BIRD’S EYE VIEW LTD - practice PDF

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BIRD’S EYE VIEW LTD.

CASE OBJECTIVES

The purpose of Bird’s Eye View Ltd. is to give us more practice dealing with various long-lived assets transactions. The case focuses on the following: 

  

The four methods of depreciation  Straight line  Unit of production  Diminishing  Double diminishing How to account for trade-ins, disposals (retirements), and sales of long-lived assets How to test and account for impairment How to account for research and development

CASE INSTRUCTIONS

This case will help you determine how to account for each of the transactions outlined in the case. We will deal with each transaction as it comes up in the case. If you have any questions you should consult your instructor.

HOT AIR BALLOON Sept. 1/11

Feb. 2/12

Aug. 31/12

Trade in balloon for helicopter

The first step of a trade in or exchange is to depreciate the asset up to the point of the trade-in or exchange. The hot air balloon uses the diminishing balance method, thus we need to find the book value (historical cost – accumulated depreciation) which, in this case, is $51,656 and multiply by one, divided by the useful life of 10 years given in the case. Finally we need to multiply by n/12 the amount of months which we used the balloon during this fiscal year. Book value × 1/Useful life × n/12 = ($120,000 – $68,344) ÷ 1/10 × 5/12 = $2,152

Our journal entry is the following: DR CR

Depreciation expense A/D, Hot air balloon

2,152 2,152

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Our next step is to figure out the asset’s book value. This is done by finding a trial balance in the account. In the case of the hot air balloon, we take the historical cost of $120,000 and subtract the accumulated depreciation of $70,496 for a balance of $49,504. This needs to be compared to the value received in the trade-in to understand if a gain or a loss was achieved upon the trade. Our equation will look like this: Net value of asset – Trade-in allowance = Gain or loss $49,504 – ????? = Gain or loss Isolating the value of the trade in allowance is complicated by the fact that we also used cash to pay for the helicopter. We solve for the trade-in value by taking the $840,000 value of the helicopter and subtracting the amount given for cash. The remainder is the hot air balloon’s trade-in value. Helicopter value = Cash + Trade-in allowance Helicopter value – Cash = Trade-in allowance $840,000 – $800,000 = Trade-in allowance $40,000 = Trade-in allowance Now we can return to our original formula to find gain or loss: Net value of asset – Trade-in allowance = Gain or loss $49,504 – $40,000 = $9,504 (Loss) It is a loss because on our books we had a value of $49,504 and we only received $40,000 on the trade in. DR DR DR

Loss on trade-in A/D, Hot air balloon Helicopter CR Cash CR Hot air balloon

9,504 70,496 840,000 800,000 120,000

*TIP: Remember that our super-T must balance with debits equaling credits. The same rule applies with each transaction we make. Whenever we are entering a large transaction with multiple debits and credits, we should check that the debits and credits equal one another. For example, in the above transaction, the sum of both debits and credits is equal to $940,000. HELICOPTER Sept. 1/11

Feb. 2/12

Aug. 31/12

Acquire helicopter

Depreciate at fiscal year-end

We must remember that the new helicopter needs to be depreciated at fiscal year-end. We are told the helicopter has an expected useful life of 2,000 flight hours and 40 flight hours took place since the purchase. Our calculation is as follows:

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(Historical cost – Residual value) ÷ Useful life in units × Number of units consumed this period ($840,000 – 0) ÷ 2,000 hours × 40 hours $420 per hour × 40 hours = $16,800 Our journal entry is as follows:

DR CR

Depreciation expense A/D, Helicopter

16,800 16,800

STORAGE FACILITY Sept. 1/11

Aug. 31/12

Purchase storage facility

Depreciate at fiscal year-end

We purchase the storage facility for cash. Our journal entry is as follows: DR CR

Storage facility Cash

86,000 86,000

We need to depreciate this asset at the end of the fiscal year, using the straight-line method. (Historical cost – Residual value) ÷ Useful life × n/12 ($86,000 – $25,200) ÷ 20 × 12/12 = $3,040 Our journal entry is as follows: DR CR

Depreciation expense A/D, Storage facility

3,040 3,040

We have further information in the case that our facility has been appraised to a lower value. This impairs our asset. We must record on our books the lower of fair market value and historical cost. We must remember that we have consumed part of the facility’s use so we must compare our book value at fiscal year-end to the market value to perform an impairment test. Our calculation is as follows: Book value – Market value = Impairment loss (or no change if a negative result) The market value of the facility at fiscal year-end was given at $78,600. The book value is the historical cost of the asset less accumulated depreciation: Historical cost – Accumulated depreciation = Book value $86,000 – $3,040 = $82,960

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Now we can test for impairment with this formula: Book value – Market value = Impairment loss (or no change if a negative result) $82,960 – $78,600 = $4,360 *TIP: When a negative number is the result of this test, this means that the market value is higher. Accounting rules state we must record the lower of book value and market value. If market value is more than the book value, we do nothing. Our journal entry is as follows: DR CR

