1. Perspective on Investing

2. Acct Class 16
Chapter 10 acquisition and disposition of property, plant and equipment Sommers – ACCT 3311
Chapter 1: Environment and Theoretical Structure of Financial Accounting.

3. Types of Operational Assets
Long-lived, Revenue-producing Assets
Expected to Benefit Future Periods
Tangible
Property, Plant, Equipment & Natural Resources
Part I.
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.
Part II.
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.
General Rule for Cost Capitalization
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.

4. Costs to be Capitalized
Land (not depreciable)
Purchase price
Real estate commissions
Attorney’s fees
Title search
Title transfer fees
Title insurance premiums
Removing old buildings
Equipment
Net purchase price
Taxes
Transportation costs
Installation costs
Modification to building necessary to install equipment
Testing and trial runs
Part I.
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.
Part II.
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.

5. Costs to be Capitalized
Land Improvements – Separately identifiable costs
Driveways
Parking lots
Fencing
Landscaping (limited life)
Private roads
Buildings
Purchase price
Attorney’s fees
Commissions
Reconditioning
Natural Resources
Acquisition costs
Exploration costs
Development costs
Restoration costs
Self Constructed Assets
Materials
Direct Labor
Overhead
Part I.
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.
Part II.
The cost of buildings includes:
the purchase price,
real estate commissions,
attorney’s fees,
reconditioning costs to get the building ready for use.

6. Discussion Questions
Q10–4 Indicate where the following items would be shown on a balance sheet. (a) A lien that was attached to the land when purchased. Land (b) Landscaping costs. Land improvements if limited life, else land. (c) Attorney’s fees and recording fees related to purchasing land (d) Variable overhead related to construction of machinery. Machinery

7. Discussion Questions
Q10–4 (e) A parking lot servicing employees in the building. Land Improvements (f) Cost of temporary building for workers during construction of building Building (g) Interest expense on bonds payable incurred during construction of a building. (h) Assessments for sidewalks that are maintained by the city. Land (i) The cost of demolishing an old building that was on the land when purchased.

8. Example 1: Continued
Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building: Title insurance $ 16,000 Legal fees for drawing the contract 5,000 Pro-rated property taxes for period after acquisition 36,000 State transfer fees 4,000 An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping (limited life). Determine the initial valuation of each asset Semtech acquired in these transactions.

9. Example 1: Continued
Purchase price $4,000,000 Title search and insurance 16,000 Legal fees 5,000 State transfer fees 4,000 Total cost $4,025,000 Fair Value % of Total Valuation Land $3,300,000 75% $3,018,750 Building 1,100,000 25% 1,006,250 $4,400, % $4,025,000 Land $3,018,750 Building 1,006,250 Land improvements: Parking lot 82,000 Landscaping 40,000

10. Example 1: Continued
Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building: Title insurance $16,000 Legal fees for drawing the contract 5,000 Pro-rated property taxes for period after acquisition 36,000 State transfer fees 4,000 An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping. Now assume that immediately after acquisition, Semtech demolished the building. Demolition costs were $250,000 and the salvaged materials were sold for $6,000. In addition, Semtech spent $86,000 clearing and grading the land in preparation for the construction of a new building.

11. Example 1: Continued
Cost of land: Purchase price $4,000,000 Title search and insurance 16,000 Legal fees 5,000 State transfer fees 4,000 Demolition of old building $250,000 Less: Sale of materials (6,000) 244,000 Clearing and grading costs 86,000 Total cost of land $4,355,000 Land improvements: Parking lot $ 82,000 Landscaping $ 40,000

12. Percent of Total Fair Value
Example 2
Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction.
On September 1, the company acquired five acres of land with a building that will be used as a warehouse. Tristar paid $100,000 in cash for the property. According to appraisals, the land had a fair value of $75,000 and the building had a fair value of $45,000.
Land 62,500
Building 37,500
Cash 100,000
Asset   
Fair Value
 Percent of Total Fair Value
Initial
Valuation
Land
$ 75,000
62.5%
$ 62,500
Building
45,000
37.5%
37,500
$120,000
100.0%
$100,000

13. Example 2: Continued
Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction.
On September 1, Tristar signed a $40,000 noninterest-bearing note to purchase equipment. The $40,000 payment is due on September 1, Assume that 8% is a reasonable interest rate.
Equipment ,037
Discount on note payable 2,963
Note payable ,000
PV(FV=40,000, PMT=0, n=1, i=8) = 37,037

14. Example 2: Continued
Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction.
On September 15, a truck was donated to the corporation. Similar trucks were selling for $2,500.
Truck 2,500
Revenue - donation of asset 2,500
On September 18, the company paid its lawyer $3,000 for organizing the corporation.
Organization cost expense 3,000
Cash 3,000

