CHAPTER 8

8-1 Tangible assets are those that can be seen and touched.
Intangible assets are those rights or economic benefits that
are not physical in nature.

8-2 All three terms refer to an allocation of costs over time.

Reduction of intangible assets is generally called amortization.
Depreciation is a reduction in buildings and equipment and
other tangible assets. Depletion is a reduction in natural
resources.

8-3 Cash discounts are reductions in original cost, not income.

8-4 When an expenditure is capitalized, it is not credited to

stockholders' equity. Rather, it becomes an asset with a
useful life in excess of one year. An asset is debited and
generally either cash or a liability is credited.

8-5 Accumulated depreciation is not cash; if specific cash is being

accumulated for the replacement of assets, such cash will be
an asset specifically labeled as a "cash fund for replacement
and expansion" or a "fund of marketable securities for
replacement and expansion." Accumulated depreciation is
the cumulative amount of an asset’s depreciable value that
has been expensed.

8-6 Valuation implies some measure of present market value. In

contrast, depreciation is the systematic allocation of the
original cost of the asset as an expense on the income
statement over the useful life of the asset.

8-7 Depreciation is a method of cost allocation, not valuation. It

simply allocates the cost of an asset to the periods that benefit
from its use.

Chapter 8 Long-Lived Assets and Depreciation 371

8-8 No. Keeping two sets of books is necessary if two separate
purposes are being legally fulfilled. In many cases two sets of
books are required, sometimes more than two. Requirements
include external financial reporting, internal managerial needs
and tax reporting.

8-9 Both choices are between initially greater current income and
asset values (straight-line and FIFO) versus initially smaller
current income and asset values (accelerated and LIFO). This
statement assumes rising price levels for inventory items. The
choices differ because the FIFO-LIFO choice affects cash
flows via its tax consequences. Why? Because the IRS
requires all firms using LIFO for tax purposes to use it for
financial reporting purposes as well. On the other hand the
accelerated versus straight-line choice does not affect cash
flow because a firm does not have to change its depreciation
method used for tax reporting because of this choice for
financial reporting.

8-10 No. Depreciation, by itself, generates no cash.

8-11 Accelerated depreciation used for tax purposes usually leads

to higher depreciation expense early in an asset’s life and
hence lower pretax income. Because pretax income is lower,
taxes are lower. Depreciation does not affect cash, but taxes
do. Lower taxes mean more cash. Remember, however, that
many firms use accelerated MACRS depreciation for tax
purposes and straight-line for financial reporting to the public.

8-12 The costs of repairs and maintenance are expenses of the

current period. They maintain a fixed asset in operating
condition. In contrast, capital improvements or betterments
are capitalized and then depreciated because they add to the
future benefits of an existing asset, often by either extending
its life or decreasing its operating costs.

372
8-13 The division's expenditures, including cash outlays to acquire
new assets, are likely to fall, but expenses (which include
depreciation on the new capital facilities) will probably not fall.

8-14 Gain on sale of equipment is a net result: revenue (that is,

proceeds) minus expense (that is, book value) equals gain.
Complete reporting would show the proceeds, the book value,
and the gain.

8-15 Patents grant the inventor exclusive rights to the invention for
a specified period of time. Copyrights give similar rights to
printed or artistic items. Trademarks are distinctive
identifications of a product or service. Franchises are
privileges granted to sell a specific product or service under
defined conditions. Goodwill is the excess of the cost of an
acquired company over the net market value of the identifiable
individual assets and liabilities acquired.

8-16 Internally acquired patents are essentially research costs,

which must be written off to expense as they are incurred.
Externally acquired patents are assets that are subject to
amortization and/or impairment review.

8-17 The preoccupation with physical evidence often results in the

expensing of outlays that many think should be treated as
assets. Thus, expenditures for research, advertising,
employee training, and the like are usually expensed, although
it seems clear that, in an economic sense, such expenditures
represent expected future benefits.

8-18 No. Improvements to leased property are capitalized just like

capital improvements or betterments except that they are
amortized over the remaining life of the lease if it is shorter
than the useful life of the improvements or betterments.

Chapter 8 Long-Lived Assets and Depreciation 373

8-19 The $5,000 gain is double-counted. The increase in cash was
$20,000, not $25,000. The $20,000 proceeds includes the
$5,000 gain. Under the indirect method of the statement of
cash flows, the gain must be subtracted from net income in the
operating section of the statement of cash flows. Under the
direct method it does not appear in the statement at all.

8-20 The asset was sold for $5,000 + $4,000 = $9,000. The entire
$9,000 should be reported as a cash inflow from investing
activities. In an indirect method statement of cash flows, the
$4,000 gain must be deducted from net income in computing
net cash provided by operating activities.

8-21 No. In a basket purchase, different assets are often depreciated

over different time periods. For example, basket purchases
sometimes include land and a building. The building is
depreciated while the land remains on the books at original
cost.

8-22 No. The recoverability test determines whether or not there is

evidence of impairment. The impairment loss is the amount by
which the book value of the asset exceeds its fair value.

8-23 The manager has a point. However, under cost-based

accounting the historical cost of long-lived assets is allocated
to the periods during which the assets will be used. We do not
recognize income from the appreciation of long-lived assets.
The complaint that the depreciation is large is worth
considering. Normally we depreciate the asset over its useful
life down to its residual value. Thus, it may be that the
company has underestimated both the residual values and the
lives of these assets.

374
8-24 Treating research and development costs as assets is
generally more consistent with the corporate perspective of the
value inherent in R&D. Companies undertake R&D in hopes of
creating future benefits, as asset accounting would suggest.

8-25 The statement of cash flows has a section that reports on the
financing actions the company has taken during the
accounting period. Both borrowing and issuing of common
stock would appear there. Of course, some capital is also
generated by operations and some could be generated by the
sale of assets. These sources of capital are revealed in the
operating and investing segments of the statement of cash
flows.

8-26 Due to continual changes in the purchasing power of the dollar,

we normally observe an increase in the value of land over time.
Over 90 years have passed since the land was acquired, so the
value today is likely to have little relationship to the value when
it was purchased. In contrast, the equipment is recently
acquired and is being depreciated over its useful life. Its book
value is likely to be closer to its market value.

8-27 (10-15 min.)

Land:
Cash, $600,000 + $150,000 demolition $ 750,000
Note 3,000,000
Total cost $ 3,750,000
Building:
Cash $ 3,000,000
Mortgage 7,000,000
Total cost $10,000,000

The important point here is to see that the $150,000 demolition

cost is a cost of land because the outlay is necessary to get the land
ready for its intended use.

Chapter 8 Long-Lived Assets and Depreciation 375

8-27 (continued)

Land 3,600,000
Cash 600,000
Note payable 3,000,000

Land 150,000
Cash 150,000

This could also be accomplished by the following compound

entry:

Land 3,750,000
Cash 750,000
Note payable 3,000,000
The second entry is:
Building 10,000,000
Cash 3,000,000
Mortgage note payable 7,000,000

The payment terms of the note and the mortgage are irrelevant
until financial statements must be prepared or payments must be
made. Some students may prepare entries for the first year.
Assuming end of year payment, these would be:
Note payable 300,000
Interest expense 300,000
Cash 600,000
Mortgage note payable 250,000
Interest expense 700,000
Cash 950,000

376
8-28 (5-10 min.)

The sales commission, the purchasing manager's salary, and

the cost of repairs after the equipment is placed in use are irrelevant.
The pertinent costs are:

Invoice price, gross $400,000

Deduct: 2% cash discount 8,000
Invoice price, net $392,000
Freight-in 4,400
Installation costs 8,000
Repair costs prior to use 9,000
Total acquisition cost $413,400

8-29 (5-10 min.)

In the absence if more reliable data, the assessed values for

property taxes are frequently used as a guide to allocating the costs
of a basket purchase.

(1) (2) (3) (2) x (3)

Assessed Total Cost Allocated
Value Weighting to Allocate Costs

Land $200,000 20/60 $720,000 $240,000

Building 400,000 40/60 720,000 480,000
Total $600,000 $720,000

Chapter 8 Long-Lived Assets and Depreciation 377

8-30 (10 min.)

