After studying this chapter, you should be able to:
Where Have All The Assets Gone?
Investments in long-lived assets, such as property, plant, and equipment, are important elements in many companies' balance sheets. As the chart on the next page indicates, major companies, such as Southwest Airlines and Wal-Mart, recently reported property, plant, and equipment (PP&E) as a percent of total assets ranging from 56 percent up to nearly 75 percent.
However, for various strategic reasons, many companies are now shedding property, plant, and equipment. Instead, they are paying others to manufacture and assemble products—functions they previously performed in their own facilities. Companies are also reducing fixed assets by outsourcing warehousing and distribution. Such logistics outsourcing can cut companies' own costs for keeping and managing inventories, and spare them the need to invest in advanced tracking technologies increasingly required by retailers. In a recent year more than 80 percent of the country's 100 biggest companies used third-party logistics providers. As a result, some companies such as Nortel and Alcatel-Lucent are decreasing their investment in long-lived assets, as the next page chart shows.
Nortel is a good example of these strategies. It has sold and outsourced certain facilities in order to reduce its direct manufacturing activities and costs. Nortel also sold its training and headset businesses. Further, it has aggressively outsourced other operations to reduce costs. Reductions in these areas will enable Nortel and other outsourcing companies to concentrate on their core operations and better manage investments in property, plant, and equipment.
Source: Adapted from Chapter 1 in Grady Means and David Schneider, MetaCapitalism: The e-Business Revolution and the Design of 21st-Century Companies and Markets (New York: John Wiley and Sons, 2000); and Kris Maher, "Global Goods Jugglers," Wall Street Journal Online (July 5, 2005).
PREVIEW OF CHAPTER 10
As we indicate in the opening story, a company like Southwest Airlines has a substantial investment in property, plant, and equipment. Conversely, other companies, such as Nortel, have a minor investment in these types of assets. In this chapter, we discuss the proper accounting for the acquisition, use, and disposition of property, plant, and equipment. The content and organization of the chapter are as follows.
Companies like Boeing, Target, and Starbucks use assets of a durable nature. Such assets are called property, plant, and equipment. Other terms commonly used are plant assets and fixed assets. We use these terms interchangeably. Property, plant, and equipment include land, building structures (offices, factories, warehouses), and equipment (machinery, furniture, tools). The major characteristics of property, plant, and equipment are as follows.
They are acquired for use in operations and not for resale. Only assets used in normal business operations are classified as property, plant, and equipment. For example, an idle building is more appropriately classified separately as an investment. Land developers or subdividers classify land as inventory.
They are long-term in nature and usually depreciated. Property, plant, and equipment yield services over a number of years. Companies allocate the cost of the investment in these assets to future periods through periodic depreciation charges. The exception is land, which is depreciated only if a material decrease in value occurs, such as a loss in fertility of agricultural land because of poor crop rotation, drought, or soil erosion.
They possess physical substance. Property, plant, and equipment are tangible assets characterized by physical existence or substance. This differentiates them from intangible assets, such as patents or goodwill. Unlike raw material, however, property, plant, and equipment do not physically become part of a product held for resale.
Most companies use historical cost as the basis for valuing property, plant, and equipment. Historical cost measures the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use. For example, companies like Kellogg Co. consider the purchase price, freight costs, sales taxes, and installation costs of a productive asset as part of the asset's cost. It then allocates these costs to future periods through depreciation. Further, Kellogg adds to the asset's cost any related costs incurred after the asset's acquisition, such as additions, improvements, or replacements, if they provide future service potential. Otherwise, Kellogg expenses these costs immediately.[137]
Subsequent to acquisition, companies should not write up property, plant, and equipment to reflect fair value when it is above cost. The main reasons for this position are as follows.
Under international accounting standards, historical cost is the benchmark (preferred) treatment for property, plant, and equipment. However, companies may also use revalued amounts. If using revaluation, companies must revalue the class of assets regularly.
Historical cost involves actual, not hypothetical, transactions and so is the most reliable.
Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold.
Even those who favor fair value measurement for inventory and financial instruments often take the position that property, plant, and equipment should not be revalued. The major concern is the difficulty of developing a reliable fair value for these types of assets. For example, how does one value a General Motors automobile manufacturing plant or a nuclear power plant owned by Consolidated Edison?
However, if the fair value of the property, plant, and equipment is less than its carrying amount, the asset may be written down. These situations occur when the asset is impaired (discussed in Chapter 11) and in situations where the asset is being held for sale. A long-lived asset classified as held for sale should be measured at the lower of its carrying amount or fair value less cost to sell. In that case, a reasonable valuation for the asset can be obtained, based on the sales price. A long-lived asset is not depreciated if it is classified as held for sale. This is because such assets are not being used to generate revenues. [1]
All expenditures made to acquire land and ready it for use are considered part of the land cost. Thus, when Wal-Mart or Home Depot purchases land on which to build a new store, its land costs typically include (1) the purchase price; (2) closing costs, such as title to the land, attorney's fees, and recording fees; (3) costs incurred in getting the land in condition for its intended use, such as grading, filling, draining, and clearing; (4) assumption of any liens, mortgages, or encumbrances on the property; and (5) any additional land improvements that have an indefinite life.
For example, when Home Depot purchases land for the purpose of constructing a building, it considers all costs incurred up to the excavation for the new building as land costs. Removal of old buildings—clearing, grading, and filling—is a land cost because this activity is necessary to get the land in condition for its intended purpose. Home Depot treats any proceeds from getting the land ready for its intended use, such as salvage receipts on the demolition of an old building or the sale of cleared timber, as reductions in the price of the land.
In some cases, when Home Depot purchases land, it may assume certain obligations on the land such as back taxes or liens. In such situations, the cost of the land is the cash paid for it, plus the encumbrances. In other words, if the purchase price of the land is $50,000 cash, but Home Depot assumes accrued property taxes of $5,000 and liens of $10,000, its land cost is $65,000.
Home Depot also might incur special assessments for local improvements, such as pavements, street lights, sewers, and drainage systems. It should charge these costs to the Land account because they are relatively permanent in nature. That is, after installation, they are maintained by the local government. In addition, Home Depot should charge any permanent improvements it makes, such as landscaping, to the Land account. It records separately any improvements with limited lives, such as private driveways, walks, fences, and parking lots, as Land Improvements. These costs are depreciated over their estimated lives.
Generally, land is part of property, plant, and equipment. However, if the major purpose of acquiring and holding land is speculative, a company more appropriately classifies the land as an investment. If a real estate concern holds the land for resale, it should classify the land as inventory.
In cases where land is held as an investment, what accounting treatment should be given for taxes, insurance, and other direct costs incurred while holding the land? Many believe these costs should be capitalized. The reason: They are not generating revenue from the investment at this time. Companies generally use this approach except when the asset is currently producing revenue (such as rental property).
The cost of buildings should include all expenditures related directly to their acquisition or construction. These costs include (1) materials, labor, and overhead costs incurred during construction, and (2) professional fees and building permits. Generally, companies contract others to construct their buildings. Companies consider all costs incurred, from excavation to completion, as part of the building costs.
But how should companies account for an old building that is on the site of a newly proposed building? Is the cost of removal of the old building a cost of the land or a cost of the new building? Recall that if a company purchases land with an old building on it, then the cost of demolition less its salvage value is a cost of getting the land ready for its intended use and relates to the land rather than to the new building. In other words, all costs of getting an asset ready for its intended use are costs of that asset.
The term "equipment" in accounting includes delivery equipment, office equipment, machinery, furniture and fixtures, furnishings, factory equipment, and similar fixed assets. The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs. Costs thus include all expenditures incurred in acquiring the equipment and preparing it for use.
Occasionally companies construct their own assets. Determining the cost of such machinery and other fixed assets can be a problem. Without a purchase price or contract price, the company must allocate costs and expenses to arrive at the cost of the self-constructed asset. Materials and direct labor used in construction pose no problem. A company can trace these costs directly to work and material orders related to the fixed assets constructed.
However, the assignment of indirect costs of manufacturing creates special problems. These indirect costs, called overhead or burden, include power, heat, light, insurance, property taxes on factory buildings and equipment, factory supervisory labor, depreciation of fixed assets, and supplies.
Companies can handle indirect costs in one of two ways:
Assign no fixed overhead to the cost of the constructed asset. The major argument for this treatment is that indirect overhead is generally fixed in nature; it does not increase as a result of constructing one's own plant or equipment. This approach assumes that the company will have the same costs regardless of whether it constructs the asset or not. Therefore, to charge a portion of the overhead costs to the equipment will normally reduce current expenses and consequently overstate income of the current period. However, the company would assign to the cost of the constructed asset variable overhead costs that increase as a result of the construction.
Assign a portion of all overhead to the construction process. This approach, called a full-costing approach, is appropriate if one believes that costs attach to all products and assets manufactured or constructed. Under this approach, a company assigns a portion of all overhead to the construction process, as it would to normal production. Advocates say that failure to allocate overhead costs understates the initial cost of the asset and results in an inaccurate future allocation.
Companies should assign to the asset a pro rata portion of the fixed overhead to determine its cost. Companies use this treatment extensively because many believe that it results in a better matching of costs with revenues.
If the allocated overhead results in recording construction costs in excess of the costs that an outside independent producer would charge, the company should record the excess overhead as a period loss rather than capitalize it. This avoids capitalizing the asset at more than its probable market value.[138]
The proper accounting for interest costs has been a long-standing controversy. Three approaches have been suggested to account for the interest incurred in financing the construction of property, plant, and equipment:
Capitalize no interest charges during construction. Under this approach, interest is considered a cost of financing and not a cost of construction. Some contend that if a company had used stock (equity) financing rather than debt, it would not incur this cost. The major argument against this approach is that the use of cash, whatever its source, has an associated implicit interest cost, which should not be ignored.
Charge construction with all costs of funds employed, whether identifiable or not. This method maintains that the cost of construction should include the cost of financing, whether by cash, debt, or stock. Its advocates say that all costs necessary to get an asset ready for its intended use, including interest, are part of the asset's cost. Interest, whether actual or imputed, is a cost, just as are labor and materials. A major criticism of this approach is that imputing the cost of equity capital (stock) is subjective and outside the framework of a historical cost system.
Capitalize only the actual interest costs incurred during construction. This approach agrees in part with the logic of the second approach—that interest is just as much a cost as are labor and materials. But this approach capitalizes only interest costs incurred through debt financing. (That is, it does not try to determine the cost of equity financing.) Under this approach, a company that uses debt financing will have an asset of higher cost than a company that uses stock financing. Some consider this approach unsatisfactory because they believe the cost of an asset should be the same whether it is financed with cash, debt, or equity.
Illustration 10-1 shows how a company might add interest costs (if any) to the cost of the asset under the three capitalization approaches.
