Solution manual intermediate accounting 9e by nicolai ch09

10-20 ANSWERS TO QUESTIONS Q9-1 For a company to include an asset in the category of property, plant, and equipment, the asset must: 1 be held for use in the normal course of business

CHAPTER 9

PROPERTY, PLANT, AND EQUIPMENT: ACQUISITION AND DISPOSAL

CONTENT ANALYSIS OF EXERCISES AND PROBLEMS

E9-1 Determination of Cost Analysis of numerous items to

determine whether or not to include in property, plant, and equipment

5-10

E9-2 Property, Plant, and Equipment Analysis of various items for

potential balance sheet inclusion

5-10

E9-3 Acquisition Costs Compute total acquisition costs of machine

and prepare journal entry to record 5-10 E9-4 Acquisition Cost Journal entry to record acquisition Analysis

E9-5 (AICPA adapted) Acquisition Cost Determination of cost and

journal entry to record acquisition 5-15 E9-6 (AICPA adapted) Acquisition of Land and Building

Computation of land and new building cost 10-15 E9-7 Lump Sum Purchase Cost assigned to land, buildings, and

E9-13 (AICPA adapted) Exchange of Assets No boot, similar

productive assets Determination of amount to be shown in the accounting records

5-10

Number Content

Time Range (minutes) E9-14 Self-Construction Determination of amount to be capitalized

Evaluation under differing outside contractor's bids 10-15 E9-15 Donation Journal entry to record acquisition Financial

statement disclosure Time differences for passage of title 10-20 E9-16 Interest During Construction Compilation of amount to be

capitalized Financial statement disclosure 5-15 E9-17 Interest During Construction Compute amount of capitalized

E9-18 Expenditures Capital vs operating Classification of various

E9-19 (Appendix) Oil and Gas Accounting Successful efforts,

full-cost methods Determination of expense and balance sheet value

10-20

P9-1 Acquisition Costs Reclassification of erroneously recorded

P9-2 Costs Subsequent to Acquisition Adjusting entries to correct

the books from improperly recorded costs Acquisition, legal fees, insurance, additions, repairs

45-60

P9-3 Cost Classification Journal entries to record various

transactions Acquisition, parking lot, sale, lease, freight, installation, taxes

25-35

P9-4 (CMA adapted) Self-Construction Computation according

to GAAP of amount to be capitalized Identification of any alternative procedures

30-45

P9-5 Acquisition Cost Acquisition, replacement, purchase Journal

entries to record various transactions

20-30

P9-6 (AICPA adapted) Comprehensive: Analysis of Changes in

Fixed Assets Preparation of schedules for changes in land, building, leasehold improvements, and machinery and equipment

25-35

P9-7 Assets Acquired by Exchange Various situations dealing with

similar or dissimilar productive assets and boot Journal entries 40-60

P9-8 Assets Acquired by Exchange Various situations dealing with

similar or dissimilar productive assets, boot, and changing fair value Journal entries

30-45

Number Content

Time Range (minutes) P9-9 Interest During Construction Computation of amount to be

capitalized and amount to be depreciated Straight-line

Effects on financial statements

20-30

P9-10 Comprehensive: Interest Capitalization Computation of

amounts of capitalized interest, interest expense, and interest revenue Journal entries to record construction costs, including interest

40-60

P9-11 Events Subsequent to Acquisition Replacement, repairs,

demolition Journal entries to record various transactions 20-30 P9-12 (AICPA adapted) Comprehensive: Adjusting Entries Analysis

of machinery and equipment account Schedules to show effect of additions and retirements on account balances

Journal entries

40-60

P9-13 (AICPA adapted) Adjusting Entries Analysis of the building

account Journal entries to adjust the account as necessary

Supporting computations

40-60

P9-14 (Appendix) Oil and Gas Accounting Successful efforts,

full-cost methods Financial statement disclosure

10-20

ANSWERS TO QUESTIONS

Q9-1 For a company to include an asset in the category of property, plant, and

equipment, the asset must: (1) be held for use in the normal course of business; (2) have an expected useful life of more than one year; and (3) be tangible property

- that is, the asset must have physical substance

Q9-2 Generally, a company capitalizes the expenditures that are necessary to obtain the

benefits to be derived from the asset and includes them as a cost of property, plant, and equipment The expenditures include the costs incurred in the acquisition of an asset and in putting the asset into operating condition The company expenses the costs of maintaining the benefits at the levels originally expected

Q9-3 A company classifies land held for investment on the balance sheet as an

investment It does not include the land as property, plant, and equipment, since it is not being used in the normal course of business in a productive capacity

Q9-4 The book value of an asset is the recorded acquisition cost less the accumulated

depreciation recorded to date

Q9-5 At the date of acquisition, the acquisition cost is equal to the market value At the

end of the life of the asset, the book value should equal the residual value (a market value) During the life of the asset, there is no defined relationship between the book value and market value because depreciation is a process of cost allocation, not of market valuation.

