Chap 010

AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment. Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment. To aid faculty in this endeavor, we have labeled each question, exercise and problem in Intermediate Accounting, 5e with the following AACSB learning skills:

Questions AACSB Tags Exercises (cont.)

AACSB Tags

10-1 Reflective thinking 10-9 Analytic10-2 Reflective thinking 10-10 Analytic10-3 Reflective thinking 10-11 Analytic10-4 Reflective thinking 10-12 Analytic10-5 Reflective thinking 10-13 Analytic10-6 Reflective thinking 10-14 Analytic10-7 Reflective thinking 10-15 Analytic10-8 Reflective thinking 10-16 Analytic10-9 Reflective thinking 10-17 Analytic10-10 Reflective thinking 10-18 Analytic10-11 Reflective thinking 10-19 Analytic10-12 Reflective thinking 10-20 Analytic10-13 Reflective thinking 10-21 Analytic10-14 Reflective thinking, Communications 10-22 Analytic10-15 Reflective thinking 10-23 Diversity10-16 Reflective thinking 10-24 Analytic10-17 Reflective thinking 10-25 Analytic10-18 Reflective thinking 10-26 Reflective thinking10-19 Reflective thinking, Communications 10-27 Analytic10-20 Reflective thinking 10-28 Analytic

Brief Exercises

CPA/CMA

10-1 Analytic 10-1 Analytic10-2 Analytic 10-2 Analytic10-3 Analytic 10-3 Analytic10-4 Analytic 10-4 Analytic10-5 Analytic 10-5 Analytic10-6 Analytic 10-6 Analytic10-7 Analytic 10-7 Analytic10-8 Analytic 10-8 Analytic10-9 Analytic 10-1 Reflective thinking10-10 Analytic 10-2 Analytic10-11 Analytic 10-3 Analytic10-12 Analytic Problems10-13 Analytic 10-1 Analytic10-14 Analytic 10-2 Analytic10-15 Analytic 10-3 Analytic10-16 Analytic 10-4 Analytic

© The McGraw-Hill Companies, Inc., 2009Solutions Manual, Vol.1, Chapter 10 10-1

Chapter 10 Operational Assets: Acquisition and Disposition

Exercises 10-5 Analytic

10-1 Analytic 10-6 Analytic10-2 Analytic 10-7 Analytic10-3 Analytic 10-8 Analytic10-4 Analytic 10-9 Analytic10-5 Analytic 10-10 Analytic10-6 Analytic 10-11 Analytic10-7 Analytic 10-12 Analytic10-8 Analytic

© The McGraw-Hill Companies, Inc., 200910-2 Intermediate Accounting, 5/e

Question 10-1 The term operational asset is used to describe the broad category of long-lived assets that are

used in the production of goods and services. The difference between tangible and intangible assets is that intangible assets lack physical substance and they primarily refer to the ownership of rights.

Question 10-2 The cost of an operational asset 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, testing, legal fees to establish title, and any other costs of bringing the asset to its condition and location for use.

Question 10-3 The cost of a developed natural resource includes the acquisition costs for the use of land, the

exploration and development costs incurred before production begins, and the restoration costs incurred during or at the end of extraction.

Question 10-4 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. Research and development costs incurred to internally develop an intangible asset are expensed in the period incurred. Filing and legal costs for both purchased and developed intangibles are capitalized.

Question 10-5 Goodwill represents the unique value of the company as a whole over and above all

identifiable tangible and intangible assets. This value results from a company’s clientele and reputation, its trained employees and management team, its unique business location, and any other unique features of the company that can’t be associated with a specific asset.

Because goodwill can’t be separated from a company, it is not possible for a buyer to acquire it without also acquiring the whole company or a substantial portion of it. Goodwill will appear as an asset in a balance sheet only when it was paid for in connection with the acquisition of another company. The capitalized cost of goodwill equals the purchase price of the acquired company less the fair value of the net assets acquired. The fair value of the net assets equals the fair value of all identifiable tangible and intangible assets less the fair value of any liabilities of the selling company assumed by the buyer.


QUESTIONS FOR REVIEW OF KEY TOPICS

Answers to Questions (continued)

Question 10-6 A lump-sum purchase price generally is allocated based on the relative fair values of the

individual assets. The relative fair value percentages are multiplied by the lump-sum purchase price to arrive at the initial valuation of each of the separate assets.

Question 10-7 Assets acquired in exchange for deferred payment contracts are valued at their fair value or the

present value of payments using a realistic interest rate. Theoretically, both alternatives should lead to the same valuation.

Question 10-8 Assets acquired through the issuance of equity securities are valued at the fair value of the

securities if known; if not known, the fair value of the assets received is used.

Question 10-9 Donated assets are valued at their fair values.

Question 10-10 When an operational asset is sold, a gain or loss is recognized for the difference between the

consideration received and the asset’s book value. Retirements and abandonments are handled in a similar fashion. The only difference is that there will be no monetary consideration received. A loss is recorded for the remaining book value of the asset.

Question 10-11 The basic principle used to value assets acquired in a nonmonetary exchange is to use the fair

value of asset(s) given up plus (minus) monetary consideration - cash - paid (received).

Question 10-12 The two exceptions are (1) when fair value is not determinable and (2) when the exchange

lacks commercial substance.

Question 10-13 GAAP require the capitalization of interest incurred during the construction of assets for a

company’s own use as well as for assets constructed for sale or lease. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Only assets that are constructed as discrete projects qualify for interest capitalization.


Answers to Questions (continued)

Question 10-14 Average accumulated expenditures for a period is an approximation of the average amount of

debt the company would have had outstanding if it borrowed all of the funds necessary for construction. If construction expenditures are incurred equally throughout the period, the average accumulated expenditures for the period can be estimated by adding the accumulated expenditures at the beginning of the period to the accumulated expenditures at the end of the period and dividing by two. If expenditures on the project are unequal throughout the period, individual expenditures, perhaps expenditures grouped by month, should be weighted by the amount of time outstanding until the end of the construction period or the end of the company’s fiscal year, whichever comes first.

Question 10-15 Applying the specific interest method, the interest rate on any construction related debt is used

up to the amount of the construction debt and any excess average accumulated expenditures is multiplied by a weighted-average interest rate of all other debt. The weighted-average method multiplies average accumulated expenditures by the weighted-average interest rate of all debt, including any construction-related debt.

Question 10-16 SFAS No. 2 defines research and development as follows:Research is planned search or critical investigation aimed at discovery of new knowledge with

the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.

Question 10-17 SFAS No. 2 specifically excludes from current R&D expense the cost of operational assets that

have “alternative future uses” beyond the current R&D project. However, the depreciation or amortization of these assets will be included as R&D expenses in the future periods the assets are used for R&D activities. If the equipment has no alternative future use, its cost is expensed as R&D immediately.

Question 10-18 GAAP require 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 incurred after technological feasibility but before the product is available for general release to customers are capitalized as an intangible asset. These costs include coding and testing costs and the production of product masters. Similar to SFAS No. 2, costs incurred after commercial production begins usually are not R&D expenditures.


Answers to Questions (concluded)

Question 10-19 The cost of developed technology is capitalized and expensed over its expected useful life.

Developed technology relates to those projects that have reached technological feasibility. Before 2009, the cost of in-process R&D was expensed in the period of the acquisition. Now, the cost of in-process R&D is capitalized and treated as an indefinite life intangible asset and not amortized. If the R&D project is completed successfully, we switch to the way we account for developed technology and amortize the capitalized amount over the estimated period the product or process developed will provide benefits. If the project instead is abandoned, we expense the entire balance immediately. Research and development costs incurred after the acquisition to complete the project are expensed as incurred, consistent with the treatment of any other R&D not acquired in an acquisition.

