Intructor manual intermediate accounting 15th kiesoch10

Subsequent to acquisition, companies should not write up property, plant, and equipment to reflect fair value when it is above cost because a historical cost involves actual, nothypothet

1 Valuation and classification

of land, buildings, and

ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)

Learning Objectives

Brief

1 Describe property, plant, and equipment.

2 Identify the costs to include in initial valuation

of property, plant, and equipment.

1 1, 2, 3, 4, 5,

11, 12, 13

1, 2, 3, 4,

5, 6, 11

3 Describe the accounting problems associated

with self-constructed assets.

4, 5, 6,

11, 12

3

4 Describe the accounting problems associated

with interest capitalization.

2, 3, 4 5, 6, 7, 8,

9, 10

5, 6, 7

5 Understand accounting issues related

to acquiring and valuing plant assets.

7 Describe the accounting treatment for the

disposal of property, plant, and equipment.

14, 15 24, 25 2, 4

ASSIGNMENT CHARACTERISTICS TABLE

Time (minut es)

E10-1 Acquisition costs of realty Moderate 15–20 E10-2 Acquisition costs of realty Simple 10–15 E10-3 Acquisition costs of trucks Simple 10–15 E10-4 Purchase and self-constructed cost of assets Moderate 20–25 E10-5 Treatment of various costs Moderate 30–40 E10-6 Correction of improper cost entries Moderate 15–20 E10-7 Capitalization of interest Moderate 20–25 E10-8 Capitalization of interest Moderate 20–25 E10-9 Capitalization of interest Moderate 20–25 E10-10 Capitalization of interest Moderate 20–25 E10-11 Entries for equipment acquisitions Simple 10–15 E10-12 Entries for asset acquisition, including self-construction Simple 15–20 E10-13 Entries for acquisition of assets Simple 20–25 E10-14 Purchase of equipment with zero-interest-bearing debt Moderate 15–20 E10-15 Purchase of computer with zero-interest-bearing debt Moderate 15–20 E10-16 Asset acquisition Moderate 25–35 E10-17 Nonmonetary exchange Simple 10–15 E10-18 Nonmonetary exchange Moderate 20–25 E10-19 Nonmonetary exchange Moderate 15–20 E10-20 Nonmonetary exchange Moderate 15–20 E10-21 Analysis of subsequent expenditures Moderate 20–25 E10-22 Analysis of subsequent expenditures Simple 15–20 E10-23 Analysis of subsequent expenditures Simple 10–15 E10-24 Entries for disposition of assets Moderate 20–25 E10-25 Disposition of assets Simple 15–20

P10-1 Classification of acquisition and other asset costs Moderate 35–40 P10-2 Classification of acquisition costs Moderate 40–55 P10-3 Classification of land and building costs Moderate 35–45 P10-4 Dispositions, including condemnation, demolition, and

trade-in.

Moderate 35–40

P10-5 Classification of costs and interest capitalization Moderate 20–30 P10-6 Interest during construction Moderate 25–35 P10-7 Capitalization of interest Moderate 20–30 P10-8 Nonmonetary exchanges Moderate 35–45 P10-9 Nonmonetary exchanges Moderate 30–40 P10-10 Nonmonetary exchanges Moderate 30–40 P10-11 Purchases by deferred payment, lump-sum, and Moderate 35–45

nonmonetary exchanges.

ASSIGNMENT CHARACTERISTICS TABLE (Continued)

Time (minut es)

CA10-1 Acquisition, improvements, and sale of realty Moderate 20–25 CA10-2 Accounting for self-constructed assets Moderate 20–25 CA10-3 Capitalization of interest Simple 20–25 CA10-4 Nonmonetary exchanges Moderate 30–40 CA10-5 Costs of acquisition Simple 20–25 CA10-6 Cost of land vs building—ethics Moderate 20–25

