Chapter 10 PROPERTY, PLANT AND EQUIPMENT, INVESTMENT PROPERTY, AND INTANGIBLE ASSETS: ACQUISITION AND DISPOSITION Chapter 10: Property, Plant, and Equipment and Intangible Assets: Acquisition and Disposition This chapter and the one that follows address the measurement and reporting issues involving property, plant, and equipment and intangible assets. These long-lived tangible and intangible assets are used in the production of goods and services. We will also discuss a special class of property held specifically by companies to earn rental income and/or for capital appreciation (classified as investment property). Chapter 10 covers the valuation at date of acquisition and the disposition of these assets.

Long-lived, Revenue-producing Assets Types of Assets Long-lived, Revenue-producing Assets Expected to Benefit Future Periods Intangible No Physical Substance Tangible Property, Plant, Equipment & Investment Property Part I. Long-lived, revenue producing assets are assets that are used actively in the business, and that are expected to benefit the operations into the future. There are two major categories of these assets. Tangible assets have physical substance. Included in this category are land, buildings, equipment, machinery, vehicles, and investment properties. Intangible assets are assets without physical substance. Included in this category are patents, copyrights, trademarks, franchises, and goodwill. Part II. Long-lived, revenue-producing assets may be acquired in a number of ways. Regardless of the method of acquisition, the assets are recorded at their original cost. The recorded cost includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use. General Rule for Cost Capitalization The initial cost of an 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 Equipment Net purchase price Taxes Transportation costs Installation costs Modification to building necessary to install equipment Testing and trial runs Land (not depreciable) Purchase price Real estate commissions Attorney’s fees Title search Title transfer fees Title insurance premiums Removing old buildings Part I. The costs to be capitalized for equipment include: the net purchase price, less discounts, taxes, transportation costs, installation costs, modification to a building necessary to install the equipment, testing and trial runs. Part II. The cost of land includes: the purchase price, real estate commissions, attorney’s fees, title search, title transfer fees, title insurance premiums, the cost of making the land ready for its intended use, including the cost of removing old buildings. Unlike other long-lived, revenue-producing assets in the property, plant and equipment category, land is not depreciated.

Costs to be Capitalized Land Improvements Separately identifiable costs of Driveways Parking lots Fencing Landscaping Private roads Buildings Purchase price Attorney’s fees Commissions Reconditioning Part I. Land improvements are enhancements to property such as driveways, parking lots, fencing, landscaping, and private roads. These are separately identifiable costs that are recorded in the land improvement asset account rather than in the land account. Unlike land, land improvements are depreciated. Part II. The cost of buildings includes: the purchase price, real estate commissions, attorney’s fees, reconditioning costs to get the building ready for use.

Costs to be Capitalized Investment Property Land costs Building costs Same as costs for property, plant and equipment Intangible Assets Patents Copyrights Trademarks Franchises Goodwill The initial cost of an intangible asset includes the purchase price and all other costs necessary to bring it to condition and location for use, such as legal and filing fees. Part I. The capitalized cost of investment property is the same as the cost of land and buildings as discussed above for property, plant and equipment Part II. Intangible assets include patents, copyrights, trademarks, franchises, and goodwill. The initial cost of an intangible asset includes the purchase price and all other costs necessary to bring it to condition and location for use, such as legal and filing fees.

Asset Retirement Obligations Often encountered with natural resource extraction when the land must be restored to a useable condition. Recognize the restoration costs as a liability and a corresponding increase in the related asset. Asset retirement obligations are often encountered with natural resource extraction when a company is required to restore the land to the original condition or to a useable condition. An asset retirement obligation is recorded as a liability and a corresponding increase in the related asset. The amount recorded is the present value of future cash flows expected to be incurred for the reclamation or restoration. Record at fair value, usually the present value of future cash outflows associated with the reclamation or restoration.

Intangible Assets Intangible Assets Lack physical substance. Exclusive Rights. Intangible Assets Intangible assets are assets without physical substance that provide the owner with exclusive rights that benefit the production of goods and services. The future benefits attributed to intangible assets usually are much less certain than those attributed to tangible assets. Future benefits less certain than tangible assets.

