A company buys an oil rig for $2,000,000 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 $400,000 (present value at 10% is $154,220).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 use the straight-line depreciation method to allocate the cost of the oil rig evenly over its 10-year life. Therefore, the annual depreciation expense would be $200,000 ($2,000,000 cost / 10 years).

In addition, the company should recognize interest expense on the outstanding balance of the rig's cost each year. On January 1, 2007, the outstanding balance would be $2,000,000. Therefore, the interest expense for the first year would be $200,000 (outstanding balance x interest rate).

Finally, the company should also recognize an expense for the present value of the dismantling cost at the end of the rig's life. The present value of the cost is $154,220, and this amount should be recognized as an expense in the first year.

Therefore, the total expense to be recorded for 2007 would be:

Depreciation expense: $200,000

Interest expense: $15,422 ($2,000,000 x 10% x 1/2 year)

Dismantling cost expense: $154,220

Total expense: $369,642

The closest choice is D, which includes the correct depreciation and interest expense amounts. It also includes the dismantling cost expense, but the total amount is incorrect. The correct total expense amount is $369,642.

A Company Buys an Oil Rig for $2,000,000 on January