Ch. 10 – Plant, Property, Equipment and Intangibles
I. TYPES OF LONG-LIVED ASSETS
A. Characteristics of Plant, Property & Equipment
Used in normal operations, not for resale or investment
Long-term in nature (>1 yr. useful life)
Possess physical substance (tangible in nature)
Examples: Land, Building, Equip, Machinery, Furniture/Fixtures, Leasehold Improvements, Wasting Assets (i.e. natural resources)
B. Characteristics of Intangibles:
Lack physical substance
Provide future benefit (increases the revenue-producing ability of the company)
3. They are not financial instruments.
1. Patents – legal life of 20 years from date granted. Legal fees for the successful defense of a patent are treated as a capital expenditure and added to the BV of the patent when incurred…not expensed.
2. Copyrights – legal life is life of creator + 70 yrs.
3. Customer Lists – usually 3 year life
4. Franchises/Licenses/Permits – amortize over term of contract
5. Trademarks/Trade names – indefinite # of renewals for periods of 10 yrs. (don’t amortize)
6. Goodwill – indefinite life (do not amortize). Only occurs as a result of one company buying an entire other company. Goodwill represents the excess of the purchase price over the FMV of the Net Assets. (Net Assets = FMV Assets less all liabilities of the company purchased.) Goodwill is not a separately identifiable asset. It derives its value from the other assets that the company uses to produce earnings in excess of normal.
II. Determining Original Cost
PP&E and intangibles can be acquired individually, lump sum purchase, using deferred payments, issuance of securities, by donation, thru exchange or self-construction
Historical cost is the usual basis for PP&E valuation.
Costs to Include in “Original Cost”:
All costs incurred to bring the asset into its productive capacity
Acquisition cost = cash paid or “cash equivalent value” (PV of note) + all costs of readying the asset for service.
Advantages of Historical Cost:
Cost = Fair Value on date of acquisition
Cost is reliable, objective & verifiable
Cost is consistent with reporting most other assets, liabilities & equity
A. Land – don’t depreciate – never “used up”
Cost = all expenditures made to acquire the land and make ready for intended use
Costs to capitalize:
+ Closing Costs/Attorney’s fees/Title fees/Broker’s commissions/past due property taxes
+ Cost of surveys
+ Costs to get the land ready for use (clear existing structures, level land)
(-) Proceeds from sale of salvage
= Historical Cost of Land
Land Improvements – Improvements with limited lives (like private driveways, parking lots, fences, sprinkler systems etc.) record as Land Improvements and depreciate separately.
C. Machinery –
all expenditures normally incurred in acquiring the equipment and preparing it for use are included
this includes purchase price less purchase discounts (if offered; regardless if taken), freight charges, insurance while in transit, assembly costs, installation, special preparation of facilities, and the cost of conducting trial runs
Devon Company purchases a machine with a contract price of $100,000 on terms of 2/10, n/30. The company does not take the cash discount. Transportation costs of $2,500 were incurred, as well as installation and testing costs of $3,000. Sales tax is 7% of invoice price. During the installation, uninsured damages of $500 are incurred and paid by Devon. Determine the original cost of the machine and record the journal entry.
D. Buildings – costs to capitalize for either purchase or construction include:
all expenditures related directly to acquisition are capitalized
this includes attorneys’ and architects’ fees, building permits, and all costs incurred beginning with architects fees and the excavation of the site and ending with completion of the building
If Purchased –Contract price + Renovation costs (before bldg is placed into service)+Closing Costs + Unpaid Property Taxes
2. If Constructed:
Contract Price from Contractor
+ Architectural Fees, Attorney Fees, Building Permits
+ Excavation costs
+ Interest Costs during Construction (i.e. capitalized interest)
= Cost of building
E. Self-Constructed Assets – PP&E intended for the company’s own use.
The critical accounting issue is identifying the “cost” of the self-constructed asset. Two difficulties arise in assigning costs to self-constructed assets:
1. Determining the amount of the company’s indirect manufacturing costs (OHD), to be allocated to construction
2. Deciding the proper treatment of interest incurred during construction.
Fixed Manufacturing Overhead Costs: Options for treating Fixed Overhead:
(a) Assign only incremental overhead to the cost of the constructed asset. The asset’s cost would include only those additional costs incurred because of the decision to self-construct.
