Slide 1PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Property, Plant, and Equipment
and Intangible Assets: Acquisition
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights
reserved.
Chapter 10: Property, Plant, and Equipment and Intangible Assets:
Acquisition and Disposition
This chapter and the one that follows address the measurement and
reporting issues involving property, plant, and equipment and
intangible assets. These long-lived tangible and intangible assets
are used in the production of goods and services. Chapter 10 covers
the valuation at date of acquisition and the disposition of these
assets.
10 - *
General Rule for Cost Capitalization
The initial cost of an asset includes the purchase price and all
expenditures necessary to bring the asset to its desired condition
and location for use.
Expected to Benefit Future Periods
Part I.
Long-lived, revenue producing assets are assets that are used
actively in the business, and that are expected to benefit the
operations into the future.
There are two major categories of these assets. Tangible assets
have physical substance. Included in this category are land,
buildings, equipment, machinery, vehicles, and natural resources
such as oil, gas, and mineral deposits. Intangible assets are
assets without physical substance. Included in this category are
patents, copyrights, trademarks, franchises, and goodwill.
Part II.
Long-lived, revenue-producing assets may be acquired in a number of
ways. Regardless of the method of acquisition, the assets are
recorded at their original cost. The recorded cost includes the
purchase price and all expenditures necessary to bring the asset to
its desired condition and location for use.
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Equipment
the net purchase price, less discounts,
taxes,
testing and trial runs.
the purchase price,
real estate commissions,
attorney’s fees,
title transfer fees,
title insurance premiums,
the cost of making the land ready for its intended use, including
the cost of removing old
buildings.
Unlike other long-lived, revenue-producing assets in the property,
plant and equipment category, land is not depreciated.
10 - *
Part I.
Land improvements are enhancements to property such as driveways,
parking lots, fencing, landscaping, and private roads. These are
separately identifiable costs that are recorded in the land
improvement asset account rather than in the land account. Unlike
land, land improvements are depreciated.
Part II.
the purchase price,
real estate commissions,
attorney’s fees,
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Costs to be Capitalized
The initial cost of an intangible asset includes the purchase price
and all other costs necessary to bring it to condition and location
for use, such as legal and filing fees.
Part I.
The capitalized cost of natural resources includes the initial
acquisition costs, exploration costs, development costs, and
restoration costs.
Part II.
Intangible assets include patents, copyrights, trademarks,
franchises, and goodwill. The initial cost of an intangible asset
includes the purchase price and all other costs necessary to bring
it to condition and location for use, such as legal and filing
fees.
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increase in the related asset.
Record at fair value, usually the
present value of future cash
outflows associated with the
extraction when the land must be
restored to a useable condition.
Asset retirement obligations are often encountered with natural
resource extraction when a company is required to restore the land
to the original condition or to a useable condition. An asset
retirement obligation is recorded as a liability and a
corresponding increase in the related asset. The amount recorded is
the present value of future cash flows expected to be incurred for
the reclamation or restoration.
10 - *
than tangible assets.
Intangible assets are assets without physical substance that
provide the owner with exclusive rights that benefit the production
of goods and services. The future benefits attributed to intangible
assets usually are much less certain than those attributed to
tangible assets.
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An exclusive right recognized by law and granted by the US Patent
Office for 20 years.
Holder has the right to use, manufacture, or sell the patented
product or process without interference or infringement by
others.
R & D costs that lead to an internally developed patent are
expensed in the period incurred.
Intangible Assets Patents
Torch, Inc. has developed a new device. Research and development
costs totaled $30,000. Patent registration costs consisted of
$2,000 in attorney fees and $1,000 in federal registration fees.
What is Torch’s patent cost?
Torch’s cost for the new patent is $3,000. The $30,000 R & D
cost is expensed as incurred.
Part I.
A patent is an exclusive right to manufacture a product or to use a
process that is granted by the United States Patent Office for a
period of 20 years. The holder of the patent essentially has a
monopoly right to use, manufacture, or sell the patented product or
process without interference or infringement by others. Purchased
patents are recorded at acquisition cost. Research and development
costs that lead to an internally developed patent are expensed in
the period incurred. Let’s consider an example dealing with patent
costs.
Part II.
