SCENARIO NO. 1 : ON SELF-CONSTRUCTED BUILDING

Brief Information

Bruce Manufacturing Company used its own maintenance crew to build additional wing to its

existing factory and incurred the followings:

Architect fee

Cost of removing snow for clearing construction site

Cash discount on construction material purchased

Cost of construction office & tool shed that to be torn down once construction

completed

Local real estate taxes

Interest on money borrowed to finance the construction

Cost of mistakes during construction

Overhead cost of the maintenance department

Cost of insurance during construction

Cost of losses/injuries not covered by the insurance

Argument For Discussion

Which of the costs are to be capitalized?

Solution & Analysis

Based on the general guideline in IAS 16 (Property, Plant & Equipment), the cost

of a self constructed asset “should comprise those costs which relate directly to the

specific asset and those that are attributable to the construction activity in general

and can be allocated to the specific asset.”

EXPENDITURES

CAPITALIZED?

JUSTIFICATION

Architect Fee

Capitalized

These are all „one-time

costs‟ incurred for making

the place ready for

construction hence, to

be capitalized.

Snow clearance

Capitalized

Cash discount

Capitalized

Construction office

Capitalized

Real estate taxes

Capitalized

Interest on money borrowed

to finance the construction

Capitalized

According to MASB 27

(Borrowing Costs), the

benchmark treatment is to

recognize the interest as

expense in the period

incurred(expensed).

However, interest cost

on construction of

qualified asset allowed to

be capitalized as part of the

construction costs. Yet,

interest capitalized cannot

exceed the company‟s total

interest cost for the period.

Mistakes Expensed

Maintenance overhead

Capitalized

The share of these

costsattributed directly to

the construction are to be

capitalized to the

construction.

Insurance Capitalized

Losses/injuries

Expensed

SCENARIO NO. 2 : ON PURCHASED LAND & BUILDING

Brief Information

1. Archer Company purchased a land (that come together with buildings on it).

Archer demolished the existing structures & builds a combined office &

hotel building on the land.

2. Suppose the owner of the old building & land wanted to build a

combined office & hotel over the old premises.

Argument for Discussion

How would (1) the buyer and (2) the owner treat the portion of purchase price of

old building and the costs of its demolishing?

Solution & Analysis

1. In Archer‟s accounts (BUYER),

Portion of Purchase Price of Old Premise

The buyer should first differentiate the price paid for the building and that for the

land. In this case, the portion of purchase price in respect to the old building shall

be reflected separately from the costs of the land (Please refer to appendix 3 for detailed

analysis).

Cost of Demolishing the Old Premise

Cost of demolishing the old building is to be capitalized in the cost of construction

of the new building because it is necessarily incurred in making the site ready for

construction.

2. As for the OWNER itself,

Portion of Purchase of Old Premise

Purchase price in owner book would be the original cost of the building. This cost

is recorded less its accumulated depreciation in owner‟s balance sheet. As the

owner want to demolish the premise, the old building cost and accumulated

depreciation would be removed from the balance sheet and any loss or gain on the

old building would be recognized.

Cost of Demolishing the Old Premise

Similar to the buyer‟s treatment cost of demolishing old structure would be

capitalized in the cost of construction of the new building.

SCENARIO NO. 3 : ON PURCHASE OF A NEW MACHINE

Brief Information

Midland Company purchased a new machine. In the course of acquisition, it

incurred the followings:

Invoice price

Transportation cost

Sale tax on purchase

Trade in difference (amount allowed as trade in > depreciated value of old machine)

Immediately after the purchase (during installation of the machine) Midlands has

to further paid for the following:

Cost of additional steel beam

Cost of outside engineer

Cost of material spoiled

in order to put the machine in its working condition.

Argument for Discussion

How would the buyer treat each of the above costs?

Solution & Analysis:

To purchase the new machine, Midland needs to pay for

INITIAL COSTS which are defined in MASB 15 & IAS 16 - Property, Plant &

Equipment as:

“…its purchase price and any directly attributable costs of bringing the asset to

working condition for its intended use”

Which are:

Invoice price – The purchase price or the „original‟ value of the new machine. This

cost will be regarded as the cost of the machine (CAPITALIZED).

Transportation costs – Necessarily incurred to put bring the machine to its intended

site of operation (CAPITALIZED).

Sale tax on purchase – The company paid the tax in relation to its purchase of the

machine (directly attributed to the machine - CAPITALIZED).

