Chapter 10, Problem 10.1COP

1.

To determine

To calculate: The amount of interest expense for each year.

Explanation of Solution

Interest Expense: The cost of debt which is occurred during a particular period of time is called interest expense. The interest amount is payable on the principal amount of debt at a fixed interest rate.

Calculate the amount of interest expense for each year.

$\begin{array}{c}\text{Interest expense}=\text{Principal}\text{amount}\times \text{ Interest rate}\times \text{Time}\\ \text{= \$1,800,000}\times 6\text{\%}\times \frac{12}{12}\\ \text{=}\text{\$108,000}\end{array}$

Conclusion

The amount of interest expense for each year is $108,000.

2. (a)

To determine

To calculate: The amount of depreciation expense for each year, using straight-line depreciation method.

Explanation of Solution

Depreciation expense: Depreciation expense is a non-cash expense, which is recorded on the income statement reflecting the consumption of economic benefits of long-term asset.

Straight-line depreciation method: The depreciation method which assumes that the consumption of economic benefits of long-term asset could be distributed equally throughout the useful life of the asset is referred to as straight-line method.

Formula for straight-line depreciation method:

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense}\end{array}\}=\text{Depreciable cost }\text{× Depreciation rate}\\ \text{= }\left(\text{Cost–Residual value}\right)\text{×}\frac{1}{\text{Useful life}}\end{array}$

Calculate the amount of depreciation expense for each year.

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense}\end{array}\}\text{= }\left(\text{Cost–Residual value}\right)\text{×}\frac{1}{\text{Useful life}}\\ =\left(\$2,220,000-\$420,000\right)\times \frac{1}{5\text{years}}\\ =\$360,000\text{per year}\end{array}$

Working note:

Calculate the amount of cost of vehicle.

$\begin{array}{l}\text{Cost of vehicles = Purchase price + }\left(\text{Purchase price }\times \text{ sales tax}\right)\hfill \\ \text{=}\text{\$2,000,000 + }\left(\text{\$2,000,000 x 11\%}\right)\hfill \\ \text{= \$2,220,000}\hfill \end{array}$

Conclusion

The amount of depreciation expense for each year is $360,000.

2. (b)

To determine

To calculate: The amount of depreciation expense for each year, using double-decline balance method.

Explanation of Solution

Depreciation expense: Depreciation expense is a non-cash expense, which is recorded on the income statement reflecting the consumption of economic benefits of long-term asset.

Double-declining-balance method: The depreciation method which assumes that the consumption of economic benefits of long-term asset is high in the early years but gradually declines towards the end of its useful life, is referred to as double-declining-balance method.

Formula for double-declining-balance depreciation method:

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense}\end{array}\}=\left(\begin{array}{l}\text{Book value at the }\\ \text{beginning of the period }\end{array}\right)\text{× Depreciation rate}\\ \text{= }\left(\text{Cost–Accumulated depreciation}\right)\text{×}\frac{\text{2}}{\text{Useful life}}\end{array}$

Calculate the amount of depreciation expense for each year.

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2016}\end{array}\}\text{= }\left(\text{Cost–Accumulated depreciation}\right)\text{×}\frac{\text{2}}{\text{Useful life}}\\ =\left(\$2,200,000-\$0\right)\times \frac{2}{5}\\ =\$888,000\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2017}\end{array}\}\text{= }\left(\text{Cost–Accumulated depreciation}\right)\text{×}\frac{\text{2}}{\text{Useful life}}\\ =\left(\$2,200,000-\$888,000\right)\times \frac{2}{5}\\ =\$532,800\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2018}\end{array}\}\text{= }\left(\text{Cost–Accumulated depreciation}\right)\text{×}\frac{\text{2}}{\text{Useful life}}\\ =\left(\$2,200,000-\left(\$888,000+\$532,800\right)\right)\times \frac{2}{5}\\ =\$319,680\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2019}\end{array}\}\text{= }\left(\text{Cost–Accumulated depreciation}\right)\text{×}\frac{\text{2}}{\text{Useful life}}\\ =\left(\$2,200,000-\left(\$888,000+\$532,800+\$319,680\right)\right)\times \frac{2}{5}\\ =\$191,808\\ =\$59,520\left(\text{Actual}\text{recorded}\right)\end{array}$

The depreciation expense for 2019 would not be $191,808 because it would cause the asset’s book value to fall below its residual value ($420,000). Instead, depreciation of $59,520 $\left(\$2,200,000-\left(\$888,000+\$532,800+\$319,680\right)-\$420,000\right)$ is recorded to make the book value of asset equal to its residual value of $420,000. In 2020, no depreciation expense would be recorded.