GAAP requires the third approach—capitalizing actual interest (with modification). This method follows the concept that the historical cost of acquiring an asset includes all costs (including interest) incurred to bring the asset to the condition and location necessary for its intended use. The rationale for this approach is that during construction, the asset is not generating revenues. Therefore, a company should defer (capitalize) interest costs. [2] Once construction is complete, the asset is ready for its intended use and a company can earn revenues. At this point the company should report interest as an expense and match it to these revenues. It follows that the company should expense any interest cost incurred in purchasing an asset that is ready for its intended use.
To implement this general approach, companies consider three items:
The objective of capitalizing interest is to obtain a measure of acquisition cost that reflects a company's total investment in the asset and to charge that cost to future periods benefitted.
To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. A company capitalizes interest costs starting with the first expenditure related to the asset. Capitalization continues until the company substantially readies the asset for its intended use.
Assets that qualify for interest cost capitalization include assets under construction for a company's own use (including buildings, plants, and large machinery) and assets intended for sale or lease that are constructed or otherwise produced as discrete projects (e.g., ships or real estate developments).
Examples of assets that do not qualify for interest capitalization are (1) assets that are in use or ready for their intended use, and (2) assets that the company does not use in its earnings activities and that are not undergoing the activities necessary to get them ready for use. Examples of this second type include land remaining undeveloped and assets not used because of obsolescence, excess capacity, or need for repair.
Recently, iGAAP changed to require companies to capitalize borrowing costs related to qualifying assets. These changes were made as part of the IASB's and FASB's convergence project.
The capitalization period is the period of time during which a company must capitalize interest. It begins with the presence of three conditions:
Expenditures for the asset have been made.
Activities that are necessary to get the asset ready for its intended use are in progress.
Interest cost is being incurred.
Interest capitalization continues as long as these three conditions are present. The capitalization period ends when the asset is substantially complete and ready for its intended use.
The amount of interest to capitalize is limited to the lower of actual interest cost incurred during the period or avoidable interest. Avoidable interest is the amount of interest cost during the period that a company could theoretically avoid if it had not made expenditures for the asset. If the actual interest cost for the period is $90,000 and the avoidable interest is $80,000, the company capitalizes only $80,000. Or, if the actual interest cost is $80,000 and the avoidable interest is $90,000, it still capitalizes only $80,000. In no situation should interest cost include a cost of capital charge for stockholders' equity. Furthermore, GAAP requires interest capitalization for a qualifying asset only if its effect, compared with the effect of expensing interest, is material. [3]
To apply the avoidable interest concept, a company determines the potential amount of interest that it may capitalize during an accounting period by multiplying the interest rate(s) by the weighted-average accumulated expenditures for qualifying assets during the period.
Weighted-Average Accumulated Expenditures. In computing the weighted-average accumulated expenditures, a company weights the construction expenditures by the amount of time (fraction of a year or accounting period) that it can incur interest cost on the expenditure.
To illustrate, assume a 17-month bridge construction project with current-year payments to the contractor of $240,000 on March 1, $480,000 on July 1, and $360,000 on November 1. The company computes the weighted-average accumulated expenditures for the year ended December 31 as follows.
To compute the weighted-average accumulated expenditures, a company weights the expenditures by the amount of time that it can incur interest cost on each one. For the March 1 expenditure, the company associates 10 months' interest cost with the expenditure. For the expenditure on July 1, it incurs only 6 months' interest costs. For the expenditure made on November 1, the company incurs only 2 months of interest cost.
Interest Rates. Companies follow these principles in selecting the appropriate interest rates to be applied to the weighted-average accumulated expenditures:
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.[139]
Illustration 10-3 shows the computation of a weighted-average interest rate for debt greater than the amount incurred specifically to finance construction of the assets.
To illustrate the issues related to interest capitalization, assume that on November 1, 2009, Shalla Company contracted Pfeifer Construction Co. to construct a building for $1,400,000 on land costing $100,000 (purchased from the contractor and included in the first payment). Shalla made the following payments to the construction company during 2010.
Pfeifer Construction completed the building, ready for occupancy, on December 31, 2010. Shalla had the following debt outstanding at December 31, 2010.
Shalla computed the weighted-average accumulated expenditures during 2010 as shown in Illustration 10-4.
Note that the expenditure made on December 31, the last day of the year, does not have any interest cost.
Shalla computes the avoidable interest as shown in Illustration 10-5.
The company determines the actual interest cost, which represents the maximum amount of interest that it may capitalize during 2010, as shown in Illustration 10-6.
The interest cost that Shalla capitalizes is the lesser of $120,228 (avoidable interest) and $239,500 (actual interest), or $120,228.
Shalla records the following journal entries during 2010:
Shalla should write off capitalized interest cost as part of depreciation over the useful life of the assets involved and not over the term of the debt. It should disclose the total interest cost incurred during the period, with the portion charged to expense and the portion capitalized indicated.
At December 31, 2010, Shalla discloses the amount of interest capitalized either as part of the nonoperating section of the income statement or in the notes accompanying the financial statements. We illustrate both forms of disclosure, in Illustrations 10-7 and 10-8.
Two issues related to interest capitalization merit special attention:
Expenditures for land.
Interest revenue.
Expenditures for Land. When a company purchases land with the intention of developing it for a particular use, interest costs associated with those expenditures qualify for interest capitalization. If it purchases land as a site for a structure (such as a plant site), interest costs capitalized during the period of construction are part of the cost of the plant, not the land. Conversely, if the company develops land for lot sales, it includes any capitalized interest cost as part of the acquisition cost of the developed land. However, it should not capitalize interest costs involved in purchasing land held for speculation because the asset is ready for its intended use.
Interest Revenue. Companies frequently borrow money to finance construction of assets. They temporarily invest the excess borrowed funds in interest-bearing securities until they need the funds to pay for construction. During the early stages of construction, interest revenue earned may exceed the interest cost incurred on the borrowed funds.
Should companies offset interest revenue against interest cost when determining the amount of interest to capitalize as part of the construction cost of assets? In general, companies should not net or offset interest revenue against interest cost. Temporary or short-term investment decisions are not related to the interest incurred as part of the acquisition cost of assets. Therefore, companies should capitalize the interest incurred on qualifying assets whether or not they temporarily invest excess funds in short-term securities. Some criticize this approach because a company can defer the interest cost but report the interest revenue in the current period.
The interest capitalization requirement is still debated. From a conceptual viewpoint, many believe that, for the reasons mentioned earlier, companies should either capitalize no interest cost or all interest costs, actual or imputed.
The requirement to capitalize interest can significantly impact financial statements. For example, when earnings of building manufacturer Jim Walter's Corporation dropped from $1.51 to $1.17 per share, the company offset 11 cents per share of the decline by capitalizing the interest on coal mining projects and several plants under construction.
How do statement users determine the impact of interest capitalization on a company's bottom line? They examine the notes to the financial statements. Companies with material interest capitalization must disclose the amounts of capitalized interest relative to total interest costs. For example, Anadarko Petroleum Corporation capitalized nearly 30 percent of its total interest costs in a recent year and provided the following footnote related to capitalized interest.
Like other assets, companies should record property, plant, and equipment at the fair value of what they give up or at the fair value of the asset received, whichever is more clearly evident. However, the process of asset acquisition sometimes obscures fair value. For example, if a company buys land and buildings together for one price, how does it determine separate values for the land and buildings? We examine these types of accounting problems in the following sections.
When a company purchases plant assets subject to cash discounts for prompt payment, how should it report the discount? If it takes the discount, the company should consider the discount as a reduction in the purchase price of the asset. But should the company reduce the asset cost even if it does not take the discount?
Two points of view exist on this question. One approach considers the discount—whether taken or not—as a reduction in the cost of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash equivalent price of the asset. In addition, some argue that the terms of cash discounts are so attractive that failure to take them indicates management error or inefficiency.
Proponents of the other approach argue that failure to take the discount should not always be considered a loss. The terms may be unfavorable, or it might not be prudent for the company to take the discount. At present, companies use both methods, though most prefer the former method.
Companies frequently purchase plant assets on long-term credit contracts, using notes, mortgages, bonds, or equipment obligations. To properly reflect cost, companies account for assets purchased on long-term credit contracts at the present value of the consideration exchanged between the contracting parties at the date of the transaction.
For example, Greathouse Company purchases an asset today in exchange for a $10,000 zero-interest-bearing note payable four years from now. The company would not record the asset at $10,000. Instead, the present value of the $10,000 note establishes the exchange price of the transaction (the purchase price of the asset). Assuming an appropriate interest rate of 9 percent at which to discount this single payment of $10,000 due four years from now, Greathouse records this asset at $7,084.30 ($10,000 × .70843). [See Table 6-2 for the present value of a single sum, PV = $10,000 (PVF4,9%).]
When no interest rate is stated, or if the specified rate is unreasonable, the company imputes an appropriate interest rate. The objective is to approximate the interest rate that the buyer and seller would negotiate at arm's length in a similar borrowing transaction. In imputing an interest rate, companies consider such factors as the borrower's credit rating, the amount and maturity date of the note, and prevailing interest rates. The company uses the cash exchange price of the asset acquired (if determinable) as the basis for recording the asset and measuring the interest element.
To illustrate, Sutter Company purchases a specially built robot spray painter for its production line. The company issues a $100,000, five-year, zero-interest-bearing note to Wrigley Robotics, Inc. for the new equipment. The prevailing market rate of interest for obligations of this nature is 10 percent. Sutter is to pay off the note in five $20,000 installments, made at the end of each year. Sutter cannot readily determine the fair value of this specially built robot. Therefore Sutter approximates the robot's value by establishing the fair value (present value) of the note. Entries for the date of purchase and dates of payments, plus computation of the present value of the note, are as follows.
Interest expense in the first year under the effective-interest approach is $7,582 [($100,000 − $24,184) × 10%]. The entry at the end of the second year to record interest and principal payment is as follows.
Interest expense in the second year under the effective-interest approach is $6,340 [($100,000 − $24,184) − ($20,000 − $7,582)] × 10%.
If Sutter did not impute an interest rate for deferred-payment contracts, it would record the asset at an amount greater than its fair value. In addition, Sutter would understate interest expense in the income statement for all periods involved.
A special problem of valuing fixed assets arises when a company purchases a group of plant assets at a single lump-sum price. When this common situation occurs, the company allocates the total cost among the various assets on the basis of their relative fair values. The assumption is that costs will vary in direct proportion to fair value. This is the same principle that companies apply to allocate a lump-sum cost among different inventory items.
To determine fair value, a company should use valuation techniques that are appropriate in the circumstances. In some cases, a single valuation technique will be appropriate. In other cases, multiple valuation approaches might have to be used.[140]
To illustrate, Norduct Homes, Inc. decides to purchase several assets of a small heating concern, Comfort Heating, for $80,000. Comfort Heating is in the process of liquidation. Its assets sold are:
Norduct Homes allocates the $80,000 purchase price on the basis of the relative fair values (assuming specific identification of costs is impracticable) in the following manner.