Player contracts may be amortized for tax purposes, but the

sports franchise itself may not. Allen would want to allocate
$299,999,999 to the contracts. In this way, he could get tax
deductions. No part of the amount allocated to the franchise is
deductible as amortization.

Note: Through the years, the Internal Revenue Service has developed
a rule for these transactions. The amount the buyer allocates to
player contracts may not exceed what the seller allocates. This is
limited to no more than 50 percent, unless the taxpayer can prove a
greater allocation is proper.

378
8-31 (15 min.)
Accumulated
Depreciation, Depreciation
Equipment Equipment Expense, Equpiment
594,000 54,000 54,000
Cash
594,000

1. Equipment 594,000
Cash 594,000
To record acquisition of assembly robots.
Depreciation expense, equipment 54,000
Accumulated depreciation, equipment 54,000
To record annual depreciation:
($594,000 – $54,000) ÷ 10 = $54,000
2. Cash 42,000
Accumulated depreciation, equipment 18,000
Loss on sale of equipment 6,000
Equipment 66,000
To record sale of equipment:
Cash proceeds $42,000
Original cost $66,000
Accumulated depreciation,
3 x $6,000 = 18,000
Book value (or carrying
amount) 48,000
Loss $ 6,000
3. Cash 52,000
Accumulated depreciation, equipment 18,000
Gain on sale of equipment 4,000
Equipment 66,000

To record sale of equipment:

Cash proceeds $52,000
Book value (see above) 48,000
Gain $ 4,000

Chapter 8 Long-Lived Assets and Depreciation 379

8-32 (10-15 min.) You may want to use T-accounts too.

1. Depreciation expense, equipment 160,000

Accumulated depreciation, equipment 160,000
To record annual depreciation:
($880,000-$80,000) ÷ 5 = $160,000

2. Cash 160,000
Accumulated depreciation, equipment 80,000
Equipment 220,000
Gain on sale of equipment 20,000

To record sale of equipment:

Cash proceeds $160,000
Original cost $220,000
Accumulated depreciation,
2 x $40,000 = 80,000
Book value (or carrying
amount) 140,000
Gain on sale $ 20,000

3. Cash 110,000
Accumulated depreciation, equipment 80,000
Loss on sale of equipment 30,000
Equipment 220,000

To record sale of equipment:

Cash proceeds $110,000
Book value (see above) 140,000
Loss on sale $ 30,000

380
8-33 (10-15 min.) You may want to use T-accounts too.

1. Depreciation expense, equipment 300,000

Allowance for depreciation, equipment 300,000
To record annual depreciation:
($1,800,000 – $300,000) ÷ 5 = $300,000

2. Cash 32,000
Allowance for depreciation, equipment 22,000
Loss on sale of equipment 6,000
Equipment 60,000

To record sale of equipment:

Cash proceeds $32,000
Original cost $60,000
Allowance for depre-
ciation, 2 x $11,000 22,000
Book value (or carrying
amount) 38,000
Loss $ 6,000

3. Cash 40,000
Allowance for depreciation, equipment 22,000
Equipment 60,000
Gain on sale of equipment 2,000

To record sale of equipment:

Cash proceeds $40,000
Book value (see above) 38,000
Gain $ 2,000

Chapter 8 Long-Lived Assets and Depreciation 381

8-34 (10-15 min.)

Year Conveyor* Truck**

1 $6,600 2/3 x $18,000 = $12,000
2 $6,600 2/3 x $ 6,000 = $ 4,000
3 $6,600 $500***

* Each year is 1/5 x ($38,000 – $5,000) = $6,600.

** DDB rate is 2 x (1/3) = 2/3.
*** $500 of depreciation reduces the book value to the $1,500 residual
value. If the DDB schedule had continued, the depreciation of 2/3 x
$2,000 = $1,333 would have reduced the book value below the residual
value.

8-35 (10 min.)

C − R ($80,000 − $5,000)
1. D= = = $.30 per mile
n (250,000)

Depreciation expense:
Year 1: $.30 x 60,000 = $18,000
Year 2: $.30 x 90,000 = $27,000

2. Net book value when sold: $80,000 – $18,000 – $27,000 =

$35,000.
Gain on sale: $40,000 – $35,000 = $5,000.

382
8-36 (15-25 min.) Numbers are in thousands.
Declining Balance at
Twice the Straight
Straight-Line* Line Rate (DDB)**
Annual Book Annual Book
Depreciation Value Depreciation Value
At acquisition $1,200 $1,200
Year
1 $250 950 $600 600
2 250 700 300 300
3 250 450 100 200
4 250 200 0 200
Total $1,000 $1,000
* Depreciation is the same each year, 25% of ($1,200,000 – $200,000).
** Straight-line rate is 100% ÷ 4 = 25%. The DDB rate is 50%.
Depreciation in the first year is 50% of $1,200,000; in the second year it
is 50% of ($1,200,000 – $600,000); in the third year depreciation is 50%
of [$1,200,000 – ($600,000 + $300,000)] etc. This continues until the
residual value is reached. Therefore, using DDB in this instance,
depreciation for the third year would be 50% of $300,000, or $150,000;
however, only $100,000 is shown because the residual value of
$200,000 is thereby reached. Although not requested in this problem,
another alternative is to use Modified DDB.

8-37 (10-15 min.)

Unit
Year Depreciation Straight-Line* DDB**
1 (60 ÷ 150) x $400,000 = $160,000 $133,333 $293,333
2 (45 ÷ 150) x $400,000 = 120,000 133,333 97,778
3 (45 ÷ 150) x $400,000 = 120,000 133,333 8,889***
Total depreciation $400,000 $400,000 $400,000

* (1/3) x $400,000 = $133,333 each year

** 2 x (1/3) x $440,000 = $293,333; 2 x (1/3) x ($440,000 – $293,333) =
$97,778

Chapter 8 Long-Lived Assets and Depreciation 383

 *** Application of DDB would result in depreciation of 2 x 1/3 x ($440,000 -
$293,333 - $97,778) = $32,593. However, this would depreciation the
asset below its residual value of $40,000. Therefore, depreciation is
only $8,889.

384
8-38 (20-30 min.)

(Equipment costs $32,000, five-year life, predicted residual value of

$2,000)

Declining Balance at
Twice the Straight
Straight-Line* Line Rate (DDB)**
Annual Book Annual Book
Depreciation Value Depreciation Value
At acquisition $32,000 $32,000
Year
1 $ 6,000 26,000 $12,800 19,200
2 6,000 20,000 7,680 11,520
3 6,000 14,000 4,608 6,912
4 6,000 8,000 2,765 4,147
5 6,000 2,000 1,659*** 2,488
Total $30,000 $29,512

* Depreciation is the same each year, 20% of ($32,000 – $2,000).

** Straight-line rate is 100% ÷ 5 = 20%. The DDB rate is 40%. Depreciation
in the first year is 40% of $32,000; in the second year it is 40% of
($32,000 – $12,800); in the third year it is 40% of [$32,000-
($12,800+$7,680)]; etc.
*** Unmodified, this method will never fully depreciate the existing book
value. Therefore, in the later years of an asset's life, companies
typically switch to a straight-line method. See the text for a fuller
explanation. If a switch to straight-line were used here, it would occur in
year 5 and the annual depreciation would be $2,147, the amount
required to reduce the book value to the end of period salvage value,
instead of $1,659.

If both methods were available for tax purposes, a company

would typically choose DDB because it records the depreciation
more quickly and reduces early tax payments. This provides an
interest free loan from the government.

Chapter 8 Long-Lived Assets and Depreciation 385

8-39 (20-30 min.) Amounts are in thousands of dollars.