Torch, Incorporated has developed a new device. Research and
development costs totaled $30,000. Patent registration costs
consisted of $2,000 in attorney fees and $1,000 in federal
registration fees. What is Torch’s patent cost that will be
recorded in the asset account?
Part III.
Torch’s cost for the new patent is $3,000. The $30,000 of research
and development cost is expensed as incurred.
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Copyrights
A form of protection given by law to authors of literary, musical,
artistic, and similar works.
Copyright owners have exclusive rights to print, reprint, copy,
sell or distribute, perform and record the work.
Generally, the legal life of a copyright is the life of the author
plus 70 years.
Trademarks
If purchased, a trademark is recorded at cost.
Registered with U.S. Patent Office and renewable indefinitely in
10-year periods.
Intangible Assets
Part I.
A copyright is an exclusive right of protection given to a creator
of a published work such as literary, musical, artistic, and
similar works. Copyright owners have exclusive rights to print,
reprint, copy, sell or distribute, perform and record the work.
Generally, the legal life of a copyright is the life of the creator
plus 70 years.
Part II.
A trademark is a symbol, design, or logo that distinctively
identifies a company, product, or service. If internally developed,
trademarks have no recorded asset cost. If purchased, a trademark
is recorded at acquisition cost. Trademarks are registered with the
United States Patent Office and are renewable indefinitely in
10-year periods.
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A contractual arrangement where the franchisor grants the
franchisee exclusive rights to use the franchisor’s trademark
within a certain area for a specified period of time.
Goodwill
Franchise
consideration exchanged exceeds
Only purchased
intangible asset.
Part I.
A franchise is a contractual arrangement under which the franchisor
grants the franchisee exclusive rights to use the franchisor’s
trademark within a geographical area for a specified period of
time. The franchisee usually makes an initial payment to the
franchisor that is capitalized as an intangible asset along with
any legal and license fees. Annual payments from operations to the
franchisor are expensed.
Part II.
Unlike other intangible assets, goodwill cannot be associated with
any specific right. It does not exist separate from the company
itself. It represents the value of a company as a whole, over and
above its identifiable net assets. Goodwill may be attributed to
many factors, including good reputation, superior employees and
management, good clientele, and good business location.
Only purchased goodwill is recognized. Purchased goodwill results
when one company buys another company for a price that exceeds the
fair value of the separate identifiable net assets acquired.
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Eddy Company paid $1,000,000 to purchase all of James Company’s
assets and assumed James Company’s liabilities of $200,000. James
Company’s assets were appraised at a fair value of $900,000. What
amount of goodwill should Eddy company record as a result of the
purchase?
Goodwill
Let’s look at an example illustrating how we determine the amount
of goodwill in company acquisition.
Eddy Company paid $1,000,000 to purchase all of James Company’s
assets and assumed James Company’s liabilities of $200,000. James
Company’s assets were appraised at a fair value of $900,000. What
amount of goodwill should Eddy Company record as a result of the
purchase?
The goodwill is $300,000. We compute the $700,000 fair value of the
net assets acquired by subtracting the $200,000 of liabilities
assumed from the $900,000 fair value of the assets. The $1,000,000
consideration given less the $700,000 fair value of the net assets
acquired results in $300,000 of goodwill.
Sheet1
FV of assets
200,000
700,000
Goodwill
$ 300,000
&A
Several assets are acquired for a single price that may
be lower than the sum of the individual asset fair values.
Lump-Sum Purchases
Asset 2
Asset 1
Asset 3
on relative fair values of the individual assets.
On May 13, we purchase land and building for $200,000 cash. The
appraised value of the building is $162,500, and the land is
appraised at $87,500. How much of the $200,000 purchase price will
be allocated to the building account?
Part I.
Lump-sum purchases occur when a group of assets is acquired for a
single purchase price.
Part II.
The lump-sum purchase price is allocated to assets based on
relative fair values of the individual assets.
Part III.
Let’s look at an example of a lump-sum purchase involving land and
a building.
On May 13, we purchase land and building for $200,000 cash. The
appraised value of the building is $162,500, and the land is
appraised at $87,500.
How much of the $200,000 purchase price will be allocated to the
building account?
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Part I.
First, we calculate the allocation percentages by dividing the
appraised value of each asset by the total of the appraised values.
For example, the total of the building appraisal of $162,500 and
the land appraisal of $87,500 is $250,000. Dividing $162,500 by
$250,000 gives us an allocation percentage of 65 percent for the
building.
