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Unformatted text preview: C H A P T E R. 10 Acquisition of Property, Plant, and Equipment 1. Acquisition cost 2. Other issues related to Acquisition cost 3. Cost subsequent to acquisition Property, Plant, and Equipment
• Also known as: Also
– – – tangible capital assets plant assets fixed assets • Major characteristics include:
1. Acquired for use in operations and not for resale Acquired operations 2. Long-term in nature and usually subject to Long-term amortization amortization 3. Possess physical substance 3. Possess physical Acquisition Cost Acquisition Cost
• Acquisition cost (recorded at initial fair value or cost) Acquisition includes: includes:
(i) the asset’s cash or cash equivalent price, and (ii) the costs of getting ready the asset for its intended use the e.g., purchase price, sales taxes, freight costs, installation costs freight • Cost depends on types of assets acquired: Costs of (1) land, (2) building, (3) equipment, Costs (4) self-constructed assets, and (5) natural resources (4) Cost of Land Cost of Land
• Land costs include:
(1) Purchase price and taxes (1) (2) Closing costs (title transfer, legal fees, etc.) (2) (3) Costs of getting land ready for use (removal of old building(s), clearing, draining, grading, filling, etc.) building(s),
- Proceeds from salvage materials reduce land cost Proceeds (4) Assumption of liens Assumption - Assumption of obligations on the land (e.g., unpaid mortgage, unpaid property tax) (e.g., Cost of Land Cost of Land • Land costs include (Cont’d)
(5) Additional improvements with an indefinite life Additional Special assessments for local improvements (e.g., streets, street lights, sidewalks, sewers, etc.) => Relatively Permanent in nature, because they are maintained by local government What about improvements with a definite life? (e.g., driveways, parking lots, fencing) => Record as Land Improvement and amortized (Landscaping) Cost of Building Cost of Building
• All necessary and reasonable costs incurred to get asset ready for its intended use • Removal of old building to construct a new building
- If the old building is purchased with land If purchased -> Capitalized as part of land cost -> land - If the old building is owned and used by the company If owned -> Expensed as a loss on disposal of old building Expensed loss - If the old building is leased by the company If leased -> Capitalized under Leasehold Improvement and Capitalized amortized by lessee by -> Improvement becomes property of lessor when Improvement property lease expires lease Cost of Equipment Cost of Equipment
E.g.,) Machinery, Factory equipment, Office equipment, E.g.,) Furniture and Fixtures, Furnishing, and Delivery equipment Furniture • All necessary and reasonable costs incurred to get asset All necessary ready for its intended use ready => Includes : =>
– – – – – Purchase price Freight and handling charges Insurance while in transit Costs of special foundation, assembly and installation Trial runs SelfConstructed Assets SelfConstructed Assets
• The cost of self-constructed assets includes:
• • • • Direct materials Direct labor Variable overhead Note that whether fixed overhead iis included as part Note fixed overhead s of asset cost is a subject of debate of
No FOH allocated to asset cost Portion of all FOH allocated FOH allocated based on lost production CICA Handbook, Section 3061: Allows for allocation of some portion of FOH Cost of Natural Resources Cost of Natural Resources
• • Includes oil and gas and mining properties Main characteristics: 1) Asset is completely removed or consumed 1) 2) Asset replacement only by act of nature 2) • Costs to be capitalized relate to three activities: 1) Property acquisition 1) 2) Exploration 2) 3) Development 3) Cost of Natural Resources Cost of Natural Resources Property acquisition costs - (i) Price paid to obtain the property rights to find undiscovered property undiscovered resources, or resources, (ii) Price paid for an already discovered resource discovered - Generally, acquisition costs for undiscovered resource charged to undiscovered “Undeveloped or Unproved Property” and remain in the account “Undeveloped until results of exploration efforts are known. until Exploration costs - After obtaining the property rights, costs incurred to find (search) After costs undiscovered natural resource undiscovered - Full cost method vs. Successful efforts method (e.g. explored on 5 Full Successful sites and 2 sites proved to be successful) sites - Exploration costs for undiscovered resource charged to undiscovered “Undeveloped or Unproved Property” and remain in the account “Undeveloped until results of exploration efforts are known. until Development costs - Costs incurred to turn a found deposit into a productive mine site or oil field (e.g., drilling costs, tunnels, shafts, and wells that are oil Full cost method vs Successful efforts method: Full cost method vs Successful efforts method: To Capitalize or To Expense? Effect on Income Statement
