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08/17/10 Intermediate Accounting, 10th Edition, Ch. 10 (Kieso et al.) 1

Chapter 10:Acquisition

ofProperty, Plant, and Equipment

Intermediate Accounting, 10th EditionKieso, Weygandt, and Warfield

Prepared byKrishnan Ranganathan, Angelo State University

San Angelo, Texas


Part 1: Acquisition Costs

andSelf-Constructed Assets


Property, Plant, and Equipment (PP&E)

* PP&E include:❶ land, building, structures and equipment❷ machinery, furniture and tools* They are not held for resale* They are long term and are subject to depreciation

(except land)* They are tangible


Acquisition Cost

• Historical cost is the basis for determining cost• Historical cost includes:❶ the asset’s cash or cash equivalent price, and❷ the cost of readying the asset for use• Costs incurred after acquisition are:❶ added to asset’s cost, if they provide future

service potential, or❷ expensed, if they do not add to service potential


Cost of Land, Building, and Equipment

* Land costs include:❶ purchase price❷ closing costs, attorney fees, and recording fees❸ costs of getting land ready for use (clearing etc)❹ special assessments for local improvements❺ assumption of liens or encumbrances, and❻ additional improvements with an indefinite life

* Sale of salvaged materials reduces cost


Land Improvements, Building, and Plant

* Improvements with limited lives are recorded as Land Improvements (and not as Land)

* Building cost includes:❶ costs of materials and labor, and overhead❷ professional fees and building permits

* Cost of equipment includes:❶ purchase price❷ freight and handling charges❸ costs of special foundation, and trial runs


Self-Constructed Assets

• These are assets constructed by the business for use in operations

• The cost of self-constructed assets includes:❶ cost of direct materials,❷ cost of direct labor,❸ variable manufacturing overhead, ❹ a pro rata portion of the fixed overhead, and❺ actual interest costs incurred during

construction (with modification)


Interest Capitalization: Rationale

• When under construction:

• asset does not produce revenue, so capitalize interest cost

• When construction is complete:

• asset produces revenue, so expense interest cost


Interest Capitalization: Factors

• Three questions must be answered:❶ What are the qualifying assets?

❷ What is the capitalization period?

❸ What is the amount of interest to be capitalized?


Interest Capitalization: Factors

• Capitalization period begins when:❶ expenditures for the asset have been made❷ activities for readying the asset are in progress❸ interest cost is being incurred


Interest to be Capitalized

• Amount of interest to be capitalized is the lesser of:

❶ the actual interest cost incurred on debt

❷ the avoidable interest for construction of asset• Avoidable interest is the amount that could have

been avoided:• if expenditures for the asset had not been made


Part 2: Valuation Methods


Interest Capitalization: Example

• Given: (self-constructed asset: building) Payment made to Contractor: $800,000 Actual interest cost (as computed): $120,000 Avoidable interest (as computed): $102,000

• Provide the journal entry to capitalize the asset.


Interest Capitalization: Example

Since the avoidable interest is less than actual interest cost:

capitalize avoidable interest as follows:

Building (cost) Dr. $800,000 Building (int.cap) Dr. $102,000 Interest Expense Dr. $ 18,000 Cash $920,000


Computing Avoidable Interest: Steps

Determineweighted-average

accumulatedexpenditures

1

Avoidable interest

Appropriateinterest rate

2

Capitalize, if lessthan actual interest

Multiplyby


Determining weighted-average accumulated expenditures

Amber makes the following two payments in 2000: Jan 31: $24,000 July 31: $18,000

Determine the w/avg accumulated expenditures

Jan 31: $24,000 * (11/12) $22,000July 31: $18,000 * (5/12) $ 7,500

----------Weighted-average accumulated exp $29,500

----------


Determining the appropriateinterest rate

• Amber (in the previous example) had the following debt outstanding throughout 2000:

❶ 10%, 2-year note specificallyfor the project: $25,000

❷ 8%, 5-year note (general debt) $20,000

• Determine the appropriate interest rates and the avoidable interest.


