COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Investments in Noncurrent Operating Assets- Acquisition Chapter 10 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Modified by A. Phassawan S.

Learning Objectives 1.Identify cost of different types of noncurrent operating assets. 2.Properly account for noncurrent operating asset acquisitions using basket purchase, deferred payment and self-construction. 3.Accounting for the acquisitions of intangible assets.

What Costs are Included in Acquisition Cost? Initially record the noncurrent operating assets (tangible & intangible) at cost. –The original bargained or cash sale price. –It also includes all expenditures required to obtain asset and place it in use. Any taxes, freight, installation, and other expenditures related to the acquisition should be include in the asset’s cost. –Postacquisition costs, costs incurred after the asset is placed into service, are usually expensed., except some major replacements or improvements.

Tangible Assets- Land Purchase price, commissions, legal fees escrow fees, surveying fees Clearing and grading costs Cost of removing unwanted structures Assessments for water lines, sewers, roads Land: Realty used for business purposes

Tangible Assets- Land Improvements Landscaping Paving parking lots On-property sidewalks Light structures (for parking and sidewalks) Fencing Cost of improvements, including expenditures for materials, labor, and overhead

Tangible Assets- Building If ready for use: –Purchase price –Commissions, legal fees, escrow fees, reconditioning costs If newly constructed by an outsider: –Contract Price –Legal Fees If self constructed: –Cost of materials, –Labor –Overhead

Tangible Assets- Equipment Purchase price Taxes, freight, insurance during shipping and installation Special foundations or reinforcing of floors Reconditioning and testing costs Note: Any expenditure incurred in preparing the asset for its intended use is charged to Equipment. Equipment: Assets used in the production of goods or in providing services. E.g. automobile, truck, machine, fixture & Furniture

Intangible Assets Patent –An exclusive right granted by a government that enables an inventor to control the manufacture, sale, and use of an invention. – COST: Purchase price, filing and registry fees, cost of subsequent litigation to protect right.

Intangible Assets Trademark –An exclusive right granted by a government that permits the use of distinctive symbols, labels, and designs. – COST: Same as Patent. Copyright –An exclusive right granted by a government that permits an author to sell, license, and control his or her work. – COST: Same as Patent.

Intangible Assets Franchise agreement –An exclusive right received by a business or individual to perform certain functions or sell certain products or services. – COST: Expenditures made to purchase the franchise. Legal fees and other costs incurred in obtaining the franchise.

Intangible Assets Goodwill –Miscellaneous intangible resources, factors, and conditions that allow the company to earn above normal income with its identifiable net assets. –It is recorded only when a business entity is acquired by a purchase. – COST: Portion of purchase price that exceeds the sum of the current market value for all identifiable net assets.

Learning Objectives 1.Identify cost of different types of noncurrent operating assets. 2.Properly account for noncurrent operating asset acquisitions using basket purchase, deferred payment and self-construction. 3.Accounting for the acquisitions of intangible assets.

Acquisitions Other than Simple Cash Transactions Basket purchase Deferred payment Leasing Exchange of nonmonetary assets Acquisition by issuance of securities Self-construction Acquisition by donation or discovery Acquisition of an asset with significant restoration costs at retirement Acquisition of the entire company

A number of assets may be acquired in a “basket purchase” for one lump sum. The total purchase price must be allocated among the individual assets. Basket purchase: Allocate cash price to individual assets based on percentage of appraised or fair market value. Basket Purchase

Ex: Land, buildings, and equipment are acquired for $160,000. The appraisal values at the acquisition date are: land, $56,000; buildings, $120,000; equipment, $24,000. Land$ 56,000 Buildings 120,000 Equipment 24,000 $200,000 $56/$200 x $160,000 = $ 44,800 $120/$200 x $160,000 = 96,000 $24/$200 x $160,000 = 19,200 $160,000

Basket Purchase The entry to record this acquisition, assuming a cash purchase. Land 44,800 Buildings 96,000 Equipment 19,200 Cash160,000 This cost allocation is important because depreciable assets may have different useful lives and some assets are non depreciable.

The acquisition of real estate or other property often involves deferred payment of all or part of the purchase price. The buyer signs a note or a mortgage that specified the terms of settlement of the obligations. –The debt contract may call for (1) one payment at a given future date or (2) a series of payments at specified intervals. –Interest charged on the unpaid balance is an expense. Deferred Payment

Land is acquired on Jan 2, 08 for $100,0000; $35,000 is paid at the time of purchase, and the balance is to be paid in semiannual installments of $5,000 plus interest on the unpaid principal at an annual rate of 10%. The first payment is due on June 30,08. Jan 2, 2008 Land 100,000 Cash 35,000 Notes Payable 65,000 June 30, 2008 Interest Expense 3,250* Notes Payable 5,000 Cash8,250 *$65,000 x 5% Ex. 1: The contract specified both a purchase price and interest at a stated rate on the unpaid balance

Deferred Payment Ex. 2: The contract may (1) provide for a payment or a series of payment without reference to interest or (2) may provide for a stated interest rate that is unreasonable in relation to the market. Solution: The note, the sales price, and cost of property, goods, or services exchanged for the note, should be recorded at (1)the FMV of the property, goods, or services, OR (2)The current market value of note Whichever value is more clearly determinable.