However, in paying for the new machine, Midland is allowed to trade in its old

machine. Hence,

Purchase Consideration = Money paid + trade in (i.e. allowed trade in value)

If,

USED MACHINE

- Costs – RM14000

- Accumulated Depreciation – RM11000

- Thus, Current Depreciated / Book Value – RM3000

- Market Value – RM3900

NEW MACHINE

- Price – RM18900

- Purchase consideration = Cash + Market value (old machine)

- RM18900 = RM15000 + RM3900

GAIN ON EXCHANGE

- RM3900 market value – RM3000 book value = RM900

The above gain (assuming exchange is of similar assets), would not be recognized.

Instead the new machine will be recorded at RM18000 (RM3000 of old machine

book value plus RM15000 cash paid)

Accounting journal entries for this would be,

DR New Machine RM18000

DR Accumulated Depreciation (old machine) RM11000

CR Used Machine RM14000

CR Cash/Bank RM15000

Exchange used van plus RM15000 cash in return for new machine.

Thus,

The difference between,

Trade in value allowed – Depreciated value of old machine (the gain)

RM3900 – RM3000 = RM900 is to be ignored.

There is no account treatment necessary for this difference.

Subsequent to purchase, Midland has to incurred some installation costs in order to

put the machine into its working / intended condition.

Cost of putting ADDITIONAL STEEL BEAMS

- is to be CAPITALIZED

- because a one time cost needed to enable the machine operating

Cost of OUTSIDE ENGINEER & HIS RELATED EXPENSES

- is to be CAPITALIZED

- due to the reason that it is necessary for ensuring the machine

functioning properly.

Cost of MATERIAL SPOILED during trial run

- is also to be CAPITALIZED

- the reason is as per above

- IAS 16 , Property, Plant & Equipment states that “…start up & pre

production costs do not form part of the cost of an asset unless they

are necessary to bring the asset to its working condition. INITIAL

OPERATING LOSSES INCURRED prior to an asset achieving

planned performance are recognized as an asset (i.e.

CAPITALIZED)”

SCENARIO 4 : ON LEASED ASSETS

Brief Information

This question deals with the outbound logistics process of the company whereby

the products manufactured, i.e. the computers, are

1) 25% sold to customer and

2) 75% remaining are leased.

The cost of the leased computer was initially recorded as an asset and depreciated

over four years. Besides selling and leasing the computers, the company also

provided an „application engineering‟ services to the customers. These services

include the activity of installing the computer and designing the systems. The cost

for these services was recorded by the company as marketing expense.

Argument for Discussion

Can the ‘application engineering services’ costs be added to the asset value of the

leased computer and amortized over the lease period? And could other marketing costs related to the leased computer be treated in the

same way? Why?

Solution & Analysis

According to the IAS 17.8 (to determine classification of leases):

Situations that would normally lead to a lease being classified as a finance lease include the

following: [IAS 17.8]

the lease transfers ownership of the asset to the lessee by the end of the

lease term;

the lease term is for the major part of the economic life of the asset, even if

title is not transferred;

The following principles should be applied in the financial statements of lessors:

the lessor should record a finance lease in the balance sheet as a receivable,

at an amount equal to the net investment in the lease; [IAS 17.28]

the lessor should recognize finance income based on a pattern reflecting a

constant periodic rate of return on the lessor's net investment outstanding in

respect of the finance lease; [IAS 17.30] and

Lease income should be recognized over the lease term on a straight-line

basis, unless another systematic basis is more representative of the time

pattern in which use benefit is derived from the leased asset is diminished.

[IAS 17.42]

Assuming that the company follows the guideline in IAS 17.8, i.e. treating the

leased computers as finance lease. It is also assumed that the cost of application

engineering services contributed to the net investment of leased computer.

According to the IAS 17.42, which stated that the revenue for the leased computer

should be recognized over the lease term, conforms to the argument to include the

cost in the asset value and amortized over the lease period. The matching concept

is assumed for the concluded conformation above.

The argument to include marketing costs in the asset value and amortized does not

follow the right accounting treatment. The cost should be expensed as incurred, as

it does not contribute to the net investment of the leased computer.

(Please refer to Appendix 1 for further information on lease)

SCENARIO NO. 5 : ON INCOME TAX CREDIT (ITC)

Brief Information

There are two methods for accounting treatment of the ITC.

