Chapter 5 Assets

1. Record the acquisition of property, plant, and equipment. 2. Determine the cost of assets acquired by the exchange of other assets. 3. Compute the cost of a self-constructed asset, including interest capitalization. 4. Record costs subsequent to acquisition. 5. Record the disposal of property, plant, and equipment. 6. Understand the disclosures of property, plant, and equipment. 7. Explain the accounting for oil and gas properties. (appendix) Learning Objectives

8. Identify the factors involved in depreciation. 9. Explain the alternative methods of cost allocation, including activity and time-based methods. 10. Record depreciation. 11. Explain the conceptual issues regarding depreciation methods. 12. Understand the disclosure of depreciation. 13. Understand additional depreciation methods, including group and composite methods. 14. Compute depreciation for partial periods. 15. Explain the impairment of noncurrent assets. 16. Understand depreciation for income tax purposes. 17. Explain changes and corrections of depreciation. 18. Understand and record depletion. Learning Objectives

Actively Used in OperationsExpected to Benefit Future Periods Tangible Physical Substance Intangible No Physical Substance Operational Assets

Expected to Benefit Future PeriodsActively Used in Operations Assets subject to depreciation Buildings and equipment Furniture and fixtures Natural resource assets subject to depletion Mineral deposits and timber Land Examples Tangible Physical Substance Operational Assets

1. The asset must be held for use and not for investment. 2. The asset must have an expected life of more than one year. 3. The asset must be tangible in nature. To be included in the property, plant, and equipment category, an asset must have three characteristics: Characteristics of Property, Plant, and Equipment

Actively Used in OperationsExpected to Benefit Future Periods Value represented by rights that produce benefits Goodwill Patents Copyrights Trademarks Assets subject to amortization Examples Intangible No Physical Substance Operational Assets

General Rule The historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. Acquisition Cost

Contract price Contract price Remodeling and reconditioning Remodeling and reconditioning Excavating for the specific building Excavating for the specific building Architectural and building permit costs Architectural and building permit costs Capitalized interest Capitalized interest Certain unanticipated costs Certain unanticipated costs Contract price Contract price Remodeling and reconditioning Remodeling and reconditioning Excavating for the specific building Excavating for the specific building Architectural and building permit costs Architectural and building permit costs Capitalized interest Capitalized interest Certain unanticipated costs Certain unanticipated costs Cost of Buildings Acquisition of Property, Plant, and Equipment

l Installation costs l Net purchase price l Modification to building necessary to install equipment l Transportation costs Cost of Machinery, Furniture, and Fixtures Acquisition of Property, Plant, and Equipment

 Contract price  Costs of closing the transaction, obtaining the title, options, legal fees, title search, insurance, past due taxes  Contract price  Costs of closing the transaction, obtaining the title, options, legal fees, title search, insurance, past due taxes Cost of Land Cost of surveys Cost of surveys Clearing and grading property to get it ready for its intended use Clearing and grading property to get it ready for its intended use Razing old buildings (net of salvage) Razing old buildings (net of salvage) Cost of surveys Cost of surveys Clearing and grading property to get it ready for its intended use Clearing and grading property to get it ready for its intended use Razing old buildings (net of salvage) Razing old buildings (net of salvage) Acquisition of Property, Plant, and Equipment

Landscaping Landscaping Streets Streets Sidewalks Sidewalks Sewers Sewers Cost of Land Improvements Acquisition of Property, Plant, and Equipment

 Driveways  Parking lots  Fencing  Landscaping Cost of Land Improvements Acquisition of Property, Plant, and Equipment

Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices. Asset 4 Asset 3 Asset 2 Asset 1 Lump-Sum Purchase

Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices. Asset 4 Asset 3 Asset 2 Asset 1 Portions of the lump-sum price attributable to particular assets are assigned to those assets. Lump-Sum Purchase

Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices. Asset 4 Asset 3 Asset 2 Asset 1 Allocation of the remaining lump-sum price is based on relative values of the individual assets. Portions of the lump-sum price attributable to particular assets are assigned to those assets. Lump-Sum Purchase