Q9-6 In a lump-sum purchase, the company allocates the total purchase price to the

individual assets on the basis of their relative fair values This allocation is necessary because some of the assets may have different economic lives, may not be

depreciable, or may be depreciated by different methods

Q9-7 When a company exchanges securities for an asset, the acquisition cost of that asset

is either the fair value of the securities given up or the fair value of the asset acquired The company makes the choice on the basis of the market that is more reliable If neither of these amounts is known, it may use an appraisal of the asset, or, as a final solution, the company's board of directors may place a value on the transaction Q9-8 The distinction between similar and dissimilar productive assets is that similar

productive assets are of the same general type and perform the same basic function and are used in the same line of business This distinction is made because, in the exchange of similar productive assets, the earning process is not considered

completed, and thus the accounting for the transaction is different than when

dissimilar productive assets are exchanged

Q9-9 When similar productive assets are exchanged, the company recognizes a gain to

the extent that it receives "boot" along with the asset The company recognizes a loss

in accordance with the conservatism principle of accounting

When dissimilar productive assets are exchanged, the earning process is considered completed and the company recognizes both gains and losses

Q9-10 The term "boot" refers to monetary consideration either paid or received For the

special rules to apply, the boot must be less than 25% of the fair value of the

transaction

Q9-11 The general principle underlying accounting for dissimilar productive assets is that the

earning process has been completed and thus gains or losses are recognized On the other hand, in accounting for similar productive assets the earning process has not been completed The company is in the same relative position, so gains on the exchange is deferred (except to the extent that boot is received) Losses are

recognized in accordance with the conservatism principle

Q9-12 According to the provisions of FASB Statement No 34, a company capitalizes interest

on the acquisition of an asset if the asset requires a period of time to get it ready for its intended use - a criterion that is met for the self-construction of an asset

Specifically, the company does not capitalize interest for the following types of

assets:

1 Inventories that are routinely manufactured or otherwise produced on a

repetitive basis

2 Assets that are in use or ready for their intended use

3 Assets that are not being used in the earning activities of the company and are not undergoing the activities necessary to get them ready for use

Since imputed interest is not capitalized, the company must have borrowed funds

to finance the self-construction of the asset

In contrast, interest on a note payable (that is not associated with the construction of an asset) is expensed as incurred.

Q9-13 A company bases the amount of interest capitalized for a self-constructed asset on

the actual amounts borrowed and the cost of those borrowings The amount is intended to be that portion of the interest cost incurred during the asset's

construction period that theoretically could have been avoided The company determines the amount that it capitalizes by applying an interest rate to the average amount of the expenditures on the self-constructed asset during the capitalization period

Q9-14 Since activities that are necessary to get the asset ready for its intended use are in

progress, the asset qualifies for interest capitalization The company capitalizes interest to the building account unless it makes specific expenditures that are

normally added to the land account, as discussed at the beginning of this chapter Q9-15 Three alternative treatments of fixed overhead costs are (1) to allocate a portion of

the total fixed overhead to the cost of the asset being constructed, (2) to include only the incremental fixed overhead that is attributable to construction in the cost of the self-constructed asset, or (3) to include no fixed overhead in the cost of the self- constructed asset Proponents of the allocation of total overhead argue that

construction should be treated the same as any other production process that receives a portion of overhead costs This method is appropriate when the company

is operating at full capacity and regular production is reduced by the

self-construction Arguments in favor of including only the incremental increase are that normal production costs should include the same amount of overhead whether construction is going on or not, the normal overhead would be incurred anyway, and that the cost of an asset and the decision to construct it should be based on

additional and incremental costs incurred This method is appropriate when the company is in an excess capacity situation The argument in favor of including no fixed overhead is that the fixed overhead does not change as a result of the

construction Therefore, to include some overhead would result in less overhead being expensed in the current period, and an increase in income

Q9-16 Under generally accepted accounting principles, a company may not recognize

profit on the self-construction of an asset The revenue recognition principle allows recognition of profit on asset use and disposal, not on the acquisition or construction

of an asset If construction costs are materially greater than the fair value of the asset, then the convention of conservatism requires the company to write-down the capitalized costs and recognize a loss

Q9-17 The distinction between a capital expenditure and an operating expenditure is

whether the costs have increased the future economic benefits of the asset above those that were originally expected The future economic benefits can be increased

by extending the life of the asset, improving productivity, producing the same

product at a lower cost, or increasing the quality of the product For example, if a machine receives a major overhaul that increases the benefits to be realized from the asset, the costs are capitalized Conversely, ordinary repairs are of a

maintenance type that do not increase the total benefits to be realized, and,

therefore, are expensed As another example, the cost of adding a new wing to an existing hospital is capitalized since it increases the total benefits of the hospital, whereas repairing the elevators does not increase the economic benefit of the hospital and so is expensed

