This case study is based on a real-life conversation between a CPA and a manager of a large company division. The business unit manager has run across a situation in which there is a discrepancy between what he feels an asset is worth (Fair Market Value or FMV) and what the company has the asset valued on the books (Book Value). The manager of the company does not want to sell an unused asset because he does not want the loss on the equipment to impact his division’s performance this period. Follow along as Dave and John discuss the issues.
In an upscale neighborhood, John Stevenson was watering grass when he noticed his neighbor Dave Richards riding a bicycle down the street. John stopped watering the grass and walked out to the street, hailing Dave with a wave of his arm. Dave did not see John at first and almost hit him with his bike. John jumped back onto the grass as Dave grabbed the front and back brakes of the bike simultaneously and skidded to a stop right where John had been previously standing. Dave grabbed the headphones from his ears and reached down to turn off his MP3 player. He looked at John and said, “Sorry, I did not see you there. I get a bit zoned out while riding and listening to my CPA exam review tapes.” John quickly replied, “No, I am sorry. I almost made you crash!” “Anyway, why did you stop me?” “Oh, oh yeah,” John replied. “I meant to call you at work today and I forgot. I need some help in dealing with an accountant at a company I am doing business with.” “Well,” Dave joked, “what do you have in mind when you say ‘help in dealing with’? I am not going to beat anyone up! We CPAs have a code of conduct, you know.” “That’s for sure!” John thought and then replied, “No, no, no. I am just having a problem with the way they keep their books. I am trying to sell a piece of their equipment, and this guy’s convoluted ideas about accounting are really getting in the way. He just doesn’t understand business! I think he is doing some funny accounting, maybe even something fraudulent. I need you to tell me how I can straighten him out and make this sale.” The next day, John and Dave met to discuss the situation. “So this accountant doesn’t know his stuff?” Dave asked. “No, no, he doesn’t,” John said. “He’s crazy. They have a machine they bought for $6 million and he is telling me that they paid $10 million. I’ve even seen the invoice, and the cost of the equipment was $6 million.”
Dave said, “Wait, back up a second. Can you give me a little background on the situation? Is this a client of yours?” “Yes,” John replied. “I’ve contracted with Right Way Industries to sell a large generator. I found a buyer who is willing to pay $2.5 million for the thing, but now the operations manager doesn’t want to sell it. He says he doesn’t want his division to incur a loss on the sale. He would rather keep the asset and continue to depreciate it year to year.” “You mean he wants more money for it?” asked Dave. “Well, that really isn’t his big problem,” replied John. “His big concern is the loss on the sale. He doesn’t want it on his books. This is where I have a problem with this guy’s business knowledge. They want to pass up $2.5 million cash because they say they are going to lose $3.4 million on the sale. That’s crazy. They only paid $6 million for the generator.” “Wait a second, John,” Dave said, looking a bit lost in the numbers. “How long have they had this machine?” “Five years,” John replied. Dave continued, “And how much did they pay for it?” “Well, that’s the crazy part,” John responded. “They paid $6 million for the machine, but they are saying it cost $10 million. Anyway, $10 million is the amount they have on their books for it. I am telling you, there is something odd about the accounting for this. I’ve been in business for 20 years and I’ve never seen such stupidity. This may even be fraudulent, I tell you! They are trying to tell me stuff like the reinforcements they made to their plant to handle this machine are part of the cost of the machine. Even worse, they have added the costs of their employees’ salaries from test runs of the machine. Can you believe that? This has to be bad accounting!” “No, I don’t think it is.” responded Dave. “Are they currently using this machine?” John replied, “Well, they haven’t used it in over a year. They currently have two of these at the same plant. Demand for the product was way less than expected. They only run one of these machines at a time now. If the other machine goes down, they can use this one. Upper management wants to try to pull the capital out of the machine for another product line that is doing very well.” Dave said, “Can you ask them to email you a copy of the capitalization worksheet for the generator?” “What’s that?” John asked. Dave replied, “It’s a breakdown of all the items they included in the cost of the machine.” “I’ll have them email that over to me,” said John. Within a few minutes, the computer on John’s desk let out an audible “ding,” and John opened the email and printed the worksheet. “Is this what you needed?” John asked Dave as he handed him the worksheet. “That’s it. Perfect!” Dave replied, visibly brightening as he reviewed the document. Dave took a few minutes to look over the capitalization worksheet, then eyed John and said, “These numbers look okay, John.” “That doesn’t make sense!” replied John. “How can they expect another company to pay them for their inflated value of the machine? I mean, why should my buyer have to deal with the costs of modifications they made to their buildings?” “They don’t expect someone to pay them those costs. That’s just the price at which they put the machine on the books,” said Dave. “But that’s not the cost of the machine!” John repeated. Dave thought about the situation for a few seconds and then said, “John, I think what we have here is a translation issue. We are really dealing with two different business languages.” Defensively, John said, “Two different languages! You sound just as crazy as they do.” “Let me explain,” said Dave. “In your business, you are worried only about the relevant facts of selling a used piece of equipment. The buyer is either going to buy a new machine at fair market value or a used machine at some fraction of the new machine cost.” “Correct,” John replied. “Well,” Dave continued, “when a company buys a machine and they are using generally accepted accounting principles, they put the machine ‘on the books’, as we say, for the purchase price of the machine, plus all relevant costs to get the machine in position and condition for use.” John interrupted, “But what do those costs have to do with the fair value of the machine now?” “They don’t,” began Dave. “Then why are they including these costs as a loss now? I don’t care about these silly accounting rules!” retorted John. “They really shouldn’t come into play in this deal. The buyer is willing to give them $2.5 million for this machine, and all they are worried about is some mythical loss on their books. They have already spent that money. The money is gone, and they are not going to get it back.”
