Transcript Topic 4

Types of Operational Assets

Actively Used in Operations Expected to Benefit Future Periods Tangible Property, Plant, Equipment & Natural Resources Intangible No Physical Substance


Costs to be Capitalized

General Rule 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.


Costs to be Capitalized

Equipment     

Net purchase price Taxes Transportation costs Installation costs Modification to building necessary to install equipment

Testing and trial runs


Recurring & maintenance costs may not be capitalized

Brief Exercise 10-1

 Beaverton Lumber purchased a milling machine for $35,000. In addition to the purchase price, Beaverton made the following expenditures: freight, $1,500; installation, $3,000; testing, $2,000; Annual personal property tax (not sales or use related) on the machine for the first year, $500.  What is the initial cost of the machine?


Brief Exercise 10-1

Capitalized cost of the machine:

  Purchase price Freight $35,000 1,500   Installation Testing 3,000 2,000  Total cost $41,500  Note: Personal property taxes on the machine for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred.


Costs to be Capitalized

Land 

Purchase price

 

Real estate commissions Attorney’s fees

Title search

Title transfer fees

Title insurance premiums

Removing old buildings

Land is not depreciable.


Costs to be Capitalized

Land Improvements

Separately identifiable costs of Driveways Parking lots Fencing Landscaping Private roads

These will be depreciated 10-7

Costs to be Capitalized

Buildings 

Purchase price

Attorney’s fees



Long term leasehold improvements are also capitalized.


Brief Exercise 10-2

 Fullerton Waste Management purchased land and a warehouse for $600,000. In addition to the purchase price, Fullerton made the following expenditures related to the acquisition:  broker’s commission, $30,000;    title insurance, $3,000 miscellaneous closing costs, $6,000.

The warehouse was immediately demolished at a cost of $18,000 in anticipation of the building of a new warehouse.  Determine the amounts Fullerton should capitalize as the cost of the land and the building.


Brief Exercise 10-2

Capitalized cost of land:

  Purchase price Broker’s commission  Title insurance  Misc. closing costs  Demolition of old building $600,000 30,000 3,000 6,000 18,000  Total cost $657,000  All of the expenditures, including the costs to demolish the old building, are included in the initial cost of the land.


Lump-Sum Purchases

Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices.

Allocation of the lump-sum price is based on relative values of the individual assets.

10-11 Asset 1 Asset 2 Asset 3

Lump-Sum Purchases

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 charged to the building account?


Lump-Sum Purchases

Asset Land Building Total Appraised Value (a) $ 87,500 162,500 $ 250,000 % of Value (b)* 35% 65% Purchase Price (c) $ 200,000 200,000 * $87,500÷$250,000 = 35% The building will be apportioned $130,000 of the total purchase price of $200,000.

Assigned Cost (b × c) $ 70,000 130,000 $ 200,000 Prepare the journal entry to record the purchase.



Lump-Sum Purchases

GENERAL JOURNAL Date Description May 13 Land Building Cash PR Debit 70,000 130,000 Page 14 Credit 200,000

Brief Exercise 10-3

 Refer to the situation described in BE 10-2. Assume that Fullerton decides to use the warehouse rather than demolishing it. An independent appraisal estimates the market values of the land and warehouse at $420,000 and $280,000, respectively.  Determine the amounts Fullerton should capitalize as the cost of the land and the building.


Brief Exercise 10-3

Cost of land and building:

  Purchase price Broker’s commission  Title insurance  Miscellaneous closing costs  Total cost $600,000 30,000 3,000 6,000 $639,000

The total must be allocated to the land and building based on their relative market values:


Brief Exercise 10-3


Costs to be Capitalized

Natural Resources

Purchase price, exploration and development costs of:


Mineral deposits

Oil and gas reserves



Asset Retirement Obligations

Often encountered with natural resource extraction when the land must be restored to a useable condition.

Recognize as a liability and a corresponding increase in the related asset.

Record at fair value, usually the present value of future cash outflows associated with the reclamation or restoration.

BE 10-4

Smithson Mining operates a silver mine in Nevada. Acquisition, exploration, and development costs totaled $5.6 million. After the silver is extracted in approximately five years, Smithson is obligated to restore the land to its original condition, including constructing a wildlife preserve. The company’s controller has provided the following three cash flow possibilities for the restoration costs: (1) $500,000, 20% probability; (2) $550,000, 45% probability; and (3) $650,000, 35% probability. The company’s credit-adjusted, risk-free rate of interest is 6%. What is the initial cost of the silver mine?