Accelerated
Depreciation
Declining Balance at
Twice the Straight
Straight-Line* Line Rate (DDB)**
Annual Book Annual Book
Depreciation Value Depreciation Value
At acquisition 280 280
Year
1 32.5 247.5 70.0 210.0
2 32.5 215.0 52.5 157.5
3 32.5 182.5 39.4 118.1

* Depreciation is the same each year, 1/8 x [($280,000 – $20,000)] =

32,500.
** Straight-line rate is 100% ÷ 8 = 12.5%. The DDB rate is 25%.
Depreciation in the first year is 25% of $280; in the second year it is 25%
of ($280 – $70.0); in the third year it is 25% of ($280 – $70.0 – $52.5); etc.
Unmodified, this method will never fully depreciate the existing book
value. In the later years of an asset's life, companies typically switch to
a straight-line method. The asset is never depreciated below its
estimated residual value, even though the latter is ignored when
applying the depreciation rate.

386
8-40 (10 min.)

BOEING COMPANY
Property, Plant, and Equipment
December 31, 2003
(In Millions)

Land $ 457
Buildings 9,171
Machines and equipment 10,824
Construction in progress 943
Less: Accumulated depreciation (12,963)*
Net property, plant, and equipment $ 8,432
*$457 + $9,171 + $10,824 + $943 − $8,432 = $12,963

8-41 (10 - 15 min.) Amounts are in thousands.

1. Historical cost = $477,581 + $440,607 = $918,188
2. Most of Oregon Steel’s assets are slightly less than 9 years old.
We know this because the accumulated depreciation is less
than half of the original cost of the property, plant, and
equipment:

$440,607 ÷ $918,888 = .48, which is slightly less than .5.

or: 18 x .48 = 8.64 years average age

Chapter 8 Long-Lived Assets and Depreciation 387

8-42 (15 min.) Amounts are in the thousands of dollars.

Original Revised
Straight-line* Straight-line**
Annual Book Annual Book
Depreciation Value Depreciation Value

At acquisition
year 75 75
2004 7 68 7 68
2005 7 61 7 61
2006 7 54 7 54
2007 7 47 7 47
2008 7 40 15.33 31.67
2009 7 33 15.33 16.34
2010 7 26 15.34 1
2011 7 19
2012 7 12
2013 7 5
Total $70 $73

*Depreciation is the same each year, 1/10 x (75,000- 5,000) = $7,000.

** Depreciation is the same for the first four years (2004 though 2007). In
2008, Nowling must recompute depreciation for the years 2008, 2009 and
2010 based on revised estimates: 1/3 x (47,000 – 1,000) ] = $15,333.

8-43 (30-45 min.)

1. See Exhibit 8-43 on the following page.

388
EXHIBIT 8-43

1. FLECK COMPANY
Income Statement
For the Year Ended December 31, 20X2
(In Thousands of Dollars)

Before Taxes After Taxes

Straight–line DDB Straight–line DDB
Depreciation Depreciation Depreciation Depreciation
Income Statement
Cash sales $180 $180 $180.0 $180
Operating expenses 100 100 100.0 100
Depreciation expense* 9 20 9.0 20
Pretax income 71 60 71.0 60
Income taxes – – 28.4 24
Net income $ 71 $ 60 $ 42.6 $ 36
Statement of Cash Flows
Cash $180 $180 $180.0 $180
Cash operating expenses 100 100 100 100
Cash tax payments – – 28.4 24
Net cash provided by operations $ 80 $ 80 $ 51.6 $ 56

* SL = 1/5 ($50,000 − $5,000) = $9,000; DDB = 2 x (1/5) x $50,000 = $20,000

390
8-43 (continued)

2. By itself, depreciation expense does not provide cash. This

point is illustrated by the part of requirement 1 that compares
the amounts shown before taxes. Note that the cash provided
by operations is exactly the same under straight-line and DDB
depreciation methods. No matter what depreciation expense is
allocated to the year (whether $9,000, $20,000, $45,000, or
zero), the $80,000 cash provided by operations will be
unaffected.

Examine the part of requirement 1 that compares amounts

after taxes. Again, by itself, depreciation does not affect the
cash inflow provided by operations. Only sales to customers
can provide more cash receipts from operations. However,
depreciation does affect the cash outflow for income taxes.
The use of accelerated depreciation, such as DDB, results in a
strange combination of showing less net income but
conserving more cash. The DDB method shows net income of
$36,000 (compared with $42,600 using straight-line), but DDB
shows an increase in net cash provided by operations (less
income taxes) of $56,000 (compared with $51,600 using
straight-line). Accordingly, the final cash balance is $4,400
higher for DDB than for straight-line.

Chapter 8 Long-Lived Assets and Depreciation 391

8-43 (continued)

3. The doubling of depreciation would cause net income to

decrease but would have no effect on the $80,000 of cash
provided by operations (shown on the third line of the following
table):

Straight-line DDB
Depreciation Depreciation
Before Doubled Before Doubled
Sales $180 $180 $180 $180
Cash operating expenses 100 100 100 100
Cash provided by operations $ 80 $ 80 $ 80 $ 80
Depreciation expense 9 18 20 40
Income before income taxes $ 71 $ 62 $ 60 $ 40
Income tax expense – – – –
Net income $ 71 $ 62 $ 60 $ 40

8-44 (5-10 min.)

1. Acceleration of depreciation for tax purposes is caused by a 3-

year instead of a 5-year depreciation schedule and the use of
the DDB method instead of the straight-line method. DDB
charges twice the straight-line rate in the first year.

2. Shareholder reporting: $1.8 million ÷ 5 = $360,000

Tax purposes: 2 x (1/3) x $1.8 million = $1,200,0000

392
8-45 (5 min.)

Leasehold Improvements would be increased, and Cash

would be decreased by $120,000. The annual amortization would be
based on the remaining life of the lease: $120,000 ÷ 4 years =
$30,000 per year. Note that amortization is over the remaining lease
term, not the physical life of the improvements.

8-46 (10 min.)

1. and 2. Neither expenses "charged to the P & L" nor "depreciation

and amortization" generate cash. Only revenue generates cash.
However, although Riccardo's statements are misleading, they have
a certain logic.

If operating income is zero, revenue is equal to cash expenses

plus noncash expenses (primarily depreciation and amortization).
Therefore, revenue generates enough cash to cover cash expenses
(including the $3.75 billion charged to the P & L) and have an
amount equal to depreciation and amortization left over (60% x $3.75
billion = $2.25 billion in this case). Positive operating income (less
taxes on that income) will contribute to covering the remaining $1.5
billion that is needed.

The key to interpreting Riccardo's statement is that he

presumes that revenues are high enough to cover all expenses;
these presumed revenues generate the cash to which he refers.

Chapter 8 Long-Lived Assets and Depreciation 393

8-47 (10 min.)

1. a, c

2. b, d, g, h, i, j.

The key questions to ask are whether the expenditure should

be capitalized as an asset (a, c) or written off immediately as an
expense (b, d, g, h, i, and j). The other outlays (e,f) are neither
capitalized nor expensed.

8-48 (10 min.)

a. E e. C
b. C f. C
c. E g. E
d. E

394
8-49 (10-15 min.)
The first two items would reduce cash and increase Repairs
and Maintenance Expense by $200 and $450, respectively.
The third item would reduce cash and increase Equipment by
$21,000. However, the increase in the residual value from $10,000 to
$11,000, results in an increase in the new depreciable amount of
only $20,000. Subsequent depreciation would be revised so that the
new unexpired cost is spread over the remaining three years as
follows:
Original Revised
Depreciation Depreciation
Schedule Schedule
Year Amount Year Amount
1 $16,000 1 $ 16,000
2 16,000 2 16,000
3 16,000 3 16,000
4 16,000 4 16,000a
5 16,000 5 12,000
6 12,000
7 12,000
Accumulated depreciation $80,000b $100,000b
a New depreciable amount is ($90,000 – $64,000 + $21,000) –
$11,000 residual value = $36,000.
New depreciation expense is $36,000 divided by remaining useful
life of 3 years, or $12,000 per year.
b Recapitulation: Net Book Value
Original Revised
Original outlay $90,000 $ 90,000
Major overhaul – 21,000
Total $90,000 $111,000
Accumulated depreciation 80,000 100,000

Chapter 8 Long-Lived Assets and Depreciation 395

 Residual value $10,000 $ 11,000

396
8-50 (10-15 min.)