Question 10-20 The successful efforts method allows companies to capitalize only exploration costs resulting

in successful wells. The full-cost method allows companies to capitalize all exploration costs incurred within a geographical area.

Capitalized cost of the machine:

Purchase price $35,000Freight 1,500Installation 3,000Testing 2,000

Total cost $41,500

Note: Personal property taxes on the machine for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred.

Capitalized cost of land:

Purchase price $600,000Broker’s commission 30,000


BRIEF EXERCISES

Brief Exercise 10-1

Brief Exercise 10-2

Title insurance 3,000Miscellaneous closing costs 6,000Demolition of old building 18,000

Total cost $657,000

All of the expenditures, including the costs to demolish the old building, are included in the initial cost of the land.

Cost of land and building:

Purchase price $600,000Broker’s commission 30,000Title insurance 3,000Miscellaneous closing costs 6,000

Total cost $639,000

The total must be allocated to the land and building based on their relative fair values:

Asset Fair Value

Percent of Total Fair Value

InitialValuation(Percent x $639,000)

Land $420,000 60% $383,400Building 280,000 40 255,600

$700,000 100% $639,000

Cost of silver mine:Acquisition, exploration, and development $5,600,000Restoration costs 429,675 †

$6,029,675

† $500,000 x 20% = $100,000 550,000 x 45% = 247,500


Brief Exercise 10-3

Brief Exercise 10-4

650,000 x 35% = 227,500$575,000 x .74726* = $429,675

*Present value of $1, n = 5, i = 6% (from Table 2)

After one year, the liability will increase to $455,456.($429,675† + ($429,675 x 6%) = $455,456)

† $500,000 x 20% = $100,000 550,000 x 45% = 247,500 650,000 x 35% = 227,500

$575,000 x .74726* = $429,675*Present value of $1, n = 5, i = 6% (from Table 2)

Actual restoration costs $596,000Less: Asset retirement liability (575,000) Loss on retirement $ (21,000)

Calculation of goodwill:

Consideration exchanged $14,000,000Less fair value of net assets:

Book value of assets $8,300,000Plus: Excess of fair value over book value of intangible assets 2,500,000 (10,800,000)

Goodwill $ 3,200,000

The initial value of machinery and note will be the present value of the note payment:

PV = $60,000 (.85734) = $51,440 Present value of $1: n = 2, i = 8% (from Table 2)

Interest expense for July 1 to December 31, 2009:


Brief Exercise 10-5

Brief Exercise 10-6

Brief Exercise 10-7

$51,440 x 8% x 6/12 = $2,058

The cost of the patent equals the fair value of the stock given in exchange:

50,000 x $22 = $1,100,000

Average PP&E for 2009 = ($740,000 + 940,000) ÷ 2 = $840,000

Net sales ÷ Average PP&E = Fixed-asset turnover ratio ? ÷ $840,000 = 3.25Average PP&E x Fixed-asset turnover ratio = Net sales $840,000 x 3.25 = $2,730,000

Proceeds $16,000Less book value: $80,000

(71,000) 9,000Gain on sale of equipment $ 7,000

Journal entry (not required):

Cash.............................................................................. 16,000Accumulated depreciation (account balance) .................... 71,000

Gain (difference).......................................................... 7,000Equipment (account balance)......................................... 80,000

Pickup trucks = Fair value of machinery plus cash paid$17,000 + 8,000 = $25,000

Loss on exchange = $20,000 (book value) – 17,000 (fair value) = $3,000



Brief Exercise 10-8

Brief Exercise 10-9

Brief Exercise 10-10


Pickup trucks (determined above) ..................................... 25,000Accumulated depreciation (account balance) .................... 45,000Loss (difference).............................................................. 3,000

Cash ......................................................................... 8,000Machinery (account balance)......................................... 65,000

Pickup trucks = Fair value of machinery plus cash paid$24,000 + 8,000 = $32,000

Gain on exchange = $24,000 (fair value) – 20,000 (book value ) = $4,000


Pickup trucks (determined above) ..................................... 32,000Accumulated depreciation (account balance) .................... 45,000

Cash ......................................................................... 8,000Gain (difference).......................................................... 4,000Machinery (account balance)......................................... 65,000

Pickup trucks = Book value of machinery plus cash paid$20,000 + 8,000 = $28,000

No gain is recognized in this situation.


Pickup trucks (determined above) ..................................... 28,000Accumulated depreciation (account balance) .................... 45,000

Cash ......................................................................... 8,000Machinery (account balance)......................................... 65,000

Average accumulated expenditures:

January 2, 2009 $500,000 x 12/12 = $ 500,000March 31, 2009 600,000 x 9/12 = 450,000





June 30, 2009 400,000 x 6/12 = 200,000October 30, 2009 600,000 x 2/12 = 100,000

$1,250,000

Interest capitalized:

$1,250,000 - 700,000 x 7% = $49,000

$ 550,000 x 6.75%* = 37,125 $ 86,125 = interest capitalized

* Weighted-average rate of all other debt:

$3,000,000 x 8% = $240,000 5,000,000 x 6% = 300,000$8,000,000 $540,000

$540,000 = 6.75% weighted average$8,000,000



January 2, 2009 $500,000 x 12/12 = $ 500,000March 31, 2009 600,000 x 9/12 = 450,000June 30, 2009 400,000 x 6/12 = 200,000October 30, 2009 600,000 x 2/12 = 100,000

$1,250,000


$1,250,000 x 6.77%* = $84,625


$ 700,000 x 7% = $ 49,0003,000,000 x 8% = 240,000

5,000,000 x 6% = 300,000$8,700,000 $589,000

$589,000 = 6.77% weighted average$8,700,000

Research and development:Salaries $220,000Depreciation on R & D facilities and equipment 125,000Utilities and other direct costs 66,000Payment to another company 120,000 Total R & D expense $531,000

Note: The patent filing and related legal costs and the costs of adapting the product to a particular customer’s needs are not included as research and development expense.




Capitalized cost of land:

Purchase price $60,000Demolition of old building $4,000Less: Sale of materials (2,000) 2,000Legal fees for title investigation 2,000

Total cost of land $64,000

Capitalized cost of building:

Construction costs $500,000Architect's fees 12,000Interest on construction loan 5,000

Total cost of building $517,000

Note: Property taxes on the land for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred.

To record the purchase of a machine.

Machine ($45,000 + 2,200 + 700 + 1,000).......................... 48,900Accounts payable...................................................... 47,200Cash.......................................................................... 1,700

To record prepaid insurance for the machine.

Prepaid insurance.......................................................... 900Cash.......................................................................... 900


EXERCISESExercise 10-1

Exercise 10-2

Exercise 10-3

Requirement 1

Cost of land and building:

Purchase price $4,000,000Title search and insurance 16,000Legal fees 5,000State transfer fees 4,000

Total cost $4,025,000

Note: The pro-rated property taxes for the period after acquisition are not included in the initial valuation of the land and building. They are recorded instead as prepaid taxes and expensed over the related period.