BE 10-5

Refer to the situation described in BE 10-4. What is the carrying value of the asset retirement liability at the end of one year? Assuming that the actual restoration costs incurred after extraction is completed are $596,000, what amount of gain or loss will Smithson recognize on retirement of the liability?


Solution BE10-5

Or 429,675 x 1.06


Noncash Acquisitions

Issuance of equity securities

Deferred payments

Donated assets

Exchanges 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.


Intangible Assets

Lack physical substance.

Exclusive Rights.

Future benefits less certain than tangible assets.

Intangible Assets Usually acquired for operational use.


Costs to be Capitalized

Intangible Assets

Record at

current cash equivalent cost

, including purchase price, legal fees, and filing fees.

 Patents  Copyrights  Trademarks  Franchises  Goodwill 10-26


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.



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.



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 .



A symbol, design, or logo associated with a business.

If internally developed, trademarks have no recorded asset cost.

If purchased, a trademark is recorded at cost.

Registered with U.S. Patent Office and renewable indefinitely in 10 year periods.



Right to sell products or provide services purchased by franchisee from franchisor.




Occurs when one company buys another company.

Only purchased goodwill is an intangible asset.

The amount by which the purchase price exceeds the fair market value of net assets acquired.

Generally, this represents the present value of future earnings 10-32


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 be recorded on Eddy Company books?


a. $100,000 b. $200,000 c. $300,000 d. $400,000


What amount of goodwill should be recorded on Eddy Company books?


a. $100,000 b. $200,000 c. $300,000 d. $400,000

Goodwill -

Brief Exercise 10-6

 Pro-tech Software acquired all of the outstanding stock of Reliable Software for $14 million. The book value of Reliable’s net assets (assets minus liabilities) was $8.3 million. The fair values of Reliable’s assets and liabilities equaled their book values with the exception of certain intangible assets whose fair values exceeded book values by $2.5 million*. Calculate the amount paid for goodwill.


Fair value of separately identified intangibles are excluded from goodwill.

Goodwill -

Brief Exercise 10-6



Deferred Payments

Note payable Market interest rate Less than market rate or noninterest bearing Record asset at face value of note Record asset at present value of future cash flows.

Let’s consider an example where we must compute the present value of a noninterest-bearing note.

Deferred Payments

On January 2, 2012, Midwestern Corporation purchased equipment by signing a noninterest-bearing requiring $50,000 to be paid on December 31, 2013. The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2012; December 31, 2012 (year-end), and December 31, 2013 (year-end).


Deferred Payments

Since we do not know the cash equivalent price in this example, we must use the present value of the future cash payment. Face amount of note × PV of $1, n=2, i=10% = PV of note (rounded) $ 50,000 0.82645

$ 41,323 GENERAL JOURNAL Date Jan. 2 Description Equipment Discount on Note Payable Note Payable

Discount = $50,000 - $41,323

PR Debit 41,323 8,677 Page 73 Credit 50,000


Deferred Payments

GENERAL JOURNAL Date Dec. 31 2012 Description Interest Expense Discount on Note Payable

Interest = 10% of $41,323

Dec. 31 Interest Expense 2013 Discount on Note Payable

Interest = 10% of ($41,323 + $4,132)

PR Debit 4,132 Page 74 Credit 4,132 4,545 4,545 Dec. 31 Note Payable 2013 Cash 50,000 50,000


Brief Exercise 10-7

 On June 30, Kimberly Farms purchased custom made harvesting machinery from a local producer. In payment, Kimberly signed a noninterest-bearing note requiring the payment of $60,000 in two years. The fair value of the machinery is not known, but an 8% interest rate properly reflects the time value of money for this type of loan agreement.  At what amount will Kimberly initially value the machinery?  How much interest expense will Kimberly recognize in its income statement for this note for the year ended December 31?


Brief Exercise 10-7

 The initial value of machinery and note will be the present value of the note payment:  PV = $60,000 (.85734) 1 =


1 Present value of $1:


= 2,


= 8% (from Table 2)  Interest expense for 2009: $51,440 x 8% x 6/12 =



Fixed-Asset Turnover Ratio

Fixed asset turnover ratio = Net sales Average fixed assets This ratio measures how effectively a company or its unit managers uses its fixed assets to generate revenue.



