CHAPTER 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENT Sommers – Intermediate I.

CHAPTER 10

ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND

EQUIPMENT

Sommers – Intermediate I

Long-lived, Revenue-producing AssetsLong-lived, Revenue-producing Assets

Tangible

Property, Plant, Equipment & Natural

Resources

Tangible

Property, Plant, Equipment & Natural

Resources

Types of Operational Assets

Expected to Benefit Future PeriodsExpected to Benefit Future Periods

General Rule for Cost CapitalizationThe initial cost of an operational asset includes the

purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.

Costs to be Capitalized

Land (not depreciable)• Purchase price• Real estate commissions• Attorney’s fees• Title search• Title transfer fees• Title insurance premiums• Removing old buildings

Equipment• Net purchase price• Taxes• Transportation costs• Installation costs• Modification to building

necessary to install equipment

• Testing and trial runs

Costs to be Capitalized

Land Improvements – Separately identifiable costs

• Driveways• Parking lots• Fencing• Landscaping• Private roads

Buildings• Purchase price• Attorney’s fees• Commissions• Reconditioning

Natural Resources• Acquisition costs• Exploration costs• Development costs• Restoration costs

Self Constructed Assets• Materials• Direct Labor• Overhead

Discussion Questions

Q10–4 Indicate where the following items would be shown on a balance sheet.

(a) A lien that was attached to the land when purchased.

(b) Landscaping costs.

(c) Attorney’s fees and recording fees related to purchasing land

(d) Variable overhead related to construction of machinery.


Q10–4

(e) A parking lot servicing employees in the building.

(f) Cost of temporary building for workers during construction of building

(g) Interest expense on bonds payable incurred during construction of a building.

(h) Assessments for sidewalks that are maintained by the city.

(i) The cost of demolishing an old building that was on the land when purchased.

Example 1: Continued

Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building:

Title insurance $ 16,000

Legal fees for drawing the contract 5,000

Pro-rated property taxes for period after acquisition 36,000

State transfer fees 4,000

An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping. Determine the initial valuation of each asset Semtech acquired in these transactions.


Purchase price $4,000,000

Title search and insurance 16,000

Legal fees 5,000


Total cost $4,025,000

Fair Value % of Total Valuation

Land $3,300,000 75% $3,018,750

Building 1,100,000 25% 1,006,250

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

Land $3,018,750

Building 1,006,250

Land improvements:

Parking lot 82,000

Landscaping 40,000


Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building:

Title insurance $16,000

Legal fees for drawing the contract 5,000

Pro-rated property taxes for period after acquisition 36,000


An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping.

Now assume that immediately after acquisition, Semtech demolished the building. Demolition costs were $250,000 and the salvaged materials were sold for $6,000. In addition, Semtech spent $86,000 clearing and grading the land in preparation for the construction of a new building.


Cost of land:

Purchase price $4,000,000

Title search and insurance 16,000

Legal fees 5,000


Demolition of old building $250,000

Less: Sale of materials (6,000) 244,000

Clearing and grading costs 86,000

Total cost of land $4,355,000

Land improvements:

Parking lot $ 82,000

Landscaping $ 40,000

Asset

Fair Value

Percent of Total

Fair ValueInitial

ValuationLand Building

Example 2

Tristar Production Company began operations on September 1, 2011. Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction.

1. On September 1, the company acquired five acres of land with a building that will be used as a warehouse. Tristar paid $100,000 in cash for the property. According to appraisals, the land had a fair value of $75,000 and the building had a fair value of $45,000.



2. On September 1, Tristar signed a $40,000 noninterest-bearing note to purchase equipment. The $40,000 payment is due on September 1, 2012. Assume that 8% is a reasonable interest rate.



3. On September 15, a truck was donated to the corporation. Similar trucks were selling for $2,500.

4. On September 18, the company paid its lawyer $3,000 for organizing the corporation.



5. On October 10, Tristar purchased machinery for cash. The purchase price was $15,000 and $500 in freight charges also were paid.

6. On December 2, Tristar acquired various items of office equipment. The company was short of cash and could not pay the $5,500 normal cash price. The supplier agreed to accept 200 shares of the company’s nopar common stock in exchange for the equipment. The fair value of the stock is not readily determinable.



7. On December 10, the company acquired a tract of land at a cost of $20,000. It paid $2,000 down and signed a 10% note with both principal and interest due in one year. Ten percent is an appropriate rate of interest for this note.

