1. Types of Operational Assets
Actively Used in Operations
Expected to Benefit Future Periods
Tangible
Property, Plant, Equipment & Natural Resources
Intangible
No Physical Substance
Operational assets are assets that are used actively in the operations of the business, and that are expected to benefit the operations into the future.
There are two major categories of operational assets. Tangible operational assets have physical substance. Included in this category are land, buildings, equipment, machinery, vehicles, and natural resources such as oil, gas, and mineral deposits. Intangible assets are operational assets without physical substance. Included in this category are patents, copyrights, trademarks, franchises, and goodwill.

2. Costs to be Capitalized
General Rule The initial cost of an operational asset includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.
Operational assets may be acquired in a number of ways. Regardless of the method of acquisition, the assets are recorded at their original cost. The recorded cost includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.

3. Costs to be Capitalized Equipment
Net purchase price
Taxes
Transportation costs
Installation costs
Modification to building necessary to install equipment
Testing and trial runs
The costs to be capitalized for equipment include:
The net purchase price, less discounts.
Taxes.
Transportation costs.
Installation costs.
Modification to a building necessary to install the equipment.
Testing and trial runs.
Recurring & maintenance costs may not be capitalized

4. Brief Exercise 10-1
Beaverton Lumber purchased a milling machine for $35,000. In addition to the purchase price, Beaverton made the following expenditures:
freight, $1,500;
installation, $3,000;
testing, $2,000;
Annual personal property tax (not sales or use related) on the machine for the first year, $500.
What is the initial cost of the machine?

5. Brief Exercise 10-1 Capitalized cost of the machine:
Purchase price $35,000
Freight 1,500
Installation 3,000
Testing ,000
Total cost $41,500
Note: Personal property taxes on the machine for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred.

6. Costs to be Capitalized Land
Purchase price
Real estate commissions
Attorney’s fees
Title search
Title transfer fees
Title insurance premiums
Removing old buildings
Land is not depreciable.
The cost of land includes:
The purchase price.
Real estate commissions.
Attorney’s fees.
Title search.
Title transfer fees.
Title insurance premiums.
The cost of making the land ready for its intended use, including the cost of removing old buildings.
Unlike other operational assets in the property, plant and equipment category, land is not depreciated.

7. Costs to be Capitalized Land Improvements
Separately identifiable costs of
Driveways
Parking lots
Fencing
Landscaping
Private roads
Land improvements are enhancements to property such as driveways, parking lots, fencing, landscaping, and private roads. These are separately identifiable costs that are recorded in the land improvement asset account rather than in the land account. Unlike land, land improvements are depreciated.
These will be depreciated

8. Costs to be Capitalized Buildings
Purchase price
Attorney’s fees
Commissions
Reconditioning
The cost of buildings includes:
The purchase price.
Real estate commissions.
Attorney’s fees.
Reconditioning costs to get the building ready for use.
Long term leasehold improvements are also capitalized.

9. Brief Exercise 10-2
Fullerton Waste Management purchased land and a warehouse for $600,000. In addition to the purchase price, Fullerton made the following expenditures related to the acquisition:
broker’s commission, $30,000;
title insurance, $3,000
miscellaneous closing costs, $6,000.
The warehouse was immediately demolished at a cost of $18,000 in anticipation of the building of a new warehouse.
Determine the amounts Fullerton should capitalize as the cost of the land and the building.

10. Brief Exercise 10-2 Capitalized cost of land: Total cost $657,000
Purchase price $600,000
Broker’s commission ,000
Title insurance ,000
Misc. closing costs ,000
Demolition of old building 18,000
Total cost $657,000
All of the expenditures, including the costs to demolish the old building, are included in the initial cost of the land.

11. Lump-Sum Purchases
Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices.
Allocation of the lump-sum price is based on relative values of the individual assets.
Part I.
Lump-sum purchases occur when a group of assets is acquired for a single purchase price.
Part II.
The lump-sum purchase price is allocated to assets based on relative fair values of the individual assets.
Asset 1
Asset 2
Asset 3

12. Lump-Sum Purchases
On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500.
How much of the $200,000 purchase price will be charged to the building account?
Let’s look at an example of a lump-sum purchase involving land and a building.
On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500.
How much of the $200,000 purchase price will be charged to the building account?

