Intermediate Financial Accounting I Operational Assets: Acquisition

Intermediate Financial Accounting I

Operational Assets: Acquisition

Operational Assets: Acquisition 2

Operational Assets

Operational assets include: Property, Plants and Equipment (i.e.,

land, buildings, computers,machinery, etc.);

Intangible assets (patents, copyrights, tradenames,etc.)

Natural Resources (i.e., oil and gas reserves, timber, mineral deposits).


Operational Assets (contd.)

Property, Plants and Equipment: Productive assets deriving their value from the use of them in operations.

Intangible assets: productive assets without physical substance with uncertain benefits.

Nature Resources :Productive assets which are physically consumed in operations.


Objectives of the Chapter

A. To learn:

1. Valuation of PPE at acquisition

2. Determination of acquisition cost of land, buildings and equipments.

B. To study the impact of payments of PPE on the cost of PPE (i.e., cash, donations, deferred payments, etc.)


Objectives of the Chapter(contd.)

C. To learn the accounting treatment for the disposition of PPE (i.e., exchange, discard).

D. To discuss the accounting treatment for costs occurred subsequent to acquisition of PPE (i.e., additions, replacements, improvements, etc.).


What Is Property, Plant and Equipment (PPE)? Assets used in operations (not for

resale) Long-term in Nature (Eco. Life > one

year) Possess physical substance $ must be material


A1. PPE Valuation (APB Opinion No. 6)

At acquisition, PPE is recorded at the acquisition cost. At the end of period, PPE is also reported at cost.

Acquisition cost includes the purchase price and any costs necessary to bring the asset to the location and condition for its intended use.


iGAAP Vs. GAAP on PPE Valuation

Under GAAP, PPE cannot be revalued. However, if the fair value of the PPE is less than its book value, the assets may be written down (i.e., the impairment loss)under GAAP.

iGAAP permits companies to report PPE at either the historical cost or use a revaluation model (IAS 16).

Operational Assets: Utilization and Disposition 9

iGAAP – PPE Valuation

Under the revaluation model, a gain (i.e., unrealized gain on revaluation) is recognized when the fair value is greater than the book value (see the example on p655

of the 14th e KWW textbook). If revaluation is used, it must be applied

for the whole class of assets and the revaluation must be performed annually.


A1. PPE Valuation (contd.)

PPE (except for land) is subject to depreciation.

Depreciation is a process of cost allocation, not a process of asset valuation.

If the acquisition cost is greater than the market value at time of delivery, LCM is applied.


A2. Determination of Acquisition Cost

Cost of Land Cost of Buildings Cost of Equipment Cost of Self-Constructed Assets


Cost of Land(held for operation, not for resale)

Any cost occurred before the land is ready for its intended use should be capitalized as cost of land.


Cost of Land (contd.)

Cost of land includes:1. Purchase price.2. Title search fee.3. Closing fee.4. Clearing fee.5. Back property taxes (unpaid by previous

owner).6. Net razing cost of an old building.7. Land improvements with unlimited life

(permanent in nature such as landscaping, pavements, street lights, etc.)



Land improvements with limited life (i.e., parking lots, fences, etc.) would be debited to land improvement account and subject to depreciation.

The capitalization rules apply to the land held for operation also apply to land held for resale.



IRS allows the deduction of property taxes, insurance, interests even if these costs are capitalized.

If land and building are purchased together and the building is used for a few years, the net razing cost of the old building would be incorporated in the retirement of the old building.


Cost of LandExample Land and building were purchased for

$200,000 on 1/1/x2. $50,000 was assigned to the cost of building. On 12/31/x5, the building was demolished. The accumulated depreciation was $35,000, the razing cost was $7,000 and the salvage value of the building was $3,000.


Cost of LandExample (contd.)

J.E. Accu. Depre. 35,000Materials 3,000Loss 19,000

Building50,000

Cash7,000


Cost of Buildings

Cost of Buildings includes:1. contract price(including materials, labor,

etc.),2. cost of remodeling,3. Architect’s fee,4. building permits,5. surveying cost before construction,6. interest cost (for self-constructed building),7. excavation cost before construction.

* Costs of strike or accidents are expensed.


Cost of Equipment

Any cost occurred to acquire and to bring the equipment to the location and condition for its intended use.


Cost of Equipment (contd.) Cost of Equipment includes:

1. purchase price,2. freight-in,3. insurance in transit, and4. foundation cost, installation cost, cost of

test runs and assembling cost. Not including: Cash discount lost,

unnecessary storage cost and hauling charges from storage for delivery of equipment.