Deferral method: Treats the ITC reduction as reduction in the original cost of the

asset which spreads the tax credit over the period of the assets‟ useful life.

Flow-through method: The ITC reduction is treated as tax reduction which is

„earned‟ as a result of acquiring assets which reduces the income tax expense.

Arguments for discussion

Why it is allowed to treat the ITC using those two methods? State the rationale.

Solution & Analysis

The rationale of permitting these two methods for ITC is that it allows companies

to suit the governing tax law limitation and its tax liability limitation with the

methods permitted to recognize the ITC.

Consider an entity that invested in Solar Application. The governing federal law

has provided some guidelines on which equipment/asset that is entitled for the ITC

and maximum limit on the permissible tax credit.

Usually, there is a limit on the amount that can be taken for tax reduction. General

guide is that the amount of tax reduction must not exceed the total tax owned by

the entity. If the amount of ITC is less than the total tax owned, the entity could use

the flow-through method. On the other hand, if the amount of ITC is higher than

the total tax owned, the entity is allowed to use other alternative to recognize the

tax reduction, which is thedeferral method.

Other than that, concerning on the period of the usage of the tax credit, if there is

limitation on the entity‟s tax liability, which inhibit the use of the credit partly or

fully, the excess can be carried forward to the preceding years.

In all, both methods would take into account the „earned‟ tax reduction. The

difference is how the reduction is treated, either expensed in full in the current

period or distributed over the period of asset‟s lifetime. It is thus up to the entity‟s

accounting policy whether to attribute the ITC to the act of acquiring the asset or

to the use of the asset.

SCENARIO NO. 6 : ON UPGRADING AN EQUIPMENT

Brief Information

There is an electronic product where a key customer was eager to buy the new

equipment for use in its own new product if the manufacturer would continue to

push to meet target of 65 ppm (65 or fewer defective part per million parts

delivered to customer). Th e manufacturing equipment was going to begin to

generate revenue, and all cost (material, labor and overhead) required to fabricate

and installed had been capitalized. The cost is 1.5 m. The engineers believed that at

least 50 K additional cost would be required to reach 65 ppm.

Argument for Discussion

Should those cost (RM50K) to be capitalized ?

Once the standard was achieved and full cost was known, should the amount of

depreciation for the initial production periods be adjusted?

A few skeptics had express the concern that the standard might never be achieved.

What implication of capitalizing the cost of assets (RM 1.5 M + RM 50K)?

Solution

Before we answer all these questions, we should consider some points, which lead

to the way we answer the problems

1. Research and Development (R&D) costs are costs incurred for the purpose of

developing new or improved product, processes or services. The purpose is to

increase revenue or lower cost.

2. FASB requires that R& D cost should be treated as period cost – that is

charged off as an expense of the current period as the reason, by their very

nature the future benefits are highly uncertain.

3. FASB has concluded that there is no objective ways of distinguishing between

projects seem reasonably assured and the unsuccessful ones.

Therefore, to the arguments,

1. The RM 50 K should not be capitalized, because for this development cost

incurred where the future success of the upgrading is uncertain. Thus, it should

be treated as an expense. In this sense we are taking the prudence approach,

though most of criteria to capitalize the cost is fulfilled (Please refer to appendix 2 for

details).

2. The depreciation cost would not be adjusted as the additional cost is not

incorporated in the equipment value (not capitalized), but expensed as the

period costs. However, if the development cost is capitalized, the depreciation

amount at the initial production process would not be adjusted. Nevertheless,

the development costs may increase the value and the life of the asset, these

variables should be adjusted in calculating the asset‟s depreciation once the

development costs incorporated in its value.

3. The implication of capitalizing the development costs is that should the

standards not achieved, would the cost remains as the capital expense ? In this

case (standards not achieved), the cost has to be expensed off in the period

recognizing that the cost incurred does not provide the expected future benefits

to the asset.

QUESTIONS & ANSWERS

A. Question(s) related to the general principles of capitalizing expenditure

1. Question : Please explain on what it is mean to classify expenditure into asset or

expense by looking at necessity and future benefit (referring to summarized chart in given

class handouts – please refer to appendix 4)

Answer : In most cases the decision to expense or capitalize expenditures is

moved around whether the cost incurred is „necessary‟ and „prolongs future

life‟.

a. „Necessary‟ – in term of the costs incurred need to be incurred in order to put

the asset into its intended use / working condition.

b. „Future benefit‟ – that costs incurred would generate future benefits, that

should be allocated over the period it is consumed.

