Chapter 10

Kun Yu, Intermediate Accounting I 8-1

AF310- Intermediate Accounting I

Chapter 10 Acquisition and Disposition

of PPE


Property, Plant, and Equipment

PPE “Used in operations” and not for resale. Long-term in nature and usually depreciated. Possess physical substance.

Use historical cost to measure PPE Cost related to the acquisition of PPE Cost related to getting PPE ready for use


Cost of Land Purchase price Closing costs, such as title to the land,

attorney’s fees, and recording fees Costs of grading, filling, draining, and

clearing Assumption of any liens, mortgages, or

encumbrances on the property Additional land improvements that have

an indefinite life.


Cost of Buildings Materials, labor, and overhead

costs incurred during construction Professional fees and building

permits


Cost of Equipment purchase price freight and handling charges insurance on the equipment while

in transit cost of special foundations if

required assembling and installation costs costs of conducting trial runs


Self-Constructed Assets Materials and direct labor Overhead can be handled in two

ways: Assign no fixed overhead Assign a portion of all overhead to the

construction process.


Interest Capitalization Interest costs during construction need to be

capitalized Interest costs after construction need to be

expensed Computation of the amount to be capitalized

Compute weighted average accumulated expenditures Expenditures are weighted by the amount of time that interest

cost is incurred. Compute avoidable interest cost and actual interest cost

Avoidable interest cost: the amount of interest that could have been avoided if expenditures for the asset had not been made

Apply the interest rate on the specific borrowings for the portion below the amount of specific borrowings

Apply weighted average interest rate on other borrowings for the portion above the amount of specific borrowings

Capitalize the lesser of avoidable interest cost or actual interest cost


Interest Capitalization Illustration: KC Corporation borrowed $200,000 at 12% interest from State Bank on Jan. 1, 2011, for specific purposes of constructing special-purpose equipment to be used in its operations. Construction on the equipment began on Jan. 1, 2011, and the following expenditures were made prior to the project’s completion on Dec. 31, 2011:Actual Expenditures:

J anuary 1, 2011 $100,000

April 30, 2011 150,000

November 1, 2011 300,000

December 31, 2011 100,000

Total expenditures $650,000

Other general debt existing on Jan. 1, 2011:

$500,000, 14%, 10-year bonds payable

$300,000, 10%, 5-year note payable

Interest Capitalization


WeightedAverage

Actual Capitalization Accumulated Date Expenditures Period Expenditures

J an. 1 100,000$ 12/ 12 100,000$ Apr. 30 150,000 8/ 12 100,000 Nov. 1 300,000 2/ 12 50,000 Dec. 31 100,000 0/ 12 -

650,000$ 250,000$

A company weights the construction expenditures by the amount of time (fraction of a year or accounting period) that it can incur interest cost on the expenditure.

Compute Weighted Average Accumulated Expenditures


Accumulated I nterest Avoidable

Expenditures Rate I nterest

200,000$ 12% 24,000$

50,000 12.5% 6,250

250,000$ 30,250$

Avoidable Avoidable InterestInterest

I nterest Actual

Debt Rate I nterest

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 InterestActual Interest

$100,000 $800,000

= 12.5%

Compute the Actual and Avoidable Interest


Avoidable interest 30,250$

Actual interest 124,000

Journal entry to Capitalize Interest:

Equipment 30,250

Interest expense30,250

Capitalize the Lesser of Avoidable Interest or Actual Interest


Valuation of PPE Valuation of PPE

the fair value of the asset given up the fair value of the asset received

Cash Discounts — whether taken or not — generally considered a reduction in the cost of the asset.

Lump-Sum Purchases — Allocate the total cost among the various assets on the basis of their fair market values.

Issuance of Stock — The market value of the stock issued is a fair indication of the cost of the property acquired.


Examples UMB Purchased a equipment with list price

$10,000 and cash discount 5/10, n/30. UMB paid cash within the discount period.

Dr. Equipment 9,500 Cr. Cash 9,500

UMB issued 1000 shares of common stock to purchase land. The market value of the common stock is $10 per share, and par value is $1 per share.

