Intermediate Financial Accounting I Operational Assets: Acquisition

2 Operational Assets Operational assets include:  Property, Plants and Equipment (i.e., land, buildings, computers,machinery, etc.);  Intangible assets (patents, copyrights, tradenames,etc.)  Natural Resources (i.e., oil and gas reserves, timber, mineral deposits).

Operational Assets: Acquisition3 Operational Assets (contd.)  Property, Plants and Equipment: Productive assets deriving their value from the use of them in operations.  Intangible assets: productive assets without physical substance with uncertain benefits.  Nature Resources :Productive assets which are physically consumed in operations.

Operational Assets: Acquisition4 Objectives of the Chapter A. To learn: 1. Valuation of PPE at acquisition 2. Determination of acquisition cost of land, buildings and equipments. B. To study the impact of payments of PPE on the cost of PPE (i.e., cash, donations, deferred payments, etc.)

Operational Assets: Acquisition5 Objectives of the Chapter(contd.) C. To learn the accounting treatment for the disposition of PPE (i.e., exchange, discard). D. To discuss the accounting treatment for costs occurred subsequent to acquisition of PPE (i.e., additions, replacements, improvements, etc.).

Operational Assets: Acquisition6 What Is Property, Plant and Equipment (PPE)? u Assets used in operations (not for resale) u Long-term in Nature (Eco. Life > one year) u Possess physical substance u $ must be material

Operational Assets: Acquisition7 A1. PPE Valuation (APB Opinion No. 6) n At acquisition, PPE is recorded at the acquisition cost. At the end of period, PPE is also reported at cost. n Acquisition cost includes the purchase price and any costs necessary to bring the asset to the location and condition for its intended use.

Operational Assets: Acquisition8 iGAAP Vs. GAAP on PPE Valuation n Under GAAP, PPE cannot be revalued. However, if the fair value of the PPE is less than its book value, the assets may be written down (i.e., the impairment loss)under GAAP. n iGAAP permits companies to report PPE at either the historical cost or use a revaluation model (IAS 16).

Operational Assets: Utilization and Disposition9 iGAAP – PPE Valuation n Under the revaluation model, a gain (i.e., unrealized gain on revaluation) is recognized when the fair value is greater than the book value ( see the example on p655 of the 14 th e KWW textbook ). n If revaluation is used, it must be applied for the whole class of assets and the revaluation must be performed annually.

Operational Assets: Acquisition10 A1. PPE Valuation (contd.) n PPE (except for land) is subject to depreciation. n Depreciation is a process of cost allocation, not a process of asset valuation. n If the acquisition cost is greater than the market value at time of delivery, LCM is applied.

Operational Assets: Acquisition11 A2. Determination of Acquisition Cost u Cost of Land u Cost of Buildings u Cost of Equipment u Cost of Self-Constructed Assets

Operational Assets: Acquisition12 Cost of Land (held for operation, not for resale) n Any cost occurred before the land is ready for its intended use should be capitalized as cost of land.

Operational Assets: Acquisition13 Cost of Land (contd.) n Cost of land includes: 1. Purchase price. 2. Title search fee. 3. Closing fee. 4. Clearing fee. 5. Back property taxes (unpaid by previous owner). 6. Net razing cost of an old building. 7. Land improvements with unlimited life (permanent in nature such as landscaping, pavements, street lights, etc.)

Operational Assets: Acquisition14 Cost of Land (contd.) n Land improvements with limited life (i.e., parking lots, fences, etc.) would be debited to land improvement account and subject to depreciation. n The capitalization rules apply to the land held for operation also apply to land held for resale.

Operational Assets: Acquisition15 Cost of Land (contd.) n IRS allows the deduction of property taxes, insurance, interests even if these costs are capitalized. n If land and building are purchased together and the building is used for a few years, the net razing cost of the old building would be incorporated in the retirement of the old building.

Operational Assets: Acquisition16 Cost of Land Example n Land and building were purchased for $200,000 on 1/1/x2. $50,000 was assigned to the cost of building. On 12/31/x5, the building was demolished. The accumulated depreciation was $35,000, the razing cost was $7,000 and the salvage value of the building was $3,000.

