DISCUSSION #3
TECHNICALLY DEPRECIATION STARTS WHEN AN ASSET IS PLACED IN SERVICE AND STOPS WHEN THE ASSET IS PERMANENTLY REMOVED FROM SERVICE. WHEN CALCULATING DEPRECIATION, THE STARTING POINT IS TO DETERMINE BEGINNING COST (AKA BASIS) OF THE ASSET. WE CAN ACQUIRE A NEW ASSET BY 1) PURCHASE, 2) TRADE-IN, 3) GIFT OR 4) INHERITANCE. HOW WOULD THE INITIAL COST (BASIS) BE DETERMINED UNDER EACH OF THE FOUR ABOVE APPROACHES.
DISCUSSION #3
TECHNICALLY DEPRECIATION STARTS WHEN AN ASSET IS PLACED IN SERVICE AND STOPS WHEN THE ASSET IS PERMANENTLY REMOVED FROM SERVICE. WHEN CALCULATING DEPRECIATION, THE STARTING POINT IS TO DETERMINE BEGINNING COST (AKA BASIS) OF THE ASSET. WE CAN ACQUIRE A NEW ASSET BY 1) PURCHASE, 2) TRADE-IN, 3) GIFT OR 4) INHERITANCE. HOW WOULD THE INITIAL COST (BASIS) BE DETERMINED UNDER EACH OF THE FOUR ABOVE APPROACHES.
Related questions
Case Study â Bethesda Mining Company Bethesda Mining is a midsized coal mining company with 20 mines located in Ohio, Pennsylvania, West Virginia, and Kentucky. The company operates deep mines as well as strip mines. Most of the coal mined is sold under contract, with excess production sold on the spot market. The coal mining industry, especially high-sulfur coal operations such as Bethesda, has been hard-hit by environmental regulations. Recently, however, a combination of increased demand for coal and new pollution reduction technologies has led to an improved market demand for high-sulfur coal. Bethesda has just been approached by Mid-Ohio Electric Company with a request to supply coal for its electric generators for the next four years. Bethesda Mining does not have enough excess capacity at its existing mines to guarantee the contract. The company is considering opening a strip mine in Ohio on 5,000 acres of land purchased 10 years ago for $5.4 million. Based on a recent appraisal, the company feels it could receive $7.3 million on an after-tax basis if it sold the land today. Strip mining is a process where the layers of topsoil above a coal vein are removed and the exposed coal is removed. Some time ago, the company would simply remove the coal and leave the land in an unusable condition. Changes in mining regulations now force a company to reclaim the land; that is, when the mining is completed, the land must be restored to near its original condition. The land can then be used for other purposes. As they are currently operating at full capacity, Bethesda will need to purchase additional equipment, which will cost $43 million. The equipment will be depreciated on a seven-year MACRS schedule. The contract only runs for four years. At that time the coal from the site will be entirely mined. The company feels that the equipment can be sold for 60 percent of its initial purchase price. However, Bethesda plans to open another strip mine at that time and will use the equipment at the new mine. The contract calls for the delivery of 500,000 tons of coal per year at a price of $60 per ton. Bethesda Mining feels that coal production will be 750,000 tons, 810,000 tons, 830,000 tons, and 720,000 tons, respectively, over the next four years. The excess production will be sold in the spot market at an average of $48 per ton, Variable costs amount to $21 per ton and fixed costs are $3.7 million per year. The mine will require a net working capital investment of 5 percent of sales. The net working capital (âNWCâ) will be built up in the year prior to the sales. Bethesda will be responsible for reclaiming the land at termination of the mining. This will occur in Year 5. The company uses an outside company for reclamation of all the companyâs strip mines. It is estimated the cost of reclamation will be $3.9 million. After the land is reclaimed, the company plans to donate the land to the state for use as a public park and recreation area as a condition to receive the necessary mining permits. This will occur in Year 5 and result in a charitable expense deduction of $7.3 million. Bethesda faces a 38 percent tax rate and has a 12 percent required return on new strip mine projects. Assume a loss in any year will result in a tax credit. You have been approached by the president of the company with a request to analyze the project. Calculate the payback period, profitability index, net present value, and internal rate of return for the new strip mine. Should Bethesda Mining take the contract and open the mine?
