1. Intermediate Accounting
Chapter 10
Property, Plant, and Equipment: Acquisition and Subsequent Investments
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2. Objectives
Describe the characteristics of property, plant, and equipment.
Identify the costs to be included in the acquisition of property, plant, and equipment.
Determine the cost of property, plant, and equipment obtained by a nonmonetary exchange of assets.
Compute the cost of a self-constructed asset, including capitalized interest.
Describe the accounting for expenditures incurred subsequent to acquisition.
(Appendix 10.1) Explain the accounting for oil and gas properties.
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3. What are the Characteristics of Property, Plant, And Equipment
What are the Characteristics of Property, Plant, And Equipment? (Slide 1 of 3)
Property, plant, and equipment (alternatively called plant assets, fixed assets, or operational assets) are the tangible noncurrent assets that a company uses in the normal operations of its business.
To be included in this category, an asset must have three characteristics:
The asset must be held for use in operations and not for investment. This characteristic does not imply that the asset must be continuously used. For example, the furniture and fixtures in coffee shops are included in its property, plant, and equipment. However, the companies that sold these items to the coffee shop would categorize them as inventory.
The asset must have an expected life of more than one year. The asset represents future economic benefits, or service potential, that the company will receive over the life of the asset as it is used in the normal course of business.
The asset must be tangible in nature. There must be a physical substance that can be seen and touched.
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4. What are the Characteristics of Property, Plant, And Equipment
What are the Characteristics of Property, Plant, And Equipment? (Slide 2 of 3)
A company initially records property, plant, and equipment assets at acquisition, or historical, cost.
Because the asset is expected to provide economic benefits to the company over a period of more than one year, the company allocates the cost of the asset as an expense to each period in which the asset is used and the company receives benefits.
The use of historical cost as the basis for reporting property, plant, and equipment provides several advantages:
The historical cost is equal to the fair value at the date of acquisition.
The cost provides a verifiable valuation of the asset.
Gains from holding the asset are recognized only when realized through a sale transaction.
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5. What are the Characteristics of Property, Plant, And Equipment
What are the Characteristics of Property, Plant, And Equipment? (Slide 3 of 3)
Because depreciation is a process of cost allocation rather than of valuation, the net book value of an asset (cost minus accumulated depreciation) does not necessarily reflect the economic value of the asset.
GAAP requires that a company report its property, plant, and equipment at its depreciated cost (cost minus accumulated depreciation).
However, when the asset becomes impaired such that its fair value is less than its book value, the asset must be written down to fair value.
Under U.S. GAAP, companies are not allowed to write up an asset if its fair value is above its historical cost. (IFRS allows this.)
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6. Real Report: Starbucks’ Property, Plant, and Equipment Disclosure (Slide 1 of 3)
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7. Real Report: Starbucks’ Property, Plant, and Equipment Disclosure (Slide 2 of 3)
Questions:
What characteristics do these assets possess that allow Starbucks to classify them as property, plant, and equipment?
Starbucks’ property, plant, and equipment have three characteristics. They are used in the business and have a life greater than a year. As noted in the notes to the financial statements, the expected lives range from 2 to 40 years. Finally, all of the fixed assets are tangible in nature.
At what value does Starbucks’s report its property, plant, and equipment?
Starbucks reports $2,416.5 million of NET property, plant, and equipment… cost ($5,888.7 million) minus accumulated depreciation ($3,472.2 million).
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8. Real Report: Starbucks’ Property, Plant, and Equipment Disclosure (Slide 3 of 3)
Why does Starbucks report both the cost of property, plant, and equipment and accumulated depreciation instead of only the net amount?
Initially, Starbucks records its property, plant, and equipment at historical costs. GAAP requires that companies report both the historical cost valuation of property, plant, and equipment and the related accumulated depreciation.
What type of asset is work in progress?
Work in progress represents the cost of self-constructed property, plant, and equipment that has not yet been completed.
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9. How Do We Account for the Acquisition of Property, Plant And Equipment?
The major types of assets that a company includes in the category of property, plant, and equipment are land, buildings, equipment, and leasehold improvements.
Natural resources, such as timberlands, oil deposits, and mineral deposits, are also included as property, plant, and equipment.