When companies acquire property by issuing securities, such as common stock, the par or stated value of such stock fails to properly measure the property cost. If trading of the stock is active, the market value of the stock issued is a fair indication of the cost of the property acquired. The stock is a good measure of the current cash equivalent price.
For example, Upgrade Living Co. decides to purchase some adjacent land for expansion of its carpeting and cabinet operation. In lieu of paying cash for the land, the company issues to Deedland Company 5,000 shares of common stock (par value $10) that have a fair market value of $12 per share. Upgrade Living Co. records the following entry.
If the company cannot determine the market value of the common stock exchanged, it establishes the fair value of the property. It then uses the value of the property as the basis for recording the asset and issuance of the common stock.
The proper accounting for exchanges of nonmonetary assets, such as property, plant, and equipment, is controversial.[141] Some argue that companies should account for these types of exchanges based on the fair value of the asset given up or the fair value of the asset received, with a gain or loss recognized. Others believe that they should account for exchanges based on the recorded amount (book value) of the asset given up, with no gain or loss recognized. Still others favor an approach that recognizes losses in all cases, but defers gains in special situations.
Ordinarily companies account for the exchange of nonmonetary assets on the basis of the fair value of the asset given up or the fair value of the asset received, whichever is clearly more evident. [5] Thus, companies should recognize immediately any gains or losses on the exchange. The rationale for immediate recognition is that most transactions have commercial substance, and therefore gains and losses should be recognized.
As indicated above, fair value is the basis for measuring an asset acquired in a nonmonetary exchange if the transaction has commercial substance. An exchange has commercial substance if the future cash flows change as a result of the transaction. That is, if the two parties' economic positions change, the transaction has commercial substance.
The FASB recently changed its accounting for exchanges to converge with iGAAP. Previously, the FASB used a "similar in nature" criterion for exchanged assets to determine whether gains should be recognized. With use of the commercial substance test, U.S. GAAP and iGAAP are now very similar.
For example, Andrew Co. exchanges some if its equipment for land held by Roddick Inc. It is likely that the timing and amount of the cash flows arising for the land will differ significantly from the cash flows arising from the equipment. As a result, both Andrew Co. and Roddick Inc. are in different economic positions. Therefore, the exchange has commercial substance, and the companies recognize a gain or loss on the exchange.
What if companies exchange similar assets, such as one truck for another truck? Even in an exchange of similar assets, a change in the economic position of the company can result. For example, let's say the useful life of the truck received is significantly longer than that of the truck given up. The cash flows for the trucks can differ significantly. As a result, the transaction has commercial substance, and the company should use fair value as a basis for measuring the asset received in the exchange.
However, it is possible to exchange similar assets but not have a significant difference in cash flows. That is, the company is in the same economic position as before the exchange. In that case, the company recognizes a loss but generally defers a gain.
As we will see in the examples below, use of fair value generally results in recognizing a gain or loss at the time of the exchange. Consequently, companies must determine if the transaction has commercial substance. To make this determination, they must carefully evaluate the cash flow characteristics of the assets exchanged.[142]
Illustration 10-10 summarizes asset exchange situations and the related accounting.
As Illustration 10-10 indicates, companies immediately recognize losses they incur on all exchanges. The accounting for gains depends on whether the exchange has commercial substance. If the exchange has commercial substance, the company recognizes the gain immediately. However, the profession modifies the rule for immediate recognition of a gain when an exchange lacks commercial substance: If the company receives no cash in such an exchange, it defers recognition of a gain. If the company receives cash in such an exchange, it recognizes part of the gain immediately.
To illustrate the accounting for these different types of transactions, we examine various loss and gain exchange situations.
When a company exchanges nonmonetary assets and a loss results, the company recognizes the loss immediately. The rationale: Companies should not value assets at more than their cash equivalent price; if the loss were deferred, assets would be overstated. Therefore, companies recognize a loss immediately whether the exchange has commercial substance or not.
For example, Information Processing, Inc. trades its used machine for a new model at Jerrod Business Solutions Inc. The exchange has commercial substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulated depreciation) and a fair value of $6,000. The new model lists for $16,000. Jerrod gives Information Processing a trade-in allowance of $9,000 for the used machine. Information Processing computes the cost of the new asset as follows.
Information Processing records this transaction as follows:
We verify the loss on the disposal of the used machine as follows:
Why did Information Processing not use the trade-in allowance or the book value of the old asset as a basis for the new equipment? The company did not use the trade-in allowance because it included a price concession (similar to a price discount). Few individuals pay list price for a new car. Dealers such as Jerrod often inflate trade-in allowances on the used car so that actual selling prices fall below list prices. To record the car at list price would state it at an amount in excess of its cash equivalent price because of the new car's inflated list price. Similarly, use of book value in this situation would overstate the value of the new machine by $2,000.[143]
Has Commercial Substance. Now let's consider the situation in which a nonmonetary exchange has commercial substance and a gain is realized. In such a case, a company usually records the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset at the fair value of the asset given up, and immediately recognizes a gain. The company should use the fair value of the asset received only if it is more clearly evident than the fair value of the asset given up.
To illustrate, Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Interstate's purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair market value of $49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi-truck. Interstate computes the cost of the semi-truck as follows.
Interstate records the exchange transaction as follows:
The gain is the difference between the fair value of the used trucks and their book value. We verify the computation as follows.
In this case, Interstate is in a different economic position, and therefore the transaction has commercial substance. Thus, it recognizes a gain.
Lacks Commercial Substance—No Cash Received. We now assume that the Interstate Transportation Company exchange lacks commercial substance. That is, the economic position of Interstate did not change significantly as a result of this exchange. In this case, Interstate defers the gain of $7,000 and reduces the basis of the semi-truck. Illustration 10-15 shows two different but acceptable computations to illustrate this reduction.
Interstate records this transaction as follows:
If the exchange lacks commercial substance, the company recognizes the gain (reflected in the basis of the semi-truck) when it later sells the semi-truck, not at the time of the exchange.
Lacks Commercial Substance—Some Cash Received. When a company receives cash (sometimes referred to as "boot") in an exchange that lacks commercial substance, it may immediately recognize a portion of the gain.[144] Illustration 10-16 shows the general formula for gain recognition when an exchange includes some cash.
To illustrate, assume that Queenan Corporation traded in used machinery with a book value of $60,000 (cost $110,000 less accumulated depreciation $50,000) and a fair value of $100,000. It receives in exchange a machine with a fair value of $90,000 plus cash of $10,000. Illustration 10-17 shows calculation of the total gain on the exchange.
Generally, when a transaction lacks commercial substance, a company defers any gain. But because Queenan received $10,000 in cash, it recognizes a partial gain. The portion of the gain a company recognizes is the ratio of monetary assets (cash in this case) to the total consideration received. Queenan computes the partial gain as follows:
Because Queenan recognizes only a gain of $4,000 on this transaction, it defers the remaining $36,000 ($40,000 − $4,000) and reduces the basis (recorded cost) of the new machine. Illustration 10-19 shows the computation of the basis.
Queenan records the transaction with the following entry.
The rationale for the treatment of a partial gain is as follows: Before a nonmonetary exchange that includes some cash, a company has an unrecognized gain, which is the difference between the book value and the fair value of the old asset. When the exchange occurs, a portion of the fair value is converted to a more liquid asset. The ratio of this liquid asset to the total consideration received is the portion of the total gain that the company realizes. Thus, the company recognizes and records that amount.
Illustration 10-20 presents in summary form the accounting requirements for recognizing gains and losses on exchanges of nonmonetary assets.[145]
Companies disclose in their financial statements nonmonetary exchanges during a period. Such disclosure indicates the nature of the transaction(s), the method of accounting for the assets exchanged, and gains or losses recognized on the exchanges. [7]
In a press release, Roy Olofson, former vice president of finance for Global Crossing, accused company executives of improperly describing the company's revenue to the public. He said the company had improperly recorded long-term sales immediately rather than over the term of the contract, had improperly booked as cash transactions swaps of capacity with other carriers, and had fired him when he blew the whistle.
The accounting for the swaps involves exchanges of similar network capacity. Companies have said they engage in such deals because swapping is quicker and less costly than building segments of their own networks, or because such pacts provide redundancies to make their own networks more reliable. In one expert's view, an exchange of similar network capacity is the equivalent of trading a blue truck for a red truck—it shouldn't boost a company's revenue.
But Global Crossing and Qwest, among others, counted as revenue the money received from the other company in the swap. (In general, in transactions involving leased capacity, the companies booked the revenue over the life of the contract.) Some of these companies then treated their own purchases as capital expenditures, which were not run through the income statement. Instead, the spending led to the addition of assets on the balance sheet (and an inflated bottom line).
The SEC questioned some of these capacity exchanges, because it appeared they were a device to pad revenue. This reaction was not surprising, since revenue growth was a key factor in the valuation of companies such as Global Crossing and Qwest during the craze for tech stocks in the late 1990s and 2000.
Source: Adapted from Henny Sender, "Telecoms Draw Focus for Moves in Accounting," Wall Street Journal (March 26, 2002), p. C7.
Companies sometimes receive or make contributions (donations or gifts). Such contributions, nonreciprocal transfers, transfer assets in one direction. A contribution is often some type of asset (such as cash, securities, land, buildings, or use of facilities), but it also could be the forgiveness of a debt.
When companies acquire assets as donations, a strict cost concept dictates that the valuation of the asset should be zero. However, a departure from the cost principle seems justified; the only costs incurred (legal fees and other relatively minor expenditures) are not a reasonable basis of accounting for the assets acquired. To record nothing is to ignore the economic realities of an increase in wealth and assets. Therefore, companies use the fair value of the asset to establish its value on the books.
What then is the proper accounting for the credit in this transaction? Some believe the credit should be made to Donated Capital (an additional paid-in capital account). This approach views the increase in assets from a donation as contributed capital, rather than as earned revenue.
Others argue that companies should report donations as revenues from contributions. Their reasoning is that only the owners of a business contribute capital. At issue in this approach is whether the company should report revenue immediately or over the period that the asset is employed. For example, to attract new industry a city may offer land, but the receiving enterprise may incur additional costs in the future (e.g., transportation or higher state income taxes) because the location is not the most desirable. As a consequence, some argue that company should defer the revenue and recognize it as the costs are incurred.
