CHAPTER 10 Acquisition and Disposition of PP&E ……..…………………………………………………………...  used in operations  long-term in nature, subject to depreciation  physical substance Characteristics of PP&E not land held for investment not drill bits not patents

Costs of PP&E  all costs of obtaining the asset, shipping the asset, and getting it ready for use Land/BuildingEquipmentInventory Closing costs Clearing & grading Insurance Shipping

Land/BuildingEquipmentInventory Foundations Building permits Testing Interest costs Manufacturing OH Cash discounts

 Actual interest costs during construction should be capitalized.  no imputation of cost of equity capital  Capitalization period begins when (and continues as long as):  asset expenditures have been made  preparation activities are underway  interest cost is being incurred INTEREST COSTS DURING CONSTRUCTION

Weighted-Average Accumulated Expenditures  Construction expenditures weighted by the fraction of the year that interest charges could be incurred. $3,000$4,800$1,200 Begin constructionEnd 1/112/313/111/17/1

Another Example of WAAE (000s) $240$480$360 Begin construction 1/112/313/111/17/1 End

Avoidable Interest  An estimate of interest expense related to weighted-average accumulated expenditures. 12%, 2-year construction loan, dated 7/1/01$300,000 8%, 10-year bonds dated 1/1/98250,000 10%, 5-year loan dated 10/1/00100,000 Use specific borrowings first Remainder charged at weighted-average rate.

PrincipalInterest 8%, 10-year bonds$250,000$20,000 10%, 5-year loan 100,000 10,000 $350,000$30,000 Weighted average interest rate = 30/350 = 8.57% Accum ExpendInterest RateAvoid Interest $300,00012%$ 36, , % 17,143 $500,000$ 53,143

Amount of Interest to Capitalize  The lower of actual or avoidable interest. Construction loan (12% x 300,000 x 6/12)$ 18, year bonds (8% x 250,000)20,000 5-year loan (10% x 100,000) 10,000 Actual Interest$ 48,000 Avoidable Interest$ 53,153 Special Issues in Interest Capitalization

VALUATION OF PP&E  Clearly evident fair market value Cash Discounts 2/10, n/30 Notes or Loans Payable Common Stock Issue Lump Sum Purchases

Exchanges of Nonmonetary Assets  Exchanging an “old” asset for a “new” asset  Exchange is based on…  fair value of asset given up, ordinarily  fair value of asset received if it is more clearly evident  Gain or loss  difference between fair value & book value  recognized only if exchange has commercial substance, i.e. if future cash flows are expected to change

Use fair value of new asset (plus or minus cash) if more clearly evident. Fair value of old asset$140,000 Book value of old asset Cost$250,000 Accum. deprec 102,000 Book value 148,000 Loss on disposal$ 8,000 Step 1: Determine total gain or loss

Step 2:Always recognize entire loss and, if the transaction has commercial substance, recognize entire gain. Fair value of old asset$140,000 Plus cash paid 30,000 Fair value of new asset$170,000 Old fair value$140,000 Old cost250,000 Old acc depr102,000 New fair value? Cash paid30,000

Step 3:If the transaction lacks commercial substance and … Fair value of old asset$160,000 Book value of old asset 148,000 Gain on disposal$ 12,000 Fair value of new asset$170,000 Less: Gain deferred 12,000 Basis of new asset$158,000 Old fair value$160,000 Old cost250,000 Old acc depr102,000 New fair value170,000 Cash paid10,000 (a)… no cash is received, do not recognize the gain.

(b)… cash received  25% of fair value, recognize the entire gain. Fair value of old asset$230,000 Book value of old asset 148,000 Gain on disposal$ 82,000 Old fair value$230,000 Old cost250,000 Old acc depr102,000 New fair value170,000 Cash rec’d60,000

(c)… cash received is < 25% of fair value, recognize a portion of the gain. Fair value of old asset$200,000 Book value of old asset 148,000 Gain on disposal$ 52,000 Fair value of new asset$170,000 Less: Gain deferred 44,200 Basis of new asset$125,800 Old fair value$200,000 Old cost250,000 Old acc depr102,000 New fair value170,000 Cash rec’d30,000 $52,000 x 17/20

COSTS SUBSEQUENT TO ACQUISITION  Additions  Improvements  Replacements that increase service potential  Reinstallation Greater future benefit Capitalize Asset maintenance Expense  Minor repairs  Major repairs

Journal Entries for Replacements  If book value of old asset can be determined… Equipment (new)125,000 Accum Deprec – Equip (old)135,000 Loss on Disposal14,000 Equipment (old)150,000 Cash124,000  If book value of old asset is unknown… Equipment (new)125,000 Equipment (old)1,000 Cash124,000 Scrap value