Q9-18 An addition is a new asset that is being "added" or utilized in conjunction with an old

asset In contrast, an improvement/ replacement involves the substitution of a new part or asset for an old one In accounting for an addition, a company capitalizes the costs of the addition, and takes out of the old asset account any portion of the old asset that is demolished or removed A company capitalizes improvement and replacement costs using the substitution method when it knows the book value of the asset being replaced, by replacing the old book value with the cost of the new asset

If it does not know the old book value, then it still capitalizes the cost of the new asset, but with either a debit to the Accumulated Depreciation account of the old asset or a debit to the old Asset account

Q9-19 The costs of ordinary repairs and maintenance are expenses incurred routinely to

keep the asset in operating condition Since these costs do not increase the future benefits of the asset, a company expenses them as they are incurred For interim financial reporting, the use of an Allowance account is appropriate in order to even out the expenses However, this account is closed at the end of the year

Extraordinary repairs are those that cannot be foreseen and do not occur in the usual course of operations, such as emergency repairs to a machine that breaks down during production Usually, a company expenses these costs, but care should

be taken to note whether these repairs increase the future benefits of the asset If they do, then the company capitalizes the costs

Q9-20 Leasehold improvements are improvements made to leased property that, upon

termination of the lease, will revert back to the lessor A company capitalizes the cost of these improvements and subsequently amortizes them over the economic life

of the improvements or the lease term, whichever is shorter

Q9-21 An Allowance for Repairs account appears only on balance sheets of interim

financial statements if a company incurs repair costs unevenly At year-end, this account is closed; thus, it does not appear on a year-end balance sheet

Q9-22 A company accounts for the disposal of an asset by removing both the asset and

accumulated depreciation to date from the ledger, recording the receipt of cash, if any, and also recording any gain or loss It reports this gain or loss in ordinary income (in the category of Other Items) on the income statement unless it meets the criteria for an extraordinary item

Q9-23 Under the successful-efforts method of accounting for oil and gas properties, a

company capitalizes only those costs incurred in drilling for successful wells while it expenses the costs of unsuccessful wells In contrast, under the full-costing method a company capitalizes all costs of drilling wells, whether the drilling was successful or not

ANSWERS TO CASES

C9-1 (AICPA adapted solution)

1 The expenditures that are capitalized when equipment is acquired for cash include the invoice price of the equipment (net of discounts) plus all incidental outlays relating to its purchase or preparation for use, such as insurance during transit, freight, duties, ownership search, ownership registration, installation, and breaking-in costs Any available discounts, whether taken or not, should be deducted from the capitalizable cost of the equipment

2 a When the market value of the equipment is not determinable by reference to a similar

cash purchase, the capitalizable cost of equipment purchased with bonds having an established market price is the market value of the bonds

b When the market value of the equipment is not determinable by reference to a similar cash purchase, and the common stock used in the exchange does not have an established market price, the capitalizable cost of equipment is the equipment's estimated fair value if that is more clearly evident that the fair value of the common stock Independent appraisals may be used to determine the fair values of the assets involved

c When the market value of equipment acquired is not determinable by reference to a similar cash purchase, the capitalizable cost of equipment purchased by exchanging similar equipment having a determinable market value is the lower of the recorded amount of the equipment relinquished or the market value of the equipment

exchanged

3 The factors that determine whether expenditures relating to property, plant, and

equipment already in use are capitalized are as follows:

Expenditures are relatively large in amount

They are nonrecurring in nature

They extend the useful life of the property, plant, and equipment

They increase the usefulness of the property, plant, and equipment

4 The net book value at the date of the sale (cost of the property, plant, and equipment less the accumulated depreciation) is removed from the accounts The excess of cash from the sale over the net book value removed is accounted for as a gain on the sale, while the excess of net book value removed over cash from the sale is accounted for as a loss

on the sale

C9-2 (AICPA adapted solution)

1 Expenditures are capitalized when they benefit future periods The cost to acquire the land is capitalized and classified as land, a nondepreciable asset Since tearing down the small factory is readying the land for its intended use, its cost is part of the cost of the land and is capitalized and classified as land As a result, this cost is not depreciated as it would be if it was classified with the capitalizable cost of the building

C9-2 (continued)

1 (continued)

Since the rock blasting and removal is required for the specific purpose of erecting the building, its cost is part of the cost of the building and is capitalized and classified with the capitalizable cost of the building This cost is depreciated over the estimated useful life of the building