The FASB's position is that in general, companies should recognize contributions received as revenues in the period received. [8][146] Companies measure contributions at the fair value of the assets received. [9] To illustrate, Max Wayer Meat Packing, Inc. has recently accepted a donation of land with a fair value of $150,000 from the Memphis Industrial Development Corp. In return Max Wayer Meat Packing promises to build a packing plant in Memphis. Max Wayer's entry is:
When a company contributes a nonmonetary asset, it should record the amount of the donation as an expense at the fair value of the donated asset. If a difference exists between the fair value of the asset and its book value, the company should recognize a gain or loss. To illustrate, Kline Industries donates land to the city of Los Angeles for a city park. The land cost $80,000 and has a fair market value of $110,000. Kline Industries records this donation as follows:
In some cases, companies promise to give (pledge) some type of asset in the future. Should companies record this promise immediately or when they give the assets? If the promise is unconditional (depends only on the passage of time or on demand by the recipient for performance), the company should report the contribution expense and related payable immediately. If the promise is conditional, the company recognizes expense in the period benefited by the contribution, generally when it transfers the asset.
The exception to the historical cost principle for assets acquired through donation is based on fair value. Another exception is the prudent cost concept. This concept states that if for some reason a company ignorantly paid too much for an asset originally, it is theoretically preferable to charge a loss immediately.
For example, assume that a company constructs an asset at a cost much greater than its present economic usefulness. It would be appropriate to charge these excess costs as a loss to the current period, rather than capitalize them as part of the cost of the asset. In practice, the need to use the prudent cost approach seldom develops. Companies typically either use good reasoning in paying a given price or fail to recognize that they have overpaid.
What happens, on the other hand, if a company makes a bargain purchase or internally constructs a piece of equipment at a cost savings? Such savings should not result in immediate recognition of a gain under any circumstances.
After installing plant assets and readying them for use, a company incurs additional costs that range from ordinary repairs to significant additions. The major problem is allocating these costs to the proper time periods. In general, costs incurred to achieve greater future benefits should be capitalized, whereas expenditures that simply maintain a given level of services should be expensed. In order to capitalize costs, one of three conditions must be present:
For example, a company like Boeing should expense expenditures that do not increase an asset's future benefits. That is, it expenses immediately ordinary repairs that maintain the existing condition of the asset or restore it to normal operating efficiency.
Companies expense most expenditures below an established arbitrary minimum amount, say, $100 or $500. Although, conceptually, this treatment may be incorrect, expediency demands it. Otherwise, companies would set up depreciation schedules for such items as wastepaper baskets and ashtrays.
It all started with a check of the books by an internal auditor for WorldCom Inc. The telecom giant's newly installed chief executive had asked for a financial review, and the auditor was spot-checking records of capital expenditures. She found the company was using an unorthodox technique to account for one of its biggest expenses: charges paid to local telephone networks to complete long-distance calls.
Instead of recording these charges as operating expenses, WorldCom recorded a significant portion as capital expenditures. The maneuver was worth hundreds of millions of dollars to World-Com's bottom line. It effectively turned a loss for all of 2001 and the first quarter of 2002 into a profit. The graph below compares WorldCom's accounting to that under GAAP. Soon after this discovery, WorldCom filed for bankruptcy.
Source: Adapted from Jared Sandberg, Deborah Solomon, and Rebecca Blumenstein, "Inside WorldCom's Unearthing of a Vast Accounting Scandal," Wall Street Journal (June 27, 2002,), p. A1.
The distinction between a capital expenditure (asset) and a revenue expenditure (expense) is not always clear-cut. Yet, in most cases, consistent application of a capital/expense policy is more important than attempting to provide general theoretical guidelines for each transaction. Generally, companies incur four major types of expenditures relative to existing assets.
Additions should present no major accounting problems. By definition, companies capitalize any addition to plant assets because a new asset is created. For example, the addition of a wing to a hospital, or of an air conditioning system to an office, increases the service potential of that facility. Companies should capitalize such expenditures and match them against the revenues that will result in future periods.
One problem that arises in this area is the accounting for any changes related to the existing structure as a result of the addition. Is the cost incurred to tear down an old wall to make room for the addition, a cost of the addition or an expense or loss of the period? The answer is that it depends on the original intent. If the company had anticipated building an addition later, then this cost of removal is a proper cost of the addition. But if the company had not anticipated this development, it should properly report the removal as a loss in the current period on the basis of inefficient planning. Normally, the company retains the carrying amount of the old wall in the accounts, although theoretically the company should remove it.
Companies substitute one asset for another through improvements and replacements. What is the difference between an improvement and a replacement? An improvement (betterment) is the substitution of a better asset for the one currently used (say, a concrete floor for a wooden floor). A replacement, on the other hand, is the substitution of a similar asset (a wooden floor for a wooden floor).
Many times improvements and replacements result from a general policy to modernize or rehabilitate an older building or piece of equipment. The problem is differentiating these types of expenditures from normal repairs. Does the expenditure increase the future service potential of the asset? Or does it merely maintain the existing level of service? Frequently, the answer is not clear-cut. Good judgment is required to correctly classify these expenditures.
If the expenditure increases the future service potential of the asset, a company should capitalize it. The accounting is therefore handled in one of three ways, depending on the circumstances:
Use the substitution approach. Conceptually, the substitution approach is correct if the carrying amount of the old asset is available. It is then a simple matter to remove the cost of the old asset and replace it with the cost of the new asset.
To illustrate, Instinct Enterprises decides to replace the pipes in its plumbing system. A plumber suggests that the company use plastic tubing in place of the cast iron pipes and copper tubing. The old pipe and tubing have a book value of $15,000 (cost of $150,000 less accumulated depreciation of $135,000), and a scrap value of $1,000. The plastic tubing system costs $125,000. If Instinct pays $124,000 for the new tubing after exchanging the old tubing, it makes the following entry:
The problem is determining the book value of the old asset. Generally, the components of a given asset depreciate at different rates. However, generally no separate accounting is made. For example, the tires, motor, and body of a truck depreciate at different rates, but most companies use one rate for the entire truck. Companies can set separate depreciation rates, but it is often impractical. If a company cannot determine the carrying amount of the old asset, it adopts one of two other approaches.
Capitalize the new cost. Another approach capitalizes the improvement and keeps the carrying amount of the old asset on the books. The justification for this approach is that the item is sufficiently depreciated to reduce its carrying amount almost to zero. Although this assumption may not always be true, the differences are often insignificant. Companies usually handle improvements in this manner.
Charge to accumulated depreciation. In cases when a company does not improve the quantity or quality of the asset itself, but instead extends its useful life, the company debits the expenditure to Accumulated Depreciation rather than to an asset account. The theory behind this approach is that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. The net carrying amount of the asset is the same whether debiting the asset or accumulated depreciation.
Companies incur rearrangement and reinstallation costs to benefit future periods. An example is the rearrangement and reinstallation of machines to facilitate future production.
If a company like Eastman Kodak can determine or estimate the original installation cost and the accumulated depreciation to date, it handles the rearrangement and reinstallation cost as a replacement. If not, which is generally the case, Eastman Kodak should capitalize the new costs (if material in amount) as an asset to be amortized over future periods expected to benefit. If these costs are immaterial, if they cannot be separated from other operating expenses, or if their future benefit is questionable, the company should immediately expense them.
A company makes ordinary repairs to maintain plant assets in operating condition. It charges ordinary repairs to an expense account in the period incurred, on the basis that it is the primary period benefited. Maintenance charges that occur regularly include replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning. A company treats these as ordinary operating expenses.
It is often difficult to distinguish a repair from an improvement or replacement. The major consideration is whether the expenditure benefits more than one year or one operating cycle, whichever is longer. If a major repair (such as an overhaul) occurs, several periods will benefit. A company should handle the cost as an addition, improvement, or replacement.[147]
An interesting question is whether a company can accrue planned maintenance overhaul costs before the actual costs are incurred. For example, assume that Southwest Airlines schedules major overhauls of its planes every three years. Should Southwest be permitted to accrue these costs and related liability over the three-year period? Some argue that this accrue-in-advance approach better matches expenses to revenues and reports Southwest's obligation for these costs. However, reporting a liability is inappropriate. To whom does Southwest owe? In other words, Southwest has no obligation to an outside party until it has to pay for the overhaul costs, and therefore it has no liability. As a result, companies are not permitted to accrue in advance for planned major overhaul costs either for interim or annual periods. [10]
Illustration 10-21 summarizes the accounting treatment for various costs incurred subsequent to the acquisition of capitalized assets.
A company, like Intel, may retire plant assets voluntarily or dispose of them by sale, exchange, involuntary conversion, or abandonment. Regardless of the type of disposal, depreciation must be taken up to the date of disposition. Then, Intel should remove all accounts related to the retired asset. Generally, the book value of the specific plant asset does not equal its disposal value. As a result, a gain or loss develops. The reason: Depreciation is an estimate of cost allocation and not a process of valuation. The gain or loss is really a correction of net income for the years during which Intel used the fixed asset.
Intel should show gains or losses on the disposal of plant assets in the income statement along with other items from customary business activities. However, if it sold, abandoned, spun off, or otherwise disposed of the "operations of a component of a business," then it should report the results separately in the discontinued operations section of the income statement. That is, Intel should report any gain or loss from disposal of a business component with the related results of discontinued operations.
Companies record depreciation for the period of time between the date of the last depreciation entry and the date of sale. To illustrate, assume that Barret Company recorded depreciation on a machine costing $18,000 for 9 years at the rate of $1,200 per year. If it sells the machine in the middle of the tenth year for $7,000, Barret records depreciation to the date of sale as:
The entry for the sale of the asset then is:
The book value of the machinery at the time of the sale is $6,600 ($18,000 − $11,400). Because the machinery sold for $7,000, the amount of the gain on the sale is $400.
Sometimes an asset's service is terminated through some type of involuntary conversion such as fire, flood, theft, or condemnation. Companies report the difference between the amount recovered (e.g., from a condemnation award or insurance recovery), if any, and the asset's book value as a gain or loss. They treat these gains or losses like any other type of disposition. In some cases, these gains or losses may be reported as extraordinary items in the income statement, if the conditions of the disposition are unusual and infrequent in nature.
To illustrate, Camel Transport Corp. had to sell a plant located on company property that stood directly in the path of an interstate highway. For a number of years the state had sought to purchase the land on which the plant stood, but the company resisted. The state ultimately exercised its right of eminent domain, which the courts upheld. In settlement, Camel received $500,000, which substantially exceeded the $200,000 book value of the plant and land (cost of $400,000 less accumulated depreciation of $200,000). Camel made the following entry.
If the conditions surrounding the condemnation are judged to be unusual and infrequent, Camel's gain of $300,000 is reported as an extraordinary item.