Site 1 2 3 4 5 Site Cost 1m 1.2m 2m 0.5m 1.3m Cost Resource discovered? No No Yes Yes No Resource The above information is given at year 0. Assume cost capitalized is amortized in 5 years using straight-line method. Also assume Co. A use full cost method while method Also Co. full Co. B use successful efforts method. Compare net Co. successful Compare income effects of the two firms each year. income Company A (full cost) property cost: $6,000,000 $6,000,000 Company B (successful efforts) property cost: $2,500,000 $2,500,000
Year 0 1 2 Year Expenses (Co. A) -0- (1.2m) (1.2m) Expenses Expenses (Co. B) (3.5m) (0.5m) (0.5m) Net income (A vs. B) 3.5m (0.7m) (0.7m) 3 (1.2m) (0.5m) (0.7m) 4 5 (1.2m) (1.2m) (0.5m) (0.5m) (0.7m) (0.7m) Interest Costs During Interest Costs During Construction
• Three available methods
1. 2. No interest capitalized All costs of financing employed are capitalized All costs
Internal financing (net income) External financing (equity and/or debt) 3. Only actual interest costs are capitalized (that is, cost of debt financing) is, • The third approach is the most common The approach in practice (Appendix 10A) approach • Notice that, in Canada, there is no guidance Notice from GAAP as to which approach to use. Asset Retirement Costs (CICA Asset Retirement Costs ( Handbook Section 3110)
• Costs associated with asset retirement obligations at the Costs Balance Sheet date Balance
– Costs incurred to terminate assets’ operations (e.g. costs to Costs close mine sites, nuclear facility, etc.) close • Costs are recognized only when there is a legal Costs commitment commitment
– Recorded at present value of future obligation – Add to the debit of an asset account (e.g. Mine Property) – Credit Asset Retirement Obligations (a liability account) • A llegal obligation may arise even though no asset has egal been recorded on the books (operating lease) been Asset Retirement Costs Asset Retirement Costs
e.g. Firkin purchased equipment for $500,000 to install in a e.g. leased building. The company is required to remove the equipment when lease expires at the end of 10 years. The estimated cost to remove the equipment is $70,000. The current discount rate is 5%. Record the purchase. The PV of obligation=70,000*PV (10, 5%)=42,974 Equipment 542,974 Cash 500,000 Asset retirement Obligation 42,974 What if the equipment is leased? What - Assume Firkin leased the equipment for $60,000 per year. The lease is an operating lease. The Equipment 42,974 Asset retirement Obligation 42,974 Other Acquisition Cost Issues Other Acquisition Cost Issues Regarding PPE
• Cash discounts Cash
– The Net-of-Discount Method is the preferred method The Net-of-Discount • Deferred payment contracts: Details will follow Deferred Details • Lump sum purchase (illustration 10-2, p. 589) • Acquisition of assets by issuing shares
– Cost is market value of shares – If market value is not determinable, cost is the fair value of the If acquired asset acquired • Exchange of assets: Details will follow Exchange Details • Contribution of assets and investment tax credit: Details will Contribution follow follow Deferred Payment Contracts Deferred Payment Contracts
• When assets are purchased through longWhen longterm credit, the payments are deferred the
– Assets are recorded as the present value of Assets present the consideration exchanged the – Discount amortized to interest expense over Discount life of debt obligation using effective interest method method – When interest rate is not stated, cash price of When is purchased asset is used to determine imputed purchased interest rate interest Deferred Payment Contracts: Deferred Payment Contracts: Illustration
Sutter Corporation, given: • Five-year, $100,000 non-interest bearing note issued Five-year, non-interest in exchange for new equipment in • 5 installments payable over 5 years—$20,000 per year • Market interest rate = 10% Record acquisition, payment, and interest amortization of Record interest the equipment the Deferred Payment Contracts: Deferred Payment Contracts: Illustration