(b) Allocate overhead on the basis of production. Full Cost Approach (i.e. apply the same fixed OHD rate as allocated to inventory). This method is preferred.
Interest Costs during construction – Capitalize interest on long-term projects as a necessary cost to bring asset into its intended use. Only capitalize interest incurred during the construction period.
Note: the cost recorded for a constructed asset can never exceed the price charged by an outside contractor
III. Capitalization of Interest (Adds to the Costs of asset, but include interest only During Construction)
Capitalize interest on long-term projects as a necessary cost to bring asset into its intended use. Achieves proper matching of expired costs in future periods as asset is depreciated or once sold as COGS.
Assets under construction for the company’s own use (building/plant/machinery)
Assets intended for sale/lease once construction is complete (i.e. long-term construction projects such as ships or real estate developments)
*Inventories that are routinely manufactured (short-term mftr. Cycle) are NOT eligible for interest capitalization.
Start capitalizing interest when:
Expenditure has been made
Construction activities have begun.
Interest is being incurred.
Stop capitalizing interest when the asset is complete & ready for its intended use.
C. Amount of Interest to Capitalize:
Limited to the lower of:
1. Actual Interest Costs incurred during the period (on all debt)
2. Avoidable Interest – interest costs that could have been avoided if expenditures for asset had not been made.
D. Average Accumulated Expenditures (WAE):
Interest should be determined for only the construction expenditures actually incurred during the capitalization period. Unless all expenditures are made at the outset of the construction (rarely!), it is necessary to determine the weighted average* amount outstanding during the construction period. The Weighted Average Expenditures (WAE) are the MAX construction costs eligible for interest capitalization.
*weighted by the # mos. each expenditure is outstanding & incurring interest.
If expenditures are incurred evenly throughout the year, then:
[Beg. Cumulative Expenditures + End. Cum. Expenditures] / 2 = WAE
E. Interest Rates to Use: USING THE SPECIFIC INTEREST METHOD ONLY!
1. If specific borrowings, use that rate first
(as long as the amount borrowed) < average accumulated expenditures)
If asset cost > specific borrowings, then interest on excess costs is based on a weighted average of all the interest rates on all non-specific borrowings.
Special issues related to interest capitalization.
– Interest costs incurred in the purchase of land to be used for a building site are part of the building’s cost (not the land’s cost).
– Interest costs incurred on land being developed for lot sales are part of the land’s cost and included in inventory.
– Interest revenue earned on funds borrowed to finance construction of assets is not netted against the interest expense incurred.
How to compute weighted avg. cost of capital & the lower of actual interest vs. avoidable interest.
ABC Co. is constructing a building at a cost of $300,000. They begin construction on Jan. 1, 2012 and complete it on Dec. 31, 2012. On Jan. 1, 2012, ABC borrowed $150,000 for this project at 11% interest. In addition, they have other long-term borrowing that consists of a $100,000, 9% Note Payable and $400,000, 10% Bond Payable. ABC made payments for the expenditures for this building as follows:
Jan 1 $ 60,000
Mar 1 $ 75,000
Jul 1 $ 70,000
Sept. 1 $ 45,000
Dec. 31 $ 50,000
Step 1: Determine Weighted Average Expenditures (WAE):
Step 2: Determine weighted avg. cost of Non-Specific Borrowings (This step is only necessary IF more than one “other debt”:
Step 3: Determine Avoidable Interest on WAE & Compare to Actual Interest:
Interest to Capitalize
Interest Exp on CY Income Statement
Cost of Building
Example: Capitalization of Interest – Partial Year for Construction Period
Sparky constructs a new building costing $2 million. Sparky begins it on April 1, 2012 by paying the following expenditures
April 1 June 1 Oct. 1 Dec. 31
$500,000 $600,000 $700,000 $200,000
The building was complete on December 31. On Jan. 1, 2012 the company borrowed $800,000 for this project at 15% interest. In addition, they have $3,000,000 in long-term borrowings at an average interest rate of 12.5%.