Some object to the recognition of a gain or loss in certain involuntary conversions. For example, the federal government often condemns forests for national parks. The paper companies that owned these forests must report a gain or loss on the condemnation. However, companies such as Georgia-Pacific contend that no gain or loss should be reported because they must replace the condemned forest land immediately and so are in the same economic position as they were before. The issue is whether condemnation and subsequent purchase should be viewed as one or two transactions. GAAP requires "that a gain or loss be recognized when a nonmonetary asset is involuntarily converted to monetary assets even though an enterprise reinvests or is obligated to reinvest the monetary assets in replacement nonmonetary assets." [11]
If a company scraps or abandons an asset without any cash recovery, it recognizes a loss equal to the asset's book value. If scrap value exists, the gain or loss that occurs is the difference between the asset's scrap value and its book value. If an asset still can be used even though it is fully depreciated, it may be kept on the books at historical cost less depreciation.
Companies must disclose in notes to the financial statements the amount of fully depreciated assets in service. For example, Petroleum Equipment Tools Inc. in its annual report disclosed, "The amount of fully depreciated assets included in property, plant, and equipment at December 31 amounted to approximately $98,900,000."
Cost of land: Includes all expenditures made to acquire land and to ready it for use. Land costs typically include (1) the purchase price; (2) closing costs, such as title to the land, attorney's fees, and recording fees; (3) costs incurred in getting the land in condition for its intended use, such as grading, filling, draining, and clearing; (4) assumption of any liens, mortgages, or encumbrances on the property; and (5) any additional land improvements that have an indefinite life.
Cost of buildings: Includes all expenditures related directly to their acquisition or construction. These costs include (1) materials, labor, and overhead costs incurred during construction, and (2) professional fees and building permits.
Cost of equipment: Includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs.
FASB Codification References
FASB ASC 360-10-35-43. [Predecessor literature: "Accounting for the Impairment or Disposal of Long-lived Assets," Statement of Financial Accounting Standards No. 144 (Norwalk, Conn.: FASB, 2001), par. 34.]
FASB ASC 835-20-05. [Predecessor literature: "Capitalization of Interest Cost," Statement of Financial Accounting Standards No. 34 (Stamford, Conn.: FASB, 1979).]
FASB ASC 835-20-15-4. [Predecessor literature: "Determining Materiality for Capitalization of Interest Cost," Statement of Financial Accounting Standards No. 42 (Stamford, Conn.: FASB, 1980), par. 10.]
FASB ASC 820-10-35. [Predecessor literature: "(Predecessor literature: "Fair Value Measurement," Statement of Financial Accounting Standards No. 157 (Norwalk, Conn.: FASB, September 2006), pars. 13-18.]
FASB ASC 845-10-30. [Predecessor literature: "Accounting for Nonmonetary Transactions," Opinions of the Accounting Principles Board No. 29 (New York: AICPA, 1973), par. 18, and "Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29," Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).]
FASB ASC 845-10-25-6. [Predecessor literature: "Interpretations of APB Opinion No. 29," EITF Abstracts No. 01-02 (Norwalk, Conn.: FASB, 2002).]
FASB ASC 845-10-50-1. [Predecessor literature: "Accounting for Nonmonetary Transactions," Opinions of the Accounting Principles Board No. 29 (New York: AICPA, 1973), par. 28, and "Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29," Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).]
FASB ASC 958-605-25-2. [Predecessor literature: "Accounting for Contributions Received and Contributions Made," Statement of Financial Accounting Standards No. 116 (Norwalk, Conn.: FASB, 1993).]
FASB ASC 845-10-30. [Predecessor literature: "Accounting for Nonmonetary Transactions," Opinions of the Accounting Principles Board No. 29 (New York: AICPA, 1973), par. 18, and "Exchanges of Nonmonetary Assets, an Amendment of APB Opinion No. 29," Statement of Financial Accounting Standards No. 153 (Norwalk, Conn.: FASB, 2004).]
FASB ASC 360-10-25-5. [Predecessor literature: "Accounting for Planned Major Maintenance Activities," FASB Staff Position AUG-AIR-1 (Norwalk, Conn.: FASB, September 2006), par. 5.]
FASB ASC 605-40-25-2. [Predecessor literature: "Accounting for Involuntary Conversions of Nonmonetary Assets to Monetary Assets," FASB Interpretation No. 30 (Stamford, Conn.: FASB, 1979), summary paragraph.]
What are the major characteristics of plant assets?
Mickelson Inc. owns land that it purchased on January 1, 2000, for $450,000. At December 31, 2010, its current value is $770,000 as determined by appraisal. At what amount should Mickelson report this asset on its December 31, 2010, balance sheet? Explain.
Name the items, in addition to the amount paid to the former owner or contractor, that may properly be included as part of the acquisition cost of the following plant assets.
Land.
Machinery and equipment.
Buildings.
Indicate where the following items would be shown on a balance sheet.
A lien that was attached to the land when purchased.
Landscaping costs.
Attorney's fees and recording fees related to purchasing land.
Variable overhead related to construction of machinery.
A parking lot servicing employees in the building.
Cost of temporary building for workers during construction of building.
Interest expense on bonds payable incurred during construction of a building.
Assessments for sidewalks that are maintained by the city.
The cost of demolishing an old building that was on the land when purchased.
Two positions have normally been taken with respect to the recording of fixed manufacturing overhead as an element of the cost of plant assets constructed by a company for its own use:
It should be excluded completely.
It should be included at the same rate as is charged to normal operations.
What are the circumstances or rationale that support or deny the application of these methods?
The Buildings account of Postera Inc. includes the following items that were used in determining the basis for depreciating the cost of a building.
Organization and promotion expenses.
Architect's fees.
Interest and taxes during construction.
Interest revenue on investments held to fund construction of a building.
Do you agree with these charges? If not, how would you deal with each of the items above in the corporation's books and in its annual financial statements?
Burke Company has purchased two tracts of land. One tract will be the site of its new manufacturing plant, while the other is being purchased with the hope that it will be sold in the next year at a profit. How should these two tracts of land be reported in the balance sheet?
One financial accounting issue encountered when a company constructs its own plant is whether the interest cost on funds borrowed to finance construction should be capitalized and then amortized over the life of the assets constructed. What is the justification for capitalizing such interest?
Provide examples of assets that do not qualify for interest capitalization.
What interest rates should be used in determining the amount of interest to be capitalized? How should the amount of interest to be capitalized be determined?
How should the amount of interest capitalized be disclosed in the notes to the financial statements? How should interest revenue from temporarily invested excess funds borrowed to finance the construction of assets be accounted for?
Discuss the basic accounting problem that arises in handling each of the following situations.
Assets purchased by issuance of capital stock.
Acquisition of plant assets by gift or donation.
Purchase of a plant asset subject to a cash discount.
Assets purchased on a long-term credit basis.
A group of assets acquired for a lump sum.
An asset traded in or exchanged for another asset.
Magilke Industries acquired equipment this year to be used in its operations. The equipment was delivered by the suppliers, installed by Magilke, and placed into operation. Some of it was purchased for cash with discounts available for prompt payment. Some of it was purchased under long-term payment plans for which the interest charges approximated prevailing rates. What costs should Magilke capitalize for the new equipment purchased this year? Explain.
Schwartzkopf Co. purchased for $2,200,000 property that included both land and a building to be used in operations. The seller's book value was $300,000 for the land and $900,000 for the building. By appraisal, the fair market value was estimated to be $500,000 for the land and $2,000,000 for the building. At what amount should Schwartzkopf report the land and the building at the end of the year?
Pueblo Co. acquires machinery by paying $10,000 cash and signing a $5,000, 2-year, zero-interest-bearing note payable. The note has a present value of $4,208, and Pueblo purchased a similar machine last month for $13,500. At what cost should the new equipment be recorded?
Stan Ott is evaluating two recent transactions involving exchanges of equipment. In one case, the exchange has commercial substance. In the second situation, the exchange lacks commercial substance. Explain to Stan the differences in accounting for these two situations.
Crowe Company purchased a heavy-duty truck on July 1, 2007, for $30,000. It was estimated that it would have a useful life of 10 years and then would have a trade-in value of $6,000. The company uses the straight-line method. It was traded on August 1, 2011, for a similar truck costing $42,000; $16,000 was allowed as trade-in value (also fair value) on the old truck and $26,000 was paid in cash. A comparison of expected cash flows for the trucks indicates the exchange lacks commercial substance. What is the entry to record the trade-in?
Once equipment has been installed and placed in operation, subsequent expenditures relating to this equipment are frequently thought of as repairs or general maintenance and, hence, chargeable to operations in the period in which the expenditure is made. Actually, determination of whether such an expenditure should be charged to operations or capitalized involves a much more careful analysis of the character of the expenditure. What are the factors that should be considered in making such a decision? Discuss fully.
What accounting treatment is normally given to the following items in accounting for plant assets?
Additions.
Major repairs.
Improvements and replacements.
New machinery, which replaced a number of employees, was installed and put in operation in the last month of the fiscal year. The employees had been dismissed after payment of an extra month's wages, and this amount was added to the cost of the machinery. Discuss the propriety of the charge. If it was improper, describe the proper treatment.
To what extent do you consider the following items to be proper costs of the fixed asset? Give reasons for your opinions.
Overhead of a business that builds its own equipment.
Cash discounts on purchases of equipment.
Interest paid during construction of a building.
Cost of a safety device installed on a machine.
Freight on equipment returned before installation, for replacement by other equipment of greater capacity.
Cost of moving machinery to a new location.
Cost of plywood partitions erected as part of the remodeling of the office.
Replastering of a section of the building.
Cost of a new motor for one of the trucks.
Neville Enterprises has a number of fully depreciated assets that are still being used in the main operations of the business. Because the assets are fully depreciated, the president of the company decides not to show them on the balance sheet or disclose this information in the notes. Evaluate this procedure.
What are the general rules for how gains or losses on retirement of plant assets should be reported in income?
$13,000 paid to rearrange and reinstall machinery.
$200,000 paid for addition to building.
$200 paid for tune-up and oil change on delivery truck.
$7,000 paid to replace a wooden floor with a concrete floor.
$2,000 paid for a major overhaul on a truck, which extends the useful life.
(a) Money borrowed to pay building contractor (signed a note)
$(275,000)
(b) Payment for construction from note proceeds
275,000
(c) Cost of land fill and clearing
10,000
(d) Delinquent real estate taxes on property assumed by purchaser
7,000
(e) Premium on 6-month insurance policy during construction
6,000
(f) Refund of 1-month insurance premium because construction completed early
(1,000)
(g) Architect's fee on building
25,000
(h) Cost of real estate purchased as a plant site (land $200,000 and building $50,000)
250,000
(i) Commission fee paid to real estate agency
9,000
(j) Installation of fences around property
4,000
(k) Cost of razing and removing building
11,000
(l) Proceeds from salvage of demolished building
(5,000)
(m) Interest paid during construction on money borrowed for construction
13,000
(n) Cost of parking lots and driveways
19,000
(o) Cost of trees and shrubbery planted (permanent in nature)
14,000
(p) Excavation costs for new building
3,000
Instructions
Identify each item by letter and list the items in columnar form, using the headings shown below. All receipt amounts should be reported in parentheses. For any amounts entered in the Other Accounts column also indicate the account title.
