Chapter 5
Assets
Learning Objectives
1.
Record the acquisition of property, plant, and equipment.
2.
Determine the cost of assets acquired by the exchange of other
assets.
3.
Compute the cost of a self-constructed asset, including interest
capitalization.
4.
Record costs subsequent to acquisition.
5.
Record the disposal of property, plant, and equipment.
6.
Understand the disclosures of property, plant, and equipment.
7.
Explain the accounting for oil and gas properties. (appendix)
Learning Objectives
8.
9.
10.
11.
12.
13.
14.
15.
16.
17.
18.
Identify the factors involved in depreciation.
Explain the alternative methods of cost allocation, including activity
and time-based methods.
Record depreciation.
Explain the conceptual issues regarding depreciation methods.
Understand the disclosure of depreciation.
Understand additional depreciation methods, including group and
composite methods.
Compute depreciation for partial periods.
Explain the impairment of noncurrent assets.
Understand depreciation for income tax purposes.
Explain changes and corrections of depreciation.
Understand and record depletion.
Operational Assets
Actively Used in Operations
Expected to Benefit Future Periods
le
Intangible
al
nce
No Physical
Substance
le
al
nce
Operational Assets
Actively Used in Operations
Examples
• Assets subject to depreciation
Expected to Benefit Future
Periods
Buildings and equipment
Furniture and fixtures
• Natural resource assets
subject to depletion
Mineral deposits and timber
• Land
Characteristics of Property, Plant, and Equipment
To be included in the property, plant, and
equipment category, an asset must have three
characteristics:
1.
The asset must be held for use and not for
investment.
2.
The asset must have an expected life of more
than one year.
3.
The asset must be tangible in nature.
Operational Assets
Actively Used in Operations
Examples
• ValueExpected
represented
rights Future Periods
toby
Benefit
that produce benefits
Goodwill
Patents
Copyrights
Intangible
Trademarks
No Physical
Substance
• Assets subject to amortization
Acquisition Cost
General Rule
The historical cost of acquiring an asset
includes the costs necessarily incurred to
bring it to the condition and location
necessary for its intended use.
Acquisition of Property,
Plant, and Equipment
Cost of Buildings
 Contract price
 Remodeling and reconditioning
 Excavating for the specific building
 Architectural and building permit
costs
 Capitalized interest
 Certain unanticipated costs
Acquisition of Property,
Plant, and Equipment
Cost of Machinery, Furniture, and Fixtures




Installation costs
Net purchase price
Modification to building
necessary to install
equipment
Transportation costs
Acquisition of Property,
Plant, and Equipment
Cost of Land
 Contract price
 Costs of closing the
transaction, obtaining
the title, options, legal
fees, title search,
insurance, past due
taxes



Cost of surveys
Clearing and grading
property to get it ready
for its intended use
Razing old buildings
(net of salvage)
Acquisition of Property,
Plant, and Equipment
Cost of Land Improvements




Landscaping
Streets
Sidewalks
Sewers
Acquisition of Property,
Plant, and Equipment
Cost of Land Improvements
Driveways
Parking lots
Fencing
Landscaping
Lump-Sum Purchase
Several assets are acquired for a single,
lump-sum price that may be lower than
the sum of the individual asset prices.
Asset
1 2
Asset
Asset
3 4
Asset
Lump-Sum Purchase
Several assets are acquired for a single,
lump-sum price that may be lower than
the sum of the individual asset prices.
Portions of the lump-sum
price attributable to
particular assets are
assigned to those assets.
Asset
1 2
Asset
Asset
3 4
Asset
Lump-Sum Purchase
Several assets are acquired for a single,
lump-sum price that may be lower than
the sum of the individual asset prices.
Portions of the lump-sum
price attributable to
particular assets are
assigned to those assets.
Asset
1 2
Asset
Asset
3 4
Asset
Allocation of the
remaining lump-sum
price is based on
relative values of
the individual assets.