The total is allocated to the land and building based on their relative fair values:

Asset Fair Value


InitialValuation(Percent x $4,025,000)

Land $3,300,000 75% $3,018,750Building 1,100,000 25 1,006,250

$4,400,000 100% $4,025,000

Assets: Land $3,018,750 Building 1,006,250 Land improvements: Parking lot 82,000 Landscaping 40,000


Exercise 10-3 (concluded)

Requirement 2

Cost of land:Purchase price $4,000,000Title search and insurance 16,000Legal fees 5,000State transfer fees 4,000Demolition of old building $250,000

Less: Sale of materials (6,000) 244,000Clearing and grading costs 86,000

Total cost of land $4,355,000

Land improvements: Parking lot 82,000 Landscaping 40,000

Requirement 1

Cost of copper mine:Mining site $1,000,000Development costs 600,000Restoration costs 303,939 †

$1,903,939

† $300,000 x 25% = $ 75,000 400,000 x 40% = 160,000 600,000 x 35% = 210,000

$445,000 x .68301* = $303,939*Present value of $1, n = 4, i = 10% (from Table 2)

Requirement 2

Copper mine (determined above).................................... 1,903,939


Exercise 10-4

Cash ($1,000,000 + 600,000)....................................... 1,600,000Asset retirement liability (determined above) ............. 303,939

Equipment (cost).......................................................... 120,000Cash........................................................................ 120,000

Organization cost expense ($12,000 + 3,000) 15,000Patent ($20,000 + 2,000)................................................... 22,000Pre-opening expenses ................................................... 40,000Furniture........................................................................ 30,000

Cash.......................................................................... 107,000



Assets $23,000,000Less: Liabilities assumed (9,500,000) (13,500,000)

Goodwill $ 3,500,000



Book value of net assets $7,800,000Plus: Fair value in excess of book value: Property, plant, and equipment 1,400,000 Intangible assets 1,000,000Less: Book value in excess of fair value:

Receivables (200,000) 10,000,000Goodwill $ 1,000,000


Exercise 10-5

Exercise 10-6

Exercise 10-7

Asset Fair Value


InitialValuation(Percent x $900,000)

Land ................. $ 300,000 30% $270,000Building A ....... 450,000 45 405,000Building B ....... 250,000 25 225,000

$1,000,000 100% $900,000

Requirement 1

Tractor ($5,000 cash + 18,783† present value of note)............. 23,783Discount on note payable (difference) ............................. 6,217

Cash.......................................................................... 5,000Note payable (face amount).......................................... 25,000

† Present value of note payment:

PV = $25,000 (.75131) = $18,783Present value of $1: n = 3, i = 10% (from Table 2)

Requirement 2

2009: Interest expense ($18,783 x 10%) = $1,8782010: Interest expense [($18,783 + 1,878) x 10%] = 2,066

Requirement 32009: $25,000 – ($6,217 – 1,878) = $20,6612010: $25,000 – ($6,217 – 1,878 – 2,066) = 22,727


Exercise 10-8

Exercise 10-9

Land:

Purchase price $1,200,000Demolition and removal of old building 80,000Clearing and grading 150,000Closing costs 42,000

Total cost of land $1,472,000

Building:Architect’s fees $ 50,000Construction costs 3,250,000

Total cost of building $3,300,000

Machinery:Purchase price $860,000Freight charges 32,000Special platforms and wire installation 12,000Cost of trial runs 7,000

Total cost of machinery $911,000

Land improvements:Landscaping $45,000Sprinkler system 5,000

Fork lifts:

PV = $16,000 + 70,000 (.93458) = $81,421Present value of $1: n = 1, i = 7% (from Table 2)

Prepaid insurance $24,000

To record the acquisition of land in exchange for common stock.

February 1, 2009Land ............................................................................. 90,000

Common stock (5,000 shares x $18).............................. 90,000


Exercise 10-10

Exercise 10-11

To record the acquisition of a building through purchase and donation.

November 2, 2009Building ........................................................................ 600,000

Cash ......................................................................... 400,000Revenue - donation of asset (difference)...................... 200,000

Requirement 1($ in millions)Average PP&E for 2007 = ($3,893 + 3,440) ÷ 2 = $3,666.5

Net sales ÷ Average PP&E = Fixed-asset turnover ratio$34,922 ÷ $3,666.5 = 9.52

Requirement 2The fixed-asset turnover ratio indicates the level of sales generated by the

company’s investment in fixed assets. Cisco is able to generate $9.52 in sales for every $1 invested in property, plant, and equipment.

Requirement 1

Cash.............................................................................. 3,000Accumulated depreciation - tractor (account balance)....... 26,000Loss on sale of tractor (difference)................................... 1,000

Tractor (account balance).............................................. 30,000

Requirement 2

Cash.............................................................................. 10,000Accumulated depreciation - tractor (account balance)....... 26,000

Tractor (account balance).............................................. 30,000


Exercise 10-12

Exercise 10-13

Gain on sale of tractor (difference).............................. 6,000

Equipment - new ($200,000 + 60,000).............................. 260,000Accumulated depreciation (account balance).................... 220,000

Cash.......................................................................... 60,000Equipment - old (account balance)................................ 400,000Gain ($200,000 - 180,000)............................................. 20,000

Equipment - new ($170,000 + 60,000)............................... 230,000Loss ($180,000 - 170,000)................................................. 10,000Accumulated depreciation (account balance).................... 220,000

Cash.......................................................................... 60,000Equipment - old (account balance)................................ 400,000

Requirement 1

Fair value of land + Cash given = Fair value of equipment$150,000 + 10,000 = $160,000

Requirement 2

Equipment ($150,000 + 10,000)......................................... 160,000Cash.......................................................................... 10,000Land (book value)........................................................ 120,000Gain ($150,000 - 120,000)............................................. 30,000

Requirement 1

Fair value of land - Cash received = Fair value of equipment


Exercise 10-14

Exercise 10-15

Exercise 10-16

Exercise 10-17

$150,000 - 10,000 = $140,000

Requirement 2

Equipment ($150,000 - 10,000)......................................... 140,000Cash.............................................................................. 10,000

Land (book value)........................................................ 120,000Gain ($150,000 - 120,000)............................................. 30,000

Requirement 1

Fair value of old land + Cash given = Fair value of new land$72,000 + 14,000 = $86,000

Requirement 2

Land–new ($72,000 + 14,000)........................................... 86,000Cash.......................................................................... 14,000Land - old (book value)................................................ 30,000Gain ($72,000 – 30,000)................................................ 42,000

Requirement 3

Land–new ($30,000 + 14,000)........................................... 44,000Cash.......................................................................... 14,000Land - old (book value)................................................ 30,000

1. To record the purchase of equipment on account.

Equipment ($25,000 x 98%)............................................. 24,500Accounts payable...................................................... 24,500


Exercise 10-18

Exercise 10-19

2. To record the acquisition of equipment in exchange for a note.

Equipment (determined below).......................................... 24,545Discount on note payable (difference)............................. 2,455

Note payable (face amount).......................................... 27,000

PV = $27,000 (.90909) = $24,545Present value of $1: n=1, i=10% (from Table 2)

3. To record the exchange of old equipment for new equipment.

Equipment - new ($2,500 + 22,000).................................. 24,500Loss ($6,000 - 2,500)........................................................ 3,500Accumulated depreciation ............................................ 8,000

Cash.......................................................................... 22,000Equipment - old......................................................... 14,000

4. To record the acquisition of equipment by the issuance of stock.

Equipment..................................................................... 24,000Common stock.......................................................... 24,000


$6,000,000 = $3,000,000 2


$3,000,000- 1,500,000 x 10% = $150,000


Exercise 10-20

1,500,000 x 7%* = 105,000$255,000 = interest capitalized


$2,000,000 x 9% = $180,000 4,000,000 x 6% = 240,000$6,000,000 $420,000

$420,000 = 7% $6,000,000

Average accumulated expenditures for 2009:

January 2, 2009 $500,000 x 12/12 = $ 500,000March 1, 2009 600,000 x 10/12 = 500,000July 31, 2009 480,000 x 5/12 = 200,000September 30, 2009 600,000 x 3/12 = 150,000December 31, 2009 300,000 x 0/12 = - 0 -

$1,350,000


$1,350,000 x 8% = $108,000

Average accumulated expenditures for 2009:

January 2, 2009 $ 600,000 x 12/12 = $ 600,000March 31, 2009 1,200,000 x 9/12 = 900,000June 30, 2009 800,000 x 6/12 = 400,000September 30, 2009 600,000 x 3/12 = 150,000December 31, 2009 400,000 x 0/12 = - 0 -

$2,050,000


$2,050,000© The McGraw-Hill Companies, Inc., 2009

Solutions Manual, Vol.1, Chapter 10 10-23

Exercise 10-21

Exercise 10-22

- 1,500,000 x 8.0% = $120,000 550,000 x 10.5%* = 57,750

$177,750 = interest capitalized


$5,000,000 x 12% = $600,000 3,000,000 x 8% = 240,000$8,000,000 $840,000

$840,000 = 10.5%

$8,000,000

IAS No. 23, as originally issued, allowed a company to choose between (1) capitalization and (2) immediate expensing of interest incurred during the construction period. In 2007, IAS No.

