Perspective on Investing. CHAPTER 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENT Sommers – ACCT 3311

Perspective on Investing

CHAPTER 10

ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND

EQUIPMENT

Sommers – ACCT 3311

Long-lived, Revenue-producing AssetsLong-lived, Revenue-producing Assets

Tangible

Property, Plant, Equipment & Natural

Resources

Tangible

Property, Plant, Equipment & Natural

Resources

Types of Operational Assets

Expected to Benefit Future PeriodsExpected to Benefit Future Periods

General Rule for Cost CapitalizationThe initial cost of an operational asset includes the

purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.

Costs to be Capitalized

Land (not depreciable)• Purchase price• Real estate commissions• Attorney’s fees• Title search• Title transfer fees• Title insurance premiums• Removing old buildings

Equipment• Net purchase price• Taxes• Transportation costs• Installation costs• Modification to building

necessary to install equipment

• Testing and trial runs

Costs to be Capitalized

Land Improvements – Separately identifiable costs

• Driveways• Parking lots• Fencing• Landscaping (limited life)• Private roads

Buildings• Purchase price• Attorney’s fees• Commissions• Reconditioning

Natural Resources• Acquisition costs• Exploration costs• Development costs• Restoration costs

Self Constructed Assets• Materials• Direct Labor• Overhead

Discussion Questions

Q10–4 Indicate where the following items would be shown on a balance sheet.

(a) A lien that was attached to the land when purchased.

Land

(b) Landscaping costs.

Land improvements if limited life, else land.

(c) Attorney’s fees and recording fees related to purchasing land

Land

(d) Variable overhead related to construction of machinery.

Machinery


Q10–4

(e) A parking lot servicing employees in the building.

Land Improvements

(f) Cost of temporary building for workers during construction of building

Building

(g) Interest expense on bonds payable incurred during construction of a building.

Building

(h) Assessments for sidewalks that are maintained by the city.

Land

(i) The cost of demolishing an old building that was on the land when purchased.

Land

Example 1: Continued

Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building:

Title insurance $ 16,000

Legal fees for drawing the contract 5,000

Pro-rated property taxes for period after acquisition 36,000

State transfer fees 4,000

An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping (limited life). Determine the initial valuation of each asset Semtech acquired in these transactions.


Purchase price $4,000,000

Title search and insurance 16,000

Legal fees 5,000


Total cost $4,025,000

Fair Value % of Total Valuation

Land $3,300,000 75% $3,018,750

Building 1,100,000 25% 1,006,250

$4,400,000 100% $4,025,000

Land $3,018,750

Building 1,006,250

Land improvements:

Parking lot 82,000

Landscaping 40,000


Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building:

Title insurance $16,000

Legal fees for drawing the contract 5,000

Pro-rated property taxes for period after acquisition 36,000


An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping.

Now assume that immediately after acquisition, Semtech demolished the building. Demolition costs were $250,000 and the salvaged materials were sold for $6,000. In addition, Semtech spent $86,000 clearing and grading the land in preparation for the construction of a new building.


Cost of land:

Purchase price $4,000,000

Title search and insurance 16,000

Legal fees 5,000


Demolition of old building $250,000

Less: Sale of materials (6,000) 244,000

Clearing and grading costs 86,000

Total cost of land $4,355,000

Land improvements:

Parking lot $ 82,000

Landscaping $ 40,000

Asset

Fair Value

Percent of Total

Fair ValueInitial

ValuationLand $ 75,000 62.5% $ 62,500Building 45,000 37.5% 37,500 $120,000 100.0% $100,000

Example 2

Tristar Production Company began operations on September 1, 2011. Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction.

1. On September 1, the company acquired five acres of land with a building that will be used as a warehouse. Tristar paid $100,000 in cash for the property. According to appraisals, the land had a fair value of $75,000 and the building had a fair value of $45,000.

Land 62,500Building 37,500

Cash 100,000



2. On September 1, Tristar signed a $40,000 noninterest-bearing note to purchase equipment. The $40,000 payment is due on September 1, 2012. Assume that 8% is a reasonable interest rate.

Equipment 37,037

Discount on note payable 2,963

Note payable 40,000

PV(FV=40,000, PMT=0, n=1, i=8) = 37,037



3. On September 15, a truck was donated to the corporation. Similar trucks were selling for $2,500.

Truck 2,500

Revenue - donation of asset 2,500

4. On September 18, the company paid its lawyer $3,000 for organizing the corporation.

Organization cost expense 3,000

Cash 3,000



5. On October 10, Tristar purchased machinery for cash. The purchase price was $15,000 and $500 in freight charges also were paid.