Intangible Assets ─ Patents An exclusive right recognized by law and granted by a sovereign state for a limited period (usually 20 years.) Holder has the right to use, manufacture, or sell the patented product or process without interference or infringement by others. Some R & D costs that lead to an internally developed patent are expensed in the period incurred, while others are capitalized Part I. A patent is an exclusive right to manufacture a product or to use a process that is granted by the United States Patent Office for a period of 20 years. The holder of the patent essentially has a monopoly right to use, manufacture, or sell the patented product or process without interference or infringement by others. Purchased patents are recorded at acquisition cost. Research and development costs that lead to an internally developed patent are expensed in the period incurred. Let’s consider an example dealing with patent costs.

Intangible Assets Copyrights Trademarks A form of protection given by law to authors of literary, musical, artistic, and similar works. Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work. Generally, the legal life of a copyright is the life of the author plus 50-100 years (or a finite period for anonymous or corporate creations). Trademarks A symbol, design, or logo associated with a business. If internally developed, trademarks have no recorded asset cost. If purchased, a trademark is recorded at cost. Registered with relevant national authority and renewable indefinitely in (usually) 10-year periods. Part I. A copyright is an exclusive right of protection given to a creator of a published work such as literary, musical, artistic, and similar works. Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work. Generally, the legal life of a copyright is the life of the creator plus 50-100 years (or a finite period for anonymous or corporate creations). Part II. A trademark is a symbol, design, or logo that distinctively identifies a company, product, or service. If internally developed, trademarks have no recorded asset cost. If purchased, a trademark is recorded at acquisition cost. Trademarks are registered with the relevant national authority and are renewable indefinitely in (usually) 10-year periods.

Intangible Assets Franchise Goodwill A contractual arrangement where the franchisor grants the franchisee exclusive rights to use the franchisor’s trademark within a certain area for a specified period of time. The amount by which the consideration exchanged exceeds the fair value of net assets acquired. Goodwill Occurs when one company buys another company. Only purchased goodwill is an intangible asset. Part I. A franchise is a contractual arrangement under which the franchisor grants the franchisee exclusive rights to use the franchisor’s trademark within a geographical area for a specified period of time. The franchisee usually makes an initial payment to the franchisor that is capitalized as an intangible asset along with any legal and license fees. Annual payments from operations to the franchisor are expensed. Part II. Unlike other intangible assets, goodwill cannot be associated with any specific right. It does not exist separate from the company itself. It represents the value of a company as a whole, over and above its identifiable net assets. Goodwill may be attributed to many factors, including good reputation, superior employees and management, good clientele, and good business location. Only purchased goodwill is recognized. Purchased goodwill results when one company buys another company for a price that exceeds the fair value of the separate identifiable net assets acquired.

Goodwill Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000. What amount of goodwill should Eddy company record as a result of the purchase? Let’s look at an example illustrating how we determine the amount of goodwill in company acquisition. Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000. What amount of goodwill should Eddy Company record as a result of the purchase? The goodwill is $300,000. We compute the $700,000 fair value of the net assets acquired by subtracting the $200,000 of liabilities assumed from the $900,000 fair value of the assets. The $1,000,000 consideration given less the $700,000 fair value of the net assets acquired results in $300,000 of goodwill.

Lump-Sum Purchases Asset 1 Asset 2 Asset 3 Several assets are acquired for a single price that may be lower than the sum of the individual asset fair values. Allocation of the lump-sum price is based on relative fair values of the individual assets. Asset 1 Asset 2 Asset 3 Part I. Lump-sum purchases occur when a group of assets is acquired for a single purchase price. Part II. The lump-sum purchase price is allocated to assets based on relative fair values of the individual assets. Part III. Let’s look at an example of a lump-sum purchase involving land and a building. On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500. How much of the $200,000 purchase price will be allocated to the building account? On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500. How much of the $200,000 purchase price will be allocated to the building account?

Lump-Sum Purchases The building will be allocated $130,000 of the total purchase price of $200,000. Part I. First, we calculate the allocation percentages by dividing the appraised value of each asset by the total of the appraised values. For example, the total of the building appraisal of $162,500 and the land appraisal of $87,500 is $250,000. Dividing $162,500 by $250,000 gives us an allocation percentage of 65 percent for the building. We multiply the allocation percentage times the lump-sum purchase price to obtain the amount allocated to each asset. For the building, 65 percent of the $200,000 purchase price is $130,000 dollars. Part II. The entry to record the lump-sum purchase results in a debit to land for $70,000, a debit to building for $130,000, and a credit to cash for $200,000. May 13: Land .......................................................... 70,000 Building ………………….…….…………… 130,000 Cash……………………………..... 200,000 To record lump-sum purchase of land and building.