The acquisition cost of property, plant, and equipment includes all costs necessary to obtain the benefits to be derived from the asset.
contract price; minus discounts taken; plus freight, assembly, installation, testing costs and retirement obligation
GAAP allows a company to either
(1) include discounts not taken as part of the cost of the asset or
(2) subtract discounts not taken from the cost of the asset and report them as an expense.
Most companies prefer the second approach.
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10. Land The recorded cost of land includes the following:
contract price
costs of closing the transaction and obtaining title, including commissions, options, legal fees, title search, insurance, and past due taxes
costs of surveys
costs of preparing the land for its particular use, such as clearing, grading, and removing old buildings (net of any proceeds from salvage) when such improvements have an indefinite life
government assessments for streets, sidewalks, sewers, and water lines for which the government is responsible for the upkeep and are permanent in nature
Because land has an indefinite economic life and its residual value is unlikely to be less than its acquisition cost, land is not depreciated.
If land is not currently used in operations, but purchased for future use, it is more representationally faithful to classify it as an investment.
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11. Example: Land
Trotter Company purchases a parcel of land as a site for a new warehouse for $150,000. Trotter demolished an existing building on the property and began construction of the warehouse. In addition to the purchase price, Trotter incurred the following costs:
Trotter was able to sell salvaged materials from the demolished building for $1,000 (subtracted from cost of land).
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12. Land Improvements and Buildings
A company will often make expenditures that improve the usefulness of the property, such as landscaping, paving, and fencing.
Because these improvements have a limited economic life, a company should record the costs of these improvements in a Land Improvements account and depreciate them over their economic lives.
The recorded cost of buildings includes the following:
contract price
costs of remodeling and reconditioning
costs of excavation for the specific building
architectural costs and the costs of building permits
capitalized interest costs
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13. Equipment
Equipment is a broad term that includes machinery, furniture and fixtures, office equipment, vehicles, and similar assets.
The recorded cost of equipment includes the following:
purchase price, minus any discounts taken, plus sales tax
transportation costs, plus any insurance costs on the equipment while in transit
installation or assembly costs
initial testing costs
Therefore, if the cost is necessary to obtain the equipment and prepare it for use, it should be capitalized as property, plant, and equipment.
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14. Example: Equipment
Devon Company purchases a machine with a contract price of $100,000 on terms of 2/10, n/30. Devon pays within the discount period and incurs transportation costs of $2,500, as well as installation and testing costs of $3,000. Sales tax is $7,000. During the installation of the machine, uninsured damages of $500 are incurred and paid by the company.
The cost of the machine is $110,500 ($100,000 − $2,000 + $2, $3,000 + $7,000). Devon makes the following journal entry to record these costs:
Note that Devon does not include the $500 of damages in the cost of the asset because it was not a “necessary” cost.
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15. Leasehold Improvements
Improvements made by the lessee to leased property that, unless specifically exempted in the lease agreement, revert to the lessor at the end of the lease
Therefore, a lessee capitalizes the cost of a leasehold improvement, such as the interior design of a retail store, and depreciates the cost over its economic life or the life of the lease, whichever is shorter.
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16. Summary: Property, Plant and Equipment
A company’s decision to expense a cost immediately, to capitalize it as a depreciable asset (e.g., building, equipment), or to capitalize it as a nondepreciable asset (e.g., land) has an impact on both the company’s income statement and balance sheet.
The general procedure is to determine whether incurring the cost will provide economic benefits for the company beyond the current period and, if so, which asset is associated with the expected future benefits.
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17. Property, Plant and Equipment Ratios
Property, plant, and equipment are often a company’s primary productive assets.
Analysts and managers are interested in company’s ability to use its investment in fixed assets to generate sales.
One measure of this efficiency is the fixed asset turnover ratio, which computes the number of dollars of sales generated during a period relative to the average dollars invested in fixed assets.
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18. Asset Retirement Obligations
The acquisition of some operational assets create an asset retirement obligation—a legal obligation related to the retirement of the asset.
In some instances, asset retirement obligations arise from environmental responsibilities and laws, such as the requirement to decommission nuclear power plants at the end of their useful lives or to reclaim the land after mining or drilling operations have concluded.
In other settings, asset retirement obligations can arise from legal arrangements related to the use of an asset.