Self-Constructed Assets

When self-constructing an asset, two accounting issues must be addressed:• overhead allocation to the self-constructed asset.

– incremental overhead only– full-cost approach

• proper treatment of interest incurred during construction

Under certain conditions, interest incurred on qualifying assets is capitalized.• Asset constructed is for a company’s own use and is a

discrete project for sale or lease.• Capitalize interest that could have been avoided if the

asset were not constructed and the money used to retire debt.

Three approaches have been suggested to account for the interest incurred in financing the construction.

Capitalize no interest during construction

Capitalize actual costs incurred during construction

Capitalize all costs of funds

GAAP

$ 0 $ ?Increase to Cost of Asset

Interest Costs During Construction

GAAP requires — capitalizing actual interest (with

modification).

Consistent with historical cost.

Capitalization considers three items:

1. Qualifying assets.

2. Capitalization period.

3. Amount to capitalize.

Interest Costs During Construction

Require a substantial period of time to get them ready

for their intended use.

Two types of assets:

Assets under construction for a company’s own

use.

Assets intended for sale or lease that are

constructed or produced as discrete projects.

Qualifying Assets

Capitalization Period

Begins when:

1. Expenditures for the asset have been made.

2. Activities for readying the asset are in progress .

3. Interest costs are being incurred.

Ends when:

The asset is substantially complete and ready for use.

Capitalization Period

Capitalize the lesser of:

1. Actual interest costs

2. Avoidable interest - the amount of interest that

could have been avoided if expenditures for the

asset had not been made.

Amount to Capitalize


Q10–10 What interest rates should be used in determining the amount of interest to be capitalized? How should interest revenue from temporarily invested excess funds borrowed to finance the construction of assets be accounted for?

Selecting Appropriate Interest Rate:

1. For the portion of weighted-average accumulated expenditures that

is less than or equal to any amounts borrowed specifically to

finance construction of the assets, use the interest rate incurred on

the specific borrowings.

2. For the portion of weighted-average accumulated expenditures that

is greater than any debt incurred specifically to finance construction

of the assets, use a weighted average of interest rates incurred on

all other outstanding debt during the period.

Calculating the Actual and Avoidable Interest

Accumulated Interest Avoidable

Expenditures Rate Interest

200,000$ 12% 24,000$

50,000 12.5% 6,250

250,000$ 30,250$

Avoidable Interest

Interest Actual

Debt Rate Interest

Specific Debt 200,000$ 12% 24,000$

General Debt 500,000 14% 70,000

300,000 10% 30,000

1,000,000$ 124,000$

Weighted-average interest rate on general debt

Actual Interest

$100,000

$800,000= 12.5%


Avoidable interest 30,250$

Actual interest 124,000

Journal entry to Capitalize Interest:

Capitalize the lesser of Avoidable interest or Actual interest.


Example 3

On January 1, 2011, the Marlee Company began construction of an office building to be used as its corporate headquarters. The building was completed early in 2012. Construction expenditures for 2011, which were incurred evenly throughout the year, totaled $6,000,000. Marlee had the following debt obligations which were outstanding during all of 2011:

Construction loan, 10% $1,500,000

Long-term note, 9% 2,000,000

Long-term note, 6% 4,000,000

Calculate the amount of interest capitalized in 2011 for the building using the specific interest method.

Example 3

Average accumulated expenditures:

Weighted-average rate of all other debt:

Interest capitalized:

Example 4

On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, 2012. Expenditures on the project were as follows:

January 1, 2011 $1,000,000 January 31, 2012$270,000March 1, 2011 600,000 April 30, 2012

585,000June 30, 2011 800,000 August 31, 2012

900,000October 1, 2011 600,000

On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and 2012. The company’s other interest-bearing debt included two long-term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and 2012. Interest is paid annually on all debt. The company’s fiscal year-end is December 31.1. Calculate the amount of interest that Mason should capitalize in 2011 and

2012 using the specific interest method.2. What is the total cost of the building?3. Calculate the amount of interest expense that will appear in the 2011 and

2012 income statements.


