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PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLE ASSETS: ACQUISITION AND DISPOSITION
OverviewThis chapter and the one that follows address the measurement and reporting issues involving
property, plant, and equipment and intangible assets, the tangible and intangible long-lived assets that are used in the production of goods and services.
This chapter covers the valuation at date of acquisition and the disposition of these assets. In Chapter 11 we discuss the allocation of the cost of property, plant, and equipment and intangible assets to the periods benefited by their use, the treatment of expenditures made over the life of these assets to maintain and improve them, and impairment.
Learning ObjectivesLO10-1 Identify the various costs included in the initial cost of property, plant, and equipment,
natural resources, and intangible assets.LO10-2 Determine the initial cost of individual property, plant, and equipment and intangible assets
acquired as a group for a lump-sum purchase price.LO10-3 Determine the initial cost of property, plant, and equipment and intangible assets acquired
in exchange for a deferred payment contract.LO10-4 Determine the initial cost of property, plant, and equipment and intangible assets acquired
in exchange for equity securities, or through donation.LO10-5 Calculate the fixed-asset turnover ratio used by analysts to measure how effectively
managers use property, plant, and equipment.LO10-6 Explain how to account for dispositions and exchanges for other nonmonetary assetsLO10-7 Identify the items included in the cost of a self-constructed asset and determine the amount
of capitalized interest.LO10-8 Explain the difference in the accounting treatment of costs incurred to purchase intangible
assets versus the costs incurred to internally develop intangible assets.LO10-9 Discuss the primary differences between U.S. GAAP and IFRS with respect to the
acquisition and disposition of property, plant, and equipment and intangible assets.
Lecture Outline
Part A: Valuation at Date of Acquisition
I. Types of AssetsA. For financial reporting purposes, long-lived, revenue-producing assets typically are
classified in two categories: (T10-1)1. Property, plant, and equipment.2. Intangible assets.
B. In practice, some companies report intangible assets as part of property, plant, and equipment, and others include them with the other assets category.
II. Costs to Be Capitalized (T10-2)
© The McGraw-Hill Companies, Inc. 2013Instructors Resource Manual 10-1
A. Property, plant, and equipment and intangible assets can be acquired through purchase, exchange, lease, donation, self-construction, or a business combination.
B. The initial cost of an asset includes all necessary cost to bring the asset to its condition and location for use.
C. Costs are capitalized, rather than expensed, if they are expected to produce benefits beyond the current period.
D. Property, plant, and equipment can be acquired through purchase.1. The cost of equipment (machinery, computers, office equipment and furniture,
vehicles, fixtures) includes the purchase price plus any sales tax, transportation costs, expenditures for installation, testing, legal fees to establish title, and any other cost of bringing the asset to its condition and location for use. (T10-3)
2. The cost of land includes the purchase price plus closing costs such as fees for the attorney, title and title search, and recording. In addition, any expenditures needed to prepare the land for its intended use are included as part of the cost of land. (T10-4)
3. The cost of land improvements (parking lots, driveways, private roads, fences, lawns, and sprinkler systems) must be separated from the cost of land because land has an indefinite life and land improvements usually do not. (T10-5)
4. The cost of buildings usually includes realtor commissions and legal fees in addition to the purchase price.
5. The cost of a natural resource includes the acquisition costs for the use of land and the exploration and development costs incurred before production begins, and restoration costs incurred during or at the end of extraction. (T10-6)
6. Restoration costs are one example of asset retirement obligations (AROs). As asset retirement obligation is measured at fair value and is recognized as a liability and corresponding increase in asset valuation.
7. GAAP recommends the use of the expected cash flow approach when estimating the fair value of an ARO by calculating the present value of estimate future cash outflows.
E. Intangible assets generally represent exclusive rights that provide benefits to the owner. Intangible assets with finite useful lives are amortized; intangible assets with indefinite useful lives are not amortized. (T10-7)1. Purchased intangibles are valued at their original cost to include the purchase price and
all other necessary costs to bring the asset to condition and location for use. (T10-8)2. A patent is an exclusive right to manufacture a product or to use a process.3. A copyright is an exclusive right of protection given to a creator of a published work
such as a song, film, painting, photograph, or book.4. A trademark, also called tradename, is an exclusive right to display a word, a
slogan, a symbol, or an emblem that distinctively identifies a company, product, or a service.
5. A franchise is a contractual agreement under which the franchisor grants the franchisee the exclusive right to use the franchisor's trademark or tradename within a geographical area usually for a specified period of time.
6. Goodwill is a unique intangible asset in that it can only be purchased through the acquisition of another company. Goodwill is the excess of the consideration exchanged (purchase price) over the fair value of the net assets acquired. (T10-9)
III. Lump-Sum Purchases
A. If a group of assets that are indistinguishable is acquired for a single sum, valuation is obvious.
B. However, if the lump-sum purchase involves different assets, the purchase price must be allocated usually in proportion to the individual assets' relative market values. (T10-10)
IV. Noncash AcquisitionsA. Assets acquired in noncash transactions generally are valued at the fair value of the assets
given or the fair value of the assets received, whichever is more clearly evident.B. Assets acquired in exchange for a deferred payment contract are valued at the fair value of
the items exchanged, either: (T10-11)1. The fair value of the note payable by computing the present value of the cash
payments at the appropriate interest rate.2. The fair value of the asset acquired.
C. Assets acquired by issuing equity securities are valued at the fair value of the securities or the fair value of the assets, whichever is more clearly evident. (T10-12)
D. Donated assets are valued at their fair values and revenue is recorded at an amount equal to the value of the donated asset(s). (T10-13)
E. For government grants, unlike U.S. GAAP, donated assets are not recorded as revenue under IFRS. IAS No. 20 requires that government grants be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. (T10-14)
Decision Makers’ Perspective A. The property, plant, and equipment and intangible asset acquisition decision, often
referred to as capital budgeting, is among the most significant decisions that management must make.