13. Lump-Sum Purchases The building will be apportioned $130,000
of the total purchase price of $200,000.
First, we calculate the allocation percentages by dividing the appraised value of each asset by the total of the appraised values. For example, the total of the building appraisal of $162,500 and the land appraisal of $87,500 is $250,000. Dividing $162,500 by $250,000 gives us an allocation percentage of 65 percent for the building.
We multiply the allocation percentage times the lump-sum purchase price to obtain the amount allocated to each asset. For the building, 65 percent of the $200,000 purchase price is $130,000 dollars.
You should verify the computations for the land before proceeding to the next slide.
Prepare the journal entry to record the purchase.

14. Lump-Sum Purchases
The entry to record the lump-sum purchase results in a debit to land for $70,000, a debit to building for $130,000, and a credit to cash for $200,000.

15. Brief Exercise 10-3
Refer to the situation described in BE Assume that Fullerton decides to use the warehouse rather than demolishing it. An independent appraisal estimates the market values of the land and warehouse at $420,000 and $280,000, respectively.
Determine the amounts Fullerton should capitalize as the cost of the land and the building.

16. Brief Exercise 10-3 Cost of land and building: Total cost $639,000
Purchase price $600,000
Broker’s commission ,000
Title insurance ,000
Miscellaneous closing costs ,000
Total cost $639,000
The total must be allocated to the land and building based on their relative market values:

17. Brief Exercise 10-3

18. Costs to be Capitalized Natural Resources
Purchase price, exploration and development costs of:
Timber
Mineral deposits
Oil and gas reserves
The cost of natural resources include the purchase price, exploration and development costs, and restoration costs.

19. Asset Retirement Obligations
Often encountered with natural resource extraction when the land must be restored to a useable condition.
Recognize as a liability and a corresponding increase in the related asset.
Asset retirement obligations are often encountered with natural resource extraction when a company is required to restore the land to the original condition or to a useable condition. An asset retirement obligation is recorded as a liability and a corresponding increase in the related asset. The amount recorded is the present value of future cash flows expected to be incurred for the reclamation or restoration.
Record at fair value, usually the present value of future cash outflows associated with the reclamation or restoration.

20. BE 10-4
Smithson Mining operates a silver mine in Nevada. Acquisition, exploration, and development costs totaled $5.6 million. After the silver is extracted in approximately five years, Smithson is obligated to restore the land to its original condition, including constructing a wildlife preserve.
The company’s controller has provided the following three cash flow possibilities for the restoration costs: (1) $500,000, 20% probability; (2) $550,000, 45% probability; and (3) $650,000, 35% probability. The company’s credit-adjusted, risk-free rate of interest is 6%.
What is the initial cost of the silver mine?

21. Solution

22. BE 10-5
Refer to the situation described in BE What is the carrying value of the asset retirement liability at the end of one year?
Assuming that the actual restoration costs incurred after extraction is completed are $596,000, what amount of gain or loss will Smithson recognize on retirement of the liability?

23. Solution BE10-5
Or 429,675 x 1.06

24. Noncash Acquisitions Issuance of equity securities Deferred payments
Donated assets
Exchanges
The asset acquired is recorded at
the fair value of the consideration given or
the fair value of the asset acquired,
whichever is more clearly evident.
Companies sometimes acquire assets without paying cash. Assets may be acquired by issuing debt or equity securities, by receiving donated assets, or by exchanging other assets.
In any noncash acquisition, the components of the transaction should be recorded at their fair values. The first indication of fair value is the fair value of the consideration given to acquire the asset. Sometimes the fair value of the asset acquired is used when that fair value is more clearly evident than the fair value of the consideration given.

25. Intangible Assets Intangible Assets Lack physical substance.
Exclusive Rights.
Intangible Assets
Intangible assets are operational assets without physical substance that provide the owner with exclusive rights that benefit the production of goods and services. The future benefits attributed to intangible assets usually are much less certain than those attributed to tangible operational assets.
Future benefits less certain than tangible assets.
Usually acquired for operational use.