Impairment loss A/D, Storage facility

4,360 4,360

BUS Sept. 1/11

Aug. 31/12

Depreciate at fiscal year-end

The bus uses the double-diminishing method of depreciation. Thus we need to know the current book value (Historical cost – Accumulated depreciation), the Useful life and the Residual value. Our formula is: Book value × 2/Useful life × n/12 = ($70,000 – $61,250) × 2/4 × 12/12 = $4,375 We must remember that with the diminishing and double diminishing methods, it is more likely to depreciate past the residual value. This is the test you must perform: New book value > or = Residual value ($70,000 – $61,250 – $4,375) > or = $5,000 $4,375 > or = $5,000 Since our book value, if we used the $4,375 from the formula, would drop below the residual value of $5,000, we need to apply the following formula to our depreciation for this period. The end result of which should fully depreciate the asset. Book value – Depreciation expense = Residual value Book value – Residual value = Depreciation expense $8,750 – $5,000 = $3,750 Our journal entry is as follows: DR CR

Depreciation expense A/D, Bus

3,750 3,750

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RESEARCH AND DEVELOPMENT Sept. 1/11

Jan. 5/12

July 3/12 Aug. 31/12 Development

Research

We must recognize that the costs associated with research are expensed since their connection to a future economic benefit is uncertain. In contrast, developmental costs can be capitalized (turned into an asset) since we anticipate future economic benefit. In this case, the time between January and July, when our part-time researcher investigates the idea, the likelihood of making this product is uncertain which makes this classified as research and should be expensed as follows: 6 months × $500 per month Our journal entry is as follows: DR CR

Research expense Cash

3,000 3,000

In July, when our researcher declares the project is feasible and we order the production process to begin, we are now in the developmental stage since it is fairly certain we will receive the economic benefit. This means we can record it as an asset and later depreciate it when we start using the asset (this will happen when the camera/tablet begins to generate revenue). 2 months × $500 per month Our journal Entry is as follows: DR CR

Development costs (asset) Cash

1,000 1,000

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Bird’s Eye View Ltd. SUPER-T ASSET ASSETS S Hot Air Balloon 120,000 O/B (2) 120,000

Cash (2) 800,000 (4) 86,000 (8) 3,000 (9) 1,000

Bus 70,000 O/B

A/D, Hot Air Balloon O/B 68,344 (1) 2,152 70,496 (2)

Storage Facility 86,000 (4)

Helicopter 840,000 (2)

A/D, Helicopter (3) 16,800

A/D, Storage Facility (5) 3,040 (6) 4,360

A/D, Bus O/B 61,250 (7) 3,750

Development Cost 1,000 (9)

EXPE EXPENSES NSES Depreciation Expense 2,152 (1) 16,800 (3) 3,040 (5) 3,750 (7)

Impairment Loss 4,360 (6)

Research Expense 3,000 (8)

Loss on Trade-in 9,504

(2)

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SUPPLEMENTARY CASE 5 FAQ This page contains instructors’ responses to your common questions. If you want the answer to a question not discussed here, contact your instructor by email (see faculty and staff link). Question 5.1:

What is a long-lived asset? Why do we depreciate assets? Answer 5.1:

Long-lived assets (formerly called fixed assets) are assets which are expected to provide future benefit. For example, a building is an asset likely to be used for many years. We establish such assets as long-lived assets so that we can depreciate these items over their useful lives, thus matching the expense of the asset with the value received.

Question 5.2:

How do I know which method of depreciation to use? Answer 5.2:

For the purposes of Business 2257, we will always provide enough information to only complete one method or we will directly state the method. In the future, accountants and managers choose the method which best reflects “the economic reality”. This simply means we depreciate the asset as close as possible to the way an asset’s value is consumed. Think about a computer. With each passing year it becomes exponentially more obsolete. The majority of a computer’s value is consumed in the beginning and tails off in later years. This works well with the double-diminishing-balance method which has large depreciation expense in the beginning and smaller ones near the end of the asset’s useful life. In contrast, an asset such as desks for an office likely provides equal value throughout their lives, thus a straight-line method is fairly reflective. Finally, think about the units-of-output method. Some assets are not used equally each year and are more tied to variations in use. Think about a projector, the bulb is estimated to last a specific number of hours. The best reflection of the use of the asset is to depreciate it with each hour of use.

Question 5.3:

What is impairment and how do we test for it? Answer 5.3:

Impairment occurs when the value we have on our books is more than what the asset is worth in the market. The reason we create financial statements in the first place is to provide a reflection of the economic situation of a company. Imagine a company that buys a luxury apartment complex in Detroit for $2 million. Then the economy collapses as a result of closure of several plants and no one wants to live in

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the area, so the market price of the building falls drastically. Let’s suppose it was only worth $500,000 today. It is unfair to list to property on the company’s books at $2 million because lenders and investors want an idea of the current value of the asset.

Question 5.4:

Can we reverse an impairment? Answer 5.4:

Yes, continuing on with the Detroit apartment building example, let’s suppose that Boeing moves a factory into the area and business booms. The new value of the property is then estimated at $3 million. The impairment may be reversed but only back to the historical cost. The company would be permitted to reverse the impairment and bring the asset value back to $2 million, but not to the $3 million market value because it must conservatively record the lower of the amount paid and the market value.

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