15. Example 2: Continued
Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction.
On October 10, Tristar purchased machinery for cash. The purchase price was $15,000 and $500 in freight charges also were paid.
Machinery 15,500
Cash 15,500
On December 2, Tristar acquired various items of office equipment. The company was short of cash and could not pay the $5,500 normal cash price. The supplier agreed to accept 200 shares of the company’s nopar common stock in exchange for the equipment. The fair value of the stock is not readily determinable.
Office equipment 5,500
Common stock 5,500

16. Example 2: Continued
Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction.
On December 10, the company acquired a tract of land at a cost of $20,000. It paid $2,000 down and signed a 10% note with both principal and interest due in one year. Ten percent is an appropriate rate of interest for this note.
Land 20,000
Cash ,000
Note payable 18,000

17. 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
Under certain conditions, interest incurred on qualifying assets is capitalized.
Asset constructed is for a company’s own use and is a discrete project for sale or lease.
Capitalize interest that could have been avoided if the asset were not constructed and the money used to retire debt.
Part I.
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.
Part II.
Interest is capitalized (included in the asset’s cost) for qualifying assets. Qualifying assets are:
assets built for a company’s own use.
assets constructed as discrete projects for sale or lease. Assets in this category are large construction projects such as a real estate development built for sale or lease.
Only the portion of interest cost incurred during the construction period that could have been avoided if the construction had not been undertaken may be capitalized.

18. Discussion Questions
Q10–9 Provide examples of assets that do not qualify for interest capitalization.
assets that are in use or ready for their intended use, and
assets that are not being used in the earnings activities of the firm.

19. Interest Costs During Construction
Three approaches have been suggested to account for the interest incurred in financing the construction.
Increase to Cost of Asset
$ 0
$ ?
Capitalize no interest during construction
Capitalize all costs of funds
Capitalize actual costs incurred during construction
GAAP

20. Interest Costs During Construction
GAAP requires — capitalizing actual interest (with modification).
Consistent with historical cost.
Capitalization considers three items:
Qualifying assets.
Capitalization period.
Amount to capitalize.

21. Qualifying Assets
Require a substantial period of time to get them ready for their intended use.
Two types of assets:
Assets under construction for a company’s own use.
Assets intended for sale or lease that are constructed or produced as discrete projects.

22. Capitalization Period
Begins when:
Expenditures for the asset have been made.
Activities for readying the asset are in progress .
Interest costs are being incurred.
Ends when:
The asset is substantially complete and ready for use.

23. Amount to Capitalize Capitalize the lesser of: Actual interest costs
Avoidable interest - the amount of interest that could have been avoided if expenditures for the asset had not been made.

24. Discussion Questions
Q10–10 What interest rates should be used in determining the amount of interest to be capitalized? How should interest revenue from temporarily invested excess funds borrowed to finance the construction of assets be accounted for? The avoidable interest is determined by multiplying (an) interest rate(s) by the weighted-average amount of accumulated expenditures on qualifying assets. For the portion of weighted-average accumulated expenditures which is less than or equal to any amounts borrowed specifically to finance construction of the assets, the capitalization rate is the specific interest rate incurred. For the portion of weighted-average accumulated expenditures which is greater than specific debt incurred, the interest rate is a weighted average of all other interest rates incurred. The amount of interest to be capitalized is the avoidable interest, or the actual interest incurred, whichever is lower.

25. Calculating the Actual and Avoidable Interest
Selecting Appropriate Interest Rate:
For the portion of weighted-average accumulated expenditures that is less than or equal to any amounts borrowed specifically to finance construction of the assets, use the interest rate incurred on the specific borrowings.
For the portion of weighted-average accumulated expenditures that is greater than any debt incurred specifically to finance construction of the assets, use a weighted average of interest rates incurred on all other outstanding debt during the period.

26. Calculating the Actual and Avoidable Interest
Actual Interest
Weighted-average interest rate on general debt
$100,000 $800,000
= 12.5%
Avoidable Interest

27. Calculating the Actual and Avoidable Interest
Capitalize the lesser of Avoidable interest or Actual interest.
Journal entry to Capitalize Interest:
Equipment 30,250 Interest expense 30,250
Not crediting cash because already paid and we are transferring (capitalizing)

28. Example 3
On January 1, 2011, the Marlee Company began construction of an office building to be used as its corporate headquarters. The building was completed early in Construction expenditures for 2011, which were incurred evenly throughout the year, totaled $6,000,000. Marlee had the following debt obligations which were outstanding during all of 2011: Construction loan, 10% $1,500,000 Long-term note, 9% 2,000,000 Long-term note, 6% 4,000,000 Calculate the amount of interest capitalized in 2011 for the building using the specific interest method.