Acquisition of Property,
Plant, and Equipment
Lump-Sum Purchases
1. Under the proportional method, the value of each asset is
based on the proportion of it’s market value to the total
market value of the group of assets being purchased.
2. The incremental method is used when market values are not
available for all of the assets.
Acquisition of Property,
Plant, and Equipment
Proportional Method
A company pays $120,000 for land and a building.
The land and building are appraised at $50,000 and
$75,000, respectively.
Appraisal
Value
Land
$ 50,000
Building 75,000
Total
$125,000
Relative Fair
Total
Value
x
Cost =
$50,000/$125,000 x $120,000 =
$75,000/$125,000 x $120,000 =
Allocated
Cost
$ 48,000
72,000
$120,000
Acquisition of Property,
Plant, and Equipment
Proportional Method
A company pays $120,000 for land and a building.
The land and building are appraised at $50,000 and
$75,000, respectively.
Land
Building
Cash
48,000
72,000
120,000
Incremental Method
Incremental Method
A company pays $120,000 for a truck and a used custom
made machine. The truck has a value of $70,000 but the
value of the machine is unknown.
Truck
Equipment
Cash
70,000
50,000
120,000
Capitalized Closure
and Removal Costs
When plant assets are used that require substantial costs
of dismantling, removal, and site reclamation at the end of
the asset’s useful life . . .
The present value of these costs should be
capitalized and the associated liability should be
recognized when the following criteria are met:
Capitalized Closure
and Removal Costs
1. The cost can be estimated.
2. The liability is the result of the future requirement to close
or remove the asset, and cannot be satisfied until the
operation of the asset ceases.
3. The liability cannot be avoided if the asset is used as
intended.
Asset Acquisition
• With cash
• On credit
• In exchange for equity securities of the acquiring
company
• Through donation from another entity
• Through construction
• In exchange for
nonmonetary assets
Purchase on Credit
The asset acquired is recorded at the
Cash equivalent price (market value)
or
Present value of future cash payments using the
prevailing market interest rate
Whichever is more objective and reliable. (APB Opinion No.
21)
Purchase on Credit
Example
On May 1, X6, Fesler, Inc. purchased equipment paying
$3,000 down and issuing a note payable. The note
requires four annual payments of $2,500 with the first
payment due on May 1, X7. The note is noninterestbearing. The prevailing market rate of interest on notes of
this nature is 12%.
Prepare the required journal entries on May 1, X6 and
December 31, X6 (year-end).
Purchase on Credit
Example
Annuity payment
$ 2,500
PVA $1, n = 4, i = 12%
3.03735
PV of note (rounded) $ 7,593
Down payment
3,000
Cost of equipment
$ 10,593
Purchase on Credit
Example
GENERAL JOURNAL
Date
5/1
Description
Equipment
Discount on Note Payable
Cash
Note Payable
Discount = $10,000 - $7,593
Page 1
PR
Debit
Credit
10,593
2,407
3,000
10,000
Purchase on Credit
Example
GENERAL JOURNAL
Date
Description
12/31 Interest Expense
Discount on Note Payable
$7,593 ×12% ×8/12 = $607
(rounded)
Page 1
PR
Debit
Credit
607
607
Purchased With Equity Securities
• Asset acquired is recorded at the market value of the
asset or the market value of the securities, whichever is
more objective and reliable.
• If the securities are actively traded, market value can be
easily determined.
• If no objective and reliable value can be determined,
board of directors assigns a reasonable value.
Donated Assets
• Municipalities may donate land and buildings to
induce a company to locate in the area.
• SFAS No. 116 defines a contribution as
“an unconditional transfer of cash or other
assets to
an entity or a settlement or cancellation of its
liabilities in a voluntary nonreciprocal transfer. . .”
Donated Assets
• SFAS NO.116:
Donated assets are capitalized at market
value and revenue from donated assets
is recognized.
Donated Assets
Assets Acquired by Donation
The CEO of Hrouda Company donates a building
worth $50,000 to the company.