Instructions
Determine the cost of the land and the cost of the building as they should be recorded on the books of Pollachek Co. Assume that the land survey was for the building.
Truck #1 has a list price of $15,000 and is acquired for a cash payment of $13,900.
Truck #2 has a list price of $20,000 and is acquired for a down payment of $2,000 cash and a zero-interest-bearing note with a face amount of $18,000. The note is due April 1, 2011. Shabbona would normally have to pay interest at a rate of 10% for such a borrowing, and the dealership has an incremental borrowing rate of 8%.
Truck #3 has a list price of $16,000. It is acquired in exchange for a computer system that Shabbona carries in inventory. The computer system cost $12,000 and is normally sold by Shabbona for $15,200. Shabbona uses a perpetual inventory system.
Truck #4 has a list price of $14,000. It is acquired in exchange for 1,000 shares of common stock in Shabbona Corporation. The stock has a par value per share of $10 and a market value of $13 per share.
Instructions
Prepare the appropriate journal entries for the foregoing transactions for Shabbona Corporation. (Round computations to the nearest dollar.)
Instructions
Compute the total cost for each of these two pieces of equipment. If an item is not capitalized as a cost of the equipment, indicate how it should be reported.
Instructions
Determine the amounts that should be debited to Land, to Buildings, and to Machinery and Equipment. Assume the benefits of capitalizing interest during construction exceed the cost of implementation. Indicate how any costs not debited to these accounts should be recorded.
Natchez Industries Inc. acquired land, buildings, and equipment from a bankrupt company, Vivace Co., for a lump-sum price of $680,000. At the time of purchase, Vivace's assets had the following book and appraisal values.
To be conservative, the company decided to take the lower of the two values for each asset acquired. The following entry was made.
Arawak Enterprises purchased store equipment by making a $2,000 cash down payment and signing a 1-year, $23,000, 10% note payable. The purchase was recorded as follows.
Ace Company purchased office equipment for $20,000, terms 2/10, n/30. Because the company intended to take the discount, it made no entry until it paid for the acquisition. The entry was:
Paunee Inc. recently received at zero cost land from the Village of Cardassia as an inducement to locate its business in the Village. The appraised value of the land is $27,000. The company made no entry to record the land because it had no cost basis.
Mohegan Company built a warehouse for $600,000. It could have purchased the building for $740,000. The controller made the following entry.
Instructions
Prepare the entry that should have been made at the date of each acquisition.
Instructions
(Carry all computations to two decimal places.)
Assume that McPherson completed the office and warehouse building on December 31, 2010, as planned at a total cost of $5,200,000, and the weighted average of accumulated expenditures was $3,800,000. Compute the avoidable interest on this project.
Compute the depreciation expense for the year ended December 31, 2011. McPherson elected to depreciate the building on a straight-line basis and determined that the asset has a useful life of 30 years and a salvage value of $300,000.
Instructions
Determine the amount of interest to be capitalized in 2010 in relation to the construction of the building.
Prepare the journal entry to record the capitalization of interest and the recognition of interest expense, if any, at December 31, 2010.
Instructions
Calculate the interest revenue, weighted-average accumulated expenditures, avoidable interest, and total interest cost to be capitalized during 2010. Round all computations to the nearest dollar.
Prepare the journal entries needed on the books of Bismarck Company at each of the following dates.
July 31, 2010.
November 1, 2010.
December 31, 2010.
Situation I
On January 1, 2010, Columbia, Inc. signed a fixed-price contract to have Builder Associates construct a major plant facility at a cost of $4,000,000. It was estimated that it would take 3 years to complete the project. Also on January 1, 2010, to finance the construction cost, Columbia borrowed $4,000,000 payable in 10 annual installments of $400,000, plus interest at the rate of 10%. During 2010, Columbia made deposit and progress payments totaling $1,500,000 under the contract; the weighted-average amount of accumulated expenditures was $900,000 for the year. The excess borrowed funds were invested in short-term securities, from which Columbia realized investment income of $250,000.
Instructions
What amount should Columbia report as capitalized interest at December 31, 2010?
Situation II
During 2010, Evander Corporation constructed and manufactured certain assets and incurred the following interest costs in connection with those activities.
All of these assets required an extended period of time for completion.
Instructions
Assuming the effect of interest capitalization is material, what is the total amount of interest costs to be capitalized?
Situation III
Antonio, Inc. has a fiscal year ending April 30. On May 1, 2010, Antonio borrowed $10,000,000 at 11% to finance construction of its own building. Repayments of the loan are to commence the month following completion of the building. During the year ended April 30, 2011, expenditures for the partially completed structure totaled $6,000,000. These expenditures were incurred evenly throughout the year. Interest earned on the unexpended portion of the loan amounted to $650,000 for the year.
Instructions
How much should be shown as capitalized interest on Antonio's financial statements at April 30, 2011?
(CPA adapted)
Chopin paid cash for the equipment 8 days after the purchase. The vendor's credit terms are 2/10, n/30. Assume that equipment purchases are recorded gross.
Chopin traded in equipment with a book value of $2,000 (initial cost $8,000), and paid $14,200 in cash one month after the purchase. The old equipment could have been sold for $400 at the date of trade. (The exchange has commercial substance.)
Chopin gave the vendor a $16,200 zero-interest-bearing note for the equipment on the date of purchase. The note was due in one year and was paid on time. Assume that the effective-interest rate in the market was 9%.
Instructions
Prepare the general journal entries required to record the acquisition and payment in each of the independent cases above. Round to the nearest dollar.
The City of Pebble Beach gives the company 5 acres of land as a plant site. The market value of this land is determined to be $81,000.
14,000 shares of common stock with a par value of $50 per share are issued in exchange for land and buildings. The property has been appraised at a fair market value of $810,000, of which $180,000 has been allocated to land and $630,000 to buildings. The stock of Impala Company is not listed on any exchange, but a block of 100 shares was sold by a stockholder 12 months ago at $65 per share, and a block of 200 shares was sold by another stockholder 18 months ago at $58 per share.
No entry has been made to remove from the accounts for Materials, Direct Labor, and Overhead the amounts properly chargeable to plant asset accounts for machinery constructed during the year. The following information is given relative to costs of the machinery constructed.
Instructions
Prepare journal entries on the books of Impala Company to record these transactions.
On July 6 Rommel Company acquired the plant assets of Studebaker Company, which had discontinued operations. The appraised value of the property is:
Rommel Company gave 12,500 shares of its $100 par value common stock in exchange. The stock had a market value of $180 per share on the date of the purchase of the property.
Rommel Company expended the following amounts in cash between July 6 and December 15, the date when it first occupied the building.
On December 20, the company paid cash for machinery, $280,000, subject to a 2% cash discount, and freight on machinery of $10,500.
Instructions
Prepare entries on the books of Rommel Company for these transactions.
Instructions
Prepare the journal entry(ies) at the date of purchase. (Round to nearest dollar in all computations.)
Prepare the journal entry(ies) at the end of the first year to record the payment and interest, assuming that the company employs the effective-interest method.
Prepare the journal entry(ies) at the end of the second year to record the payment and interest.
Assuming that the equipment had a 10-year life and no salvage value, prepare the journal entry necessary to record depreciation in the first year. (Straight-line depreciation is employed.)
Instructions
Prepare the journal entry(ies) at the date of purchase. (Round to two decimal places.)
Prepare the journal entry(ies) at December 31, 2010, to record the payment and interest (effective-interest method employed).
Prepare the journal entry(ies) at December 31, 2011, to record the payment and interest (effective-interest method employed).
Assets 1 and 2
These assets were purchased as a lump sum for $104,000 cash. The following information was gathered.
Asset 3
This machine was acquired by making a $10,000 down payment and issuing a $30,000, 2-year, zero-interest-bearing note. The note is to be paid off in two $15,000 installments made at the end of the first and second years. It was estimated that the asset could have been purchased outright for $35,900.
Asset 4
This machinery was acquired by trading in used machinery. (The exchange lacks commercial substance.) Facts concerning the trade-in are as follows.
Asset 5
Office equipment was acquired by issuing 100 shares of $8 par value common stock. The stock had a market value of $11 per share.
Construction of Building
A building was constructed on land purchased last year at a cost of $180,000. Construction began on February 1 and was completed on November 1. The payments to the contractor were as follows.
To finance construction of the building, a $600,000, 12% construction loan was taken out on February 1. The loan was repaid on November 1. The firm had $200,000 of other outstanding debt during the year at a borrowing rate of 8%.
Instructions
Record the acquisition of each of these assets.
Instructions
For each company, prepare the necessary journal entry to record the exchange. (The exchange has commercial substance.)
Instructions
Prepare the journal entry(ies) necessary to record this exchange, assuming that the exchange (a) has commercial substance, and (b) lacks commercial substance. Montgomery's year ends on December 31, and depreciation has been recorded through December 31, 2010.
Instructions
Prepare the journal entries to record the exchange on the books of both companies. Assume that the exchange lacks commercial substance.
Prepare the journal entries to record the exchange on the books of both companies. Assume that the exchange has commercial substance.
Instructions
Prepare the general journal entry to record this transaction, assuming that the exchange has commercial substance.
Assuming the same facts as in (a) except that fair value information for the assets exchanged is not determinable. Prepare the general journal entry to record this transaction.
During the current year, the following expenditures were made to the plant facility.
Because of increased demands for its product, the company increased its plant capacity by building a new addition at a cost of $270,000.
The entire plant was repainted at a cost of $23,000.
The roof was an asbestos cement slate. For safety purposes it was removed and replaced with a wood shingle roof at a cost of $61,000. Book value of the old roof was $41,000.
The electrical system was completely updated at a cost of $22,000. The cost of the old electrical system was not known. It is estimated that the useful life of the building will not change as a result of this updating.
A series of major repairs were made at a cost of $47,000, because parts of the wood structure were rotting. The cost of the old wood structure was not known. These extensive repairs are estimated to increase the useful life of the building.
Instructions
Indicate how each of these transactions would be recorded in the accounting records.
Instructions
Prepare general journal entries for the transactions. (Round to the nearest dollar.)
Instructions
For each of the following items, indicate whether the expenditure should be capitalized (C) or expensed (E) in the period incurred.
__________ Improvement.
__________ Replacement of a minor broken part on a machine.
__________ Expenditure that increases the useful life of an existing asset.
__________ Expenditure that increases the efficiency and effectiveness of a productive asset but does not increase its salvage value.
__________ Expenditure that increases the efficiency and effectiveness of a productive asset and increases the asset's salvage value.
__________ Ordinary repairs.
__________ Improvement to a machine that increased its fair market value and its production capacity by 30% without extending the machine's useful life.
__________ Expenditure that increases the quality of the output of the productive asset.
Depreciation is computed at $72,000 per year on a straight-line basis.