1. Proceeds $12,000
Net book value of equipment sold is
$29,000 − (4 x $5,000)
a
9,000
Gain on sale of equipment $ 3,000

A =L+ SE
Accumulated
Depreciation, Retained
Cash + Equipment + Equipment Earnings

+12,000 -29,000 +20,000 = +3,000*

*Gain on sale of equipment.

a Annual depreciation is 1/5 x [$29,000 – $4,000] = $5,000. Accumulated

depreciation for four years is 4 x $5,000 = $20,000. The effect on assets
of removing the net book value is a decrease of $9,000, consisting of a
decrease in Equipment of $29,000 and a decrease in Accumulated
Depreciation of $20,000. Note that the effect of a decrease in Accumulated
Depreciation (by itself) is an increase in assets. This $9,000 decrease in
assets is offset by the $12,000 in cash received, resulting in a net $3,000
increase in assets.

b The $3,000 is usually carried separately in the general ledger until

the end of the year as Gain on Sale of Equipment, or Gain on
Disposal of Equipment.

Income statement effects:

Gain on Sale of Equipment may be shown as a separate item

on an income statement as a part of "other income" or some similar
category.

Chapter 8 Long-Lived Assets and Depreciation 397

8-50 (continued)

In single-step income statements the gain is shown at the top

along with other revenue items, for example:

Revenue:
Sales of products $XXX
Interest income X
Other income: gain on sale of equipment X
Total sales and other income $XXX

In multiple-step income statements, the gain is often shown after the

operating income generated by the sales of major products.

2. a. Cash 12,000
Accumulated depreciation 20,000
Equipment 29,000
Gain on sale of equipment 3,000

b. Cash 7,000
Accumulated depreciation 20,000
Loss on sale of equipment 2,000
Equipment 29,000

398
8-51 (10 min.)

1. Cash received $25,000

Book value, $45,000 – (3 x $8,000) 21,000
Gain on sale of fixed assets $ 4,000

Cash 25,000
Accumulated depreciation 24,000
Equipment (van) 45,000
Gain on sale of fixed assets 4,000

2. Cash received $17,000

Book value (see above) 21,000
Loss on sale of fixed assets $ 4,000

Cash 17,000
Accumulated depreciation 24,000
Loss on sale of fixed assets 4,000
Equipment (van) 45,000

Chapter 8 Long-Lived Assets and Depreciation 399

8-52 (10 min.)

1. The only effect would be a $30,000 cash inflow

listed with the investing activities:
Proceeds from the sale of equipment $30,000

2. The proceeds should be listed as an investing activity:

Proceeds from the sale of equipment $40,000

In addition, a $10,000 gain appeared on Icarus’s income

statement, calculated as: proceeds of $40,000 less book value
of $30,000 ($120,000 cost less $90,000 of accumulated
depreciation). In the statement reconciling net income and net
cash provided by operating activities, the gain must be
removed from net income by deducting the $10,000 from net
income in the reconciliation of net income to net cash
provided by operating activities:

Net income $XXXXXX

Deduct: gain on sale of equipment 10,000

3. The proceeds should be listed as an investing activity:

Proceeds from the sale of equipment $20,000

In addition, a $10,000 loss appeared in Icarus’s income

statement (proceeds of $20,000 less book value of $30,000).
The loss must be added back to net income in the
reconciliation of net income to net cash provided by operating
activities:

Net income $XXXXXX

Add: loss on sale of equipment 10,000

400
8-53 (10-20 min.)
1. $3,000,000 ÷ 2 = $1,500,000

2. Company C must record the $6 million as an expense of 20X1,

whereas Company D must show the $6 million as an asset—
Patents -- on its balance sheet of December 31, 20X1.
Company D must then amortize the $6 million on a straight-line
basis over the useful life of the patents. The useful life of an
intangible asset is the shorter of its economic life and lit legal
life, if any.

3. $420,000 ÷ 4 = $105,000

4. a) Goodwill 4,000,000
Assets 22,000,000
Liabilities 16,000,000
Cash 10,000,000

b) Yes. The journal entry is:

Impairment loss 1,000,000
Goodwill 1,000,000

8-54 (10-15 min.)

1. $800,000 ÷ 5 = $160,000

2. Income statement:
a) Total amount charged as an expense.
b) Nothing charged as an expense. This assumes that the
purchase was late enough in December that no
amortization is charged in 2002.
Balance sheet:
a) Nothing recorded.
b) $1,000 million recorded as an asset, to be amortized over
the useful life of patents.

Chapter 8 Long-Lived Assets and Depreciation 401

8-54 (continued)

3. The key is that in a stable process, year-to-year expense

recognition would not change but the amount shown on the
balance sheet would be larger.

Assume all projects are finished at year end and appear in the
balance sheet at full cost and then are amortized over the next
three years. At any year-end the asset account would reflect
that year’s spending, plus 2/3 of the prior year, plus 1/3 of the
second year prior for a total of 1 + 2/3 + 1/3 = 2 times spending.
The expense each year would be 3 x (1/3) = 1 times spending.

If the amortization period changes to four years, the balance

sheet asset account would rise to 1 + 3/4 + 2/4 + 1/4 = 2.5 times
spending. The annual amortization in year five and
subsequent years would be the same as the annual amount
spent as long as annual spending was constant. The expense
would be 4 x (1/4) = 1 times spending.

8-55 (10 min.)

Step 1: Recoverability test. The net book value of $11 million

exceeds the undiscounted expected future cash flows of $9 million,
so there is evidence of impairment.

Step 2: The net book value of $11 million exceeds the fair value of
$7.5 million so Vincent must record an impairment loss of $11 million
- $7.5 million = $3.5 million.

402
8-56 (5-10 min.)

1. Depletion rate is $14,400,000 ÷ 900,000 = $16.00 per ton

Depletion for 20X4: $16.00 x 120,000 = $1,920,000

2. Depletion for 20X5: $16.00 x 100,000 = $1,600,00

8-57 (20-30 min.) Amounts are in thousands of dollars.

Accelerated Depreciation
Declining Balance at
Twice the Straight
Straight-Line* Line Rate (DDB)**
Annual Book Annual Book
Depreciation Value Depreciation Value
At acquisition 30,000 30,000
Year
1 1,200 28,800 3,000 27,000
2 1,200 27,600 2,700 24,300
3 1,200 26,400 2,430 21,870

* Depreciation is the same each year, 5% of ($30 million – $6 million).

** Straight-line rate is 100% ÷ 20 = 5%. The DDB rate is 10%.
Depreciation in the first year is 10% of $30,000; in the second year is
10% of ($30,000 – $3,000); in the third year is 10% of ($30,000 –
$3,000 − $2,700); etc. Unmodified, this method will never fully
depreciate the existing book value. In the later years of an asset's
life, companies typically switch to a straight-line method. The asset
is never depreciated below its estimated residual value, even though
the latter is ignored when applying the depreciation rate.

Chapter 8 Long-Lived Assets and Depreciation 403

8-58 (10-15 min.) Amounts are in millions of dollars.

1. Let X = amount written off.

Land, Buildings, and Equipment

Balance 4,618 Write-offs X
Additions 711
Balance 4,929

4,618 + 711 – X = 4,929

X = 400

2. Let Y = accumulated depreciation written off

Accumulated Depreciation
Write-offs Y Balance 1,854
Depreciation 365
Balance 1,949

1,854 + 365 – Y = 1,949

Y = 270

3. Book value of assets written off = $400 – 270 = $130. The

amounts in requirements 1 and 2 can be checked using the
information that there was no gain or loss on disposal of
assets:

Gain or loss = cash received – book value

0 = 130 – 130

404
8-59 (15 min.) Amounts are in millions.

1. Buildings ¥158,424 + ¥216,865 = ¥375,289

Machinery and equipment ¥156,156 + ¥875,757 =
¥1,031,913
Land ¥63,150
Construction in progress ¥22,089
Other ¥15,374 + ¥86,795 = ¥102,169

2. Land is not depreciated, and depreciation has not started yet

on the construction in progress.