Building
50,000
Gain from Donation of Land
50,000
(by a nongovernmental unit)
The gain is reported in the Other section of the
income statement.
Donated Assets
Assets Acquired by Donation
The City of Julesberg (a governmental
unit) donates land worth $20,000 to the
Klemme Company.
Land
20,000
Donated Capital
(by a governmental unit)
20,000
Donated Assets
• Contributed services that enhance nonfinancial assets
are recognized as expenses and revenues on receipt.
• Contribution of collectibles, like works of art for public
display, are disclosed, but not recognized in the
accounts.
Self-Constructed Assets
The cost of materials, labor,
and overhead used in the
self-construction of
property, plant, and
equipment intended for a
firm’s production process
are added to the cost of the
asset.
Self-Constructed Assets
• The asset’s recorded cost must never exceed its fair
market value.
• If costs actually incurred exceed fair market value, a loss
must be recognized.
Self-Constructed Assets
Assume that Kelvin Corporation complete a
project with total construction costs as
follows:
Material
$ 200,000
Labor
500,000
Incremental overhead
60,000
Applied general overhead
40,000
Capitalized interest
Total
100,000
$ 900,000
Self-Constructed Assets
If the asset’s market value at completion
equals or exceeds $900,000:
Equipment
900,000
Equipment under construction
900,000
If the asset’s market value is only $880,000
Equipment
880,000
Loss on construction of equipment 20,000
Equipment under construction
900,000
41
Interest Capitalization - Qualifying Assets
•
They must require a period of time to
make them ready for use.
•
There are two types of qualifying
assets:
1. Assets under construction for use in
operations, and
2. Discrete assets intended for sale or lease.
Interest Capitalization
Interest cannot be capitalized for the following types of assets:
1. Inventories that are routinely manufactured or otherwise
produced in large quantities 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.
Interest Capitalization
• Capitalization begins when . . .
Qualifying expenditures have been made, and
Construction activities are underway, and
Interest cost has been incurred.
• Capitalization ends when . . .
The asset is substantially complete and ready
for
its intended use.
Interest Capitalization
– Avoidable interest
interest that could have been avoided if the asset
were not con-structed and the money used to retire
debt.
45
Interest Capitalization-Computing Avoidable
Interest
1
Determine
weighted-average
accumulated
expenditures
2
Multiply
by
Avoidable interest
Appropriate
interest rate(s)
Interest Capitalization
• Interest is capitalized on Average Accumulated
Expenditures (AAE)
Qualifying expenditures weighted for the number of months
outstanding during the current accounting period.
• Qualifying Expenditures
Cash payments for construction
Transfer of other assets
Incurrence of interest-bearing liabilities
47
Determining Weighted-Average
AccumulatedExpenditures (WAAE): Example
Amber makes the following two payments in 2004:
Jan 31: $24,000
July 31: $18,000
Capitalization period ran from Jan 31 – Dec 31.
What is the WAAE?
Jan 31:
July 31:
$24,000 × (11/12)
$18,000 × (5/12)
WAAE
$22,000
$ 7,500
$29,500
Interest Capitalization
• Interest Potentially Capitalizable (IPC)
Multiply the AAE by the capitalization rate or rates.
Interest Capitalization
• Capitalization Rate(s)
If the qualifying asset is financed through a
specific new borrowing, the interest rate on
the new borrowing is used for the
computation of IPC.
If the qualifying asset is internally financed,
the capitalization rate will be the weightedaverage cost of debt.
Use both rates, if partially financed with a
new borrowing.
Interest Capitalization
AAE less than specific new borrowing
Capitalize AAE
using specific
borrowing rate
AAE
Specific
new
borrowing
Interest Capitalization
AAE more than specific new borrowing
Other debt
Capitalize this part of AAE
using weighted average
rate of other debt
Capitalize this part
of AAE using specific
borrowing rate
Specific new
borrowing
AAE
Interest Capitalization
Steps in the capitalization process
1. Compute actual interest expense.
2. Compute AAE.
3. Compute IPC.
4. Capitalize the smaller of actual interest or IPC.
Interest Capitalization
Example
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 recorded total interest expense of $175,000 during
the year, including construction borrowing of $1,000,000 on
May 1, from Bub’s Bank for 10 years at 12%.
