CHAPTER 11 Acquisition of Property, Plant, and Equipment To be considered for each asset account • What's included? - Recognition, classification • What value? - Measurement • How reported? - Presentation, disclosure • Mechanics – Accounting entries, control systems • Meaning – Analysis Property, Plant, and Equipment • Also known as: – tangible capital assets – plant assets – fixed assets • Major characteristics include: 1. Acquired for use in operations and not for resale 2. Long-term in nature and usually subject to amortization 3. Possess physical substance Acquisition Cost • Historical cost is the basis for determining cost • Historical cost includes: – the asset’s cash or cash equivalent price, and – the cost of readying the asset for its intended use • Costs incurred after acquisition are: – added to asset’s cost, if they provide future service potential, or – expensed, if they do not add to service potential 1 Cost of Building Cost of Land • Land costs include: 1. Purchase price 2. Closing costs (land, legal, and recording fees) 3. Costs of getting land ready for use (removal of old building(s), clearing, grading, etc.) 4. Assumption of liens or encumbrances 5. Additional improvements with an indefinite life • Building costs include: – Costs of materials and labor, and overhead – Professional fees and building permits • Sale of salvaged materials reduce cost of land • Special assessments for local improvements (e.g. pavement) part of land cost Cost of Equipment • All necessary and reasonable costs incurred to get asset ready for its intended use • Includes : – – – – Purchase price Freight and handling charges Insurance while in transit Costs of special foundation, assembly and installation – Trial runs Self-Constructed Assets • These are assets constructed by the business for use in operations • The cost of self-constructed assets includes: • • • • Direct materials, Direct labour, Variable manufacturing overhead Proration of fixed manufacturing overhead 2 Interest Capitalization • CICA Handbook Section 3850.03 Where interest is capitalized the amount should be disclosed • GAAP = choice • Following FASB Statement 34 three questions must be answered: • What are the qualifying assets? • What is the capitalization period? • What is the amount of interest to be capitalized? Amount to Capitalize • Interest amount must be directly related to asset • Lower of actual interest or avoidable interest – Interest does not include cost of capital for shareholders’ equity • Weighted-average accumulated expenditures (WAAE) method used to find capitalizable interest Capitalization Period • Capitalization period begins when three conditions are present: 1. Expenditures for the asset have been made 2. Activities for readying the asset are in progress 3. Interest cost is being incurred • Capitalization continues for as long as these three conditions exist • Capitalization ends when asset is substantially complete and ready for use Shalla Corporation – Example Given: • November 1, 2001 contracts with Pfeifer Construction Co. Ltd. To construct a $1.4 million building (on land costing $100,000) • First payment made by Shalla to Pfeifer includes the payment for the land • Payments made in 2002: – January 1 – March 1 – May 1 $ 210,000 $ 300,000 $ 540,000 December 31 $ 450,000 Total $1,500,000 • Building completed December 31, 2002 3 Shalla Corporation – Example • Debt outstanding at December 31, 2002 – Specific Construction Debt: $750,000 15%, three year note – Other Debt: 10%, five year note $550,000 12%, ten year bonds $600,000 Shalla Corporation – Example Weighted-Average Accumulated Expenditures: Jan. 1 Mar. 1 May. 1 Dec. 31 WAAE $ 210,000 300,000 540,000 450,000 12/12 10/12 8/12 0/12 = = = = $210,000 250,000 360,000 0 $820,000 Note: Land payment is included in WAAE Next step: Avoidable interest and appropriate interest rate calculation Shalla Corporation – Example 5-year note 10-year note Total Interest Principal $550,000 $600,000 Interest $ 55,000 72,000 $127,000 Weighted-Average Interest Rate = Total Interest ÷ Total Principal (Do not include Construction Specific Debt) $127,000 ÷ (550,000 + 600,000) = 11.04% Shalla Corporation – Example The rates of interest for avoidable interest calculation are: Construction Note: 15% All Other Amounts: 11.04% Avoidable Interest: (WAAE up to Construction Specific Debt x Rate) + (Any residual amount of WAAE x Rate) 4 Shalla Corporation – Example Avoidable Interest: $750,000 x 15% 70,000 x 11.04% $820,000 = = $112,500 7,728 $120,228 This amount compared to actual interest paid Other Cost Issues • Cash Discounts • Deferred Payment Contracts – Assets purchased through long term credit (such as notes payable) recorded at present value of consideration exchanged • Lump Sum Purchase Shalla Corporation – Example Actual Interest: $750,000 x 15% 550,000 x 10% 600,000 x 12% Total Actual Interest Paid = = = $112,500 55,000 72,000 $239,500 Avoidable Interest = $120,228 Actual Interest = $239,500 The lesser of these two amounts is capitalized Entry: Dr. Building 120,228 Cr. Interest Expense 120,228 Other Cost Issues • Issuance of Shares – Market value of publicly traded shares serve as the cost of the acquired asset – When shares have no determinable market value use the fair value of the acquired asset • Nonmonetary Exchange of Assets – Cost of assets acquired at a single lump sum price allocated to assets on basis of relative fair market values 5 Exchange of Nonmonetary Assets • The basic standard is that the exchange is valued at: Other Cost Issues • Contribution of Assets • Investment Tax Credit (ITC) – the fair value of the asset given up, or – the fair value of the asset received whichever is clearly more evident, and • The rules for gain / loss recognition depend upon whether the assets exchanged are: – dissimilar assets or – similar assets One Approach to Case Analysis Costs Subsequent to Acquisition • If costs incurred increase future benefits, capitalize costs (Capital Expenditure) • If costs maintain a given level of services, expense costs (Revenue Expenditure) • Costs incurred after acquisition can be: – Additions: Increase or extension of existing assets – Improvements and replacements: Substitution of an existing asset for an improved one – Rearrangement and reinstallation: Moving asset from one location to another – Repairs: Costs that maintain assets in operating condition Major Sections of Case Write-Up 1. Context 2. Role 3. Stakeholders 4. For Each Financial Reporting Issue A) State Issue B) Relevant GAAP C) Recommendation D) More Information 5. Ethical Issue 6