26. Costs to be Capitalized Intangible Assets
Record at current cash equivalent cost, including purchase price, legal fees, and filing fees.
Patents
Copyrights
Trademarks
Franchises
Goodwill
Intangible assets include patents, copyrights, trademarks, franchises, and goodwill. Like other purchased assets, an intangible asset is recorded at its original cost which includes the purchase price plus all other costs necessary to bring it to condition and location for its intended use.

27. Patents
An exclusive right recognized by law and granted by the US Patent Office for 20 years.
Holder has the right to use, manufacture, or sell the patented product or process without interference or infringement by others.
R & D costs that lead to an internally developed patent are expensed in the period incurred.
A patent is an exclusive right to manufacture a product or to use a process that is granted by the United States Patent Office for a period of 20 years. The holder of the patent essentially has a monopoly right to use, manufacture, or sell the patented product or process without interference or infringement by others. Purchased patents are recorded at acquisition cost. Research and development costs that lead to an internally developed patent are expensed in the period incurred.
Let’s consider an example dealing with patent costs.

28. What is Torch’s patent cost?
Patents
Torch, Inc. has developed a new device. Research and development costs totaled $30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees.
What is Torch’s patent cost?
Part I.
Torch, Incorporated has developed a new device. Research and development costs totaled $30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. What is Torch’s patent cost that will be recorded in the asset account?
Part II.
Torch’s cost for the new patent is $3,000. The $30,000 of research and development cost is expensed as incurred.
Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as incurred.

29. Copyrights
A form of protection given by law to authors of literary, musical, artistic, and similar works.
Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work.
Generally, the legal life of a copyright is the life of the author plus 70 years.
A copyright is an exclusive right of protection given to a creator of a published work such as literary, musical, artistic, and similar works. Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work. Generally, the legal life of a copyright is the life of the creator plus 70 years.

30. Trademarks A symbol, design, or logo associated with a business.
If internally developed, trademarks have no recorded asset cost.
If purchased, a trademark is recorded at cost.
Registered with U.S. Patent Office and renewable indefinitely in 10-year periods.
A trademark is a symbol, design, or logo that distinctively identifies a company, product, or service. If internally developed, trademarks have no recorded asset cost. If purchased, a trademark is recorded at acquisition cost. Trademarks are registered with the United States Patent Office and are renewable indefinitely in 10-year periods.

31. Franchises
Right to sell products or provide services purchased by franchisee from franchisor.
A franchise is a contractual arrangement under which the franchisor grants the franchisee exclusive rights to use the franchisor’s trademark within a geographical area for a specified period of time. The franchisee usually makes an initial payment to the franchisor that is capitalized as an intangible asset along with any legal and license fees. Annual payments from operations to the franchisor are expensed.

32. Goodwill Goodwill Occurs when one company buys another company.
The amount by which the purchase price exceeds the fair market value of net assets acquired.
Only purchased goodwill is an intangible asset.
Unlike other intangible assets, goodwill cannot be associated with any specific right. It does not exist separate from the company itself. It represents the value of a company as a whole over and above its identifiable net assets. Goodwill may be attributed to many factors, including good reputation, superior employees and management, good clientele, and good business location.
Only purchased goodwill is recognized. Purchased goodwill results when one company buys another company for a price that exceeds the fair value of the separate identifiable net assets acquired.
Generally, this represents the present value of future earnings

33. Goodwill
Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.
Let’s look at an example illustrating how we determine the amount of goodwill in company acquisition..
Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.

34. What amount of goodwill should be recorded on Eddy Company books?

35. What amount of goodwill should be recorded on Eddy Company books?
The correct answer is choice c, $300,000, computed as follows:
We compute the $700,000 fair market value of the net assets acquired by subtracting the $200,000 of liabilities assumed from the $900,000 fair market value of the assets. The $1,000,000 price less the $700,000 fair market value of the net assets acquired results in $300,000 of goodwill.

36. Goodwill - Brief Exercise 10-6
Pro-tech Software acquired all of the outstanding stock of Reliable Software for $14 million. The book value of Reliable’s net assets (assets minus liabilities) was $8.3 million. The fair values of Reliable’s assets and liabilities equaled their book values with the exception of certain intangible assets whose fair values exceeded book values by $2.5 million*. Calculate the amount paid for goodwill.
Let’s look at an example illustrating how we determine the amount of goodwill in company acquisition..
Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000.
Fair value of separately identified intangibles are excluded from goodwill.