Interest Capitalization
Example
Actual interest expense is $175,000.
Compute AAE:
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
Example
Compute IPC:
Since we have a specific new borrowing, and
the amount of the borrowing ($1,000,000)
exceeds the AAE ($225,000), we use the
interest rate on the specific new borrowing for
the capitalization.
IPC = AAE × Capitalization rate
IPC = $225,000 × 12% = $27,000
Interest Capitalization
Example
Capitalize the smaller of actual interest or IPC.
Actual interest = $175,000
IPC = $27,000
Capitalize $27,000
Interest Capitalization
Example
GENERAL JOURNAL
Date
Description
12/31 Construction-In-Progress
Interest Expense
Page 14
PR
Debit
Credit
27,000
27,000
Interest Capitalization
Example
GENERAL JOURNAL
Date
Page 14
Description
PR
12/31 Construction-In-Progress
Interest Expense
Description
12/31
Balance
12/31
Capitalization of interest
Credit
27,000
27,000
ACCOUNT NAME: C-I-P
Date
Debit
Account No. 142
PR
Debit
Credit
Balance
785,000
27,000
812,000
Interest Capitalization
Example
GENERAL JOURNAL
Date
Page 14
Description
PR
12/31 Construction-In-Progress
Interest Expense
Description
12/31
Balance
12/31
Capitalization of Interest
Credit
27,000
27,000
ACCOUNT NAME: Interest Expense
Date
Debit
PR
Account No. 571
Debit
Credit
Balance
175,000
27,000
148,000
Disposal of Plant Assets
• Update depreciation to date of disposal.
• Original cost of asset and accumulated depreciation are
removed from the accounts.
• The difference between book value of the asset and the
amount received in the disposal process is recorded as
a gain or loss.
Disposal of Plant Assets
Example
On June 30,2006, MeLo, Inc. sells equipment for
$6,350 cash. The equipment was purchased on
January 1, 19X1 at a cost of $15,000. The asset has a
useful life of 10 years and no salvage value. MeLo last
recorded depreciation on the equipment on December
31, 2005, its year-end.
Prepare the journal entries necessary to record the
disposal of this equipment.
Disposal of Plant Assets
Example
Update depreciation to date of sale.
GENERAL JOURNAL
Date
Description
6/30 Depreciation Expense
Accumulated Depreciation
$15,000 ÷ 10 yrs. ÷ 2 = $750
Page 9
PR
Debit
Credit
750
750
Disposal of Plant Assets
Example
Remove asset and Accumulated Depreciation and
recognize gain or loss.
6/30 Accumulated Depreciation
Cash
Loss on Sale
Equipment
($15,000 ÷10 years) ×5.5years = $8,250
8,250
6,350
400
15,000
Nonmonetary Asset Exchanges
The general exchange principle is that
the cost of a nonmonetary asset acquired
in exchange for another nonmonetary
asset is the fair value of the asset
surrendered.
Nonmonetary Asset Exchanges
• Cost of asset acquired is
Fair value of asset transferred plus cash paid or
minus cash
received
or
Fair value of asset acquired, if it is more readily
determinable.
Nonmonetary Asset Exchanges
The Company acquiring the asset
recognizes a gain or loss on the
exchange as the difference between the
fair value of the asset surrendered and its
book value.
Nonmonetary Asset Exchanges
•
A nonmonetary exchange is considered to
have commercial substance if the
company
(1) Expects a change in future cash flows as a result
of
the exchange and
(2) That expected change is significant relative to the
fair value of the assets exchanged.
Nonmonetary Asset Exchanges
A company would not recognize a gain
if the transaction lacks “commercial
substance; that is, future cash flows are
not expected change significantly.