Noncash Acquisitions Issuance of equity securities Deferred payments Donated Assets Exchanges 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. Part I. Companies sometimes acquire assets without paying cash. Assets may be acquired by issuing debt or equity securities, by receiving donated assets, or by exchanging other assets. Part II. In any noncash acquisition, the components of the transaction should be recorded at their fair values. The first indication of fair value is the fair value of the consideration given to acquire the asset. Sometimes the fair value of the asset received is used when that fair value is more clearly evident than the fair value of the consideration given.

Deferred Payments Note payable Market interest rate Record asset at face value of note Less than market rate or noninterest bearing Record asset at present value of future cash flows. A deferred payment contract is usually a note payable. If the note includes a realistic interest rate (market rate), the asset acquired is recorded at the face amount of the note. If the note includes an unrealistically low interest rate or is a noninterest bearing note, the asset is recorded at the present value of the future cash payments. The interest rate used for the present values computations should be a current market rate of interest.

Deferred Payments On January 2, 2013, Midwestern Corporation purchased equipment by signing a noninterest-bearing note requiring $50,000 to be paid on December 31, 2014. The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2013; December 31, 2013 (year-end), and December 31, 2014 (year-end). We do not know the cash equivalent price, so we must use the present value of the future cash payment. Part I. On January 2, 2013, Midwestern Corporation purchased equipment by signing a noninterest-bearing note requiring $50,000 to be paid on December 31, 2014. The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2013, December 31, 2013 (year-end), and December 31, 2014 (year-end). Part II. Since we do not know the cash equivalent price in this example, we must compute the present value of the future cash payment by multiplying the $50,000 face amount of the note times the present value of a dollar interest factor for two years and 10 percent. The present value is $41,323. Now, we are ready to make the journal entry for January 2, 2013.

Deferred Payments January 2, 2013: Equipment ........................................................... 41,323 Discount on note payable ….….…….…………… 8,677 Note payable ………………………….... 50,000 To record equipment acquisition. December 31, 2013: Interest expense (10% of $41,323)...................... 4,132 Discount on note payable ……………… 4,132 To record interest expense. December 31, 2014: Interest expense (10% of ($41,323+$4,132)) ...... 4,545 Discount on note payable ……..……..… 4,545 December 31, 2014 Note payable ........................................................ 50,000 Cash ……..……………………………..… 50,000 To record payment of note. Part I. On January 2, 2013, we record the equipment acquisition with a debit to equipment for $41,323, a debit to discount on note payable for $8,677, and a credit to note payable for the face amount of $50,000. The discount is computed by subtracting the $41,323 present value from the $50,000 face amount of the note payable. At the date of issue, January 2, 2013, the carrying value of the of the note is equal to the face amount of $50,000 less the unamortized discount of $8,677, or $41,323. Part II. On December 31 of each year, we record interest expense for the year. Interest expense is computed by multiplying the carrying value of the note (note payable less the unamortized discount on note payable) times the interest rate. On December 31, 2013, interest expense is equal to the $41,323 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,132. This process is referred to as amortizing the discount to interest expense. As a result, the carrying value of the note in the next period will be greater because the unamortized discount is smaller. On December 31, 2014, the carrying value of the note is increased by the amount of the discount amortized to interest expense on December 31, 2014. The new carrying value equals $41,323 plus $4,132, or $45,455. On December 31, 2014, interest expense is equal to the $45,455 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,545. Finally, on December 31, 2014, we record the cash payment at maturity by debiting note payable and crediting cash for $50,000. At the maturity date, the discount on note payable has a zero balance because it has been fully amortized to interest expense.

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 records The donated asset at fair value. Revenue equal to the fair value of the donated asset. Part I. When an asset is acquired with the issuance of equity securities, it 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. Part II. On occasion, companies acquire assets through donation. The donation usually is an enticement to get the company to do something that benefits the donor. Donated assets are recorded at fair value with a debit on the recipient company’s books and (usually) a corresponding credit to a revenue account for the fair value of the asset. Although IASB does not have any explicit standards or interpretations on donations, the rational behind crediting revenue (instead of paid-in capital) is that the company receiving the asset is usually (implicitly) performing a service for the donor in exchange for the asset donated. The donation received is not equity as it is not a capital contribution from shareholders.