3. If Asahi had used straight-line depreciation, the net values of

the assets would be larger and the accumulated depreciation
would be less. It is more difficult to determine the average age
of a company’s assets if a company uses declining-balance
depreciation rather than straight-line depreciation. For
example, almost 85% (¥875,757 ÷ ¥1,031,913) of Asahi’s cost
of machinery and equipment has been depreciated. If straight-
line depreciation had been used, it would be clear that these
assets had passed the midpoint of their economic life. But with
declining-balance depreciation, it is possible that the assets are
still in the first half of their economic life because more than half
of the depreciation is taken before the midpoint of an asset’s
life.

Chapter 8 Long-Lived Assets and Depreciation 405

8-60 (30-40 min.)

Gradually, students should become familiar with the effects of

typical transactions. All numbers are in millions of dollars. Here are
the T-accounts:

Land, Plant, and Equipment

Balance 52,981 Disposals at
Acquisitions, original cost Z
at cost ZZ
Balance 60,113

Accumulated Depreciation
Accum. depreciation Balance 26,568
on disposals YY Depreciation for
current year Y
Balance 30,112

Special Tools, net

Balance 9,939 Amortization for
Acquisitions 3,000 current year X
Disposals, book
value 0
Balance 11,992

1. Let X = special tool amortization

9,939 + 3,000 – X = 11,992
X = 947

2. The cost of new acquisitions was $8,113. Using the T-

accounts, this can be computed using the following three
steps:

a. If depreciation plus amortization = $5,472, depreciation

was $5,472 − $947 = $4,525 = Y

406
8-60 (continued)

b. There is now one unknown in the Accumulated

Depreciation T-account, so:

Let YY = Accumulated depreciation of items disposed

26,568 + 4,525 – YY = 30,112
YY = 981

c. For fully depreciated assets accumulated depreciation is

the same as total historical cost so Z = $981

Use the T account.

Let ZZ = current acquisitions at cost
52,981 + ZZ – 981 = 60,113
ZZ = 8,113

Chapter 8 Long-Lived Assets and Depreciation 407

8-61 (15-25 min.)

This problem is not difficult, but it may appear so because the

topic was not discussed in the text. It forces students to think about
the meaning of accumulated depreciation and net book value.
Amounts are in millions.

1. Total depreciable value ÷ average useful life = average annual

depreciation.
131,755 ÷ X = 8,500
X = 131,755 ÷ 8,500 = 15.5 years

2. Accumulated depreciation ÷ average age of assets = average

annual depreciation.
83,265 ÷ X = 8,500
X = 83,265 ÷ 8,500 = 9.8 years.
or

Average age of assets = (Accumulated depreciation ÷ total

depreciable value) x average useful
life
= ($83,265 ÷ $131,755) x 15.5 = 9.8
years

408
8-62 (25-35 min.) Amounts in tables are in thousands of dollars.
1. Zero Income Taxes 2. 40% Income Taxes

Straight-line Accelerated Straight-line Accelerated

Depreciation Depreciation Depreciation Depreciation
Revenues (in cash) 900 900 900 900
Cash operating expenses 600 600 600 600
Cash provided by operations
before income taxes 300 300 300 300
Depreciation expense 50 100 50 100
Operating income 250 200 250 200
Income tax expense – – 100 80
Net income 250 200 150 120

Supplementary analysis:
Cash provided by operations
before income taxes 300 300 300 300
Income tax payments – – 100 80
Net cash provided by
operations 300 300 200 220

Chapter 8 Long-Lived Assets and Depreciation 409

8-62 (continued)

3. By itself, depreciation expense does not provide cash. This

point is illustrated by part 1 that compares the amounts shown
before taxes. Note that the cash provided by operations (and
the ending cash balances) are exactly the same. No matter
what depreciation expense is allocated to the year (whether
$50,000, $100,000, or zero), the $300,000 cash provided by
operations and the ending cash will be unaffected.

Examine part 2, that compares amounts after taxes. Again, by

itself, depreciation does not affect the cash inflow provided by
operations. However, depreciation does affect the cash
outflow for income taxes. The use of accelerated depreciation
results in a strange combination of showing less net income
but conserving more cash. The accelerated method shows
net income of $120,000 (compared with $150,000 using
straight-line), but accelerated shows a net increase in cash
provided by operations (less income taxes) of $220,000
(compared with $200,000 using straight-line). Accordingly, the
final cash balance is $20,000 higher for accelerated than for
straight-line.

4. Journal entries (not required) may clarify the effects:

Depreciation expense 50,000 more

Accumulated depreciation 50,000 more

Income tax expense 20,000 less

Cash 20,000 less
Note: A smaller credit to cash increases the balance in cash.

410
8-62 (continued)

The reduction of retained earnings would be $50,000 – $20,000.

That is, net income (and hence retained earnings) would be $30,000
lower. In summary:
Cash, increase by tax savings, .40 x $50,000 = $20,000
Accumulated depreciation, increase by $50,000
Operating income, decrease by $50,000
Income tax expense, decrease by $20,000
Retained earnings, decrease by $30,000

5. The doubling of depreciation would cause net income to

decrease but in the absence of tax effects would have no
effect on cash provided by operations:

Straight-line Accelerated
Depreciation Depreciation
Before Doubled Before Doubled
Revenues (all cash) 900 900 900 900
Cash operating expenses 600 600 600 600
Cash provided by operations 300 300 300 300
Depreciation expense 50 100 100 200
Income before income taxes 250 200 200 100
Income tax expense − − − −
Net income 250 200 200 100

Chapter 8 Long-Lived Assets and Depreciation 411

8-63 (25-35 min.) Amounts are in millions of dollars.

1. Zero Income Taxes 2. 40% Income Taxes

Straight-line Accelerated Straight-line Accelerated

Depreciation Depreciation Depreciation Depreciation
Revenues $246,525 $246,525 $246,525$246,525
Cash operating expenses 229,449 229,449 229,449 229,449
Cash provided by operations
before income taxes 17,076 17,076 17,076 17,076
Depreciation expense 3,432 5,432 3,432 5,432
Operating income 13,644 11,644 13,644 11,644
Income tax expense − − 5,458 4,658
Net income $ 13,644 $ 11,644 $ 8,186 $ 6,986

Supplementary analysis:
Cash provided by operations
before income taxes $17,076 $17,076 $17,076 $17,076
Income tax expense − − 5,458 4,658
Net cash provided by operations $17,076 $17,076 $11,618 $12,418

3. By itself, depreciation expense does not provide cash. This

point is illustrated by part 1, which compares the amounts
shown with zero income taxes. Note that the cash provided by
operations (and the ending cash balances) are exactly the
same. No matter what depreciation expense is allocated to the
year (whether $3,432 million, $5,432 million, or zero), the
$17,076 million cash provided by operations and the ending
cash will be unaffected.

412
8-63 (continued)
Examine part 2, that compares amounts after taxes. Again, by
itself, depreciation does not affect the cash inflow provided by
operations. Only sales to customers can provide more cash
receipts from operations. However, depreciation does affect
the cash outflow for income taxes. The use of accelerated
depreciation results in a strange combination of showing less
net income but conserving more cash. The accelerated
method shows net income of $6,986 million (compared with
$8,186 million using straight-line), but accelerated shows a net
increase in cash provided by operations after considering
income taxes of $12,418 million (compared with $11,618 million
using straight-line). Accordingly, the final cash balance would
be $800 million higher for accelerated than for straight-line.
4. Cash, increase by tax savings, .40 x $2,000 million = $800
million
Accumulated depreciation, increase by $2,000 million
Operating income, decrease by $2,000 million
Income tax expense, decrease by $800 million
Retained earnings, decrease by $1,200 million
New balances: cash, $2,758 million + $800 million = $3,558
million
Accumulated depreciation, $15,147 million + $2,000 million =
$17,147 million
Journal entries (not required) may clarify the effects (in
millions):
Depreciation expense 2,000 more
Accumulated depreciation 2,000 more
Income tax expense 800 less
Cash 800 less
Note: A smaller credit to cash increases the balance in cash.

Chapter 8 Long-Lived Assets and Depreciation 413

 The effect on retained earnings would be $2,000 million – $800
million = $1,200 million. That is, net income (and hence
retained earnings) would be $1,200 million lower.

