Question: Long-Term Asset Acquisition
Roxy and Harley (R & H) is considering a significant equipment replacement. R & H would like to replace some of their equipment before December 31, 2017. The equipment originally cost $840,000 and the equipment's accumulated depreciation balance at the end of 2016 is will be $790,000. At this point the equipment is depreciated to its salvage value.
Your long-term asset accountant, Joe, tells you about four equipment options as follows:
construct new equipment and sell the old equipment,
exchange the old equipment for new equipment that is more efficient,
purchase new equipment that is more efficient and sell the old equipment, or
overhaul the old equipment.
The estimated life of any new equipment is 7 years.
R & H 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. R & H would take out a one-year construction loan for $900,000 at the time construction begins at a short-term borrowing rate of 10% for the construction Anticipated actual expenditures for constructing the equipment are $980,000, and on a weighted-average basis the expenditures are approximately $625,000. The bulk of the $980,000 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 year-end of 2017.)
Option 2: Exchange the equipment for a similar piece of equipment with a fair value of $995,000. The fair value of the old equipment is $60,000. R & H can borrow $850,000 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 $199,000 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 $199,000 payment would be made in late December 2016. 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 $55,000.
(2) The cost of re-wiring interior components in an overhaul would be $250,000.
(3) Replacing old worn components would cost $148,000 with associated labor costs of $310,000 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, 2008.) The costs will be financed at the end of 2017 through a one-year loan for at 10%.
Instructions: (a) Prepare journal entries in general journal form for each of the four options.
(b) 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 R & H should consider in their analysis.
(d) At the next management team meeting, Roxy & Harley express some concern that any new equipment acquired to replace the old equipment may become obsolete within the next three to six years. Roxy & Harley 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.