B. The fixed-asset turnover ratio, calculated by dividing net sales by average fixed assets, measures a company's effectiveness in managing property, plant, and equipment. (T10-15)
Part B: Dispositions and ExchangesA. When an asset is sold, a gain or loss is recognized for the difference between the
consideration received and the asset’s book value. (T10-16)B. An asset acquired in a nonmonetary exchange generally is recorded at the cash equivalent
value of the assets exchanged. (T10-17)1. If we can't determine the fair value of either asset in the exchange, the asset received is
valued at the book value of the asset given.2. In exchanges that lack commercial substance, the acquired asset is valued at the book
value of the asset given.
Part C: Self-Constructed Assets and Research and Development
I. Self-Constructed AssetsA. The cost of a self-constructed asset includes identifiable materials and labor and a portion
of the company's manufacturing overhead.1. The incremental approach to overhead allocation includes only those additional costs
that are incurred because of the decision to construct the asset.2. By the full-cost approach, all overhead costs are allocated both to production and to
self-constructed assets based on the relative amount of a chosen cost driver incurred. This is the generally accepted approach.
B. Interest is capitalized during the construction period for (a) assets built for a company's own use as well as for (b) assets constructed as discrete projects for sale or lease. (T10-18)1. Interest is not capitalized on inventories that are routinely manufactured in large
quantities on a repetitive basis.2. Only interest incurred during the construction period is eligible for capitalization.3. The interest capitalization period begins when construction begins and the first
expenditure is made as long as interest costs are actually being incurred.4. The first step in the capitalization procedure is to determine average accumulated
expenditures. This amount approximates the average debt necessary for construction.a. If expenditures are made fairly evenly throughout the construction period, the
average accumulated expenditures can be determined as a simple average of accumulated expenditures at the beginning and end of the period.
b. If expenditures are not incurred evenly throughout the period, a weighted average is determined by time weighting individual expenditures or groups of expenditures by the number of months from their incurrence to the end of the construction period or the end of the reporting period, whichever comes first.
5. The second step is to determine the amount of interest capitalized by multiplying an interest rate or rates by the average accumulated expenditures.a. The specific interest method uses rates from specific construction loans to the
extent of specific borrowings and then applies the weighted-average rate on all other debt to any excess of average accumulated expenditures over specific construction borrowings.
b. By the weighted-average method, the weighted-average interest rate on all debt, including construction-specific borrowings, is multiplied by average accumulated expenditures.
6. The third step in the procedure is to compare calculated capitalized interest with actual interest incurred during the period. Capitalized interest is limited to the amount of interest incurred. (T10-19)
7. If material, the amount of interest capitalized during the period must be disclosed in a note.
II. Research and Development (R&D) (T10-20)
A. In 1974 the FASB issued SFAS No. 2 which requires all research and development costs to be charged to expense when incurred.1. R&D costs entail a high degree of uncertainty of future benefits.2. It is difficult to match R&D costs with future revenues.
B. Research is planned search or critical investigation aimed at the discovery of new knowledge and development is the translation of research findings or other knowledge into a plan or design for a new product or process or for significant improvement to an existing product or process.1. R&D costs include labor costs, materials, depreciation and amortization of assets used
in R&D activities, and a reasonable allocation of indirect costs related to those activities. (T10-21)
2. In general, costs incurred before the start of commercial production are all expensed as R&D.
C. GAAP requires disclosure of total R&D expense incurred during the period.D. R&D costs incurred for others under contract are capitalized as inventory and carried
forward into future years until the project is complete. Income can be recognized using either the percentage-of-completion method or the completed contract method.
E. Start-up costs, including organization costs, are expensed in the period incurred.F. An exception to expensing all R&D costs exists for the computer software industry.
(T10-22)1. Computer software companies expense R&D costs until technological feasibility is
achieved.2. Costs incurred after technological feasibility but before the product is available for
general release to customers are capitalized as an intangible asset.3. The periodic amortization of capitalized computer software development costs is the
greater of (1) the ratio of current revenues to current and anticipated revenues or (2) the straight-line percentage over the useful life of the asset.
G. International Financial Reporting Standards draw a distinction between research activities and development activities. Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized. (T10-23)
H. Under IFRS, the U.S. approach for amortizing computer software development costs is allowed, but not required. (T10-24)
I. When one company buys another, we assign fair values to the tangible and intangible assets, as well as to developed technology and in-process research and development.1. The amount allocated to developed technology is capitalized and amortized as any
other intangible asset.2. Beginning in 2009, the amount allocated to in-process R&D is capitalized as an
indefinite life intangible asset. If the research project is completed successfully, the amount capitalized is amortized over the useful life of the developed intangible. If the project is unsuccessful, we write-off the amount capitalized.
Appendix 10: Oil and Gas Accounting
A. There are two generally accepted methods that companies can use to account for oil and gas exploration costs. (T10-25)1. The successful efforts method requires that exploration costs that are known not to
have resulted in the discovery of oil or gas (sometimes referred to as dry holes) be included as expenses in the period the expenditures are made.
2. The full-cost method allows costs incurred in searching for oil and gas within a large geographical area to be capitalized as assets and expensed in the future as oil and gas from the successful wells are removed from that area.
B. The method used must be disclosed in a note.
PowerPoint SlidesA PowerPoint presentation of the chapter is available at the textbook website.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or you can use the disk version of this manual and first modify them to suit your particular needs or preferences.
For financial reporting purposes, long-lived, revenue-producing assets typically are classified in two categories:
Property, plant, and equipment. Assets in this category include land, buildings, equipment, machinery, autos, and trucks. Natural resources such as oil and gas deposits, timber tracts, and mineral deposits also are included.
Intangible assets. Unlike property, plant, and equipment and natural resources, these assets lack physical substance and the extent and timing of their future benefits typically are highly uncertain. They include patents, copyrights, trademarks, franchises, and goodwill.
