INTERMEDIATE
ACCOUNTING
CCOUNTING
INTERMEDIATE A
Chapter 10
Property, Plant, and Equipment: Acquisition and Subsequent
Investments
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What are the Characteristics of Property,
Plant, And Equipment? (Slide 1 of 3)
• Property, plant, and equipment (alternatively called plant assets, fixed
assets, or operational assets) are the tangible noncurrent assets that a
company uses in the normal operations of its business.
• To be included in this category, an asset must have three characteristics:
• The asset must be held for use in operations and not for investment. This
characteristic does not imply that the asset must be continuously used.
For example, the furniture and fixtures in coffee shops are included in its
property, plant, and equipment. However, the companies that sold these
items to the coffee shop would categorize them as inventory.
• The asset must have an expected life of more than one year. The asset
represents future economic benefits, or service potential, that the
company will receive over the life of the asset as it is used in the normal
course of business.
• The asset must be tangible in nature. There must be a physical substance
that can be seen and touched.
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What are the Characteristics of Property,
Plant, And Equipment? (Slide 2 of 3)
• A company initially records property, plant, and equipment
assets at acquisition, or historical, cost.
• Because the asset is expected to provide economic benefits to
the company over a period of more than one year, the
company allocates the cost of the asset as an expense to each
period in which the asset is used and the company receives
benefits.
• The use of historical cost as the basis for reporting property,
plant, and equipment provides several advantages:
• The historical cost is equal to the fair value at the date of acquisition.
• The cost provides a verifiable valuation of the asset.
• Gains from holding the asset are recognized only when realized through
a sale transaction.
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What are the Characteristics of Property,
Plant, And Equipment? (Slide 3 of 3)
• Because depreciation is a process of cost allocation rather than
of valuation, the net book value of an asset (cost minus
accumulated depreciation) does not necessarily reflect the
economic value of the asset.
• GAAP requires that a company report its property, plant, and
equipment at its depreciated cost (cost minus accumulated
depreciation).
• However, when the asset becomes impaired such that its fair
value is less than its book value, the asset must be written down to
fair value.
• Under U.S. GAAP, companies are not allowed to write up an
asset if its fair value is above its historical cost. (IFRS allows this.)
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How Do We Account for the Acquisition of
Property, Plant And Equipment?
•
The major types of assets that a company includes in the category of
property, plant, and equipment are land, buildings, equipment, and
leasehold improvements.
•
•
The acquisition cost of property, plant, and equipment includes all costs
necessary to obtain the benefits to be derived from the asset.
•
•
Natural resources, such as timberlands, oil deposits, and mineral deposits, are
also included as property, plant, and equipment.
contract price; minus discounts taken; plus freight, assembly, installation, testing
costs and retirement obligation
GAAP allows a company to either
•
•
(1) include discounts not taken as part of the cost of the asset or
(2) subtract discounts not taken from the cost of the asset and report them as an
expense.
•
Most companies prefer the second approach.
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Land
• The recorded cost of land includes the following:
• contract price
• costs of closing the transaction and obtaining title, including commissions, options,
legal fees, title search, insurance, and past due taxes
• costs of surveys
• costs of preparing the land for its particular use, such as clearing, grading, and
removing old buildings (net of any proceeds from salvage) when such improvements
have an indefinite life
• government assessments for streets, sidewalks, sewers, and water lines for which the
government is responsible for the upkeep and are permanent in nature
• Because land has an indefinite economic life and its residual value is
unlikely to be less than its acquisition cost, land is not depreciated.
• If land is not currently used in operations, but purchased for future use, it is
more representationally faithful to classify it as an investment.
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Land Improvements and Buildings
• A company will often make expenditures that improve the
usefulness of the property, such as landscaping, paving, and
fencing.
• Because these improvements have a limited economic life, a company
should record the costs of these improvements in a Land Improvements
account and depreciate them over their economic lives.
