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Chapter 11: Q11-1AAP (page 599)

Electroboy Enterprises, Inc. operates several stores throughout the western United States. As part of an operational and financial reporting review in a response to a downturn in its markets, the company’s management has decided to perform an impairment test on five stores (combined). The five stores’ sales have declined due to aging facilities and competition from a rival that opened new stores in the same markets. Management has developed the following information concerning the five stores as of the end of fiscal 2016.

Original cost \(36million

Accumulated depreciation \)10 million

Estimated remaining useful life 4 years

Estimated expected future

annual cash flows (not discounted) \(4.0 million per year

Appropriate discount rate 5 percent

Accounting

  1. Determine the amount of impairment loss, if any, that Electroboy should report for fiscal 2016 and the book value at which Electroboy should report the five stores on its fiscal year-end 2016 balance sheet. Assume that the cash flows occur at the end of each year.
  2. Repeat part (a), but instead assume that (1) the estimated remaining useful life is 10 years, (2) the estimated annual cash flows are \)2,720,000 per year, and (3) the appropriate discount rate is 6 percent.

Analysis

Assume that you are a financial analyst and you participate in a conference call with Electroboy management in early 2017 (before Electroboy closes the books on fiscal 2016). During the conference call, you learn that management is considering selling the five stores, but the sale won’t likely be completed until the second quarter of fiscal 2017. Briefly discuss what implications this would have for Electroboy’s 2016 financial statements. Assume the same facts as in part (b) above.

Principles

Electroboy management would like to know the accounting for the impaired asset in periods subsequent to the impairment. Can the assets be written back up? Briefly discuss the conceptual arguments for this accounting.

Short Answer

Expert verified

Answer

No, an impairment charge is necessary as the undiscounted value is less than the book value when the estimated cash flow is $2,720,000. Electroboy will need to write the stores down to $20,019,445 from $26 million. If the assets are held-for-sale, the assets can be written back up.

Step by step solution

01

Step-by-Step SolutionStep 1: Meaning of depreciation

In financial accounting, depreciation could be a strategy for spreading out the cost of tangible resources over their functional lives. Essentially, it is the disintegration of the value of an asset, which happens over time due to continuous use and abrasion of the asset.

02

(a) Explaining the “accounting” part

Calculating the undiscounted future cash flows

Undiscounted future cash value=Expected future annual cash flow×Estimated remaining life=$4 million×4 year=$16 million

Calculating the book value

Book value=Original cost−Accumulated depreciation=$36 million−$10 million=$26 million

The impairment test suggests that an impairment charge is necessary as the undiscounted value is less than the book value.

Calculating the estimated fair value

Estimated fair value=Estimated expected future annual cash flow×PVF-OA4,5%=$4 million×3.54595=$14,183,800

Calculating the impairment charge

Impairment charge=Book value−Estimated fair value=$26,000,000−$14,183,800=$11,816,200

Post-impairment book value = $14,183,800

03

(b) Explaining the “accounting” part

Calculating the undiscounted future cash flows

Undiscounted future cash value=Expected future annual cash flow×Estimated remaining life=$2.72 million×10 year=$27.2 million

Calculating the book value

Book value=Original cost−Accumulated depreciation=$36 million−$10 million=$26 million

It is found that the undiscounted future cash flow is greater than the book value; the impairment test suggests that no impairment charge is necessary.

Book value at fiscal year-end = $26 million.

04

Explaining the “analysis” part

If the stores are being sold, they will very certainly be classified as “held-for-sale” for financial reporting purposes. The impairment test is based on discounted cash flows rather than undiscounted cash flows if they are held-for-sale. It's essentially a lower-of-cost-or-market strategy.

Calculating the estimated fair value

Estimated fair value=Estimated expected future annual cash flow×PVF-OA4,5%=$2.72 million×7.36009=$20,019,445

As a result, Electroboy will have to write down the stores from $26 million to $20,019,445. When management wants to sell the assets, fixed asset write-downs are more likely.

05

Explaining the “principles” part

Once an asset has been written down to an impairment value, it cannot be written up again under GAAP. This provision is based on a combination of caution and concerns about the accuracy of measures for upward revaluations of the respective impairment.

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Most popular questions from this chapter

Identify the factors that are relevant in determining the annual depreciation charge, and explain whether these factors are determined objectively or whether they are based on judgment.