23 was revised to require capitalization of interest. So, Highlands Company must capitalize $177,750 in interest as with U.S. GAAP.

To expense R&D costs incorrectly capitalized.

Research and development expense (below)...................3,180,000Patent........................................................................ 3,180,000

Research and development expenditures:

Basic research to develop the technology $2,000,000Engineering design work 680,000Development of a prototype 300,000Testing and modification of the prototype 200,000 Total $3,180,000

To capitalize cost of equipment incorrectly capitalized as patent.


Exercise 10-23

Exercise 10-24

Equipment..................................................................... 60,000Patent........................................................................ 60,000

To record depreciation on equipment used in R&D projects.

Research and development expense.............................. 10,000Accumulated depreciation - equipment...................... 10,000

Research and development expense:

Salaries and wages for lab research $ 400,000Materials used in R&D projects 200,000Fees paid to outsiders for R&D projects 320,000Depreciation on R&D equipment 120,000 Total $1,040,000

The patent filing and legal costs are capitalized as the cost of the patent. The salaries, wages, and supplies for R&D performed for another company are included as inventory and expensed as cost of goods sold using either the completed contract or percentage-of-completion method.


Exercise 10-25

Exercise 10-26

List A List B

f 1. Depreciation a. Exclusive right to display a word, a symbol, or an emblem.

d 2. Depletion b. Exclusive right to benefit from a creative work. i 3. Amortization c. Operational assets that represent rights. g 4. Average accumulated d. The allocation of cost for natural resources.

expenditures h 5. Revenue - donation of asset e. Purchase price less fair value of net

identifiable assets. j 6. Nonmonetary exchange f. The allocation of cost for plant and equipment. k 7. Natural resources g. Approximation of average amount of debt if all

construction funds were borrowed. c 8. Intangible assets h. Account credited when assets are donated to a

corporation. b 9. Copyright i. The allocation of cost for intangible assets. a 10. Trademark j. Basic principle is to value assets acquired using fair

value of assets given. e 11. Goodwill k. Wasting assets.

Requirement 1

($ in millions)Research and development expense.............................. 4Software development costs.......................................... 2

Cash.......................................................................... 6

Requirement 2(1) Percentage-of-revenue method:

$4,000,000 = 40% x $2,000,000 = $800,000$10,000,000

(2) Straight-line method:1/5 or 20 % x $2,000,000 = $400,000.

The percentage-of-revenue method is used since it produces the greater amortization, $800,000.


Exercise 10-27

Requirement 3Software development costs $2,000,000Less: Amortization to date (800,000) Net $1,200,000


Requirement 1

Oil wells ....................................................................... 450,000Cash.......................................................................... 450,000

Requirement 2

Oil wells ($50,000 + 60,000 + 80,000)................................ 190,000Exploration expense...................................................... 260,000

Cash.......................................................................... 450,000

CPA Exam Questions

1. d. Simons Company should value the land at $170,500. All expenditures incurred to purchase land should be part of the capitalized asset. $150,000 + ($150,000 x .07) + $5,000 + $5,000

2. c. Costs attributable to land: $60,000 + $2,000 + $5,000 - $3,000 = $64,000Costs attributable to building: $8,000 + $350,000 = $358,000

3. d. There are eight payments due, the first one due immediately, and the remaining seven due each year on December 31. Therefore, the correct factor to use is the present value of an annuity in advance (annuity due) for 8 periods, or 5.712 x $20,000 = $114,240, the present value at the inception of the note and therefore the initial value of the machine. Another way to calculate the answer is to view the annuity as a 7 period ordinary annuity, with a down payment today of $20,000. This would yield a calculation of $20,000 + ($20,000 x 4.712) or $114,240.

4. b. The recorded cost of the new asset is equal to the fair value of the asset given up, $20,000. In this case, there are two new assets acquired, new


Exercise 10-28

CPA / CMA REVIEW QUESTIONS

truck, $15,000, and cash, $5,000. The gain on the trade is $8,000 (FV old truck $20,000 - $12,000 book value).

5. c. Dahl Corporation should capitalize the materials, engineering fees, and labor and electricity for construction and testing: ($20,000 + $5,000 + $3,000 + $1,000 + $1,000 + $1,000). The labor and electricity to run the machine should not be capitalized. These should be expensed because they are not part of the construction costs and were not incurred prior to activating the asset.


CPA Exam Questions (concluded)

6. b. The interest cost capitalized is the lesser of the formula amount based on average accumulated expenditures or the actual interest cost incurred. In this case the formula amount ($40,000) is the smaller amount and should be the amount capitalized as part of the cost of the building.

7. a. Amortization of capitalized software is the lesser of the amount calculated using the percentage-of-revenue method and the straight-line method. In this case, the straight-line percentage is 20% (1/5) and the percentage-of-revenue method is 30%. Therefore, we amortize 30% of the cost yielding book value of 70%.

8. d. All of the expenditures are considered research and development.

CMA Exam Questions

1. a. The costs of fixed assets (plant and equipment) are all costs necessary to acquire these assets and to bring them to the condition and location required for their intended use. These costs include shipping, installation, pre-use testing, sales taxes, interest, capitalization, etc. The original cost of the machinery to be recorded in the books is the sum of the purchase price, installation, and delivery charges.

2. d. SFAS No. 153, “Exchanges of Nonmonetary Assets – an amendment of APB Opinion No. 29”, states that the basic principle to be followed in these exchanges is to value the asset received at fair value and to recognize gain or loss (the difference between the fair value and the book value of the asset given up). Harper’s used machine has a book value of $64,000 ($162,500 cost - $98,500 accumulated depreciation). The fair value of the used machine is $80,000 resulting in a gain of $16,000 ($80,000 – 64,000). The only exceptions to using fair value are (1) when fair value is not determinable and (2) when the exchange lacks commercial substance.

3. c. The answer is the same as question 2.


1. To record the acquisition of land and building.

Land (determined below)..................................................................... 62,500Building (determined below)............................................. 37,500

Cash.......................................................................... 100,000

Asset Fair Value


InitialValuation (Percent x $100,000)

Land $ 75,000 62.5% $ 62,500Building 45,000 37.5 37,500

$120,000 100.0% $100,000

2. To record the acquisition of equipment for cash and a note.

Equipment (determined below).......................................... 37,037Discount on note payable (difference)............................. 2,963

Note payable (face amount).......................................... 40,000

Present value of note payments:

PV = $40,000 (.92593) = $37,037Present value of $1: n = 1, i=8% (from Table 2)

3. To record the acquisition of a truck by donation.

Truck............................................................................. 2,500Revenue - donation of asset....................................... 2,500


PROBLEMSProblem 10-1

Problem 10-1 (concluded)

4. To capitalize organization costs.

Organization cost expense............................................. 3,000Cash.......................................................................... 3,000

5. To record the purchase of machinery.

Machinery ($15,000 + 500).............................................. 15,500Cash.......................................................................... 15,500

6. To record the acquisition of office equipment by the issuance of common stock.

Office equipment........................................................... 5,500Common stock.......................................................... 5,500

7. To record the acquisition of land in exchange for cash and a note.

Land.............................................................................. 20,000Cash.......................................................................... 2,000Note payable............................................................. 18,000