LEARNING OBJECTIVES

1 Describe property, plant, and equipment

2 Identify the costs to include in initial valuation of property, plant, and equipment

3 Describe the accounting problems associated with self-constructed assets

4 Describe the accounting problems associated with interest capitalization

5 Understand accounting issues related to acquiring and valuing plant assets

6 Describe the accounting treatment for costs subsequent to acquisition

7 Describe the accounting treatment for the disposal of property, plant, and equipment

CHAPTER REVIEW

1 Chapter 10 presents a discussion of the basic accounting problems associated with theincurrence of costs related to property, plant, and equipment; and the accounting methodsused to retire or dispose of these costs These assets, also referred to as fixed assets,are of a durable nature and include land, building structures, and equipment Fixed assetsare an important part of the operations of most business organizations They provide the majormeans of support for the production and/or distribution of a company’s product or service

2 (L.O 1) Property, plant, and equipment possess certain characteristics that distinguish

them from other assets owned by a business enterprise These characteristics may beexpressed as follows: (a) acquired for use in operations and not for resale, (b) long-term

in nature and usually depreciated, and (c) possess physical substance An asset must beused in the normal business operations to be classified as a fixed asset These assetslast for a number of years and their costs must be allocated to the periods which benefitfrom their use

Acquisition of Property, Plant, and Equipment

3 (L.O 2) Property, plant and equipment are valued in the accounts by most companies at 

their historical cost Historical cost is measured by the cash or cash equivalent price of

obtaining the asset and bringing it to the location and condition necessary for its intendeduse Thus, charges associated with freight costs and installation are considered a part ofthe asset’s cost The topic of depreciation is presented in Chapter 11

4 Subsequent to acquisition, companies should not write up property, plant, and equipment

to reflect fair value when it is above cost because (a) historical cost involves actual, nothypothetical transactions and so is the most reliable, and (b) gains and losses should not

be anticipated, but should be recognized only when the asset is sold

5 The assets normally classified on the balance sheet as property, plant, and equipmentinclude land, buildings, and various kinds of machinery and equipment The cost of eachitem includes the acquisition price plus those expenditures incurred in getting the assetready for its intended use

6 The cost of land, cost typically includes

(a) purchase price

(b) closing costs such as title to the land, attorneys’ fees, and recording fees

(c) costs of grading, filling, draining, and clearing the property

(d) assumption of any liens, mortgages, or encumbrances on the property

(e) any additional land improvements that have an indefinite life

(f) costs of removing an old building from land purchased for the purpose of constructing

a new building

When improvements that have a limited life (fences, driveways, etc.) are made to the landthey should be set up in a separate Land Improvements account so they can bedepreciated over their estimated useful life

7 Building costs include materials, labor, and overhead costs incurred during construction.

Any fees such as those incurred for building permits or the services of attorneys andarchitects are included in acquisition cost In general, all costs incurred from excavation ofthe site to the completion of the building are considered part of the building costs

8 With respect to equipment, cost includes the purchase price plus all expenditures related

to the purchase that occur subsequent to acquisition but prior to actual use These relatedcosts would include such items as freight charges, insurance charges on the asset while

in transit, assembly and installation, special preparation of facilities, and asset testing costs

Self-Constructed Assets

9 (L.O 3) When machinery and equipment to be used by a company are constructed 

rather than purchased, a problem exists concerning the allocation of overhead costs.

These costs may be handled in one of two ways: (a) assign no fixed overhead to the cost

of the constructed asset, or (b) assign a portion of all overhead to the construction

process The second method called a full-costing approach appears preferable

because of its consistency with the historical cost principle It should be noted that thecost recorded for a constructed asset can never exceed the price charged by an outsideproducer

Interest Costs During Construction

10 (L.O 4) Capitalization of interest costs incurred in connection with financing the construction 

or acquisition of property, plant, and equipment generally follows the rule of capitalizing

only the actual interest costs incurred during construction While some modification

to this general rule occurs, its adoption is consistent with the concept that the historicalcost of acquiring an asset includes all costs incurred to bring the asset to the conditionand location necessary for its intended use

11 To qualify for interest capitalization, assets must require a period of time to get them readyfor their intended use Assets that qualify for interest cost capitalization include assetsunder construction for a company’s own use (such as buildings, plants, and machinery)and assets intended for sale or lease that are constructed or otherwise produced asdiscrete projects (like ships or real estate developments) The period during which interestmust be capitalized begins when three conditions are present: (a) expenditures for theasset have been made; (b) activities that are necessary to get the asset ready for itsintended use are in progress; and (c) interest cost is being incurred