414
8-63 (continued)

5. The $2,500 million increase of depreciation would cause net

income to decrease but would have no effect on cash
provided by operations.

Straight-line Accelerated
Depreciation Depreciation
Before After Before After
Sales $246,525 $246,525 $246,525$246,525
Cash operating expenses 229,449 229,449 229,449 229,449
Cash provided by operations 17,076 17,076 17,076 17,076
Depreciation expense 3,432 5,932 5,432
7,932
Income before income taxes 13,644 11,144 11,644 9,144
Income tax expense − − − −
Net income 13,644 11,144 11,644 9,144

Chapter 8 Long-Lived Assets and Depreciation 415

8-64 (25-35 min.) Amounts in table and narrative are in millions of
Euros.

1. Zero Income Taxes 2. 60% Income Taxes

Straight-line Accelerated Straight-line Accelerated
Depreciation Depreciation Depreciation Depreciation
Revenues (all cash) 50,288 50,288 50,28850,288
Cash operating expenses
(47,884 – 1,974) 45,910 45,910 45,91045,910
Cash provided by operations
before income taxes 4,378 4,378 4,378 4,378
Depreciation expense 1,974 2,474 1,974 2,474
Operating income 2,404 1,904 2,404 1,904
Income tax expense − − 1,442 1,142
Net income 2,404 1,904 962 762

Supplementary analysis:
Cash provided by operations
before income taxes 4,378 4,378 4,378 4,378
Income tax expense − − 1,442
1,142
Net cash provided by operations 4,378 4,378 2,936 3,236

3. By itself, depreciation expense does not provide cash. This

point is illustrated by part 1, which compares the amounts
shown before taxes. Note that the cash provided by
operations and the ending cash balances are exactly the same.
No matter what depreciation expense is allocated to the year
(whether €1,974, €2,474, or zero), the €4,378 cash provided by
operations and the ending cash will be unaffected.

416
8-64 (continued)

Examine part 2, which compares amounts after taxes. Again,

by itself, depreciation does not affect the cash inflow provided
by operations. Only sales to customers can provide more
cash receipts from operations. However, depreciation does
affect the cash outflow for income taxes. The use of
accelerated depreciation results in a strange combination of
showing less net income but conserving more cash. The
accelerated method shows net income of €762 (compared
with €962 using straight-line), but accelerated depreciation
shows a net increase in cash provided by operations (less
income taxes) of €3,236 (compared with €2,936 using straight-
line). Accordingly, the final cash balance is €300 higher for
accelerated than for straight-line depreciation.

4. Journal entries (not required) may clarify the effects:

Depreciation expense 500 more

Accumulated depreciation 500 more

Income tax expense 300 less

Cash 300 less
Note: A smaller credit to cash increases the balance in cash.

The effects on retained earnings would be €500 – €300. That

is, net income (and hence retained earnings) would be €200
lower. In summary:

Chapter 8 Long-Lived Assets and Depreciation 417

8-64 (continued)

Cash, increase by reduction in taxes, .60 x €500 = €300

Accumulated depreciation, increase by €500
Operating income, decrease by €500
Income tax expense, decrease by €300
Retained earnings, decrease by €200
New balances: Cash, €7,666 + €300 = €7,966
Accumulated Depreciation €17,230 + €500
= €17,730

5. The doubling of depreciation would cause net income to

decrease but would have no effect on cash provided by
operations:

Straight-line Accelerated
Depreciation Depreciation
Before Doubled Before Doubled
Sales 50,288 50,288 50,288 50,288
Cash operating expenses 45,910 45,910 45,910 45,910
Cash provided by operations 4,378 4,378 4,378 4,378
Depreciation expense 1,974 3,948 2,474 4,948
Income before income taxes 2,404 430 1,904 (570)
Income tax expense − − − −
Net income (loss) 2,404 430 1,904 (570)

418
8-65 (30 min.) All amounts are stated in thousands of
Deutchmarks.

1. and 2. Part (1) Part (2)

20X8 Change 20X9 20X8 Change 20X9
Revenue DM2,100 DM1,000 DM3,100 DM2,100 DM1,000 DM3,100
Operating expense
other than
depreciation 1,700 800 2,500 1,700 800 2,500
Cash (C) provided
by operations DM 400 DM 200 DM 600 DM 400 DM 200 DM 600
Depreciation 200 100 300 200 50 250
Income before
income taxes DM 200 DM 100 DM 300 DM 200 DM 150 DM 350

3. Part (3a) Part (3b)

20X8 Change 20X9 20X8 Change 20X9
Income before
income taxes DM 200 DM 100 DM 300 DM 200 DM 150 DM 350
Income taxes at 30% 60 30 90 60 45 105
Net income after
income taxes DM 140 DM 70 DM 210 DM 140 DM 105 DM 245
Cash provided by
operations after
income taxes [(C)
above minus
income taxes] DM 340 DM 170 DM 510 DM 340 DM 155 DM 495

4. By itself, depreciation does not provide "cash inflow" (cash

provided by operations). Note in parts (1) and (2) that the cash
provided by operations went up from DM400 to DM600, a
DM200 increase, because revenues (the basic source of cash)
increased by DM1,000 and operating expenses increased by
DM800. Whether depreciation is DM50, DM100, DM1,000, or
zero will not affect cash provided by operations (if income
taxes are ignored).

Chapter 8 Long-Lived Assets and Depreciation 419

8-65 (continued)

Depreciation does affect the amount of income tax cash

outflow. If only DM50 rather than DM100 is deducted as
depreciation, the income tax bill will be DM15 higher, 30% of
(DM100 - DM50). That is why cash provided by operations is
less by DM15 in part (3b). The important point is that income
tax cash outflows are affected by depreciation. Otherwise,
depreciation has no direct effect on cash inflows or outflows.

8-66 (15-25 min.)

This problem is more challenging than most because it raises

conceptual issues regarding how to account for depreciation. Dollar
amounts are in millions.

1. Depreciation expense 4.5

Accumulated depreciation 4.5
To record 3 months of depreciation:
Acquisition cost $70.0
Predicted residual value 52.0
Depreciable amount $18.0
Amount per month, $18 ÷ 12 $ 1.5
For 3 months: $1.5 per month x 3 months $ 4.5

2. Depreciation expense 13.5

Accumulated depreciation 13.5
To record 9 months of depreciation
(9 months x $1.5 per month)

420
8-66 (continued)
3. Cash 58
Accumulated depreciation 18
Revenue-earning equipment 70
Depreciation expense 6
To record the sale of equipment
Note the entry to depreciation expense instead of gain on sale
of automobiles. This method recognizes that, if the autos were
sold for $58, the residual value was underestimated, and
therefore too much depreciation was charged. The entry
adjusts the depreciation expense for this estimation error.
4. This part illustrates how the predictions of useful lives and
residual values can affect depreciation expenses. It also
underscores the general "prospective" approach to
depreciation expense. That is, 2003 depreciation charges
would not be "corrected" retroactively. However, up-to-date
knowledge can affect depreciation being taken currently (2004).

2003 2004
As Perfect As Perfect
Reported Prediction Reported Prediction
Depreciation in millions 4.5 3 7.5* 9

*$13.5 – $6

Depreciation expense for the 12 months of ownership spread

over the two calendar years is $12. Under the same circumstances,
some companies would show depreciation expense of 9 x $1.5 =
$13.5 for 2004 for a total of $18 and show a $6 gain on sale of
equipment. This underscores the fact that the final gains or losses
on sales of fixed assets are affected by the depreciation policies
followed while the assets are in service.

Chapter 8 Long-Lived Assets and Depreciation 421

8-67 (10-15 min.)

Conceptually, a strong case can be made for deferring the $2

million and amortizing it over the useful life of the product or process
developed. However, the FASB requires that research and
development costs be written off to expense as they are incurred.

The history of accounting for research and development may

be of interest as an illustration of a long debate about the meaning
and measurement of an asset. Until the FASB requirement for
expensing this cost as incurred became effective in 1975, many
companies deferred research costs and amortized them. There was
no uniformity, to say the least. For example, in 1973, the American
Institute of CPAs issued an audit guide that pertained to companies
"in the development stage." The accounting for the Mori
Pharmaceuticals Company would have been covered by this audit
guide, which required the capitalization of these costs as
"investments for the future" unless such costs were clearly
unrecoverable. In a sense, then, one set of principles was applicable
to companies in the development stage that may not have been
equally applicable to mature companies having similar outlays.

