Emmett & Gracie (E & G) is considering a significant equipment replacement. E & G would like to replace some of their equipment before December 31, 2016. The equipment originally cost $840,000 and the equipment's accumulated depreciation balance at the end of 2015 is will be $790,000. At this point the equipment is depreciated to its salvage value. Your long-term asset accountant, Joe, tells you about this equipment options as follows:
The estimated life of any new equipment is 7 years.
E & G would like you to analyze option 1 to determine the financial impact of each decision and any non-financial considerations that may result from each decision.
Option 1: Construct the new equipment in-house and sell the old equipment for cash at a fair value of $60,000. E & G would take out a one-year construction loan for $900,000 at the time construction begins at a short-term borrowing rate of 10% for the construction. Anticipated actual expenditures for constructing the equipment are $980,000, and on a weighted-average basis the expenditures are approximately $625,000. The bulk of the $980,000 will be financed with the construction loan, and the balance will be financed through accounts payable. The interest on the short-term note is due and payable by year-end. (Note: Construction is assumed to be completed at year-end of 2016.)
Instructions:
(A) Prepare journal entries in general journal form for option 1 and
(B) explain on how option 1 affects the financial statements and the strengths and weakness of this option.