| 1. Calculate the Sales Forecast for this Project: | ||||
| Year 1 | Year 2 | Year 3 | Year 4 | |
| Tons produced | ||||
| Contract sales price | ||||
| Spot sales price | ||||
| Contract sales | ||||
| Spot sales | ||||
| Total Sales | ||||
| 2. Cash Flow Today: | ||||
| Equipment | ||||
| Land | ||||
| NWC | ||||
| Total | - | |||
| 3. Calculate the Operating Cash Flows for years 1 to 6 | ||||||
| Tons produced | ||||||
| Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | |
| Sales | ||||||
| Variable costs | ||||||
| Fixed costs | ||||||
| Depreciation | ||||||
| Earnings before tax | ||||||
| Tax | ||||||
| Net Income | ||||||
| Operating Cash Flow | ||||||
| Depreciation Calculation: | - | |||||
| Rate* | Depreciation | |||||
| Yr 1 | 14.29% | |||||
| Yr 2 | 24.49% | |||||
| Yr 3 | 17.49% | |||||
| Yr 4 | 12.49% | |||||
| Yr 5 | 8.93% | |||||
| Yr 6 | 8.92% | |||||
| Yr 7 | 8.93% | |||||
| Yr 8 | 4.46% | |||||
| 100.00% | ||||||
| *per IRS table A-1 | ||||||
Bushman Case
The Bushman Company is a publicly traded corporation that produces different types of digital control systems. My name is Alan Smith and I have worked for this company for the last ten years in the controllerâs office. I was both an accounting and finance major in university. The company currently produces 300 products and does not anticipate any new products coming out over the next three years. I have previously mentioned to my superiors that it is not appropriate for our firm to use a traditional accounting system (where overhead costs are allocated across products at a rate of 400% of direct labor costs) when different products require different amounts of indirect overhead resources. For example, under the traditional system all costs associated with testing of products for quality assurance purposes are part of overhead costs and therefore allocated across products based on direct labor costs. Yet, some of our products require as much as 5 hours of testing whereas some products require less than 1 minute of testing with no connection to direct labor costs. Given that traditional costing systems result in significant cost distortions when determining products costs and given that the firm now has revenues of over $700,000,000 a year, Bushman has decided to adopt activity based costing over the next year or two.
Bushmanâs management has hired Deloitte Consulting to help us implement activity based costing. I will be acting as the liaison between our firm and Deloitte. As part of the initial implementation phase, I have asked Deloitte to derive the costs and product margins associated with two of our products, delta and vega, so that these costs and product margins could be compared with the costs and product margins under our current traditional accounting system. I picked these products since Bushman management believe they have very different demands on indirect overhead resources. Further, delta is sold in large quantities whereas vega is sold in small quantities and traditional accounting systems can cause large cost distortions in different directions for products sold in large and small quantities.
Current information from our existing system on a per unit basis is shown in Exhibit 1.
Exhibit 1
| delta | vega | |
| Direct material | $10 | $10 |
| Direct labor hours | 1 | 1 |
| Direct labor wage rate per hour | $20 | $20 |
| Sales price per unit | $160 | $170 |
My staff has identified for Deloitte five activity cost pools. Information on those cost pools and the related activity measures are provided in Exhibit 2.
Exhibit 2
| Activity cost pool | Total costs | Activity measure | Activity level |
| Equipment setups | $20,000,000 | number of setups | 50,000 |
| Purchase orders | $15,000,000 | number of purchase orders | 300,000 |
| Machining | $90,000,000 | number of machine hours | 2,000,000 |
| Testing | $13,300,000 | number of testing hours | 700,000 |
| Packaging | $24,000,000 | number of containers | 2,000,000 |
Although fixed costs are lumped in with variable costs across the five different cost pools, I am aware that machining related costs consists almost exclusively of depreciation costs. Hence, with respect to all questions asked in this case, machining costs will be treated as entirely fixed with respect to machine hours. Each machine is used in the production of multiple product lines. The resale value of machines is only affected by the passage of time and not by how much they are used in a given year.
In all questions asked in this case, the firm will assume that costs associated with equipment setups, purchase orders, testing, and packaging are variable with respect to their respective activity measures. Currently, we believe our assumptions on cost behavior patterns are quite reasonable.
All products are produced in batches, where the size of a batch differs across products. For example, if we produce 80 units of a product in batch sizes of 40, then the product will be produced in two batches. An equipment setup must be performed before producing each batch of a product. Hence, in the example above, two equipment setups would be performed. Units of product are packaged in containers and sent to distributors.
Production volumes are set equal to sales volumes since the company only produces products that they have orders for. Consequently, the firm never has a beginning or ending work in process inventory, and it does not have a beginning or ending finished goods inventory.