Incidentally, the audit guide took the following position

regarding established companies:

"The guide does not apply to established companies

developing new products, services, or markets, or to the
development activities of their subsidiaries, even though
the subsidiaries are in the development stage, when
included in consolidated financial statements. It does,
however, apply to separate financial statements of a
subsidiary in the development stage and is applicable to
consolidated financial information when the group as a
whole is considered to be in the development stage."

422
8-68 (15-20 min.) The purpose of this problem is to stress the
limitations of the use of historical costs, particularly where there are
significant amounts of property, plant, and equipment.
The balance sheet values do not come close to the current
market value of the land and building, $1,800,000 ÷ .60, or
$3,000,000. Consequently, in terms of current values before
expansion and modernization, stockholders' equity is understated
(in thousands):
Market value of land and building $3,000
Net book value:
Land $500
Building 200 700
Excess of market value over net book value $2,300

As conventionally prepared after the expansion and

modernization, the balance sheet would be (in thousands):

Cash $ 300 Liabilities:

Land 500 Mortgage
Building at cost $2,600 payable $1,800
Accumulated Stockholders'
depreciation 600 equity 1,000
Net book value 2,000 Total
liabilities and
Total assets $2,800 stockholders’ equity $2,800
The balance sheet would be unusually deceiving. The
mortgage would appear to be exceedingly high in relation to the
book value of the assets. The historical costs and resulting
stockholders' equity have lost all meaning.
Note that, on a market value basis, the land and building are
worth $3,000,000 before the borrowing and the renovation and
therefore worth $4,800,000 after. This is $2,300,000 above the book

Chapter 8 Long-Lived Assets and Depreciation 423

value of the land and building of $2,500,000. Measured at market
values, the stockholders' equity would be $3,300,000.

424
8-69 (10-15 min.)

The answers are drawn from The Accountant's Weekly Report,

published by Prentice Hall, Inc. Sometimes drawing a line is difficult.

Legal fees paid in connection with a taxpayer's business are

deductible as business expenses. But no current deduction is
allowed for capital expenditures, and such expenses as the cost of
defending or perfecting title to business property are considered
capital expenditures.

1. (a) Yes, it’s deductible. Here the litigation was to allow Rock to
continue in business. Since the claim arose out of his
profit-seeking activities, the legal expense is deductible.

2. (b) They’re capital expenditures. Here the suit originated in

Rock's wish to expand the business by adding to the
property. Since the crusher was a permanent
improvement, all the expenses of acquiring it, including
legal fees, must be capitalized -- and recovered through
depreciation.

Chapter 8 Long-Lived Assets and Depreciation 425

8-70 (20-30 min.)

This problem illustrates how some companies follow "more

conservative" accounting policies than others -- even though the
equipment is identical and the industry is the same.

1. The change may not be judged as material in relation to the

total depreciation expense. However, in relation to net income,
it is material. Additional depreciation of $9,000,000 would have
decreased net income by .54 x $9,000,000 = $4,860,000. This is
11.5 percent of reported net income.

2. All other things being equal, depreciation would be halved: .5 x

$220,979,000 = $110,489,500. Accordingly, net income would
be higher by .54 x $110,489,500 = $59,664,330. The latter is
40.7 percent of reported net income.

3. Useful Lives in Years

10 20
†
Depreciation 72,000,000 36,000,000
Net income 22,793,000* 42,233,000

†
($800 million – residual value of $80 million) ÷ useful life
* $42,233,000 – [.54 x ($72,000,000 – $36,000,000)] or $42,233,000 –
$19,440,000

426
8-71 (15-20 min.) Data are in millions.

1. Proceeds $22
Net book value of equipment sold is $26 − (6 x $1) 20
Gain on sale of equipment $ 2

A =L+ SE
Accumulated
Depreciation, Retained
Cash + Equipment + Equipment Earnings

+22,000 -26,000 +6,000a =

+2,000b
a Accumulated depreciation for six years is 6 x $1 = $6. The effect of
removing the net book value is $20, consisting of a decrease in
Equipment of $26 and a decrease in Accumulated Depreciation of
$6. Thus, $22 – $20 = $2. Note that the effect of a decrease in
Accumulated Depreciation (by itself) is an increase in assets.
b The $2 is usually carried separately until the end of the year as Gain
on Sale of Equipment, or Gain on Disposal of Equipment.

Income statement effects:

Alaska would include the Gain on Sale of Equipment as a part

of "other income (expense)."

2. a. Cash 22
Accumulated depreciation 6
Equipment 26
Gain on sale of equipment 2

b. Cash 19
Accumulated depreciation 6
Loss on sale of equipment 1

Chapter 8 Long-Lived Assets and Depreciation 427

 Equipment 26

428
8-72 (15-20 min.) Amounts are in millions of dollars.

1. Proceeds $ 4.0
Net book value of equipment sold
$4 − ($8.5) = 12.5
Loss on sale of equipment (given) $ 8.5

Book value = Original cost – Accumulated depreciation

$12.5 = $65 – Accumulated depreciation
Accumulated depreciation = $65 – $12.5
= $52.5

A = L+ SE
Decrease

Decrease
Decrease
Increase

Accumulate

Loss
   
Equipment

       

Equipment
52.5

Sale
Depreciati
a

b
8.5
65

on
+     + = −
Cash

   

of
4

d
-

       
on

a Accumulated depreciation is $52.5. The effect on assets of

removing the net book value is a decrease of $12.5, consisting of a
decrease in Equipment of $65 and a decrease in Accumulated
Depreciation of $52.5. Note that the net effect of a decrease in
Accumulated Depreciation (by itself) is an increase in assets.
b The $8.5 is usually carried separately until the end of the year as
Loss on Sale of Equipment, or Loss on Disposal of Equipment.

Income statement effects:

Loss on Sale of Equipment may be shown as a separate item

on an income statement as a part of "other expense" or some
similar category.

In single-step income statements the loss is shown along with

other expense items, for example:

Chapter 8 Long-Lived Assets and Depreciation 429

8-72 (continued)
Revenue:
Sales of products $XXX
Interest income X
Total sales and other income $XXX
Cost of goods sold X
Selling, general and administrative expense X
Other expense: loss on sale of equipment X
Income before taxes $XXX
In multiple-step income statements, the loss is often shown
after the operating income generated by the sales of major
products.

2. a. Loss on sale of equipment 8.5

Cash 4.0
Accumulated depreciation 52.5
Equipment 65

Cash Equipment
4 65
Accumulated Depreciation, Equip. Loss on Sale of Equipment
52.5 8.5

b. Assume that the equipment and accumulated

depreciations amounts from part a do not change:
Cash 14.0
Accumulated depreciation 52.5
Equipment 65.0
Gain on sale of equipment 1.5
Cash Equipment
14 65

Accumulated Depreciation, Equip. Gain on Sale of Equipment

430
 52.5 1.5

Chapter 8 Long-Lived Assets and Depreciation 431

8-73 (10-20 min.)

A lively discussion usually ensues. This problem could also be

assigned near the end of the course as an example of the strengths
and weaknesses of accounting theory.

1. There would be a "gain from insurance on crashed airplane"

recognized on the income statement:

Insurance payment received $6,500,000

Book value of airplane 962,000
Gain from insurance on crashed airplane $5,538,000

Total assets would increase by $5,538,000, the amount of the

gain. The fleet of airplanes would be the same as before the
crash, but a 727 with a book value of $6.5 million has replaced a
similar 727 with a book value of only $962,000.

2. Accounting for casualties is very controversial. It gets to the

heart of the question of what is income and what is capital.
Does the $6.5 million insurance payment represent a return of
capital or a payment of both capital and income?

The historical-cost model (using nominal dollars) ignores

changes in general purchasing power and intervening
changes in specific prices while an asset is held. When an
asset is disposed of, the gain or loss is measured in nominal
dollars (almost always without regard to the intended use of the
proceeds).