The road is a land improvement, and its cost is capitalized and classified separately as a land improvement This cost is depreciated over its estimated useful life

The added four stories is an addition, and its cost is capitalized and classified with the capitalizable cost of the building This cost is depreciated over the remaining life of the original office building because that life is shorter than the estimated useful life of the addition

2 The gain is recognized on the sale of the land and building because income is realized whenever the earning process is complete and the sale takes place

The book value at the date of the sale is composed of the capitalized cost of the land, the land improvement, and the building, as determined above, less the accumulated

depreciation on the land improvement and the building The excess of the proceeds received from the sale over the net book value at the date of sale is accounted for as part of income from continuing operations in the income statement

C9-3 (AICPA adapted solution)

1 The capitalizable cost includes all costs relating to purchase or preparation for use Such cost may include delivery and installation The capitalizable cost represents the cash equivalent price and accordingly would not include interest charges

2 Normal maintenance performed on the new machine should not be capitalized as part of the machine's cost It should be expensed as incurred if the machine is not used in the manufacturing process or should be inventoried as part of factory overhead if the

machine is used in the manufacturing process Normal maintenance does not enhance the service potential of the machine

3 The wing added to the manufacturing building should be capitalized The addition should

be depreciated over its estimated useful life or the remaining useful life of the building of which it is an integral part, whichever is shorter The addition should be included in the property, plant, and equipment section of the balance sheet

4 The leasehold improvements made to the office space should be capitalized The

leasehold improvements should be depreciated (amortized) over their estimated useful lives or the term of the lease, whichever is shorter The unamortized portion of the

leasehold improvements could be included as a separate caption in the property, plant, and equipment section or the intangible assets section of the balance sheet The

amortized portion of the leasehold improvements would be shown as an expense in the income statement

C9-4 (AICPA adapted solution)

1 The following costs, if applicable, should be capitalized as a cost of land:

(a) Negotiated purchase price

(h) Existing unpaid taxes, interest, or liens assumed by the buyer

(i) Clearing, grading, landscaping, and subdividing

(j) Cost of removing old building (less salvage)

(k) Special assessments such as lighting or sewers if they are permanent in nature

2 A plant asset acquired on a deferred-payment plan should be recorded at an equivalent cash price excluding interest If interest is not stated in the sales contract, an imputed interest should be determined The asset should then be recorded at its present value, which is computed by discounting the payments at the stated or imputed interest rate The interest portion (stated or imputed) of the contract price should be charged to interest expense over the life of the contract

3 In general, plant assets should be recorded at the fair value of the consideration given or the fair value of the asset received, whichever is more clearly evident This general

theoretical preference is somewhat constrained by the requirements of APB Opinion No

29

Specifically when exchanging an old machine and paying cash for a new machine, the new machine should be recorded at the amount of monetary consideration (cash) paid plus the undepreciated cost of the nonmonetary asset (old machine) surrendered if there

is no indicated loss An indicated loss should be recognized; this would reduce the

recorded amount of the new machine No indicated gain, however, should be

recognized by the party paying monetary consideration

C9-5 (AICPA adapted solution)

1 Capital expenditures benefit future periods Revenue (operating) expenditures benefit the current period only

2 a The purchase price of the land should be capitalized The land should be shown as a

noncurrent asset on the balance sheet at its original cost and it is not subject to

depreciation

C9-5 (continued)

2 (continued)

b The cost of constructing the factory should be capitalized and depreciated over the expected life of the factory The depreciation should be added to cost of inventory, via factory overhead, as goods are produced, and is expensed as cost of sales as goods are sold The factory expenditures, net of accumulated depreciation, should

be shown as a noncurrent asset on the balance sheet Inventory should be reported

as a current asset on the balance sheet, and cost of sales should be reported as an expense on the income statement

c The cost of grading and paving the parking lot should be capitalized and

depreciated over the expected life of either the factory or parking lot, whichever is shorter The depreciation should be added to cost of inventory, via factory overhead,

as goods are produced, and is expensed as cost of sales as goods are sold The land improvement expenditures, net of accumulated depreciation, should be shown as a noncurrent asset on the balance sheet Inventory should be reported as a current asset on the balance sheet, and cost of sales should be reported as an expense on the income statement

d The cost of maintaining the factory once production has begun is a "revenue type" expenditure However, since it is a factory cost, it should be added to cost of

inventory, via factory overhead, as goods are produced, and is expensed as cost of sales as goods are sold Inventory should be reported as a current asset on the

balance sheet, and cost of sales should be reported as an expense on the income statement

