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ADMS 3585 Winter 2010 Chapter 10

ADMS 3585 Winter 2010 Chapter 10 - CHAPTER 10 Acquisition...

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Unformatted text preview: CHAPTER 10 Acquisition of Property, Plant, and Equipment 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 Acquired operations not resale resale 2. Long-term in nature and usually subject to Long-term amortization 3. Possess physical substance 3. Possess physical Accounting Issues Accounting Issues • Acquisition (Ch10) – – – Acquisition cost Other cost issues Cost subsequent to acquisition • Subsequent valuation on B/S date (Ch11) – Amortization – Impairment • Disposition (Ch11) • Financial statement presentation and analysis Financial (Ch11) (Ch11) Acquisition Cost Acquisition Cost • Historical cost is the basis for determining cost • Acquisition cost includes: – the asset’s cash or cash equivalent price, and – the cost of readying the asset for its intended use • Cost depends on types of assets acquired - Cost of land - Cost of building - Cost of equipment - Cost of self-constructed assets - Cost of natural resources Cost of Land Cost of Land • Land costs include: 1. Purchase price 2. Closing costs (title, legal, and recording fees) 3. Costs of getting land ready for use (such as removal of old building, clearing, grading, filling and draining) 4. Assumption of liens (liabilities, obligations) - e.g. unpaid mortgage, unpaid property tax e.g. 1. Additional improvements with an indefinite life Sale of salvaged materials reduces cost of land • Land Improvements Land Improvements • PERMANENT improvements to the land are added to the Land account to • Permanent improvements include – Permanent improvements made by the owner (e.g. Permanent landscaping, trees, etc.) landscaping, – Special amounts assessed for local improvements Special assess (e.g. street lights, sidewalks, sewers) – will be (e.g. maintained and replaced by government maintained • Improvements with LIMITED liife (such as driveways, Improvements LIMITED l walkways, fences, and parking lots) are recorded in a separate Land Improvements account Land – These costs are separated from Land as they are These amortized over their estimated useful lives amortized Cost of Buildings Cost of Buildings • Costs include all costs directly related to buying or constructing the building cost of materials, labor, and overhead cost professional fees and building permits professional acquisition costs acquisition etc. etc. Cost to remove old building for Cost to remove old building for construction of 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 If owned company company - > Expensed as a loss on disposal of old building Expensed • If the old building is leased by the company If leased by - > Capitalized under Leasehold Improvement Capitalized Leasehold and amortized over the lesser of the remaining lease life and the useful life lease - > Improvement becomes property of lessor Improvement when lease expires when Cost of Equipment Cost of Equipment • Costs include all necessary and reasonable costs Costs necessary incurred to get asset ready for its intended use incurred • Includes : – Purchase price • GST and HST paid are usually treated as tax credit GST (according to tax laws), and therefore normally not included as cost of equipment included • They should be used to reduce tax payable – Freight and handling charges – Costs of special foundation, assembly and Costs installation installation – Trial runs – Etc. Self­Constructed Assets Self­Constructed Assets • These are assets constructed by the business for use in operations • The cost of self-constructed assets includes: • Direct materials, • Direct labour, • Variable manufacturing overhead Self­Constructed Assets Self­Constructed Assets • Fixed Overhead (FOH) (e.g., heat, power, light, insurance) are accounted for in one of three ways: one 1. No FOH allocated to the asset’s cost 2. Portion of all FOH allocated to the asset - A full costing concept full - Assume the assignment of FOH to assets constructed should be treated in the same way as that to products manufactured way 1. FOH allocated based on lost production - An opportunity cost concept; attractive theoretically, but hard to measure theoretically, - FOH contributed to asset construction represent an opportunity cost of lost production of regular manufacturing Self­Constructed Assets Self­Constructed Assets • CICA Handbook, Section 3061: – Allows for allocation of some portion of some FOH to the asset (i.e., any overhead costs directly attributable to the construction activity are allocated to the asset’s cost) asset’s – If the allocated FOH results in total If construction costs being more than the costs that would be charged by an outside independent producer, the excess FOH should be recorded as a period loss period Interest Costs During Construction Interest Costs During Construction • Three available methods 1. 