37. Goodwill - Brief Exercise 10-6

38. Deferred Payments Note payable Market interest rate
Record asset at face value of note
Less than market rate or noninterest bearing
Record asset at present value of future cash flows.
Part I
A deferred payment contract is usually a note payable, If the note includes a realistic interest rate (market rate), the asset acquired is recorded at the face amount of the note. If the note includes an unrealistically low interest rate or is a noninterest bearing note, the asset is recorded at the present value of the future cash payments. The interest rate used for the present values computations should be a current market rate of interest.
Part II.
Let’s consider an example where we must compute the present value of a noninterest-bearing note.
Let’s consider an example where we must compute the present value of a noninterest-bearing note.

39. Deferred Payments
On January 2, 2012, Midwestern Corporation purchased equipment by signing a noninterest-bearing requiring $50,000 to be paid on December 31, The prevailing market rate of interest on notes of this nature is 10%.
Prepare the required journal entries for Midwestern on January 2, 2012; December 31, 2012 (year-end), and December 31, 2013 (year-end).
On January 2, 2006, Midwestern Corporation purchased equipment by signing a noninterest-bearing requiring $50,000 to be paid on December 31, The prevailing market rate of interest on notes of this nature is 10%.
Prepare the required journal entries for Midwestern on January 2, 2006; December 31, 2006 (year-end), and December 31, 2007 (year-end).

40. Deferred Payments
Since we do not know the cash equivalent price in this example, we must use the present value of the future cash payment.
Part I.
Since we do not know the cash equivalent price in this example, we must compute the present value of the future cash payment by multiplying the $50,000 face amount of the note times the present value of a dollar interest factor for two years and 10 percent. The present value is $41,323.
Now let’s make the journal entry for January 2, 2006.
Part II
On January 2, 2006, we record the equipment acquisition with a debit to equipment for $41,323, a debit to discount on note payable for $8,677, and a credit to note payable for the face amount of $50,000.
The discount is computed by subtracting the $41,323 present value from the $50,000 face amount of the note payable.

41. Deferred Payments
On December 31 of each year, we record interest expense for the year. Interest expense is computed by multiplying the carrying value of the note (note payable less the discount on note payable) times the interest rate. On December 31, 2006, interest expense is equal to the $41,323 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,132. This process is referred to as amortizing the discount to interest expense. As a result, the carrying value of the note in the next period will be greater because the discount is smaller.
On December 31, 2007, the carrying value of the note is increased by the amount of of the discount amortized to interest expense on December 31, The new carrying value equals $41,323 plus $4,132, or $45,455. On December 31, 2007, interest expense is equal to the $45,455 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,545.
Finally, on December 31, 2007, we record the cash payment at maturity by debiting note payable and crediting cash for $50,000. At the maturity date, the discount on note payable has a zero balance because it has been fully amortized to interest expense

42. Brief Exercise 10-7
On June 30, Kimberly Farms purchased custom-made harvesting machinery from a local producer. In payment, Kimberly signed a noninterest-bearing note requiring the payment of $60,000 in two years. The fair value of the machinery is not known, but an 8% interest rate properly reflects the time value of money for this type of loan agreement.
At what amount will Kimberly initially value the machinery?
How much interest expense will Kimberly recognize in its income statement for this note for the year ended December 31?

43. Brief Exercise 10-7
The initial value of machinery and note will be the present value of the note payment:
PV = $60,000 (.85734)1 = $51,440
1Present value of $1: n = 2, i = 8% (from Table 2)
Interest expense for 2009:
$51,440 x 8% x 6/12 = $2,058

44. Fixed-Asset Turnover Ratio
Net sales
Average fixed assets
Fixed asset
turnover
ratio =
This ratio measures how effectively a company or its unit managers uses its fixed assets to generate revenue.
The fixed-asset turnover ratio measures how effectively a company manages its fixed assets to generate revenue. It is computed by dividing net sales by average fixed assets.
Consider the following example comparing two computer manufacturing companies, Dell and Apple.