Instructions
Presented below is a set of independent situations. For each independent situation, indicate the journal entry to be made to record the transaction. Make sure that depreciation entries are made to update the book value of the machine prior to its disposal.
A fire completely destroys the machine on August 31, 2011. An insurance settlement of $630,000 was received for this casualty. Assume the settlement was received immediately.
On April 1, 2011, Chrysler sold the machine for $1,040,000 to Avanti Company.
On July 31, 2011, the company donated this machine to the Mountain King City Council. The fair value of the machine at the time of the donation was estimated to be $1,100,000.
Instructions
Prepare the journal entries to record the transactions on April 1 and August 1, 2010.
During 2010 the following transactions occurred.
Land site number 621 was acquired for $850,000. In addition, to acquire the land Reagan paid a $51,000 commission to a real estate agent. Costs of $35,000 were incurred to clear the land. During the course of clearing the land, timber and gravel were recovered and sold for $13,000.
A second tract of land (site number 622) with a building was acquired for $420,000. The closing statement indicated that the land value was $300,000 and the building value was $120,000. Shortly after acquisition, the building was demolished at a cost of $41,000. A new building was constructed for $330,000 plus the following costs.
The building was completed and occupied on September 30, 2010.
A third tract of land (site number 623) was acquired for $650,000 and was put on the market for resale.
During December 2010 costs of $89,000 were incurred to improve leased office space. The related lease will terminate on December 31, 2012, and is not expected to be renewed. (Hint: Leasehold improvements should be handled in the same manner as land improvements.)
A group of new machines was purchased under a royalty agreement that provides for payment of royalties based on units of production for the machines. The invoice price of the machines was $87,000, freight costs were $3,300, installation costs were $2,400, and royalty payments for 2010 were $17,500.
Instructions
Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2010.
Disregard the related accumulated depreciation accounts.
List the items in the situation that were not used to determine the answer to (a) above, and indicate where, or if, these items should be included in Reagan's financial statements.
(AICPA adapted)
During 2010 the following transactions occurred.
A tract of land was acquired for $150,000 as a potential future building site.
A plant facility consisting of land and building was acquired from Mendota Company in exchange for 20,000 shares of Lobo's common stock. On the acquisition date, Lobo's stock had a closing market price of $37 per share on a national stock exchange. The plant facility was carried on Mendota's books at $110,000 for land and $320,000 for the building at the exchange date. Current appraised values for the land and building, respectively, are $230,000 and $690,000.
Items of machinery and equipment were purchased at a total cost of $400,000. Additional costs were incurred as follows.
Expenditures totaling $95,000 were made for new parking lots, streets, and sidewalks at the corporation's various plant locations. These expenditures had an estimated useful life of 15 years.
A machine costing $80,000 on January 1, 2002, was scrapped on June 30, 2010. Double-declining-balance depreciation has been recorded on the basis of a 10-year life.
A machine was sold for $20,000 on July 1, 2010. Original cost of the machine was $44,000 on January 1, 2007, and it was depreciated on the straight-line basis over an estimated useful life of 7 years and a salvage value of $2,000.
Instructions
Prepare a detailed analysis of the changes in each of the following balance sheet accounts for 2010.
(Hint: Disregard the related accumulated depreciation accounts.)
List the items in the fact situation that were not used to determine the answer to (a), showing the pertinent amounts and supporting computations in good form for each item. In addition, indicate where, or if, these items should be included in Lobo's financial statements.
(AICPA adapted)
The Land and Building account reported the following items during 2011.
The following additional information is to be considered.
To acquire land and building the company paid $80,000 cash and 800 shares of its 8% cumulative preferred stock, par value $100 per share. Fair market value of the stock is $117 per share.
Cost of removal of old buildings amounted to $9,800, and the demolition company retained all materials of the building.
Legal fees covered the following.
Insurance premium covered the building for a 2-year term beginning May 1, 2011.
The special tax assessment covered street improvements that are permanent in nature.
General expenses covered the following for the period from January 2, 2011, to June 30, 2011.
Because of a general increase in construction costs after entering into the building contract, the board of directors increased the value of the building $53,800, believing that such an increase was justified to reflect the current market at the time the building was completed. Retained earnings was credited for this amount.
Estimated life of building—50 years.
Depreciation for 2011—1% of asset value (1% of $400,000, or $4,000).
Instructions
Prepare entries to reflect correct land, building, and depreciation accounts at December 31, 2011.
Show the proper presentation of land, building, and depreciation on the balance sheet at December 31, 2011.
(AICPA adapted)
The following additional information is available.
Land
On February 15, a condemnation award was received as consideration for unimproved land held primarily as an investment, and on March 31, another parcel of unimproved land to be held as an investment was purchased at a cost of $35,000.
Building
On April 2, land and building were purchased at a total cost of $75,000, of which 20% was allocated to the building on the corporate books. The real estate was acquired with the intention of demolishing the building, and this was accomplished during the month of November. Cash proceeds received in November represent the net proceeds from demolition of the building.
Warehouse
On June 30, the warehouse was destroyed by fire. The warehouse was purchased January 2, 2007, and had depreciated $16,000. On December 27, the insurance proceeds and other funds were used to purchase a replacement warehouse at a cost of $90,000.
Machine
On December 26, the machine was exchanged for another machine having a fair market value of $6,300 and cash of $900 was received. (The exchange lacks commercial substance.)
Furniture
On August 15, furniture was contributed to a qualified charitable organization. No other contributions were made or pledged during the year.
Automobile
On November 3, the automobile was sold to Jared Winger, a stockholder.
Instructions
Indicate how these items would be reported on the income statement of Hollerith Co.
(AICPA adapted)
Blair entered into a $3,000,000 fixed-price contract with Slatkin Builders, Inc. on March 1, 2010, for the construction of an office building on land site number 101. The building was completed and occupied on September 30, 2011. Additional construction costs were incurred as follows.
The building is estimated to have a 40-year life from date of completion and will be depreciated using the 150% declining-balance method.
To finance construction costs, Blair borrowed $3,000,000 on March 1, 2010. The loan is payable in 10 annual installments of $300,000 plus interest at the rate of 10%. Blair's weighted-average amounts of accumulated building construction expenditures were as follows.
Instructions
Prepare a schedule that discloses the individual costs making up the balance in the land account in respect of land site number 101 as of September 30, 2011.
Prepare a schedule that discloses the individual costs that should be capitalized in the office building account as of September 30, 2011. Show supporting computations in good form.
(AICPA adapted)
Architectural plans were also formalized on December 1, 2010, when the architect was paid $30,000. The necessary building permits costing $3,000 were obtained from the city and paid for on December 1 as well. The excavation work began during the first week in December with payments made to the contractor as follows.
The building was completed on July 1, 2011.
To finance construction of this plant, Grieg borrowed $600,000 from the bank on December 1, 2010. Grieg had no other borrowings. The $600,000 was a 10-year loan bearing interest at 8%.
Instructions
Compute the balance in each of the following accounts at December 31, 2010, and December 31, 2011. (Round amounts to the nearest dollar.)
Land.
Buildings.
Interest Expense.
On June 1, 2010, Laserwords contracted with Black Construction to have a new building constructed for $4,000,000 on land owned by Laserwords. The payments made by Laserwords to Black Construction are shown in the schedule below.
Construction was completed and the building was ready for occupancy on May 27, 2011. Laserwords had no new borrowings directly associated with the new building but had the following debt outstanding at May 31, 2011, the end of its fiscal year.
10%, 5-year note payable of $2,000,000, dated April 1, 2007, with interest payable annually on April 1.
12%, 10-year bond issue of $3,000,000 sold at par on June 30, 2003, with interest payable annually on June 30.
The new building qualifies for interest capitalization. The effect of capitalizing the interest on the new building, compared with the effect of expensing the interest, is material.
Instructions
Compute the weighted-average accumulated expenditures on Laserwords' new building during the capitalization period.
Compute the avoidable interest on Laserwords' new building.
Some interest cost of Laserwords Inc. is capitalized for the year ended May 31, 2011.
Identify the items relating to interest costs that must be disclosed in Laserwords' financial statements.
Compute the amount of each of the items that must be disclosed.
(CMA adapted)
Dorsett Company offered to exchange a similar machine plus $23,000. (The exchange has commercial substance for both parties.)
Winston Company offered to exchange a similar machine. (The exchange lacks commercial substance for both parties.)
Liston Company offered to exchange a similar machine, but wanted $3,000 in addition to Holyfield's machine. (The exchange has commercial substance for both parties.)
In addition, Holyfield contacted Greeley Corporation, a dealer in machines. To obtain a new machine, Holyfield must pay $93,000 in addition to trading in its old machine.
Instructions
For each of the four independent situations, prepare the journal entries to record the exchange on the books of each company.
Instructions
Assuming that the exchange of Assets A and B has commercial substance, record the exchange for both Hyde, Inc. and Wiggins, Inc. in accordance with generally accepted accounting principles.
Assuming that the exchange of Assets A and B lacks commercial substance, record the exchange for both Hyde, Inc. and Wiggins, Inc. in accordance with generally accepted accounting principles.
Instructions
Assuming that this exchange is considered to have commercial substance, prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing.
Assuming that this exchange lacks commercial substance for Marshall, prepare the journal entries on the books of Marshall Construction.
Assuming the same facts as those in (a), except that the fair value of the old crane is $98,000 and the cash paid is $102,000, prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing.
Assuming the same facts as those in (b), except that the fair value of the old crane is $97,000 and the cash paid $103,000, prepare the journal entries on the books of (1) Marshall Construction and (2) Brigham Manufacturing.
Transaction 1
On June 1, 2010, Klamath Company purchased equipment from Wyandot Corporation. Klamath issued a $28,000, 4-year, zero-interest-bearing note to Wyandot for the new equipment. Klamath will pay off the note in four equal installments due at the end of each of the next 4 years. At the date of the transaction, the prevailing market rate of interest for obligations of this nature was 10%. Freight costs of $425 and installation costs of $500 were incurred in completing this transaction. The appropriate factors for the time value of money at a 10% rate of interest are given below.
Transaction 2
On December 1, 2010, Klamath Company purchased several assets of Yakima Shoes Inc., a small shoe manufacturer whose owner was retiring. The purchase amounted to $220,000 and included the assets listed below. Klamath Company engaged the services of Tennyson Appraisal Inc., an independent appraiser, to determine the fair values of the assets which are also presented below.
During its fiscal year ended May 31, 2011, Klamath incurred $8,000 for interest expense in connection with the financing of these assets.