Step 1: Determine WAE’s eligible for interest capitalization:
Step 2: Determine avoidable interest (i.e. how much interest should be added to cost of building)
Determine the following:
a. Cost of Building: $_____________
b. Interest Expense for ’12: $_____________
c. If Sparky had only $50,000 of
non-specific borrowing, how
much interest should be capitalized? $_____________
Example: Expenditures incurred evenly throughout the year.
Winston Company constructs a building during 2012 that qualifies for interest capitalization. The construction begins on January 1, 2012, the cost is $1,400,000, and expenditures occur evenly throughout the year. The construction was completed on December 31. On March 1, the company borrowed $750,000 at 10% for the project. The total interest on the company’s other debt is $72,000, and the total of the other debt (non-specific borrowings) is $600,000.
a. Determine the cost of the building. $_______________
b. Determine interest expense for 2012. $_______________
IV. Valuation of Long-Lived Fixed Assets
Rule: An asset should be recorded at the fair value of what is given up or at the fair value of the asset received, whichever is more clearly evident. This represents the cash equivalent value of what a willing participant would settle for today.
Cash Discounts – Discounts off the selling price to encourage prompt payment.
Terms 2/10; net 30. Always record the asset net of “Cash Discounts.” Better indicator of “Fair Value”
Deferred Payment Contracts
Fair Value = Present value of consideration given.
On January 1, 2012, ABC Corp. purchased equipment by giving a $20,000 cash down payment and issuing a $150,000 non-interest-bearing note, payable in three payments of $50,000 each made at the end of each year for the next 3 years. Imputed interest = 12%.
PVOA (12%, 3n)
On January 1, 2012, Prosser Company acquired used equipment by issuing a two-year, non-interest-bearing note for $200,000. In recent borrowing, Prosser has paid 10% interest.
On January 7, the company installed the equipment. Estimated costs of installation were $1,750 for labor and $670 for materials. On January 12, the company paid $780 for freight and insurance charges during shipment. The company plans to depreciate the asset over 8 years, straight-line method, no salvage. Interest is recognized by the effective interest method.
determine the historical cost of the asset
determine depreciation expense
determine interest expense for 2012
PV of $1(10%, 2n)
Lump Sum Purchases (Group Purchase)
Allocate the Total Cost of the group purchase on the basis of each asset’s relative fair value.
If cash paid > Fair Value; record at Fair Value (excess is Goodwill)
If cash paid < Fair Value; record using weighted avg. method to find orig. cost.
Fair Values – Use insurance appraisals, property tax assessments, or independent appraisals as indicators of relative market values
Example: Cash paid for group purchase is LESS than Fair Value. Weighted Average Approach
On July 6 Zone Company acquired the plant assets of Doonesbury Company, which had discontinued operations. Zone paid $2,100,000 for this group purchase. The appraised value of the property is:
Land $ 400,000
Determine the Original Cost of each asset acquired:
Issuance of Stock in Exchange for Asset
Bring on the asset at:
The fair value of the stock (if the stock is traded daily and the market price is known.)
The fair value (appraised value) of the asset, if the market price of the stock is not readily determinable.
Fred Couples Company issued 13,000 shares of common stock with a par value of $50 per share in exchange for land. The property has been appraised at a fair value of $810,000. The stock of Fred Couples Company is listed on the NYSE and at yesterday’s close traded at $60 per share.
