In class we saw the effect of revaluation of PP&E on a Greek shipping company. Assume we want to estimate how revaluation would affect a similar U.S. company (although revaluation of PP&E is not permitted in U.S. GAAP). Look at the 10-K filing for 11/30/2016 (the end of the financial year) of the cruise lines company Carnival (the company uses U.S. GAAP):
a. What is the useful life of ships? What is their residual value (in % of cost)? (see note 2 to the financial statements, ignore ship improvements)
b. Look in note 4 to find what the gross cost of the ships at the end of 2016 is and what their accumulated depreciation is (ignore ships in construction, and also assume for simplicity that all of the accumulated depreciation is associated with the ships and not with the other assets).
c. Using your answers from parts a and b, what is your estimate of the average age of the ships in the fleet? (hint: as the ships are depreciated on a straight line, the ratio of accumulated depreciation to the total cost minus residual is the percentage of useful life already used.)
d. Now assume that the company wants to switch to the revaluation model for the ships and perform the revaluation at the end of the 2016 financial year (11/30/2016). Assume that on average the fair value of the ships goes up 3% every year (3% was chosen for the example because this is the average rate of inflation in the U.S. for the last couple of decades). What would be the revaluation surplus that will be created at the end of 2016? (hint: to get the net revalued amount you should multiply the net historical cost of the ships by 1.03 in the power of the average age of the ships you found in part c. The revaluation surplus will be the difference between the net historical cost and the net revalued amount).
e. What would be the journal entry recorded for the revaluation? Assume that the company will use the proportionate restatement method we studied in class (so both the gross and the accumulated depreciation amounts are restated proportionately).
f. How would the revaluation change the ratio of (Total equity)/(Total assets) for the end of 2016? Calculate the ratio before and after, and determine if the company looks more risky or less risky after the revaluation.
g. What would be the expected additional depreciation expense in 2017 due to the revaluation? (assume Carnival keeps all the ships it has at the end of 2016, and no additional revaluations were done in 2017). Looking at the 2016 earnings before tax, would that decrease in earnings be significant (calculate the percentage change in earnings before tax)? What would be the journal entries required to record the annual depreciation expense under the revaluation model (hint: remember that the revaluation surplus should also be adjusted)?
h. Assume the company did revalue its ships on 11/30/2016 as described above. If on 12/1/2016 (a day after the 2016 balance sheet) Carnival sells 25% of its fleet for $12 Billion, what are the journal entries required (hint: remember to also adjust the revaluation surplus)?
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