12 The amount of interest to capitalize is limited to the lower of (a) actual interest cost incurred

during the period or (b) the amount of interest cost incurred during the period thattheoretically could have been avoided if the expenditure for the asset had not been made

(avoidable interest) The potential amount of interest that may be capitalized during an

accounting period is determined by multiplying interest rate(s) by the weighted-average

amount of accumulated expenditures for qualifying assets during the period.

13 A comprehensive illustration of interest capitalization is shown on pages 544–546 Thisillustration includes both the computations and the related journal entries that should bemade in a situation when an asset is constructed and capitalizable interest is a part of thetransaction.

14 Two special issues relate to interest capitalization If a company purchases land as a sitefor a plant, interest costs capitalized during the period of construction are part of the cost

of the plant, not the land In addition, companies should generally not net or offset interestrevenue against interest cost, even when construction funds are temporarily invested

Acquisition and Valuation

15 (L.O 5) In general, an asset should be recorded at the fair value of what is given up to 

acquire it or at the fair value of the asset received, whichever is more clearly evident.Determining fair value is not always as easy as it might appear Some problems that may

be encountered in determining proper valuation follow

16 The purchase of a plant asset is often accompanied by a cash discount for prompt

payment If the discount is taken, it results in a reduction in the purchase price of theasset However, when the discount is allowed to lapse, should a loss be recorded orshould the asset be recorded at a higher purchase price? Currently, while the “lossapproach” is preferred, both methods are employed in practice

17 Plant assets purchased on deferred payment contracts should be accounted for at the

present value of the consideration exchanged on the date of purchase When theobligation stipulates no interest rate, or the rate is unreasonable, an imputed rate ofinterest must be determined for use in calculating the present value Factors to beconsidered in imputing an interest rate are the borrower’s credit rating, the amount andmaturity date of the note, and prevailing interest rates If determinable, the cashexchange price of the asset acquired should be used as the basis for recording the assetand measuring the interest element

18 In some instances a company may purchase a group of plant assets at a single lump sum

purchase price The best way to allocate the purchase price of the assets to the

individual items is to base the allocation on the relative fair values of the assets acquired

To determine fair value, a company should use valuation techniques that are appropriate

in the circumstances

19 When assets are acquired in exchange for a company’s own stock, the best measure ofcost is the fair (market) value of the stock issued

Exchanges of Nonmonetary Assets

20 Nonmonetary assets such as inventory or property, plant, and equipment are items

whose price may change over time Controversy exists in regard to the accounting forthese assets when one nonmonetary asset is exchanged for another nonmonetary asset

21 Ordinarily, companies account for the exchange of nonmonetary assets on the basis ofthe fair value of the asset given up or the fair value of the asset received, whichever isclearly more evident Companies should recognize immediately any gains or losses on theexchange The rationale for immediate recognition is that most transactions have

commercial substance and therefore, should be recognized at the completion of the

earnings process An exchange has commercial substance if the future cash flows change

as a result of the transaction An exchange of trucks with different useful lives might havecommercial substance, while an exchange of trucks with no significant difference in usefullives would probably not

22 When a transaction involves an exchange of nonmonetary assets, losses are alwaysrecognized Accounting for gains depends on whether the exchange has commercialsubstance If the exchange has commercial substance, the company recognizes any gainimmediately Gains are deferred (not immediately recognized) if the exchange has nocommercial substance, unless cash or some other form of monetary consideration is

received, in which case a partial gain is recognized The portion to be recognized is equal

to the ratio of the cash received to the total consideration received times the total gainindicated

23 A gain or loss on the exchange on nonmonetary assets is computed by comparing thebook value of the asset given up with the fair value of that same asset The examplesshown below demonstrate the various situations where exchanges of nonmonetary assetsare included

Exchange with Commercial Substance

Al Company exchanged a used machine with a book value of $26,000 (cost $54,000 less