T10-1
TYPES OF ASSETS
Property, plant, and equipment and intangible assets can be acquired through purchase, exchange, lease, donation, self-construction, or a business combination.
If purchased, the initial cost includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.
Costs are capitalized, rather than expensed, if they are expected to produce benefits beyond the current period.
T10-2
COSTS TO BE CAPITALIZED
COST OF EQUIPMENT The cost of equipment includes:
The purchase price (less any discounts received from the seller).
Transportation costs paid by the buyer to transport the asset to the location in which it will be used.
Expenditures for installation and testing.
Legal fees to establish title.
Any other costs of bringing the asset to its condition and location for use.
T10-3
COST OF EQUIPMENT(continued)
Central Machine Tools purchased an industrial lathe to be used in its manufacturing process. The purchase price was $62,000. Central paid a freight company $1,000 to transport the machine to its plant location plus $300 shipping insurance. In addition, the machine had to be installed and mounted on a special platform built specifically for the machine at a cost of $1,200. After installation, several trial runs were made to ensure proper operation. The cost of these trials including wasted materials was $600. At what amount should Central capitalize the lathe?
Purchase price $62,000Freight and handling 1,000Insurance during shipping 300Special foundation 1,200Trial runs 600
$65,100
Each of the expenditures described was necessary to bring the machine to its condition and location for use and should be capitalized and expensed in the future periods in which the asset is used.
Illustration 10–4
T10-3 (continued)
COST OF LAND The cost of land includes:
The purchase price plus closing costs such as fees for the attorney, title and title search, and recording.
Back taxes, liens, mortgages, or other obligations.
Clearing, filling, and draining.
Cost of removing old buildings.
Any other costs of bringing the asset to its condition and location for use.
T10-4
COST OF LAND(continued)
The Byers Structural Metal Company purchased a six-acre tract of land and an existing building for $500,000. The company plans to raze the old building and construct a new office building on the site. In addition to the purchase price, the company made the following expenditures at closing of the purchase:
Title insurance $ 3,000Commissions 16,000Property taxes 6,000
Shortly after closing, the company paid a contractor $10,000 to tear down the old building and remove it from the site. An additional $5,000 was paid to grade the land. The $6,000 in property taxes included $4,000 of delinquent taxes paid by Byers on behalf of the seller and $2,000 attributable to the portion of the current fiscal year after the purchase date. What should be the capitalized cost of the land?
Capitalized cost of land:Purchase price of land (and building to be razed) $500,000Title insurance 3,000Commissions 16,000Delinquent property taxes 4,000Cost of removing old building 10,000Cost of grading 5,000Total cost of land $538,000
Two thousand dollars of the property taxes relate only to the current period and should be expensed. Other costs were necessary to acquire the land and are capitalized.
Illustration 10-5
T10-4 (continued)
LAND IMPROVEMENTS
It’s important to distinguish between the cost of land and the cost of land improvements because land has an indefinite life and land improvements usually do not.
Land improvements include the cost of parking lots, driveways, and private roads and the costs of fences and lawn and garden sprinkler systems.
Costs are separately identified and capitalized.
Cost depreciates over periods benefited by their use.
T10-5
COST OF NATURAL RESOURCES Natural resources include timber tracts, mineral deposits, and
oil and gas deposits.
Benefits are derived from their physical consumption, rather than through their use in the production of goods and services.
Initial valuation can include
Acquisition costs — Amounts paid to acquire the rights to explore for undiscovered natural resources or to extract proven natural resources.
Exploration costs — Such as drilling a well or excavating a mine as well as any other costs of searching for natural resources.
Development costs — Expenditures incurred after the resource has been discovered but before production has begun such as the costs of tunnels, wells and shafts.
Restoration costs — Costs to restore land or other property to its original condition after extraction of the natural resource.
Equipment and other assets used during drilling or excavation usually are considered depreciable plant and equipment. If the asset cannot be moved and has no alternative use, its depreciable life is limited by the useful life of the natural resource.
T10-6
COST OF NATURAL RESOURCES(continued)
The Jackson Mining Company paid $1,000,000 for the right to explore for a coal deposit on 500 acres of land in Pennsylvania. Costs of exploring for the coal deposit totaled $800,000 and intangible development costs incurred in digging and erecting the mine shaft were $500,000. In addition, Jackson purchased new excavation equipment for the project at a cost of $600,000. After the coal is removed from the site, the equipment will be sold.
Jackson is required by its contract to restore the land to a condition suitable for recreational use after it extracts the coal. The company has provided the following three cash flow possibilities (A, B and C) for the restoration costs to be paid in three years, after extraction is completed:
Cash Outflow ProbabilityA $500,000 30%B 600,000 50%C 700,000 20%
The company’s credit-adjusted risk free interest rate is 8%.
Total capitalized cost for the coal deposit is:
Purchase of rights to explore $1,000,000Exploration costs 800,000Development costs 500,000Restoration costs 468,360 *
Total cost of coal deposit $2,768,360
* Present value of expected cash outflow for restoration costs (asset retirement obligation):
$500,000 x 30% = $150,000 600,000 x 50% = 300,000 700,000 x 20% = 140,000
$590,000 x .79383 = $468,360 (.79383 is the present value of $1, n = 3, i = 8%)
Journal Entries:Coal mine (determined above) 2,768,360
Cash ($1,000,000 + 800,000 + 500,000) 2,300,000Asset retirement liability (determined above) 468,360
Excavation equipment 600,000Cash (cost) 600,000
Illustration 10-6T10-6 (continued)
COST OF NATURAL RESOURCES(continued)
This cost will be allocated to future periods as depletion by calculating a depletion rate based on the estimated amount of coal discovered.
The $600,000 cost of the excavation equipment is recorded as a plant asset and depreciated.
T10-6 (continued)
INTANGIBLE ASSETS Intangible assets generally represent exclusive rights that
provide benefits to the owner.