C9-6

1 a It is clear that considerable value attaches to the television rights A conservative

approach to the valuation is to compute the present value of the cash flows

expected under the currently existing television contract However, since it can be expected that a new television contract will be signed to replace the existing

contract, probably at different rates, it could be argued that a longer time period should be considered Certainly a buyer would be including a longer time period in the estimation of the future cash flows expected if the franchise is purchased

b The value assigned to the television rights is considered depreciable because the service provided by the franchise (that is, playing the games) is partially used up each season The depreciation is over the period used in determining the value of the television rights The argument against depreciating the value of the television rights would be that the televising of football games can be expected to continue

indefinitely in the future, and, therefore, the value does not decline

c The purchase price assignable to player contracts is the present value of the benefits generated by the player less the salaries payable under current contracts This is a subjective valuation that would be very difficult to determine in practice

d The value assigned to the player contracts is depreciated over the estimated playing career or the contract period, whichever is shorter

C9-6 (continued)

1 (continued)

e The value of the franchise is the present value of the future cash flows, after tax, generated by the franchise Thus, it includes the expected cash inflow from television rights, ticket sales, etc., less the expected cash outflow for players' contracts, franchise operations, etc Presumably, this is believed by the buyer to be greater than $8.5 million

2 Students may raise ethical issues, such as:

a Conflicts between the interests of different stakeholders particularly management, stockholders, and the government

b The allocation of cost to each depreciable asset and the selection of the estimated useful life, and the effects of those choices on net income

c The allocation of a tax basis to each depreciable asset, and the effect of that choice

on the depreciation deduction used to compute taxable income

C9-7

1 There is no doubt that the first 2,000 acres qualifies for interest capitalization because it meets the various criteria of FASB Statement No 34 It meets the criteria of a qualifying asset and the three criteria for the start of the capitalization period - expenditures have been made, activities are in progress, and interest cost is being incurred

The remaining 3,000 acres of the initial 5,000 acres also qualify for interest capitalization FASB Statement No 34 specifies that the term "activities" is to be construed broadly and should include more than physical construction Since the 5,000 acres were acquired for a single development, "activities" are in progress on the entire 5,000 acres

It is less definite whether the adjacent parcel of land qualifies for interest capitalization The decision will probably be determined by how the company has developed its plans If the plans indicate that the entire project is a single integrated development on which design work has been performed and permits obtained, then the adjacent parcel of land would also qualify for interest capitalization On the other hand, if the company's plans indicate that the additional acreage was acquired for speculative reasons and the design work and permits do not include this additional acreage, then the adjacent parcel of land does not qualify for interest capitalization

The development also qualifies for interest capitalization because it meets the criteria of FASB Statement No 34

2 The company could commence activities on all the land, by starting such activities as planning the future expansion Since FASB Statement No 34 states that the term activities

is to be construed broadly, such actions would allow the company to compute the

interest capitalized on the amounts borrowed to acquire all the land This would increase the interest capitalized and the asset value, thereby reducing interest expense and

increasing net income

C9-8

Capitalize at $100,000: The option costs are not applicable to the purchase price and are, therefore, not a cost of the land Rather, they are an expense incurred during the year required to make a decision and should not be capitalized The option was for a period of one year and thus its usefulness has expired and should not be capitalized

Capitalize at $105,000: Because the option cost of $5,000 was necessary in order to

purchase the desired site, this amount should be capitalized along with the contract price

of $100,000 The option for the site not chosen has no usefulness once the other site was purchased and should be expensed

Capitalize at $110,000: In order for the company to make the best choice as to sites, it was necessary to acquire both options Therefore, regardless of which site was chosen, the total cost of both options should be capitalized along with the contract price

C9-9

According to APB Opinion No 29, donated assets are recorded at their fair value The controller's argument of no payment by the company is what makes the acquisition a nonreciprocal transfer and thus governed by APB No 29 This procedure also makes the recording of the asset consistent with the treatment of other assets that are recorded at their fair value at the date of acquisition

The alteration costs of $15,000 are necessary in order for the company to put the building into operating condition These are considered a cost of the building and are capitalized The possibility of the building being returned to the city is not relevant to the capitalization

of these costs, unless the return is considered probable under the terms of FASB Statement

No 5 The argument that exclusion of the $15,000 will closer approximate the market value of the building is invalid There is no relationship between an asset's recorded value and its fair value, except by coincidence The issue of reducing income taxes is also not relevant to financial reporting

C9-10 (AICPA adapted solution)

1 The valuation of assets that are acquired by a corporation in exchange for its own

common stock is sometimes difficult because of:

a The absence of a readily determinable fair value for the assets acquired because they are not traded actively

b The absence of a readily determinable fair value for the securities given in exchange, either because they are not traded actively or because the proportion of the number

of shares in this single issue to all shares being traded is large enough to affect the market price substantially

c The absence of arm's length or independent bargaining leading to the exchange

d Widely varying estimates of the value of the asset acquired because of its nature (for example, unexplored or unproved mineral deposits, manufacturing rights and

patents)