Dr. Land 10,000 Cr. Common stock 1,000 APIC 9,000


Accounting for Exchanges of nonmonetary Assets

Commercial substance Effect of the transaction on future cash flows

Exchanges have commercial substance Recognize gains and losses immediately

Exchanges have no commercial substance No cash received

Defer gains, but recognize losses immediately Cash received

Recognize partial gains, but recognize losses immediately


Illustration: Information Processing, Inc. trades its used machine for a new model at Jerrod Business Solutions Inc. The exchange has commercial substance. The used machine has a book value of $8,000 (original cost $12,000 less $4,000 accumulateddepreciation) and a fair value of $6,000. The new model lists for $16,000. Jerrod gives Information Processing a trade-in allowance of $9,000 for the used machine. Information Processing computes the cost of the new asset as follows.

Exchanges: Loss Situation


Equipment 13,000

Accumulated Depreciation—Equipment 4,000

Loss on Disposal of Equipment 2,000

Equipment

12,000

Cash

7,000

Exchanges: Loss Situation


Illustration: Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck. The used trucks have a combined book value of $42,000 (cost $64,000 less $22,000 accumulated depreciation). Interstate’s purchasing agent, experienced in the second-hand market, indicates that the used trucks have a fair market value of $49,000. In addition to the trucks, Interstate must pay $11,000 cash for the semi-truck. Interstate computes the cost of the semi-truck as follows.

Gains With Commercial Substance


Semi-truck 60,000

Accumulated Depreciation—Trucks 22,000

Trucks 64,000

Gain on disposal 7,000

Cash 11,000

Gains with Commercial Substance


Now assume that Interstate Transportation Company

exchange lacks commercial substance. That is, the

economic position of Interstate did not change

significantly as a result of this exchange. In this case,

Interstate defers the gain of $7,000 and reduces the

basis of the semi-truck.

Gains without Commercial Substance: No cash Received


Semi-truck 53,000

Accumulated Depreciation—Trucks 22,000

Trucks 64,000

Cash 11,000

Gains without Commercial Substance: No cash Received


When a company receives cash (sometimes referred

to as “boot”) in an exchange that lacks commercial

substance, it may immediately recognize a portion of

the gain. The general formula for gain recognition

when an exchange includes some cash is as follows:

Gains without Commercial Substance: Some cash Received


Illustration: Queenan Corporation traded in used

machinery with a book value of $60,000 (cost $110,000

less accumulated depreciation $50,000) and a fair value

of $100,000. It receives in exchange a machine with a

fair value of $90,000 plus cash of $10,000.



Exchanges without Commercial Substance—Some Cash Received



Cash 10,000

Machine 54,000

Accumulated Depreciation—Machine 50,000

Machine 110,000

Gain on disposal of machine4,000


Summary of Gain and Loss Recognition on Exchanges


Cost Subsequent to Acquisition

Capitalizing vs. expensing Costs incurred to achieve greater future benefits

should be capitalized (e.g., Additions, improvements or replacements)

Useful life of the asset must be increased. Quantity of units produced from asset must be increased. Quality of units produced must be enhanced

Expenditures that simply maintain a given level of services should be expensed (e.g. ordinary repairs)

WorldCom: Capitalize a significant amount of expenditures to report positive net income


Disposal of PPE Gain (loss) = Selling price of PPE – Net book value

of PPE

Eliminate all the accounts related to the sold PPE PPE Accumulated Depreciation

E.g. Federal Express sold a small delivery truck that had been used in the business for the last three years. The company’s records shows the following:

Delivery truck cost $28K Accumulated depreciation $23K


Disposal of PPE Give the journal entry assuming the truck was sold for:

1. $5.2k

1. $4.6K

Dr. Cr.Cash (+A) 5.2Accumulated depreciation (-XA, +A) 23

Delivery truck Inventory (-A) 28 Gain (+SE) 0.2

Dr. Cr.Cash (+A) 4.6

Accumulated depreciation (-XA, +A) 23Loss (-SE) 0.4

Delivery truck Inventory (-A) 28

Chapter 10

Documents

cost of equipment

accounting period

total cost

use kun yu

historical cost

permits kun yu

acquisition of ppe cost

disposition of ppe kun