• The recorded cost of buildings includes the following:
•
•
•
•
•
contract price
costs of remodeling and reconditioning
costs of excavation for the specific building
architectural costs and the costs of building permits
capitalized interest costs
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Equipment
• Equipment is a broad term that includes machinery, furniture
and fixtures, office equipment, vehicles, and similar assets.
• The recorded cost of equipment includes the following:
• purchase price, minus any discounts taken, plus sales tax
• transportation costs, plus any insurance costs on the equipment while in
transit
• installation or assembly costs
• initial testing costs
• Therefore, if the cost is necessary to obtain the equipment and
prepare it for use, it should be capitalized as property, plant,
and equipment.
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Leasehold Improvements
• Improvements made by the lessee to leased property that,
unless specifically exempted in the lease agreement, revert to
the lessor at the end of the lease
• Therefore, a lessee capitalizes the cost of a leasehold
improvement, such as the interior design of a retail store, and
depreciates the cost over its economic life or the life of the
lease, whichever is shorter.
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Asset Retirement Obligations
• The acquisition of some operational assets create an asset
retirement obligation—a legal obligation related to the
retirement of the asset.
• In some instances, asset retirement obligations arise from
environmental responsibilities and laws, such as the
requirement to decommission nuclear power plants at the end
of their useful lives or to reclaim the land after mining or
drilling operations have concluded.
• In other settings, asset retirement obligations can arise from
legal arrangements related to the use of an asset.
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Lump-Sum Purchase
• A company may acquire several fixed assets for a single lump-sum
purchase price. To account for the assets on an individual basis, the total
purchase price must be allocated among the individual assets.
• A company allocates the acquisition price in a lump-sum purchase based on
the relative fair values of the individual assets. If only part of the purchase
price can be identified with a specific asset, the specifically identified cost
should be assigned to that asset with the remainder allocated among the
remaining assets based on their relative fair values.
• Evidence of fair value can be obtained from independent sources such as
appraisals, assessed values for property taxes, or other reasonably
accurate approximations of the assets’ market values.
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Deferred (Future) Payments
• When a company acquires property, plant, and equipment in
exchange for making future payments, such as by issuing notes
or bonds or assuming a mortgage, it records the asset at its
fair value or the fair value of the liability on the date of the
transaction, whichever is more clearly evident.
• Note that GAAP’s fair value hierarchy allows a company to
measure fair value as the present value of the future payments
when observable market values are not available.
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Issuance of Securities
• When a company acquires property, plant, and equipment by issuing
securities such as common stock or preferred stock, the company records the
exchange at the fair value of the asset acquired or of the stock issued,
whichever is more clearly evident and representationally faithful.
• Normally the two fair value measures would be very similar, but if they are
materially different, it is necessary to select one. In some situations, one of
the values may be considered more representationally faithful because it is
quoted in an active market.
• Alternatively, if the stock is not actively traded but the asset is one that is
commonly traded, the asset’s fair value would be the better choice.
• If neither of the two fair values is readily observable, the company must
assign the value that it believes to be the most faithful representation of the
transaction (a level 3 input in the FASB’s fair value hierarchy).
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Assets Acquired by Donation
• In certain circumstances, when a company acquires
property, plant, and equipment through donation, it is
a nonreciprocal transfer of nonmonetary assets.
• In general, GAAP requires that a donated asset should be
recorded at its fair value with a corresponding increase in
either revenue or gain, depending on whether the
transaction was part of the company’s ongoing operations
or was a peripheral or incidental transaction.
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Nonmonetary Asset Exchanges
(Slide 1 of 2)
• A nonmonetary exchange is a reciprocal transfer between a company
and another entity in which the company acquires nonmonetary assets or
services by surrendering other nonmonetary assets (Inventory, PP&E) or
services (e.g., trade-in, swap).
• In general, the cost of a nonmonetary asset acquired in exchange for
another nonmonetary asset is the fair value of the asset surrendered.