We multiply the allocation percentage times the lump-sum purchase
price to obtain the amount allocated to each asset. For the
building, 65 percent of the $200,000 purchase price is $130,000
dollars.
Part II.
The entry to record the lump-sum purchase results in a debit to
land for $70,000, a debit to building for $130,000, and a credit to
cash for $200,000.
Sheet1
Appraised
% of
Purchase
Assigned
Asset
Value
Value
Price
Cost
(a)
(b)*
(c)
the fair value of the consideration given
or
whichever is more clearly evident.
Part I.
Companies sometimes acquire assets without paying cash. Assets may
be acquired by issuing debt or equity securities, by receiving
donated assets, or by exchanging other assets.
Part II.
In any noncash acquisition, the components of the transaction
should be recorded at their fair values. The first indication of
fair value is the fair value of the consideration given to acquire
the asset. Sometimes the fair value of the asset received is used
when that fair value is more clearly evident than the fair value of
the consideration given.
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value of future cash flows.
A deferred payment contract is usually a note payable. If the note
includes a realistic interest rate (market rate), the asset
acquired is recorded at the face amount of the note. If the note
includes an unrealistically low interest rate or is a noninterest
bearing note, the asset is recorded at the present value of the
future cash payments. The interest rate used for the present values
computations should be a current market rate of interest.
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On January 2, 2011, Midwestern Corporation purchased equipment by
signing a noninterest-bearing note requiring $50,000 to be paid on
December 31, 2012. The prevailing market rate of interest on notes
of this nature is 10%.
Prepare the required journal entries for Midwestern on January 2,
2011; December 31, 2011 (year-end), and December 31, 2012
(year-end).
We do not know the cash equivalent price, so we must use the
present value of the future cash payment.
Deferred Payments
Part I.
On January 2, 2011, Midwestern Corporation purchased equipment by
signing a noninterest-bearing note requiring $50,000 to be paid on
December 31, 2012. The prevailing market rate of interest on notes
of this nature is 10%. Prepare the required journal entries for
Midwestern on January 2, 2011, December 31, 2011 (year-end), and
December 31, 2012 (year-end).
Part II.
Since we do not know the cash equivalent price in this example, we
must compute the present value of the future cash payment by
multiplying the $50,000 face amount of the note times the present
value of a dollar interest factor for two years and 10 percent. The
present value is $41,323.
Now, we are ready to make the journal entry for January 2,
2011.
Sheet1
0.82645
Note payable ………………………….... 50,000
Discount on note payable ……………… 4,132
To record interest expense.
Discount on note payable ……..……..… 4,545
To record interest expense.
Part I.
On January 2, 2011, we record the equipment acquisition with a
debit to equipment for $41,323, a debit to discount on note payable
for $8,677, and a credit to note payable for the face amount of
$50,000. The discount is computed by subtracting the $41,323
present value from the $50,000 face amount of the note payable. At
the date of issue, January 2, 2011, the carrying value of the of
the note is equal to the face amount of $50,000 less the
unamortized discount of $8,677, or $41,323.
Part II.
On December 31 of each year, we record interest expense for the
year. Interest expense is computed by multiplying the carrying
value of the note (note payable less the unamortized discount on
note payable) times the interest rate. On December 31, 2011,
interest expense is equal to the $41,323 carrying value of the note
times 10 percent. To record the interest, we debit interest expense
and credit discount on note payable for $4,132. This process is
referred to as amortizing the discount to interest expense. As a
result, the carrying value of the note in the next period will be
greater because the unamortized discount is smaller.
On December 31, 2012, the carrying value of the note is increased
by the amount of the discount amortized to interest expense on
December 31, 2012. The new carrying value equals $41,323 plus
$4,132, or $45,455. On December 31, 2012, interest expense is equal
to the $45,455 carrying value of the note times 10 percent. To
record the interest, we debit interest expense and credit discount
on note payable for $4,545.
Finally, on December 31, 2012, we record the cash payment at
maturity by debiting note payable and crediting cash for $50,000.
At the maturity date, the discount on note payable has a zero
balance because it has been fully amortized to interest
expense.
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Issuance of Equity Securities
Asset acquired is recorded at the fair value of the asset or the
market value of the securities, whichever is more clearly
evident.
