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Perspective on Investing

Perspective on Investing. Chapter 10 acquisition and disposition of property, plant and equipment Sommers – ACCT 3311. Expected to Benefit Future Periods. Tangible Property, Plant, Equipment & Natural Resources. Types of Operational Assets. Long-lived, Revenue-producing Assets.

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Perspective on Investing

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  1. Perspective on Investing

  2. Chapter 10acquisition and disposition of property, plant and equipmentSommers – ACCT 3311

  3. Expected to Benefit Future Periods Tangible Property, Plant, Equipment & Natural Resources Types of Operational Assets Long-lived, Revenue-producing Assets General Rule for Cost Capitalization The 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.

  4. 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 buildingnecessary to install equipment • Testing and trial runs

  5. Costs to be Capitalized Land Improvements – Separately identifiable costs • Driveways • Parking lots • Fencing • Landscaping • 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

  6. 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 (c) Attorney’s fees and recording fees related to purchasing land Land (d) Variable overhead related to construction of machinery. Machinery

  7. Discussion Questions 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

  8. 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. Determine the initial valuation of each asset Semtech acquired in these transactions.

  9. Example 1: Continued Purchase price $4,000,000 Title search and insurance 16,000 Legal fees 5,000 State transfer fees 4,000 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

  10. 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. 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.

  11. Example 1: Continued Cost of land: Purchase price $4,000,000 Title search and insurance 16,000 Legal fees 5,000 State transfer fees 4,000 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

  12. 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. • 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 62,500 Building 37,500 Cash100,000

  13. Example 2: Continued 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. • 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

  14. Example 2: Continued 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. • 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 • On September 18, the company paid its lawyer $3,000 for organizing the corporation. Organization cost expense 3,000 Cash 3,000

  15. Example 2: Continued 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. • 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 • 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

  16. Example 2: Continued 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. • 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

  17. 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.

  18. Interest Costs During Construction Three approaches have been suggested to account for the interest incurred in financing the construction. Increase to Cost of Asset $ 0 $ ? Capitalize no interest during construction Capitalize all costs of funds Capitalize actual costs incurred during construction GAAP

  19. Interest Costs During Construction • GAAP requires — capitalizing actual interest (with modification). • Consistent with historical cost. • Capitalization considers three items: • Qualifying assets. • Capitalization period. • Amount to capitalize.

  20. Qualifying Assets • 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.

  21. Capitalization Period Begins when: • Expenditures for the asset have been made. • Activities for readying the asset are in progress . • Interest costs are being incurred. Capitalization Period Ends when: The asset is substantially complete and ready for use.

  22. Amount to Capitalize Capitalize the lesser of: • Actual interest costs • Avoidable interest - the amount of interest that could have been avoided if expenditures for the asset had not been made.

  23. Discussion Questions 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.

  24. Calculating the Actual and Avoidable Interest Selecting Appropriate Interest Rate: • 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. • 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.

  25. Calculating the Actual and Avoidable Interest Actual Interest Weighted-average interest rate on general debt $100,000 $800,000 = 12.5% Avoidable Interest

  26. Calculating the Actual and Avoidable Interest Capitalize the lesser of Avoidable interest or Actual interest. Journal entry to Capitalize Interest: Equipment 30,250 Interest expense*30,250 *Not crediting cash because already paid and we are transferring (capitalizing)

  27. 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.

  28. 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

  29. 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 $270,000 March 1, 2011 600,000 April 30, 2012 585,000 June 30, 2011 800,000 August 31, 2012 900,000 October 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. • Calculate the amount of interest that Mason should capitalize in 2011 and 2012 using the specific interest method. • What is the total cost of the building? • Calculate the amount of interest expense that will appear in the 2011 and 2012 income statements.