45. Receivables Management
Dell vs. Apple comparison
(All dollar amounts in millions)
Use the information on your screen to compute the 2004 fixed-asset turnover ratios for Dell and Apple.
Compute the fixed asset turnover ratio for both companies

46. Receivables Management
Net sales
Average fixed assets
Fixed asset
turnover
ratio =
Dell
$41,444
($1,517 + $913)/2
= 34.1
Apple
$8,279
($707 + $669)/2
= 12.0
Part I.
The fixed asset ratio is computed by dividing net sales by average fixed assets.
Part II.
Dell’s fixed-asset turnover ratio for 2004 was 34.1.
Part III.
Apple’s fixed asset ratio for 2004 was 12.0.
We can conclude that Dell generates nearly three times more sales dollars for each dollar invested in fixed assets than Apple does.
Dell generated nearly three times the sales dollars for each dollar invested in fixed assets.

47. Dispositions Update depreciation or amortization to date of disposal.
Remove original cost of asset and accumulated depreciation or amortization from the books.
The difference between book value of the asset and the amount received is recorded as a gain or loss.
On June 30, 2013, MeLo Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2008, at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated 10-year life with zero residual value. MeLo last recorded depreciation on the equipment on December 31, 2012, its year-end.
Prepare the journal entries necessary to record the disposition of this equipment.
After using property, plant, and equipment and intangible assets, companies dispose of them by sale, retirement, or exchanging them for other assets. Three accounting steps are involved in dispositions:
 Update depreciation or amortization to the date of disposal.
 Remove the original cost of the asset and its accumulated depreciation or amortization from the books.
 Record a gain or loss for the difference between the book value of the asset and the amount received.
Consider the following example where an asset is sold for cash.
On June 30, 2013, MeLo Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2008, at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated 10-year life with zero salvage value. MeLo last recorded depreciation on the equipment on December 31, 2012, its year-end.
Prepare the journal entries necessary to record the disposition of this equipment.

48. Dispositions Update depreciation to date of sale.
June 30, 2013:
Depreciation expense ($15,000 ÷ 10 years) × ½)
Accumulated depreciation ………………
To update depreciation to date of sale.
Remove original asset cost and accumulated depreciation.
Record the gain or loss.
June 30, 2013:
Accumulated depreciation ,250
Cash ………………………….…………… ,350
Loss on sale …………………………………………….…
Equipment ………………………… … ,000
To record sale of equipment.
($15,000 ÷ 10 years) × 5½) = $8,250
Part I.
Our first step is to update the depreciation to the date of sale. It has been six months since the last depreciation entry. Since there was no salvage value, depreciation for one year is the $15,000 purchase price divided by 10 years, resulting in $1,500. For the six months of 2013, the depreciation is one-half of $1,500, or $750.
We debit depreciation expense for $750 and credit accumulated depreciation for $750 to update the depreciation to June 30.
Part II.
Our second and third steps are to remove the original cost and the related accumulated depreciation from the books, and to record any gain or loss on the sale.
Since the asset was acquired on January 1, 2008, and sold on June 30, 2013, it has been used for a total of five and one-half years. The accumulated depreciation balance on June 30 is $8,250, an amount obtained by multiplying 5½ years times $1,500 of depreciation per year.
The book value at the date of sale is $6,750 dollars computed by subtracting the $8,250 of accumulated depreciation from the $15,000 cost of the asset. Since the book value of $6,750 exceeds the cash sale price of $6,350 by $400, we recognize a $400 loss on the sale.
To record the entry, we debit accumulated depreciation for $8,250, debit cash for $6,350, debit loss on sale for $400, and credit equipment for $15,000.

49. Exchanges General Valuation Principle: Cost of asset acquired is:
fair value of asset given up plus cash paid or minus cash received or
fair value of asset acquired, if it is more clearly evident
In the exchange of assets fair value is used except in rare situations in which the fair value cannot be determined or the exchange lacks commercial substance.
Property, plant, and equipment and intangible assets are sometimes acquired in exchanges for other assets. Trade-ins of old assets in exchange for new assets are probably the most frequent type of exchange. Cash is involved in the transactions to equalize fair values. The general principle to be followed is that the cost of the asset acquired is
equal to the fair value of asset given up plus cash paid or minus cash received, or
equal to the fair value of asset acquired, if that is more clearly evident.
A gain or loss is recognized for the difference between the fair value of the asset given up and its book value.
We follow the general principle based on fair value in the exchange of assets except in rare situations in which the fair value cannot be determined or the exchange lacks commercial substance.
When fair value cannot be determined or the exchange lacks commercial substance, the asset(s) acquired are valued at the book value of the asset(s) given up, plus (or minus) any cash exchanged. No gain or loss is recognized. Let’s look at an example where fair value cannot be determined.
When fair value cannot be determined or the exchange lacks commercial substance, the asset(s) acquired are valued at the book value of the asset(s) given up, plus (or minus) any cash exchanged. No gain or loss is recognized.