Lump-Sum Purchases 1.Under the proportional method, the value of each asset is based on the proportion of it’s market value to the total market value of the group of assets being purchased. 2.The incremental method is used when market values are not available for all of the assets. Acquisition of Property, Plant, and Equipment

Proportional Method A company pays $120,000 for land and a building. The land and building are appraised at $50,000 and $75,000, respectively. Appraisal Relative Fair TotalAllocated Value Value x Cost = Cost Land$ 50,000$50,000/$125,000x $120,000 = $ 48,000 Building 75,000$75,000/$125,000x $120,000 = 72,000 Total$125,000$120,000 Acquisition of Property, Plant, and Equipment

Proportional Method A company pays $120,000 for land and a building. The land and building are appraised at $50,000 and $75,000, respectively. Land48,000 Building72,000 Cash 120,000 Acquisition of Property, Plant, and Equipment

A company pays $120,000 for a truck and a used custom made machine. The truck has a value of $70,000 but the value of the machine is unknown. Truck70,000 Equipment50,000 Cash 120,000 Incremental Method

When plant assets are used that require substantial costs of dismantling, removal, and site reclamation at the end of the asset’s useful life... The present value of these costs should be capitalized and the associated liability should be recognized when the following criteria are met: Capitalized Closure and Removal Costs

1. The cost can be estimated. 2. The liability is the result of the future requirement to close or remove the asset, and cannot be satisfied until the operation of the asset ceases. 3. The liability cannot be avoided if the asset is used as intended. Capitalized Closure and Removal Costs

With cash On credit In exchange for equity securities of the acquiring company Through donation from another entity Through construction In exchange for nonmonetary assets Asset Acquisition

The asset acquired is recorded at the Cash equivalent price (market value) or Present value of future cash payments using the prevailing market interest rate Whichever is more objective and reliable. (APB Opinion No. 21) Purchase on Credit

On May 1, X6, Fesler, Inc. purchased equipment paying $3,000 down and issuing a note payable. The note requires four annual payments of $2,500 with the first payment due on May 1, X7. The note is noninterest- bearing. The prevailing market rate of interest on notes of this nature is 12%. Prepare the required journal entries on May 1, X6 and December 31, X6 (year-end). Purchase on Credit Example

Asset acquired is recorded at the market value of the asset or the market value of the securities, whichever is more objective and reliable. 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. Purchased With Equity Securities

Municipalities may donate land and buildings to induce a company to locate in the area. SFAS No. 116 defines a contribution as “ an unconditional transfer of cash or other assets to an entity or a settlement or cancellation of its liabilities in a voluntary nonreciprocal transfer... ” Donated Assets

SFAS NO.116: Donated assets are capitalized at market value and revenue from donated assets is recognized. Donated Assets

Assets Acquired by Donation The CEO of Hrouda Company donates a building worth $50,000 to the company. Building50,000 Gain from Donation of Land50,000 (by a nongovernmental unit) The gain is reported in the Other section of the income statement. Donated Assets

Assets Acquired by Donation The City of Julesberg (a governmental unit) donates land worth $20,000 to the Klemme Company. Land20,000 Donated Capital20,000 (by a governmental unit) Donated Assets

Contributed services that enhance nonfinancial assets are recognized as expenses and revenues on receipt. Contribution of collectibles, like works of art for public display, are disclosed, but not recognized in the accounts. Donated Assets

The cost of materials, labor, and overhead used in the self-construction of property, plant, and equipment intended for a firm’s production process are added to the cost of the asset. Self-Constructed Assets

The asset’s recorded cost must never exceed its fair market value. If costs actually incurred exceed fair market value, a loss must be recognized. Self-Constructed Assets

Assume that Kelvin Corporation complete a project with total construction costs as follows: Material $ 200,000 Labor 500,000 Incremental overhead 60,000 Applied general overhead 40,000 Capitalized interest 100,000 Total $ 900,000 Self-Constructed Assets

If the asset ’ s market value at completion equals or exceeds $900,000: Equipment 900,000 Equipment under construction 900,000 If the asset ’ s market value is only $880,000 Equipment 880,000 Loss on construction of equipment 20,000 Equipment under construction 900,000 Self-Constructed Assets