C9-10 (continued)

1 (continued)

e The common presumption that when capital stock has a par or stated value it

imputes a value to the assets for which it is exchanged

2 a The directors of Brahe Corporation appraised the leases at $600,000 and the

transaction involving the stock issuance to Messrs Moses and Price supports that appraisal In the exchange transaction, a price of $6 per share was imputed to the Brahe Corporation common stock when 75,000 shares were given to Messrs Moses and Price ($6 x 75,000 = $450,000) in exchange for assets worth $200,000 and options which, based on the appraisal of the directors, were worth $250,000 This transaction was followed by a public sale of 180,000 shares of Brahe Corporation common stock

at $6 per share, the same price that was imputed to the stock earlier when Messrs Moses and Price obtained 75,000 shares in connection with the exchange The fact that the public was willing to purchase, and did purchase, substantial shares at the same price would indicate that the appraisal value of leases recorded on the books is

a reasonable one Furthermore, the law allows boards of directors broad discretion in establishing values, provided there is no fraud

b Brahe Corporation might have taken additional steps to demonstrate the

reasonableness of the $600,000 appraisal of leases so that more information would be available if questions were raised about their possible overvaluation Because the appraisal was based solely upon the lease price of certain other acreage in the area,

it would have been wise to obtain supplementary appraisals by independent

competent technicians to support the value This is particularly true because the board was not independent, having been elected by Messrs Moses and Price, who were the sole stockholders, and also the parties who were offering the options to Brahe Corporation In addition, Brahe Corporation could have compiled data to substantiate beyond doubt the reasons why an acceptable bargain purchase did exist here in permitting the purchase with options for only $350,000 of leases worth the substantially higher amount of $600,000

3 Based on available information, Brahe Corporation should charge 1/10 of the value of the leases against income at December 31, 2001, in accordance with generally accepted accounting principles However, this should not be done if (a) the total lease acreage can be regarded as a unitary whole, or (b) the investment was made with anticipation that some portion of the total acreage obtained would prove worthless

C9-11

Note to Instructor: This case does not have a definitive answer From a financial reporting perspective, GAAP is identified and summarized From an ethical perspective, various issues are raised for discussion purposes

From a financial reporting perspective, there are 3 issues The first issue relates to when interest capitalization begins Under GAAP, it begins when (1) expenditures for the asset have been made, (2) activities that are necessary to get the asset ready for its intended use are in progress, and (3) interest cost is being incurred Assuming that the company has debt and that the architect has been paid (often a retainer is paid), then the three

conditions probably were met in 2003 A second issue is the costs that can be included The expenditures on which interest is capitalized are the cumulative capitalized

expenditures on the project This would allow including 1/12 of the accountant's salary

C9-11 (continued)

and similar expenditures, although it would be necessary to have documentation that such costs were directly related to the project The third issue is how to report the interest cost if there was no capitalization in 2003 If interest was not capitalized, then this is an error because there was a misapplication of accounting principles The error would be accounted for as a prior period adjustment So the CEO has to accept the "good" of maximizing the interest capitalization in 2004 and the "bad" of admitting to an error in applying accounting principles (even though income in 2003 will be increased by the error correction) Of course, the suggestion of including 2003's interest capitalization in 2004 is not appropriate

From an ethical perspective, the issue is whether it is appropriate to "dump" costs into the project so that the costs are maximized, interest capitalized is maximized, interest expense and other expenses are minimized, and net income is maximized The primary

stakeholders are the company's current and potential stockholders and creditors

Accounting principles allow for judgment on these issues and expect that professional judgment be exercised On the other hand, if the net income amount is not grounded in economic reality, current and potential stockholders may be misled about the value of an investment in the company Also, the CEO should be reminded that the higher cost of the building will result in higher depreciation expense, although that long-term perspective may be of no concern

C9-12

Note to Instructor: Students are expected to cite paragraphs from the FASB Original

Pronouncements in their research of this issue Since the Statements of Concepts are not

included in the FASB Current Text, reference is made to Intermediate Accounting Also, the issues in this case are addressed by the FASB Emerging Issues Task Force Issue No 89-13 which is included in a separate published volume

1 To: President, Tenth National Bank

From: Student

I have researched the issue of how to account for the costs of removing the asbestos from the two buildings According to the FASB Original Pronouncements, Concepts Statement

No 6, par 25 and 26 (Intermediate Accounting, p 59) assets are probable future

economic benefits obtained or controlled by a particular entity as a result of past

transactions or events Also, an asset involves a capacity to contribute directly or

indirectly to future cash flows

First, I will deal with the office building that was purchased with a known asbestos problem The $2 million cost of removing the asbestos may be considered to be a cost that was necessary to prepare the building for its intended use It may also be argued that the cost

of $2 million indirectly contributes to the future cash inflows because without the cost the building could not be used Both these arguments assume that the selling price was

reduced because of the known estimated costs of removing the asbestos Based on these issues, I recommend that the $2 million be capitalized to the cost of the building