Assets Acquired by
Exchange of Other Assets
Commercial Substance
Arnold Company
Cost
$100,000
Accum. depr.
54,000
Fair value
40,000
Carbon Company
Cost
Accum. depr.
Fair value
$60,000
32,000
40,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance
Arnold Company
Equipment
Accum. depr.
Loss
Building
Cost
$100,000
Accum. depr.
54,000
Fair value
40,000
Book value
Fair value
Loss
40,000
54,000
6,000
100,000
$46,000
40,000
$6,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance
Company A
Equipment
Accum. depr.
Loss
Building
Cost
$40,000
Book value
Fair value
Loss
40,000
54,000
6,000
100,000
$46,000
40,000
$6,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance
Carbon Company
Building
Accum. Depr.
Equipment
Gain
Book value
Fair value
Gain
40,000
32,000
60,000
12,000
$28,000
40,000
$12,000
Cost
$60,000
Accum. Depr. 32,000
Fair value
40,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance
Carbon Company
Building
Accum. Depr.
Equipment
Gain
Book value
Fair value
Gain
40,000
32,000
60,000
12,000
$28,000
40,000
$12,000
Cost
$40,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance with Boot
Arnold Company
Cost
$100,000
Accum. depr.
54,000
Fair value
40,000
Cash received
5,000
Carbon Company
Cost
Accum. depr.
Fair value
Cash paid
$60,000
32,000
35,000
5,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance with Boot
Arnold Company
Cost
$100,000
Accum. depr.
54,000
Fair value
40,000
Cash received
5,000
Equipment
Accum. depr.
Cash
Loss
Building
Book value
Fair value
Loss
35,000
54,000
5,000
6,000
100,000
$46,000
40,000
$6,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance with Boot
Arnold Company
Cost
$35,000
Equipment
Accum. depr.
Cash
Loss
Building
35,000
54,000
5,000
6,000
100,000
Assets Acquired by
Exchange of Other Assets
Commercial Substance with Boot
Carbon Company
Building
Accum. Depr.
Equipment
Cash
Gain
Book value
Fair value
Gain
40,000
32,000
60,000
5,000
7,000
$28,000
35,000
$7,000
Cost
$60,000
Accum. Depr. 32,000
Fair value
35,000
Cash paid
5,000
Let’s change the subject.
79
Post-Acquisition Expenditures
• If cost incurred increase future benefits,
capitalize costs.
•
If costs maintain a given level of
services,
expense costs.
Post-Acquisition Expenditures
The future economic benefits of a productive asset or
product can be increased by- Extending the life of the asset.
 Improving the productivity.
 Producing the same product at lower
cost.
 Increasing the quality of the product.
Post-Acquisition Expenditures
• Maintenance and ordinary repairs.
• Improvements (betterments), replacements,
and extraordinary repairs.
• Additions.
• Rearrangements and other adjustments.
Post-Acquisition Expenditures
Normally we debit an expense account for
amounts spent on:
Maintenance and Ordinary Repairs
Post-Acquisition Expenditures
Maintenance and Ordinary Repairs
1. Incurred approach
2. Allocation approach
Repair and maintenance expense
xxx
Allowance for repairs and maintenance xxx
Post-Acquisition Expenditures
Normally we debit the asset account for
amounts spent on:
Improvements, Replacements,
and Extraordinary Repairs
Concept: increase useful life or productivity
of the original asset.
Improvements and Replacements
A company decides to replace its oil furnace with a gas furnace.
The oil furnace is carried on the books at a cost of $50,000 with
an accumulated depreciation of $30,000. The scrap value of the
old furnace is $5,000, and the new furnace costs $70,000.
Furnace
Accumulated Depreciation: Furnace
Loss on Disposal of Furnace
Furnace
Cash
Substitution Method
70,000
30,000
15,000
50,000
65,000
Improvements, Replacements and Additions
A capital expenditure of $80,000 is incurred to
enlarge a factory.
