation of the fair values of the acquired assets Conceptually, if all of the fair values have been appropriately estimated, it would be a rare case in which an acquirer would pay less than the aggregate fair value of the assets acquired After setting aside the current assets and the financial assets, for which the probability of significant measurement error is low, the estimated fair values of the remaining noncurrent assets (and acquired R&D) are reduced proportionately Essentially, this procedure assumes that the unobservable measurement error is spread proportionately throughout the remaining noncurrent assets 110 SOLUTIONS TO NET WORK EXERCISES Net Work Exercise (p 709): Texas Stadium opened in 1971 The Cowboys won their first Super Bowl on January 16, 1972, beating the Miami Dolphins by a score of 243 Net Work Exercise (p 726): As of the end of 2001, ChevronTexaco’s worldwide net proved reserves were reported as 8,542 billion barrels of oil and 19,410 billion cubic feet of natural gas These reserves were estimated to have a discounted net present value of $30.144 billion 111 SOLUTIONS TO BOXED ITEMS Interest Capitalization: Not Everyone Agrees (pp 724–725) One practical difficulty with capitalizing the implicit interest on equity funds is that the interest rate itself must be estimated In addition, one must consider what the credit side of the equity interest capitalization entry would be Because no cash is being paid for this equity “interest” and because there is no payable amount, what is the credit? Also, if this implicit equity interest is to be recognized for companies that are engaged in the self-construction of assets, why shouldn’t it be recognized for all companies? Obviously, opinions can vary on this question One can make a good argument that interest on the funds used to finance a self-construction project are just like any other cost of the project and should be capitalized This is the FASB position On the other hand, one can argue that interest is interest, no matter how the funds are used and that interest costs should always be expensed because they not benefit future periods This is the IASB position Who Sets Accounting Standards in the United States? The Case of Acquired In-Process R&D (pp 742–743) It is likely that the FASB will require companies to capitalize and then amortize any costs associated with acquired in-process R&D This treatment makes sense because the fact that the R&D was paid for as part of an acquisition reduces any uncertainty over whether there is probable future benefit associated with the in-process R&D The case of acquired in-process R&D illustrates that ultimate authority for accounting standards in the United States rests with the SEC For the time being, the FASB has explicitly backed away from attempting to change the practice of expensing acquired in-process R&D However, because the SEC has administratively discouraged the practice, the amount of acquired in-process R&D being expensed has been reduced dramatically When the SEC speaks about accounting standards and practice, U.S companies listen 112 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 12–1 (The Walt Disney Company) Because Disney has developed its brand name itself instead of purchasing it from another company, no value is recognized in the financial statements However, Disney does recognize the costs of registering and successfully defending its rights and trademarks In Note 5, Disney discloses: “The Company capitalizes interest on assets constructed for its parks, resorts and other property, and on theatrical and television productions in process In 2001, 2000 and 1999, respectively, total interest costs incurred were $606 million, $702 million and $826 million, of which $94 million, $132 million and $109 million were capitalized.” Supplemental cash flow information at the bottom of Disney’s cash flow statement states that cash paid for interest in 2001 was $625 million This cash paid relates to interest reported as interest expense, not to the capitalized interest If it is assumed that all the capitalized interest was paid in cash in 2001, the summary journal entry to record interest for the year is as follows: Projects in Progress Interest Expense ($606 – $94) Interest Payable Cash ($625 + $94) 94 512 113 719 Note explains Disney’s amortization policy for intangible assets The following explanation is included under the subheading “Accounting Changes”: SFAS 142 addresses the financial accounting and reporting for acquired goodwill and other intangible assets Under the new rules, the Company is no longer required to amortize goodwill and other intangible assets with indefinite lives, but will be subject to periodic testing for impairment SFAS 142 supersedes APB Opinion No 17, Intangible Assets Effective October 1, 2001, the Company will adopt SFAS 142 and is evaluating the effect that such adoption may have on its consolidated results of operations and financial position However, the Company expects that a substantial amount of its intangible assets will no longer be amortized The company’ policy before the issuance of SFAS 142 (described under the subheading “Intangible & Other Assets” was as follows: Intangible assets are amortized over periods ranging from two to forty years The Company