The appropriate interest rate and avoidable interest

$2,500avoidableWeighted-

averageaccumulatedexpenditures:

$29,500

1Up to

specific loan,$25,000 at

10%

2

($29,500 less$25,000)

at8%

3

+

$2,860

$360avoidable


Comparing actual and avoidable interest

• Avoidable interest: $2,860

• Actual interest:

• $25,000 @ 10% = $2,500

• $20,000 @ 8% = $1,600 $4,100

• Capitalize avoidable interest of $2,860.

• Expense $1,240 ($4,100 less $2,860)


Avoidable Interest: Extended Example

• Amber (in the previous example) had the following debt outstanding throughout 2000:

❶ 10%, 2-year note specificallyfor the project: $25,000

❷ 8%, 5-year note (general debt) $20,000

❸ 9%, 3-year note (general debt) $30,000

• Determine the appropriate interest rates and the avoidable interest.


Avoidable Interest: Extended Example

• Since there are two loans (debts) outstanding, we must first compute a weighted-average interest rate for these loans:

8%, 5-year note (general debt) $20,000 * 8% = $1,6009%, 3-year note (general debt) $30,000 * 9% = $2,700

--------$50,000 = $4,300

---------Weighted-average interest rate = $4,300 / $50,000 = 8.6%


The avoidable interest: extended example

$2,500avoidableWeighted-

averageaccumulatedexpenditures:

$29,500

1Up to

specific loan,$25,000 at

10%

2

($29,500 less$25,000)

at8.6%

3

+

$2,887

$387avoidable

W/avg interest rate


Extended example

❶Avoidable interest: $2,887

❷Actual interest:

$25,000 @ 10% = $2,500

$20,000 @ 8% = $1,600

$30,000 @ 9% = $2,700 $6,800

❸Capitalize avoidable interest of $2,887.

❹Expense $3,913 ($6,800 less $2,887)


Part 3: Valuation Issues


Valuation Issues

• A cash discount, whether taken or not, reduces purchase price of asset.

• Assets, purchased through long term credit, are recorded at:

the present value of the consideration exchanged• Cost of assets, acquired in a basket purchase, is

allocated to assets: on the basis of their relative fair market values


Exchange of nonmonetary assets

• The basic rule is that the exchange must be based on:

the fair value of the asset given up, or the fair value of the asset received whichever is clearly more evident.• The rules for gain / loss recognition depend upon

whether the assets exchanged are: dissimilar assets or similar assets


Accounting for Exchanges

Types of Accounting Rationale Exchange Guidance

Dissimilar Recognize gain Earnings processassets and losses is complete

Similar Recognize loss; Earnings processassets (cash Gain up to boot is partiallyreceived (partial gain) complete

Similar Recognize loss; Earnings processassets (No Defer gain is not completecash received)


Dissimilar Assets

• Amber company exchanges a number of trucks for land from Becktel company.

• Fair value of trucks: $ 49,000.• Book value of trucks: $ 42,000

(Cost, $64,000; Accu. Depr, $ 22,000) • Cash paid to Becktel: $ 17,000• Record the purchase in Amber’s books.


Dissimilar Assets

Amber BecktelLand,

FMV= $66,000

Cash, $17,000plus

Trucks,FMV= $49,000

Amber recognizes gain= FMV less Book value = $7,000


Dissimilar Assets

Land Dr. $ 66,000

Accu. Dep (Trucks) Dr. $ 22,000

Trucks $ 64,000

Cash $ 17,000

Gain on disposal $ 7,000


Similar Assets (loss)

• Amber company exchanges a used machine for a similar machine from Becktel company.

• Fair value of used machine: $ 6,000.• Book value of used machine: $ 8,000

(Cost, $12,000; Accu. Depr, $ 4,000) • Cash paid to Becktel: $ 7,000• Record the purchase in Amber’s books.