$28,000 accumulated depreciation) and cash of $8,000 for a delivery truck The machine

is estimated to have a fair value of $36,000

Cost of truck:

Fair value of machine exchanged $36,000Cash paid 8,000Cost of truck $44,000Journal entry:

Trucks $44,000Accumulated Depreciation—Machinery 28,000Machinery 54,000Gain on Disposal of Machinery 10,000Cash 8,000

Exchange with No Commercial Substance

Al Company trades drill press A for drill press B from another company Drill Press A has

a book value of $11,000 (cost $32,000 less $21,000 accumulated depreciation) and a fairvalue of $8,000 Drill press B has a list price of $38,000, and the seller has allowed atrade-in allowance of $15,000 on the press

Cost of new machine:

List price of drill press B $38,000Less trade-in allowance 15,000Cash payment due 23,000Fair value of drill press A 8,000Cost of drill press B $31,000

Journal entry:

Equipment 31,000Accumulated Depreciation—Equipment 21,000Loss on Disposal of Equipment 3,000Equipment 32,000Cash 23,000

Loss verification:

Book value of drill press A $11,000Fair value of drill press A 8,000Loss on disposal of drill press A $ 3,000

Exchange with No Commercial Substance

Al Company contracts with Peg Company to exchange delivery vans Al Company willtrade four Dodge Caravans for four Ford Freestars owned by Peg Company The fairvalue of the Caravans is $51,000 with a book value of $38,000 (cost $65,000 less

$27,000 accumulated depreciation) The Freestars have a fair value of $66,000 and

Al Company gives $15,000 in cash in addition to the Caravans

Computation of Gain:

Fair value of Caravans $51,000Book value of Caravans 38,000Total gain (unrecognized) $13,000

Basis of new vans to Al Company:

Fair value of Freestars $66,000Less gain deferred 13,000Basis of Freestar vans $53,000

OR

Book value of Caravans $38,000Cash paid 15,000Basis of Freestar vans $53,000

Al Company journal entry:

Freestar Vans 53,000Accumulated Depreciation 27,000Caravan Vans 65,000Cash 15,000

Exchange with No Commercial Substance-Gain Situation

(Some Cash Received)

From the previous example, assume the book value of the Freestar Vans exchanged byPeg Company was $52,000 (cost $75,000 less $23,000 of accumulated depreciation).Thus, the total gain on the exchange to Peg Company is as follows:

Fair value of vans exchanged $66,000Book value of vans exchanged 52,000Total gain $14,000

Recognized gain due to cash received:

[$15,000 ÷ ($15,000 + $51,000)] × $14,000 = $3,182Deferred gain: $14,000 – $3,182 = $10,818

Basis of new vans to Peg Company:

Fair value of Caravans $51,000Less gain deferred (10,818)Basis of Caravans $40,182

Peg Company journal entry:

Cash 15,000Caravan Vans 40,182Accumulated Depreciation 23,000Freestar Vans 75,000Gain on Disposal of Vans 3,182

Accounting for Contributions

24 Many companies receive assets through donations from other organizations, individuals,

or the federal government These transactions are known as nonreciprocal transfers

Assets Received When an asset is received through donation or gift, the appraisal or

fair value of the asset should be used to establish its value on the books In theory, thecredit for this transaction could be made to (1) a Donated Capital account that wouldappear in stockholders’ equity, or (2) revenue A FASB standard states that, in general,contributions received should be recorded as revenue in the period received

Assets Contributed When a plant asset is contributed, recognize contribution expense

for the fair value of the asset donated The difference between the fair value and the bookvalue of the contributed asset is reported as a recognized gain or loss

Other Asset Valuation Methods

25 Valuation of property, plant, and equipment on a basis other than historical cost has beenwidely discussed by those concerned with the financial reporting process However,historical cost continues to be recognized as the accepted method for valuing theseassets in the financial statements One valuation approach that is sometimes allowed and

not considered a violation of historical cost is a method referred to as prudent cost This

concept holds that if for some reason you were ignorant about a certain price and paidtoo much for an asset originally, it is theoretically preferable to charge a loss immediately