PV = 20,000*Annuity (5, 10%) =$20,000*3.79079=$75,816 20,000*Annuity At acquisition date Equipment 75,816 Discount on Notes Payable 24,184 Notes Payable 100,000 At year end date – first payment date Note Payable 20,000 Cash 20,000 Cash Interest Expense 7,582 Discount on Note Payable 7,582 Discount At year end date – Intst. Amort. Year1 Year2 … Year 5 Interest Expense 7582 6340 … 1817 Discount on Note Payable 7582 6340 … 1817 Amortization Schedule Amortization Schedule (Effective Interest Method)
PV = 20,000* Annuity (5, 10%) =$20,000*3.79079=$75,816 20,000* (1) Payment (1) at end of each year each Date of issue End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5 ($20,000) ($20,000) ($20,000) ($20,000) ($20,000) ($100,000) ($24,184) ($75,816) $-0(2) Interest (3) (4) Carrying (2) (3) (4) Expense Principle Amount Paid Paid (Outstanding Paid Principle) Principle) (=CV*10%) (= (1) -(2)) (= $ 75,816 Amortization Schedule Amortization Schedule (Effective Interest Method)
PV = 20,000* Annuity (5, 10%) =$20,000*3.79079=$75,816 20,000* (1) (2) Interest (3) (4) Carrying (1) (2) (3) (4) Payment Expense Principle Amount Paid Paid (Outstanding Paid at end of Principle) Principle) each year (=CV*10%) (= (1) -(2)) each (= $ 75,816 ($20,000) ($20,000) ($20,000) ($20,000) ($20,000) ($100,000) ($7,582) ($6,340) ($4,974) ($3,471) ($1,817) ($24,184) ($12,418) ($13,660) ($15,026) ($16,529) ($18,183) ($75,816) $63,398 $49,738 $34,712 $18,183 $-0- Date of issue End of Year 1 End of Year 2 End of Year 3 End of Year 4 End of Year 5 Deferred Payment Contracts Deferred Payment Contracts
• In the previous example, the market interest In rate is given. What if the market rate is unknown? unknown?
Example: Two options are available from seller for office Example: equipment: (1) buy now for $75,816 (2) pay 5 installments of $20,000 at the end of each year. Calculate imputed interest rate to make both options the same. the Cash payment of option 1 = PV of annuity of option 2 Cash $75,816= 20,000*Annuity(n=5, i=?) => i=10% $75,816= Exchange of Assets Exchange of Assets
* Exchange of monetary assets with non-monetary assets Exchange monetary non-monetary
– Cash paid to acquire equipment – Truck disposed for cash * Exchange of non-monetary assets with non-monetary assets Exchange non-monetary non-monetary
– Truck in exchange for another truck – Truck in exchange for equipment =>The new asset acquired is recorded by two approaches =>
– Fair value of either the asset given up or the asset being received, whichever is more reliably measurable: A gain or loss is recognized gain – Carrying (book) value of the asset given up plus any cash paid to change hand: No gain is recognized but a loss is recognized is but Exchange of Assets Exchange of Assets
Example Co. 1 (asset A) Co. 2 (asset B) Example Co. Co. Original cost $7,600 $9,200 Accu. Amort. 5,800 6,200 Book value 1,800 3,000 Fair value 4,000 4,500 Cash to change hands: $500 paid by Co. 1 to Co. 2 Record the exchange for Co. 1.
Recorded at fair value Recorded New asset 4,500 New Accu. Amort 5,800 Old asset 7,600 Old Cash 500 Cash Gain on exchange 2,200 Gain Recorded at book value New asset 2,300 Accu. Amort. 5,800 Old asset 7,600 Old Cash 500 Cash Exchange of Assets: Exchange of Assets: Compare and Contrast two methods
• Both methods record the disposal of the old asset • Both methods record the cash payment • The fair value treatment records the new asset at The fair new fair value ($4,500); and a gain ($2,200) is gain recognized recognized • The book value treatment records the new asset The book new at book value of the old asset ($1,800) plus cash paid ($500); and no gain is recognized no Which method to use? Two questions need to be answered: 1. Does the transaction have commercial Does substance? Fair value substance 2. If it does, is the fair value of assets given up or If fair the fair value of asset received a more reliable fair estimate?
Consider Case 1 Case 2 Case 3 Consider Case Case Fair value of assets given up $16,000 $100,000 $73,000 Fair value of asset received 50,000 ? ? Cash paid 34,000 4,000 Cash received 50,000 What amount to record as the cost of asset received? What received Case 1: $50,000; Case 2: $104,000; Case 3: $23,000 Exchange of Assets: Which Method to Exchange of Assets: Which Method to Use? • Commercial substance exists if Exchange of Assets: Commercial Exchange of Assets: Commercial Substance – There is a change in the company’s expected There future cash flows ((i) risk, timing, or amount; or (ii) assets’ value-in-use or entity-specific value). assets’ Example: exchange truck for equipment Example:
=> Fair value approach • If the company is in exactly the same position after the If exchange as it was before, the transaction lacks commercial substance – Example: exchange of similar assets; exchange Example: similar merely to facilitate sales; etc. merely etc.