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19. Example: Asset Retirement Obligations
Reed Company spent $100,000 in the interior redesign of a retail store that it had acquired through a 10-year lease. The lease requires Reed to restore the leased building to its original condition upon termination of the lease. Reed estimates that in 10 years the restoration costs will be $31,125. Based on Reed’s 10% interest rate, the present value of these future restoration costs at the time of the redesign is $12,000. The following journal entry is made to record the leasehold improvement and the associated asset retirement obligation:
In subsequent periods, the asset is depreciated over its useful life. In addition, the company recognizes accretion expense, which is classified as an operating expense and represents the increase of the asset retirement obligation each year that the asset is used.
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20. Lump-Sum Purchase
A company may acquire several fixed assets for a single lump-sum purchase price. To account for the assets on an individual basis, the total purchase price must be allocated among the individual assets.
A company allocates the acquisition price in a lump-sum purchase based on the relative fair values of the individual assets. If only part of the purchase price can be identified with a specific asset, the specifically identified cost should be assigned to that asset with the remainder allocated among the remaining assets based on their relative fair values.
Evidence of fair value can be obtained from independent sources such as appraisals, assessed values for property taxes, or other reasonably accurate approximations of the assets’ market values.
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21. Example: Lump Sum Purchase
Sample Company pays $120,000 for land and a building. An appraisal of the land and building indicates values of $50,000 and $75,000, respectively. Sample allocates the lump-sum purchase price as follows:
Sample records the land at a cost of $48,000 and the building at a cost of $72,000. If the cost of obtaining an appraisal is material, the company should add it to the purchase price so it is allocated to the respective assets.
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22. Deferred (Future) Payments
When a company acquires property, plant, and equipment in exchange for making future payments, such as by issuing notes or bonds or assuming a mortgage, it records the asset at its fair value or the fair value of the liability on the date of the transaction, whichever is more clearly evident.
Note that GAAP’s fair value hierarchy allows a company to measure fair value as the present value of the future payments when observable market values are not available.
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23. Examples: Deferred Payments
Note with a Stated Interest Rate: Antush Company purchases equipment by issuing a $7,500, 5-year note with a stated interest rate of 12%, which is equivalent to the market rate of interest. Antush would record the acquisition as follows:
Non-Interest Bearing Rate: Antush Company purchases equipment by issuing a $10,000 non-interest-bearing 5-year note, when the market rate for obligations of this type is 12%. The note will be paid off at the rate of $2,000 at the end of each year. Because neither the fair value of the equipment nor the note is observable, Antush values the equipment at the present value of the payments, which is $7,210 ($2,000 × , the factor from Table 4 of the Time Value of Money Module for 5 years and a 12% rate). Antush records the acquisition of the equipment as follows:
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24. Issuance of Securities
When a company acquires property, plant, and equipment by issuing securities such as common stock or preferred stock, the company records the exchange at the fair value of the asset acquired or of the stock issued, whichever is more clearly evident and representationally faithful.
Normally the two fair value measures would be very similar, but if they are materially different, it is necessary to select one. In some situations, one of the values may be considered more representationally faithful because it is quoted in an active market.
Alternatively, if the stock is not actively traded but the asset is one that is commonly traded, the asset’s fair value would be the better choice.
If neither of the two fair values is readily observable, the company must assign the value that it believes to be the most faithful representation of the transaction (a level 3 input in the FASB’s fair value hierarchy).
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25. Example: Issuance of Securities
Barrett Company issued 10,000 shares of $1 par common stock in exchange for land. Barrett’s common stock, as evidenced by recent activity on a stock exchange, has a fair value of $15 per share. Barrett records this transaction as follows:
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26. Assets Acquired by Donation
In certain circumstances, when a company acquires property, plant, and equipment through donation, it is a nonreciprocal transfer of nonmonetary assets.
In general, GAAP requires that a donated asset should be recorded at its fair value with a corresponding increase in either revenue or gain, depending on whether the transaction was part of the company’s ongoing operations or was a peripheral or incidental transaction.