If the securities are actively traded, market value can be easily
determined.
If the securities given are not actively traded, the fair value of
the asset received, as determined by appraisal, may be more clearly
evident than the fair value of the securities.
Donated Assets
The donated asset at fair value.
Revenue equal to the fair value of the donated asset.
Part I.
When an asset is acquired with the issuance of equity securities,
it is recorded at the fair value of the asset or the market value
of the securities, whichever is more clearly evident. If the
securities are actively traded, market value can be easily
determined. If the securities given are not actively traded, the
fair value of the asset received, as determined by appraisal, may
be more clearly evident than the fair value of the
securities.
Part II.
On occasion, companies acquire assets through donation. The
donation usually is an enticement to get the company to do
something that benefits the donor. Donated assets are recorded at
fair value with a debit on the recipient company’s books and a
corresponding credit to a revenue account for the fair value of the
asset. The reasoning is that the company receiving the asset is
performing a service for the donor in exchange for the asset
donated.
10 - *
Dispositions
Update depreciation to date of disposal.
Remove original cost of asset and accumulated depreciation from the
books.
The difference between book value of the asset and the amount
received is recorded as a gain or loss.
On June 30, 2011, MeLo, Inc. sold equipment for $6,350 cash. The
equipment was purchased on January 1, 2006 at a cost of $15,000.
The equipment was depreciated using the straight-line method over
an estimated ten-year life with zero salvage value. MeLo last
recorded depreciation on the equipment on December 31, 2010, its
year-end.
Prepare the journal entries necessary to
record the disposition of this equipment.
Part I.
After using property, plant, and equipment and intangible assets,
companies dispose of them by sale, retirement, or exchanging them
for other assets. Three accounting steps are involved in
dispositions:
update depreciation to the date of disposal.
remove the original cost of the asset and its accumulated
depreciation from
the books.
record a gain or loss for the difference between the book value of
the asset and
the amount received.
Consider the following example where an asset is sold for
cash.
Part II.
On June 30, 2011, MeLo, Inc. sold equipment for $6,350 cash. The
equipment was purchased on January 1, 2006 at a cost of $15,000.
The equipment was depreciated using the straight-line method over
an estimated ten-year life with zero salvage value. MeLo last
recorded depreciation on the equipment on December 31, 2010, its
year-end.
Prepare the journal entries necessary to record the disposition of
this equipment.
10 - *
Dispositions
Accumulated depreciation ………………........ 750
June 30, 2011:
Accumulated depreciation
............................................ 8,250
($15,000 ÷ 10 years) × 5½) = $8,250
Remove original asset cost and accumulated depreciation.
Record the gain or loss.
Part I.
Our first step is to update the depreciation to the date of sale.
It has been six months since the last depreciation entry. Since
there was no salvage value, depreciation for one year is the
$15,000 purchase price divided by 10 years, resulting in $1,500.
For the six months of 2011, the depreciation is one-half of $1,500,
or $750.
We debit depreciation expense for $750 and credit accumulated
depreciation for $750 to update the depreciation to June 30.
Part II.
Our second and third steps are to remove the original cost and the
related accumulated depreciation from the books, and to record any
gain or loss on the sale.
Since the asset was acquired on January 1, 2006, and sold on June
30, 2011, it has been used for a total of five and one-half years.
The accumulated depreciation balance on June 30 is $8,250, an
amount obtained by multiplying 5 ½ years times $1,500 of
depreciation per year.
The book value at the date of sale is $6,750 dollars computed by
subtracting the $8,250 of accumulated depreciation from the $15,000
cost of the asset. Since the book value of $6,750 exceeds the cash
sale price of $6,350 by $400, we recognize a $400 loss on the
sale.
To record the entry, we debit accumulated depreciation for $8,250,
debit cash for $6,350, debit loss on sale for $400, and credit
equipment for $15,000.
10 - *
Exchanges
General Valuation Principle (GVP): Cost of asset acquired is:
fair value of asset given up plus cash paid or minus cash received
or
fair value of asset acquired, if it is more clearly evident
In the exchange of assets fair value is used except in rare
situations in which the fair value cannot be determined or the
exchange lacks commercial substance.
When fair value cannot be determined or the exchange lacks
commercial substance, the asset(s) acquired are valued at the book
value of the asset(s) given up, plus (or minus) any cash exchanged.