Intangible assets include:
Patents Copyrights Trademarks Franchises Goodwill
Despite their lack of physical existence, these assets can be extremely valuable resources for a company.
The future benefits that we attribute to intangible assets usually are much less certain than for tangible assets.
Intangible assets with finite useful lives are amortized; intangible assets with indefinite useful lives are not amortized.
T10-7
PURCHASED INTANGIBLES Valued at their original cost to include the purchase price and
all other necessary costs to bring the asset to condition and location for use.
Patent — Exclusive right to manufacture a product or to use a process (granted by the U.S. Patent Office for a period of 20 years).
Attorney fees and other costs of successfully defending a patent are added.
When a patent is developed internally, the research and development costs of doing so are expensed as incurred.
Copyright — Exclusive right of protection given to a creator of a published work such as a song, film, painting, photograph, or book.
For the life of the creator plus 70 years.
Trademark (also called tradename) — Exclusive right to display a word, a slogan, a symbol, or an emblem that distinctively identifies a company, product, or a service.
Protected from use by others for an indefinite number of 10-year periods, so indefinite life.
T10-8
Franchise — Contractual arrangement providing the exclusive right to use the franchisor’s trademark or tradename within a geographical area usually for a specified period of time.
The initial franchise fee plus any legal costs associated with the contract agreement are capitalized and then amortized over the life of the franchise agreement.
Periodic payments usually relate to services such as advertising provided by the franchisor on a continuing basis and are expensed as incurred.
T10-8 (continued)
GOODWILL A unique intangible asset in that its cost can’t be directly
associated with any specifically identifiable right and is not separable from the company as a whole.
Represents the unique value of the company as a whole over and above all identifiable tangible and intangible assets.
Can only be purchased through the acquisition of another company.
Excess of the consideration exchanged over the fair value of the net assets acquired.
T10-9
GOODWILL(continued)
The Smithson Corporation acquired all of the outstanding common stock of the Rider Corporation in exchange for $18 million in cash. Smithson assumed all of Rider’s long-term debt which had a fair value of $12 million at date of acquisition. The fair values of all identifiable assets of Rider are as follows ($ in millions):
Receivables $ 5Inventory 7Property, plant, and equipment 9Patent 4 Total $25
The cost of the goodwill resulting from the acquisition is $5 million:
Fair value of consideration exchanged $18Less: Fair value of assets acquired Assets $25 Less: Fair value of liabilities assumed (12) (13)Goodwill $ 5
The Smithson Company records the acquisition as follows:
Receivables (fair value)......................................... 5Inventory (fair value)............................................. 7Property, plant, and equipment (fair value)........... 9Patent (fair value).................................................. 4Goodwill (difference)............................................ 5 Liabilities (fair value)....................................... 12 Cash (purchase price) ....................................... 18
Illustration 10-8
T10-9 (continued)
LUMP-SUM PURCHASES The purchase price is allocated in proportion to the relative
fair values of the assets acquired.
The Smyrna Hand & Edge Tools Company purchased an existing factory for a single sum of $2,000,000. The price included title to the land, the factory building, and the manufacturing equipment in the building, a patent on a process the equipment uses, and inventories of raw materials. An independent appraisal estimated the fair values of the assets (if purchased separately) at $330,000 for the land, $550,000 for the building, $660,000 for the equipment, $440,000 for the patent and $220,000 for the inventories. The lump-sum purchase price of $2,000,000 is allocated to the separate assets as follows: Fair values
Land $ 330,000 15%Building 550,000 25Equipment 660,000 30Patent 440,000 20Inventories 220,000 10 Total $2,200,000 100%
Land (15% x $2,000,000).................... 300,000Building (25% x $2,000,000).................... 500,000Equipment (30% x $2,000,000).................... 600,000Patent (20% x $2,000,000).................... 400,000Inventories (10% x $2,000,000).................... 200,000 Cash ................................................ 2,000,000
Illustration 10-9
T10-10
DEFERRED PAYMENTS
On January 2, 2013, the Midwestern Steam Gas Corporation purchased an industrial furnace. In payment, Midwestern signed a noninterest-bearing note requiring $50,000 to be paid on December 31, 2014. If Midwestern had borrowed cash to buy the furnace, the bank would have required an interest rate of 10%.
PV = $50,000 (.82645*) = $41,323
*Present value of $1: n=2, i=10% (from Table 2)
The furnace should be recorded at its real cost, $41,323, as follows:
Furnace (determined above).......................... 41,323Discount on note payable (difference)........ 8,677
Note payable (face amount)...................... 50,000
Sometimes, the fair value of an asset acquired in a noncash transaction is readily available from price lists, previous purchases, or otherwise. In that case, this fair value may be more clearly evident than the fair value of the note and it would serve as the best evidence of the exchange value of the transaction.
Illustration 10-10
T10-11
ISSUANCE OF EQUITY SECURITIES Assets acquired by issuing equity securities are valued at the
fair value of the securities or the fair value of the assets; whichever is more clearly evident.
On March 31, 2013 the Elcorn Company issued 10,000 shares of its nopar common stock in exchange for land. On the date of the transaction, the fair value of the common stock, evidenced by its market price, was $20 per share. The journal entry to record this transaction is:
Land ........................................................ 200,000 Common stock (10,000 shares x $20)........ 200,000
Illustration 10-12
If the fair value of the common stock had not been reliably determinable, the value of the land as determined through an independent appraisal would be used as the cost of the land and the value of the common stock.
T10-12
DONATED ASSETS Donated assets are valued at their fair values.
Revenue is recorded for the amount contributed by an unrelated party.