2. 3. • • No interest capitalized All costs of financing employed are capitalized All costs Internal financing (net income) External financing (equity and/or debt) Only actual interest costs are capitalized (that is, cost of debt financing) - the most common most approach in practice approach Note that, in Canada, capitalization of interest is allowed Note but not required by GAAP but FASB and IASB’s position: – – Require capitalization of actual interest cost Require actual However, FASB and IASB have different However, opinions on how the actual interest cost is determined (e.g. what are qualifying assets, period of capitalization, and the amount to Class Exercise Class Exercise Indicate whether the following costs are recorded in Indicate Land, Land Improvement, Building, or other accounts. accounts. (a) Cost paid to purchase a plant site: land $200,000, Cost building $50,000. Building is to be removed. building (b) Commission fee paid to real estate agency $9,000 (c) Removing the building purchased with land $11,000 (d) Cost of land filling and clearing $8,000 (e) Installation of fences around land $4,000 (f) Cost of parking lots and driveways $19,000 (g) Cost of trees and shrubbery planted (permanent in Cost nature) $14,000 nature) Class Exercise Continued Class Exercise Continued (h) Interest paid during construction of building on money (h) borrowed for construction $13,000 borrowed (i) Excavation costs for new building $3,000 (a) GST on excavation cost $210 is treated as tax credit (b) Premium on six-month insurance policy during Premium construction of a new building $6,000 construction Solution Land: _______________________________ Land improvement: _________________________ Building: ______________________ Other: _______________________________ Cost of Natural Resources Cost of Natural Resource • • • Also known as wasting assets Includes: petroleum, mineral deposits, and Includes: standing timber standing Main characteristics: 1. Asset is completely removed (consumed) 2. Asset replaced only by act of nature Costs to be capitalized relate to four activities: 1. Acquisition 2. Exploration 3. Development 4. Restoration (asset retirement costs) • Acquisition Costs Acquisition Cost • Acquisition cost is the price paid: – To obtain property rights to locate To UNDISCOVERED natural resource, or UNDISCOVERED natural or – Cost of already DISCOVERED resource Cost DISCOVERED resource (e.g. timber properties; proved mineral deposits) deposits) • Costs for undiscovered resource charged to Costs “Undeveloped or Unproved Property” “Undeveloped – Costs remain in this account until results of Costs exploration efforts are known exploration • Cost of already discovered resources directly Cost charged to the natural resource property account (that is, debit Timber Properties, Mining Properties, Exploration Costs Exploration Costs • • • Include all operating costs incurred for the Include exploration activity exploration Includes depreciation of assets used in Includes exploration exploration Cost treatment follows one of two methods: – Successful efforts approach Successful Only – Only costs directly related to successful projects remain capitalized successful – Full-cost approach Full-cost – All costs are capitalized regardless of All the success of the project the Full­Cost Approach vs. Full­Cost Approach vs. Successful Efforts Approach Site 1 2 3 4 5 Site Cost of acqui. and explor. 1m 1.2m 2m 0.5m 1.3m Cost Resource discovered? No No Yes Yes No Resource Assume cost capitalized is amortized in 5 years using straight-line method. Also assume Co. A use full cost Co. method while Co. B use successful efforts method. method Co. successful Compare net income effects of the two firms each year. Compare Company A (full cost) property cost: $____________ Company B (successful efforts) property cost: $________ 0 1 2 3 4 5 Expenses (full cost) -0- (1.2m) (1.2m) (1.2m) (1.2m) (1.2m) Expenses (succ. effo.) (3.5m) (0.5m) (0.5m) (0.5m) (0.5m) (0.5m) Net income difference 3.5m (0.7m) (0.7m) (0.7m) (0.7m) (0.7m) Development Costs Development Costs • Costs incurred to turn a found deposit into a Costs productive mine site or oil field, include productive – operating costs required to gain access to operating proven reserves and – operating costs for extracting, treating, operating gathering, and storing the resource gathering, • Any equipment costs are charged directly to Any the Equipment account and are amortized to Equipment development costs as used development Restoration Costs (Asset Restoration Retirement Costs) • Restoration costs are also called asset retirement costs • Asset retirement costs may incur for both nature Asset resource properties and other properties, plants and equipment equipment • These are costs incurred to