No gain is recognized.
Part I.
Property, plant, and equipment and intangible assets are sometimes
acquired in exchanges for other assets. Trade-ins of old assets in
exchange for new assets is probably the most frequent type of
exchange. Cash is involved in the transactions to equalize fair
values. The general principle to be followed is that the cost of
the asset acquired is:
equal to the fair value of asset given up plus cash paid or minus
cash
received, or
equal to the fair value of asset acquired, if that is more clearly
evident.
A gain or loss is recognized for the difference between the fair
value of the asset given up and its book value.
Part II.
We follow the general principle based on fair value in the exchange
of assets except in rare situations in which the fair value cannot
be determined or the exchange lacks commercial substance.
When fair value cannot be determined or the exchange lacks
commercial substance, the asset(s) acquired are valued at the book
value of the asset(s) given up, plus (or minus) any cash exchanged.
No gain is recognized. Let’s look at an example where fair value
cannot be determined.
10 - *
Fair Value Not Determinable
Matrix, Inc. exchanged used equipment for newer equipment. Due to
the nature of the assets exchanged, Matrix could not determine the
fair value of the asset given up or received. The asset given up
originally cost $600,000, and had an accumulated depreciation
balance of $400,000 at the time of the exchange. Matrix exchanged
the asset and paid $100,000 cash.
Let’s record this unusual transaction.
Part I.
Matrix, Inc. exchanges one used equipment for another newer
equipment. Due to the nature of the assets exchanged, Matrix could
not determine the fair value of the asset given up or received. The
asset given up originally cost $600,000, and had an accumulated
depreciation balance of $400,000 at the time of the exchange.
Matrix exchanged the asset and paid $100,000 cash. Let’s record
this unusual transaction.
Part II.
First, we compute the book value of the asset given up in the
exchange. Book value is equal to $200,000, determined by
subtracting the $400,000 of accumulated depreciation from the
$600,000 original cost.
In addition to giving up book value of $200,000, Matrix paid
$100,000 to acquire the newer asset.
The asset acquired will be recorded at the book value given up plus
the cash paid. Now we are ready for the journal entry.
Sheet1
Matrix, Inc.
The journal entry below shows the proper recording of the
exchange.
Fair Value Not Determinable
Equipment ($200,000 + $100,000) ................. 300,000
To record equipment acquired in exchange.
To record the equipment acquired, we debit equipment for $300,000,
the book value given up plus the cash paid. We remove the asset
given up with a credit to equipment for its cost of $600,000 and a
debit to accumulated depreciation for $400,000. Finally, we credit
cash for the $100,000 paid in the transaction. Since fair value is
not known, Matrix did not recognize a gain or a loss on the
exchange.
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Exchange Lacks Commercial Substance
When exchanges are recorded at fair value, any gain or loss is
recognized for the difference between the fair value and book value
of the asset(s) given-up. To preclude the possibility of companies
engaging in exchanges of appreciated assets solely to be able to
recognize gains, fair value can only be used in legitimate
exchanges that have commercial substance.
A nonmonetary exchange is considered to have commercial substance
if the company:
expects a change in future cash flows as a result of the
exchange, and
value of the assets exchanged.
Part I.
When exchanges are recorded at fair value, any gain or loss is
recognized for the difference between the fair value and book value
of the asset(s) given-up. To preclude the possibility of companies
engaging in exchanges of appreciated assets solely to be able to
recognize gains, fair value can only be used in legitimate
exchanges that have commercial substance.
Part II.
A nonmonetary exchange is considered to have commercial substance
if the company:
expects a change in future cash flows as a result of the exchange,
and
the expected change in cash flows is significant relative to the
fair value of
the assets exchanged.
If the exchange does not meet these two conditions, it lacks
commercial substance and, book value is used to value the asset(s)
acquired. No gain is recognized.
10 - *
Exchanges
Matrix, Inc. exchanged new equipment and $10,000 cash for equipment
owned by Float, Inc.
Below is information about the asset exchanged by Matrix. Record
the transaction assuming the exchange has commercial
substance.
Gain = Fair Value – Book Value
Gain = $205,000 – $200,000 = $5,000
Part I.
Matrix, Inc. exchanged new equipment and $10,000 cash for equipment
owned by Float, Inc. The equipment originally cost Matrix $500,000.