Expenditures for 2011:

January 1, 2011 $1,000,000 x 12/12 = $1,000,000

March 1, 2011 600,000 x 10/12 = 500,000

June 30, 2011 800,000 x 6/12 = 400,000

October 1, 2011 600,000 x 3/12 = 150,000

Accumulated expenditures

(before interest) - $3,000,000

Average accumulated expenditures - $2,050,000


$2,050,000 x 10% = $205,000 = Interest capitalized in 2011

Example 4: ContinuedExpenditures for 2012:

January 1, 2012 $3,205,000 x 9/9 = $3,205,000January 31, 2012 270,000 x 8/9 = 240,000April 30, 2012 585,000 x 5/9 = 325,000August 31, 2012 900,000 x 1/9 = 100,000Accumulated expenditures (before interest) - $4,960,000Average accumulated expenditures - $3,870,000

Weighted-average rate of all other debt:$ 4,000,000 x 6% = $240,000 $ 720,000 6,000,000 x 8% = 480,000 $10,000,000 = 7.2%$10,000,000 $720,000

Interest capitalized:$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 2012

Example 4: ContinuedCost of Building:

Expenditures in 2011 $3,000,000Interest capitalized in 2011 205,000Expenditures in 2012 1,755,000Interest capitalized in 2012 271,980 Total cost of building $5,231,980

Interest Expense for 2011:$3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 6,000,000 x 8% = 480,000Total interest incurred 1,020,000Less: Capitalized (205,000) 2011 expense $ 815,000

Interest Expense for 2012:Total interest incurred $1,020,000Less: Capitalized (271,980) 2012 expense $ 748,020

Example 4b: Continued

On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, 2012. Expenditures on the project were as follows:

January 1, 2011 $1,000,000 January 31, 2012$270,000March 1, 2011 600,000 April 30, 2012

585,000June 30, 2011 800,000 August 31, 2012

900,000October 1, 2011 600,000

On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and 2012. The company’s other interest- bearing debt included two long- term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and 2012. Interest is paid annually on all debt. The company’s fiscal year-end is December 31.1. Calculate the amount of interest that Mason should capitalize in 2011 and

2012 using the weighted-average method.2. What is the total cost of the building?3. Calculate the amount of interest expense that will appear in the 2011 and

2012 income statements.


Weighted-average rate of all debt:$ 3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 $ 1,020,000 6,000,000 x 8% = 480,000 $13,000,000 = 7.85%$13,000,000 $1,020,000

Expenditures for 2011:

Accumulated expenditures (before interest) - $3,000,000

Average accumulated expenditures - $2,050,000


$2,050,000 x 7.85% = $160,925 = Interest capitalized in 2011


Expenditures for 2012:January 1, 2012 $3,160,925 x 9/9 = $3,160,925January 31, 2012 270,000 x 8/9 = 240,000April 30, 2012 585,000 x 5/9 = 325,000August 31, 2012 900,000 x 1/9 = 100,000Accumulated 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 2012

Example 4b: ContinuedCost of Building:

Expenditures in 2011 $3,000,000Interest capitalized in 2011 160,925Expenditures in 2012 1,755,000Interest capitalized in 2012 225,251 Total cost of building $5,141,176



Noncash Acquisitions

The asset acquired is recorded at the fair value of the consideration given or the fair value of the asset acquired, whichever is more clearly evident.

• Issuance of equity securities

• Deferred payments

• Donated Assets

• Exchanges

Noncash Acquisitions

Issuance of Equity Securities• Asset acquired is recorded at the fair value of the asset or the

market value of the securities, whichever is more clearly evident.

• If the securities are actively traded, market value can be easily determined.

• If the securities given are not actively traded, the fair value of the asset received, as determined by appraisal, may be more clearly evident than the fair value of the securities.

Donated Assets• On occasion, companies acquire assets through donation.• The receiving company is required to record

– The donated asset at fair value.– Revenue equal to the fair value of the donated asset.

Example 5

On January 1, 2011, Byner Company purchased a used tractor. Byner paid $5,000 down and signed a noninterest-bearing note requiring $25,000 to be paid on December 31, 2013. The fair value of the tractor is not determinable. An interest rate of 10% properly reflects the time value of money for this type of loan agreement. The company’s fiscal year-end is December 31.

• Prepare the journal entry to record the acquisition of the tractor.

• How much interest expense will the company include in its 2011 and 2012 income statements for this note?

• What is the amount of the liability the company will report in its 2011 and 2012 balance sheets for this note?


Prepare the journal entry. PV(FV=25,000, pmt=0, n=3, i=10%) = 18,783

How much interest expense will the company include in its 2011 and 2012 income statements for this note?

What is the amount of the liability the company will report in its 2011 and 2012 balance sheets for this note?