Requirement 1

Blackstone CorporationLAND ACCOUNT (Site Number 11)

As of September 30, 2010

Acquisition cost $600,000


Problem 10-2

Real estate broker’s commission 36,000Legal fees 6,000Title insurance 18,000Cost of razing existing building 75,000Balance, September 30, 2010 $735,000

Requirement 2Blackstone Corporation

CAPITALIZED COST OF OFFICE BUILDINGAs of September 30, 2010

Contract cost $3,000,000Plans, specifications, and blueprints 12,000Architects’ fees for design and supervision 95,000Capitalized interest for 2009: $900,000 x 14% x 10/12 105,000Capitalized interest for 2010: $2,300,000 x 14% x 9/12 241,500Total capitalized cost, September 30, 2010 $3,453,500

Requirement 1

Pell CorporationANALYSIS OF CHANGES IN PLANT ASSETS

For the Year Ended December 31, 2009

Balance Balance 12/31/08 Increase Decrease 12/31/09

Land $ 350,000 $438,000 [1] $ 788,000 Land improvements 180,000 180,000 Building 1,500,000 1,500,000 Machinery and equipment 1,158,000 287,000 [2] $58,000 1,387,000 Automobiles 150,000 19,000 [3] 18,000 151,000 Totals $3,338,000 $744,000 $76,000 $4,006,000

Explanation of Amounts: [1] Cost of land acquired 11/1/09:

Pell stock exchanged (10,000 shares x $38) $380,000 Legal fees and title insurance 23,000


Problem 10-3

Razing existing building 35,000$438,000

[2] Cost of machinery and equipment purchased 1/2/09: Invoice cost $260,000 Installation cost 27,000

$287,000 [3] Cost recorded for new automobile 12/31/09:

Fair value of trade-in $ 3,750 Cash paid 15,250

$ 19,000



Requirement 2Pell Corporation

GAIN OR LOSS FROM PLANT ASSET DISPOSALSFor the Year Ended December 31, 2009

Sale of machine on 3/31/09: Selling price $36,500 Less: Book value of machine ($58,000 - 24,650) (33,350) Gain on sale of machine $ 3,150

Trade-in of automobile on 12/31/09: Book value of trade-in ($18,000 - 13,500) $ 4,500 Less: Fair value of trade-in (3,750) Loss on trade-in $ 750

To reclassify various expenditures incorrectly charged to the intangible asset account.

Organization cost expense............................................. 7,000Prepaid insurance.......................................................... 6,000Copyright...................................................................... 20,000Research and development expense.............................. 40,000Patent ($3,000 + 12,000)................................................... 15,000Franchise....................................................................... 40,000Advertising expense...................................................... 16,000

Intangible asset.......................................................... 144,000

To reclassify amount paid for Stiltz Corp. incorrectly charged to the intangible asset account.

Receivables................................................................... 100,000Equipment..................................................................... 350,000


Problem 10-4

Patent............................................................................ 150,000Goodwill (determined below)............................................ 120,000

Note payable............................................................. 220,000Intangible asset.......................................................... 500,000


Consideration exchanged $500,000Less: Fair value of net assets (380,000)Goodwill $120,000

1. To expense R&D costs.

Research and development expense.............................. 12,000Cash.......................................................................... 12,000

2. To expense legal fees for unsuccessful defense of patent.

Legal fees expense........................................................ 7,500Cash.......................................................................... 7,500

3. To capitalize the cost of equipment.

Equipment (cash price).................................................... 23,000Discount on note payable (difference)............................. 1,000

Cash (amount paid)...................................................... 6,000Note payable (face amount).......................................... 18,000

4. To capitalize cost of the sprinkler system.


Problem 10-5

Building - sprinkler system............................................ 28,000Cash.......................................................................... 28,000

5. To capitalize legal fees for successful defense of patent.

Patent............................................................................ 12,000Cash.......................................................................... 12,000



6. To record the trade-in of an old machine for a new machine.

Machine - new ($2,000* + 8,000)..................................... 10,000Accumulated depreciation - machine ($7,400 - 3,000)...... 4,400Loss on trade-in ($3,000 – 2,000*).................................... 1,000

Cash.......................................................................... 8,000Machine - old............................................................ 7,400

*Fair value of old machine (Fair value of new machine - Cash given):$10,000 - 8,000 = $2,000

Southern Company:

Cash.............................................................................. 140,000Building - new ($1,400,000 - 140,000)............................... 1,260,000Accumulated depreciation - building (account balance). . . . 1,200,000

Building - old (account balance).................................... 2,000,000Gain ($1,400,000 – 800,000).......................................... 600,000

Eastern Company:

The fair value of Eastern’s building is $1,260,000 ($1,400,000 fair value of Southern’s building less $140,000 cash given).

Building - new ($1,260,000 + 140,000).............................. 1,400,000Accumulated depreciation - building (account balance). . . . 650,000

Cash.......................................................................... 140,000Building - old (account balance).................................... 1,600,000Gain on exchange of buildings ($1,260,000 – 950,000). . 310,000


Problem 10-6

Robers:

Cash.............................................................................. 5,000New asset ($75,000 - 5,000).............................................. 70,000Accumulated depreciation - old asset (account balance).... 55,000

Old asset (account balance)........................................... 120,000Gain on exchange of assets ($75,000 – 65,000)............. 10,000

Phifer:

New asset ($70,000 + 5,000)............................................. 75,000Accumulated depreciation - old asset (account balance).... 63,000Loss ($77,000 – 70,000) ........................................................... 7,000

Cash.......................................................................... 5,000Old asset (account balance)........................................... 140,000

Case A.

Requirement 1Book value less fair value = loss on exchange $12,000 - 9,000 = $3,000 loss

Fair value of old tractor + cash given = Initial value of new tractor $9,000 + 20,000 = $29,000


New tractor ($9,000 + 20,000).......................................... 29,000Accumulated depreciation - old asset (account balance).... 16,000Loss ($12,000 – 9,000) ............................................................. 3,000

Cash ......................................................................... 20,000


Problem 10-7

Problem 10-8

Old tractor (account balance)......................................... 28,000

Requirement 2Fair value less book value = gain on exchange $14,000 - 12,000 = $2,000 gain

Fair value of old tractor + cash given = Initial value of new tractor $14,000 + 20,000 = $34,000


New tractor ($14,000 + 20,000)......................................... 34,000Accumulated depreciation - old asset (account balance).... 16,000

Cash ......................................................................... 20,000Old tractor (account balance)......................................... 28,000Gain ($14,000 – 12,000) ............................................... 2,000


Problem 10-8 (continued)

Case B.

Requirement 1Fair value less book value = gain on exchange $700,000 - 500,000 = $200,000 gain

Fair value of old land + cash given = Initial value of new land $700,000 + 50,000 = $750,000


New land ($700,000 + 50,000).......................................... 750,000Cash ......................................................................... 50,000Old land (account balance)............................................ 500,000Gain ($700,000 – 200,000) ........................................... 200,000

Requirement 2Book value less fair value = loss on exchange $500,000 - 400,000 = $100,000 loss

Fair value of old land + cash given = Initial value of new land $400,000 + 50,000 = $450,000


New land ($400,000 + 50,000).......................................... 450,000Loss ($500,000 – 400,000) ................................................ 100,000

Cash ......................................................................... 50,000Old land (account balance)............................................ 500,000



Requirement 3If the exchange lacked commercial substance, no gain is recognized.