At the date of the exchange, the equipment had accumulated
depreciation of $300,000, book value of $200,000, and fair value of
$205,000. Record the transaction assuming the exchange has
commercial substance.
Part II.
First, we must determine the gain or loss. The fair value of the
asset given up exceeds its book value by $5,000 which means there
is a gain in this transaction of $5,000.
Sheet1
Accumulated
Book
Fair
Cost
Depreciation
Value
Value
Matrix's
Equipment
$ 500,000
$ 300,000
$ 200,000
$ 205,000
Sheet2
Sheet3
10 - *
Exchanges
Record the same transaction assuming the exchange lacks commercial
substance.
Equipment ...............................................
215,000
Equipment ...............................................
210,000
$205,000 fair value + $10,000 cash
$200,000 book value + $10,000 cash
Part I.
Since the transaction has commercial substance, we will record the
asset acquired at the fair value of the asset given up plus the
cash paid, and we will recognize the gain.
To record the equipment acquired, we debit equipment for the sum of
the $205,000 of fair value given up plus the $10,000 cash paid. We
remove the asset given up with a credit to equipment for its cost
of $500,000 and a debit to accumulated depreciation for $300,000.
We credit cash for the $10,000 paid in the transaction, and credit
the gain of $5,000.
Part II.
Now let’s see how we would record this transaction if it lacks
commercial substance.
Part III.
Since the transaction lacks commercial substance, the equipment
acquired should be valued at book value of equipment given up plus
the cash paid. The $5,000 gain is not recognized.
To record the equipment acquired, we debit equipment for $210,000,
the book value given up plus the cash paid. We remove the asset
given up with a credit to equipment for its cost of $500,000 and a
debit to accumulated depreciation for $300,000. Finally, we credit
cash for the $10,000 paid in the transaction
10 - *
When self-constructing an asset, two accounting issues must be
addressed:
overhead allocation to the self-constructed asset.
incremental overhead only
proper treatment of interest incurred during construction
Interest that could have been avoided if the asset were not
constructed and the money used to retire debt.
Asset constructed:
As a discrete project for sale or lease.
Under certain conditions, interest incurred on qualifying assets is
capitalized.
Part I.
There are two difficult accounting issues that must be addressed
when a company is constructing assets for its own use:
determining the amount the company’s manufacturing overhead to
be
included in the asset’s cost.
deciding on the proper treatment of interest incurred during
the
construction period.
One approach to assigning overhead to self-constructed assets is
the incremental approach, where actual incremental overhead costs
are recorded in the asset account. However, the most commonly used
method is to assign overhead using a predetermined overhead rate,
based on an overhead cost driver activity, that is used to assign
the company’s overhead to regular production. This approach is
called the full cost approach.
Unlike purchased assets, self-constructed assets may take a long
period of time to be made ready for their intended use. The
construction activities during this period require construction
financing. Following our general rule for the cost of an asset, all
costs necessary to make the asset ready for its intended use,
including interest during the construction period, should be
included in the asset’s cost.
Part II.
Interest is capitalized (included in the asset’s cost) for
qualifying assets. Qualifying assets are:
assets built for a company’s own use.
assets constructed as discrete projects for sale or lease. Assets
in this
category are large construction projects such as a real estate
development
built for sale or lease.
Only the portion of interest cost incurred during the construction
period that could have been avoided if the construction had not
been undertaken may be capitalized.
10 - *
Capitalization ends when:
the asset is substantially complete and ready for its intended use,
or
when interest costs no longer are being incurred.
Interest Capitalization
The interest capitalization period begins when the first qualifying
construction expenditures are incurred for materials, labor, or
overhead, and when interest costs are incurred. The interest
capitalization period ends when the asset is substantially complete
and ready for its intended use or when interest costs no longer are
being incurred.
Consider the following example of interest incurred on a
self-constructed asset.
10 - *
Qualifying expenditures (construction labor, material, and
overhead) weighted for the number of months outstanding during the
current accounting period.
If the qualifying asset is financed through a specific new
borrowing
. . . use the specific rate of the new borrowing as the
capitalization rate.
If there is no specific new borrowing, and the company has other
debt
. . . use the weighted average cost of other debt as the
capitalization rate.
Interest Capitalization
Part I.