50. Fair Value Not Determinable
Matrix Inc. exchanged used equipment for newer equipment. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up originally cost $600,000, and had an accumulated depreciation balance of $400,000 at the time of the exchange. Matrix exchanged the asset and paid $100,000 cash.
Let’s record this unusual transaction.
Matrix Inc. exchanges used equipment for newer equipment. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up originally cost $600,000, and had an accumulated depreciation balance of $400,000 at the time of the exchange. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction.
First, we compute the book value of the asset given up in the exchange. Book value is equal to $200,000, determined by subtracting the $400,000 of accumulated depreciation from the $600,000 original cost.
In addition to giving up book value of $200,000, Matrix paid $100,000 to acquire the newer asset.
The asset acquired will be recorded at the book value given up plus the cash paid. Now we are ready for the journal entry.

51. Self-Constructed Assets
When self-constructing an asset, two accounting issues must be addressed:
Overhead allocation to the self-constructed asset.
Incremental overhead only
Full-cost approach
Proper treatment of interest incurred during construction
There are two difficult accounting issues that must be addressed when a company is constructing assets for its own use:
Determining the amount the company’s manufacturing overhead to be included in the asset’s cost.
 Deciding on the proper treatment of interest incurred during the construction period. One approach to assigning overhead to self-constructed assets is the incremental approach, where actual incremental overhead costs are recorded in the asset account. However the most commonly used method is to assign overhead using a predetermined overhead rate, based on an overhead cost driver activity, that is used to assign the company’s overhead to regular production. This approach is called the full cost approach.
Unlike purchased assets, self-constructed assets may take a long period of time to be made ready for their intended use. The construction activities during this period require construction financing. Following our general rule for the cost of an asset, all costs necessary to make the asset ready for its intended use, including interest during the construction period, should be included in the asset’s cost.

52. Interest Capitalization
Capitalization begins when
construction begins
interest is incurred, and
qualifying expenses are incurred.
Capitalization ends when . . .
The asset is substantially complete and ready for its intended use,
or when interest costs no longer are being incurred.
The interest capitalization period begins when the first qualifying construction expenditures are incurred for materials, labor, or overhead, and when interest cost are incurred. The interest capitalization period ends when the asset is substantially complete and ready for its intended use or when interest costs no longer are being incurred.
Consider the following example of interest incurred on a self-constructed asset.

53. Interest Capitalization
Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, Oct. 1, $200,000; and Dec. 1, $300,000.
Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize.
Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, October 1, $200,000; and December 1, $300,000.
Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize.
How much interest should Welling capitalize on the construction project?

54. Interest Capitalization
Average Accumulated Expenditures
First we calculate the the average accumulated expenditures by time-weighting the individual expenditures made during the period. For example the $125,000 expenditure made on May 1 occurs eight months from the end of the period. So the time-weighted amount of this expenditure is eight-twelfths of $125,000 or $83,333. We calculate the time-weighted amounts for the other expenditures and sum them to get the average accumulated expenditures of $225,000.

55. Interest Capitalization
Since the $1,000,000 of specific borrowing is sufficient to cover the $225,000 of average accumulated expenditures for the year, use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize.
Interest = AAE × Specific Borrowing Rate
Interest = $225,000 × 10% = $22,500
Part I.
Since the $1,000,000 of specific borrowing is sufficient to cover the $225,000 of average accumulated expenditures for the year, we will use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize.
Ten percent of $225,000 is equal to $22,500, the amount of interest that will be capitalized.
Part II.
The journal entry to record the capitalized interest requires us to transfer $22,500 of interest expense on the specific borrowing to the asset construction-in-progress. We debit construction-in-progress for $22,500 and credit interest expense for $22,500.