29. Example 3
Average accumulated expenditures: $6,000,000 / 2 = $3,000,000 Weighted-average rate of all other debt: $2,000,000 x 9% = $180,000 4,000,000 x 6% = 240,000 $6,000,000 $420,000 $420,000 / $6,000,000 = 7% Interest capitalized: $3,000, ,500,000 x 10% = $150,000 1,500,000 x 7% = 105,000 $255,000 Interest capitalized

30. Example 4
On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, Expenditures on the project were as follows:
January 1, 2011 $1,000,000 January 31, 2012 $270,000
March 1, ,000 April 30, ,000
June 30, ,000 August 31, ,000
October 1, ,000
On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and The company’s other interest-bearing debt included two long-term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and Interest is paid annually on all debt. The company’s fiscal year-end is December 31.
Calculate the amount of interest that Mason should capitalize in 2011 and 2012 using the specific interest method.
What is the total cost of the building?
Calculate the amount of interest expense that will appear in the 2011 and 2012 income statements.

31. Example 4: Continued
Expenditures for 2011: January 1, 2011 $1,000,000 x 12/12 = $1,000,000 March 1, ,000 x 10/12 = 500,000 June 30, ,000 x 6/12 = 400,000 October 1, ,000 x 3/12 = 150,000 Accumulated expenditures (before interest) - $3,000,000 Average accumulated expenditures - $2,050,000 Interest capitalized: $2,050,000 x 10% = $205,000 = Interest capitalized in 2011

32. Example 4: Continued
Expenditures for 2012: January 1, 2012 $3,205,000 x 9/9 = $3,205,000 January 31, ,000 x 8/9 = 240,000 April 30, ,000 x 5/9 = 325,000 August 31, ,000 x 1/9 = 100,000 Accumulated expenditures (before interest) - $4,960,000 Average accumulated expenditures - $3,870,000 Weighted-average rate of all other debt: $ 4,000,000 x 6% = $240,000 $ 720,000 6,000,000 x 8% = 480,000 $10,000,000 = 7.2% $10,000,000 $720,000 Interest capitalized: $3,000,000 x 10.0% x 9/12 = $225, ,000 x 7.2% x 9/12 = 46,980 $271,980 = Interest capitalized in 2012

33. Example 4: Continued
Cost of Building: Expenditures in 2011 $3,000,000 Interest capitalized in ,000 Expenditures in ,755,000 Interest capitalized in ,980 Total cost of building $5,231,980 Interest Expense for 2011: $3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 6,000,000 x 8% = 480,000 Total interest incurred 1,020,000 Less: Capitalized (205,000) 2011 expense $ 815,000 Interest Expense for 2012: Total interest incurred $1,020,000 Less: Capitalized (271,980) 2012 expense $ 748,020

34. Example 4b: Continued
On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, Expenditures on the project were as follows:
January 1, 2011 $1,000,000 January 31, 2012 $270,000
March 1, ,000 April 30, ,000
June 30, ,000 August 31, ,000
October 1, ,000
On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and The company’s other interest- bearing debt included two long- term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and Interest is paid annually on all debt. The company’s fiscal year-end is December 31.
Calculate the amount of interest that Mason should capitalize in 2011 and 2012 using the weighted-average method.
What is the total cost of the building?
Calculate the amount of interest expense that will appear in the 2011 and 2012 income statements.

35. Example 4b: Continued
Weighted-average rate of all debt: $ 3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 $ 1,020,000 6,000,000 x 8% = 480,000 $13,000,000 = 7.85% $13,000,000 $1,020,000 Expenditures for 2011: Accumulated expenditures (before interest) - $3,000,000 Average accumulated expenditures - $2,050,000 Interest capitalized: $2,050,000 x 7.85% = $160,925 = Interest capitalized in 2011

36. Example 4b: Continued
Expenditures for 2012: January 1, 2012 $3,160,925 x 9/9 = $3,160,925 January 31, ,000 x 8/9 = 240,000 April 30, ,000 x 5/9 = 325,000 August 31, ,000 x 1/9 = 100,000 Accumulated expenditures (before interest) - $4,915,925 Average accumulated expenditures - $3,825,925 Interest capitalized: $3,825,925 x 7.85% x 9/12 = $225,251 = Interest capitalized in 2012

37. Acct Class 16
Example 4b: Continued
Cost of Building: Expenditures in 2011 $3,000,000 Interest capitalized in ,925 Expenditures in ,755,000 Interest capitalized in ,251 Total cost of building $5,141,176 Interest Expense for 2011: Total interest incurred $1,020,000 Less: Capitalized (160,925) 2011 expense $ 859,075 Interest Expense for 2012: Less: Capitalized (225,251) 2012 expense $ 794,749