Operational Assets: Acquisition17 Cost of Land Example (contd.) J.E. Accu. Depre.35,000 Materials3,000 Loss19,000 Building50,000 Cash7,000

Operational Assets: Acquisition18 Cost of Buildings n Cost of Buildings includes: 1. contract price(including materials, labor, etc.), 2. cost of remodeling, 3. Architect’s fee, 4. building permits, 5. surveying cost before construction, 6. interest cost (for self-constructed building), 7. excavation cost before construction. * Costs of strike or accidents are expensed.

Operational Assets: Acquisition19 Cost of Equipment n Any cost occurred to acquire and to bring the equipment to the location and condition for its intended use.

Operational Assets: Acquisition20 Cost of Equipment (contd.) n Cost of Equipment includes: 1. purchase price, 2. freight-in, 3. insurance in transit, and 4. foundation cost, installation cost, cost of test runs and assembling cost. n Not including: Cash discount lost, unnecessary storage cost and hauling charges from storage for delivery of equipment.

Operational Assets: Acquisition21 Cost of Self-Constructed (S-C) Assets n Cost of self-constructed assets includes: 1. direct materials, 2. direct labor, 3. factory overhead (variable overhead and fixed overhead).

Operational Assets: Acquisition22 Cost of Self-Constructed (S-C) Assets (contd.) n Treatment of fixed overhead: 1) When operation is at full capacity 2) When operation is under the full capacity

Operational Assets: Acquisition23 Interest Costs During Construction n Background of SFAS No. 34 (effective in 1979) n Only capitalize the interest on funds borrowed for construction.

Operational Assets: Acquisition24 Interest Costs During Construction (contd.) n Interest can only be capitalized for qualifying assets which must meet the following criteria: 1. Assets require a period of time to get ready for its intended use. 1. Examples: Assets are constructed for firm’s own use or constructed as discrete projects for sale or lease to others (i.e., ships, real estate developments). 2. Capitalization will make a difference on the earnings per share.

Operational Assets: Acquisition25 Interest Costs During Construction (contd.) u Capitalization period: Starting when: 1. Expenditures for the assets have been made; 2. Construction activities are in progress; and 3. Interest cost is being incurred. Ending when: F Assets are substantially completed and ready for intended use.

Operational Assets: Acquisition26 Interest Costs During Construction (contd.) n Interest revenue: Interest earnings on unexpended portion of the loan cannot be used to offset the amount eligible for capitalization. n The actual capitalized interest amount should not exceed the interest expense occurred during the period. n Interest on fund borrowed to develop (purchase) land for resale purposes should (should not) be capitalized.

Operational Assets: Acquisition27 Example - Interest Capitalization for Self-Constructed Assets v Capitalization period: 1/2/x7 to 6/30/x8 v Specific construction debt: $1,500,000 at 11% annual int. rate. This debt was borrowed on 9/30/x6 to finance the project. v Other debt outstanding during the construction period: 1. $4,000,000 at 12% annual int. rate. 2. $8,000,000 at 15% annual int. rate. v These loans have been outstanding since 1/1/x7.

Operational Assets: Acquisition28 Example (contd.) u Weighted Average Interest Rate (of other debt): Total interest = 480,000 +1,200,000 = 14% Total Principle 12,000,000 or 12% x 4,000, % x 8,000,000 = 14% 12,000,000 12,000,000 u Expenditures on the construction during 20x7 and 20x8 were as follows:1/2/x7$800,000 7/1/x7$1,000,000 10/1/x7$600,000 3/1/x8$900,000 6/1/x8$1,800,000

Operational Assets: Acquisition29 Example (contd.) u The amount of interest to be capitalized for 20x7: Computing the Weighted-Average Accumulated Expenditures (WAAE): 1/2/x7 $800,000 x 12/12 =$800,000 7/1/x7 1,000,000 x 6/12 =500,000 10/1/x7 600,000 x 3/12 = 150,000 2,400,000$1,450,000 u Capitalized Interest (Avoidable Interest) for 20x7: $1,450,000 x 11% x 12/12= $159, $1,450,000 < $1,500,000 11% int. loan borrowed specifically to finance the project

