McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. OPERATIONAL ASSETS: ACQUISITION AND DISPOSITION Chapter 10

Slide Actively Used in Operations Tangible Property, Plant, Equipment & Natural Resources Tangible Property, Plant, Equipment & Natural Resources Intangible No Physical Substance Intangible No Physical Substance Types of Operational Assets Expected to Benefit Future Periods General Rule for Cost Capitalization The 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.

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

Slide 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

Slide Costs to be Capitalized Natural Resources Acquisition costs Exploration costs Development costs Restoration costs 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. Intangible Assets Patents Copyrights Trademarks Franchises Goodwill

Slide Asset Retirement Obligations Recognize the restoration costs as a liability and a corresponding increase in the related asset. Record at fair value, usually the present value of future cash outflows associated with the reclamation or restoration. Often encountered with natural resource extraction when the land must be restored to a useable condition.

Slide Intangible Assets Lack physical substance. Exclusive Rights. Intangible Assets Future benefits less certain than tangible assets.

Slide An exclusive right recognized by law and granted by the US Patent Office for 20 years. Holder has the right to use, manufacture, or sell the patented product or process without interference or infringement by others. R & D costs that lead to an internally developed patent are expensed in the period incurred. Intangible Assets ─ Patents Torch, Inc. has developed a new device. Research and development costs totaled $30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. What is Torch’s patent cost? Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as incurred.

Slide Copyrights 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 70 years. Intangible Assets 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 U.S. Patent Office and renewable indefinitely in 10-year periods.

Slide Occurs when one company buys another company. The amount by which the consideration given price exceeds the fair value of net assets acquired. Only purchased goodwill is an intangible asset. Intangible Assets 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. Goodwill Franchise

Slide 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. Goodwill What amount of goodwill should be recorded in Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 What amount of goodwill should be recorded in Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000

Slide Several assets are acquired for a single price that may be lower than the sum of the individual asset prices. Lump-Sum Purchases Asset 2 Asset 1Asset 3 Allocation of the lump-sum price is based on relative fair values of the individual assets. 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 charged to the building account?

Slide The building will be apportioned $130,000 of the total purchase price of $200,000. The building will be apportioned $130,000 of the total purchase price of $200,000. Lump-Sum Purchases

Slide Noncash Acquisitions Issuance of equity securities Deferred payments Donated Assets Exchanges 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. 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.

Slide Deferred Payments Let’s consider an example where we must compute the present value of a noninterest-bearing note. 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.

Slide Deferred Payments On January 2, 2009, Midwestern Corporation purchased equipment by signing a noninterest-bearing note requiring $50,000 to be paid on December 31, The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2009; December 31, 2009 (year-end), and December 31, 2010 (year-end). We do not know the cash equivalent price, so we must use the present value of the future cash payment.

Slide Deferred Payments

Slide 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 no objective and reliable value can be determined, board of directors assigns a “reasonable value.” Donated Assets On occasion, companies acquire operational assets through donation. SFAS No. 116 requires the receiving company to Record the donated asset at fair value. Record revenue equal to the fair value of the donated asset.

Slide 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 = Dell generates nearly two times more sales dollars for each dollar invested in fixed assets than Apple does. = 15.4 $57,420 ($2,409 + $1,993)/2 = 26 $24,006 ($1,832 + $1,281)/2

Slide 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, 2009, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2004 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, 2008, its year-end. Prepare the journal entries necessary to record the disposition of this equipment.

Slide  Update depreciation to date of sale. Dispositions  Remove original asset cost and accumulated depreciation.  Record the gain or loss.

Slide 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 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.

Slide Fair Value Not Determinable Matrix, Inc. exchanged one unique operational asset for another operational asset. 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.

Slide Matrix, Inc. The journal entry below shows the proper recording of the exchange. Matrix, Inc. The journal entry below shows the proper recording of the exchange. Fair Value Not Determinable

Slide 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. 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.

Slide 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. Gain = Fair Value – Book Value Gain = $205,000 – $200,000 = $5,000

Slide Exchanges $205,000 fair value + $10,000 cash $200,000 book value + $10,000 cash Record the same transaction assuming the exchange lacks commercial substance.

Slide 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 Interest that could have been avoided if the asset were not constructed and the money used to retire debt. Asset constructed:  For a company’s own use.  As a discrete project for sale or lease. Under certain conditions, interest incurred on qualifying assets is capitalized.

Slide Interest Capitalization Capitalization begins when: construction begins interest is incurred, and qualifying expenses are incurred. Capitalization ends when: the asset is substantially complete and ready for its intended use, or when interest costs no longer are being incurred.

Slide Interest 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. Interest Capitalization If the qualifying asset is financed through a specific new borrowing... use the specific rate of the new borrowing as the capitalization rate. If there is no specific new borrowing, and the company has other debt... use the weighted average cost of other debt as the capitalization rate.

Slide 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 Interest Capitalization

Slide 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 Interest Capitalization The loan, initiated on May 1, is outstanding for 8 months of the year.

Slide 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 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

Slide If specific new borrowing had been insufficient to cover the average accumulated expenditures... Specific new borrowing AAE... Capitalize this portion using the 10 percent specific borrowing rate. Other debt... Capitalize this portion using the 12 percent weighted- average cost of debt. Interest Capitalization

Slide Research and Development (R&D) Research Planned search or critical investigation aimed at discovery of new knowledge... Development The translation of research findings or other knowledge into a plan or design... Most R&D costs are expensed as incurred. (Must be disclosed if material.) Research Planned search or critical investigation aimed at discovery of new knowledge... Development The translation of research findings or other knowledge into a plan or design... Most R&D costs are expensed as incurred. (Must be disclosed if material.) R&D costs incurred under contract for other companies are expensed against revenue from the contract. Operational assets used in R&D should be capitalized if they have alternative future uses. R&D costs incurred under contract for other companies are expensed against revenue from the contract. Operational assets used in R&D should be capitalized if they have alternative future uses.

Slide Software Development Costs SFAS No. 86 Start of R&D Activity Technological Feasibility Date of Product Release Sale of Product Costs Expensed as R&D Costs Capitalized Operating Costs All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred. Costs incurred after technological feasibility is established and before the software is available for release to customers are capitalized as an intangible asset. All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred. Costs incurred after technological feasibility is established and before the software is available for release to customers are capitalized as an intangible asset.

Slide Software Development Costs SFAS No. 86 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. 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 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. 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.

Slide 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. Political pressure prevented the FASB from requiring all companies to use the successful efforts method.

Slide The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells in 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 and Gas Accounting Full Cost

McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. End of Chapter 10