Cost of Self-Constructed (S-C) Assets

Cost of self-constructed assets includes:1. direct materials,2. direct labor,3. factory overhead (variable overhead

and fixed overhead).


Cost of Self-Constructed (S-C) Assets (contd.)

Treatment of fixed overhead:

1) When operation is at full capacity

2) When operation is under the full capacity


Interest Costs During Construction

Background of SFAS No. 34 (effective in 1979)

Only capitalize the interest on funds borrowed for construction.


Interest Costs During Construction (contd.)

Interest can only be capitalized for qualifying assets which must meet the following criteria:

1. Assets require a period of time to get ready for its intended use.

1. Examples: Assets are constructed for firm’s own use or constructed as discrete projects for sale or lease to others (i.e., ships, real estate developments).

2. Capitalization will make a difference on the earnings per share.


Interest Costs During Construction (contd.) Capitalization period:

Starting when:1. Expenditures for the assets have

been made;2. Construction activities are in progress;

and3. Interest cost is being incurred.

Ending when: Assets are substantially completed

and ready for intended use.


Interest Costs During Construction (contd.) Interest revenue: Interest earnings on

unexpended portion of the loan cannot be used to offset the amount eligible for capitalization.

The actual capitalized interest amount should not exceed the interest expense occurred during the period.

Interest on fund borrowed to develop (purchase) land for resale purposes should (should not) be capitalized.


Example - Interest Capitalization for Self-Constructed Assets Capitalization period: 1/2/x7 to 6/30/x8 Specific construction debt: $1,500,000 at

11% annual int. rate. This debt was borrowed on 9/30/x6 to finance the project.

Other debt outstanding during the construction period: 1. $4,000,000 at 12% annual int. rate.2. $8,000,000 at 15% annual int. rate.

These loans have been outstanding since 1/1/x7.


Example (contd.) Weighted Average Interest Rate (of other debt):

Total interest = 480,000 +1,200,000 = 14%Total Principle 12,000,000

or 12% x 4,000,000 +15% x 8,000,000 = 14% 12,000,000 12,000,000

Expenditures on the construction during 20x7 and 20x8 were as follows: 1/2/x7 $800,000 7/1/x7 $1,000,000

10/1/x7 $600,0003/1/x8 $900,0006/1/x8 $1,800,000


Example (contd.) The amount of interest to be capitalized for 20x7:

Computing the Weighted-Average Accumulated Expenditures (WAAE):

1/2/x7 $800,000 x 12/12 = $800,000 7/1/x7 1,000,000 x 6/12 = 500,00010/1/x7 600,000 x 3/12 = 150,000 2,400,000 $1,450,000

Capitalized Interest (Avoidable Interest) for 20x7:$1,450,000 x 11% x 12/12= $159,5001

1.$1,450,000 < $1,500,000 11% int. loan borrowed specifically to finance the project


Example (contd.)

Actual interest incurred in 20x7:$1,500,000 x11% + $4,000,000 x 12% +

$8,000,000 x 15% = $1,845,000.

Interest exp. = actual int. - capitalized int. = $1,845,000 - 159,500 = $1,685,500


Example (contd.)

Journal entry to record the construction costs and interest expense for 20x7:

Building 2,559,5001

Interest Expense 1,685,500 Cash 4,245,000

1.construction costs of 20x7 plus the capitalized interest of 20x7 (2,400,000+159,500=2,559,500).


Example (contd.)

The amount of interest to be capitalized for 20x8:WAAE of 20x8:1/1/x8 $2,559,500 x 6/6 =$2,559,5003/1/x8 900,000 x 4/6 = 600,0006/1/x8 1,800,000 x 1/6 = 300,000

$3,459,500 Capitalized interest for 20x8:

WAAE Int. Rate $1,500,000 x 11% x 6/12= $ 82,500 1,959,5001 x 14% x 6/12= 137,165 219,6651. 3,459,500-1,500,000


A More Conservative Alternative

The amount of interest to be capitalized for 20x8:WAAE of 20x8:1/1/x8 $2,559,500 x 6/12 =$1,279,7503/1/x8 900,000 x 4/12 = 300,0006/1/x8 1,800,000 x 1/12 = 150,000

$1,729,750 Capitalized interest for 20x8:

WAAE Int. Rate $1,500,000 x 11% = $165,000 229,0001 x 14% = 32,060 $197,0601. 1,279,750-1,500,000


Example (contd.)