2. (c)

To determine

To calculate: The amount of depreciation expense for each year, using units-of- production method.

Explanation of Solution

Units-of-production method: The depreciation method which assumes that the consumption of economic benefits of long-term asset is based on the production capacity or output, is referred to as units-of-production method.

Formula for units-of-production depreciation method:

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense}\end{array}\}=\text{Depreciable cost }\text{× Depreciation rate}\\ \text{= }\left(\text{Cost–Residual value}\right)\text{×}\frac{\text{Actual production}}{\text{Estimated total production}}\end{array}$

Calculate the amount of depreciation expense for each year.

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2016}\end{array}\}=\left(\text{Cost–Residual value}\right)\text{×}\frac{\text{Actual production}}{\text{Estimated total production}}\\ =\left(2,220,000-\$420,000\right)\times \frac{15,000\text{miles}}{60,000\text{miles}}\\ =\$450,000\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2017}\end{array}\}=\left(\text{Cost–Residual value}\right)\text{×}\frac{\text{Actual production}}{\text{Estimated total production}}\\ =\left(2,220,000-\$420,000\right)\times \frac{20,000\text{miles}}{60,000\text{miles}}\\ =\$600,000\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2018}\end{array}\}=\left(\text{Cost–Residual value}\right)\text{×}\frac{\text{Actual production}}{\text{Estimated total production}}\\ =\left(2,220,000-\$420,000\right)\times \frac{10,000\text{miles}}{60,000\text{miles}}\\ =\$300,000\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2019}\end{array}\}=\left(\text{Cost–Residual value}\right)\text{×}\frac{\text{Actual production}}{\text{Estimated total production}}\\ =\left(2,220,000-\$420,000\right)\times \frac{10,000\text{miles}}{60,000\text{miles}}\\ =\$300,000\end{array}$

$\begin{array}{c}\begin{array}{l}\text{Depreciation }\\ \text{expense for 2020}\end{array}\}=\left(\text{Cost–Residual value}\right)\text{×}\frac{\text{Actual production}}{\text{Estimated total production}}\\ =\left(2,220,000-\$420,000\right)\times \frac{5,000\text{miles}}{60,000\text{miles}}\\ =\$150,000\end{array}$

Working note:

Calculate the amount of estimated total production.

$\begin{array}{c}\text{Estimated total production =15,000 + 20,000 + 10,000 + 10,000 + 5,000 miles}\\ \text{= 60,000 miles}\end{array}$

3. (a)

To determine

Net income and two loan covenant ratios (Times interest earned ratio and fixed asset turnover ratio) in each year, assuming the company chooses straight-line depreciation method.

Explanation of Solution

Times-Interest-Earned ratio: It is the ratio that quantifies a business ability to pay interest expense.

Fixed asset turnover: This ratio analyzes number of times sales or revenue generated from the available fixed assets.

Determine net income and two loan covenant ratios (Times interest earned ratio and fixed asset turnover ratio) in each year.

(in 000s)	2016	2017	2018	2019	2020
Income before depreciation  and interest	$1,000	$1,200	$1,400	$1,500	$1,600
Depreciation	360	360	360	360	360
Interest	108	108	108	108	108
Net Income	$532	$732	$932	$1,032	$1,132
Times Interest Earned Ratio	5.93	7.78	9.63	10.56	11.48
Fixed Asset Turnover Ratio	0.98	1.49	2.12	3.02	5.00

Table (1)

Notes:

• The times interest earned ratio for each year is calculated by using the following formula:

$\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio}\end{array}\}=\frac{\text{Net income}+\text{Income tax expense}+\text{Interest expense}}{\text{Interest expense}}$

• The income tax expense for each year is $0.
• The fixed asset turnover ratio for each year is calculated by using the following formula:

$\text{Fixed asset turnover = }\frac{\text{Sales Revenue}}{\text{ Average fixed assets}}$

• Average fixed assets is determined as $\left(\left(\text{Beginning vehicle, net +}\text{Ending vehicle, net}\right)\text{/2}\right)$.
• The ending vehicle, net for each year is determined as $\left(\text{Beginning book value }–\text{Depreciation for the current year}\right)$.