  30. Example 4: Continued 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 Interest capitalized: $2,050,000 x 10% = $205,000 = Interest capitalized in 2011

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

  32. Example 4: Continued Cost of Building: Expenditures in 2011 $3,000,000 Interest capitalized in 2011 205,000 Expenditures in 2012 1,755,000 Interest 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% = 480,000 Total interest incurred 1,020,000 Less: Capitalized (205,000) 2011 expense $ 815,000 Interest Expense for 2012: Total interest incurred $1,020,000 Less: Capitalized (271,980) 2012 expense $ 748,020

  33. 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 $270,000 March 1, 2011 600,000 April 30, 2012 585,000 June 30, 2011 800,000 August 31, 2012 900,000 October 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. • Calculate the amount of interest that Mason should capitalize in 2011 and 2012 using the weighted-average method. • What is the total cost of the building? • Calculate the amount of interest expense that will appear in the 2011 and 2012 income statements.

  34. Example 4b: Continued 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 Interest capitalized: $2,050,000 x 7.85% = $160,925 = Interest capitalized in 2011

  35. Example 4b: Continued Expenditures for 2012: January 1, 2012 $3,160,925 x 9/9 = $3,160,925 January 31, 2012 270,000 x 8/9 = 240,000 April 30, 2012 585,000 x 5/9 = 325,000 August 31, 2012 900,000 x 1/9 = 100,000 Accumulated expenditures (before interest) - $4,915,925 Average accumulated expenditures - $3,825,925 Interest capitalized: $3,825,925 x 7.85% x 9/12 = $225,251 = Interest capitalized in 2012

  36. Example 4b: Continued Cost of Building: Expenditures in 2011 $3,000,000 Interest capitalized in 2011 160,925 Expenditures in 2012 1,755,000 Interest capitalized in 2012 225,251 Total cost of building $5,141,176 Interest Expense for 2011: Total interest incurred $1,020,000 Less: Capitalized (160,925) 2011 expense $ 859,075 Interest Expense for 2012: Total interest incurred $1,020,000 Less: Capitalized (225,251) 2012 expense $ 794,749

  37. Noncash Acquisitions The asset acquired is recorded at the fair value of the consideration given or the fair value of the asset acquired, whichever is more clearly evident. • Issuance of equity securities • Deferred payments • Donated Assets • Exchanges

  38. Noncash Acquisitions 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 • On occasion, companies acquire assets through donation. • The receiving company is required to record • The donated asset at fair value. • Revenue equal to the fair value of the donated asset.

  39. Example 5 On January 1, 2011, Byner Company purchased a used tractor. Byner paid $5,000 down and signed a noninterest-bearing note requiring $25,000 to be paid on December 31, 2013. The fair value of the tractor is not determinable. An interest rate of 10% properly reflects the time value of money for this type of loan agreement. The company’s fiscal year-end is December 31. • Prepare the journal entry to record the acquisition of the tractor. • How much interest expense will the company include in its 2011 and 2012 income statements for this note? • What is the amount of the liability the company will report in its 2011 and 2012 balance sheets for this note?

  40. Example 5: Continued Prepare the journal entry. PV(FV=25,000, pmt=0, n=3, i=10%) = 18,783 Tractor ($5,000 cash + $18,783 note) 23,783 Discount on note payable (difference) 6,217 Cash 5,000 Note payable (face amount) 25,000 How much interest expense will the company include in its 2011 and 2012 income statements for this note? 2011: Interest expense ($18,783 x 10%) = $1,878 2012: Interest expense [($18,783 + $1,878) x 10%] = 2,066 What is the amount of the liability the company will report in its 2011 and 2012 balance sheets for this note? 2011: $25,000 – ($6,217 – $1,878) = $20,661 2012: $25,000 – ($6,217 – $1,878 – $2,066) = 22,727

  41. Dispositions Steps: • Update depreciation to date of disposal. • Remove original cost of asset and accumulated depreciation from the books. • Record what you received. • The difference between book value of the asset and the amount received is recorded as a gain or loss.

  42. Exchanges Generally 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 operational assets, fair value is used except in rare situations in which the fair value cannotbe 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.