Same as above EXCEPT Fred Couples Company stock is not listed on any exchange, but a block of 100 shares was sold by a stockholder 12 months ago at $65 per share, and a block of 200 shares was sold by another stockholder 18 months ago at $58 per share.
Valuation of Intangibles: Costs to capitalize:
a. If purchased – capitalize all costs at Fair Value of everything given up (purchase price, legal fees, incidental expenses.)
b. If internally created –capitalize only direct costs incurred to establish the legal rights associated with it. Legal fees, registration fees, design costs, etc…but never R&D.
*Research & Development costs are expensed as incurred (follows asset measurement principle and matching.)
1. Can only be identified w/ business as a whole
2. Only recorded when business is purchased
3. Valuation of Goodwill is based on Going Concern Concept (value of Goodwill cannot be separated from the business as a whole.)
4. Internally generated goodwill is expensed when incurred.
Goodwill is – is a condition that contributes to the earning power of a firm:
To Record –
Purchase Price > FMV of Net Assets [FMV Assets – FMV Liabilities]
RESEARCH & DEVELOPMENT
R& D is:
1. Research: To discover new knowledge for significantly improved product/process
2. Development: translation of knowledge into new Design/product/process
Treatment of R&D costs:
Expense most R&D costs as incurred based on:
Asset measurement principle – to be considered an asset, it must generate a future benefit (revenue). Too much uncertainty about whether or not the cost incurred today will ever generate a future benefit. Therefore cannot follow matching.
Costs to expense as R&D –
Material, Equip, Facilities – expense in period incurred IF no alternative future use. If they do have alternative future use, depreciate over useful life but expense as R&D Expense.
R&D Personnel (salaries & wages) – expense as incurred
Intangibles purchased from others- expense unless they have alternative future uses
Contract services – if others are hired to perform R&D, expense as incurred
Indirect costs – must be clearly related to the R&D.
Purchased R&D –capitalize cost. In future periods, accounting for Purchased R&D depends on if the research/development was successful or not.
Thomas More Company incurred the following costs during 2012 in connection with its research and development activities.
Cost of equipment acquired that will have alternative
Uses in future R&D projects over the next 5 years
(s-l depreciation) $280,000
Materials consumed in R&D projects 59,000
Consulting fees paid to outsiders for R&D Projects 100,000
Personnel costs of persons involved in R&D projects 128,000
Indirect costs reasonably allocable to R&D projects 50,000
Materials purchased for future R&D projects 34,000
Compute the amount to be reported as research and development expense by More on its income statement for 2012. Assume equipment is purchased at beginning of year.
VI. SALE & EXCHANGE OF FIXED ASSETS
A. Sale of Asset
Sold machine for $7,500 on June 30, 2012. The machine was purchased on Jan 1, 2010 for $12,000, $2,000 salvage, 5-year life, S-L depr.
B. Involuntary Conversions
Asset’s service is terminated early due to a casualty (fire/theft/accident) or condemnation.
On December 31, 2012, Britt, Inc. has a machine with a book value of $940,000. The original cost and related accumulated depreciation at this date are as follows:
Machine $ 1,300,000
Accum. Depr. 360,000
Book Value $ 940,000
Depreciation is computed at $60,000 per year on a straight-line basis.
On August 31, 2013, a fire completely destroys the machine. An insurance settlement of $430,000 was received for this casualty. Assume the settlement was received immediately.
Record the disposal:
Exchanges of Non-monetary Assets
Non-monetary exchanges mean you are trading one asset for another asset (i.e. a delivery truck for a machine). Monetary consideration (i.e. cash or note payable) can still be part of the exchange, but to receive the accounting treatment of “Exchanges of Non-monetary Assets”, the cash/note pay must be less than 25% of the Fair Value of the assets exchanged.
The rules of an exchange are based on:
The fair value of the asset(s) given up, or
The fair value of the asset(s) received, whichever is clearly more evident.
