A company buys an oil rig for $1,000,000 on January 1, 2007.The life of the rig is 10 years and the expected cost to dismantle the rig at the end of 10 years is $200,000 (present value at 10% is $77,110).10% is an appropriate interest rate for this company.What expense should be recorded for 2007 as a result of these events?

Question

Quizplus · Accepted Answer

The company should record depreciation expense for 2007 using the straight-line method, which is the cost of the asset minus the salvage value divided by the useful life:

($1,000,000 - $200,000) / 10 = $80,000

However, the company should also adjust this amount for the time the asset was in use during the year. Assuming the rig was purchased on January 1, 2007 and put into use immediately, the company should record 1/12 of the annual depreciation expense for January:

$80,000 / 12 = $6,667

Therefore, the total depreciation expense for 2007 is:

$6,667 + ($80,000 x 11/12) = $73,333

In addition to depreciation expense, the company should also record interest expense for the year based on the carrying value of the asset, which is the cost minus accumulated depreciation:

Carrying value as of January 1, 2007: $1,000,000
Depreciation expense for 2007: $73,333
Carrying value as of December 31, 2007: $926,667

Using a 10% interest rate, the interest expense for the year is:

$926,667 x 10% = $92,667

However, this amount should also be adjusted for the time the asset was in use during the year, which is 11/12:

$92,667 x 11/12 = $84,078

Therefore, the total interest expense for 2007 is:

$84,078

The best choice is D, which is the correct amount for depreciation and interest expense for 2007.

A Company Buys an Oil Rig for $1,000,000 on January