Further information on our two products is provided in Exhibit 3
Exhibit 3
| delta | vega | |
| annual sales and production in units | 800,000 | 12,000 |
| number of units per batch | 200 | 150 |
| number of purchase orders | 400 | 100 |
| number of machine hours per unit | 0.2 | 3 |
| total number of testing hours | 7,000 | 21,000 |
| total number of containers | 5,000 | 2,000 |
REQUIRED:
1. (20 Points) Prepare an income statement for delta and an income statement for vega using the traditional accounting system where overhead is applied at a rate of 400% of direct labor costs. (For simplicity, there are no SG&A expenses for the firm.) The income statements should be prepared on a total basis and then show the average net operating income per unit using the following template for guidance:
delta vega
Sales $$$ $$$
Direct materials $$$ $$$
Direct labor $$$ $$$
Manufacturing overhead $$$ $$$
Total Costs $$$ $$$
Net operating income $$$ $$$
Average net operating income
per unit $$$ $$$
2. (20 Points) Calculate the five activity rates under activity based costing.
3. (35 Points) Prepare an income statement for delta and an income statement for vega using activity based costing. (For simplicity, there are no SG&A expenses for the firm.) The income statements should be prepared on a total basis and then show the average net operating income per unit using the following template for guidance:
delta vega
Sales $$$ $$$
Direct materials $$$ $$$
Direct labor $$$ $$$
Equipment Setups $$$ $$$
Purchase orders $$$ $$$
Machining $$$ $$$
Testing $$$ $$$
Packaging $$$ $$$
Total Costs $$$ $$$
Net operating income $$$ $$$
Average net operating income
per unit $$$ $$$
4. (10 Points) Assume next year that the activity rates remain the same as you calculated in question (2). Assume that the demand for delta is expected to increase significantly. Consequently, the firm expects to produce more batches of delta next year than this year and the firm plans to produce in batch sizes of 500 rather than 200. Calculate what the equipment setup cost per unit of delta will be next year if it can be calculated. If it cannot be calculated, then explain in words why the equipment setup cost per unit of delta cannot be determined in the absence of more information. Excluding your quantitative analysis if any, your explanation should not be more than 1/3 page double spaced with a 12 font size. Your grade will be lowered for poor writing (e.g., grammar).
5. (15 Points) Question 5 is independent of question 4. Next year, because of an expected increase in product demand, machine hours are expected to increase from 2,000,000 to 2,500,000. The company will not need any new machinery since the current machinery is highly underutilized. Also, the number of purchase orders will increase from 300,000 to 360,000. Assume that these new levels of operations are within the firmâs relevant range. Calculate what the activity rate for the cost pool of machining would be next year if it can be calculated. Also, calculate what the activity rate for the cost pool of purchase order would be next year if it can be calculated. If one or both rates cannot be calculated, then explain in words why the calculations cannot be determined in the absence of more information. Excluding any quantitative analysis, your explanation should not be more than 1/3 page double spaced with 12 font. Your grade will be lowered for poor writing (e.g., grammar).
Natalie Lawson spent much of her youth playing sports. Shepassed many hours on the soccer field and in the dance studio. AsNatalie grew older, her passion for healthy living continued as shestarted practising yoga. Now, at the start of her second year incollege, Natalie is investigating various possibilities forstarting her own business as part of the requirements of theEntrepreneurship program she is taking. A long-time friend insiststhat Natalie has to somehow include healthy living in her businessplan and, after a series of brainstorming sessions, Natalie settleson the idea of operating a smoothie business. She will start on apart-time basis. She will make the product at home, bottle it, andtake it to the yoga studio where she exercises because they haveagreed to purchase it on a regular basis. Now that she has startedthinking about it, the possibilities seem endless. During thesummer, she will concentrate on fresh fruit and vegetablesmoothies. The first difficult decision is coming up with theperfect name for her business. In the end, she settles on âHealthySmoothiesâ and then moves on to more important issues.