continually reviews the recoverability of the carrying value of these assets using the methodology prescribed in SFAS 121 The Company also reviews long-lived assets and the related intangible assets for impairment whenever events or changes in circumstances indicate the carrying amounts of such assets may not be recoverable Upon such an occurrence, recoverability of these assets is determined by comparing the forecasted undiscounted net cash flows of the operation to which the assets relate, to the carrying amount, including associated intangible assets, of such operation If the operation is determined to be unable to recover the carrying amount of its assets, then intangible assets are written down first, followed by the other long-lived assets of the operation, to fair value Fair value is determined based on discounted cash flows, appraised values or management's estimates, depending upon the nature of the assets The business segment information in Note 11 states that capital expenditures for each of Disney’s operating segments were as follows in 2001 (in millions): Media Networks $ 207 Parks and Resorts 1,278 Studio Entertainment 36 Consumer Products 70 Corporate 204 Total $1,795 113 Deciphering 12–2 (3M: Minnesota Mining and Manufacturing) A T-account will be used to estimate the book value of the PP&E that was sold during the year Property, Plant, and Equipment (net) 12/31/00 5,823 01 Purchases 980 01 Book value of disposals ???? Depreciation expense 1,089 12/31/01 5,615 From the T-account data, the book value of the disposed assets in 2001 is $99 A T-account will be used to estimate the book value of assets disposed of during the year: Property, Plant, and Equipment 12/31/00 14,170 01 Purchases 980 01 Disposals 12/31/01 14,365 ???? From the T-account data, the indicated historical cost of 2001 disposals is $785 Accumulated Depreciation 01 Disposals 12/31/00 01 Depreciation 12/31/01 ???? 8,347 1,089 8,750 From the T-account data, the indicated accumulated depreciation on items disposed of in 2001 is $686 Estimated gain or loss on disposal: Proceeds Book value ($785 – $686) Estimated gain on disposal $102 99 $ Deciphering 12–3 (Eastman Kodak Company) Interest expense Earnings (before taxes) Net PP&E Total assets Total liabilities Total equity Net cash provided by operating activities Net cash used in investing activities Net cash used in financing activities Interest capitalized during the year 114 Reported $ 219 345 5,659 13,362 10,468 2,894 2,065 (1,047) (808) 12 Adjust +12 –12 –12 –12 –12 –12 +12 –12 Expense Interest $ 231 333 5,647 13,350 10,468 2,882 2,053 (1,035) (808) Interest expense Earnings (before taxes) Net PP&E Total assets Total liabilities Total equity Net cash provided by operating activities Net cash used in investing activities Net cash used in financing activities Interest capitalized during the year Expense Interest $ 231 333 5,647 13,350 10,468 2,882 2,053 (1,035) (808) Add Back Depr +3 +3 +3 +3 0 0 Total 231 336 5,650 13,353 10,468 2,885 2,053 (1,035) (808) $ SAMPLE CPA EXAM QUESTIONS The correct answer is b Capitalized interest will be based on the amount of avoidable interest caused by the building construction When that amount exceeds the specific funds borrowed, interest on unrelated liabilities will be capitalized When that amount is lower than the funds borrowed, as is the case here, the amount to be capitalized will be the lower amount of $40,000 The correct answer is b The only time costs are capitalized as goodwill is when a business combination occurs and the cost of the acquisition exceeds the fair market value of the underlying net identifiable assets acquired Neither the cost of developing nor maintaining goodwill is capitalized Writing Assignment: Is it an asset or not? To: Controller, Hunter Company From: Me Subject: Accounting for the Finch Land Transfer The land to be transferred from Rosalyn Finch should be recorded as an asset on the books of Hunter Company The title to the land is being transferred unconditionally, so there really is no question on this issue The difficult issue here is how to value the land The two major concerns are as follows: Rosalyn Finch is an officer of the company, so this qualifies as a related-party transaction The consideration given to Finch may not be an unbiased indication of the fair value of the land It may be advisable for Hunter Company to commission an external appraisal in order to determine an independent value for the land Computing a value for the employment contract and royalty contract given to Finch in exchange for the machine will be very difficult Regarding the employment contract, unless it involves an agreement to pay Finch a salary in excess of the fair value of her services, the contract should not be accounted for any differently than any other employment contract—that is, no value should be attached to the contract The royalty provision is based on future sales, making the value of the contract difficult to estimate For the two reasons outlined above, every attempt should be made to value the land using an independent outside appraisal 115 Research Project: Advertising costs: Capitalize or expense? Concern about the diversity of practice in accounting for advertising costs led the AICPA's Accounting Standards Executive