Problem 17 - Accounting

Question

Equipment acquired on January 3, 2007, at a cost of \(504,000, has an estimated useful life of 12 years, has an estimated residual value of \)42,000, and is depreciated by the straight-line method. a. What was the book value of the equipment at December 31, 2010, the end of the year? b. Assuming that the equipment was sold on April 1, 2011, for $315,000, journalize the entries to record (1) depreciation for the three months until the sale date, and (2) the sale of the equipment.

Step-by-Step Solution

Answer

The book value of the equipment on December 31, 2010, was $350,000. The journal entry for depreciation on sale is to debit Depreciation Expense and credit Accumulated Depreciation by 9,625. For the sale, debit Cash 315,000, Accumulated Depreciation 163,625, and Loss on Sale 25,375, and credit Equipment 504,000.

Step 1: Calculate the Annual Depreciation

Use the straight-line depreciation formula: \( \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} \). Plug in the values: \( \frac{504,000 - 42,000}{12} = 38,500 \). The annual depreciation is \(38,500\).

Step 2: Calculate Total Depreciation Until December 31, 2010

To find the total depreciation from January 3, 2007, to December 31, 2010, count the full years: 2007, 2008, 2009, and 2010. Multiply by the annual depreciation: \(4 \times 38,500 = 154,000\).

Step 3: Determine the Book Value at December 31, 2010

Subtract the total depreciation up to December 31, 2010, from the original cost to find the book value: \(504,000 - 154,000 = 350,000\). The book value is \(350,000\).

Step 4: Calculate Depreciation for 2011 Until Sale

Determine depreciation for the first quarter of 2011 (three months) by dividing the annual depreciation by 4: \(\frac{38,500}{4} = 9,625\).

Step 5: Journalize Depreciation Up to Sale Date

Record the depreciation entry: **Debit Depreciation Expense** 9,625 **Credit Accumulated Depreciation** 9,625.

Step 6: Journalize Sale of Equipment

First, calculate accumulated depreciation at sale: \(154,000 + 9,625 = 163,625\). The book value at sale is \(504,000 - 163,625 = 340,375\). Record the sale: **Debit Cash** 315,000, **Debit Accumulated Depreciation** 163,625, **Credit Equipment** 504,000, **Debit Loss on Sale of Equipment** 25,375.

Key Concepts

Journal Entries

To keep accurate financial records, businesses need to track every transaction. In accounting, this is done through journal entries. A journal entry records the financial details of a transaction showing the amounts to be debited and credited to the respective accounts.
Journal entries follow the double-entry bookkeeping system, meaning each entry has at least two accounts affected – one debited and another credited.

• **Debit**: This increases assets or expenses and decreases liabilities, equity, and income.
• **Credit**: This increases liabilities, equity, and income and decreases assets or expenses.

For instance, when recording depreciation for three months until an asset's sale, you would debit the Depreciation Expense account and credit Accumulated Depreciation. Doing so reduces the book value of the asset and ensures expenses are matched to the revenue they help generate. Similarly, when selling equipment, entries record the cash received, the reversal of the accumulated depreciation, the original equipment cost, and any gain or loss from the sale. This meticulous record-keeping helps in creating accurate financial statements.

Book Value

Book value denotes the net value of an asset as it appears on the balance sheet. Calculating book value involves subtracting the accumulated depreciation from the initial cost of the asset.
In our example, equipment starts with a cost of $504,000. Over time, its value decreases because of wear and tear. Using straight-line depreciation, we calculate accumulated depreciation for the duration the asset was in use.

• In this case, the total depreciation until December 31, 2010, was $154,000.
• By subtracting this depreciation from the initial cost, the book value on that date was $350,000.

The book value gives businesses a number to track the current worth of assets in their financial statements and is crucial for assessing the need to replace or upgrade assets. It also influences decisions on sales, as seen when determining gains or losses upon disposing of assets.

Straight-Line Method

Depreciation is an accounting technique to spread out the cost of an asset over its useful life. The straight-line method is the simplest and most commonly used method.
Under this method, the same amount of depreciation is expensed each year over the asset's life. This approach assigns an equal portion of the cost less residual value to each accounting period.
The formula used in straight-line depreciation is:\[ \text{Annual Depreciation} = \frac{\text{Cost} - \text{Residual Value}}{\text{Useful Life}} \]For example, if equipment costs \(504,000, has a residual value of \)42,000, and lasts 12 years, the annual depreciation is calculated as:

• \( \frac{504,000 - 42,000}{12} = 38,500 \)

This consistent expense allocation simplifies financial planning and reporting, as each year reflects a stable portion of the asset's original cost. Managers find this method helpful as it provides a straightforward way to account for the decreasing value of physical assets.