Example: Hrouda Company accepts a donation of a building worth $50,000. Hrouda records the donation as follows:
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27. Nonmonetary Asset Exchanges (Slide 1 of 2)
A nonmonetary exchange is a reciprocal transfer between a company and another entity in which the company acquires nonmonetary assets or services by surrendering other nonmonetary assets (Inventory, PP&E) or services (e.g., trade-in, swap).
In general, the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset is the fair value of the asset surrendered.
If the fair value of the asset received is more clearly evident than the fair value of the asset surrendered, it can be used to measure the cost of the asset acquired.
A gain or loss on the exchange is recognized as the difference between the fair value of the asset surrendered and its book value.
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28. Nonmonetary Asset Exchanges (Slide 2 of 2)
When a small amount of cash, often referred to as boot, is also given or received, the cost of the asset acquired and the gain or loss on the nonmonetary asset surrendered is determined by these equations:
AND
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29. Example: Exchanges of Nonmonetary Assets (Slide 1 of 2)
No Cash Included in the Exchange: Arnold entered into an agreement with Carbon to exchange one of its small buildings for a specialized piece of equipment owned by Carbon.
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30. Example: Exchanges of Nonmonetary Assets (Slide 2 of 2)
Cash Included in Exchange:
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31. Exception to the General Rule to Use Fair Value for Nonmonetary Exchanges
The conceptual basis of valuing the acquired asset at fair value and allowing for immediate gain or loss recognition is that, in most exchanges, the economic position of the two companies has changed as a result of the exchange.
When the company’s future cash flows are expected to significantly change as a result of the exchange, the transaction has commercial substance.
If an exchange does not have commercial substance and results in a loss, the general rule discussed earlier is followed. If the exchange does not have commercial substance and results in a gain, GAAP requires the gain to be deferred by reducing the cost of the asset.
If a nonmonetary exchange which lacks commercial substance results in a gain and cash is received, GAAP allows a portion of the gain to be recognized. The recognized gain is determined based on a proportion of the cash received to the total consideration received.
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32. Example: Exception to the General Rule to Use Fair Value for Nonmonetary Exchanges
Messenger Company owns a truck with a book value of $30,000 (cost of $50,000 and accumulated depreciation of $20,000) and a fair value of $33,000. Messenger exchanges the truck and $2,000 for a used truck from Leninger Company that has a fair value of $35,000. Because the trucks are so similar, Messenger’s cash flows are not expected to change significantly as a result of this exchange. Messenger would record the truck it received at $32,000, which is the fair value of the asset surrendered plus cash paid ($33, ,000) minus the $3,000 gain ($33,000 fair value of the truck surrendered − $30,000 book value of the truck surrendered). Messenger would record the exchange as follows:
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33. What Is The Cost Of Self-Constructed Assets?
Sometimes a company constructs an item of property, plant, and equipment that it intends to use in its operations.
Similar to purchased assets, the cost of a self-constructed asset includes all expenditures necessary to build the asset and put it in operating condition.
The costs directly related to construction—direct material and direct labor—and should be added to the cost of the asset.
The treatment of two other costs—overhead costs and interest costs— have generated considerable debate.
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34. Overhead Costs (Slide 1 of 2)
There are two alternatives for a company to include overhead costs in the cost of a self-constructed asset.
Allocate a portion of overhead to the self-constructed asset in the same manner it allocates overhead to units of inventory produced. Those in favor of this alternative argue that:
Construction related overhead is a relevant component of the asset’s cost and should be accounted for in the same way as regular products, even though this means that the regular products will be allocated less of the overhead.
The cost of the constructed asset will be a more faithful representation of the cost to acquire and prepare the asset for use.
Allocating overhead to self-constructed assets enhances comparability with the cost of an equivalent purchased asset because the seller normally would include fixed overhead in its selling price.
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35. Overhead Costs (Slide 2 of 2)
2. Include only the incremental overhead in the cost of the self- constructed asset. Those in favor of this alternative argue that:
To be representationally faithful, the cost of the asset should only include the additional costs incurred to produce it.
To be comparable, the allocation of overhead to normal operations should not change because the overhead would have been incurred whether or not the construction takes place.
Common practice is to allocate both variable overhead and a proportional share of fixed overhead to self-constructed assets.
If the allocation of overhead causes the cost of the self-constructed asset to be greater than the fair value of the asset, the asset should be recorded at its fair value with the excess recognized as a loss in the current period.