Donated Assets: Government Grants IAS No. 20 requires government grants to be categorized as either asset related or income related Income related Grants with a primary condition is that the qualifying entity purchase, construct or otherwise acquire long-term assets Income Related All other government grants IFRS requires government grants to be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate. Under IAS No. 20, government grants can be categorized as related to either asset or income. Grants related to assets refer to government grants whose primary condition is that an entity qualifying for them should purchase, construct or otherwise acquire long-term assets. All other grants are considered to be related to income.

Donated Assets : Government Grants Income related Accounted for as: Deferred income Deduction against carrying value of related asset Income Related Account for as: Income in statement of comprehensive income Deduction to the related expenses Asset related grants can be accounted for either as (a) deferred income that is subsequently amortized to income on a systematic basis, or (b) as a deduction against the carrying amount of the related asset – where it is amortized together with the useful life of the asset. (T10-13) Income related grants can be accounted as (a) an income to the statement of comprehensive income or (b) as a deduction to the related expense. For grants, additional disclosure may be necessary for proper understanding of the financial statements. Impact on statement of comprehensive income is the same for either accounting method. Additional disclosures may be required.

Fixed-Asset Turnover Ratio This ratio measures how effectively a company manages its fixed assets to generate revenue. Net sales Average fixed assets Fixed asset turnover ratio = = 5.13 $14,526 ($2,933 + $3,267)/2 = 4.69 $1,001 ($204 + $186)/2 Part I. The fixed-asset turnover ratio measures how effectively a company manages its fixed assets to generate revenue. It is computed by dividing net sales by average fixed assets. Consider the following example comparing two companies in the apparel industry, The GAP, Inc. and The Gymboree Corporation. Part II. GAP’s fixed-asset turnover ratio for 2009 is 4.69. Part III. Gymboree’s fixed asset ratio for 2009 is 5.13. Gymboree generates 44 cents more in sales dollars for each dollar invested in fixed assets. Gymboree generates $0.44 more in sales dollars for each dollar invested in fixed assets.

Dispositions Update depreciation to date of disposal. Remove original cost of asset and accumulated depreciation from the books. The difference between book value of the asset and the amount received is recorded as a gain or loss. On June 30, 2013, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2008 at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated ten-year life with zero salvage value. MeLo last recorded depreciation on the equipment on December 31, 2012, its year-end. Prepare the journal entries necessary to record the disposition of this equipment. Part I. After using property, plant, and equipment, investment property, and intangible assets, companies dispose of them by sale, retirement, or exchanging them for other assets. Three accounting steps are involved in dispositions:  update depreciation to the date of disposal.  remove the original cost of the asset and its accumulated depreciation from the books.  record a gain or loss for the difference between the book value of the asset and the amount received. Consider the following example where an asset is sold for cash. Part II. On June 30, 2013, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2008 at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated ten-year life with zero salvage value. MeLo last recorded depreciation on the equipment on December 31, 2012, its year-end. Prepare the journal entries necessary to record the disposition of this equipment.

Dispositions Update depreciation to date of sale. June 30, 2013: Depreciation expense ($15,000 ÷ 10 years) × ½) ....... 750 Accumulated depreciation ………………........ 750 To update depreciation to date of sale. Remove original asset cost and accumulated depreciation. Record the gain or loss. June 30, 2013: Accumulated depreciation ............................................ 8,250 Cash ………………………….……………...................... 6,350 Loss on sale …………………………………………….… 400 Equipment …………………………...............… 15,000 To record sale of equipment. ($15,000 ÷ 10 years) × 5½) = $8,250 Part I. Our first step is to update the depreciation to the date of sale. It has been six months since the last depreciation entry. Since there was no salvage value, depreciation for one year is the $15,000 purchase price divided by 10 years, resulting in $1,500. For the six months of 2011, the depreciation is one-half of $1,500, or $750. We debit depreciation expense for $750 and credit accumulated depreciation for $750 to update the depreciation to June 30. Part II. Our second and third steps are to remove the original cost and the related accumulated depreciation from the books, and to record any gain or loss on the sale. Since the asset was acquired on January 1, 2008, and sold on June 30, 2013, it has been used for a total of five and one-half years. The accumulated depreciation balance on June 30 is $8,250, an amount obtained by multiplying 5 ½ years times $1,500 of depreciation per year. The book value at the date of sale is $6,750 dollars computed by subtracting the $8,250 of accumulated depreciation from the $15,000 cost of the asset. Since the book value of $6,750 exceeds the cash sale price of $6,350 by $400, we recognize a $400 loss on the sale. To record the entry, we debit accumulated depreciation for $8,250, debit cash for $6,350, debit loss on sale for $400, and credit equipment for $15,000.