Actual interest incurred in 20x8:Same as in x7 = $1,845,000.Int. exp. of x8 = 1,845,000-219,665= 1,625,335

Journal entry to record the construction costs and int. exp. for x8:Building 2,919,6651

Interest Exp. 1,625,335 Cash 4,545,000

1.$900,000 + 1,800,000 + 219,665 = 2,919,665 (costs of 20x8 plus the capitalized interest)


Example (contd.) Reporting:

Income Statement (for the year ended 12/31/x7) Other Revenues & Expenses:

Interest Expenses $1,845,000 Less: Capitalized Int. (159,500)

$ 1,685,500 Notes:Accounting Policy Capitalized interest: during 20X7, total interest

expense was $1,845,000 of which $159,500 was capitalized and $1,685,500 was charged to expense.

The Convergence of Standards – the Case on Interest Capitalization IAS 23 originally issued allowed the choice of

capitalizing or immediate expensing of interest incurring during the construction.

IAS 23 revised in 2007 required the capitalization of such interest in most situations for qualifying assets.

This revision effectively eliminated the major differences between the IAS and the U.S. standards in accounting for interest capitalization.


How the Boards Moving toward Convergence of Standards

1. Revise IAS to converge with U.S. standards (i.e., the case of accounting for interest capitalization).

2. Revise U.S. standards to converge with IAS (i.e., the accounting for assets exchange and the accounting for changes in depreciation method).

3. Two Boards (the IASB and the FASB) work jointly to develop common standards (i.e., the accounting for leases).



B. The Impact of Payments of PPE on the Cost of PPEa. Cash

b. Issuance of stock

c. Deferred payments

d. Payment in advance

e. Donations

f. Lump sum purchase

g. Exchange of PPE


Payments of PPE

a. Cash

Cash: Regardless of whether cash discount is taken or not, the cost of the asset is the net amount. The discount lost is recognized as an expense.


Payments of PPE

b. Issuance of Stock

Issuance of stock to acquire assets: assets are recorded at the market value of stock if the stock is traded frequently. If not, assets would be recorded at their fair value.


Payments of PPE

c. Deferred Payments Example: assets were purchased using a

$10,000 non-interest bearing note, payable in four years from now. The market rate is 10%.

Present value: $10,000x0.683 = 6,830

Building 6,830Discount on N/P 3,170 N/P 10,000


Payments of PPE

d. Payment in Advance

SFAS No. 34 requires to capitalize the implicit interest of the advanced payment.


Payment in Advance (contd.) Example: Equipment costing $500,000.

$100,000 was paid on 1/1/x5 and the equipment was delivered on 12/31/x5.1/1/x5 Advances 100,000

Cash 100,00012/31/x5 Equipment 500,000

Advances 100,000Cash 400,000

Equipment 1 10,000 Interest Exp. 10,000

1. assume market rate of 10%


e. Donations (receive or make contributions; nonreciprocal transfers)

Contributions received are recorded at the fair value of the assets (SFAS No. 116): Land $$$$

Contribution Revenue $$$$ Non-monetary contributions made are also

recorded at the fair value of the assets: Contribution Expense $$$$

Land $$$$ Gain on Disposal of Land $$$$


Payments of PPE

e. Donations (contd.) SFAS No. 116 applied to private sector

donations; may not apply to donations from governmental units.


Payments of PPE

f. Lump Sum Purchase Example: A building and land were

purchased at $100,000. The market value of building and land was $30,000 and $90,000, respectively. The cost allocation is based on the relative fair value of each asset.

Building 25,0001

Land 75,0002

Cash 100,0001. 30,000/(30,000+90,000)=25%, 25%x100,000 = 25,0002. 90,000/(30,000+90,000)=75%, 75%x100,000 = 75,000


g. Exchange of Property, Plant, and Equipment (nonmonetary assets) Book value = Cost - Acc. Depr. Gain: fair value of the old asset > book

value of the old asset. Loss: fair value of the old asset < book

value of the old asset.


Payments of PPE

g. Exchange of PPE (contd.) Cash paid=>

Fair value of the old asset < fair value of the new asset.

Cash received=>

Fair value of the old asset >Fair value of the new asset.