Machinery 15,500

Cash 15,500

6. On December 2, Tristar acquired various items of office equipment. The company was short of cash and could not pay the $5,500 normal cash price. The supplier agreed to accept 200 shares of the company’s nopar common stock in exchange for the equipment. The fair value of the stock is not readily determinable.

Office equipment 5,500

Common stock 5,500



7. On December 10, the company acquired a tract of land at a cost of $20,000. It paid $2,000 down and signed a 10% note with both principal and interest due in one year. Ten percent is an appropriate rate of interest for this note.

Land 20,000

Cash 2,000

Note payable 18,000

Self-Constructed Assets

When self-constructing an asset, two accounting issues must be addressed:• overhead allocation to the self-constructed asset.

– incremental overhead only– full-cost approach

• proper treatment of interest incurred during construction

Under certain conditions, interest incurred on qualifying assets is capitalized.• Asset constructed is for a company’s own use and is a

discrete project for sale or lease.• Capitalize interest that could have been avoided if the

asset were not constructed and the money used to retire debt.


Q10–9 Provide examples of assets that do not qualify for interest capitalization.

(1) assets that are in use or ready for their intended use, and

(2) assets that are not being used in the earnings activities of the firm.

Three approaches have been suggested to account for the interest incurred in financing the construction.

Capitalize no interest during construction

Capitalize actual costs incurred during construction

Capitalize all costs of funds

GAAP

$ 0 $ ?Increase to Cost of Asset

Interest Costs During Construction

GAAP requires — capitalizing actual interest (with

modification).

Consistent with historical cost.

Capitalization considers three items:

1. Qualifying assets.

2. Capitalization period.

3. Amount to capitalize.

Interest Costs During Construction

Require a substantial period of time to get them ready

for their intended use.

Two types of assets:

Assets under construction for a company’s own

use.

Assets intended for sale or lease that are

constructed or produced as discrete projects.

Qualifying Assets

Capitalization Period

Begins when:

1. Expenditures for the asset have been made.

2. Activities for readying the asset are in progress .

3. Interest costs are being incurred.

Ends when:

The asset is substantially complete and ready for use.

Capitalization Period

Capitalize the lesser of:

1. Actual interest costs

2. Avoidable interest - the amount of interest that

could have been avoided if expenditures for the

asset had not been made.

Amount to Capitalize


Q10–10 What interest rates should be used in determining the amount of interest to be capitalized? How should interest revenue from temporarily invested excess funds borrowed to finance the construction of assets be accounted for?

The avoidable interest is determined by multiplying (an) interest rate(s) by the weighted-average amount of accumulated expenditures on qualifying assets. For the portion of weighted-average accumulated expenditures which is less than or equal to any amounts borrowed specifically to finance construction of the assets, the capitalization rate is the specific interest rate incurred. For the portion of weighted-average accumulated expenditures which is greater than specific debt incurred, the interest rate is a weighted average of all other interest rates incurred.

The amount of interest to be capitalized is the avoidable interest, or the actual interest incurred, whichever is lower.

Selecting Appropriate Interest Rate:

1. 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.

2. 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.

Calculating the Actual and Avoidable Interest

Accumulated Interest Avoidable

Expenditures Rate Interest

200,000$ 12% 24,000$

50,000 12.5% 6,250

250,000$ 30,250$

Avoidable Interest

Interest Actual

Debt Rate Interest

Specific Debt 200,000$ 12% 24,000$

General Debt 500,000 14% 70,000

300,000 10% 30,000

1,000,000$ 124,000$

Weighted-average interest rate on general debt

Actual Interest

$100,000

$800,000= 12.5%


Avoidable interest 30,250$

Actual interest 124,000

Journal entry to Capitalize Interest:

Equipment 30,250Interest expense 30,250

Not crediting cash because already paid and we are transferring (capitalizing)

Capitalize the lesser of Avoidable interest or Actual interest.


Example 3

On January 1, 2011, the Marlee Company began construction of an office building to be used as its corporate headquarters. The building was completed early in 2012. Construction expenditures for 2011, which were incurred evenly throughout the year, totaled $6,000,000. Marlee had the following debt obligations which were outstanding during all of 2011:

Construction loan, 10% $1,500,000

Long-term note, 9% 2,000,000

Long-term note, 6% 4,000,000

Calculate the amount of interest capitalized in 2011 for the building using the specific interest method.