Operational Assets: Acquisition30 Example (contd.) u Actual interest incurred in 20x7: $1,500,000 x11% + $4,000,000 x 12% + $8,000,000 x 15% = $1,845,000. Interest exp. = actual int. - capitalized int. = $1,845, ,500 = $1,685,500

Operational Assets: Acquisition31 Example (contd.) u Journal entry to record the construction costs and interest expense for 20x7: Building2,559,500 1 Interest Expense1,685,500 Cash4,245,000 1.construction costs of 20x7 plus the capitalized interest of 20x7 (2,400, ,500=2,559,500).

Operational Assets: Acquisition32 Example (contd.) u The amount of interest to be capitalized for 20x8: WAAE of 20x8: 1/1/x8 $2,559,500 x 6/6=$2,559,500 3/1/x8 900,000 x 4/6=600,000 6/1/x8 1,800,000 x 1/6= 300,000 $3,459,500 u Capitalized interest for 20x8: WAAE Int. Rate $1,500,000 x 11% x 6/12= $ 82,500 1,959,500 1 x 14% x 6/12= 137, , ,459,500-1,500,000

Operational Assets: Acquisition33 A More Conservative Alternative u The amount of interest to be capitalized for 20x8: WAAE of 20x8: 1/1/x8 $2,559,500 x 6/12=$1,279,750 3/1/x8 900,000 x 4/12=300,000 6/1/x8 1,800,000 x 1/12= 150,000 $1,729,750 u Capitalized interest for 20x8: WAAE Int. Rate $1,500,000 x 11% = $165, ,000 1 x 14% = 32,060 $197, ,279,750-1,500,000

Operational Assets: Acquisition34 Example (contd.) u Actual interest incurred in 20x8: Same as in x7 = $1,845,000. Int. exp. of x8 = 1,845, ,665= 1,625,335 u Journal entry to record the construction costs and int. exp. for x8: Building 2,919,665 1 Interest Exp. 1,625,335 Cash4,545,000 1.$900, ,800, ,665 = 2,919,665 (costs of 20x8 plus the capitalized interest)

Operational Assets: Acquisition35 Example (contd.) u Reporting: Income Statement (for the year ended 12/31/x7) Other Revenues & Expenses: Interest Expenses $1,845,000 Less: Capitalized Int. (159,500) $ 1,685,500 Notes: Accounting Policy F Capitalized interest: during 20X7, total interest expense was $1,845,000 of which $159,500 was capitalized and $1,685,500 was charged to expense.

The Convergence of Standards – the Case on Interest Capitalization  IAS 23 originally issued allowed the choice of capitalizing or immediate expensing of interest incurring during the construction.  IAS 23 revised in 2007 required the capitalization of such interest in most situations for qualifying assets.  This revision effectively eliminated the major differences between the IAS and the U.S. standards in accounting for interest capitalization. Operational Assets: Acquisition36

How the Boards Moving toward Convergence of Standards 1.Revise IAS to converge with U.S. standards (i.e., the case of accounting for interest capitalization). 2.Revise U.S. standards to converge with IAS (i.e., the accounting for assets exchange and the accounting for changes in depreciation method). 3.Two Boards (the IASB and the FASB) work jointly to develop common standards (i.e., the accounting for leases). Operational Assets: Acquisition37

Operational Assets: Acquisition38 B. The Impact of Payments of PPE on the Cost of PPE a.Cash b.Issuance of stock c.Deferred payments d.Payment in advance e.Donations f.Lump sum purchase g.Exchange of PPE

Operational Assets: Acquisition39 Payments of PPE a. Cash n Cash: Regardless of whether cash discount is taken or not, the cost of the asset is the net amount. The discount lost is recognized as an expense.

Operational Assets: Acquisition40 Payments of PPE b. Issuance of Stock n Issuance of stock to acquire assets: assets are recorded at the market value of stock if the stock is traded frequently. If not, assets would be recorded at their fair value.