A gain or loss on the exchange on nonmonetary assets is computed by comparing the book value of the asset given up with the fair value of that same asset
Losses – immediately recognize losses on all exchanges
Gains – The rules for gain recognition depend upon whether the non-monetary exchange has commercial substance.
Commercial Substance – if the future cash flows generated by the asset will change as a result of the non-monetary exchange, then the transaction has commercial substance.
An exchange of trucks with different useful lives changes the future cash flows; Has commercial substance (recognize all gains and losses immediately)
An exchange of trucks with no significant difference in useful lives; lacks commercial substance (recognize losses immediately, not necessarily gains)
An exchange of Land for Equipment; has commercial substance; recognize all gain/losses immediately.
Types of Exchange:
1. Has Commercial Substance –
The asset received should be recorded at fair value of the asset(s) given up, and
Recognize gain or loss immediately
Example: New Asset = FMV(Old) + Cash Paid/note pay
or (-) Cash Received
To Calculate Gain/Loss:
If FMV(Old) > BV (Old) = Gain
FMV(Old) < BV(Old) = Loss
Example #1: Exchange Has Commercial Substance; Cash is being paid.
ABC Co. exchanged equipment with an orig. cost of $54,000 and Accum. Depr. of $12,000 for land. The Fair Value of the old asset (equipment) was $40,000. Also, ABC paid $6,000 cash. The exchange has commercial substance.
Example #2: Exchange has Commercial Substance; Cash is being RECEIVED.
ABC Co. exchanged equipment with an orig. cost of $64,000 and Accum. Depr. of $20,000 for equipment that performed the same function, but offered cost savings. The Fair Value of the new asset is $42,000. Also, ABC received $7,000 cash. The exchange has commercial substance.
2) Lacks Commercial Substance – Economic position of company did not change as
a result of the exchange.. No gains, only losses recognized (unless cash is received)
a. Lacks Commercial Substance – No cash received
Asset received is recorded at Book value of asset(s) given up plus the cash paid, or
Fair value of Asset received less the deferred gain
The cash paid is less than 25% of the transaction. (If the cash paid is greater than 25% of the transaction, it is considered a “monetary” transaction.)
Example: Lacks Substance, Cash is being paid.
XYZ trades its old machine with an orig. cost of $15,000, Accum. Depr. of $6,000 for a similar new model. XYZ also paid $3,000. The new model has a fair value of $14,500. The exchange lacks commercial substance.
Example: Lacks Substance, Cash is being paid.
You exchange a fixed asset whose orig. cost was $150,000, Accum. Depr = $15,000 for a similar asset with a fair value of $170,000 and also pay $10,000 in cash. The exchange lacks commercial substance.
b. Lacks Commercial Substance, Gain Situation & Cash Received:
Recognize a portion of the gain. When boot is received, it is assumed that part of old asset was sold & part was exchanged. (Cash received is less than 25% of the transaction.)
Total Gain =
Hist Cost =
You exchange a fixed asset with cost of $200,000, Accum. Depr. of $64,000 for a similar fixed asset with a Fair Value of $160,000 and $10,000 cash is received. The exchange lacks commercial substance.
Non-Reciprocal Transfers –
Transfers of assets in one direction. The company is either receiving or giving a gift (i.e. asset or forgiveness of debt.)
Even though no “Cost” is involved (in receiving the asset), use the FMV of asset to capitalize on books.
Record as “Contribution Revenue” in the period received. The benefit is considered “earned”.
In Bryan, Texas, Sanderson Farms received a parcel of land with a FMV of $250,000 from the Bryan Economic Development Corp. in return for a promise to build a new processing plant. The original cost of the land to the BEDC was $100,000.
Entry for Sanderson:
Entry for Bryan EDC: Contributions given – Record gift as “Contribution Expense” at FMV of asset given up. Recognize gain/loss (the earnings process is complete on that asset.)
When to record:
If the promise to give the asset is “conditional” – record in period the asset is transferred.
If the promise is “Unconditional” – record in the current period.