They must require a period of time to make them ready for use. There are two types of qualifying assets: 1. Assets under construction for use in operations, and 2. Discrete assets intended for sale or lease. 41 Interest Capitalization - Qualifying Assets

Interest cannot be capitalized for the following types of assets: 1.Inventories that are routinely manufactured or otherwise produced in large quantities on a repetitive basis. 2.Assets that are in use or ready for their intended use. 3.Assets that are not being used in the earning activities of the company and are not undergoing the activities necessary to get them ready for use. Interest Capitalization

Capitalization begins when... Qualifying expenditures have been made, and Construction activities are underway, and Interest cost has been incurred. Capitalization ends when... The asset is substantially complete and ready for its intended use. Interest Capitalization

–Avoidable interest interest that could have been avoided if the asset were not con-structed and the money used to retire debt. Interest Capitalization

Determine weighted-average accumulated expenditures 1 Avoidable interest Appropriate interest rate(s) 2 Multiply by 45 Interest Capitalization-Computing Avoidable Interest

Interest is capitalized on Average Accumulated Expenditures (AAE) Qualifying expenditures weighted for the number of months outstanding during the current accounting period. Qualifying Expenditures Cash payments for construction Transfer of other assets Incurrence of interest-bearing liabilities Interest Capitalization

Amber makes the following two payments in 2004: Jan 31: $24,000 July 31: $18,000 Capitalization period ran from Jan 31 – Dec 31. What is the WAAE? Jan 31:$24,000 × (11/12) $22,000 July 31:$18,000 × (5/12)$ 7,500 WAAE $29, Determining Weighted-Average AccumulatedExpenditures (WAAE): Example

Interest Potentially Capitalizable (IPC) Multiply the AAE by the capitalization rate or rates. Interest Capitalization

Capitalization Rate(s) If the qualifying asset is financed through a specific new borrowing, the interest rate on the new borrowing is used for the computation of IPC. If the qualifying asset is internally financed, the capitalization rate will be the weighted- average cost of debt. Use both rates, if partially financed with a new borrowing. Interest Capitalization

AAE less than specific new borrowing Specific new borrowing AAE Capitalize AAE using specific borrowing rate Interest Capitalization

AAE more than specific new borrowing Specific new borrowing AAE Capitalize this part of AAE using specific borrowing rate Other debt Capitalize this part of AAE using weighted average rate of other debt Interest Capitalization

Steps in the capitalization process 1. Compute actual interest expense. 2. Compute AAE. 3. Compute IPC. 4. Capitalize the smaller of actual interest or IPC. 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 recorded total interest expense of $175,000 during the year, including construction borrowing of $1,000,000 on May 1, from Bub ’ s Bank for 10 years at 12%. Interest Capitalization Example

Actual interest expense is $175,000. Compute AAE: Interest Capitalization Example

Compute IPC: Since we have a specific new borrowing, and the amount of the borrowing ($1,000,000) exceeds the AAE ($225,000), we use the interest rate on the specific new borrowing for the capitalization. IPC = AAE × Capitalization rate IPC = $225,000 × 12% = $27,000 Interest Capitalization Example

Capitalize the smaller of actual interest or IPC. Actual interest = $175,000 IPC = $27,000 Capitalize $27,000 Interest Capitalization Example

Update depreciation to date of disposal. Original cost of asset and accumulated depreciation are removed from the accounts. The difference between book value of the asset and the amount received in the disposal process is recorded as a gain or loss. Disposal of Plant Assets

On June 30,2006, MeLo, Inc. sells equipment for $6,350 cash. The equipment was purchased on January 1, 19X1 at a cost of $15,000. The asset has a useful life of 10 years and no salvage value. MeLo last recorded depreciation on the equipment on December 31, 2005, its year-end. Prepare the journal entries necessary to record the disposal of this equipment. Disposal of Plant Assets Example

Update depreciation to date of sale. Disposal of Plant Assets Example

Remove asset and Accumulated Depreciation and recognize gain or loss. Disposal of Plant Assets Example