=> Book value approach => – Note that, when book value approach is used, Note an asset cannot be recognized at an amount that exceeds its fair value that Exchange of Assets: Example (Loss Exchange of Assets: Example (Loss case: Fair Value method)
Davis Rent-A-Car exchanges a number of Ford vehicles Davis for GM vehicles. The transaction is considered no commercial substance. commercial • Fair value of GM vehicles $126,000 • Book value of Ford vehicles: $125,000 (Cost: $150,000; Accu. Amort.: $ 25,000) (Cost: • Cash paid to seller of GM vehicles $ 3,000 Record purchase in Davis’s books
Incorrect entry Incorrect Vehicles (GM) 128,000 Vehicles Accu. Amort 25,000 Vehicles (Ford) 150,000 Cash 3,000 Cash Correct entry Correct Vehicles (GM) 126,000 Loss on exchange 2,000 Accu. Amort 25,000 Vehicles (Ford) 150,000 Cash 3,000 Cash Contribution of Assets Contribution of Assets (Nonreciprocal Transfer)
• • Fair market value should be used: CICA Sec.3830 Two approaches to record the credit: Two 1. Capital Approach 1.
Donation is viewed as a contributed capital Donation contributed Asset is amortized and exp. is matched with rev. Usually used to account for donation by owners Usually owners Usually used to account for contribution from Usually government and investment tax credit (ITC) government Donation is viewed as deferred income and is Donation deferred recognized in the period the asset is used recognized
a) Cost Reduction Method b) Deferral Method 2. Income Approach Contribution of Assets: Example Contribution of Assets: Example
A company received a grant of $225,000 from government to upgrade its equipment facility government
Capital Approach (not common for non-owner donations) Cash 225,000 Cash Donated Capital 225,000 Donated Income Approach a) Cost Reduction Method a) Cash Equipment
b) Deferral Method: b) 225,000 225,000 Cash Cash Deferred Revenue 225,000 Costs Subsequent to Acquisition: Costs Subsequent to Acquisition: Capitalized or Expensed?
If costs incurred increase future benefits If costs incurred increase future benefits =>Added to asset’s cost (Capitalized) i.e.,
1. Useful life increased 1. 2. The quantity of units produced increased 2. 3. The quantity of units produced increased The quantity of units produced increased 4. The associated operating costs are reduced The associated operating costs are reduced If costs do not add to service potential => Expensed Costs Subsequent to Acquisition: Costs Subsequent to Acquisition: Capitalized or Expensed?
Book, p.601, Illustration 10-10: Normal accounting treatment
- Additions: Increase or extension of existing assets - Improvements and replacements: Substitution of an improved Substitution asset for an existing asset asset Generally capitalized - Rearrangement and reinstallation: Moving asset from one Moving location to another location - Repairs: Costs that maintain assets in good operating Costs condition condition Expensed or Capitalized (case by case) Capitalization Approaches Capitalization Approaches (Improvements and Replacements)
• If carrying value of asset is known
– Substitution approach Substitution • If carrying value of the asset is unknown
– Capitalize the new cost (without removing the old Capitalize asset from the pool), or asset – Debit accumulated amortization (when the production Debit quantity or quality has not been improved but useful life of asset has been extended: e.g., replacement) life Capitalization Approaches: Example Capitalization Approaches: Example (Improvements and Replacements)
A shingle roof with an original cost of $20,000 shingle and now 80% depreciated is replaced by a fireproof tile roof costing $60,000. Record the replacement. Record
Substitution Substitution To record new roof To Building (new roof) 60,000 Cash 60,000 (building has the new roof in its cost: theoretically sound) cost: To remove old roof Accum. Depr 16,000 Loss on asset improv. 4,000 Loss Building (old roof) 20,000 Building Capitalizing new cost (addition) Building (new roof) 60,000 Cash 60,000 Cash (building has two roofs in its (building cost) cost) Charging to accum. depr Charging Accu. Depr. 60,000 Cash 60,000 Cash (building has the old roof in its (building cost with extended life.) Let do Exercise • • • • • • E-5 E-6 E-7 E-23 E-24 E-25 ...
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This note was uploaded on 04/27/2010 for the course ADMS 3585 taught by Professor Sandra during the Spring '10 term at York University.
- Spring '10