Chapter 10

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Chapter 10:
Acquisition and Disposition of
Property, Plant and Equipment
1
Classification of PP&E

Long-term assets have a number of
classifications. Assets are classified in
PP&E if they possess the following
characteristics:
– Acquired for use in operations and not for
resale. For example, if land is held for resale it
would either be classified in inventory or
investment.
– Long term in nature and usually depreciated
(except for land).
– Possess physical substance. This
characteristic excludes intangibles such as
patents and goodwill.
2
Costs to Capitalize

General Rule:
– Capitalize (add to an asset account) the costs
to acquire the asset and to prepare it for its
intended use.
 Note: for all acquisitions, part of the cost is the
purchase price, specifically the “cash equivalent”
purchase price (the amount we would pay if we
paid cash). This excludes any cost of financing
the purchase (interest expense).
3
Costs to Capitalize
Land
– purchase price, clearing costs, survey
costs, accrued taxes, closing costs,
brokerage fees, commissions, title
insurance, etc. Note that proceeds from
salvage of materials from clearing land
are used to offset the cost of the land.
 Land improvements
– purchase price, for some landscaping
(temporary), parking lots, sidewalks
and fences.

4
Costs to Capitalize
Machinery and equipment
– purchase price, taxes, freight, insurance
while in transit, installation, assembly, trial
runs, testing and inspection during set up
(preproduction costs).
 Buildings
– purchase price (or cost to construct –
material, labor, overhead), closing costs,
attorney’s fees, building permits, etc.

5
Costs to Capitalize

Note: interest is not capitalized on purchase of
PP&E; it is treated as a finance charge
(interest expense).
 If a purchase discount is offered, the asset is
recorded net of the discount (cash equivalent
price), even if the discount is not taken.
 One exception to the non-capitalization of
interest: For self-constructed assets
(equipment, buildings, etc), companies are
allowed to capitalize interest costs (put the
interest in the asset account), but only for the
interest incurred during the construction period.
6
Interest Cost Capitalization

Applicable to self-constructed assets where an
extended period is required and significant
expenditures are made during construction.
 Types of assets that qualify:
– Assets constructed by a company for its own
use.
– Assets that are intended for sale or lease that
are discrete projects (e.g., real estate
developments).
 Capitalization period begins when
– Expenditures have been made.
– Construction activities are underway.
– Interest cost is being incurred.
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Interest Cost Capitalization
1. Calculate Average Accumulated Expenditures
(AAE), the amount to which interest costs will be
assigned; weighted average based on time
outstanding during the construction period.
Example 1 (for period ending 12/31/12),
assuming construction has begun by April 1,
2012:
Date
Payment Fraction
April 1 $90,000 x 9/12 =
$ 67,500
June 1 45,000 x 7/12 =
26,250
Dec. 1 12,000 x 1/12 =
1,000
Avg. Accumulated Expenditures $94,750
This is the annualized average spending for the
year, and is the basis for the interest calculation.
8
Interest Cost Capitalization
If construction ended on December 1, 2012, the
numerator is changed to reflect the period
outstanding through December 1:
Date
Payment Fraction
April 1 $90,000 x 8/12 =
$ 60,000
June 1 45,000 x 6/12 =
22,500
Dec. 1 12,000 x 0/12 =
__0___
Avg. Accumulated Expenditures $82,500
If construction goes into the second year, the
balance in the Building (Construction in
Progress) account, including capitalized interest,
is carried forward as the starting expenditures for
the second year.
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Interest Cost Capitalization
2. Calculate the avoidable interest.
First: use the specific borrowing rate on any funds
borrowed specifically for the project.
Next: if applicable, use the weighted average
borrowing rate on the remaining borrowings.
If specific borrowing in Example 1 is $50,000 at a 4
percent interest rate, and the remainder of the
borrowing is $200,000 at an average rate of 5%:
Specific borrowing $50,000 x .04 = $2,000
Other borrowing
44,750 x .05 = 2,238
Total
$94,750
$4,238
Avoidable Int.
.
10
Interest Cost Capitalization
3. Compare avoidable interest to total interest where
total interest (assuming all notes have been
outstanding since January 1, 2012) is calculated
as follows:
50,000 x .04 = 2,000
200,000 x .05 = 10,000
Total interest =
12,000 (greater than avoidable)
So capitalize avoidable interest (cannot have
negative interest expense).
11
Interest Cost Capitalization
4. Summary journal entries for 2012:
(a) Actual expenditures (90,000+ 45,000+12,000)
Building (CIP)
147,000
Cash
147,000
(b) Actual interest paid:
Interest Expense 12,000
Cash
12,000
(c) Capitalization of avoidable interest:
Building (CIP)
4,238
Interest Expense
4,238
If construction continues in 2013, the starting
balance for expenditures will be $151,238.
12
Additional Valuation Issues
Nonmonetary Exchanges – exchange of PP&E
where cash is a small part of the exchange (see
handout on Nonmonetary Exchanges.
Deferred Payment Contracts – even when note is
“non-interest bearing” transaction to record asset
purchase must separate interest component from
cash equivalent price of the asset (use present
value to estimate the cash equivalent price).
Lump Sum Purchases – use proportional fair
market value to allocate cost to specific assets.
Purchase with the Issuance of Stock – if stock
price known, use stock price to value asset
received; if stock price not known, use fair value of
asset received to value stock issued.
13
Costs Subsequent to Acquisition
If cost is incurred to achieve greater future
benefit, the cost should be capitalized.
If cost is incurred to maintain existing
performance, the cost should be expensed.
Capitalization requires one of the three
following conditions to be met:
1. The useful life of the asset is increased
2. The quantity of output from the asset is
increased.
3. The quality of output must be enhanced.
14
Treatment of Subsequent Costs
Additions – new asset is created, and the costs
should be capitalized.
Improvements and Replacements –
Improvements (betterments) substitute a better
asset for the existing asset. Replacements
substitute a similar asset for the existing asset.
Alternate treatments:
1. Substitution approach – remove old asset,
record new asset, recognize gain or loss.
2. Capitalize new cost, and leave old asset or
component on the books.
3. Reduce Accumulated Depreciation – if the
cost extends the useful life.
15
Treatment of Subsequent Costs
Rearrangement and Reinstallation – incurred to
increase efficiency and to benefit future
periods. Usually capitalize new costs and
amortize over periods benefitted (old costs
may be difficult to separate and remove).
Repairs –
Ordinary repairs undertaken to maintain
existing conditions should be expensed in the
period incurred.
Major repairs often improve the asset’s
performance or extend its useful life; these
expenditures should be capitalized.
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