Operational Assets: Acquisition41 Payments of PPE c. Deferred Payments n Example: assets were purchased using a $10,000 non-interest bearing note, payable in four years from now. The market rate is 10%. Present value: $10,000x0.683 = 6,830 Building6,830 Discount on N/P3,170 N/P10,000

Operational Assets: Acquisition42 Payments of PPE d. Payment in Advance n SFAS No. 34 requires to capitalize the implicit interest of the advanced payment.

Operational Assets: Acquisition43 Payment in Advance (contd.) n Example: Equipment costing $500,000. $100,000 was paid on 1/1/x5 and the equipment was delivered on 12/31/x5. 1/1/x5 Advances100,000 Cash100,000 12/31/x5 Equipment500,000 Advances100,000 Cash400,000 Equipment 1 10,000 Interest Exp.10, assume market rate of 10%

Operational Assets: Acquisition44 e. Donations (receive or make contributions; nonreciprocal transfers) n Contributions received are recorded at the fair value of the assets (SFAS No. 116): Land$$$$ Contribution Revenue$$$$ n Non-monetary contributions made are also recorded at the fair value of the assets: Contribution Expense$$$$ Land$$$$ Gain on Disposal of Land $$$$

Operational Assets: Acquisition45 Payments of PPE e. Donations (contd.)  SFAS No. 116 applied to private sector donations; may not apply to donations from governmental units.

Operational Assets: Acquisition46 Payments of PPE f. Lump Sum Purchase n Example: A building and land were purchased at $100,000. The market value of building and land was $30,000 and $90,000, respectively. The cost allocation is based on the relative fair value of each asset. Building25,000 1 Land75,000 2 Cash100, ,000/(30,000+90,000)=25%, 25%x100,000 = 25, ,000/(30,000+90,000)=75%, 75%x100,000 = 75,000

Operational Assets: Acquisition47 g. Exchange of Property, Plant, and Equipment (nonmonetary assets) n Book value = Cost - Acc. Depr. n Gain: fair value of the old asset > book value of the old asset. n Loss: fair value of the old asset < book value of the old asset.

Operational Assets: Acquisition48 Payments of PPE g. Exchange of PPE (contd.) n Cash paid=> Fair value of the old asset < fair value of the new asset. n Cash received=> Fair value of the old asset >Fair value of the new asset.  If the fair value of the new is unknown, its fair value can be derived as the fair value of the old + cash paid (or – cash received).

Operational Assets: Acquisition49 g. Exchange of PPE (contd.) (SFAS 153: amends APB 29) n Acquisition cost of the new asset is the fair value of the new asset except in the following cases: n 1. When the fair values of both assets (new and old) are undeterminable; or n 2. The exchange lacks commercial substance (i.e., the exchange has no impact on future cash flows of companies.).

Operational Assets: Acquisition50 Payments of PPE g. Exchange of PPE (contd.) (SFAS 153) n Exchange with commercial substance and a fair value is known (See Cases 1 to 4):  The new asset is recorded at the its fair value and gains and losses would be recognized.  If the fair value of the new asset is unknown, its fair value will be derived as the fair value of the old asset + cash paid (or - cash received).

Operational Assets: Acquisition51 iGAAP n The FASB issued SFAS 153 (ASC in 2004 to require gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance. n Per SFAS 153, the accounting nonmonetary assets exchange has converged between iGAAP and US GAAP.

Operational Assets: Acquisition52 CASE 1 (With Commercial Substance) : Loss and Cash Paid Cost of old asset=$20,000 Book value of old asset=6,000 Fair value of old asset=4,000 Fair value of new asset=9,000 New Asset9,000 Acc. Depr.14,000 Loss on Disposal of ass. 2,000 Old ass.20,000 Cash5,000

Operational Assets: Acquisition53 CASE 2 (With Commercial Substance): Loss and Cash Received Cost of old asset=$20,000 Book value of old asset=6,000 Fair value of old asset=4,000 Fair value of new asset=2,000 New Asset2,000 Cash2,000 Acc. Depr.14,000 Loss on Disposal of ass. 2,000 Old ass.20,000