Exchanges General Valuation Principle (GVP): 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 assets fair value is used except in rare situations in which the fair value cannot be determined or the exchange lacks commercial substance. Part I. Property, plant, and equipment, investment property, and intangible assets are sometimes acquired in exchanges for other assets. Trade-ins of old assets in exchange for new assets is probably the most frequent type of exchange. Cash is involved in the transactions to equalize fair values. The general principle to be followed is that the cost of the asset acquired is: equal to the fair value of asset given up plus cash paid or minus cash received, or equal to the fair value of asset acquired, if that is more clearly evident. A gain or loss is recognized for the difference between the fair value of the asset given up and its book value. Part II. We follow the general principle based on fair value in the exchange of assets 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. Let’s look at an example where fair value cannot be determined. When fair value cannot be determined or the exchange lacks commercial substance, the asset(s) acquired are valued at the net book value of the asset(s) given up, plus (or minus) any cash exchanged. No gain is recognized.

Fair Value Not Determinable Matrix, Inc. exchanged used equipment for newer equipment. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up originally cost $600,000, and had an accumulated depreciation balance of $400,000 at the time of the exchange. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction. Part I. Matrix, Inc. exchanges one used equipment for another newer equipment. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up originally cost $600,000, and had an accumulated depreciation balance of $400,000 at the time of the exchange. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction. Part II. First, we compute the book value of the asset given up in the exchange. Book value is equal to $200,000, determined by subtracting the $400,000 of accumulated depreciation from the $600,000 original cost. In addition to giving up book value of $200,000, Matrix paid $100,000 to acquire the newer asset. The asset acquired will be recorded at the book value given up plus the cash paid. Now we are ready for the journal entry.

Fair Value Not Determinable Matrix, Inc. The journal entry below shows the proper recording of the exchange. Equipment ($200,000 + $100,000) ................. 300,000 Accumulated depreciation ….……………........ 400,000 Equipment ……………………………. 600,000 Cash …………………………............. 100,000 To record equipment acquired in exchange. To record the equipment acquired, we debit equipment for $300,000, the book value given up plus the cash paid. We remove the asset given up with a credit to equipment for its cost of $600,000 and a debit to accumulated depreciation for $400,000. Finally, we credit cash for the $100,000 paid in the transaction. Since fair value is not known, Matrix did not recognize a gain or a loss on the exchange.

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: expects a change in future cash flows as a result of the exchange, and that expected change is significant relative to the fair value of the assets exchanged. Part I. When exchanges are recorded at fair value, any gain or loss is recognized for the difference between the fair value and net 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. Part II. A nonmonetary exchange is considered to have commercial substance if the company: expects a change in future cash flows as a result of the exchange, and the expected change in cash flows is significant relative to the fair value of the assets exchanged. If the exchange does not meet these two conditions, it lacks commercial substance and, book value is used to value the asset(s) acquired. No gain is recognized.

Exchanges Matrix, Inc. exchanged new equipment and $10,000 cash for equipment owned by Float, Inc. Below is information about the asset exchanged by Matrix. Record the transaction assuming the exchange has commercial substance. Part I. Matrix, Inc. exchanged new equipment and $10,000 cash for equipment owned by Float, Inc. The equipment originally cost Matrix $500,000. At the date of the exchange, the equipment had accumulated depreciation of $300,000, book value of $200,000, and fair value of $205,000. Record the transaction assuming the exchange has commercial substance. Part II. First, we must determine the gain or loss. The fair value of the asset given up exceeds its book value by $5,000 which means there is a gain in this transaction of $5,000. Gain = Fair Value – Book Value Gain = $205,000 – $200,000 = $5,000