Committee to prepare a statement of position (SOP 93-7) entitled "Reporting on Advertising Costs." The provisions of the standard are as follows:  In general, advertising costs should be expensed because of the uncertainty of the future benefits  In those cases in which the future benefits are more certain, advertising costs should be capitalized This type of advertising involves targeted advertising to customers who have purchased products in the past This type of advertising is characterized by the ability to estimate how many customers will respond favorably The Debate: R&D accounting will bring down the U.S economy! Economic Consequences The requirement that U.S firms expense all R&D costs puts them at a competitive disadvantage to foreign firms Foreign firms are able to capitalize R&D costs incurred after technological feasibility has been established This harms U.S firms in the following ways:  Reported R&D expenses are higher  Reported net income is lower Lower income means that banks are less willing to loan money and investors are less willing to invest  Shortage of financing causes U.S R&D firms to cut back their research activities  A slowdown in U.S research activity puts U.S firms behind foreign firms in terms of technical advancement We must not allow the FASB to cripple the U.S economy!!!! Efficient Market Bankers and investors, with millions of dollars on the line, not blindly read financial statements They are aware of the conservative R&D accounting rule set by the FASB, and they make the correct adjustments to their valuation and forecasting models when they use the financial statements of companies that perform R&D Bankers and investors are interested in the economic performance of companies, not in accounting performance The claim that bankers and investors will reduce financing to firms that report low net income as a result of expensing R&D implies that bankers and investors are completely trusting of whatever numbers accountants choose to report This is absurd!!!! Ethical Dilemma: Dumping costs into a landfill The general outline of facts in this ethical dilemma matches the actual facts of the Chambers Development case The same audit firm had been on the Chambers engagement for a number of years, and former audit partners from the firm were employed by Chambers The heroes in this case were the members of the new team of auditors who were able to overcome the obvious pressures to cover up the wrongful capitalization of landfill costs This case illustrates a difficult conflict between doing what is best for the firm that employs you and doing what will please your immediate supervisor If the auditors on the Chambers job had just ignored the accounting irregularities they found, their audit firm could have been liable for huge damages in subsequent years when the truth was finally revealed So, it was clearly in the best interests of the audit firm for the auditors to blow the whistle However, a staff auditor would still be reluctant to raise the issue with a manager or partner who may have approved the “fishy” accounting in previous years The accounting announcement on March 17, 1992, was just the beginning of troubles for Chambers Continuing business problems eventually forced the board of directors of Chambers to put the company up for sale Chambers was acquired by USA Waste on June 30, 1995 116 Articles that contain more information on the interesting Chambers Development case include: Gabriella Stern and Laurie P Cohen, "Chambers Development Switches Accounting Plan," The Wall Street Journal, March 19, 1992, p B4 Roula Khalaf, "Fuzzy Accounting," Forbes, June 22, 1992, p 96 Gabriella Stern, "Audit Report Shows How Far Chambers Would Go for Profits," The Wall Street Journal, October 21, 1992, p A1 Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis Solutions CD-ROM, provided with this manual Internet Search Total revenue R&D Advertising As a percentage of revenue: R&D Advertising General Electric $125,913 2,349 n/a 1.9% n/a Procter & Gamble $40,238 1,601 3,773 4.0% 9.4% Microsoft $28,365 4,310 1,270 15.2% 4.5% General Electric—Year ended December 31, 2001 Procter & Gamble—Year ended June 30, 2002 Microsoft—Year ended June 30, 2002 a Microsoft mentions the following four categories of intangible assets: goodwill, patents and licenses, existing technology, and trademarks and tradenames b Coca-Cola mentions the following two categories of intangible assets: trademarks and bottling and distribution rights c Intel mentions the following two categories of intangible assets: goodwill and acquisition-related intangibles The acquisition-related intangibles are primarily developed technology 117 ... statements for succeeding years, but by successively decreasing amounts until the charge has been fully written off Net income will be overstated for the first year by the difference between the An... succeeding years, but by successively decreasing amounts until the asset no longer makes a contribution to periodic revenue Net income will be understated in the first year by the excess of the... interest rate), and a weighted-average present value is computed by summing the present value of the cash flows in each outcome, multiplied by the estimated probability of that outcome judgment of professional