If the fair value of the new is unknown, its fair value can be derived as the fair value of the old + cash paid (or – cash received).


g. Exchange of PPE (contd.) (SFAS 153: amends APB 29) Acquisition cost of the new asset is

the fair value of the new asset except in the following cases:

1. When the fair values of both assets (new and old) are undeterminable; or

2. The exchange lacks commercial substance (i.e., the exchange has no impact on future cash flows of companies.).


Payments of PPE

g. Exchange of PPE (contd.) (SFAS 153) Exchange with commercial substance and

a fair value is known (See Cases 1 to 4): The new asset is recorded at the its fair

value and gains and losses would be recognized.

If the fair value of the new asset is unknown, its fair value will be derived as the fair value of the old asset + cash paid (or - cash received).


iGAAP The FASB issued SFAS 153 (ASC845-10-

30 in 2004 to require gains on exchanges of nonmonetary assets be recognized if the exchange has commercial substance.

Per SFAS 153, the accounting nonmonetary assets exchange has converged between iGAAP and US GAAP.


CASE 1 (With Commercial Substance): Loss and Cash Paid

Cost of old asset =$20,000Book value of old asset = 6,000Fair value of old asset = 4,000Fair value of new asset = 9,000

New Asset 9,000Acc. Depr. 14,000Loss on

Disposal of ass. 2,000 Old ass. 20,000 Cash 5,000


CASE 2 (With Commercial Substance): Loss and Cash Received

Cost of old asset = $20,000Book value of old asset = 6,000Fair value of old asset = 4,000Fair value of new asset = 2,000

New Asset 2,000Cash 2,000Acc. Depr. 14,000Loss on

Disposal of ass. 2,000 Old ass. 20,000


CASE 3 (With Commercial Substance) : Gain and Cash Paid Cost of old asset =$20,000Book value of old asset= 6,000Fair value of old asset = 8,000Fair value of new asset = 12,000

New Asset 12,000 Acc. Depr. 14,000 Old ass. 20,000 cash. 4,000 Gain 2,000


CASE 4 (With Commercial Substance ): Gain and Cash Received Cost of old asset = $20,000Book value of old asset = 6,000Fair value of old asset = 8,000Fair value of new asset = 5,000

New Asset 5,000 Acc. Depr. 14,000 Cash 3,000

Old ass. 20,000 Gain on Disp. 2,000


Treatments for Exception 1 (Fair values of Both Assets Are Unknown) (SFAS 153)

When fair values of both assets are unknown, the new asset is recorded at:

Book Value of old Asset + Cash Paid or – Cash Received (See Cases 5 and 6).

In this case, no gain or loss will be recognized .


CASE 5: Fair value of Both Assets Are Unknown – Cash Received

Cost of old asset = $20,000Book value of old asset = 6,000cash received = 1,000

Cash 1,000

New Asset 5,000

Acc. Depr. 14,000 Old ass. 20,000


CASE 6: Fair Value of both Assets Unknown – Cash Paid

Cost of old asset = $20,000Book value of old asset = 6,000cash paid = 2,000

New Asset 8,000

Acc. Depr. 14,000 Old ass. 20,000 Cash 2,000


Treatments for Exception 2 (Exchange Lacks of Commercial Substance) (SFAS 153)

When the exchange lacks commercial value, the company recognizes a loss but not a gain unless cash is received (Conservatism!!).

This is to prevent a company from exchanging appreciated assets only to recognize the appreciation of the assets.

As a result, gains can only be recognized when there is commercial substance.


Exchange Lacks Commercial Substance With a loss: The new asset is recorded at

the fair value of the old + cash paid (or - cash received) (See Case 7).

With a gain and cash paid: No gain is recognized and the new asset is recorded at the book value of old + cash paid (See Case 8).

With a gain and cash received: partial gain is recognized and the new asset is recorded at the book value of old - cash received + partial gain (See Case 9).


CASE 7: No Commercial Substance with a Loss (loss is recognized)

Cost of old asset =$20,000Book value of old asset =6,000Fair value of old asset =4,000Fair value of new asset =9,000

New Asset 9,000 Acc. Depr. 14,000Loss on

Disposal of ass. 2,000 Old ass. 20,000 Cash 5,000Note: the new asset is recorded at its fair value.