432
8-73 (continued)

Many theorists and practitioners define the income of a going

concern to be a function of whether the proceeds will be
reinvested in the same types of assets. These individuals
maintain that no gain is realized on the airplane crash, because
the $6.5 million is really a return of capital (where capital is
thought of in physical terms as airplanes, inventories, etc.).
Thus, the "gain" would not be shown in the income statement.
Instead, it would appear as a special balance sheet item called
Revaluation Equity, or a similar title.

8-74 (10-15 min.) Amounts are in millions.

This case highlights how current values of equipment may

have little relation to book values.

1. Sales price, 7 x $25 $175

Book value:
Acquisition cost, 7 x $25 = 175
Accumulated depreciation:
$25 − $2.5
7 x 8 yrs. x = 126 49
10yrs.
Gain on sale $126

2. Cash (or Receivables) 175

Accumulated depreciation 126
Aircraft 175
Gain on sale of aircraft 126

Chapter 8 Long-Lived Assets and Depreciation 433

8-75 (15 min.)

1. 20X1: Research and development expense 800,000

Cash 800,000
20X2: Research and development expense 400,000
Cash 400,000
Capitalized software development
costs 1,000,000
Cash 1,000,000

2. The capitalized software development costs must be

amortized .

Note: The amortization of capitalized software costs was not

discussed in the text. However, the instructor may be interested
in discussing the amortization process. If total estimated sales
are $4,000,000 and 20X3 actual sales revenue is $800,000,
amortization would be computed as follows.

20X3 Revenue ÷ Total Revenue = $800,000 ÷ $4,000,000 = .20

20X3 Amortization = .20 x $1,000,000 = $200,000

Amortization of capitalized
software development costs 200,000
Capitalized software development costs 200,000

434
8-76 (10-15 min.)

This problem illustrates how choices among accounting

alternatives can be important to both managers and accountants.
Note that the covenant will be amortized over three years.

1. The tangible assets are deductible over a period of ten years

compared to a three-year amortization of the covenant, so the
buyer should favor Allocation One. In this way, the buyer will
get larger deductions during the first three years, [($72,000 ÷ 3)
+ ($28,000 ÷ 10) = $26,800 per year, instead of ($48,000 ÷3) +
$52,000 ÷10) = $21,200], but smaller deductions in the next
seven years ($2,800 per year instead of $5,200).

2. Managers and accountants differ as to proper reporting to

shareholders. Because the tangible assets are depreciated
over ten years and the covenant is amortized over three years
for shareholder reporting, many would favor Allocation Two
because reported income before taxes would be $5,600 higher
during each of the first three years (in dollars).

Each of Next
First three Seven
Years Years
Allocation ONE TWO ONE TWO
Amortization expense:
Covenant 24,000 16,000 -- --
Tangible assets 2,800 5,200 2,800 5,200
Total 26,800 21,200 2,8005,200

Effects on reported income

of Allocation Two 5,600 higher 2,400 lower

Chapter 8 Long-Lived Assets and Depreciation 435

8-77 (10 min.)
Choosing a lengthy economic life for depreciation purposes is
not inherently unethical, provided it is within the guidelines of
generally accepted accounting principles (GAAP). However, GAAP
allows great flexibility in its depreciation rules, and when a company
uses methods that do not fairly reflect the underlying economics of
a situation, a possible ethical violation occurs.
Some accountants would maintain that any financial reporting
policies that are consistent with GAAP are ethical. These same
persons might maintain that any business practices that do not
violate the law are ethical. The authors do not advocate such a
position. Ethical standards go beyond the law. Therefore, even
reporting policies that meet GAAP are unethical if they deliberately
try to mislead users of the financial statements.
GAAP is intentionally flexible so that different economic
situations can be reflected differently. For example, one theater may
legitimately plan to remodel its theaters every five years while
another plans remodeling only every ten years. The economic life of
the seats, carpets, etc. should reflect this management philosophy.
Nevertheless, there are some economic assumptions that are so far
from reality as to be absurd. Often these can be identified when one
company's policies are far from the norm of the industry. Both
Cineplex Odeon and Blockbuster may fit this category.
Another sign that depreciable lives are chosen to manipulate
income rather than to reflect economic reality is when changes to
longer lives are made just when additional income is needed. It is
unethical to manipulate income by changing accounting policies
when the new policies are clearly in conflict with the economics of
the situation.
In summary, using different accounting policies than other
similar companies is not unethical if the underlying economics
support the differences. However, when differences are intended to
mislead users of the financial statements, there is a clear ethical
violation.

436
8-78 (60 min. or more)

The purpose of this exercise is to help students see what can

be learned from the fixed asset section of a company’s balance
sheet. They can estimate the average age of the company’s assets,
and they can see how this is affected by the depreciation method
used. Comparisons are especially insightful if some companies use
accelerated depreciation; students can see how difficult it is to
compare the fixed assets of a straight-line company to those of an
accelerated-depreciation company.
The ranking of companies by the ratio of their accumulated
depreciation to the original cost of assets can lead to insights into
how the average age of assets can depend on the industry, the
growth rate of the company, management strategies, and other
factors.

8-79 (30-60 min.)

Each solution will be unique and will change each year. The
purpose of this problem is to examine how using different
depreciation methods affects the financial statements.

Chapter 8 Long-Lived Assets and Depreciation 437

8-80 (20-30 min.) (Amounts in millions of dollars)

1. Note 1 reveals that equipment is depreciated over two to seven

years; buildings over 30 to 40 years; and leasehold
improvements over the shorter of their estimated useful lives
or the related lease life, generally 10 years.

2. If lives are increased by 50%, depreciation is reduced by one

third. For example a $400 asset amortized over 4 years is
$400÷ 4 =$100 per year, over 6 years it is $400 ÷6 = $66.67. If
depreciation and amortization were reduced by one third, it
would have been $158,538, $79,269 less than the reported
$237,807. But this would increase pretax earnings and taxes.
The apparent tax rate is $167,989/$436,335 = 38.5%. Thus net
earnings would go up by $79,269 (1-.385) = $48,750, rising from
$268,346 to $317,096, an increase of 18.2%

8-81 (30-60 min.)

NOTE TO INSTRUCTOR. This solution is based on the web site as it

was in late 2004. Be sure to examine the current web site before
assigning this problem, as the information there may have changed.
1. Gap is a global specialty retailer of casual apparel,
accessories and personal care products for men, women and
children. They sell their products under several brand names
including Gap, Banana Republic and Old Navy. Gap sells their
products through both traditional retail stores and online
stores. You would expect Gap to have buildings, furniture,
display equipment and leasehold improvements.

438
2. Information on the method of depreciation and amortization
used is found in Note A to the financial statements: Summary of
Significant Accounting Policies. The company uses straight-line
depreciation and amortization. Other information available in this
note are: 1) estimated useful lives of property and equipment, 2)
interest capitalized on property and equipment under construction,
3) the fact that property and equipment are stated at cost, and 4)
items listed under property and equipment.
3. Technically leasehold improvements are intangible assets, but
they are listed in Note A as property and equipment. Leasehold
improvements are amortized over the life of the lease, not to exceed
12 years. Gap also has lease rights estimated at $170 million as of
January 31, 2004. These rights represent costs to acquire the lease
of specific commercial property. They are amortized over the
estimated useful lives of the leases, not to exceed 20 years. These
rights are probably included in “other assets” on the balance sheet.
At January 31, 2004, the balance sheet lists other assets of $286
million, so Gap may have other intangible assets.
4. The amount listed on the balance sheet for property and
equipment represents cost. If Gap purchases no additional property
and equipment, the net book value will decrease over time.
5. Depreciation and amortization expense for the year ended
January 31, 2004 was $664 million. This number is found on the
statement of cash flows where it is added back to net income in
order to arrive at net cash provided by operating activities.
Depreciation and amortization expense is not obvious from looking
at the income statement because it is combined with other costs. It
likely appears in the line items called Cost of Goods Sold and
Occupancy Expenses and/or Operating Expenses.

Chapter 8 Long-Lived Assets and Depreciation 439