Interest is capitalized based on average accumulated expenditures
during the construction period. Average accumulated expenditures is
an amount based on a weighted average computation of the qualifying
expenditures times the number of months from the incurrence of the
qualifying expenditures to the end of the construction period.
Qualifying expenditures include labor, material, and overhead
incurred on the construction project during the accounting
period.
Part II.
Interest capitalization on self-constructed assets does not require
the company to borrow for the specific construction project.
However, if the construction is financed through a specific new
borrowing, the interest rate of the new borrowing is used for the
capitalization rate.
Part III.
If the construction does not require specific new borrowing, but is
financed with other debt, use the weighted-average interest rate on
the other debt for the capitalization rate.
10 - *
Welling, Inc. is constructing a building for its own use.
Construction activities started on May 1 and have continued through
Dec. 31. Welling made the following qualifying expenditures: May 1,
$125,000; July 31, $160,000, Oct. 1, $200,000; and Dec. 1,
$300,000. Welling borrowed $1,000,000 on May 1, from Bub’s Bank for
10 years at 10 percent to finance the construction. The loan is
related to the construction project and the company uses the
specific interest method to compute the amount of interest to
capitalize.
Average Accumulated Expenditures
Interest Capitalization
Part I.
Welling, Inc. is constructing a building for its own use.
Construction activities started on May 1 and have continued through
Dec. 31. Welling made the following qualifying expenditures: May 1,
$125,000; July 31, $160,000, October 1, $200,000; and December 1,
$300,000.
Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years
at 10 percent to finance the construction. The loan is related to
the construction project and the company uses the specific interest
method to compute the amount of interest to capitalize. How much
interest should Welling capitalize on the construction
project?
Part II.
First, we calculate the average accumulated expenditures by
time-weighting the individual expenditures made during the
eight-month construction period. For example the $125,000
expenditure made on May 1 occurs eight months from the end of the
period. So the time-weighted amount of this expenditure is
eight-eighths of $125,000 or $125,000. We calculate the
time-weighted amounts for the other expenditures and sum them to
get the average accumulated expenditures of $337,500.
Sheet1
10 - *
Since the $1,000,000 of specific borrowing is sufficient to cover
the $337,500 of average accumulated expenditures for the year, use
the specific borrowing rate of 10 percent to determine the amount
of interest to capitalize.
Interest = AAE × Specific Borrowing Rate × Time
Interest = $337,500 × 10% × 8/12 = $22,500
Interest Capitalization
The loan, initiated on May 1, is
outstanding for 8 months of the year.
Since the $1,000,000 of specific borrowing is sufficient to cover
the $337,500 of average accumulated expenditures for the year, we
will use the specific borrowing rate of 10 percent to determine the
amount of interest to capitalize. The loan, initiated on May 1, is
outstanding for 8 months of the year. Ten percent of $337,500
multiplied by 8/12 is equal to $22,500, the amount of interest that
will be capitalized.
10 - *
project, it would have used the weighted-average interest
method. The weighted average interest rate on other debt
would have been used to compute the amount of interest to
capitalize. For example, if the weighted-average interest
rate on other debt is 12 percent, the amount of interest
capitalized would be:
Interest Capitalization
If Welling had not borrowed specifically for this construction
project, it would have used the weighted-average interest method.
The weighted average interest rate on other debt would have been
used to compute the amount of interest to capitalize.
For example, if the weighted-average rate of interest on other debt
is 12 percent, the amount of interest capitalized would be 12
percent of $337,500 times 8/12, or $27,000.
10 - *
If specific new borrowing had been insufficient to cover the
average accumulated expenditures . . .
Specific
new
borrowing
AAE
. . . Capitalize this portion using the 10 percent specific
borrowing rate.
Other
debt
. . . Capitalize this portion using the 12 percent weighted-
average cost of debt.
Interest Capitalization
If specific new borrowing had been insufficient to cover the
average accumulated expenditures for the year, the portion of the
average accumulated expenditures financed with specific new
borrowing is capitalized using the interest rate on the specific
new borrowing, and the remainder of the average accumulated
expenditures is capitalized using the weighted-average interest
cost of other debt excluding the specific new borrowing. This
situation exists when the construction project is partially
financed with specific new borrowing and partially financed with
other existing debt.
10 - *
Research
Planned search or critical investigation aimed at discovery of new
knowledge . . .
Development
The translation of research findings or other knowledge into a plan
or design . . .
