Intermediate Financial Accounting I Operational Assets Acquisition Operational

Intermediate Financial Accounting I Operational Assets: Acquisition

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: Acquisition 2

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. Operational Assets: Acquisition 3

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. ) Operational Assets: Acquisition 4

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. ). Operational Assets: Acquisition 5

What Is Property, Plant and Equipment (PPE)? Assets used in operations (not for resale) u Long-term in Nature (Eco. Life > one year) u Possess physical substance u $ must be material u Operational Assets: Acquisition 6

A 1. PPE Valuation (APB Opinion No. 6) n n 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. Operational Assets: Acquisition 7

i. GAAP Vs. GAAP on PPE Valuation n n 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. i. GAAP permits companies to report PPE at either the historical cost or use a revaluation model (IAS 16). Operational Assets: Acquisition 8

i. GAAP – PPE Valuation n n 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 p 655 of the 14 th e KWW textbook). If revaluation is used, it must be applied for the whole class of assets and the revaluation must be performed annually. Operational Assets: Utilization and Disposition 9

A 1. PPE Valuation (contd. ) n n n 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. Operational Assets: Acquisition 10

A 2. Determination of Acquisition Cost u u Cost of Land Cost of Buildings Cost of Equipment Cost of Self-Constructed Assets Operational Assets: Acquisition 11

Cost of Land (held for operation, not for resale) n Any cost occurred before the land is ready for its intended use should be capitalized as cost of land. Operational Assets: Acquisition 12

Cost of Land (contd. ) n 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. ) Operational Assets: Acquisition 13

Cost of Land (contd. ) n n 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. Operational Assets: Acquisition 14

Cost of Land (contd. ) n n IRS allows the deduction of property taxes, insurance, interests even if these costs are capitalized. If land 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. Operational Assets: Acquisition 15

Example n Cost of Land and building were purchased for $200, 000 on 1/1/x 2. $50, 000 was assigned to the cost of building. On 12/31/x 5, 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. Operational Assets: Acquisition 16

Example (contd. ) J. E. Accu. Depre. Materials Loss Building Cash Cost of Land 35, 000 3, 000 19, 000 Operational Assets: Acquisition 50, 000 7, 000 17

Cost of Buildings n 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. Operational Assets: Acquisition 18

Cost of Equipment n Any cost occurred to acquire and to bring the equipment to the location and condition for its intended use. Operational Assets: Acquisition 19

Cost of Equipment (contd. ) n n Cost of Equipment includes: 1. purchase price, 2. freight-in, 3. insurance in transit, and 4. 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. Operational Assets: Acquisition 20

Cost of Self-Constructed (S-C) Assets n Cost of self-constructed assets includes: 1. direct materials, 2. direct labor, 3. factory overhead (variable overhead and fixed overhead). Operational Assets: Acquisition 21

Cost of Self-Constructed (S-C) Assets (contd. ) n Treatment of fixed overhead: 1) When operation is at full capacity 2) When operation is under the full capacity Operational Assets: Acquisition 22

Interest Costs During Construction n n Background of SFAS No. 34 (effective in 1979) Only capitalize the interest on funds borrowed for construction. Operational Assets: Acquisition 23

Interest Costs During Construction (contd. ) n 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. Operational Assets: Acquisition 24

Interest Costs During Construction (contd. ) u Capitalization period: Starting when: 1. Expenditures for the assets have been made; 2. Construction activities are in progress; and 3. Interest cost is being incurred. Ending when: F Assets are substantially completed and ready for intended use. Operational Assets: Acquisition 25

Interest Costs During Construction (contd. ) n n n 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. Operational Assets: Acquisition 26

Example - Interest Capitalization for Self-Constructed Assets v Capitalization period: 1/2/x 7 to 6/30/x 8 v Specific construction debt: $1, 500, 000 at 11% annual int. rate. This debt was borrowed on 9/30/x 6 to finance the project. v Other debt outstanding during the construction period: 1. $4, 000 at 12% annual int. rate. 2. $8, 000 at 15% annual int. rate. v These 1/1/x 7. loans have been outstanding since Operational Assets: Acquisition 27