Costs Subsequent to Acquisition

26 (L.O 6) Costs related to plant assets that are incurred after the asset is placed in use are 

either added to the asset account (capitalized) or charged against operations (expensed)

when incurred In general, costs incurred to achieve greater future benefits from the asset

should be capitalized, whereas expenditures that simply maintain a given level of serviceshould be expensed

27 For the costs to be capitalized, one of three conditions must be present: (a) the useful life ofthe asset must be increased, (b) the quantity of units produced from the asset must beincreased, or (c) the quality of the units produced must be enhanced In many instances,

a considerable amount of judgment is required in deciding whether to capitalize or expense

an item However, consistent application of a capital/expense policy is normally moreimportant than attempting to provide theoretical guidelines Generally, expendituresrelated to plant assets being used in a productive capacity may be classified as: (a)additions, (b) improvements and replacements, (c) rearrangement and reinstallationcosts, and (d) repairs

28 Because additions result in the creation of new assets, they should be capitalized.

29 Improvements and replacements are substitutions of one asset for another.

Improvements substitute a better asset for the one currently used, whereas a replacementsubstitutes a similar asset The major problem in accounting for improvements andreplacements concerns differentiating these expenditures from normal repairs If animprovement or replacement increases the future service potential of the asset, it should

be capitalized Capitalization may be accomplished by: (a) substituting the cost of thenew asset for the cost of the asset replaced, (b) capitalizing the new cost withouteliminating the cost of the asset replaced, or (c) debiting the expenditure to AccumulatedDepreciation The specific facts related to the situation will aid in determining the mostappropriate method to use

30 Rearrangement and reinstallation costs are generally carried forward as a separate

asset and amortized against future income

31 Ordinary repairs are expenditures made to maintain plant assets in operating condition They are charged to an expense account in the period in which they are incurred Major

repairs are capitalized as an addition, improvement, or replacement, as appropriate Disposition of Plant Assets

32 (L.O 7) When a plant asset is disposed of, the accounting records should be relieved of 

the cost and accumulated depreciation associated with the asset Depreciation should berecorded on the asset up to the date of disposal, and any resulting gains or losses should

be recognized

33 Plant assets may be retired voluntarily or disposed of by sale, exchange, involuntary

conversion, or abandonment.

LECTURE OUTLINE

Chapter 10 presents issues related to the acquisition and disposition of plant assets Thechapter, which can generally be covered in three class sessions, deals with three major topics:

1 General principles involved in accounting for the acquisition and disposition of

plant assets: Students should be familiar with these from elementary accounting 

courses

2 Capitalization of interest cost during construction: Students generally have 

difficulty with the computational procedures required

3 Nonmonetary exchanges: This is a difficult topic for some students Students should 

be encouraged to understand the meaning of commercial substance

A (L.O 1) Characteristics of Property, Plant, and Equipment.

1 Acquired for use in operations and not for resale

2 Long-term in nature and usually depreciated, except for land

3 Possess physical substance

B (L.O 2) Acquisition and Valuation of Property, Plant, and Equipment.

1 Historical cost is the usual basis for valuation This is the cash or cash equivalent price

of obtaining the asset and bringing it to the location and condition necessary for itsintended use

2 Subsequent to acquisition, companies should not write up property, plant, andequipment to reflect fair value when it is above cost The main reasons for this positionare: (1) historical cost involves actual, not hypothetical, transactions and so is the most

reliable, and (2) companies should not anticipate gains and losses, but should

recognize gains and losses only when the asset is sold

3 Components of cost

are included in the cost of the land Special assessments for relatively permanent

improvements such as pavements and drainage systems are included in the land account Improvements with limited lives (fences, parking lots) are recorded

separately as Land Improvements and depreciated over their estimated lives.

b Cost of Buildings: All expenditures related directly to acquisition or construction

are capitalized as part of the building cost This includes attorneys’ and architects’fees, building permits, and all costs incurred beginning with excavation and endingwith completion of the building

c Cost of Equipment: All expenditures incurred in acquiring the equipment and 

preparing it for use are included This includes the purchase price, freight charges,