3. (b)

To determine

Net income and two loan covenant ratios (Times interest earned ratio and fixed asset turnover ratio) in each year, assuming the company chooses double decline balance method.

Explanation of Solution

Times-Interest-Earned ratio: It is the ratio that quantifies a business ability to pay interest expense.

Fixed asset turnover: This ratio analyzes number of times sales or revenue generated from the available fixed assets.

Determine net income and two loan covenant ratios (Times interest earned ratio and fixed asset turnover ratio) in each year.

(in 000s)	2016	2017	2018	2019	2020
Income before depreciation  and interest	$1,000	$1,200	$1,400	$1,500	$1,600
Depreciation	888	532.8	319.7	59.5	0
Interest	108	108	108	108	108
Net Income	$4	$559.2	$972.3	$1,332.5	$1,492
Times Interest Earned Ratio	1.04	6.18	10.00	13.34	14.81
Fixed Asset Turnover Ratio	1.13	2.35	4.38	6.45	7.14

Table (2)

Notes:

• The times interest earned ratio for each year is calculated by using the following formula:

$\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio}\end{array}\}=\frac{\text{Net income}+\text{Income tax expense}+\text{Interest expense}}{\text{Interest expense}}$

• The income tax expense for each year is $0.
• The fixed asset turnover ratio for each year is calculated by using the following formula:

$\text{Fixed asset turnover = }\frac{\text{Sales Revenue}}{\text{ Average fixed assets}}$

• Average fixed assets is determined as $\left(\left(\text{Beginning vehicle, net +}\text{Ending vehicle, net}\right)\text{/2}\right)$.
• The ending vehicle, net for each year is determined as $\left(\text{Beginning book value }–\text{Depreciation for the current year}\right)$.

3. (c)

To determine

Net income and two loan covenant ratios (Times interest earned ratio and fixed asset turnover ratio) in each year, assuming the company chooses Units-of-production method.

Explanation of Solution

Times-Interest-Earned ratio: It is the ratio that quantifies a business ability to pay interest expense.

Fixed asset turnover: This ratio analyzes number of times sales or revenue generated from the available fixed assets.

Determine net income and two loan covenant ratios (Times interest earned ratio and fixed asset turnover ratio) in each year.

(in 000s)	2016	2017	2018	2019	2020
Income before depreciation  and interest	$1,000	$1,200	$1,400	$1,500	$1,600
Depreciation	450	600	300	300	150
Interest	108	108	108	108	108
Net Income	$442	$492	$992	$1,092	$1,342
Times Interest Earned Ratio	5.09	5.56	10.19	11.11	13.43
Fixed Asset Turnover Ratio	1.00	1.70	2.75	4.03	6.06

Table (3)

Notes:

• The times interest earned ratio for each year is calculated by using the following formula:

$\begin{array}{l}\text{Times-interest-}\\ \text{earned ratio}\end{array}\}=\frac{\text{Net income}+\text{Income tax expense}+\text{Interest expense}}{\text{Interest expense}}$

• The income tax expense for each year is $0.
• The fixed asset turnover ratio for each year is calculated by using the following formula:

$\text{Fixed asset turnover = }\frac{\text{Sales Revenue}}{\text{ Average fixed assets}}$

• Average fixed assets is determined as $\left(\left(\text{Beginning vehicle, net +}\text{Ending vehicle, net}\right)\text{/2}\right)$.
• The ending vehicle, net for each year is determined as $\left(\text{Beginning book value }–\text{Depreciation for the current year}\right)$.

4. (a)

To determine

To indicate: Whether the loan covenants would be violated under straight-line depreciation method.

Explanation of Solution

Under straight-line depreciation method, the fixed asset turnover ratio (0.98) in 2016 is not maintained a loan covenant of 1.0. Hence, the loan covenants would be violated under straight-line depreciation method.

4. (b)

To determine

To indicate: Whether the loan covenants would be violated under double declining-balance method.

Explanation of Solution

Under double-declining balance method, the time interest earned ratio (1.04) in 2016 is not maintained a loan covenant of 3.0. Hence, the loan covenants would be violated under double-declining balance method.

4. (c)

To determine

To indicate: Whether the loan covenants would be violated under Units-of-production method.

Explanation of Solution

Under Units-of-production method, the time interest earned ratio and fixed assets ratio in all the years are maintained the loan covenant of 3.0 and 1.0 respectively. Hence, the loan covenants would not be violated under Units-of-production method.