CHAPTER 10: ACQUISITION AND DISPOSITION OF
PROPERTY, PLANT AND EQUIPMENT
Objectives: Be able to illustrate your understanding
of and record transactions related to the life cycle of
a fixed asset:
1.
Acquisition of fixed assets.
2.
Capitalization of interest cost during
construction.
3.
Nonmonetary exchanges
4.
Additions and Improvements.
5.
Disposition of fixed assets.
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Objective 1: Acquisition of fixed assets:
1. Valuation: historical cost. All costs
associated with getting it ready for use.
2. Components of cost
Land: up to excavation for building included in land,
e.g. all costs to acquire and prepare it for use, such as
closing costs, removing old building, clearing,
grading, filling, draining, clearing, assumptions of
liens. It also includes special assessments for local
improvement such as pavements, street lights, sewers,
drainage (key is it is considered “permanent” and
taken care of by local government) PLUS permanent
improvements made by owner (landscaping).
Depreciable land improvements are those that are
considered to have limited lives such as private
driveways, walks, fences, parking lots. These costs
go into a separate land improvement account are
depreciated.
Buildings: costs associated directly to acquisition and
construction including architects' fees, building
permits, attorney fees.
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Equipment: costs associated with getting it ready for
use including freight, in transit insurance, cost of
assembly.
Self-constructed: all costs directly traced to fixed
assets. What about indirect costs?
Allocate portion of fixed overhead
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Objective 2, Capitalization of interest cost
There are seven steps involved in the capitalization of interest.
1. Determine Which Assets Qualify for Capitalization of
Interest.
Qualifying assets include assets under construction for the
firm's own use (such as buildings, machinery) and assets under
construction for sale or lease as part of discrete projects (such
as real estate projects).
2. Determine the Capitalization Period.
The capitalization period begins when all three of the following
conditions have been met:
(i) Expenditures for the asset have been made (i.e., the firm
has made cash payments or has incurred debt for
construction of the asset).
(ii) Necessary activities to get the asset ready for its intended
use are in progress (i.e., actual construction work is taking
place).
(iii) Interest cost of some kind is being incurred (i.e., the firm
has some type of interest-bearing debt outstanding).
This debt need not be specific debt incurred on the asset. it
may be general debt such as bonds payable.
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Objective 2, continued
Therefore a company may capitalize interest cost even
though the entire construction cost of the asset was paid for
in cash, continued so long as the company has some type of
interest-bearing debt outstanding.
The capitalization period ends when any one of these three
conditions is no longer being met.
3.
Compute the Expenditures Made During the
Capitalization Period.
An expenditure may be financed either with cash payments
or with the incurrence of debt. Whenever an expenditure is
made on a qualifying asset, the qualifying asset account is
debited and either the cash account or a liability account is
credited.
4.
Compute Weighted-Average Accumulated Expenditures.
The amount of expenditures on qualifying assets usually
varies considerably; it builds up or accumulates as
additional expenditures are made during the year. In order
to determine the interest cost associated with these
expenditures, it is necessary first to compute the weightedaverage accumulated expenditures. This figure represents
the average amount of funds tied up in construction
throughout the year.
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Objective 2, continued
5.
Compute Avoidable interest.
The purpose of this computation is to estimate the amount of
interest that theoretically could have been avoided if
expenditures had not been made on qualifying assets. Three
procedures must be followed before avoidable interest can
be computed:
(i) Identify the company's outstanding debt and classify either
as:
a. Specific debt--debt incurred specifically to finance the
construction of assets.
b. General debt--all company debt excluding specific
debt.
(ii) Determine the appropriate interest rate to apply to the
weighted average accumulated expenditures.
a. Specific debt rate--the interest rate associated with
specific debt.
b. General debt rate--a weighted-average of interest rates
incurred on all other outstanding debt during the period.
(iii)Compute the avoidable interest.
a. Multiply the specific debt interest rate times the portion
of the weighted-average accumulated expenditures that
is less than or equal to the amount of specifically
borrowed debt.
b. Multiply the weighted-average of interest rates incurred
on all other general debt times the weighted-average
accumulated expenditures that is greater than the debt
incurred specifically to finance asset construction.
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Objective 2, continued
6.
Compute the Actual Interest Cost Incurred.
It would not be reasonable to capitalize more interest than
the total amount of interest cost actually incurred.
7.
Determine the Interest Cost to be Capitalized.
The interest cost to be capitalized is the avoidable interest or
the actual interest, whichever is less. The amount of interest
capitalized is debited to an asset account along with the
construction and other costs of acquiring the asset. These
costs are depreciated over the asset's expected useful life.
The amount of interest cost expensed is written off
immediately to Interest Expense.
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Objective 2, continued
CAPITALIZATION OF INTEREST EXAMPLE
XMen Corporation borrowed $200,000 at 12% interest from Magneto Bank on
January 1, 2007, for the specific purpose of constructing special-purpose
equipment to be used in its operations. Construction on the equipment began on
January 1, 2007 and the following expenditures were made prior to the project's
completion on December 31,2007:
January 1
April 30
November 1
December 31
Total expenditures
$100,000
$150,000
$300,000
$100,000
$650,000
Other general debt existing on January 1, 2007, and issued in 2006 at par was:
$500,000, 14%, 10-year bonds payable
$300,000, 10%, 5-year note payable
Step 1:
Determine which assets qualify for capitalization of Interest.
Special purpose equipment qualifies for interest capitalization
because it requires a period of time to get ready and it will be used in
XMen's operations.
Step 2:
Determine the capitalization period.