Exchanges $205,000 fair value + $10,000 cash Equipment ............................................... 215,000 Accumulated depreciation………............. 300,000 Equipment ……………………… 500,000 Cash ……………………………. 10,000 Gain on exchange …………….. 5,000 To record the exchange of equipment. Record the same transaction assuming the exchange lacks commercial substance. Part I. Since the transaction has commercial substance, we will record the asset acquired at the fair value of the asset given up plus the cash paid, and we will recognize the gain. To record the equipment acquired, we debit equipment for the sum of the $205,000 of fair value given up plus the $10,000 cash paid. We remove the asset given up with a credit to equipment for its cost of $500,000 and a debit to accumulated depreciation for $300,000. We credit cash for the $10,000 paid in the transaction, and credit the gain of $5,000. Part II. Now let’s see how we would record this transaction if it lacks commercial substance. Part III. Since the transaction lacks commercial substance, the equipment acquired should be valued at book value of equipment given up plus the cash paid. The $5,000 gain is not recognized. To record the equipment acquired, we debit equipment for $210,000, the book value given up plus the cash paid. We remove the asset given up with a credit to equipment for its cost of $500,000 and a debit to accumulated depreciation for $300,000. Finally, we credit cash for the $10,000 paid in the transaction $200,000 book value + $10,000 cash Equipment ............................................... 210,000 Accumulated depreciation………............. 300,000 Equipment ……………………… 500,000 Cash …………………………….. 10,000 To record the exchange of equipment.

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, borrowing costs incurred on qualifying assets is capitalized. Part I. There are two difficult accounting issues that must be addressed when a company is constructing assets for its own use: determining the amount the company’s manufacturing overhead to be included in the asset’s cost.  deciding on the proper treatment of interest incurred during the construction period. One approach to assigning overhead to self-constructed assets is the incremental approach, where actual incremental overhead costs are recorded in the asset account. However, the most commonly used method is to assign overhead using a predetermined overhead rate, based on an overhead cost driver activity, that is used to assign the company’s overhead to regular production. This approach is called the full cost approach. Unlike purchased assets, self-constructed assets may take a long period of time to be made ready for their intended use. The construction activities during this period require construction financing. Following our general rule for the cost of an asset, all costs necessary to make the asset ready for its intended use, including interest during the construction period, should be included in the asset’s cost. Part II. Interest is capitalized (included in the asset’s cost) for qualifying assets. Qualifying assets are: assets built for a company’s own use. assets constructed as discrete projects for sale or lease. Assets in this category are large construction projects such as a real estate development built for sale or lease. Only the portion of interest cost incurred during the construction period that could have been avoided if the construction had not been undertaken may be capitalized. Interest and other costs that are incurred in connection with the borrowing of funds that are directly attributable to the acquisition, construction or production of the qualifying asset Asset that necessarily takes a substantial period of time to get ready for its intended use.

Borrowing Cost Capitalization Capitalization begins when: construction begins Borrowing cost is incurred, and qualifying expenses are incurred. Capitalization ends when: the asset is substantially complete and ready for its intended use, or when borrowing costs no longer are being incurred. The borrowing cost capitalization period begins when the first qualifying construction expenditures are incurred for materials, labor, or overhead, and when borrowing costs are incurred. The borrowing cost capitalization period ends when the asset is substantially complete and ready for its intended use or when borrowing costs no longer are being incurred. Consider the following example of interest incurred on a self-constructed asset.

Interest Capitalization Borrowing Cost is capitalized based on Average Accumulated Expenditures (AAE). Qualifying expenditures (construction labor, material, and overhead) weighted for the number of months outstanding during the current accounting period. If the qualifying asset is financed through a specific new borrowing If there is no specific new borrowing, and the company has other debt Part I. Borrowing cost is capitalized based on average accumulated expenditures during the construction period. Average accumulated expenditures is an amount based on a weighted average computation of the qualifying expenditures times the number of months from the incurrence of the qualifying expenditures to the end of the construction period. Qualifying expenditures include labor, material, and overhead incurred on the construction project during the accounting period. Part II. Borrowing cost capitalization on self-constructed assets does not require the company to borrow for the specific construction project. However, if the construction is financed through a specific new borrowing, the interest rate of the new borrowing is used for the capitalization rate. Part III. If the construction does not require specific new borrowing, but is financed with other debt, use the weighted-average interest rate on the other debt for the capitalization rate. . . . use the specific rate of the new borrowing as the capitalization rate. . . . use the weighted average cost of other debt as the capitalization rate.

Interest Capitalization Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec. 31. Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, Oct. 1, $200,000; and Dec. 1, $300,000. Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize. Average Accumulated Expenditures Part I. Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec. 31. Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, October 1, $200,000; and December 1, $300,000. Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize. How much interest should Welling capitalize on the construction project? Part II. First, we calculate the average accumulated expenditures by time-weighting the individual expenditures made during the eight-month construction period. For example the $125,000 expenditure made on May 1 occurs eight months from the end of the period. So the time-weighted amount of this expenditure is eight-eighths of $125,000 or $125,000. We calculate the time-weighted amounts for the other expenditures and sum them to get the average accumulated expenditures of $337,500.