Example (contd. ) u Weighted Average Interest Rate (of other debt): Total interest = 480, 000 +1, 200, 000 = 14% Total Principle 12, 000 or 12% x 4, 000 +15% x 8, 000 = 14% 12, 000, 000 u Expenditures on the construction during 20 x 7 and 20 x 8 were as follows: 1/2/x 7 $800, 000 7/1/x 7 $1, 000 10/1/x 7 $600, 000 3/1/x 8 $900, 000 6/1/x 8 $1, 800, 000 Operational Assets: Acquisition 28

Example (contd. ) u The amount of interest to be capitalized for 20 x 7: Computing the Weighted-Average Accumulated Expenditures (WAAE): 1/2/x 7 $800, 000 x 12/12 = $800, 000 7/1/x 7 1, 000 x 6/12 = 500, 000 10/1/x 7 600, 000 x 3/12 = 150, 000 2, 400, 000 $1, 450, 000 u Capitalized Interest (Avoidable Interest) for 20 x 7: $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 Operational Assets: Acquisition 29

Example (contd. ) u Actual interest incurred in 20 x 7: $1, 500, 000 x 11% + $4, 000 x 12% + $8, 000 x 15% = $1, 845, 000. Interest exp. = actual int. - capitalized int. = $1, 845, 000 - 159, 500 = $1, 685, 500 Operational Assets: Acquisition 30

Example (contd. ) u Journal entry to record the construction costs and interest expense for 20 x 7: Building 2, 559, 5001 Interest Expense 1, 685, 500 Cash 4, 245, 000 1. construction costs of 20 x 7 plus the capitalized interest of 20 x 7 (2, 400, 000+159, 500=2, 559, 500). Operational Assets: Acquisition 31

Example (contd. ) u The amount of interest to be capitalized for 20 x 8: WAAE of 20 x 8: 1/1/x 8 $2, 559, 500 x 6/6 =$2, 559, 500 3/1/x 8 900, 000 x 4/6 = 600, 000 6/1/x 8 1, 800, 000 x 1/6 = 300, 000 $3, 459, 500 u Capitalized interest for 20 x 8: WAAE Int. Rate $1, 500, 000 x 11% x 6/12= $ 82, 500 1, 959, 5001 x 14% x 6/12= 137, 165 219, 665 1. 3, 459, 500 -1, 500, 000 Operational Assets: Acquisition 32

A More Conservative Alternative u The amount of interest to be capitalized for 20 x 8: WAAE of 20 x 8: 1/1/x 8 $2, 559, 500 x 6/12 =$1, 279, 750 3/1/x 8 900, 000 x 4/12 = 300, 000 6/1/x 8 1, 800, 000 x 1/12 = 150, 000 $1, 729, 750 u Capitalized interest for 20 x 8: WAAE Int. Rate $1, 500, 000 x 11% = $165, 000 229, 0001 x 14% = 32, 060 $197, 060 1. 1, 279, 750 -1, 500, 000 Operational Assets: Acquisition 33

Example (contd. ) u Actual interest incurred in 20 x 8: Same as in x 7 = $1, 845, 000. Int. exp. of x 8 = 1, 845, 000 -219, 665= 1, 625, 335 u Journal entry to record the construction costs and int. exp. for x 8: Building Interest Exp. Cash 2, 919, 6651 1, 625, 335 4, 545, 000 1. $900, 000 + 1, 800, 000 + 219, 665 = 2, 919, 665 (costs of 20 x 8 plus the capitalized interest) Operational Assets: Acquisition 34

Example (contd. ) u Reporting: Income Statement (for the year ended 12/31/x 7) Other Revenues & Expenses: Interest Expenses $1, 845, 000 Less: Capitalized Int. (159, 500) $ 1, 685, 500 Notes: Accounting Policy F Capitalized interest: during 20 X 7, total interest expense was $1, 845, 000 of which $159, 500 was capitalized and $1, 685, 500 was charged to expense. Operational Assets: Acquisition 35

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. Operational Assets: Acquisition 36

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). Operational Assets: Acquisition 37

B. The Impact of Payments of PPE on the Cost of PPE a. Cash b. Issuance of stock c. Deferred payments d. Payment in advance e. Donations f. Lump sum purchase g. Exchange of PPE Operational Assets: Acquisition 38

a. Cash n Payments of PPE 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. Operational Assets: Acquisition 39