Dispositions

Steps:

1. Update depreciation to date of disposal.

2. Remove original cost of asset and accumulated depreciation from the books.

3. Record what you received.

4. The difference between book value of the asset and the amount received is recorded as a gain or loss.

Exchanges

Generally cost of asset acquired is: – fair value of asset given up plus cash paid or minus

cash received or– fair value of asset acquired, if it is more clearly

evident• In the exchange of operational assets, fair value is used

except in rare situations in which the fair value cannot be determined or the exchange lacks commercial substance.

• When fair value cannot be determined or the exchange lacks commercial substance, the asset(s) acquired are valued at the book value of the asset(s) given up, plus (or minus) any cash exchanged. No gain is recognized.

Example 6

Southern Company owns a building that it leases. The building’s fair value is $1,400,000 and its book value is $800,000 (original cost of $2,000,000 less accumulated depreciation of $1,200,000). Southern exchanges this for another building owned by the Eastern Company. The building’s book value on Eastern’s books is $950,000 (original cost of $1,600,000 less accumulated depreciation of $650,000). Eastern also gives Southern $140,000 to complete the exchange. The exchange has commercial substance for both companies. Prepare the journal entries to record the exchange on the books of Southern.


Southern Company owns a building that it leases. The building’s fair value is $1,400,000 and its book value is $800,000 (original cost of $2,000,000 less accumulated depreciation of $1,200,000). Southern exchanges this for another building owned by the Eastern Company. The building’s book value on Eastern’s books is $950,000 (original cost of $1,600,000 less accumulated depreciation of $650,000). Eastern also gives Southern $140,000 to complete the exchange. The exchange has commercial substance for both companies. Prepare the journal entries to record the exchange on the books of Eastern.


Q10–16 Stan Ott is evaluating two recent transactions involving exchanges of equipment. In one case, the exchange has commercial substance. In the second situation, the exchange lacks commercial substance. Explain to Stan the differences in accounting for each situation?

Exchange Lacks Commercial Substance

• When exchanges are recorded at fair value, any gain or loss is recognized for the difference between the fair value and book value of the asset(s) given-up. To preclude the possibility of companies engaging in exchanges of appreciated assets solely to be able to recognize gains, fair value can only be used in legitimate exchanges that have commercial substance.

A nonmonetary exchange is considered to have commercial substance if the company:

1. expects a change in future cash flows as a result of the exchange, and

2. that expected change is significant relative to the fair value of the assets exchanged.

Example 7

The Tinsley Company exchanged land that it had been holding for future plant expansion for a more suitable parcel located farther from residential areas. Tinsley carried the land at its original cost of $30,000. According to an independent appraisal, the land currently is worth $72,000. Tinsley gave $14,000 in cash to complete the transaction.

What is the fair value of the new parcel of land received by Tinsley?



Prepare the journal entry to record the exchange assuming the exchange has commercial substance.



Prepare the journal entry to record the exchange assuming the exchange lacks commercial substance.

LO 5

When a company contributes a non-monetary asset, it should

record the amount of the donation as an expense at the fair

value of the donated asset.

Example: Kline Industries donates land to the city of Los

Angeles for a city park. The land cost $80,000 and has a fair

value of $110,000. Kline Industries records this donation as

follows.

Contribution Expense 110,000

Land 80,000

Gain on Disposal of Land 30,000

Accounting for Contributions


Q10–19 What accounting treatment is normally given to the following items in accounting for plant assets? (a) additions, (b) major repairs, (c) improvements and replacements.


Q10–19

A company may retire plant assets voluntarily or dispose of

them by

Sale.

Involuntary conversion.

Depreciation must be taken up to the date of disposition.

Disposition of PP&E

Example: Ottawa Corporation owns machinery that cost $20,000

when purchased on July 1, 2009. Depreciation has been recorded

at a rate of $2,400 per year, resulting in a balance in accumulated

depreciation of $8,400 at December 31, 2012. The machinery is

sold on September 1, 2013, for $10,500.

Prepare journal entries to

a) update depreciation for 2013 and

b) record the sale.

Sale of Plant Assets

Example 8

a) Depreciation for 2013

b) Record the sale


Sometimes an asset’s service is terminated through some type of involuntary conversion such as fire, flood, theft, or condemnation.

Companies report the difference between the amount recovered (e.g., from a condemnation award or insurance recovery), if any, and the asset’s book value as a gain or loss.

They treat these gains or losses like any other type of disposition.

Involuntary Conversion

Disposition of PP&E

CHAPTER 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENT Sommers – Intermediate I.

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