Question

1. Long-Term Asset Acquisition

Bruce and Emmett (B & E) is considering a significant equipment replacement. B & E would like to replace some of their equipment before December 31, 2019. The equipment originally cost $500,000 and the equipment’s accumulated depreciation balance at the end of 2019 is will be $450,000. At this point the equipment is depreciated to its salvage value.

Your long-term asset accountant, Boris, tells you about four equipment options as follows:

1. construct new equipment and sell the old equipment,
2. exchange the old equipment for new equipment that is more efficient,
3. purchase new equipment that is more efficient and sell the old equipment, or
4. overhaul the old equipment.

The estimated life of any new equipment is 5 years.

All loans would start as of January 1, 2019

B & E would like you to analyze the four options to determine the financial impact of each decision and any non-financial considerations that may result from each decision. Additional information about each option is presented below:

Option 1: Construct the new equipment in-house and sell the old equipment for cash at a fair value of $60,000. B & E would take out a one-year construction loan for $500,000 at the time construction begins at a short-term borrowing rate of 10% for the construction      Anticipated actual expenditures for constructing the equipment are $580,000. The bulk of the $580,000 will be financed with the construction loan, and the balance will be financed through accounts payable. The interest on the short-term note is due and payable by year-end. (Note: Construction is assumed to be completed at December 31,2019.)

Option 2: Exchange the equipment for a similar piece of equipment with a fair value of $600,000. The fair value of the old equipment is $60,000. B & E can borrow $540,000 on a one-year, 10% note. the balance will be funded with an accounts payable arrangement with the supplier. (Assume the exchange has commercial substance.)

Option 3: Purchase the new equipment by giving a non-interest-bearing note with five payments of $120,000 to the supplier (starting on the first day of note’s term and each year thereafter) and selling the old equipment for $60,000 cash. The first $120,000 payment would be made in late December 2019. The prevailing interest rate for obligations of this nature is 10%.

Option 4: Overhaul the existing equipment. The following expenses are anticipated under this approach: (1) The normal annual cost for lubrication and replacement of minor parts to maintain the integrity of the exterior body would be $30,000. (2) The cost of re-wiring interior components in an overhaul would be $150,000. (3) Replacing old worn components would cost $100,000 with associated labor costs of $210,000 for installation. The overhaul is estimated to extend the useful life of the equipment another four years. (The present equipment’s original useful life was eight years, starting January 1, 2014) The costs will be financed through the end of 2019 with a one-year loan at a 10% interest rate.

Instructions

1. Prepare journal entries in general journal form for each of the four options.
2. Write a brief memo on how each option affects the financial statements. Include your journal entry(ies) in the body of your memo for each option. Discuss the strengths and weaknesses of each option.

(c) Since you are now in the process of analyzing the quantitative effects of this decision, you decide to also consider whether the acquisition of any new equipment will cause any employees to lose jobs. Also you wonder if there are other non-financial and/or ethical considerations you should include in your analysis. Write a memo describing other qualitative or subjective issues that you think B & E should consider in their analysis.

(d) At the next management team meeting, Bruce & Emmett express some concern that any new equipment acquired to replace the old equipment may become obsolete within the next three to six years. Bruce & Emmett want to know how the accounting rules for impairments would apply to any new equipment. Research the accounting literature (e.g., access the FASB Codification), to determine the official guidance for information on impairments including the timing and calculation of the amount. Be sure you describe the reasons for recording impairments and how recording any impairment actually can benefit the financial statements.

(e)   You seem to remember that asset impairments could be used to “manage earnings.” Search the Internet and accounting journals for recent stories in the business press about asset impairments and earnings management. Prepare a memo explaining how earnings might be managed through asset impairments

.

(f) What if you found out that the Research and Development account included current year costs of $190,000 and R& D Equipment with a cost of $100,000 and an estimated useful life of 5 years. Describe how that would impact the financial statements (do not revise the financial statements) and prepare the necessary journal entries assuming the financial statements have not been issued yet

Answer 1

a.	Jouranal Entries	Dr	Cr
Option 1 .	Construct the New Equipment inhouse and sell the old equipment for Cash at fair value of 60000	Amount ($)	Amount ($)
31.12.2018	Bank A/C                                       DR	60000
	To Equipment A/C		50000
	To Profit & Loss A/C		10000
	( Being the Old equipment sold and Profit on sale accounted for.
01.01.2019	Bank A/C                                       DR	500000
	To Construction Loan A/C		500000
	Being Construction loan received)
31.12.2019	New Equipment A/C              Dr	580000
	To Bank A/C		500000
	To Notes Payable		80000
	(Being construction of new equipment completed )
31.12.2019	New Equipment A/C              Dr	58000
	To Construction Loan A/C		50000
	To Notes Payable A/C		8000
	( Being Interest on Constrcution Loan and Notes payable Capitalized tom New Equipment at year end)
Option 2	Exchange the Old equipment with a New Equipment
01.01.2019	New Equipment A/C                                 Dr	600000
	To Old Equipment		60000
	To Notes Payable		540000
	(Being Exchange of Old equipment with a new Equipment and balance exchange price to be paid by Notes)
31.12.2019	New Equipment A/C                                 Dr	54000
	To Notes Payable		54000
	( Interest on Notes payable for one year @ 10% capitalized)
31.12.2019	Depreciation A/C                              Dr	130800
	To Provision for Depreciation		130800
	(Depreciation for first year accounted for considering useful life of 5 year)
Option 3	Purchase the New Equipment with Non interest bearing Notes Payable
31.12.2018	Bank A/C                                                            Dr.	60000
	To Old Equipment   A/C		50000
	To Profit & Loss A/c		10000
	(Being old equipmet dsiposed off and Profit on sale of Old equipment credited P/L A/c)
01.01.2019	New Equipment A/c                                         Dr	600000
	To Notes Payable		600000
	(Being new equipment purchased through Non interest bearing Notes)
31.12.2019	Notes Payable A/c                                          Dr	120000
	To Bank A/C		120000
	( Being payment of first instalment of Non interest bering Notes)
31.12.2019	New Equipment A/c                                         Dr	120000
	To Provision for Depreciation		120000
	(Being depreciation for first year accounted for)
Option 4	Ovehauling old equipment
01.01.2019	Repair and Maintenance Expenses A/C                             Dr	490000
	To Loan		490000
	( Being overhaul expenses incurred for old equipment)
31.12.2019	Interest on Loan A/C                                                                    Dr	49000
	To Profit & Loss A/c		49000
	( Being Interest on Loan of $ 490000 @ 10% p.a. debited to P/L A/C)