The general exchange principle is that the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered. Nonmonetary Asset Exchanges

Cost of asset acquired is Fair value of asset transferred plus cash paid or minus cash received or Fair value of asset acquired, if it is more readily determinable. Nonmonetary Asset Exchanges

The Company acquiring the asset recognizes a gain or loss on the exchange as the difference between the fair value of the asset surrendered and its book value. Nonmonetary Asset Exchanges

A nonmonetary exchange is considered to have commercial substance if the company (1) Expects a change in future cash flows as a result of the exchange and (2) That expected change is significant relative to the fair value of the assets exchanged. Nonmonetary Asset Exchanges

A company would not recognize a gain if the transaction lacks “commercial substance; that is, future cash flows are not expected change significantly. Nonmonetary Asset Exchanges

Commercial Substance Arnold CompanyCarbon Company Cost $100,000 Accum. depr.54,000 Fair value40,000 Cost $60,000 Accum. depr.32,000 Fair value40,000 Assets Acquired by Exchange of Other Assets

Arnold Company Cost $100,000 Accum. depr.54,000 Fair value40,000 Equipment40,000 Accum. depr.54,000 Loss6,000 Building100,000 Book value$46,000 Fair value40,000 Loss$6,000 Commercial Substance Assets Acquired by Exchange of Other Assets

Company A Equipment40,000 Accum. depr.54,000 Loss6,000 Building100,000 Cost $40,000 Book value$46,000 Fair value40,000 Loss$6,000 Commercial Substance Assets Acquired by Exchange of Other Assets

Cost $60,000 Accum. Depr.32,000 Fair value40,000 Building40,000 Accum. Depr.32,000 Equipment60,000 Gain12,000 Book value$28,000 Fair value40,000 Gain$12,000 Commercial Substance Carbon Company Assets Acquired by Exchange of Other Assets

Cost $40,000 Book value$28,000 Fair value40,000 Gain$12,000 Building40,000 Accum. Depr.32,000 Equipment60,000 Gain12,000 Commercial Substance Carbon Company Assets Acquired by Exchange of Other Assets

Commercial Substance with Boot Arnold Company Cost $100,000 Accum. depr.54,000 Fair value40,000 Cash received5,000 Cost $60,000 Accum. depr.32,000 Fair value35,000 Cash paid5,000 Carbon Company Assets Acquired by Exchange of Other Assets

Arnold Company Cost $100,000 Accum. depr.54,000 Fair value40,000 Cash received5,000 Equipment35,000 Accum. depr.54,000 Cash5,000 Loss6,000 Building100,000 Book value$46,000 Fair value40,000 Loss$6,000 Commercial Substance with Boot Assets Acquired by Exchange of Other Assets

Arnold Company Equipment35,000 Accum. depr.54,000 Cash5,000 Loss6,000 Building100,000 Cost $35,000 Commercial Substance with Boot Assets Acquired by Exchange of Other Assets

Cost $60,000 Accum. Depr.32,000 Fair value35,000 Cash paid5,000 Building40,000 Accum. Depr.32,000 Equipment60,000 Cash5,000 Gain7,000 Book value$28,000 Fair value35,000 Gain$7,000 Commercial Substance with Boot Carbon Company Assets Acquired by Exchange of Other Assets

Let’s change the subject.

If cost incurred increase future benefits, capitalize costs. If costs maintain a given level of services, expense costs. 79 Post-Acquisition Expenditures

 Extending the life of the asset.  Improving the productivity.  Producing the same product at lower cost.  Increasing the quality of the product.  Extending the life of the asset.  Improving the productivity.  Producing the same product at lower cost.  Increasing the quality of the product. The future economic benefits of a productive asset or product can be increased by-- Post-Acquisition Expenditures

Maintenance and ordinary repairs. Improvements (betterments), replacements, and extraordinary repairs. Additions. Rearrangements and other adjustments. Post-Acquisition Expenditures

expense Normally we debit an expense account for amounts spent on: Maintenance and Ordinary Repairs Post-Acquisition Expenditures