Deferred Payment On January 2, 08, equipment with a cash price of $50,000 is acquired under a deferred payment contract. The contract specifies a down payment of $15,000 plus seven annual payments of $7, 189 each (a total price, including interest of $65,323). On January 2, 08, equipment with a cash price of $50,000 is acquired under a deferred payment contract. The contract specifies a down payment of $15,000 plus seven annual payments of $7, 189 each (a total price, including interest of $65,323). (1) What is the different between cash price and the down payment? (2) What is the effective interest rate implicit in this contract? $35,000 10% PV n = R (PVAF ni ) 35,000 = 7,189 (Table IV 7i ) = (Table IV 7i ) = 10%

Deferred Payment As the FMV of asset $50,000 varies from the contract price $65,323 (due to delayed payments), the difference should be recorded at a discount (contra liability) and amortize over the life of the contract. Equipment 50,000 Discount on Notes Payable 15,323 Notes Payable 50,323 Cash 15,000

Deferred Payment 12/31/08: Made first payment of $7,189. Amortization of debt discount: [($50,323 – $15,323) = $35,000 x 10%] = $3,500. Note payable 7,189 Cash 7,189 Interest Expense3,500 Discount on note payable 3,500

Deferred Payment 12/31/09 : Made second payment of $7,189 and amortized debt discount: Notes Payable7,189 Cash7,189 Interest Expense3,131 Discount on Notes Payable3,131 N/P : $50,323 – $7,189 = $43,134 Discount: $15,323 – $3,500 = 11,823 $31,311 31,311 x 10 % $ 3,131

Self-Construction Self-construction assets –Like purchase, the assets are recorded at cost, including all expenditures incurred to build the asset and make it ready for its intended use.

Interest During Period of Construction When assets are acquired by self-construction, interest incurred on funds borrowed to finance construction can be capitalized. Capitalized interest is the interest added to the cost of a self-constructed, long-term asset; instead of being expensed on the current period’s income statement. This capitalized interest will be part of the asset’s cost reported on the balance sheet, and will be part of the asset’s depreciation expense that will be reported in future income statements.

Interest Capitalization: Basic Guidelines Interest charges begin when the first expenditures are made on the project and continue until the asset is completed. Interest capitalization is calculated on average amount of accumulated expenditures, meaning cash disbursement, not accruals. Interest rate used is in the following order: (1) actual rate on debt incurred specifically for the project (2) weighted average interest rate on all borrowings not specifically for the project. If the construction period covers more than one fiscal period, accumulated expenditures include prior years’ capitalized interest. The maximum interest that can be capitalized is the total interest incurred for the year.

Interest Capitalization- Example Construction will begin January 1, It is estimated that the construction period will be about 18 months. Construction costs are estimated at $6.4 million, excluding capitalized interest. A 12%, $2 million construction loan is obtained and will become effective on January 1, 2008, at the beginning of construction. Cutler, Inc., a construction company, decides to build a new computerized assembly plant.

Interest Capitalization Cutler Industries, Inc.’s other debts are: –5-year, 11% notes payable$3,000,000 –9% mortgage4,800,000 **Used to calculate the weighted-average interest rate on the nonconstruction debts** Notes payable$3,000,00011%$330,000 Mortgage 4,800,0009% 432,000 $7,800, % $762,000 Notes payable$3,000,00011%$330,000 Mortgage 4,800,0009% 432,000 $7,800, % $762,000

Interest Capitalization 2008 Expenditures incurred on the project were: –January 1:$1,200,000 –October 1:1,800,000 3,000,000 Expendi- Interest Fraction Capital- ture Cap. of the Year ized Date Amount Rate O/S Interest 01/01/08$1,200,00012%12/12$144,000 10/01/08800,000123/1224,000 1,000, /12 24,500 Total capitalized interest for 2008$192,500

Interest Capitalization Remember that the amount of interest capitalized cannot exceed total interest incurred during the year. The actual interest was $1,002,000 and the calculated interest was $192,500 (interest capitalized). Thus, the 2008 entry is as follows: The actual interest was $1,002,000 and the calculated interest was $192,500 (interest capitalized). Thus, the 2008 entry is as follows: Construction in Progress 192,500 Interest Expense 809,500 Cash1,002,000

Interest Capitalization Income Statement Other expenses and losses: Total interest incurred 1,002,000 Less Capitalized interest 192, , 500

Interest Capitalization Assume that additional construction expenditures of $3,200,000 were made on Feb 1, 2009, and the project was completed on May 31, 2009 Expendi- Interest Fraction Capital- ture Cap. of the Year ized Date Amount Rate O/S Interest Accumulated in 2008$2,000,00012%5/12$100,000 1,192, /12 48,694 02/01/093,200, /12104,533 Total capitalized interest for 2009$253,227

Interest Capitalization Remember that the amount of interest capitalized cannot exceed total interest incurred during the year. The actual interest was $1,002,000 and the calculated interest was $253,227 (interest capitalized). Thus, the 2009 entry is as follows: The actual interest was $1,002,000 and the calculated interest was $253,227 (interest capitalized). Thus, the 2009 entry is as follows: Construction in Progress 253,227 Interest Expense 748,773 Cash1,002,000

Interest Capitalization Total recorded cost of the building on May 31, 09, which is put into service is; Expenditure incurred in 2008 $3,000,000 Interest capitalized ,500 Expenditure incurred in ,200,000 Interest capitalized ,227 Total building cost, May 31, 2009 $6,645,727

Learning Objectives 1.Identify cost of different types of noncurrent operating assets. 2.Properly account for noncurrent operating asset acquisitions using basket purchase, deferred payment and self-construction. 3.Accounting for the acquisitions of intangible assets.

Accounting for the Acquisition of Intangibles 1.Intangible acquired in a basket purchase Same as tangible assets 2.Intangible acquired in the acquisition of a business Goodwill is the a residual amount Use the fair market value to record the acquired assets. + Goodwill is recorded on debit. - Goodwill is allocated to reduce the record amounts of the noncurrent assets (and acquired R&D) based on their relative fair value.