C9-12 (continued)

1 (continued)

Note that a counter argument is that the $2 million is a "maintenance" cost that does not extend the useful life or improve the physical structure beyond the state in which it was originally intended to be used Under this argument, the cost would be expensed

The second issue is the shopping mall in which the asbestos problem was not known at the time the building was acquired The following alternatives may be considered:

a Expense the $1 million because it is a "maintenance" cost that does not extend the useful life or improve the property beyond its original state Instead the cost returns the building to its normal state of repair Also, it may be argued that the "extra" cost does not benefit future periods

b Capitalize the $1 million for the reasons outlined earlier for the office building Also, it may be argued that incurring the costs has extended the life of the mall because without the costs the life would be very short However, these arguments assume that the mall can be sold at a profit; that is, the $1 million can be recovered through a sale If a loss is expected, the cost must be expensed

c Capitalize the portion of the $1 million that relates to "normal" replacement of the affected portions of the building and expense any "special" costs incurred because of the asbestos problem

I recommend that the $1 million be expensed (unless it can be demonstrated that the amount will be recovered through a sale which seems unlikely since the building was obtained through a foreclosure)

Another issue is how to classify the expense Three alternatives are:

a Report as an extraordinary item because it is considered to be unusual and infrequent (FASB Current Text, par I17.401 or FASB Original Pronouncements, APB 30, par 20) This alternative is difficult to justify because of the numerous asbestos problems affecting large numbers of buildings

b Report as an unusual or infrequent item that is disclosed as a separate line item in the income statement This alternative is easier to justify because asbestos problems have occurred infrequently for this bank

c Report as an operating expense with no special disclosure in the income statement

I recommend that the $1 million be classified as an operating expense with no special disclosure in the income statement because asbestos problems have become so

widespread and banks frequently repossess buildings, thereby making the cost neither unusual nor infrequent However, disclosure in the notes to the financial statements may

be appropriate

Note that this recommendation does not consider the value at which the repossessed shopping mall is carried AICPA Statement of Position No 92-3 states that foreclosed assets held for sale are carried at the lower of the cost or fair value, less estimated costs to sell

C9-12 (continued)

2 Students may raise ethical issues, such as:

a Conflicts between the interests of different stakeholders particularly management, stockholders, and the government

b The disclosure responsibilities of sellers

c The liability exposure of professionals who provide estimates of future costs

a Does the transaction qualify as a nonmonetary exchange? Since no cash was

exchanged, it is a nonmonetary exchange However, according to the FASB Current Text, par N35.407 (FASB Original Pronouncements, APB 29, par 3e), similar productive assets are of the same general type, that perform the same function, or that are employed in the same line of business Clearly the exchange of shares for land and a building does not meet this criterion Therefore, the exchange is of dissimilar

productive assets and the transaction must be recorded at fair value

b What is the value to place on the transaction and its components? According to the FASB Current Text, par N35.105 (FASB Original Pronouncements, APB 29, par 18), either the value of the shares or the value of the land and building may be used, but the most reliable value should be used If both values are equally unreliable, it is preferable to use the value of the assets because it is independent of the value of the shares A final alternative is to have the Board of Directors place a value on the transaction

2 Students may raise ethical issues, such as:

a Conflicts between the interests of different stakeholders particularly management, stockholders, and the government

b The value assigned by each entity will affect net income, and perhaps management compensation such as bonuses

c The allocation of a tax basis to each depreciable asset, and the effect of that choice

on the depreciation deduction used to compute taxable income

ANSWERS TO MULTIPLE CHOICE

8 Overhaul costs before use

9 Costs of grading land prior to construction

10 Tax assessment for street improvements

11 Delinquent property taxes on property acquired

13 Cost of insurance during construction (could be expensed)

15 Interest costs during construction (not imputed interest)

16 Landscaping costs

18 Cost of tearing down a building on newly acquired land

19 Replacement of an electric motor in a machine (if benefits are increased)

20 Expansion of the heating/cooling system

The following are not included in the cost:

2 List price

4 Discounts taken (unless equal to discounts available, which are not included in the cost)

5 Discounts not taken

12 Cost of tearing down an old building (already owned)

14 Excess of costs over revenue during development stage

17 Severance pay for employees dismissed because of acquisition

21 Service contract for 2 years on the acquired asset

22 Cost of training new employees

E9-2

The following are included in property, plant, and equipment:

6 Fully depreciated assets still being used

7 Leasehold improvements

The following are not included in property, plant, and equipment:

1 Idle equipment awaiting sale

2 Land held for future use as a plant site

3 Land held for investment

E9-2 (continued)

4 Deposits on machinery not yet received

5 Progress payments on building being constructed

8 Assets leased to others

preferred stock

Present value of note: Four annual payments of $30,000

Present value factor n=4, i=10% 3.169865*

E9-5 (AICPA adapted solution)

The asset should be recorded at its cash equivalent price of $9,500 plus

installation costs of $300 This forces a discount to be reported on the note payable, and interest to be recognized even though recognition of interest on

a note of less than one year is not required by APB Opinion No 21

E9-6 (AICPA adapted solution)

Building: Warehouse (new) 30,000b

Accumulated Depreciation: Building 55,000

aLoss = FV of asset surrendered - BV of asset surrendered

= $30,000 - $35,000

bCost = Fair value of asset surrendered

Bristol Company

Building: Warehouse (new) 20,000a

Accumulated Depreciation: Building 25,000

aGain is not recognized (since no boot is received)

Cost = BV of asset surrendered

Note: Denver Company's journal entry is consistent with alternative 1 in Exhibit 9-2 Bristol Company's journal entry is consistent with alternative 2 in Exhibit 9-2

E9-9

Denver Company

Building: Warehouse (new) 30,000b

Accumulated Depreciation: Building 55,000

Building: Warehouse (new) 18,667b

Accumulated Depreciation: Building 25,000

aTotal gain = FV of asset surrendered - BV of asset surrendered

$10,000 = $30,000 - $20,000

Gain recognized = Boot x (FV-BV) = $2,000 x$10,000 = $667

Boot + Fair value ($2,000+$28,000) (rounded)

of asset received

bCost = BV + Gain recognized - Boot received = $20,000 + $667 - $2,000

Note: Denver Company's journal entry is consistent with alternative 3 in Exhibit 9-2 Bristol Company's journal entry is consistent with alternative 6 in Exhibit 9-2 E9-10

Denver Company

Building: Warehouse (new) 30,000b

Accumulated Depreciation: Building 55,000

aLos s = FV of asset surrendered - BV of asset surrendered

= $33,000 - $35,000

bCost = FV of asset surrendered - Boot received = $33,000 - $3,000

E9-10 (continued)

Bristol Company

Building: Warehouse (new) 23,000b

Accumulated Depreciation: Building 25,000

aGain is not recognized (since no boot was received)

bCost = BV of asset surrendered + Boot paid = $20,000 + $3,000

Note: Denver Company's journal entry is consistent with alternative 5 in Exhibit 9-2 Bristol Company's journal entry is consistent with alternative 4 in Exhibit 9-2 E9-11

The exchange is of dissimilar productive assets

The exchange is of similar productive assets and, therefore, is recorded at cost and not fair value Minor will value Smith's contract at $145,000 Better will value Doe's contract at $140,000

E9-14 (continued)

Under this alternative, the construction is accounted for in the same way as regular products The overtime might be excluded if it has been included in the overhead rate An unfavorable variance might be charged to the

to the construction project, so that the unit cost of the regular products is not reduced This alternative recognizes that the cost of the asset is the additional cost incurred to produce it and that the overhead would be incurred whether

or not the construction takes place

Note that these two solutions are the logically desirable results under the

conditions described, but there is no requirement that companies actually use the alternative in these particular circumstances

2 If the bid from the outside contractors was $80,000, it is questionable whether the use of the full overhead rate is appropriate The incremental approach seems more reasonable in this situation

If the bid was $60,000, the Harshman Company has clearly incurred excessive costs to construct the building The building should be recorded at $60,000 and the excess costs should be recorded as a loss on construction

E9-15 (continued)

3 Even though title would not pass to the company for 10 years, the land and building is still recorded on the books of the company Disclosure of the contingency associated with the title is included in the notes to the financial statements

= ($5,000,000 - $2,000,000) x 11%

= $330,000 E9-18

The following are recorded as capital expenditures:

1 Cost of installing machinery

2 Cost of moving machinery

4 Cost of major overhaul

5 Installation of safety device (unless no economic benefits are realized)

7 Property taxes on land and buildings held for investment

8 Cost of rearranging offices

The following are recorded as operating expenditures:

3 Repairs as a result of an accident

6 Property taxes on land and buildings

9 Cost of repainting offices

10 Ordinary repairs

2 Value on balance sheet (before recording depletion)

a Successful-efforts method 60% of drilling efforts are successful Therefore:

60% x $4,000,000 = $2,400,000 appears on the balance sheet

as oil and gas properties

b Full-cost method All drilling costs are capitalized; therefore, $4,000,000 appears on the balance sheet as oil and gas properties