Similar Assets (Loss)

Cash, $ 7,000plus

used machine,FMV= $ 6,000

Amber recognizes loss ==> Book value less FMV = $2,000

Amber BecktelNew machine, FMV= $13,000


Similar Assets (Loss)

New Machine Dr. $ 13,000

Accu. Dep (Old) Dr. $ 4,000

Loss on disposal Dr. $ 2,000

Machine (old) $ 12,000

Cash $ 7,000


Similar Assets (Deferred gain)

• Davis company exchanges Ford cars for GM cars from Nertz company.

• Fair value of Ford cars: $ 160,000.• Book value of Ford cars: $ 135,000

(Cost, $150,000; Accu. Depr, $ 15,000) • Cash paid to Nertz: $ 10,000• Fair value of GM cars: ($160,000 + $ 10,000)

$ 170,000• Record the purchase in Davis’ books.


Similar Assets (Deferred Gain)

Cash, $ 10,000plus

Ford cars,FMV= $ 160,000

Davis defers gain ==> FMV less book value = $25,000

Davis NertzGM cars,

FMV= $170,000


Similar Assets (Deferred Gain)

GM cars Dr. $ 145,000 (see below)

Accu. Dep (Ford) Dr. $ 15,000

Ford cars (old) $ 150,000

Cash $ 10,000

Fair value of GM cars $170,000Gain deferred ($ 25,000)

GM cars (basis) $145,000


Similar Assets (Partial gain)

• Davis company exchanges Ford cars for GM cars from Nertz company.

• Fair value of Ford cars: $ 160,000.• Cash paid to Nertz: $ 10,000• Fair value of GM cars: ($160,000 + $ 10,000)

$ 170,000• Book value of GM cars: $ 136,000

(Cost, $200,000; Accu. Depr, $ 64,000) • Record the purchase in Nertz’s books.


Similar Assets (Partial Gain)

Cash, $ 10,000plus

Ford cars,FMV= $ 160,000

Nertz: Gain realized: FMV less book value = $34,000

Davis NertzGM cars,

FMV= $170,000



• Since Nertz receives cash (boot) as part of the exchange, Nertz recognizes partial gain as follows:

FMV less Book value = Realized gain $170,000 less $136,000 = $ 34,000

• Recognized gain: (next slide)



• Nertz recognizes partial gain as follows:

(boot / total consideration) * Realized gain

($10,000 / $ 170,000) * $34,000

= $ 2,000. Total gain less gain recognized = deferred gain

$34,000 less $2,000 = $32,000


Nertz company (Partial Gain) Ford cars Dr. $ 128,000 (see below)

Accu. Dep (GM) Dr. $ 64,000

Cash Dr. $ 10,000

GM cars (old) $ 200,000 Gain on disposal $ 2,000

Fair value of Ford cars $160,000 Gain deferred ($ 32,000) Ford cars (basis) $128,000


Part 4: Dispositions

of Assets


Dispositions of PP&E

• Plant assets may be:• retired voluntarily, or• disposed of by sale, exchange, involuntary

conversion• Depreciation is recorded up to the date of disposal

before determining gain or loss• Gains or losses from involuntary conversion are

often reported as extraordinary items.


Costs subsequent to Acquisition

• If cost incurred increase future benefits, capitalize costs

• If costs maintain a given level of services, expense costs

• Costs incurred after acquisition can be:❶ additions❷ improvements and replacements❸ rearrangements and reinstallation ❹ repairs


Improvements and ReplacementsCapitalize costs, if

Improvements Replacementsor

They increase future service potential

Substitution ofa better assetfor present

asset

Substitution ofa similar asset

for present asset


Capitalization Approaches

• Carrying value of asset is known

• Carrying value of the asset is unknown

• Substitution approach

• Capitalize the new asset (without removing the old asset from the pool), or

• Debit accumulated depreciation (when expenditures extend useful life of asset)


Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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