Interest Capitalization Since the $1,000,000 of specific borrowing is sufficient to cover the $337,500 of average accumulated expenditures for the year, use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize. Interest = AAE × Specific Borrowing Rate × Time Interest = $337,500 × 10% × 8/12 = $22,500 Since the $1,000,000 of specific borrowing is sufficient to cover the $337,500 of average accumulated expenditures for the year, we will use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize. The loan, initiated on May 1, is outstanding for 8 months of the year. Ten percent of $337,500 multiplied by 8/12 is equal to $22,500, the amount of interest that will be capitalized. The loan, initiated on May 1, is outstanding for 8 months of the year.

Interest Capitalization If Welling had not borrowed specifically for this construction project, it would have used the weighted-average interest method. The weighted average interest rate on other debt would have been used to compute the amount of interest to capitalize. For example, if the weighted-average interest rate on other debt is 12 percent, the amount of interest capitalized would be: Interest = AAE × Weighted-average Rate × Time Interest = $337,500 × 12% × 8/12 = $27,000 If Welling had not borrowed specifically for this construction project, it would have used the weighted-average interest method. The weighted average interest rate on other debt would have been used to compute the amount of interest to capitalize. For example, if the weighted-average rate of interest on other debt is 12 percent, the amount of interest capitalized would be 12 percent of $337,500 times 8/12, or $27,000.

Interest Capitalization If specific new borrowing had been insufficient to cover the average accumulated expenditures . . . . . . Capitalize this portion using the 12 percent weighted- average cost of debt. Other debt If specific new borrowing had been insufficient to cover the average accumulated expenditures for the year, the portion of the average accumulated expenditures financed with specific new borrowing is capitalized using the interest rate on the specific new borrowing, and the remainder of the average accumulated expenditures is capitalized using the weighted-average interest cost of other debt excluding the specific new borrowing. This situation exists when the construction project is partially financed with specific new borrowing and partially financed with other existing debt. . . . Capitalize this portion using the 10 percent specific borrowing rate. AAE Specific new borrowing

Research and Development (R&D) Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. . . Development Development is the application of research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, process, systems or services before the start of commercial production or use . . . Most R&D costs are expensed as incurred. (Must be disclosed if material.) Part I. Research is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development is the application of research findings or other knowledge into a plan or design for the production of new or substantially improved materials, devices, products, process, systems or services before the start of commercial production or use.. Most research and development costs are expensed as incurred. The costs are incurred with the intent of future benefits, but the future benefits are uncertain, and even if the benefits materialize, it is difficult to relate the benefits to revenues of future periods. Part II. An exception to the immediate expensing of research and development costs is provided for work done under contract for other companies. These research and development costs are capitalized as inventory and carried forward into future years. Income from these contracts can be recognized using either the percentage-of-completion method or the completed contract method. If operational assets are purchased for exclusive use in research and development, the cost is expensed, regardless of the length of the assets’ useful life. If the assets have alternative future uses beyond the research and development project period, the cost should be capitalized and depreciated or amortized over the current and future periods of use. R&D costs incurred under contract for other companies are capitalized as inventory and carried forward into future years. Costs of assets purchased for R&D purposes are expensed in the period unless they have alternative future uses.

(Enter Development Phase) R&D Costs All expenditure in the research phase are to be expensed when incurred. Expenditure incurred in the development phase, but before the R&D is successfully completed, are to be capitalized Costs Expensed as R&D Operating Costs and Amortization Part I. IFRS now requires all expenditure on research to be expensed when incurred, while allowing expenditure on development to be capitalized. Expenditure on development is capitalized if and only if all the following are demonstrated (capitalization criterion): (a) The completion of asset for use or sale is technically feasible (b) There is intention to complete the asset for use or sale (c) There is ability to use or sell the asset (d) The asset can generate probable future economic benefits(i.e. existence of external market or inhouse usefulness) (e) The availability of adequate technical, financial and other resources to complete the asset for use or sale (f) The expenditure attributable to the development can be reliably measured Consider the following timeline to illustrate these concepts. Part II. Costs are expensed from the start of research and development until the capitalization criterion is satisfied. Costs incurred after the capitalization criterion is satisfied, but before the R&D is successfully completed, are capitalized as an intangible asset. Costs incurred after the product is available for release to customers are treated as operating costs. In addition, the intangible asset created from the R&D has to undergo amortization. Costs Capitalized Start of R&D Activity Capitalization Criterion (Enter Development Phase) R&D Completed Successfully Sale of Product