Transaction 3
On March 1, 2011, Klamath Company exchanged a number of used trucks plus cash for vacant land adjacent to its plant site. (The exchange has commercial substance.) Klamath intends to use the land for a parking lot. The trucks had a combined book value of $35,000, as Klamath had recorded $20,000 of accumulated depreciation against these assets. Klamath's purchasing agent, who has had previous dealings in the secondhand market, indicated that the trucks had a fair value of $46,000 at the time of the transaction. In addition to the trucks, Klamath Company paid $19,000 cash for the land.
Instructions
Plant assets such as land, buildings, and equipment receive special accounting treatment. Describe the major characteristics of these assets that differentiate them from other types of assets.
For each of the three transactions described above, determine the value at which Klamath Company should record the acquired assets. Support your calculations with an explanation of the underlying rationale.
The books of Klamath Company show the following additional transactions for the fiscal year ended May 31, 2011.
Acquisition of a building for speculative purposes.
Purchase of a 2-year insurance policy covering plant equipment.
Purchase of the rights for the exclusive use of a process used in the manufacture of ballet shoes.
For each of these transactions, indicate whether the asset should be classified as a plant asset. If it is a plant asset, explain why it is. If it is not a plant asset, explain why not, and identify the proper classification.
(CMA adapted)
Three years after the office building was occupied, Tonkawa Company added four stories to the office building. The four stories had an estimated useful life of 5 years more than the remaining estimated useful life of the original office building.
Ten years later the land and building were sold at an amount more than their net book value, and Tonkawa Company had a new office building constructed in another state for use as its new corporate headquarters.
Instructions
Which of the expenditures above should be capitalized? How should each be depreciated or amortized? Discuss the rationale for your answers.
How would the sale of the land and building be accounted for? Include in your answer an explanation of how to determine the net book value at the date of sale. Discuss the rationale for your answer.
CA10-2 (Accounting for Self-Constructed Assets) Troopers Medical Labs, Inc., began operations 5 years ago producing stetrics, a new type of instrument it hoped to sell to doctors, dentists, and hospitals. The demand for stetrics far exceeded initial expectations, and the company was unable to produce enough stetrics to meet demand.
The company was manufacturing its product on equipment that it built at the start of its operations. To meet demand, more efficient equipment was needed. The company decided to design and build the equipment, because the equipment currently available on the market was unsuitable for producing stetrics.
In 2010, a section of the plant was devoted to development of the new equipment and a special staff was hired. Within 6 months a machine developed at a cost of $714,000 increased production dramatically and reduced labor costs substantially. Elated by the success of the new machine, the company built three more machines of the same type at a cost of $441,000 each.
Instructions
In general, what costs should be capitalized for self-constructed equipment?
Discuss the propriety of including in the capitalized cost of self-constructed assets:
The increase in overhead caused by the self-construction of fixed assets.
A proportionate share of overhead on the same basis as that applied to goods manufactured for sale.
Discuss the proper accounting treatment of the $273,000 ($714,000 − $441,000) by which the cost of the first machine exceeded the cost of the subsequent machines. This additional cost should not be considered research and development costs.
CA10-3 (Capitalization of Interest) Langer Airline is converting from piston-type planes to jets. Delivery time for the jets is 3 years, during which substantial progress payments must be made. The multimillion-dollar cost of the planes cannot be financed from working capital; Langer must borrow funds for the payments.
Because of high interest rates and the large sum to be borrowed, management estimates that interest costs in the second year of the period will be equal to one-third of income before interest and taxes, and one-half of such income in the third year.
After conversion, Langer's passenger-carrying capacity will be doubled with no increase in the number of planes, although the investment in planes would be substantially increased. The jet planes have a 7-year service life.
Instructions
Give your recommendation concerning the proper accounting for interest during the conversion period. Support your recommendation with reasons and suggested accounting treatment. (Disregard income tax implications.)
(AICPA adapted)
Total cost amounted to $5,200,000, and the weighted average of accumulated expenditures was $3,500,000.
Jane Esplanade, the president of the company, has been shown the costs associated with this construction project and capitalized on the balance sheet. She is bothered by the "avoidable interest" included in the cost. She argues that, first, all the interest is unavoidable—no one lends money without expecting to be compensated for it. Second, why can't the company use all the interest on all the loans when computing this avoidable interest? Finally, why can't her company capitalize all the annual interest that accrued over the period of construction?
Instructions
You are the manager of accounting for the company. In a memo, explain what avoidable interest is, how you computed it (being especially careful to explain why you used the interest rates that you did), and why the company cannot capitalize all its interest for the year. Attach a schedule supporting any computations that you use.
Instructions
Record the trade-in on Client A's books assuming the exchange has commercial substance.
Record the trade-in on Client A's books assuming the exchange lacks commercial substance.
Write a memo to the controller of Company A indicating and explaining the dollar impact on current and future statements of treating the exchange as having versus lacking commercial substance.
Record the entry on Client B's books assuming the exchange has commercial substance.
Record the entry on Client B's books assuming the exchange lacks commercial substance.
Write a memo to the controller of Company B indicating and explaining the dollar impact on current and future statements of treating the exchange as having versus lacking commercial substance.
CA10-6 (Costs of Acquisition) The invoice price of a machine is $50,000. Various other costs relating to the acquisition and installation of the machine including transportation, electrical wiring, special base, and so on amount to $7,500. The machine has an estimated life of 10 years, with no residual value at the end of that period.
The owner of the business suggests that the incidental costs of $7,500 be charged to expense immediately for the following reasons.
If the machine should be sold, these costs cannot be recovered in the sales price.
The inclusion of the $7,500 in the machinery account on the books will not necessarily result in a closer approximation of the market price of this asset over the years, because of the possibility of changing demand and supply levels.
Charging the $7,500 to expense immediately will reduce federal income taxes.
Instructions
Discuss each of the points raised by the owner of the business.
(AICPA adapted)
Instructions
Answer the following questions.
What stakeholder interests are in conflict?
What ethical issues does Carter face?
How should these costs be allocated?
Johnson & Johnson, the world's leading and most diversified healthcare corporation, serves its customers through specialized worldwide franchises. Each of its franchises consists of a number of companies throughout the world that focus on a particular health care market, such as surgical sutures, consumer pharmaceuticals, or contact lenses. Information related to its property, plant, and equipment in its 2007 annual report is shown in the notes to the financial statements as follows.
Johnson & Johnson's provided the following selected information in its 2007 cash flow statement.
Instructions
What was the cost of buildings and building equipment at the end of 2007?
Does Johnson & Johnson use a conservative or liberal method to depreciate its property, plant, and equipment?
What was the actual interest expense incurred by the company in 2007?
What is Johnson & Johnson's free cash flow? From the information provided, comment on Johnson & Johnson's financial flexibility.
Your client is in the planning phase for a major plant expansion, which will involve the construction of a new warehouse. The assistant controller does not believe that interest cost can be included in the cost of the warehouse, because it is a financing expense. Others on the planning team believe that some interest cost can be included in the cost of the warehouse, but no one could identify the specific authoritative guidance for this issue. Your supervisor asks you to research this issue.
Instructions
Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses.
Is it permissible to capitalize interest into the cost of assets? Provide authoritative support for your answer.
What are the objectives for capitalizing interest?
Discuss which assets qualify for interest capitalization.
Is there a limit to the amount of interest that may be capitalized in a period?
If interest capitalization is allowed, what disclosures are required?
Go to the book's companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to the accounting for property, plant, and equipment.
[137] Additional costs to be included in the cost of property, plant, and equipment are those related to asset retirement obligations (AROs). These costs, such as those related to decommissioning nuclear facilities or reclamation or restoration of a mining facility, reflect a legal requirement to retire the asset at the end of its useful life. The expected costs are recorded in the asset cost and depreciated over the useful life. (See Chapter 13.)
[138] The Accounting Standards Executive Committee (AcSEC) of the AICPA has issued an exposure draft related to property, plant, and equipment. In this exposure draft, AcSEC argues against allocation of overhead. Instead, it basically supports capitalization of only direct costs (costs directly related to the specific activities involved in the construction process). AcSEC was concerned that the allocation of overhead costs may lead to overly aggressive allocations and therefore misstatements of income. In addition, not reporting these costs as period costs during the construction period may affect comparisons of period costs and resulting net income from one period to the next. See Accounting Standards Executive Committee, "Accounting for Certain Costs and Activities Related to Property, Plant, and Equipment," Exposure Draft (New York: AICPA, June 29, 2001).
[139] The interest rate to be used may rely exclusively on an average rate of all the borrowings, if desired. For our purposes, we use the specific borrowing rate followed by the average interest rate because we believe it to be more conceptually consistent. Either method can be used; GAAP does not provide explicit guidance on this measurement. For a discussion of this issue and others related to interest capitalization, see Kathryn M. Means and Paul M. Kazenski, "SFAS 34: Recipe for Diversity," Accounting Horizons (September 1988); and Wendy A. Duffy, "A Graphical Analysis of Interest Capitalization," Journal of Accounting Education (Fall 1990).
[140] The valuation approaches that should be used are the market, income, or cost approach, or a combination of these approaches. The market approach uses observable prices and other relevant information generated by market transactions involving comparable assets. The income approach uses valuation techniques to convert future amounts (for example, cash flows or earnings) to a single present value amount (discounted). The cost approach is based on the amount that currently would be required to replace the service capacity of an asset (often referred to as current replacement cost). In determining the fair value, the company should assume the highest and best use of the asset. [4]
[141] Nonmonetary assets are items whose price in terms of the monetary unit may change over time. Monetary assets—cash and short- or long-term accounts and notes receivable—are fixed in terms of units of currency by contract or otherwise.
[142] The determination of the commercial substance of a transaction requires significant judgment. In determining whether future cash flows change, it is necessary to do one of two things: (1) Determine whether the risk, timing, and amount of cash flows arising for the asset received differ from the cash flows associated with the outbound asset. Or, (2) evaluate whether cash flows are affected with the exchange versus without the exchange. Also note that if companies cannot determine fair values of the assets exchanged, then they should use recorded book values in accounting for the exchange.
[143] Recognize that for Jerrod (the dealer), the asset given up in the exchange is considered inventory. As a result, Jerrod records a sale and related cost of goods sold. The used machine received by Jerrod is recorded at fair value.
[144] When the monetary consideration is significant, i.e., 25 percent or more of the fair value of the exchange, both parties consider the transaction a monetary exchange. Such "monetary" exchanges rely on the fair values to measure the gains or losses that are recognized in their entirety. [6]
[145] Adapted from an article by Robert Capettini and Thomas E. King,"Exchanges of Nonmonetary Assets: Some Changes," The Accounting Review (January 1976).
[146] GAAP is silent on how to account for the transfers of assets from governmental units to business enterprises. However, we believe that the basic requirements should hold also for these types of contributions. Therefore, companies should record all assets at fair value and all credits as revenue.
[147] AcSEC has proposed (see footnote 2) that companies expense as incurred costs involved for planned major expenditures unless they represent an additional component or the replacement of an existing component.