Payments of PPE b. Issuance of Stock n 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. Operational Assets: Acquisition 40

Payments of PPE c. Deferred Payments n 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, 000 x 0. 683 = 6, 830 Building Discount on N/P 6, 830 3, 170 Operational Assets: Acquisition 10, 000 41

Payments of PPE d. Payment in Advance n SFAS No. 34 requires to capitalize the implicit interest of the advanced payment. Operational Assets: Acquisition 42

Payment in Advance (contd. ) n Example: Equipment costing $500, 000. $100, 000 was paid on 1/1/x 5 and the equipment was delivered on 12/31/x 5. 1/1/x 5 Advances 100, 000 Cash 100, 000 12/31/x 5 Equipment 500, 000 Advances 100, 000 Cash 400, 000 Equipment 1 10, 000 Interest Exp. 10, 000 1. assume market rate of 10% Operational Assets: Acquisition 43

e. Donations (receive or make contributions; nonreciprocal transfers) n n Contributions received are recorded at the fair value of the assets (SFAS No. 116): Land $$$$ Contribution Revenue $$$$ Non-monetary contributions made are also recorded at the fair value of the assets: Contribution Expense $$$$ Land $$$$ Gain on Disposal of Land $$$$ Operational Assets: Acquisition 44

Payments of PPE e. Donations (contd. ) § SFAS No. 116 applied to private sector donations; may not apply to donations from governmental units. Operational Assets: Acquisition 45

Payments of PPE f. Lump Sum Purchase n 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, 000 1. 30, 000/(30, 000+90, 000)=25%, 25%x 100, 000 = 25, 000 2. 90, 000/(30, 000+90, 000)=75%, 75%x 100, 000 = 75, 000 Operational Assets: Acquisition 46

g. Exchange of Property, Plant, and Equipment (nonmonetary assets) n n n 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. Operational Assets: Acquisition 47

Payments of PPE g. Exchange of PPE (contd. ) n Cash paid=> Fair value of the old asset < fair value of the new asset. n 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). Operational Assets: Acquisition 48

g. Exchange of PPE (contd. ) (SFAS 153: amends APB 29) n n n 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. ). Operational Assets: Acquisition 49

Payments of PPE g. Exchange of PPE (contd. ) (SFAS 153) n Exchange with commercial substance and a fair value is known (See Cases 1 to 4): Ø The new asset is recorded at the its fair value and gains and losses would be recognized. Ø 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). Operational Assets: Acquisition 50

i. GAAP n n The FASB issued SFAS 153 (ASC 845 -1030 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 i. GAAP and US GAAP. Operational Assets: Acquisition 51

CASE 1 (With Commercial Substance): Loss and Cash Paid Cost of old asset =$20, 000 Book value of old asset = 6, 000 Fair value of old asset = 4, 000 Fair value of new asset = 9, 000 New Asset 9, 000 Acc. Depr. 14, 000 Loss on Disposal of ass. 2, 000 Old ass. 20, 000 Cash 5, 000 Operational Assets: Acquisition 52

CASE 2 (With Commercial Substance): Loss and Cash Received Cost of old asset = $20, 000 Book value of old asset = 6, 000 Fair value of old asset = 4, 000 Fair value of new asset = 2, 000 New Asset 2, 000 Cash 2, 000 Acc. Depr. 14, 000 Loss on Disposal of ass. 2, 000 Old ass. 20, 000 Operational Assets: Acquisition 53

CASE 3 (With Commercial Substance) : Gain and Cash Paid Cost of old asset Book value of old asset Fair value of new asset New Asset Acc. Depr. =$20, 000 = 6, 000 = 8, 000 = 12, 000 14, 000 Old ass. cash. Gain Operational Assets: Acquisition 20, 000 4, 000 2, 000 54

CASE 4 (With Commercial Substance ): Gain and Cash Received Cost of old asset Book value of old asset Fair value of new asset =$20, 000 = 6, 000 = 8, 000 = 5, 000 New Asset 5, 000 Acc. Depr. 14, 000 Cash 3, 000 Old ass. 20, 000 Gain on Disp. 2, 000 Operational Assets: Acquisition 55