Example 3

Average accumulated expenditures:

$6,000,000 / 2 = $3,000,000

Weighted-average rate of all other debt:

$2,000,000 x 9% = $180,000

4,000,000 x 6% = 240,000

$6,000,000 $420,000

$420,000 / $6,000,000 = 7%

Interest capitalized:

$3,000,000

- 1,500,000 x 10% = $150,000

1,500,000 x 7% = 105,000

$255,000 Interest capitalized

Example 4

On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, 2012. Expenditures on the project were as follows:

January 1, 2011 $1,000,000 January 31, 2012$270,000March 1, 2011 600,000 April 30, 2012

585,000June 30, 2011 800,000 August 31, 2012

900,000October 1, 2011 600,000

On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and 2012. The company’s other interest-bearing debt included two long-term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and 2012. Interest is paid annually on all debt. The company’s fiscal year-end is December 31.1. Calculate the amount of interest that Mason should capitalize in 2011 and

2012 using the specific interest method.2. What is the total cost of the building?3. Calculate the amount of interest expense that will appear in the 2011 and

2012 income statements.


Expenditures for 2011:

January 1, 2011 $1,000,000 x 12/12 = $1,000,000

March 1, 2011 600,000 x 10/12 = 500,000

June 30, 2011 800,000 x 6/12 = 400,000

October 1, 2011 600,000 x 3/12 = 150,000

Accumulated expenditures

(before interest) - $3,000,000

Average accumulated expenditures - $2,050,000


$2,050,000 x 10% = $205,000 = Interest capitalized in 2011

Example 4: ContinuedExpenditures for 2012:

January 1, 2012 $3,205,000 x 9/9 = $3,205,000January 31, 2012 270,000 x 8/9 = 240,000April 30, 2012 585,000 x 5/9 = 325,000August 31, 2012 900,000 x 1/9 = 100,000Accumulated expenditures (before interest) - $4,960,000Average accumulated expenditures - $3,870,000

Weighted-average rate of all other debt:$ 4,000,000 x 6% = $240,000 $ 720,000 6,000,000 x 8% = 480,000 $10,000,000 = 7.2%$10,000,000 $720,000

Interest capitalized:$3,000,000 x 10.0% x 9/12 = $225,000 870,000 x 7.2% x 9/12 = 46,980

$271,980 = Interest capitalized in 2012

Example 4: ContinuedCost of Building:

Expenditures in 2011 $3,000,000Interest capitalized in 2011 205,000Expenditures in 2012 1,755,000Interest capitalized in 2012 271,980 Total cost of building $5,231,980

Interest Expense for 2011:$3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 6,000,000 x 8% = 480,000Total interest incurred 1,020,000Less: Capitalized (205,000) 2011 expense $ 815,000

Interest Expense for 2012:Total interest incurred $1,020,000Less: Capitalized (271,980) 2012 expense $ 748,020

Example 4b: Continued

On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, 2012. Expenditures on the project were as follows:

January 1, 2011 $1,000,000 January 31, 2012$270,000March 1, 2011 600,000 April 30, 2012

585,000June 30, 2011 800,000 August 31, 2012

900,000October 1, 2011 600,000

On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and 2012. The company’s other interest- bearing debt included two long- term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and 2012. Interest is paid annually on all debt. The company’s fiscal year-end is December 31.1. Calculate the amount of interest that Mason should capitalize in 2011 and

2012 using the weighted-average method.2. What is the total cost of the building?3. Calculate the amount of interest expense that will appear in the 2011 and

2012 income statements.


Weighted-average rate of all debt:$ 3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 $ 1,020,000 6,000,000 x 8% = 480,000 $13,000,000 = 7.85%$13,000,000 $1,020,000

Expenditures for 2011:

Accumulated expenditures (before interest) - $3,000,000

Average accumulated expenditures - $2,050,000


$2,050,000 x 7.85% = $160,925 = Interest capitalized in 2011


Expenditures for 2012:January 1, 2012 $3,160,925 x 9/9 = $3,160,925January 31, 2012 270,000 x 8/9 = 240,000April 30, 2012 585,000 x 5/9 = 325,000August 31, 2012 900,000 x 1/9 = 100,000Accumulated expenditures (before interest) - $4,915,925Average accumulated expenditures - $3,825,925

Interest capitalized:$3,825,925 x 7.85% x 9/12 = $225,251 = Interest capitalized in 2012

Example 4b: ContinuedCost of Building:

Expenditures in 2011 $3,000,000Interest capitalized in 2011 160,925Expenditures in 2012 1,755,000Interest capitalized in 2012 225,251 Total cost of building $5,141,176



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Perspective on Investing. CHAPTER 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENT Sommers – ACCT 3311