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36. Interest During Construction
The FASB considered three alternatives to account for interest (whether external financing costs or internal cost of capital) during the construction of property, plant, and equipment.
Do not capitalize any interest during construction. Under this alternative, a company would treat interest as a financing cost and would record the interest as an expense during the period incurred.
Capitalize an amount of interest (actual or imputed) for all funds used for construction. Under this alternative, a company would assign an interest cost to all funds used in construction, whether borrowed or not.
Capitalize the actual interest on incremental funds borrowed for the construction. Under this alternative, a company would treat the cost of borrowed funds as part of the cost of constructing an asset, similar to the treatment of materials and labor.
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37. GAAP for Interest Capitalization (Slide 1 of 2)
To implement the approach required by GAAP, a company must address three issues:
Does the asset qualify for interest capitalization? A company is required to capitalize interest on assets that are either constructed for its own use (not land) or constructed as discrete projects for sale or lease to others. Interest cannot be capitalized for inventories that are routinely manufactured, assets that are in use or ready for their intended use, or assets that are idle and are not undergoing the activities necessary to get them ready for use.
Over what period can interest be capitalized? The capitalization period begins when (1) expenditures for the asset have begun, (2) activities that are necessary to get the asset ready for its intended use are in progress, and (3) interest cost is being incurred. The capitalization period ends when the asset is substantially complete and ready for its intended use.
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38. GAAP for Interest Capitalization (Slide 2 of 2)
What amount of interest can be capitalized? The amount of interest capitalized for a qualifying asset is the portion of the interest cost that could have been avoided if the construction had not occurred. This amount is known as avoidable interest. A company determines avoidable interest by applying an interest rate to the weighted average accumulated expenditures for the qualifying asset during the capitalization period. The specific steps necessary to determine the amount of avoidable interest that can be capitalized are described next.
If a company suspends substantially all the activities related to the construction of the asset, it suspends interest capitalization until the activities are resumed.
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39. Interest Capitalization Procedures (Slide 1 of 2)
Step 1: Determine the Weighted average accumulated expenditures for the period, defined as the sum of the construction expenditures weighted by the amount of time that interest cost could have been incurred on those expenditures during the construction period.
Step 2: Determine the appropriate interest rate.
If the weighted average accumulated expenditures are less than or equal to the funds borrowed specifically to finance the construction of a qualifying asset, the company uses the interest rate on that specific borrowing.
If the weighted average expenditures on the asset are greater than the specific borrowing or if no specific borrowing is made, the company uses both the interest rate on the specific borrowing and a weighted average interest rate on all other borrowings
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40. Interest Capitalization Procedures (Slide 2 of 2)
Step 3: Compute avoidable interest by applying the appropriate interest rate(s) to the weighted average accumulated expenditures.
Step 4: Capitalize the lesser of avoidable interest or actual interest. The total amount of interest cost that a company capitalizes each period may not exceed the actual interest cost incurred.
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41. Example: Self-Constructed Asset – Expenditures Less Than Borrowed (Slide 1 of 3)
On January 1, 2013, Cia Company started the construction of a building to use as its corporate headquarters. The project was completed and ready for occupancy on December 31, Cia incurred the following expenditures related to construction during 2013:
Cia had a $2,000,000, 12% note payable and a $4,000,000, 13% note payable, both of which are unrelated to the construction project, outstanding during the entire year.
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42. Example: Self-Constructed Asset – Expenditures Less Than Borrowed (Slide 2 of 3)
In order to finance construction, on January 1, 2013, Cia obtained a $1,000,000 construction loan with a 10% interest rate. Below shows the computation of capitalized interest related to Cia’s construction project when weighted average accumulated expenditures are less than the amount specifically borrowed for construction.
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43. Example: Self-Constructed Asset – Expenditures Less Than Borrowed (Slide 3 of 3)
Cia would make the following journal entry to record total interest cost incurred, assuming that all interest was paid in cash:
In future periods, Cia will depreciate the capitalized interest cost over the useful life of the building.
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44. Example: Self-Constructed Asset – Expenditures More Than Borrowed (Slide 1 of 3)
In order to finance construction, on January 1, 2013, Cia obtained a $400,000 construction loan with a 10% interest rate. Cia will finance the remainder of the construction with internally generated funds.