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. Operational Assets: Acquisition 56

CASE 5: Fair value of Both Assets Are Unknown – Cash Received Cost of old asset = $20, 000 Book value of old asset = 6, 000 cash received = 1, 000 Cash 1, 000 New Asset 5, 000 Acc. Depr. 14, 000 Old ass. Operational Assets: Acquisition 20, 000 57

CASE 6: Fair Value of both Assets Unknown – Cash Paid Cost of old asset Book value of old asset cash paid New Asset Acc. Depr. = $20, 000 = 6, 000 = 2, 000 8, 000 14, 000 Old ass. Cash Operational Assets: Acquisition 20, 000 2, 000 58

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. Operational Assets: Acquisition 59

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). Operational Assets: Acquisition 60

CASE 7: No Commercial Substance with a Loss (loss is recognized) Cost of old asset =$20, 000 Book value of old asset = 6, 000 Fair value of old asset = 4, 000 Fair value of new asset = 9, 000 New Asset 9, 000 Acc. Depr. 14, 000 Loss on Disposal of ass. 2, 000 Old ass. 20, 000 Cash 5, 000 Note: the new asset is recorded at its fair value. Operational Assets: Acquisition 61

CASE 8: No Commercial Substance, Gain and Cash Paid (Gain is deferred) Cost of old asset Book value of old asset Fair value of new asset New Asset Acc. Depr. =$20, 000 = 6, 000 = 8, 000 = 12, 000 10, 000* 14, 000 Old ass. cash. 20, 000 4, 000 *The new asset is recorded at the book value of the old +cash paid (6, 000+4, 000) Operational Assets: Acquisition 62

CASE 9: No Commercial Substance , Gain and Cash Received (Partial gain is recognized) Cost of old asset =$20, 000 Book value of old asset = 6, 000 Fair value of old asset = 8, 000 Fair 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, 000 x ($1, 000/$8, 000) = $250 New Asset = Book Value of old – cash received + partial Operational Assets: Acquisition Gain 63

Case 9 (contd. ) § Partial Gain=total gain x (cash received. /fair value of old) § Partial Gain = $2, 000 x ($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). Operational Assets: Acquisition 64

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. Operational Assets: Acquisition 65

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. Operational Assets: Acquisition 66

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. Operational Assets: Acquisition 67

C. Disposition of Property, Plant and Equipment n n Exchange Discard Sold for Cash Involuntary Conversion: Operational Assets: Acquisition 68

C. Disposition of Property, Plant and Equipment (contd. ) Involuntary Conversion: An asset’s service is terminated due to fire, flood, theft or condemnation. u 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. u Operational Assets: Acquisition 69

D. Costs Subsequent to Acquisition n Basic principle for capitalization of these costs: Capitalize the cost if it can: a. extend the life of the existing asset, or b. increase the service quality of the existing asset, or c. increase the productivity of the existing asset (including the reduction of unit cost). Otherwise, expense the cost. Operational Assets: Acquisition 70

D. Costs Subsequent to Acquisition (contd. ) n Types of costs occurred subsequent to acquisition: a. Additions b. Improvements, Replacements c. Rearrangement and Reinstallation d. Repairs e. Maintenance Operational Assets: Acquisition 71

a. Additions n An addition is an extension of existing assets. By definition, a new asset has been created. Thus, costs of the additions should be capitalized. Operational Assets: Acquisition 72

b. Improvements & Replacements n n 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. Operational Assets: Acquisition 73

c. Rearrangement & Reinstallation n Movement of assets from one location to another. The costs of movements would benefit the company for the future period and should be capitalized. Operational Assets: Acquisition 74

d & e. Repairs & Maintenance d. Repair: u Ordinary repair: Expense u 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 Operational Assets: Acquisition 75

Method of Capitalization n n 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. Operational Assets: Acquisition 76

When The Cost of The Old Asset Is Known n 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. Operational Assets: Acquisition 77

When The Cost of The Old Asset Is Known (contd. ) n 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, 000 Acc. Depr. 135, 000 Loss on Disposal of Plant Assets 15, 000 Plumbing System 150, 000 Cash 125, 000 Operational Assets: Acquisition 78

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) Operational Assets: Acquisition 79