The Elcorn Company decided to relocate its office headquarters to the city of Westmont. The city agreed to pay 20% of the $20 million cost of building the headquarters in order to entice Elcorn to relocate. The building was completed on May 3, 2013. Elcorn paid its portion of the cost of the building in cash. Elcorn records the transaction as follows:
Building ............................................. 20,000,000 Cash ............................................... 16,000,000 Revenue—donation of asset (20% x $20 million) 4,000,000
Illustration 10-13
T10-13
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Government Grants. Both U.S. GAAP and IFRS require that companies value donated assets at their fair values. For government grants, though, the way that value is recorded is different under the two sets of standards. Unlike U.S. GAAP, donated assets are not recorded as revenue under IFRS. IAS No. 20 requires that government grants be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. So, for example, IAS No. 20 allows two alternatives for grants related to assets:
1. Deduct the amount of the grant in determining the initial cost of the asset.2. Record the grant as a liability, deferred income, in the balance sheet and recognize it in the income statement systematically over the asset’s useful life.
In Illustration 10-13, if a company chose the first option, the building would be recorded at $16 million. If instead the company chose the second option, the building would be recorded at $20 million, but rather than recognizing $4 million in revenue as with U.S. GAAP, a $4 million credit to deferred income would be recorded and recognized as income over the life of the building
Siemens, a global electronics and electrical engineering company based in Germany, prepares its financial statements according to IFRS, and sometimes receives government grants for the purchase or production of fixed assets. The following disclosure note included with recent financial statements indicates that Siemens uses the first option, deducting the amount of the grant from the initial cost of the asset.
Government Grants (in part)Expenditures Grants awarded for the purchase or the production of fixed assets(grants related to assets) are generally offset against the acquisition or productionscosts of the respective assets and reduce future depreciations accordingly.
T10-14
DECISION MAKERS’ PERSPECTIVE
The property, plant, and equipment and intangible asset acquisition decision, often referred to as capital budgeting, is among the most significant decisions that management must make.
If the present value of all future net cash flows exceeds the acquisition costs, the asset is acquired.
Investors and creditors monitor a company's investment in property, plant, and equipment by calculating the fixed-asset turnover ratio. The ratio measures a company's effectiveness in managing property, plant, and equipment.
Fixed-asset turnover ratio = Net sales Average fixed assets
T10-15
DISPOSITION OF ASSETS When assets are sold, a gain or loss is recognized for the
difference between the consideration received and the asset's book value.
The Robosport Company sold machinery that originally cost $20,000 for $6,000. Depreciation of $12,000 had been recorded up to the date of sale. Since the $8,000 book value of the asset ($20,000 - 12,000) exceeded the $6,000 consideration received, the company recognized a $2,000 loss. The sale was recorded as follows:
Cash (selling price)........................................... 6,000Accumulated depreciation (account balance).... 12,000Loss on disposal of machinery (difference)..... 2,000 Machinery (account balance)....................... 20,000
Illustration 10-14
Retirements and abandonments are treated similarly. The only difference is that there will be no monetary consideration received. A loss is recorded for the remaining book value of the asset.
Assets to be disposed of by sale are classified as held for sale and measured at the lower of book value or fair value less cost to sell.
T10-16
NONMONETARY EXCHANGESAn asset acquired in a nonmonetary exchange generally is recorded at the fair value of the assets exchanged.
If we can't determine the fair value of either asset in the exchange, the asset received is valued at the book value of the asset given.
In exchanges that lack commercial substance, the asset received is valued at the book value of the asset given.
T10-17
NONMONETARY EXCHANGES (continued)
The Elcorn Company traded its laser equipment for the newer air-cooled ion lasers manufactured by American Laser Corporation. The old equipment had a book value of $100,000 (cost of $500,000 less accumulated depreciation of $400,000) and a fair value of $150,000. To equalize the fair values of the assets exchanged, in addition to the old machinery, Elcorn paid American Laser $430,000 in cash. This means that the fair value of the new laser equipment is $580,000. We know this because American Laser was willing to trade the new lasers in exchange for old lasers worth $150,000 plus $430,000 in cash. The following journal entry records the transaction:
Laser equipment – new ($150,000 + 430,000) 580,000Accumulated depreciation ..................... 400,000 Laser equipment - old .................... 500,000 Cash ............................................... 430,000 Gain ($150,000 – 100,000)............ 50,000
The new laser equipment is recorded at $580,000, the fair value of the old equipment, $150,000, plus the cash given of $430,000. This also equals the fair value of the new lasers. Elcorn recognizes a gain of $50,000, which is simply the difference between the old equipment’s fair value of $150,000 and its $100,000 book value as well as the amount needed to allow the debits to equal the credits in the journal entry.
Illustration 10-15A
T10-17 (continued)
NONMONETARY EXCHANGES (continued)
Exchange Lacks Commercial Substance
The Elcorn Company traded a tract of land to Sanchez Development for a similar tract of land. The old land had a book value of $2,500,000 and a fair value of $4,500,000. To equalize the fair values of the assets exchanged, in addition to the land, Elcorn paid Sanchez $500,000 in cash. This means that the fair value of the land acquired is $5,000,000. The following journal entry records the transaction, assuming that the exchange lacks commercial substance:
Land – new (book value + cash: $2,500,000 + 500,000) 3,000,000 Land – old (account balance)................. 2,500,000 Cash (amount paid) .............................. 500,000
The new land is recorded at $3,000,000, the book value of the old land, $2,500,000, plus the cash given of $500,000. No gain is recognized.
Illustration 10-16
T10-17 (continued)
INTEREST CAPITALIZATION Interest is capitalized during the construction period for (a)
assets built for a company’s own use as well as for (b) assets constructed as discrete projects for sale or lease (a ship or a real estate development, for example).
Excludes inventories routinely manufactured in large quantities on a repetitive basis and assets already in use or ready for intended use.
Interest costs incurred during the productive life of the asset are expensed as incurred.
The capitalization period starts with the first expenditure (materials, labor, or overhead) and ends either when the asset is substantially complete and ready for use or when interest costs no longer are being incurred.