Receivables Management

Dell vs. Apple comparison

2004 Dell 2003 2004 Apple 2003 Property, plant, and equipment (net) Net sales $ 1,517 41,444 $ 913 $ 707 8,279 $ 669

(All dollar amounts in millions)

Compute the fixed asset turnover ratio for both companies


Receivables Management

2004 Dell 2003 2004 Apple 2003 Property, plant, and equipment (net) Net sales $ 1,517 41,444 $ 913 $ 707 8,279 $ 669 Fixed asset turnover ratio = Net sales Average fixed assets

Dell Apple $41,444 ($1,517 + $913)/2 = 34.1 $8,279 ($707 + $669)/2 = 12.0 Dell generated nearly three times the sales dollars for each dollar invested in fixed assets.


 Update depreciation or amortization to date of disposal.

 Remove original cost of asset and accumulated depreciation or amortization from the books.

 The difference between book value of the asset and the amount received is recorded as a gain or loss .

10-47 On June 30, 2013, MeLo Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2008, at a cost of $15,000. The equipment was depreciated using the straight-line method over an estimated 10-year life with zero residual value. MeLo last recorded depreciation on the equipment on December 31, 2012, its year-end.

Prepare the journal entries necessary to record the disposition of this equipment.

Dispositions  Update depreciation to date of sale.

June 30, 2013:

Depreciation expense ($15,000 ÷ 10 years) × ½) .......

Accumulated depreciation ………………........

To update depreciation to date of sale.

750  Remove original asset cost and accumulated depreciation.

 Record the gain or loss .


June 30, 2013:

Accumulated depreciation ............................................ 8,250 Cash ………………………….……………...................... 6,350 Loss on sale …………………………………………….… 400 Equipment …………………………...............…

To record sale of equipment.

15,000 ($15,000 ÷ 10 years) × 5½) = $8,250 10-48

Exchanges General Valuation Principle: 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


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 or loss

is recognized.


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.


Matrix Inc.

Cost of asset given up Accumulated depreciation Book value $ 600,000 400,000 $ 200,000

Self-Constructed Assets

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

 Incremental overhead only  Full-cost approach  Proper treatment of interest incurred during construction 10-51

Interest Capitalization

Capitalization begins when

  

construction begins interest is incurred, and qualifying expenses are incurred.

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

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.


Interest Capitalization

Average Accumulated Expenditures Date 5/1 7/31 10/1 12/1 Expenditure $ 125,000 160,000 200,000 300,000 $ 785,000 Fraction of Year 8/12 5/12 3/12 1/12 AAE $ 83,333 66,667 50,000 25,000 $ 225,000



Interest Capitalization

Since the $1,000,000 of specific borrowing is sufficient to cover the $225,000 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 Interest = $225,000 × 10% = $22,500

GENERAL JOURNAL Date Description Dec. 31 Construction-In-Progress Interest Expense PR Debit 22,500 Page 14 Credit 22,500

Research and Development (R&D)



Planned search or critical investigation aimed at discovery of new knowledge . . .


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.)

Research and Development (R&D)

 R&D costs incurred under contract for other companies are expensed against revenue from the contract.

 Operational assets used in R&D should be capitalized if they have alternative future uses.


Software Development Costs   All costs incurred to establish the computer software product are treated as R&D and expensed as incurred.

technological feasibility of a Costs incurred after technological feasibility is established and before the software is available for release to customers are capitalized as an intangible asset.

Costs Expensed as R&D Costs Capitalized Operating Costs


Start of R&D Activity Technological Feasibility Date of Product Release Sale of Product

Software Development Costs   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.


Balance Sheet  The unamortized portion of capitalized computer software cost is an asset.

Income Statement  Amortization expense associated with computer software cost.

 R&D expense associated with computer software development cost.


U.S. GAAP vs. IFRS Research and Development Expenditures 10-60   Except for software development costs incurred after technological feasibility, all research and development expenditures are expensed in the period incurred.

Direct costs to secure a patent are capitalized.

  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.

Brief Exercise 10-16

 Maxtor Technology incurred the following costs during the year related to the creation of a new type of personal computer monitor: 10-61 What amount should Maxtor report as research and development expense in its income statement?

Brief Exercise 10-16

 Research and development:  Salaries  Depreciation R&D  Utilities and other direct costs  Payment to another company  Total R & D expense $220,000 125,000 66,000 120,000


Note: The patent filing and related legal costs and the costs of adapting the product to a particular customer’s needs are not included as research and development expense.