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45. Example: Self-Constructed Asset – Expenditures More Than Borrowed (Slide 2 of 3)
Cia would make the following journal entry to record total interest cost incurred, assuming that all interest was paid in cash:
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46. Example: Self-Constructed Asset – Expenditures More Than Borrowed (Slide 3 of 3)
Because weighted average accumulated expenditures exceed the amount borrowed specifically for construction, the interest rate on the specific borrowing is used to compute avoidable interest for an amount up to the construction-related borrowing. For the excess of weighted average accumulated expenditures over the amount of the construction loan, a weighted average interest rate on other borrowings is used.
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47. Capitalized Interest – Multiple Accounting Periods
It is common for the construction project to extend beyond the end of a company’s fiscal year.
In this situation, the procedure shown previously is repeated for the subsequent year with one adjustment—the total expenditures plus capitalized interest from the previous year is considered to be an outstanding expenditure as of the first day of the subsequent year.
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48. Example: Capitalized Interest – Multiple Accounting Periods (Slide 1 of 3)
Using the information in the previous Example, assume that Cia’s construction project was not completed and ready for occupancy until March 1, In order to finance construction, on January 1, 2013, Cia obtained a $1,000,000 construction loan with a 10% interest rate. In addition to $1,200,000 of expenditures and $58,750 of capitalized interest in 2013, Cia incurred the following expenditures related to construction during 2014:
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49. Example: Capitalized Interest – Multiple Accounting Periods (Slide 2 of 3)
The computation of capitalized interest for the second year of Cia’s construction project is as follows.
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50. Example: Capitalized Interest – Multiple Accounting Periods (Slide 3 of 3)
On January 1, 2014, the expenditure amount represents the total expenditures plus capitalized interest from Second, because the capitalization period ends when construction is complete (March 1, 2014), all expenditures receive a weighting from the beginning of the year to the end of the construction period. Cia would make the following journal entries to record total interest cost incurred, assuming that all interest was paid in cash:
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51. Impact of Interest Capitalization
When a company capitalizes interest costs instead of expensing them, it triggers two effects on the financial statements:
The company will report higher amounts for property, plant, and equipment due to the capitalized interest being added to the acquisition cost of the equipment.
The company does not report the capitalized amount of interest as interest expense during the construction period. Therefore, the company will report higher income than it otherwise would if it had expensed the full amount of interest. In addition, all things being equal, the capitalized interest will result in higher depreciation expense in future periods. Therefore, the capitalization of interest is essentially a question of asset valuation and timing of the expense recognition.
GAAP requires that companies disclose both the capitalized interest amount and the total interest cost incurred in the notes to its financial statements.
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52. How Do We Account for Expenditures Subsequent to Acquisition
How Do We Account for Expenditures Subsequent to Acquisition? (Slide 1 of 2)
After initial acquisition, companies make various expenditures relating to property, plant, and equipment for purposes ranging from routine repairs to major overhauls and improvements.
The related accounting decision is whether to report these expenditures as investments that enhance property, plant, and equipment or to expense them.
Conceptually, if the expenditure is expected to increase the future economic benefits of the asset, it should be capitalized (recorded as an asset).
Otherwise, it should be recorded as an expense.
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53. How Do We Account for Expenditures Subsequent to Acquisition
How Do We Account for Expenditures Subsequent to Acquisition? (Slide 2 of 2)
An expenditure that increases the expected future economic benefits of the asset above those that originally were expected is called a capital expenditure.
The future economic benefits can be increased by:
extending the life of the asset
improving productivity of the asset by enabling the asset to produce more goods at the same cost or by producing the same quantity of goods at a lower cost
increasing the quality of the product
An expenditure that does not increase the economic benefits but is incurred to maintain the existing benefits is an operating expenditure (revenue expenditure) and is expensed in the period incurred.
Many companies establish a lower limit, or materiality threshold, on the amount of expenditure that will be capitalized. Any amount below the lower limit will be expensed, regardless of whether it provides future benefits or not.
Subsequent expenditures can be classified as additions, improvements and replacements, rearrangements, and repairs and maintenance.
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54. Additions
An addition involves enlarging an existing asset by adding a new component and they are capitalized as an asset.