Interest costs incurred can pertain to borrowings other than those obtained specifically for the construction project.
T10-18
INTEREST CAPITALIZATION ILLUSTRATION
On January 1, 2013, the Mills Conveying Equipment Company began construction of a building to be used as its office headquarters. The building was completed on June 30, 2014. Expenditures on the project, mainly payments to subcontractors, were as follows:
January 3, 2013 $ 500,000March 31, 2013 400,000September 30, 2013 600,000
Accumulated expenditures at Dec. 31, 2013 (before interest capitalization) $1,500,000
January 31, 2014 600,000April 30, 2014 300,000
On January 2, 2013, the company obtained a $1 million construction loan with an 8% interest rate. The loan was outstanding during the entire construction period. The company’s other interest-bearing debt included two long-term notes of $2,000,000 and $4,000,000 with interest rates of 6% and 12%, respectively. Both notes were outstanding during the entire construction period.
Illustration 10-17
T10-19
INTEREST CAPITALIZATION ILLUSTRATION(continued)
2013:Step 1: Determine the average accumulated expenditures.
January 3, 2013 $500,000 x 12/12 = $500,000March 31, 2013 400,000 x 9/12 = 300,000September 30, 2013 600,000 x 3/12 = 150,000 Average accumulated expenditures for 2013 $950,000
Step 2: Calculate the amount of interest to be capitalized. Use the construction loan rate because average accumulated expenditures is less than the specific construction loan rate. This is known as the specific interest method.
Interest capitalized for 2013 = $950,000 x 8% = $76,000
Interest capitalized is limited to interest incurred.Step 3: Compare calculated interest with actual interest incurred.
Actual CalculatedLoans Rate Interest Interest
$1,000,000 x 8% = $ 80,0002,000,000 x 6% = 120,0004,000,000 x 12% = 480,000
$680,000 $76,000
Use lower amount The interest of $76,000 is added to the cost of the building, bringing
accumulated expenditures at December 31, 2013 to $1,576,000 ($1,500,000 + $76,000). The remaining interest cost incurred but not capitalized is expensed.
T10-19 (continued)
INTEREST CAPITALIZATION ILLUSTRATION(continued)
2014:
Step 1: Determine the average accumulated expenditures.
January 1, 2014 $1,576,000 x 6/6 = $1,576,000January 31, 2014 600,000 x 5/6 = 500,000April 30, 2014 300,000 x 2/6 = 100,000 Average accumulated expenditures for 2014 $2,176,000
Step 2: Calculate the amount of interest to be capitalized. The weighted-average interest rate on all other debt is applied to the excess of average accumulated expenditures over specific construction borrowings.
Loans Rate Interest$2,000,000 x 6% = $120,000 4,000,000 x 12% = 480,000$6,000,000 $600,000
Weighted-average rate: = 10%
Average Accumulated Annual Fraction Expenditures Rate of Year Interest
$2,176,000Specific borrowing 1,000,000 x 8% x 6/12 = $40,000Excess $1,176,000 x 10% x 6/12 = 58,800 Capitalized interest $98,800
T10-19 (continued)
INTEREST CAPITALIZATION ILLUSTRATION(continued)
Step 3: Compare calculated interest with actual interest incurred.
Actual CalculatedLoans Rate Interest Interest
$1,000,000 x 8% x 6/12 = $ 40,0002,000,000 x 6% x 6/12 = 60,0004,000,000 x 12% x 6/12 = 240,000
$340,000 $98,800
Use lower amount
For the first six months of 2014, $98,800 interest would be capitalized, bringing the total capitalized cost of the building to $2,574,800 ($2,476,000 + 98,800), and $241,200 in interest would be expensed ($340,000 - 98,800).
Sometimes it's difficult to associate specific borrowings with projects. In these situations, it's acceptable to use the weighted average rate on all interest-bearing debt, including construction loans. This is known as the weighted average method.
If material, the amount of interest capitalized during the period must be disclosed.
T10-19 (continued)
RESEARCH AND DEVELOPMENT All research and development costs are charged to expense in
the period incurred. R&D costs entail a high degree of uncertainty of future
benefits. It is difficult to match R&D costs with future revenues.
Research is planned search or critical investigation aimed at discovery of new knowledge.
Development is the translation of research findings into a plan for a new product or process or for a significant improvement to an existing product or process.
R&D costs include labor costs, materials, depreciation and amortization of assets used in R&D activities, and a reasonable allocation of indirect costs related to those activities.
In general, R&D costs pertain to activities that occur prior to the start of commercial production.
GAAP requires disclosure of total R&D expense incurred during the period.
T10-20
RESEARCH AND DEVELOPMENT(continued)
|_____________________________________________|______________________________________________| | | |
Start of Start of Sale ofR&D Commercial ProductActivity Production or Process
Examples of R&D Costs: | Examples of Non-R&D Costs:|
• Laboratory research aimed at | • Engineering follow-through discovery of new knowledge | in an early phase of commercial
| production|
• Searching for applications of | • Quality control during commercialnew research findings or | production including routine other knowledge | testing of products
|• Design, construction, and | • Routine ongoing efforts to
testing of preproduction | refine, enrich, or otherwiseprototypes and models | improve on the qualities of an
| existing product|
• Modification of the formulation | • Adaptation of an existing or design of a product or process | capability to a particular
| requirement or customer’s need as| part of a continuing commercial| activity
Illustration 10-19
T10-20 (continued)
RESEARCH AND DEVELOPMENT COSTS
The Askew Company made the following cash expenditures during 2013 related to the development of a new industrial plastic:
R&D salaries and wages $10,000,000R&D supplies consumed during 2013 3,000,000Purchase of R&D equipment 5,000,000Patent filing and legal costs 100,000Payments to others for services performed in connection with R&D activities 1,200,000 Total $19,300,000
The project resulted in a new product to be manufactured in 2014. A patent was filed with the U.S. Patent Office. The equipment purchased will be employed in other projects. Depreciation on the equipment for 2013 was $500,000.