Operational Assets: Acquisition54 CASE 3 (With Commercial Substance) : Gain and Cash Paid Cost of old asset=$20,000 Book value of old asset= 6,000 Fair value of old asset= 8,000 Fair value of new asset= 12,000 New Asset 12,000 Acc. Depr. 14,000 Old ass. 20,000 cash. 4,000 Gain 2,000

Operational Assets: Acquisition55 CASE 4 (With Commercial Substance ) : Gain and Cash Received Cost of old asset=$20,000 Book value of old asset= 6,000 Fair value of old asset = 8,000 Fair value of new asset= 5,000 New Asset 5,000 Acc. Depr. 14,000 Cash 3,000 Old ass. 20,000 Gain on Disp.2,000

Operational Assets: Acquisition56 Treatments for Exception 1 (Fair values of Both Assets Are Unknown) (SFAS 153)  When fair values of both assets are unknown, the new asset is recorded at: Book Value of old Asset + Cash Paid or – Cash Received (See Cases 5 and 6).  In this case, no gain or loss will be recognized.

Operational Assets: Acquisition57 CASE 5: Fair value of Both Assets Are Unknown – Cash Received Cost of old asset = $20,000 Book value of old asset = 6,000 cash received = 1,000 Cash 1,000 New Asset 5,000 Acc. Depr. 14,000 Old ass.20,000

Operational Assets: Acquisition58 CASE 6: Fair Value of both Assets Unknown – Cash Paid Cost of old asset = $20,000 Book value of old asset= 6,000 cash paid = 2,000 New Asset 8,000 Acc. Depr. 14,000 Old ass. 20,000 Cash 2,000

Operational Assets: Acquisition59 Treatments for Exception 2 (Exchange Lacks of Commercial Substance) (SFAS 153)  When the exchange lacks commercial value, the company recognizes a loss but not a gain unless cash is received (Conservatism!!).  This is to prevent a company from exchanging appreciated assets only to recognize the appreciation of the assets.  As a result, gains can only be recognized when there is commercial substance.

Operational Assets: Acquisition60 Exchange Lacks Commercial Substance  With a loss: The new asset is recorded at the fair value of the old + cash paid (or - cash received) (See Case 7).  With a gain and cash paid: No gain is recognized and the new asset is recorded at the book value of old + cash paid (See Case 8).  With a gain and cash received: partial gain is recognized and the new asset is recorded at the book value of old - cash received + partial gain (See Case 9).

Operational Assets: Acquisition61 CASE 7: No Commercial Substance with a Loss (loss is recognized) Cost of old asset=$20,000 Book value of old asset=6,000 Fair value of old asset=4,000 Fair value of new asset=9,000 New Asset9,000 Acc. Depr.14,000 Loss on Disposal of ass. 2,000 Old ass.20,000 Cash5,000 Note: the new asset is recorded at its fair value.

Operational Assets: Acquisition62 CASE 8: No Commercial Substance, Gain and Cash Paid (Gain is deferred) Cost of old asset=$20,000 Book value of old asset= 6,000 Fair value of old asset= 8,000 Fair value of new asset= 12,000 New Asset 10,000* Acc. Depr. 14,000 Old ass. 20,000 cash. 4,000 *The new asset is recorded at the book value of the old +cash paid (6,000+4,000)

Operational Assets: Acquisition63 CASE 9: No Commercial S ubstance, Gain and Cash Received (Partial gain is recognized) Cost of old asset=$20,000 Book value of old asset= 6,000 Fair value of old asset = 8,000 Fair value of new asset= 7,000 New Asset 5,250 Acc. Depr. 14,000 Cash 1,000 Old ass. 20,000 Gain on Disp.250 Partial Gain=total gain x (cash received./fair value of old) Partial Gain = $2,000x ($1,000/$8,000) = $250 New Asset = Book Value of old – cash received + partial Gain

Case 9 (contd.)  Partial Gain=total gain x (cash received./fair value of old)  Partial Gain = $2,000x ($1,000/$8,000) = $250  New Asset = Book Value of old – cash received + partial Gain  If cash received is 25% or more of fair value of the old asset, entire gain is recognized (see illustration of the textbook). Operational Assets: Acquisition64

Operational Assets: Acquisition65 Prudent Cost Concept  The cost of an asset recorded can never exceed its market value.  When the cost of an asset exceeds it market value, the asset should be recorded at the market value and a loss would be recognized.  The loss equals the difference between the cost and the market value.