56. Research and Development (R&D)
Planned search or critical investigation aimed at discovery of new knowledge . . .
Development
The translation of research findings or other knowledge into a plan or design . . .
Most R&D costs are expensed as incurred. (Must be disclosed if material.)
Research is planned search or critical investigation aimed at discovery of new knowledge with the the hope that the new knowledge will result in new, or the improvement of, existing, products, services or processes.
Development is the translation of research findings into new, or the improvement of existing, products, services or processes.
Most research and development costs are expensed as incurred. The costs are incurred with the intent of future benefits, but the future benefits are uncertain, and even if the benefits materialize, it is difficult to relate the benefits to revenues of future periods.

57. Research and Development (R&D)
R&D costs incurred under contract for other companies are expensed against revenue from the contract.
Operational assets used in R&D should be capitalized if they have alternative future uses.
An exception to the immediate expensing of research and development costs is provided for work done under contract for other companies. These research and development costs are capitalized and then expensed against revenue from the contract in future periods.
If operational assets are purchased for exclusive use in research and development, the cost is expensed, regardless of the length of the assets’ useful life. If the assets have alternative future uses beyond the research and development project period, the cost should be capitalized and depreciated over the current and future periods of use.

58. Software Development Costs
All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred.
Costs incurred after technological feasibility is established and before the software is available for release to customers are capitalized as an intangible asset.
Costs Expensed as R&D
Costs Capitalized
Operating Costs
All costs incurred to establish the technological feasibility of computer software products are treated as research and development costs and expensed as incurred. Costs incurred after technological feasibility is established and before the software is available for release to customers are capitalized as an intangible asset. Technological feasibility is established when all planning, designing, coding, and testing activities have been completed to determine that the software meets its design specifications including functions, features, and technical performance requirements.
Consider the following timeline to illustrate these concepts.
Costs are expensed from the start of research and development until technological feasibility is established. Costs incurred after technological feasibility is established, but before the product is released, are capitalized as an intangible asset. Costs incurred after the product is available for release to customers are treated as operating costs.
Start of R&D Activity
Technological Feasibility
Date of Product Release
Sale of Product

59. Software Development Costs
Amortization of capitalized computer software costs starts when the product begins to be marketed.
Two methods, the percentage-of-revenue method and the straight-line method, are compared and the method producing the largest amount of amortization is used.
Balance Sheet
The unamortized portion of capitalized computer software cost is an asset.
Income Statement
Amortization expense associated with computer software cost.
R&D expense associated with computer software development cost.
Disclosure
Amortization of capitalized computer software costs starts when the product begins to be marketed. Two methods, the percentage-of-revenue method and the straight-line method, are compared and the method producing the largest amount of amortization is used.
The periodic amortization percentage is the greater of
the ratio of current revenues to current and anticipated revenues (the percentage of revenues method) or
the straight-line percentage over the useful life of the asset (the straight-line method).
The unamortized portion of capitalized computer software cost is reported in the balance sheet as an asset. The periodic amortization expense associated with the capitalized computer software cost is reported in the income statement. The research and development expense associated with computer software development is reported in the income statement.

60. Research and Development Expenditures
U.S. GAAP vs. IFRS
Research and Development Expenditures
Except for software development costs incurred after technological feasibility, all research and development expenditures are expensed in the period incurred.
Direct costs to secure a patent are capitalized.
Research expenditures are expensed in the period incurred. Development expenditures that meet specified criteria are capitalized as an intangible asset.
Direct costs to secure a patent are capitalized.
Except for software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred. IAS No. 38 draws a distinction between research activities and development activities. Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized as an intangible asset. Under both U.S. GAAP and IFRS, any direct costs to secure a patent, such as legal and filing fees, are capitalized.

61. Brief Exercise 10-16
Maxtor Technology incurred the following costs during the year related to the creation of a new type of personal computer monitor:
What amount should Maxtor report as research and development expense in its income statement?

62. Brief Exercise 10-16 Research and development: Salaries $220,000
Depreciation R&D ,000
Utilities and other direct costs ,000
Payment to another company ,000
Total R & D expense $531,000
Note: The patent filing and related legal costs and the costs of adapting the product to a particular customer’s needs are not included as research and development expense.