The various expenditures would be recorded as follows:
R&D expense................................................. 14,200,000 ($10,000,000 + 3,000,000 + 1,200,000)
Cash............................................................ 14,200,000
Equipment...................................................... 5,000,000Cash............................................................ 5,000,000
R&D expense................................................. 500,000Accumulated depreciation—equipment..... 500,000
Patent.............................................................. 100,000Cash............................................................ 100,000
Illustration 10-20
T10-21
COMPUTER SOFTWARE DEVELOPMENT COSTS
GAAP requires the capitalization of software development costs incurred after technological feasibility is established.
Technological feasibility is established “when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements.”
Costs expensed as Costs R&D Capitalized Costs not R&D
|____________________|_____________________|_____________________|| | | |
Start of Technological Date of Sale of R&D Feasibility Product Release Product Activity
Illustration 10-21
The periodic amortization percentage for software development costs is the greater of (1) the ratio of current revenues to current and anticipated revenues (percentage-of-revenue method) or (2) the straight-line percentage over the useful life of the asset.
T10-22
COMPUTER SOFTWARE DEVELOPMENT COSTS(continued)
The Astro Corporation develops computer software graphics programs for sale. A new development project begun in 2012 reached technological feasibility at the end of June 2013, and the product was available for release to customers early in 2014. Development costs incurred in 2013 prior to June 30 were $1,200,000 and costs incurred from June 30 to the product availability date were $800,000. 2014 revenues from the sale of the new product were $3,000,000 and the company anticipates an additional $7,000,000 in revenues. The economic life of the software is estimated at four years.
The Astro company would expense the $1,200,000 in costs incurred prior to the establishment of technological feasibility and capitalize the $800,000 in costs incurred between technological feasibility and the product availability date. 2014 amortization of the intangible asset, software development costs, is calculated as follows:
1. Percentage-of-revenue method:
$3,000,000 = 30% x $800,000 = $240,000
$3,000,000 + $7,000,000
2. Straight-line method:
1/4 or 25 % x $800,000 = $200,000.
The percentage of revenue method is used because it produces the greater amortization, $240,000.
Illustration 10-22
T10-22 (continued)
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Research and Development Expenditures. Other than software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred. IAS No. 38 draws a distinction between research activities and development activities. Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized as an intangible asset. Under both U.S. GAAP and IFRS, any direct costs to secure a patent, such as legal and filing fees, are capitalized. Heineken, a company based in Amsterdam, prepares its financial statements according to IFRS. The following disclosure note describes the company’s adherence to IAS No. 38. The note also describes the criteria for capitalizing development expenditures.
Software, research and development and other intangible assets (in part)Expenditures on research activities, undertaken with the prospect of gaining
new technical knowledge and understanding, are recognized in the income statement when incurred. Development activities involve a plan or design for the production of new or substantially improved products and processes. Development expenditures are capitalized only if development costs can be measured reliably, the product or process is technically and commercially feasible, future economic benefits are probable, and Heineken intends to and has sufficient resources to complete development and to use or sell the asset.
The expenditures capitalized include the cost of materials, direct labor andoverhead costs that are directly attributable to preparing the asset for itsintended use and capitalized borrowing costs.
Amortization of capitalized development costs begins when development is complete and the asset is available for use. Heineken disclosed that it amortizes its capitalized development costs using the straight-line method over an estimated 3-year useful life.
T10-23
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Software Development Costs. The percentage we use to amortize computer software development costs under U.S. GAAP is the greater of (1) the ratio of current revenues to current and anticipated revenues or (2) the straight-line percentage over the useful life of the software. This approach is allowed under IFRS, but not required.
T10-24
OIL AND GAS ACCOUNTING
Two generally accepted methods to account for oil and gas exploration costs are:
The successful efforts method requires that exploration costs that are known not to have resulted in the discovery of oil or gas (sometimes referred to as dry holes) be included as expenses in the period the expenditures are made.
The full-cost method allows costs incurred in searching for oil and gas within a large geographical area to be capitalized as assets and expensed in the future as oil and gas from the successful wells are removed from that area.
The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells drilled in 2013 in West Texas. Eight of the 10 wells were dry holes.
The accounting treatment of the $20 million in total exploration costs will vary significantly depending on the accounting method used. The summary journal entries using each of the alternative methods are as follows:
Successful Efforts Full Cost
Oil deposit 4,000,000 Oil deposit 20,000,000Exploration expense 16,000,000 Cash 20,000,000 Cash 20,000,000
Illustration 10A-1
T10-25
Suggestions for Class Activities
1. Guest Speaker
The assigning of fair value to assets acquired in an acquisition is an interesting topic for students. The accounting issues are interesting, as are the valuation issues.
Through your contacts at local CPA firms, preferably one of the Big 4 firms, arrange for a set of speakers to address these issues. If possible, organize a visit of one manager/partner in the audit area and one in the valuation services area. The auditor can speak about the accounting issues and can provide an update as to the FASB/SEC activity in this area. The valuation services person can go through the valuation techniques they use to assign values to all of the items acquired in a purchase. Students are very interested in these topics, particularly the valuation issues. It is a wonderful opportunity to open their minds to the many different types of services accounting firms provide to their clients. It is interesting to note that the Big 4 firms have ceased providing acquisition valuation services to their firm’s audit clients. Due to the independence issue, Sarbanes-Oxley, and SEC scrutiny, they now provide these services only to audit clients of other accounting firms.
2. Research Activity
At the end of its 2011 fiscal year, Toro Company, the lawn mower company, reported approximately $191 million in property, plant, and equipment and another $128 million in intangible assets in its balance sheet.