Book value of old land + cash given = Initial value of new land $500,000 + 50,000 = $550,000


New land ($500,000 + 50,000).......................................... 550,000Cash ......................................................................... 50,000Old land (account balance)............................................ 500,000

Requirement 1

2009:Expenditures for 2009:January 3, 2009 $1,000,000 x 12/12 = $1,000,000March 1, 2009 600,000 x 10/12 = 500,000June 30, 2009 800,000 x 6/12 = 400,000October 1, 2009 600,000 x 3/12 = 150,000

Accumulated expenditures (before interest) - $3,000,000Average accumulated expenditures - $2,050,000


$2,050,000 x 10% = $205,000 = Interest capitalized in 2009

2010:January 1, 2010 ($3,000,000 + 205,000) $3,205,000 x 9/9 = $3,205,000January 31, 2010 270,000 x 8/9 = 240,000April 30, 2010 585,000 x 5/9 = 325,000


Problem 10-9

August 31, 2010 900,000 x 1/9 = 100,000

Accumulated expenditures (before interest) - $4,960,000Average accumulated expenditures - $3,870,000


$3,870,000- 3,000,000 x 10.0% x 9/12 = $225,000 870,000 x 7.2%* x 9/12 = 46,980

$271,980 = Interest capitalized in 2010


$ 4,000,000 x 6% = $240,000 $720,000 6,000,000 x 8% = 480,000 = 7.2%$10,000,000 $720,000 $10,000,000



Requirement 2Accumulated expenditures 9/30/10 before interest capitalization (above) $4,960,0002010 interest capitalized (above) 271,980 Total cost of building $5,231,980

Requirement 32009

$3,000,000 x 10% = $ 300,0004,000,000 x 6% = 240,0006,000,000 x 8% = 480,000Total interest incurred 1,020,000Less: Interest capitalized (205,000) 2009 interest expense $ 815,000

2010Total interest incurred $1,020,000Less: Interest capitalized (271,980) 2010 interest expense $ 748,020

Requirement 1

2009Expenditures for 2009January 3, 2009 1,000,000 x 12/12 = $1,000,000March 1, 2009 600,000 x 10/12 = 500,000June 30, 2009 800,000 x 6/12 = 400,000October 1, 2009 600,000 x 3/12 = 150,000

Accumulated expenditures (before interest) — $3,000,000Average accumulated expenditures - $2,050,000

Interest capitalized:$2,050,000 x 7.85%* = $160,925 = Interest capitalized in 2009

* Weighted-average rate of all debt:© The McGraw-Hill Companies, Inc., 200910-44 Intermediate Accounting, 5/e

Problem 10-10

$ 3,000,000 x 10% = $ 300,000 $1,020,000 4,000,000 x 6% = 240,000 = 7.85% (rounded)

6,000,000 x 8% = 480,000 $13,000,000$13,000,000 $1,020,000

2010:January 1, 2010 ($3,000,000 + 160,925) $3,160,925 x 9/9 = $3,160,925January 31, 2010 270,000 x 8/9 = 240,000April 30, 2010 585,000 x 5/9 = 325,000August 31, 2010 900,000 x 1/9 = 100,000

Accumulated expenditures (before interest) — $4,915,925Average accumulated expenditures - $3,825,925

Interest capitalized:$3,825,925 x 7.85% x 9/12 =$225,251 = Interest capitalized in 2010



Requirement 2Accumulated expenditures 9/30/10, before interest capitalization (above) $4,915,9252010 interest capitalized (above) 225,251 Total cost of building $5,141,176

Requirement 32009:

$3,000,000 x 10% = $ 300,0004,000,000 x 6% = 240,0006,000,000 x 8% = 480,000Total interest incurred 1,020,000Less: Interest capitalized (160,925)2009 interest expense $ 859,075

2010:Total interest incurred $1,020,000Less: Interest capitalized (225,251)2010 interest expense $ 794,749

To capitalize the cost of equipment to be used on future projects incorrectly charged to R&D expense.

Equipment..................................................................... 400,000Research and development expense........................... 400,000

To record depreciation on equipment used in R&D projects. $400,000 ÷ 5 years = $80,000

Research and development expense.............................. 80,000Accumulated depreciation - equipment...................... 80,000

To capitalize filing and legal fees for patent incorrectly charged to R&D expense.


Problem 10-11

Patent............................................................................ 40,000Research and development expense........................... 40,000

To reclassify the expenditures made for quality control during commercial production.

Inventory*..................................................................... 20,000Research and development expense........................... 20,000

*Quality control costs would either be treated as manufacturing overhead and included in the cost of inventory (as in this journal entry), or expensed in the period incurred.

Requirement 1

LandPurchase price (determined below) $714,404Closing costs 20,000Removal of old building 70,000Clearing and grading 50,000

$854,404

Purchase price of land: Cash paid $200,000 Value of note† 514,404

$714,404

† Present value of note payment:

PV = $600,000 (.85734) = $514,404Present value of $1: n = 2, i = 8% (from Table 2)

Land improvementsParking lot and landscaping $285,000


Problem 10-12

BuildingConstruction expenditures:

May 30 $1,200,000July 30 1,500,000September 1 900,000October 1 1,800,000 Total expenditures 5,400,000

Interest capitalized (determined below) 94,000 Total cost of building $5,494,000



Average accumulated expenditures:May 31, 2009 $1,200,000 x 5/6 = $ 1,000,000 July 30, 2009 1,500,000 x 3/6 = 750,000September 1, 2009 900,000 x 2/6 = 300,000 October 1, 2009 1,800,000 x 1/6 = 300,000

$2,350,000

Interest capitalized:$2,350,000 x 8% x 6/12 = $94,000

Equipment and furniture and fixtures

InitialPercent of Total Valuation

Fair Value Fair Value % x $600,000Equipment $455,000 65% $390,000Furniture & fixtures 245,000 35 % 210,000

Totals $700,000 100% $600,000

Initial valuation:Equipment $390,000Furniture & fixtures 210,000

Requirement 2

Interest expense:Note issued to purchase land and building, $514,404 x 8% x 9/12 = $ 30,864Construction loan, $3,000,000 x 8% x 8/12 160,000Long-term note, $2,000,000 x 9% 180,000Long-term bonds, $4,000,000 x 6% 240,000 Total 610,864Less: Interest capitalized (determined above) (94,000)

Interest expense $516,864


Requirement 1All costs necessary to bring the land to its condition for use should be capitalized

as the cost of the land. This should include the following costs :

Purchase price. Title insurance. Escrow fees. Delinquent property taxes. Cost of removing old building. Cost of grading and other land preparation costs.

Requirement 2Assets acquired in exchange for deferred payment contracts are valued at their

fair value or the present value of payments using a realistic interest rate.

Requirement 3In general, operational assets received in exchange for other nonmonetary assets

should be valued at the fair value of the nonmonetary assets given up plus (minus) monetary consideration given (received). There are certain exceptions when the assets received are valued at the book value of the nonmonetary assets given up plus (minus) monetary consideration given (received).

The new machine acquired by exchanging an older, similar machine generally would be valued at the fair value of the old machine plus (minus) any cash given (received). However, if fair value cannot be determined or if the exchange lacks commercial substance, then the new machine would be valued at the book value of the old machine plus (minus) any cash given (received).

Requirement 1

SFAS No. 143, “Accounting for Asset Retirement Obligations,” requires that an existing legal obligation associated with the retirement of a tangible, long-lived asset be recognized as a liability and measured at fair value. When the liability is credited, the offsetting debit is to the related operational asset. Usually, the fair value is estimated by calculating the present value of estimated future cash outflows.

Traditionally, the way uncertainty has been considered in present value calculations has been by discounting the “best estimate” of future cash flows applying a discount rate that has been adjusted to reflect the uncertainty or risk of those cash flows. That's not the approach taken here. Instead, we follow the approach described in the FASB’s Concept Statement No. 7, which is to adjust the cash flows, not the


CASESJudgment Case 10-1

Research Case 10-2

discount rate, for the uncertainty or risk of those cash flows. This expected cash flow approach incorporates specific probabilities of cash flows into the analysis. We use a discount rate equal to the credit-adjusted risk free rate. The higher a company’s credit risk, the higher will be the discount rate.