Increase the Asset Account
Factory
Cash
80,000
80,000
Improvements and Replacements
A capital expenditure of $60,000 is incurred in
replacing a roof on a factory building.
Reduce Accumulated Depreciation
Accumulated Depreciation
Cash
60,000
60,000
Post-Acquisition Expenditures
Normally we debit the asset account for
amounts spent on:
Additions
Concept: expansion of an existing asset.
Post-Acquisition Expenditures
Normally we debit an other asset account
for amounts spent on:
Rearrangements and Other Adjustments
Concept: increase efficiency of
operations.
Disposal of Property, Plant,
and Equipment
Bean Company has a machine that originally cost
$10,000, has accumulated depreciation of $8,000 at
the beginning of the current year, and is being
depreciated at $1,000 per year. On December 30, the
company sells the machine for $600.
Depreciation
Accumulated Depreciation
1,000
To bring depreciation to point of sale.
1,000
Disposal of Property, Plant,
and Equipment
Bean Company has a machine that originally cost
$10,000, has accumulated depreciation of $8,000 at
the beginning of the current year, and is being
depreciation at $1,000 per year. On December 30,
the company sells the machine for $600.
Cash
Accumulated Depreciation
Loss on Disposal
Machine
600
9,000
400
To record disposal of machine for $600.
10,000
Depreciation Concepts
• The acquisition cost of an operational asset
represents a bundle of future services that help
earn future revenues.
• The matching principle requires that part of the
acquisition cost be expensed in periods when the
future revenues are earned.
Acquisition
Cost
Expense
(Unused)
(Used)
Depreciation Concepts
Depreciation, depletion, and amortization are
cost allocation processes that systematically and
rationally allocate acquisition costs of operational
assets to periods benefited by their use.
Acquisition
Cost
(Unused)
Cost
Expense
Allocation
(Used)
Depreciation Concepts
Type of
Operational
Asset
Expense
Debit
Account Credited
Property, Plant
and Equipment
Depreciation
Accumulated Depreciation
Natural Resource
Depletion
Natural Resource Asset
Intangible
Amortization
Intangible Asset
Depreciation is a cost allocation process
and has nothing to do with asset valuation.
Depreciation Concepts
Depreciation Expense
Accumulated Depreciation
• Temporary account,
reported on the income
statement.
• Permanent account,
reported on the balance
sheet as a deduction from
plant assets.
• Balance in Depreciation
Expense indicates how
much depreciation has
been recorded in the
current year.
• Balance in Accumulated
Depreciation is a
cumulative total of all
depreciation recorded on
an asset.
Depreciation on the Balance Sheet
Property, plant, and equipment:
Land and buildings
Machinery and equipment
Office furniture and equipment
Land improvements
Total
Less Accumulated depreciation
Net property, plant, and equipment
$ 150,000
200,000
175,000
50,000
$ 575,000
(122,000)
$ 453,000
Net property, plant, and equipment is the undepreciated
cost (book value) of the plant assets.
8
Depreciation Concepts
• Depreciation is a means of cost
allocation.
• It is not a method of valuation.
• Depreciation involves:
allocating the cost of tangible assets to
expense in a systematic and rational manner
to periods expected to benefit from use of its
depreciable assets.
Factors Involved in Depreciation
Asset cost
Service life
Residual value
Method of cost allocation
Factors Involved in Depreciation
Residual Value
Residual, or salvage value, is
the net amount that can be
expected to be obtained when
the asset is disposed.
Factors Involved in Depreciation
Service Life
Service life is the measure of the
number of units of service expected
from the asset before its disposal.
Factors Involved in Depreciation
Service Life
The factors that limit the service life
of an asset can be divided into two
general categories.
Physical causes
 Functional causes

Depreciation Methods
Straight-line.
Based on inputs and outputs.
Service hours (SH) method.
Productive output (PO) or units-of-production method.
Accelerated methods.
Sum-of-the-years?digits (SYD).
Double-declining-balance (DB).
Tax depreciation.
Depreciation systems.
Inventory appraisal.
Group and composite.