  43. Example 6 Southern Company owns a building that it leases. The building’s fair value is $1,400,000 and its book value is $800,000 (original cost of $2,000,000 less accumulated depreciation of $1,200,000). Southern exchanges this for another building owned by the Eastern Company. The building’s book value on Eastern’s books is $950,000 (original cost of $1,600,000 less accumulated depreciation of $650,000). Eastern also gives Southern $140,000 to complete the exchange. The exchange has commercial substance for both companies. Prepare the journal entries to record the exchange on the books of Southern. Cash 140,000 Building - new ($1,400,000 - 140,000) 1,260,000 Accumdeprec - building (acct balance) 1,200,000 Building - old (acct balance) 2,000,000 Gain ($1,400,000 – 800,000) 600,000

  44. Example 6: Continued Southern Company owns a building that it leases. The building’s fair value is $1,400,000 and its book value is $800,000 (original cost of $2,000,000 less accumulated depreciation of $1,200,000). Southern exchanges this for another building owned by the Eastern Company. The building’s book value on Eastern’s books is $950,000 (original cost of $1,600,000 less accumulated depreciation of $650,000). Eastern also gives Southern $140,000 to complete the exchange. The exchange has commercial substance for both companies. Prepare the journal entries to record the exchange on the books of Eastern. Building - new 1,400,000 Accumdeprec - building (acct balance) 650,000 Cash 140,000 Building - old (acct balance) 1,600,000 Gain on exch of bldgs 310,000

  45. Discussion Questions Q10–16 Stan Ott is evaluating two recent transactions involving exchanges of equipment. In one case, the exchange has commercial substance. In the second situation, the exchange lacks commercial substance. Explain to Stan the differences in accounting for each situation? Ordinarily accounting for the exchange of nonmonetary assets should be based on the fair value of the asset given up or the fair value of the asset received, whichever is more clearly evident. Thus any gains and losses on the exchange should be recognized immediately. If the fair value of either asset is not reasonably determinable, the book value of the asset given up is usually used as the basis for recording the nonmonetary exchange. This approach is always employed when the exchange has commercial substance.

  46. Discussion Questions Q10–16 Stan Ott is evaluating two recent transactions involving exchanges of equipment. In one case, the exchange has commercial substance. In the second situation, the exchange lacks commercial substance. Explain to Stan the differences in accounting for each situation? The general rule is modified when exchanges lack commercial substance. In this case, the enterprise is not considered to have completed the earnings process and therefore a gain should not be recognized. However, a loss should be recognized immediately. In certain situations, gains on an exchange that lacks commercial substance may be recorded when monetary consideration is received. When monetary consideration is received, it is assumed that a portion of the earnings process is completed, and therefore, a partial gain is recognized.

  47. 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 • that expected change is significant relative to the fair value of the assets exchanged.

  48. Example 7 The Tinsley Company exchanged land that it had been holding for future plant expansion for a more suitable parcel located farther from residential areas. Tinsley carried the land at its original cost of $30,000. According to an independent appraisal, the land currently is worth $72,000. Tinsley gave $14,000 in cash to complete the transaction. What is the fair value of the new parcel of land received by Tinsley? FV of old land + Cash given = FV of new land $72,000 + 14,000 = $86,000

  49. Example 7: Continued The Tinsley Company exchanged land that it had been holding for future plant expansion for a more suitable parcel located farther from residential areas. Tinsley carried the land at its original cost of $30,000. According to an independent appraisal, the land currently is worth $72,000. Tinsley gave $14,000 in cash to complete the transaction. Prepare the journal entry to record the exchange assuming the exchange has commercial substance. Land - new ($72,000 + 14,000) 86,000 Cash 14,000 Land - old (book value) 30,000 Gain ($72,000 – 30,000) 42,000

  50. Example 7: Continued The Tinsley Company exchanged land that it had been holding for future plant expansion for a more suitable parcel located farther from residential areas. Tinsley carried the land at its original cost of $30,000. According to an independent appraisal, the land currently is worth $72,000. Tinsley gave $14,000 in cash to complete the transaction. Prepare the journal entry to record the exchange assuming the exchange lacks commercial substance. Land - new ($30,000 + 14,000) 44,000 Cash 14,000 Land - old (book value) 30,000

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