2. Question : Why costs of injuries/losses not covered by insurance be expensed ?

Answer : The costs were expensed because as if in normal situation, the

occurrence of such happenings could not be determined. Hence, it is proper

to write off (expense) the costs in the period incurred.

3. Question : How to value intangible asset (e.g. brand name) & how it is allocated?

Answer : Usually, it is difficult to estimate the value and the useful life of

intangibles. For example, goodwill could be measured as the difference

between the net value of assets and purchase consideration paid on the

assets. However, for brand name, it requires valuation from a valuator in

order to determine the worth of the intangible (i.e. brand name).

As for allocation, the useful life of the intangible must first be determined.

Should the assets have determinable services life (e.g. patent limited to 25

years), the costs should be allocated over the service life. If no determinable

service life, it depend to the company to amortize over how long, yet to

comply with the maximum assumption of life stipulates in account standards

(IAS 38 – not more than 20 years).

B. Question(s) related to Scenario 3 : On purchase of a new machine

4. Question : Referring to Scenario no 3, the additional beam installed should be

expensed not capitalized. Please explain.

Answer : Conceptually, the costs associated directly to the machine, in

order to make the machine ready for use should be capitalized and not

expensed.

IAS 16 (Property, Plant & Equipment) makes it clear that initial cost

includes „any directly attributable costs of bringing the asset to working

condition for its intended use.” In this case, adding the beam is necessary in

order to allow the use of the machine at the plant. 5. Question : Why the costs of the additional beam should be capitalized in the cost of

the machine and not to the building?

Answer : However, the principle is clear that the additional beam should be

capitalized instead of expensed. The purpose of installing the additional

beams is to strengthen the base to support the new machine (to allow for the

intended use of the machine). Consequently, the cost should be capitalized

to the machine and not to the building.

A member of the floor also noted that based on his experience, for such

cases, the tax authority requires that the costs be associated to the machine

and not to the premise.

C. Question(s) related to Scenario 4 : On lease

6. Question : If there is capital allowance for a leased asset, is it to be taken into account

in the leasor‟s book or the leasee‟s ?

Answer : According to IAS 17, in finance lease, the leasee would records

the leased item as its fixed asset, whereas leasor would record it as

receivable (not fixed assets). Hence, capital allowance should be accounted

for in the leasee‟s book and not the leasor‟s. However, for income tax

purpose, the lease rentals will not be allowable for the claims of capital

allowances.

7. Question (4): How would the leasee treats the its leased asset at the end of the lease

period ?

Answer : Assumption made for this question is that the lease is a finance

lease. The assumption made based on the logic that the buyers wanted to

buy computers, Yet, as they could not pay for the full amount, they finance

the purchase through lease whereby at the end of the lease the computer‟s

ownership would be transferred to the them (the leasee). In this type of

lease, although the asset is legally owned by the leasor, it would be

accounted for as if owned by the leasee.

Then after, the asset is to be depreciated like other fixed assets (IAS 17).

And, the liability should be reduced periodically during the lease period.

Hence, the question of how the leasee treats the leased computer at the end

of the lease shouldn‟t arise as it already accounted as asset in the leasee‟s

book at the inception of the lease (strictly assuming this as finance lease

where ownership is transferred). Therefore, it would be treated like other

fixed assets in the leasee‟s book. (Please refer to Appendix 3 for further elaboration on

lease)

Question(s) related to Scenario 6 : On upgrading an equipment

8. Question (6): Why the development costs treated as expenses ?

Answer : Accounting for R&D costs is a complicated process because some

costs may never result in future benefits. In this case, the upgrading of

output quality of the machine could not known for certain. Hence, the

additional RM 50K for debugging to upgrade the quality of the equipment to

the intended standard is to be expensed in the period incurred. The reason of

not capitalizing it is that achieving the expected improvement to the

standard could not be ascertained for sure (highly uncertain). Should the

result of not achieving be known, the cost would be avoided. But, this is not

possible. Thus, though writing the cost into income statement in the period

would go against the MATCHING principle, the PRUDENCE concept takes

precedence over MATCHING

CONCLUSION

The answer to the question of whether expenditure should be capitalized or not lies

in various factors attached to specific situation (be it building construction,

purchase, lease, tax, or product development)