The capitalization period is from January 1, 2007 through December
31, 2007 because expenditures are being made and interest costs are
being incurred during this period while construction is taking place.
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Step 3:
Compute the expenditures made during the capitalization
period.
January 1
April 30
November 1
December 31
Total expenditures
Step 4:
Date
Jan. 1
Apr. 30
Nov. 1
Dec. 31
Step 5:
$100,000
$150,000
$300,000
$100,000
$650,000
Compute the weighted-average accumulated expenditures.
Amount
Capitalization
WeightedPeriod
Average
$100,000
12/12
$100,000
$150,000
8/12
$100,000
$300,000
2/12
$ 50,000
$100,000
0/12
$ 0_____
$650,000
$250,000
Compute Avoidable Interest.
Specific debt:
$200,000 X 12% = $ 24,000
General debt:
$500,000 X 14% = $ 70,000
$300,000 X 10% = $ 30,000
Total annual interest expense
= $124,000
Weighted-average interest rate on general debt =
$100,000/$800,000 = 12.5%
Accumulated
Expenditures
$200,000
$ 50,000
$250,000
Step 6:
Interest Rates
Avoidable Interest
12%
12.5%
$ 24,000
$ 6,250
$ 30,250
Compute the actual interest cost incurred.
The actual interest cost incurred during the capitalization period is
$124,000 (See step 5).
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Objective 2, continued
Step 7:
Determine the interest cost to be capitalized.
Avoidable interest of $30,250 (Step 5) is less than actual interest of
$124,000 (Step 6); therefore, $30,250 interest costs can be
capitalized..
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Objective 3, Nonmonetary exchanges
The following steps may be used to account for nonmonetary exchanges.
1.
Compute the net book value (carrying value) of the old asset. This is equal to
original cost minus accumulated depreciation on the date of exchange.
2. Compute the realized gain or loss. This is equal to the difference between the
fair market value (FMV) and the net book value of the old asset on the date of
exchange.
Type of asset
Dissimilar
Similar
Realized Loss
Record loss . New Asset
is recorded at FMV.
Record loss. New Asset is
recorded at FMV.
Realized Gain
Record gain. New Asset
is recorded at FMV.
If no cash is exchanged or
if cash is paid:
Record no gain. New
asset is recorded at FMVamount of gain.
If cash is received:
Record portion of gain.*
New asset is recorded at
FMV-amount of gain not
recognized.
* Gain Recorded = Gain realized x [Cash received/Cash received +FMV of New
Asset]
3. Prepare the Journal entry to record the exchange. This entry involves the
following:
a. Remove the cost and accumulated depreciation of the old asset from the
books.
b. Record any cash paid or received.
c. Record any gain or loss as determined in Step 2.
d. Record the cost basis of the new asset.
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Objective 3, continued
Example:
EXCHANGE OF SIMILAR NONMONETARY ASSETS
(With and Without Boot)
Gamble Company exchanges its delivery trucks and $150,000 for similar type
delivery trucks from Proctor Company. Relevant information on the date of
exchange is as follows:
GAMBLE COMPANY
Gamble trucks
Accumulated depreciation
Book value
Fair market value of Gamble trucks
$400,000
$100,000
$300,000
$350,000
PROCTOR COMPANY
Proctor trucks
Accumulated depreciation
Book value
Fair market value of Proctor trucks
$600,000
$200,000
$400,000
$500,000
Gamble Company Analysis (they pay cash):
1.
Book value of Gamble trucks ($300,000)
2.
Gain realized ($350,000 - $300,000 = $50,000)
3.
Defer gain (earnings process not complete).
4.
Value assigned to Proctor trucks ($500,000 - $50,000 = $450,000)
Gamble JE:
Trucks (Proctor: 500,000-50,000)…………….450,000
Accumulated Depreciation (Gamble truck)……100,000
Trucks (Gamble)…………………………………400,000
Cash (paid by Gamble)…………………………..150,000
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Objective 3, continued
Proctor Company Analysis
1.
Book value of Proctor trucks ($400,000)
2.
Gain realized ($500,000 - $400,000=$100,000)
3.
Recognize gain for portion of asset sold
$100,000 X [$150,000/$150,000+350,000] = $ 30,000
4.
Defer portion of gain on asset considered exchanged
$100,000 -$30,000 = $ 70,000
5.
Value assigned to Gamble trucks
$350,000 - $70,000 = $280,000
Proctor Company JE
Cash………………………………………150,000
Trucks (Gamble)………………………….280,000
Accumulated Depreciation (Proctor)……..200,000
Trucks (Proctor)………………………………..600,000
Gain on sale of trucks……………………………30,000
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Objective 4, COSTS SUBSEQUENT TO ACQUISITION OF PROPERTY,
PLANT, AND EQUIPMENT
Focus is on future service potential (Chart from page 520). In general, the two
approaches are to debit accumulated depreciation (extending life) or debiting the
asset account.
Type of Expenditure
Normal Accounting Treatment
Addition
Capitalize cost of addition to asset account
Improvements and
replacements (substituting
one asset for another)
Carrying value known: Remove cost and
accumulated depreciation on old asset and recognize
any gain or loss. Capitalize cost of improvement or
replacement.
Carrying value unknown:
1. If the assets’ useful life is extended, debit
accumulated depreciation for the cost of
improvement or replacement
2. If the quantity or quality of the assets’
productivity is increased, debit the asset account.
Repairs
Generally expense unless major, then refer to above.
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Objective 5, Dispositions
a.
Record depreciation to date of disposal
b.
Record gain or loss
c.
If involuntary disposition, it is considered an extraordinary
item
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