terminate assets’ operations These (e.g. costs to close mine sites, nuclear facility, etc.) (e.g. • These costs are recognized only when there is a legal These commitment to clean up the asset by the time the asset is retired is • These costs should be estimated at the time of asset These acquisition based on present value concepts and acquisition present included in the PP&E asset cost included • A llegal obligation may arise even though no asset has egal been recorded on the books (operating lease) been Illustration Illustration 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%)=42,794 Equipment 542,794 Cash 500,000 Asset retirement Obligation 42,794 How about the equipment is leased? - Assume Firkin leased the equipment for $60,000 per year. The lease is an operating lease. Equipment 42,794 Asset retirement Obligation 42,794 Other Cost Issues Other Cost Issues • Cash discounts (p.587) – The Net-of-Discount Method is the preferred method The Net-of-Discount • • • Deferred payment contracts Lump sum purchase (illustration 10-2, p. 589) Acquisition of assets by issuing shares (p.589-590) – Cost is market value of shares unless the shares Cost market are not actively traded (that is, market value is not determinable); Under such case, cost is the fair value of the acquired asset acquired • Exchange of assets • Contributed (donated) assets and investment tax credit (p.595-598) (p.595-598) 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 the consideration exchanged the – When effective (market) interest rate is not When is stated, cash price of purchased asset used to determine imputed interest rate determine – Discount amortized to interest expense over Discount life of debt obligation using effective interest method method Deferred Payment Contracts: Deferred Payment Contracts: Illustration Sutter Corporation, given: • Five-year, $100,000 non-interest bearing note Five-year, issued in exchange for new equipment issued • Market interest rate = 10% • Payable over 5 years—$20,000 per year at Payable year end year Record acquisition, payment, and interest Record amortization of the equipment amortization Deferred Payment Contracts: Deferred Payment Contracts: Illustration PV = 20,000* Annuity (5, 10%) =$20,000*3.79079=$75,816 20,000* At acquisition date Equipment 75,816 Discount on Note Payable 24,184 Note Payable 100,000 At year end date - Payment 75816*10% = 7582 Note Payable 20,000 Cash 20,000 Cash =[(75816+(20000­7582)] *10% 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* Payment at end of each year 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) $-0Interest Expense Paid (=CV*10%) Principle Paid Carrying Amount (Outstanding Principle) $ 75,816 Amortization Schedule Amortization Schedule (Effective Interest Method) PV = 20,000* Annuity (5, 10%) =$20,000*3.79079=$75,816 20,000* Payment at end of each year 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) ($7,582) ($6,340) ($4,974) ($3,471) ($1,817) ($24,184) ($12,418) ($13,660) ($15,026) ($16,529) ($18,183) ($75,816) Interest Expense Paid (=CV*10%) Principle Paid Carrying Amount (Outstanding Principle) $ 75,816 $63,398 $49,738 $34,712 $18,183 $-0- 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. Prepare relevant accounting entries if the second option is used. option Calculate imputed interest rate PV of annuity of option 2 = cash payment of option 1 $75,816= 20,000* Annuity (n=5, i=?) => i=10% Entry to record Same as the previous example • Monetary exchange of assets occurs when: Exchange of Assets Exchange of Assets – Non-monetary assets are acquired for cash and/or Non-monetary and/or other monetary assets (accounts and notes receivable) receivable) • e.g. Cash paid to acquire equipment e.g. Cash – Non-monetary assets are disposed of in exchange Non-monetary for cash and/or other monetary assets (accounts monetary and notes payable) and • e.g. Truck disposed for cash • Non-monetary transaction or exchange of assets occurs when: when: – Non-monetary asset is exchanged for another nonmonetary asset, for example • Truck in exchange for another truck Exchange of Non­Monetary Assets Exchange of Non­Monetary Assets • The cost of the asset acquired is The determined by one of the two treatments determined 1. Fair value of either the asset given up or the asset being received, whichever is more reliably measurable (fair value more fair treatment) treatment 2. Book value (carrying value) of the asset given up plus any cash paid to change hand (book value treatment) hand Illustration: Illustration: Exchange of Non­monetary 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 Fair Value Treatment Fair Value Treatment vs. Book Value Treatment • Both treatments record the disposal of the old Both asset asset • Both treatments record the cash payment • The fair value treatment records the new asset The fair at fair value ($4,500); and a gain ($2,200) is recognized recognized • The book value treatment records the new The book asset at book value of the old asset ($1,800) plus cash paid ($500); and no gain is recognized recognized Which treatment to use? Which Treatment to Use? Which Treatment to Use? • The basic principle is the fair value treatment principle fair • That is, the non-monetary exchange is valued That at: at: – the fair value of the asset(s) given up, or given – the fair value of the asset(s) received received whichever is more reliably measurable, and more – gain or loss on the exchange is recognized in income in Which Treatment to Use? Which Treatment to Use? EXCEPTION to basic principle: basic • If one or more of the following conditions exist: 1. transaction lacks commercial substance, 1. transaction 2. fair values are not determinable, 2. fair 3. exchange merely to facilitate a sale to 3. exchange customers customers • Then the book value treatment should be used the book should – new asset cost equals book value of assets new book given up plus any cash paid to change hands given any – No gain or loss is recognized Commercial Substance Commercial Substance The transaction has commercial substance when The commercial there is a change in the company’s expected future cash flows (risk, timing, amount) – e.g. exchange truck for equipment truck => Fair value treatment => Which fair value to use: fair value of asset acquired or Which fair acquired given up? – Whichever gives more reliable estimate given Whichever estimate Consider Case 1 Case 2 Case 3 Case Case Fair value of asset 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? Case 1: $_______; Case 2: $_______; Case 3: $________ Commercial Substance (Cont’d) Commercial Substance The transaction lacks commercial substance The when the company is in exactly the same position after the exchange as it was before – e.g. exchange of similar assets; exchange merely to facilitate sales; etc. => Book value approach => – Note that, when book value approach is Note used, an asset cannot be recognized at an amount that exceeds its fair value an Example Example 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) • 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 entry Vehicles (GM) 126,000 Loss on exchange 2,000 Accu. Amort 25,000 Vehicles (Ford) 150,000 Cash 3,000 Cash Contributed Assets Contributed Assets • • • Transfer is nonreciprocal (that is, one way; no Transfer consideration given up) consideration Fair market value of the asset received should be used Fair as cost of the asset as Two approaches: Two 1. When the contribution is made by owner 1. When => Capital Approach: Donation is viewed as a Capital contributed capital (an equity account) (an 1. When the contribution is not made by owner When e.g. contributor is employee, charity, or government => Income Approach: Donation is viewed as deferred income and is recognized in the deferred period the asset is used period a) Cost Reduction Method Investment Tax Credit (ITC) Investment Tax Credit (ITC) • Governed by tax legislation; an incentive an provided by government to encourage investment investment • Income tax is reduced in the year of acquisition by a prescribed percentage of the cost of eligible capital assets cost • ITCs are accounted for following the ITCs Accounting Standards Board policy for government contributions; taken into income using either using 1. Cost Reduction Method, or 2. Deferral Method Contribution of Assets: Example Contribution of Assets: Example A company received $225,000 as donation to upgrade its equipment facility. Prepare entry to record the transaction. Capital Approach (if the donation is made by owner) Cash 225,000 Cash Donated Capital 225,000 Donated The N/I of current and future period is not affected as a result of this The not transaction transaction Income Approach (if the amt. is a government grant or ITC) a) Cost Reduction Method Cash 225,000 Equipment 225,000 The N/I of future period is increased (as a result of decreased amorti. exp.) increased b) Deferral Method: Cash Cash Deferred Revenue Deferred 225,000 225,000 The N/I of future period is increased (when defer. rev. becomes rev.) The increased Costs Subsequent to Acquisition Costs Subsequent to Acquisition • • • If costs incurred achieve greater future benefits, capitalize costs (Capital expenditure) If costs do not add to future benefits, expense costs (Revenue expenditure) Major types of expenditures are: 1. Additions: Increase or extension of existing assets 2. Improvements and replacements: Substitution of an improved asset for an existing asset 3. Rearrangement and reinstallation: Moving an asset from one location to another 4. Repairs: Costs that maintain assets in good operating condition 1. Additions: normally capitalized 2. Improvements and replacements: normally capitalized 3. Rearrangement and reinstallation Normally