For Accounting only

Judgment Case 11–5

Capitalize or expense;

materiality

• LO11–9

Redline Publishers, Inc. produces various manuals ranging from computer

software instructional booklets to manuals explaining the installation and use of

large pieces of industrial equipment. At the end of 2013, the company's balance

sheet reported total assets of $62 million and total liabilities of $40 million. The

income statement for 2013 reported net income of $1.1 million, which

represents an approximate 3% increase from the prior year. The company's

effective income tax rate is 30%.

Near the end of 2013, a variety of expenditures were made to overhaul the

company's manufacturing equipment. None of these expenditures exceeded

$750, the materiality threshold the company has set for the capitalization of any

such expenditure. Even though the overhauls extended the service life of the

equipment, the expenditures were expensed, not capitalized.

John Henderson, the company's controller, is worried about the treatment of the

overhaul expenditures. Even though no individual expenditure exceeded the

$750 materiality threshold, total expenditures were $70,000.

Required:

Should the overhaul expenditures be capitalized or expensed?

Communication Case

11–6

Capitalize or expense;

materiality

• LO11–9

The focus of the case is the situation described in Case 11–5. Your instructor

will divide the class into two to six groups depending on the size of the class.

The mission of your group is to determine the treatment of the overhaul

expenditures.

Required:

1. Each group member should deliberate the situation independently

and draft a tentative argument prior to the class session for which

the case is assigned.

2. In class, each group will meet for 10 to 15 minutes in different

areas of the classroom. During the meeting, group members will

take turns sharing their suggestions for the purpose of arriving at a

single group treatment.

3. After the allotted time, a spokesperson for each group (selected

during the group meetings) will share the group's solution with the

class. The goal of the class is to incorporate the views of each

group into a consensus approach to the situation.

Judgment Case 11–5 There is no necessarily correct answer to the question. The support made for the

answer given is more important than the answer itself. Materiality is the critical

consideration.

Information is material if it can have an effect on a decision made by users. One

consequence of materiality is that GAAP needs to be followed only if an item is

material. The threshold for materiality will depend principally on the relative

dollar

amount of the transaction.

In this case, is the $70,000 material? Net-of-tax income would be $49,000 higher

if the expenditures were capitalized instead of expensed [$70,000 x (1 – .30)]. This

represents a 4.45% increase in income ($49,000 ÷ $1,100,000). The effect on the

balance sheet is small. Shareholders' equity would be higher by $49,000 if the

expenditures were capitalized. This represents an increase of less than one-half of

one

percent. Would these differences have an effect on decision makers? There is no

single answer to this question. The FASB has been reluctant to establish any

quantitative materiality guidelines. The threshold for materiality has been left to

subjective judgment of the company preparing the financial statement and its

auditors.

Communication Case 11–6 There is no right or wrong answer to this case. Both views, expense and

capitalize, can be defended once consideration is given to the materiality issue. The

process of developing and synthesizing the arguments will likely be more

beneficial

than any single solution. Each student should benefit from participating in the

process, interacting first with his or her partner, then with the class as a whole. It is

important that each student actively participate in the process. Domination by one

or

two individuals should be discouraged.

A significant benefit of this case is that it is forcing students to consider the

subjective nature of materiality when applying GAAP.