Operational Assets: Acquisition66 Asset Turnover Ratio  Financial analysts often use activity ratios to assess the effectiveness of a company’s utilizing of its assets – a key to profitability.  The activity ratios include: inventory turnover rate, accounts receivable turnover rate and asset turnover rate.  Asset turnover rate = Net sales/Average fixed assets.

Operational Assets: Acquisition67 Asset Turnover Ratio (contd.)  The ratio indicates the level of sales generated by the company’s investment in PPE.  PPE are usually company’s primary revenue generating assets.  The efficient use of these assets is critical to generate return to the owners.  The ratios of competitors can be compared.

Operational Assets: Acquisition68 C. Disposition of Property, Plant and Equipment n Exchange n Discard n Sold for Cash n Involuntary Conversion:

Operational Assets: Acquisition69 C. Disposition of Property, Plant and Equipment (contd.) Involuntary Conversion: u An asset’s service is terminated due to fire, flood, theft or condemnation. u The gains or losses are treated no differently from those in other types of dispositions except they may be reported as an extraordinary item if conditions of the disposition are both infrequent and unusual.

Operational Assets: Acquisition70 D. Costs Subsequent to Acquisition n Basic principle for capitalization of these costs: Capitalize the cost if it can: a. extend the life of the existing asset, or b. increase the service quality of the existing asset, or c. increase the productivity of the existing asset (including the reduction of unit cost). Otherwise, expense the cost.

Operational Assets: Acquisition71 D. Costs Subsequent to Acquisition (contd.) n Types of costs occurred subsequent to acquisition: a. Additions b. Improvements, Replacements c. Rearrangement and Reinstallation d. Repairs e. Maintenance

Operational Assets: Acquisition72 a. Additions n An addition is an extension of existing assets. By definition, a new asset has been created. Thus, costs of the additions should be capitalized.

Operational Assets: Acquisition73 b. Improvements & Replacements n Improvements: Substitution of a better asset for an existing asset. n Replacement: Replace with same kind of asset. If the costs can increase the future service potential, the costs should be capitalized.

Operational Assets: Acquisition74 c. Rearrangement & Reinstallation n Movement of assets from one location to another. The costs of movements would benefit the company for the future period and should be capitalized.

Operational Assets: Acquisition75 d & e. Repairs & Maintenance d. Repair: u Ordinary repair: Expense u Major repair: Capitalize if costs increase future service potential or extend the life. Treat these costs as improvements or replacements as appropriate. e. Maintenance: Expense

Operational Assets: Acquisition76 Method of Capitalization n When the cost of the old asset is known: Substitution approach n When the cost of the old asset is unknown: a. Adding the costs to the existing asset account. b. Charging the costs to the accumulated depreciation account.

Operational Assets: Acquisition77 When The Cost of The Old Asset Is Known n Substitution approach (if quantity increased or quality improved) : Remove the acc. depre. and the cost of the old asset and replace with the cost of the new asset.

Operational Assets: Acquisition78 When The Cost of The Old Asset Is Known (contd.) n Example: MMR Corp. decides to replace the pipe in its plumbing system. The old pipe has a book value of $15,000 with 135,000 acc. Depre. and zero salvage value. The new pipe has a cost of $125,000. Plumbing System125,000 Acc. Depr.135,000 Loss on Disposal of Plant Assets15,000 Plumbing System150,000 Cash125,000

Operational Assets: Acquisition79 When The Cost of The Old Asset Is Unknown (i.e., parts of machines ) a.Adding the costs to the existing asset account (i.e., for improvements) b.Charging the costs to the accumulated depreciation account (i.e., for replacements)