Requirement 2The cost of the coal mine is $24,513,419 determined as follows:

Mining site $15,000,000Development costs 6,000,000Restoration costs 3,513,419 †

$24,513,419† $3 million x 20% = $ 600,000

4 million x 30% = 1,200,000 5 million x 25% = 1,250,000 6 million x 25% = 1,500,000

$4,550,000 x .77218* = $3,513,419*Present value of $1, n = 3, i = 9%

Requirement 3

Coal mine (determined above)........................................ 24,513,419Cash ($15,000,000 + 6,000,000)................................... 21,000,000Asset retirement liability (determined above) ............. 3,513,419


Case 10-2 (concluded)

Requirement 4$3,513,419 x 9% = $316,208 x 6/12 = $158,104

Requirement 5

If the actual restoration costs are more (less) than the recorded liability at the retirement date, a loss (gain) on retirement of the obligation is recognized for the difference.

Asset retirement liability (maturity amount)................... 4,550,000Loss (difference)........................................................... 150,000

Cash ....................................................................... 4,700,000

Requirement 6An entity shall disclose the following information about its asset retirement

obligations:

a. A general description of the asset retirement obligations and the associated long-lived assets.

b. The fair value of assets that are legally restricted for purposes of settling asset retirement obligations.

c. A reconciliation of the beginning and ending aggregate carrying amount (book value) of asset retirement obligations showing separately the changes attributable to (1) liabilities incurred in the current period, (2) liabilities settled in the current period, (3) accretion expense (interest expense), and (4) revisions in estimated cash flows, whenever there is a significant change in one or more of those four components during the reporting period.

If the fair value of an asset retirement obligation cannot be reasonably estimated, that fact and the reasons therefor shall be disclosed.

Requirement 1

The cost of a self-constructed asset includes identifiable materials and labor and a portion of the company's manufacturing overhead costs.


Judgment Case 10-3

Requirement 2The treatment of manufacturing overhead cost and its allocation between

construction projects and normal production is a difficult issue. One alternative is to include only the incremental overhead costs in the total cost of construction. That is, only those additional costs that are incurred because of the decision to construct the asset should be added to the cost of the asset. This would exclude such indirect costs as depreciation and the salaries of supervisors that would be incurred whether or not the construction project is undertaken. If, however, a new construction supervisor were hired specifically to work on the project, then that salary would be included in asset cost.

A second alternative is to assign overhead on the same basis that is used for the regular manufacturing process. For example, all overhead costs might be allocated both to production and to self-constructed assets based on the relative amount of labor hours incurred. This is known as the full-cost approach and is the generally accepted method used to determine the cost of a self-constructed asset.

Requirement 3Generally accepted accounting principles provide specific guidelines for the

treatment of interest costs incurred during construction. These guidelines pertain to the construction of assets for a company’s own use as well as for assets constructed for sale or lease. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Only assets that are constructed as discrete projects qualify for interest capitalization.

The construction of equipment by the Chilton Company appears to qualify for interest capitalization. The cost of the equipment would include interest if, during the construction period, interest costs were actually being incurred.

Requirement 1

Only assets that are constructed as discrete projects qualify for interest capitalization. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose.

Requirement 2The capitalization period for a self-constructed asset starts when (1) expenditures

(materials, labor and overhead) have been made and (2) interest cost is being incurred. The interest cost incurred does not have to pertain to specific borrowings related to the construction project. The capitalization period ends either when the asset is substantially complete and ready for use or when interest costs are no longer incurred.


Judgment Case 10-4

Requirement 3Average accumulated expenditures is an approximation of the average amount of

debt that the company would have had outstanding during the period if every dollar spent on the project was borrowed. If construction expenditures are incurred equally throughout the period, the average accumulated expenditures for the period can be estimated by adding the accumulated expenditures at the beginning of the period to the accumulated expenditures at the end of the period and dividing by two. If expenditures on the project are unequal throughout the period, individual expenditures, perhaps expenditures grouped by month, should be weighted by the amount of time outstanding until the end of the construction period or the end of the company’s fiscal year, whichever comes first.

Requirement 4One method that could be used to determine the appropriate interest rate(s) to be

used in capitalizing interest is the specific interest method. If debt financing has been obtained specifically for the construction project, its interest rate is applied to the average accumulated expenditures up to the amount of the specific borrowing. Any remaining average accumulated expenditures in excess of specific borrowings is multiplied by the weighted-average rate on all other outstanding interest-bearing debt.

Sometimes it is difficult to associate specific borrowings with projects. In these situations, it is easier to just use the weighted-average rate on all interest-bearing debt, including all construction loans. This is the weighted-average method.


Case 10-4 (concluded)

Requirement 5The three steps used to determine the amount of interest capitalized during a

period are:1. Determine the average accumulated expenditures for the period.2. Multiply average accumulated expenditures by the appropriate interest rate(s).3. Compare interest capitalized with total interest cost incurred. Interest capitalized

can’t exceed interest cost incurred.(Note: This case requires the student to reference a journal article.]

Requirement 2The FASB has tentatively decided that purchased goodwill does meet the criteria

in Concepts Statement 5 for initial recognition as an asset. Goodwill does represent “future economic benefits” that are in the “control” of the enterprise and that have arisen from a “past transaction or event.”

Requirement 3Some believe that goodwill is not an asset because of concerns about 1) equating

costs and assets, 2) exchangeability of goodwill, and 3) controllability.

($ in millions)

Increase in property, plant and equipment, net ($6,903 – 5,831) $1,072Increase in intangible assets, net ($1,687 – 828) 859 Net increase 1,931Add: Depreciation and amortization for the year 938Less: Additions to property, plant and equipment (2,007)Less: Additions to intangible assets (901)

Book value of equipment sold * (39)Proceeds from sale of equipment 112Gain on sale of equipment $73

*OR,Book value of property, plant and equipment and intangibles, beginning of the year $6,659


Research Case 10-5

Real World Case 10-6

Add: additions ($2,007 + 901) 2,908Less: depreciation and amortization (938)Less: book value of property, plant and equipment and intangibles, end of the year (8,590)Book value of equipment sold $ 39

Requirement 1

Goodwill represents the unique value of a company as a whole over and above all identifiable tangible and intangible assets. This value results from a company’s clientele and reputation, its trained employees and management team, its unique business location, and any other unique features of the company that can’t be associated with a specific asset.

Requirement 2The controller would be correct in her valuation of goodwill only if the total fair

value of all of the identifiable net assets (assets less liabilities) of Georgia, Inc. equals the total book value of Georgia’s net assets ($2,800,000). Goodwill, by definition, is the excess of the consideration exchanged (purchase price) over the fair value of net assets, not the book value of net assets.

Requirement 1

A company undertakes an R&D project because it believes the project will eventually provide benefits that exceed the current expenditures. Unfortunately, though, it’s difficult to predict which individual research and development projects will ultimately provide benefits. In fact, only one in ten actually reach commercial production. Moreover, even for those projects that pan out, a direct relationship between research and development costs and specific future revenue is difficult to establish. In other words, even if R&D costs do lead to future benefits, it’s difficult to objectively determine the size of the benefits and in which periods the costs should be expensed if they are capitalized. These are the issues that prompted the FASB to require immediate expensing.

Requirement 2Possible reasons include:

1. The larger a firm is, the more likely it is to prefer income-reducing accounting methods (e.g., expense R&D). This is particularly true in politically sensitive industries where excessive profits could trigger intervention into a firm's activities by government, unions, and other special interest groups.