(Depreciation—Strike, Units-of-Production, Obsolescence) The following are three different and unrelated situations involving depreciation accounting. Answer the question(s) at the end of each situation.

Situation I: Recently, Broderick Company experienced a strike that affected a number of its operating plants. The controller of this company indicated that it was not appropriate to report depreciation expense during this period because the equipment did not depreciate and an improper matching of costs and revenues would result. She based her position on the following points.

1. It is inappropriate to charge the period with costs for which there are no related revenues arising from production.

2. The basic factor of depreciation in this instance is wear and tear. Because equipment was idle, no wear and tear occurred.

Instructions

Comment on the appropriateness of the controller’s comments.

Situation II: Etheridge Company manufactures electrical appliances, most of which are used in homes. Company engineers have designed a new type of blender which, through the use of a few attachments, will perform more functions than any blender currently on the market. Demand for the new blender can be projected with reasonable probability. In order to make the blenders, Etheridge needs a specialized machine that is not available from outside sources. It has been decided to make such a machine in Etheridge’s own plant.

Instructions

  1. Discuss the effect of projected demand in units for the new blenders (which may be steady, decreasing, or increasing) on the determination of a depreciation method for the machine.
  2. What other matters should be considered in determining the depreciation method? (Ignore income tax considerations.)

Situation III: Haley Paper Company operates a 300-ton-per-day kraft pulp mill and four sawmills in Wisconsin. The company is in the process of expanding its pulp mill facilities to a capacity of 1,000 tons per day and plans to replace three of its older, less efficient sawmills with an expanded facility. One of the mills to be replaced did not operate for most of 2017 (current year), and there are no plans to reopen it before the new sawmill facility becomes operational.

In reviewing the depreciation rates and discussing the salvage values of the sawmills that were to be replaced, it was noted that if present depreciation rates were not adjusted, substantial amounts of plant costs on these three mills would not be depreciated by the time the new mill came on stream.

Instructions

What is the proper accounting for the four sawmills at the end of 2017?

(Depletion and Depreciation—Mining) Khamsah Mining Company has purchased a tract of mineral land for \(900,000. It is estimated that this tract will yield 120,000 tons of ore with sufficient mineral content to make mining and processing profitable. It is further estimated that 6,000 tons of ore will be mined the first and last year and 12,000 tons every year in between. (Assume 11 years of mining operations.) The land will have a salvage value of \)30,000.

The company builds necessary structures and sheds on the site at a cost of \(36,000. It is estimated that these structures can serve 15 years but, because they must be dismantled if they are to be moved, they have no salvage value. The company does not intend to use the buildings elsewhere. Mining machinery installed at the mine was purchased secondhand at a cost of \)60,000. This machinery cost the former owner $150,000 and was 50% depreciated when purchased. Khamsah Mining estimates that about half of this machinery will still be useful when the present mineral resources have been exhausted, but that dismantling and removal costs will just about offset its value at that time. The company does not intend to use the machinery elsewhere. The remaining machinery will last until about one-half the present estimated mineral ore has been removed and will then be worthless. Cost is to be allocated equally between these two classes of machinery.

Instructions

  1. As chief accountant for the company, you are to prepare a schedule showing estimated depletion and depreciation costs for each year of the expected life of the mine.
  2. Also compute the depreciation and depletion for the first year assuming actual production of 5,000 tons. Nothing occurred during the year to cause the company engineers to change their estimates of either the mineral resources or the life of the structures and equipment.

It has been suggested that plant and equipment could be replaced more quickly if depreciation rates for income tax and accounting purposes were substantially increased. As a result, business operations would receive the benefit of more modern and more efficient plant facilities. Discuss the merits of this proposition.

(Book vs. Tax (MACRS) Depreciation) Shimei Inc. purchased computer equipment on March 1, 2017, for \(31,000. The computer equipment has a useful life of 10 years and a salvage value of \)1,000. For tax purposes, the MACRS class life is 5 years.

Instructions

a. Assuming that the company uses the straight-line method for book and tax purposes, what is the depreciation expense reported in

  1. the financial statements for 2017 and
  2. the tax return for 2017?

b. Assuming that the company uses the double-declining-balance method for both book and tax purposes, what is the depreciation expense reported in

  1. the financial statements for 2017 and
  2. the tax return for 2017?

c. Why is depreciation for tax purposes different from depreciation for book purposes even if the company uses the same depreciation method to compute them both?
See all solutions

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