When an addition involves changing an existing asset, an issue arises as to how to account for the cost of such changes.
Example: When a company adds a new wing to a building, it frequently makes alterations to the old building. If these alterations are necessary to acquire and prepare the addition for use, or if the alterations increase the economic benefits originally anticipated for the old building, the cost of alteration is capitalized as an asset. If the alterations do not increase the original benefits of the old building, the cost is expensed.
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55. Improvements and Replacements (Slide 1 of 4)
An improvement (betterment) is the substitution of a better asset for the one currently used, such as the installation of a new solar heating system in a building.
A replacement (renewal) is the substitution of an equivalent asset, such as a new engine in a truck. Expenditures related to improvements and replacements are capitalized as assets.
There are three alternative methods for a company to account for such capitalized expenditures:
Substitution
Reduction of Accumulated Depreciation
Capitalization as a New Asset
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56. Improvements and Replacements (Slide 2 of 4)
Substitution: Under this method, the book value of the old asset is removed and a new asset is recorded. This only works if the book value of the old asset is known. This may not happen when purchased as part of a bigger asset, like a building.
Example Pippa Company decides to replace its old oil furnace with a new gas furnace. The oil furnace has a historical cost of $50,000 with accumulated depreciation of $30,000. The scrap value of the old furnace is $5,000, and the new furnace costs $70,000. Pippa records this transaction as follows:
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57. Improvements and Replacements (Slide 3 of 4)
Reduction of Accumulated Depreciation: This method reduces accumulated depreciation, thereby increasing the asset’s book value, for the cost of the improvement or replacement. This method is appropriate when the expenditure extends the service life of the asset which, in effect, restores some of the service potential of the asset that had previously been depreciated.
Example Bradbury Company incurs a capital expenditure of $60,000 to replace a roof on its factory. Bradbury had not planned to replace the roof, but the replacement has extended the life of the factory. Bradbury records the cost as follows:
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58. Improvements and Replacements (Slide 4 of 4)
Capitalization as a New Asset: Under this method, the expenditure is capitalized as a new asset without removing the carrying amount of the old asset. This method is most appropriate for additions. This method is also appropriate for improvements and replacements, particularly if the book value of the old asset has been sufficiently depreciated to an immaterial amount.
Example Heller Company records a capital expenditure of $80,000 to enlarge a factory that increases its usefulness as follows:
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59. Rearrangement and Moving
The costs of rearranging the facilities within a building or moving them to a new location are capitalized as assets and depreciated over the period expected to benefit.
If these costs are immaterial or if it’s uncertain that the costs will provide future benefits, the company should expense such costs in the period incurred.
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60. Repairs and Maintenance
Routine expenditures for repair and maintenance do not increase the future economic benefits of the asset but, instead, maintain the existing benefits provided by the asset and should be expensed in the period incurred.
Examples include expenditures such as painting, lubricating a machine, and making periodic adjustments to equipment
Usually a company expenses the cost of these major repairs.
If these repairs increase the future benefits of the asset similar to an improvement or replacement, the cost should be capitalized.
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61. Oil and Gas Properties (Slide 1 of 2)
Conceptually, any exploration costs that provide future benefits should be capitalized.
Differences of opinion exist as to the proper accounting for unsuccessful exploration activities.
Two alternative methods exist.
Successful-efforts method—Only those exploration costs that result in the discovery of oil and gas are capitalized as part of the oil and gas reserve and amortized as the oil and gas is produced.
Full-cost method—All costs incurred in the exploration and discovery of oil and gas—even the costs associated with dry wells—are capitalized as part of cost of the oil and gas reserves that are discovered, and amortized as the oil and gas is produced.
The principal difference between the two methods concerns the treatment of the cost of dry wells.
Both methods are used extensively.
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62. Oil And Gas Properties (Slide 2 of 2)
Regardless of the accounting policy regarding exploration costs, GAAP requires the following disclosures:
Estimates of quantities of proven oil and gas reserves—oil and gas reserves which are expected to be recoverable with reasonable certainty
Capitalizable costs related to oil and gas activities
Results of operations of oil- and gas-producing activities
A standardized measure of discounted future cash flows
Change in standardized future cash flows
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