Start-up Costs and Software Development Costs Start-up costs, including pre-operating costs and establishment costs, are expensed in the period incurred. IFRS applies the same accounting treatment for R&D expenditure to software development costs. Balance Sheet The unamortized portion of capitalized computer software cost is an asset. Income Statement Amortization expense associated with computer software cost. R&D expense associated with computer software development cost. Disclosure Part I. Start-up costs, including pre-operating costs and establishment costs, are expensed in the period incurred. IFRS applies the same accounting treatment for R&D expenditure to software development costs Under U.S. GAAP, amortization of capitalized computer software costs starts when the product begins to be marketed. Two methods, the percentage of revenue method and the straight-line method, are compared and the method producing the largest amount of amortization is used. The periodic amortization percentage is the greater of: the ratio of current revenues to current and anticipated revenues (the percentage of revenues method). the straight-line percentage over the useful life of the asset. (the straight-line method). These two methods are also allowed under IFRS, but not required Part II. The unamortized portion of capitalized computer software cost is reported in the balance sheet as an asset. The periodic amortization expense associated with the capitalized computer software cost is reported in the income statement. The research and development expense associated with computer software development is reported in the income statement.

Research and Development Costs U.S. GAAP vs. IFRS Research and Development Costs Except for software development costs incurred after technological feasibility, all research and development expenditures are expensed in the period incurred. Direct costs to secure a patent are capitalized. Research expenditures are expensed in the period incurred. Development expenditures that meet specified criteria are capitalized as an intangible asset. Direct costs to secure a patent are capitalized. Except for software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred. IAS No. 38 draws a distinction between research activities and development activities. Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized as an intangible asset. Under both U.S. GAAP and IFRS, any direct costs to secure a patent, such as legal and filing fees, are capitalized.

Software Development Costs U.S. GAAP vs. IFRS Software Development Costs The percentage used to amortize software development costs is the greater of (1) the ratio of current revenues to current and anticipated revenues or (2) the straight-line percentage over the useful life of the software. The same approach is allowed, but not required. The percentage we use to amortize computer software development costs under U.S. GAAP is the greater of (1) the ratio of current revenues to current and anticipated revenues or (2) the straight-line percentage over the useful life of the software. The approach is allowed under IFRS, but not required.

Appendix 10 ─ Oil and Gas Accounting Two acceptable accounting alternatives Successful efforts method Full-cost method Exploration costs resulting in unsuccessful wells (dry holes) are expensed. Exploration costs resulting in unsuccessful wells may be capitalized. Appendix 10 – Oil and Gas Accounting Part I. There are two generally accepted methods that companies can use to account for oil and gas exploration costs. The successful efforts method requires expensing of exploration costs that result in unsuccessful wells (called dry holes). Only the exploration costs that result in successful, producing wells are capitalized. The full-cost method allows the exploration costs incurred in a wide geographical area, with many unsuccessful wells, to be capitalized if some successful wells are drilled in the area. For both methods, capitalized costs are expensed in future periods as oil and gas is removed. Part II. Political pressure prevented the FASB from requiring all companies to use the successful efforts method. Political pressure prevented the FASB from requiring all companies to use the successful efforts method.

Oil and Gas Accounting The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells in 2013. Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Successful Efforts: Oil deposit ..................................... 4,000,000 Exploration expense ……………… 16,000,000 Cash ………………………. 20,000,000 Part I. Let’s consider an example to illustrate the two methods of accounting of oil and gas exploration costs. The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells in 2013. Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Part II. Let’s start with the successful efforts method. Two of the ten (twenty percent) of the wells were successful. We debit the asset oil deposit for $4,000,000, which is 20 percent of the total exploration costs. Eighty percent of the wells were unsuccessful. We debit exploration expense for $16,000,000, which is 80 percent of the exploration costs incurred. Credit cash for $20,000,000. Part III. Now let’s make the entry using the full cost method. Since some of the wells were successful, we debit the asset oil deposit for $20,000,000, the entire amount of the exploration costs. Full Cost: Oil deposit ..................................... 20,000,000 Cash ………………………. 20,000,000

End of Chapter 10 End of chapter 10.