Maintenance and Ordinary Repairs 1.Incurred approach 2.Allocation approach Repair and maintenance expense xxx Allowance for repairs and maintenance xxx Post-Acquisition Expenditures

asset Normally we debit the asset account for amounts spent on: Improvements, Replacements, and Extraordinary Repairs Concept: increase useful life or productivity of the original asset. Post-Acquisition Expenditures

A company decides to replace its oil furnace with a gas furnace. The oil furnace is carried on the books at a cost of $50,000 with an accumulated depreciation of $30,000. The scrap value of the old furnace is $5,000, and the new furnace costs $70,000. Furnace70,000 Accumulated Depreciation: Furnace30,000 Loss on Disposal of Furnace15,000 Furnace50,000 Cash65,000 Substitution Method Improvements and Replacements

A capital expenditure of $80,000 is incurred to enlarge a factory. Factory80,000 Cash80,000 Increase the Asset Account Improvements, Replacements and Additions

A capital expenditure of $60,000 is incurred in replacing a roof on a factory building. Accumulated Depreciation60,000 Cash60,000 Reduce Accumulated Depreciation Improvements and Replacements

asset Normally we debit the asset account for amounts spent on:Additions Concept: expansion of an existing asset. Post-Acquisition Expenditures

other asset Normally we debit an other asset account for amounts spent on: Rearrangements and Other Adjustments Concept: increase efficiency of operations. Post-Acquisition Expenditures

Bean Company has a machine that originally cost $10,000, has accumulated depreciation of $8,000 at the beginning of the current year, and is being depreciated at $1,000 per year. On December 30, the company sells the machine for $600. Depreciation1,000 Accumulated Depreciation1,000 To bring depreciation to point of sale. Disposal of Property, Plant, and Equipment

Cash600 Accumulated Depreciation9,000 Loss on Disposal400 Machine10,000 To record disposal of machine for $600. Bean Company has a machine that originally cost $10,000, has accumulated depreciation of $8,000 at the beginning of the current year, and is being depreciation at $1,000 per year. On December 30, the company sells the machine for $600. Disposal of Property, Plant, and Equipment

The acquisition cost of an operational asset represents a bundle of future services that help earn future revenues. The matching principle requires that part of the acquisition cost be expensed in periods when the future revenues are earned. Acquisition Cost Expense (Unused) (Used) Depreciation Concepts

Depreciation, depletion, and amortization are cost allocation processes that systematically and rationally allocate acquisition costs of operational assets to periods benefited by their use. Cost Allocation Acquisition Cost Expense (Unused)(Used) Depreciation Concepts

cost allocation Depreciation is a cost allocation process and has nothing to do with asset valuation. Depreciation Concepts

Depreciation Expense Temporary account, reported on the income statement. Balance in Depreciation Expense indicates how much depreciation has been recorded in the current year. Accumulated Depreciation Permanent account, reported on the balance sheet as a deduction from plant assets. Balance in Accumulated Depreciation is a cumulative total of all depreciation recorded on an asset. Depreciation Concepts

Net property, plant, and equipment is the undepreciated cost (book value) of the plant assets. Depreciation on the Balance Sheet

Depreciation is a means of cost allocation. It is not a method of valuation. Depreciation involves: allocating the cost of tangible assets to expense in a systematic and rational manner to periods expected to benefit from use of its depreciable assets. 8 Depreciation Concepts

Asset cost Service life Residual value Method of cost allocation Factors Involved in Depreciation

Residual Value Residual, or salvage value, is the net amount that can be expected to be obtained when the asset is disposed. Factors Involved in Depreciation

Service Life Service life is the measure of the number of units of service expected from the asset before its disposal. Factors Involved in Depreciation

Service Life The factors that limit the service life of an asset can be divided into two general categories.  Physical causes  Functional causes Factors Involved in Depreciation

Straight-line. Based on inputs and outputs. Service hours (SH) method. Productive output (PO) or units-of-production method. Accelerated methods. Sum-of-the-years?digits (SYD). Double-declining-balance (DB). Tax depreciation. Depreciation systems. Inventory appraisal. Group and composite. Depreciation Methods