Suggestions:Have the class access Toro’s financial statements for the fiscal year ended October 31, 2011,
using Edgar at: www.sec.gov. Ask them to answer the following questions:
1. What types of assets does Toro include under the property, plant, and equipment classification?
2. What types of assets does Toro include as intangibles?3. What was the company’s fixed-asset turnover ratio for 2011?4. How much did Toro report as research & development expense in 2011?
Points to Note:Students will need to access the disclosure notes and other parts of the 10-K to answer the
majority of these questions. For example, in 2011, Toro reported $57 million in engineering and research expense. However, this was not reported on the face of the income statement, but in Item 1 in the 10-K.
3. Dell Analysis
Have students, individually or in groups, go to the most recent Dell annual report using Edgar at: www.sec.gov. Ask them to:
1. Compare the net amount of property and equipment with that in the 2011 financial statements included in Appendix B of the text. What is happening to the company's asset base? Is the company expanding its operations?
2. Compute the fixed-asset turnover ratio for the current year and compare your result with the 2011 ratio. Has the ratio changed significantly, and if so, what are the possible implications?
3. Use Edgar to locate the most recent annual report information for Hewlett-Packard, Dell’s competitor. Using the most recent annual report information for both companies, compare the fixed-asset turnover ratio and the growth in property, plant, and equipment and intangible assets.
4. Professional Skills Development Activities
The following are suggested assignments from the end-of-chapter material that will help your students develop their communication, research, analysis and judgment skills.
Communication Skills. In addition to Communication Case 10-11, Judgment Case 10-8 can be adapted to ask students to write a memo from a junior accountant to a controller answering each of the questions. Communication Case 10-10 and Ethics Case 10-12 do well as group assignments. Problem 10-11, Real World Case 10-6, and Ethics Case 10-12 create good class discussions. Judgment Case 10-4, Research Case 10-5, and Analysis Case 10-14 are suitable for student presentation(s).
Research Skills. In their careers, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. Research Case 10-2 and Exercises 10-20 and 10-21 provide excellent opportunities to help students develop this skill. In addition, Judgment Case 10-15 can be adapted to require students to research the authoritative literature on accounting for computer software development costs.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct students to gather, assemble, organize, process, or interpret data to provide options for making business and investment decisions. In addition to Analysis Cases 10-14 and 10-17, Real World Case 10-16 also provides opportunities to develop and sharpen analytical skills.
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require students to critically analyze issues to apply concepts learned to business situations in order to evaluate options for decision-making and provide an appropriate conclusion. In addition to Judgment Cases 10-1, 10-3, 10-4, 10-7, 10-8, 10-9, and 10-15, Communication Case 10-11 also requires students to exercise judgment.
CPA Simulation. Students can test their knowledge of the concepts discussed in this chapter and at the same time practice critical professional skills necessary for career success and preparation for the computer-based CPA Exam. The simulation for this chapter, Yamashita
Corporation, tests students’ knowledge of accounting for interest capitalization. Access the simulations at the text website: www.mhhe.com/spiceland7e.
5. Ethical Dilemma
The chapter contains the following ethical dilemma:
ETHICAL DILEMMA
Grandma's Cookie Company purchased a factory building. The company Controller, Don Nelson, is in the process of allocating the lump-sum purchase price between land and building. Don suggests to the company's chief financial officer, Judith Prince, that they fudge a little by allocating a disproportionately higher share of the price to land. Don reasons that this will reduce depreciation expense, boost income, increase their profit-sharing bonus and, hopefully, increase the price of the company's stock. Judith has some reservations about this because the higher reported income will also cause income taxes to be higher than they would have been if a correct allocation of the purchase price is made.
What are the ethical issues? What stakeholders' interests are in conflict?
You may wish to discuss this in class. If so, discussion should include these elements.
Step 1—The Facts:Grandma's Cookie Company has purchased a factory building. The controller, Don Nelson,
suggests that the company allocate a higher share of the purchase price to land, permitting lower depreciation, higher net income, and higher profit-sharing bonuses in future years. The CFO, Judith Prince, has reservations, as higher net income will result in higher income taxes in the future. Generally accepted accounting principles require the lump-sum acquisition price to be allocated among the items in proportion to the assets' relative market values.
Step 2—The Ethical Issue and the Stakeholders:The ethical issue or dilemma is whether the controller's obligation to his employer to increase net
income is greater than his obligation to provide information that is not misleading to users of the financial statements, including the tax authorities.
Stakeholders include Don Nelson, controller, Judith Prince, CFO, other recipients of the profit-sharing plan, government entities, current and future creditors, and current and future investors.
Step 3—Values: Values include competence, honesty, integrity, objectivity, loyalty to the company, loyalty to
other managers, and responsibility to users of financial statements.
Step 4—Alternatives:1. Record the land at a proportionately higher value than the building.2. Record the allocation of the purchase price between the land and the building based upon the
current relative market values.
Step 5—Evaluation of Alternatives in Terms of Values:1. Alternative 1 illustrates loyalty to placing the Cookie Company in a favorable financial
position.2. Alternative 2 reflects values of competence, honesty, integrity, objectivity, and responsibility
to users of the financial statements.
Step 6—Consequences:Alternative 1Positive consequences: Future net income will be increased, profit-sharing plan members will
benefit, the price of the company's stock will increase, investors will experience higher returns on their investments, and taxing authorities will receive more tax revenue.
Negative consequences: Users of the financial statements, including taxing authorities, would be misinformed regarding the specific value of the land and building and future net income. The company will be paying higher taxes. If top management detects the manipulation, both the controller and the CFO may lose their jobs.
Alternative 2Positive consequences: Users of financial statements, including taxing authorities, would receive
net income figures according to GAAP. The controller and CFO would maintain their integrity. The company would be paying correct taxes and would save cash due to the lower taxes paid.
Negative consequences: The controller and CFO may incur the disfavor of higher management and lose their jobs. The price of the company's stock may not rise and profit sharing may not be as lucrative as with alternative 1.
Step 7—Decision: Student(s) must decide their course of action.