CASE 8: No Commercial Substance, Gain and Cash Paid (Gain is deferred)Cost of old asset =$20,000Book value of old asset= 6,000Fair value of old asset = 8,000Fair value of new asset = 12,000

New Asset 10,000* Acc. Depr. 14,000 Old ass. 20,000 cash. 4,000 *The new asset is recorded at the book value of the old +cash paid (6,000+4,000)


CASE 9: No Commercial Substance , Gain and Cash Received (Partial gain is recognized)

Cost of old asset = $20,000Book value of old asset = 6,000Fair value of old asset = 8,000Fair value of new asset = 7,000

New Asset 5,250 Acc. Depr. 14,000 Cash 1,000

Old ass. 20,000 Gain on Disp. 250

Partial Gain=total gain x (cash received./fair value of old) Partial Gain = $2,000x ($1,000/$8,000) = $250 New Asset = Book Value of old – cash received + partial Gain

Case 9 (contd.)

Partial Gain=total gain x (cash received./fair value of old)

Partial Gain = $2,000x ($1,000/$8,000) = $250

New Asset = Book Value of old – cash received + partial Gain

If cash received is 25% or more of fair value of the old asset, entire gain is recognized (see illustration 10-20 of the textbook).



Prudent Cost Concept

The cost of an asset recorded can never exceed its market value.

When the cost of an asset exceeds it market value, the asset should be recorded at the market value and a loss would be recognized.

The loss equals the difference between the cost and the market value.


Asset Turnover Ratio

Financial analysts often use activity ratios to assess the effectiveness of a company’s utilizing of its assets – a key to profitability.

The activity ratios include: inventory turnover rate, accounts receivable turnover rate and asset turnover rate.

Asset turnover rate = Net sales/Average fixed assets.


Asset Turnover Ratio (contd.)

The ratio indicates the level of sales generated by the company’s investment in PPE.

PPE are usually company’s primary revenue generating assets.

The efficient use of these assets is critical to generate return to the owners.

The ratios of competitors can be compared.


C. Disposition of Property, Plant and Equipment Exchange Discard Sold for Cash Involuntary Conversion:


C. Disposition of Property, Plant and Equipment (contd.)

Involuntary Conversion: An asset’s service is terminated due to

fire, flood, theft or condemnation. The gains or losses are treated no

differently from those in other types of dispositions except they may be reported as an extraordinary item if conditions of the disposition are both infrequent and unusual.


D. Costs Subsequent to Acquisition Basic principle for capitalization of these

costs:Capitalize the cost if it can:a. extend the life of the existing asset, orb. increase the service quality of the

existing asset, orc. increase the productivity of the existing

asset (including the reduction of unit cost).

Otherwise, expense the cost.


D. Costs Subsequent to Acquisition(contd.)

Types of costs occurred subsequent to acquisition:a. Additions

b. Improvements, Replacements

c. Rearrangement and Reinstallation

d. Repairs

e. Maintenance


a. Additions

An addition is an extension of existing assets. By definition, a new asset has been created. Thus, costs of the additions should be capitalized.


b. Improvements & Replacements

Improvements: Substitution of a better asset for an existing asset.

Replacement: Replace with same kind of asset.

If the costs can increase the future service potential, the costs should be capitalized.


c. Rearrangement & Reinstallation

Movement of assets from one location to another. The costs of movements would benefit the company for the future period and should be capitalized.


d & e. Repairs & Maintenance

d. Repair: Ordinary repair: Expense Major repair: Capitalize if costs

increase future service potential or extend the life. Treat these costs as improvements or replacements as appropriate.

e. Maintenance: Expense


Method of Capitalization

When the cost of the old asset is known:Substitution approach

When the cost of the old asset is unknown:a. Adding the costs to the existing asset

account.b. Charging the costs to the accumulated

depreciation account.


When The Cost of The Old Asset Is Known Substitution approach (if quantity

increased or quality improved) : Remove the acc. depre. and the cost of the old asset and replace with the cost of the new asset.


When The Cost of The Old Asset Is Known (contd.)

Example: MMR Corp. decides to replace the pipe in its plumbing system. The old pipe has a book value of $15,000 with 135,000 acc. Depre. and zero salvage value. The new pipe has a cost of $125,000.

Plumbing System 125,000Acc. Depr. 135,000Loss on Disposal of Plant Assets 15,000

Plumbing System 150,000Cash 125,000


When The Cost of The Old Asset Is Unknown (i.e., parts of machines)

a. Adding the costs to the existing asset account (i.e., for improvements)

b. Charging the costs to the accumulated depreciation account (i.e., for replacements)

Documents

Intermediate Financial Accounting I Operational Assets: Acquisition