2. Large firms may tend to have more R&D activities occurring simultaneously, creating a portfolio effect. That is, the number of successful R&D projects relative


Judgment Case 10-7

Judgment Case 10-8

to total projects may be fairly stable from year to year in large firms. There may be much more variability in smaller firms creating larger variability in income if R&D is expensed.

3. Earnings-based management compensation schemes may be more prevalent in smaller R&D companies, thus creating a preference for accounting methods that can be more easily manipulated (e.g., capitalize R&D).

4. Smaller companies may be more dependent on debt financing. Debt covenants (contractual limitations on debt) could create a preference for accounting methods that can be more easily manipulated (e.g., capitalize R&D).

Requirement 1

The costs of research equipment used exclusively for Trouver would be reported as research and development expenses in the period incurred.

The costs of research equipment used on both Trouver and future research projects would be capitalized and shown as equipment (less accumulated depreciation) in the balance sheet. An appropriate method of depreciation should be used. Depreciation on capitalized research equipment should be reported as a research and development expense.

Requirement 2a. Matching refers to the process of expense recognition by associating costs

with revenues on a cause and effect basis.b. Research and development costs usually are expensed in the period incurred

and may not be matched with revenues. This accounting treatment is justified by the high degree of uncertainty regarding the amount and timing of future benefits. A direct relationship between research and development costs and future revenues generally cannot be demonstrated.

Requirement 3Corporate headquarters’ costs allocated to research and development would be

classified as general and administrative expenses in the period incurred, because they are not clearly related to research and development activities.

Requirement 4The legal expenses incurred in defending the patent should be capitalized as part

of the cost of the intangible asset, patent.You may wish to suggest to your students

that they consult Appendix B of SFAS No. 2, Basis for Conclusions, which discusses factors

deemed significant by members of the FASB in reaching their conclusion, including


Judgment Case 10-9

Communication Case 10-10

the various alternatives considered and reasons for accepting some and rejecting others.

While SFAS No. 2 does dictate GAAP in this case, both views, expense and capitalize, can and often are convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than just acceptance of the standard. Each student should benefit from participating in the process, interacting first with his or her partner, and then witnessing or participating in a debate on the issue. It is important that each student actively participate in the process of arriving at a consensus argument. Domination by one individual should be discouraged.

Arguments supporting the expense view should include the reasons cited by the FASB as factors they deemed significant in arriving at their conclusion. Arguments supporting the capitalize view should include reference to violations to the matching principle for successful R&D projects.

A solution and extensive discussion materials accompany each case in the Deloitte & Touche

Trueblood Case Study Series.Suggested Grading Concepts and

Grading Scheme:Content (70%)_______ 20 Defines research and development according to SFAS No.2.

_______ 30 Explains the conceptual reasons for the conclusion reached by the FASB on accounting for R&D.______ High degree of uncertainty regarding the amount and timing of future benefits.______ Lack of direct relationship between R&D costs and future

revenues.

_______ 20 Describes the treatment of equipment costs.______ $200,000 should be expensed as R&D.______ $300,000 should be capitalized and depreciated.

_____________ 70 points

Writing (30%)_______ 6 Terminology and tone appropriate to the audience of a

company president.

_______ 12 Organization permits ease of understanding.


Trueblood Accounting Case 10-11

Communication Case 10-12

______ Introduction that states purpose.______ Paragraphs that separate main points.

_______ 12 English______ Sentences grammatically clear and well organized,

concise.______ Word selection.______ Spelling.______ Grammar and punctuation.

_____________ 30 points

Requirement 1

If the equipment is to be used only in the single R&D project (as is likely) the correct treatment is to expense the entire $30 million. If capitalized, only $6 million would be expensed ($30 million divided by 5 years). Therefore, Alice's treatment will increase before tax earnings by $24 million ($30 million - 6 million).

Requirement 2Discussion should include these elements.

Ethical Dilemma:Is Alice's responsibility to follow GAAP by expensing the equipment purchase

greater than her responsibility to assist the company in seeking new financing?

Who is affected?

AlicePresident and other managersOther employeesShareholdersPotential shareholdersCreditorsCompany auditors

Requirement 1

Cadbury Schweppes values its property, plant and equipment at cost less accumulated depreciation. International standards also allow the valuation of these assets at fair value (revaluation). If revaluation is chosen, all assets within a class of PP&E must be revalued on a regular basis. U.S. GAAP does not allow the revaluation


Ethics Case 10-13

IFRS Case 10-14

option. Property, plant and equipment must be valued at cost less accumulated depreciation.

Requirement 2The company expenses all research expenditures in the financial year in which it

is incurred. Development expenditures are assessed and capitalized if they meet all of the following criteria:

- an asset is created than can be identified;- it is probable that the asset created will generate future economic benefits; and- the development cost of the asset can be measured reliably.

U.S. GAAP requires that both research and development expenditures be expensed in the period incurred. The only exception is the capitalization of certain computer software development costs.


Requirement 1

The fixed-asset turnover ratio is computed by dividing net sales by average fixed assets. A ratio of 3.18 for National indicates that they are able to generate $3.18 in net sales for each dollar invested in fixed assets (property, plant, and equipment).

Requirement 2($ in millions)Book value of PP&E, beginning of 2007 $628 Add: purchases during 2007 107 Deduct: book value of PP&E sold during 2007 (6) Deduct: depreciation for 2007 (145)Book value of PP&E, end of 2007 $584

Average PP&E for 2007 = ($628 + 584) ÷ 2 = $606

Turnover ratio = Net sales ÷ Average PP&E

3.18 = Net sales ÷ $606

Net sales = $1,927

Requirement 1

Elegant was not correct in its treatment of the software development costs. Generally accepted accounting principles require companies to expense costs incurred to develop computer software to be sold, leased or otherwise marketed as R&D costs until technological feasibility of the product or process has been established. Only those costs incurred after technological feasibility has been attained and before the product is available for general release to customers can be capitalized.

Requirement 2The amortization of capitalized computer software development costs begins with

the start of commercial production. The periodic amortization percentage 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.


Analysis Case 10-15

Judgment Case 10-16

Requirement 3

The following is based on Home Depot's 2007 (year ending January 30, 2007) financial statements. Answers will vary depending on the financial statement dates chosen.

a. The company lists land, buildings, furniture, fixtures and equipment, leasehold improvements, construction in progress, and capital leases under Property and equipment. Goodwill (cost in excess of fair value of net assets acquired) is listed as a separate noncurrent asset.

b. $3,542 million.c. Note 4 indicates that $47 million of interest was capitalized in fiscal 2007.d. Fixed-asset turnover ratio = Net sales ÷ Average PP&E

($ in millions)= $90,837 = 3.53 $25,753*

* Average PP&E for 2007 = ($26,605 + 24,901) ÷ 2 = $25,753

Requirement 1

In its balance sheet, Google lists Property and equipment, Intangible assets, and Goodwill as its operational assets. In its disclosure notes, Google lists Information technology assets, Construction in Progress, Land and buildings, Leasehold improvements, and Furniture and fixtures under property and equipment, and it includes Patents and developed technology, customer relationships, and Tradenames and other as Intangible assets.

Requirement 2The statement of cash flows reports that $2,402,840 thousand was spent in 2007

to purchase property and equipment. This compares to $1,902,798 thousand in 2006.

Requirement 3The fixed-asset turnover ratio is computed by dividing net sales (revenues) by

average fixed assets. Using 2007 data, the ratio for Google is 5.16.

($ in thousands) $16,593,986 = 5.16

$3,217,250*

*Average plant and equipment for 2007 = ($4,039,261 + 2,395,239) ÷ 2 = $3,217,250


Real World Case 10-17

Analysis Case 10-18

The ratio is intended to measure a company's effectiveness in managing property, plant, and equipment. It indicates the level of sales generated by the company's investment in these assets. Like any ratio, it is but one piece of a larger puzzle and should not be interpreted in isolation.


Chap 010

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