ASSIGNMENT: It’s now time for you to take the role of CPA Dave Richards. Using your business knowledge and accounting skills, advise John Stevenson on the accounting treatment for capitalizing assets. You should also advise him on how he can convince Right Way Industries to sell this piece of equipment. Do your best to answer each of the following questions. Case Questions 1. What costs do you think Right Way Industries should have included in the cost of the asset? Under Generally Accepted Accounting Principles (GAAP), firms must record all costs related to the acquisition of the asset. Acquisition cost may include the original price paid for the asset, setup cost, installation cost, and any amount paid for shipping the asset to the purchaser. For Right Way Industries, this cost includes all of the items detailed in the Capitalization Worksheet. This capitalized cost will be used to calculate the annual depreciation cost for Right Way Industries. 2. John seems to think that the amount paid for the machine itself is all that should matter in valuing the asset for sale. Is John correct? Why would we have a difference between the book value of the asset valued using GAAP and the current market value of the asset? Right Way Industries is accounting for the purchase of the asset using GAAP. The concept behind the accounting for assets under GAAP is the matching concept, requiring us to recognize in our financial statements our expenses in the period in which the expenses were incurred. In capitalizing assets, companies try to reflect the fact that the money spent to acquire the assets and ensure that they are in a good condition for use will benefit the company long term. Thus, all these costs are included in the company’s costs basis in the equipment, and the company then selects a depreciation method to allocate the costs of the asset over its useful life. The main assumption with GAAP accounting is that the asset will remain in use during its expected life. The book value of an asset was never designed to reflect the current value of an asset. Once an asset is no longer in service, the company should write the asset down to the expected salvageable value. John is worried about what an outside company would be willing to pay for the asset in its current condition. The costs paid by Right Way Industries to deliver the machine to its location and get the machine running add no value to the machine for an outside company. John is correct that the accounting book value means nothing when trying to sell the asset to an outside company. 3. What does the accumulated depreciation represent for the business? Depreciation refers to the annual allocation of the cost of the asset over the period for which the asset is used. As time passes, firms depreciate the fixed asset in order to match the expense for the period of use. This amount is subtracted from the original acquisition cost of the asset to determine its current book value. All of this depreciation is collected in the accumulated depreciation account and remains on the financial statements until the firm disposes of the fixed asset. Accumulated depreciation is important to the firm because the balance may indicate that the current year’s depreciation has not yet been made. Since depreciation is an expense that lowers the operating income, it directly lowers the firm’s tax liability. In addition, when the asset is sold, the accumulated depreciation is subtracted from the original acquisition cost to determine its current book value. The difference between the current book value and the amount received for the disposal of the asset is the asset’s gain or loss. Any gain or loss received will directly affect the firm’s tax liability.
4. According to the accounting standards, how should Right Way Industries treat an asset that is no longer in service? If the asset is considered obsolete or no longer in use, the firm must write the asset down to its current market value. The company would incur a loss on the difference between the current market value of the asset and the current book value of the asset. 5. If John can convince Right Way Industries to sell the asset and take the loss, what are the tax ramifications for Right Way Industries? In order for John to determine the tax ramifications for the disposal of the fixed asset, he must first calculate its current book value. Book value is the difference between the asset’s original acquisition cost, including all setup and delivery costs, as mentioned in question one, and the accumulated depreciation collected over the life of the asset. Under U.S. GAAP, firms may choose how to depreciate the asset. For example, one asset may use the straight-line method, while a different asset uses an accelerated method. The straight-line method assigns depreciation cost evenly over the life of the asset. The accelerated method allocates greater amounts of depreciation in the early years and smaller amounts near the end of the asset’s life. Thus, the choice of depreciation method greatly affects the book value of the fixed asset. The difference between the book value and the amount received at the time of disposal is a gain or loss. All gains are taxable at the firm’s corporate rate, thus increasing the firm’s tax liability. A loss could potentially lower the firm’s tax liability, assuming it has income for the period. While the manager at Right Way Industries does not want to sell the machine and incur a loss in the current period, the loss on the sale of the equipment can benefit the company’s cash flow in this period if it has positive taxable income. 6. The manager at Right Way Industries said that he does not want to sell the asset and incur the loss right now. Is this what is best for the company? Discuss in terms of goal conflict and goal congruence. It appears that the manager is more worried about his departmental operations than the firm’s operations as a whole. While the loss could look bad for his division, the fact that the asset is not currently in service means that the company should have written the asset down to current market value as soon as it was removed from operations. By continuing to hold the asset as if it were in service and continuing to depreciate the asset, the company is violating GAAP. In this situation, we have what is considered a goal conflict, as the manager of Right Way Industries is more worried about what is good for his division’s performance measures than what is best for the company overall. The best course of action is to sell the asset and use the loss to offset some of the net income of the company for tax purposes. The manager of Right Way Industries needs to make a business case to his superiors that selling the asset makes sense from a cash flow standpoint.
Robert D. Slater, Ph.D., CPA, is an assistant professor of accounting at the University of North Florida; email@example.com (corresponding author). Vincent Shea, Ph.D, is an assistant professor of accounting at St. John’s University in Queens, NY; firstname.lastname@example.org. © 2013 The Clute Institute Copyright by author(s) Creative Commons License Journal of Business Case Studies – September/October 2013 Volume 9, Number 5