capitalized unless the original rearrangement or reinstallation costs are unknown AND amount is immaterial 4. Repairs: Normally expensed; however, for major repairs that benefit more than one period (such as engine overhaul), practice has been to capitalize Costs Subsequent to Acquisition: Costs Subsequent to Acquisition Accounting Treatment Capitalization Approaches Capitalization Approaches • If the costs are to be capitalized, two If approaches are available depending on whether carrying value of asset is known whether a. Carrying value of asset is known a. known – Substitution approach Substitution b. Carrying value of the asset is unknown unknown – Capitalize the new asset (without removing the Capitalize old asset from the pool), or old – Debit accumulated amortization (when Debit expenditures extend useful life of asset) expenditures Capitalization Approaches: Example Capitalization Approaches: Example A shingle roof with an original cost of $20,000 is replaced by a fireproof tile roof costing $60,000. Record the replacement. Assume it is known that the Assume roof is 80% depreciated roof Substitution () Substitution To remove old roof To Accum. Depr 16,000 Loss on asset improv. 4,000 Loss Building (old roof) 20,000 Building To record new roof Building (new roof) 60,000 Cash 60,000 (building has the new roof in its cost: theoretically sound) cost: Assume the carrying value of the roof is unknown roof Capitalizing new cost (addition) Building (new roof) 60,000 Cash 60,000 Cash (building has two roofs in its (building 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) cost Capitalization Approaches: Example Capitalization Approaches: Example Assume the original cost of the building (with the replace roof) is $300,000 and it is 50% depreciated, decide the new balances of Building account and Accumulated Amortization account under the three approaches Substitution Substitution New balance of Building account Building 300,000 300,000 - 20,000 + 60,000 = 340,000 60,000 New balance of Acc. New Amor. account Amor. 150,000 150,000 - 16,000 = 134,000 Capitalizing new cost (addition) New balance of Building account 300,000+60,000=360,000(building has two 300,000+60,000=360,000(building roofs) roofs) New balance of Acc. Amor. account 150,000 (unchanged) Charging to accum. depr New balance of Building account 300,000 (building has old roof) New balance of Acc. Amor. account 150,000-60,000=90,000 (building is now 150,000-60,000=90,000 30% depreciated=> extended life) 30% Current IFRS GAAP Comparisons Main differences: • If components of a capital asset have varying useful lives, IFRS requires that If these components be separately identified at initial recognition. Under IFRS, component depreciation is required if components of an asset have differing patterns of benefit. Major repairs or overhauls are capitalized as part of the cost of the asset with Major the estimated cost of the part of the asset repaired or overhauled and the related accumulated depreciation removed from the accounts. Borrowing costs that are incurred during acquisition, construction or production Borrowing of qualifying assets are must be capitalized as part of the asset’s cost, provided they meet the definition of an asset. Under IFRS, investment property is separately defined under IAS 40. Under Investment property may be measured after recognition using either the cost Investment model or the fair value model. Since IFRS requires separate recognition for investment properties, many Since disclosures are required detailing information regarding the investment properties. The fair value of the investment property has to be reported, even if the cost 7 The 4 model is used. • • • • • • GAAP versus IFRS Comparison 1. C-GAAP requires components C-GAAP be separated on initial recognition when practicable and reasonable estimates of their useful lives can be made (i.e. practicability exemption) (i.e. 2. C-GAAP is silent on the C-GAAP accounting treatment of such replacements – see also comments above under 1 comments 3. Interest charges may be Interest capitalized (i.e. choice permitted) permitted) 1. If components of a capital asset have If varying useful lives, IFRS requires that these components be separately identified at initial recognition. Under IFRS, component depreciation is required if components of an asset have differing patterns of benefit. 2. Major repairs or overhauls are 2. Major capitalized as part of the cost of the asset with the estimated cost of the part of the asset repaired or overhauled and the related accumulated depreciation removed from the accounts. 3. Borrowing costs that are incurred 3. Borrowing during acquisition, construction or production of qualifying assets must be capitalized as part of the asset’s cost, provided they meet the definition of an asset. 48 ...
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