During the month of April 2017, the following activities takeplace:
Apr. | 12 | Natalie cashes her Canada Savings Bonds and receives $980, whichshe deposits in her personal bank account. |
13 | She opens a bank account under the name âHealthy Smoothiesâ andtransfers $900 from her personal account to the new account. | |
15 | Natalie realizes that her initial cash investment is not enough.Her mother lends her $3,000 cash, for which Natalie signs aone-year, 3% note payable in the name of the business. Nataliedeposits the money in the business bank account. | |
18 | Natalie pays $325 to advertise in the April 20 issue of hercommunity newspaper. Natalie hopes that this ad will generaterevenue during the months of May and June. | |
20 | She buys supplies, such as protein powder, cups, straws, andfresh fruit and vegetables, for $198 cash. | |
22 | Natalie starts to investigate juicing machines for her business.She selects an excellent top-of-the-line juicer that costs $825.She pays for it using her own personal account. | |
23 | Natalie prepares her first batch of smoothies to bring to theyoga studio. At the end of the first day, Natalie leaves an invoicefor $300 with the studio owner. The owner says the invoice will bepaid sometime in May. | |
24 | A $98 invoice is received for the use of Natalie's cell phone.The cell phone is used exclusively for the Santé Smoothiesbusiness. The invoice is for services provided in April and is dueon April 30. | |
28 | The yoga studio where Natalie sold her first smoothies orderssmoothies for the next month. Natalie is thrilled! She receives$125 in advance as a down payment. |
PART 1: APRIL MONTH (33 marksavailable)
Requirement 1: Natalie has hired youto be her bookkeeper. Prepare the required journalentries for the above events. Explanations are notrequired and round to the nearest dollar. (17 marks)
Requirement 2: Post the entries tothe general ledger using the t-account format. (9marks)
Requirement 3: Prepare theunadjusted trial balance as of July 31, 2013. (7 marks)
PART 2: APRIL MONTH END (36marks)
It is the end of April and Natalie has been in touch with hermother. Her mother is curious to know if Natalie has beenprofitable and if Natalie requires another loan to help finance herbusiness. Natalie too would like to know if she has been profitableduring her first month of operation. Natalie realizes that, inorder to determine Santé Smoothies' income, she must first makeadjustments. Natalie puts together the following additionalinformation:
1. A count reveals that $105 of supplies remain at the end ofApril.
2. Natalie was invited to deliver smoothies to a summer barbecueat her local community centre. At the end of the day, she left aninvoice for $175 with the facility manager. Natalie had not hadtime to record this invoice in her accounting records.
3. Because there were so many guests expected to attend thebarbecue in item 2, she asked a friend to help with making thesmoothies and promised to pay her $12 an hour. The payment to herfriend was made on May 4, 2017, for four hours of work.
4. Natalie estimates that all of her equipment will have auseful life of three years or 36 months. (Assume Natalie decides torecord a full month's worth of depreciation, regardless of when theequipment was acquired by the business.)
5. Recall that Natalie's mother is charging 3% interest on thenote payable extended on April 15. The loan plus interest is to berepaid in 12 months. (Calculate interest to the nearest month.)
Requirement 4: Prepare the necessaryadjusting journal entries. (10 marks)
Requirement 5: Post the adjustingjournal entries. (15.5 marks)
Requirement 6: Prepare the adjustedtrial balance. (10.5 marks)
PART 3: FINANCIAL STATEMENTS (19marks)
Natalie had a very busy May. At the end of the month, Nataliejournalized and posted her adjusting entries, and prepared thefollowing adjusted trial balance at May 31, 2017:
| HEALTHY SMOOTHIES Adjusted Trial Balance May 31, 2017 | ||
|---|---|---|
Debit | Credit | |
Cash | $3,060 | |
Accounts receivable | 675 | |
Supplies | 95 | |
Equipment | 1,550 | |
Accumulated depreciationâequipment | $66 | |
Accounts payable | 88 | |
Unearned revenue | 100 | |
Interest payable | 11 | |
Notes payable, 3%, principal and interest due April 15, 2018 | 3,000 | |
N. Koebel, capital | 1,725 | |
Revenue | 1,225 | |
Advertising expense | 325 | |
Salaries expense | 48 | |
Telephone expense | 174 | |
Supplies expense | 211 | |
Depreciation expense | 66 | |
Interest expense | 11 | |
$6,215 | $6,215 | |
Using the information in the adjusted trial balance, do thefollowing:
Requirement 7: Prepare an incomestatement for the two months ending May 31, 2017. (5 marks)
Requirement 8: Prepare the Statementof Ownerâs Equity for the two months ended May 31, 2017,(3marks)
Requirement 9: Prepare a ClassifiedBalance Sheet at May 31, 2017. (8 marks)
Requirement 10:Calculate Healthy Smoothies'
current ratio and acid-test ratio. (2 marks)
Comment on Healthy Smoothiesâ liquidity. (1 marks)
PART 4: CLOSING (12 marks)
Requirement 11: Natalie has decidedthat her year-end will be May 31, 2017. Prepare closing entries.(5.5 marks)
Requirement 12: Prepare apost-closing trial balance. (6.5 marks)