Most R&D costs are expensed as incurred. (Must be disclosed if
material.)
R&D costs incurred under contract for other companies are
capitalized as inventory and carried forward into future
years.
Costs of assets purchased for R&D purposes are expensed in the
period unless they have alternative future uses.
Part I.
Research is a planned search or critical investigation aimed at
discovery of new knowledge with the hope that the new knowledge
will result in new, or the improvement of, existing, products,
services or processes.
Development is the translation of research findings into new, or
the improvement of existing, products, services or processes.
Most research and development costs are expensed as incurred. The
costs are incurred with the intent of future benefits, but the
future benefits are uncertain, and even if the benefits
materialize, it is difficult to relate the benefits to revenues of
future periods.
Part II.
An exception to the immediate expensing of research and development
costs is provided for work done under contract for other companies.
These research and development costs are capitalized as inventory
and carried forward into future years. Income from these contracts
can be recognized using either the percentage-of-completion method
or the completed contract method.
If operational assets are purchased for exclusive use in research
and development, the cost is expensed, regardless of the length of
the assets’ useful life. If the assets have alternative future uses
beyond the research and development project period, the cost should
be capitalized and depreciated or amortized over the current and
future periods of use.
10 - *
Costs
Capitalized
Operating
Costs
All costs incurred to establish the technological feasibility of a
computer software product are treated as R&D and expensed as
incurred.
Costs incurred after technological feasibility is established and
before the software is available for release to customers are
capitalized as an intangible asset.
Software Development Costs
Part I.
All costs incurred to establish the technological feasibility of
computer software products are treated as research and development
costs and expensed as incurred. Costs incurred after technological
feasibility is established and before the software is available for
release to customers are capitalized as an intangible asset.
Technological feasibility is established when all planning,
designing, coding, and testing activities have been completed to
determine that the software meets its design specifications
including functions, features, and technical performance
requirements.
Consider the following timeline to illustrate these concepts.
Part II.
Costs are expensed from the start of research and development until
technological feasibility is established. Costs incurred after
technological feasibility is established, but before the product is
released, are capitalized as an intangible asset. Costs incurred
after the product is available for release to customers are treated
as operating costs.
10 - *
Amortization of capitalized computer software costs starts when the
product begins to be marketed.
Two methods, the percentage of revenue method and the straight-line
method, are compared and the method producing the largest amount of
amortization is used.
Part I.
Amortization of capitalized computer software costs starts when the
product begins to be marketed. Two methods, the percentage of
revenue method and the straight-line method, are compared and the
method producing the largest amount of amortization is used.
The periodic amortization percentage is the greater of:
the ratio of current revenues to current and anticipated revenues
(the
percentage of revenues method).
the straight-line percentage over the useful life of the asset.
(the straight-line
method).
Part II.
The unamortized portion of capitalized computer software cost is
reported in the balance sheet as an asset. The periodic
amortization expense associated with the capitalized computer
software cost is reported in the income statement. The research and
development expense associated with computer software development
is reported in the income statement.
10 - *
Direct costs to secure a patent are capitalized.
Research and Development Costs
Research expenditures are expensed in the period incurred.
Development expenditures that meet specified criteria are
capitalized as an intangible asset.
Direct costs to secure a patent are capitalized.
Except for software development costs incurred after technological
feasibility has been established, U.S. GAAP requires all research
and development expenditures to be expensed in the period incurred.
IAS No. 38 draws a distinction between research activities and
development activities. Research expenditures are expensed in the
period incurred. However, development expenditures that meet
specified criteria are capitalized as an intangible asset. Under
both U.S. GAAP and IFRS, any direct costs to secure a patent, such
as legal and filing fees, are capitalized.
10 - *
U.S. GAAP vs. IFRS
The percentage used to amortize software development costs is the
greater of (1) the ratio of current revenues to current and
anticipated revenues or (2) the straight-line percentage over the
useful life of the software.
Software Development Costs
The same approach is allowed, but not required.
The percentage we use to amortize computer software development
costs under U.S. GAAP is the greater of (1) the ratio of current
revenues to current and anticipated revenues or (2) the
straight-line percentage over the useful life of the software. The
approach is allowed under IFRS, but not required.
Consideration given1,000,000$
FV of assets900,000$
Goodwill300,000$
= PV of note (rounded)41,323$
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