• If the fair value of the asset received is more clearly evident than the fair value
of the asset surrendered, it can be used to measure the cost of the asset
acquired.
• A gain or loss on the exchange is recognized as the difference between the
fair value of the asset surrendered and its book value.
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Nonmonetary Asset Exchanges
(Slide 2 of 2)
• When a small amount of cash, often referred to as boot, is also given or
received, the cost of the asset acquired and the gain or loss on the
nonmonetary asset surrendered is determined by these equations:
AND
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Exception to the General Rule to
Use Fair Value for Nonmonetary Exchanges
• The conceptual basis of valuing the acquired asset at fair value and
allowing for immediate gain or loss recognition is that, in most exchanges,
the economic position of the two companies has changed as a result of the
exchange.
• When the company’s future cash flows are expected to significantly change
as a result of the exchange, the transaction has commercial substance.
• If an exchange does not have commercial substance and results in a loss,
the general rule discussed earlier is followed. If the exchange does not
have commercial substance and results in a gain, GAAP requires the gain to
be deferred by reducing the cost of the asset.
• If a nonmonetary exchange which lacks commercial substance results in a
gain and cash is received, GAAP allows a portion of the gain to be
recognized. The recognized gain is determined based on a proportion of
the cash received to the total consideration received.
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What Is The Cost Of Self-Constructed Assets?
• Sometimes a company constructs an item of property, plant,
and equipment that it intends to use in its operations.
• Similar to purchased assets, the cost of a self-constructed asset
includes all expenditures necessary to build the asset and put it
in operating condition.
• The costs directly related to construction—direct material and
direct labor—and should be added to the cost of the asset.
• The treatment of two other costs—overhead costs and interest costs—
have generated considerable debate.
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Overhead Costs
(Slide 1 of 2)
• There are two alternatives for a company to include overhead
costs in the cost of a self-constructed asset.
1. Allocate a portion of overhead to the self-constructed asset in the
same manner it allocates overhead to units of inventory
produced. Those in favor of this alternative argue that:
• Construction related overhead is a relevant component of the asset’s
cost and should be accounted for in the same way as regular
products, even though this means that the regular products will be
allocated less of the overhead.
• The cost of the constructed asset will be a more faithful representation
of the cost to acquire and prepare the asset for use.
• Allocating overhead to self-constructed assets enhances comparability
with the cost of an equivalent purchased asset because the seller
normally would include fixed overhead in its selling price.
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Overhead Costs
(Slide 2 of 2)
2. Include only the incremental overhead in the cost of the selfconstructed asset. Those in favor of this alternative argue that:
• To be representationally faithful, the cost of the asset should only
include the additional costs incurred to produce it.
• To be comparable, the allocation of overhead to normal operations
should not change because the overhead would have been incurred
whether or not the construction takes place.
• Common practice is to allocate both variable overhead and a
proportional share of fixed overhead to self-constructed assets.
• If the allocation of overhead causes the cost of the self-constructed
asset to be greater than the fair value of the asset, the asset should
be recorded at its fair value with the excess recognized as a loss in
the current period.
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Interest During Construction
• The FASB considered three alternatives to account for interest
(whether external financing costs or internal cost of capital)
during the construction of property, plant, and equipment.
• Do not capitalize any interest during construction. Under this alternative, a
company would treat interest as a financing cost and would record the
interest as an expense during the period incurred.
• Capitalize an amount of interest (actual or imputed) for all funds used for
construction. Under this alternative, a company would assign an interest
cost to all funds used in construction, whether borrowed or not.
• Capitalize the actual interest on incremental funds borrowed for the
construction. Under this alternative, a company would treat the cost of
borrowed funds as part of the cost of constructing an asset, similar to the
treatment of materials and labor.
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GAAP for Interest Capitalization
(Slide 1 of 2)
• To implement the approach required by GAAP, a company
must address three issues:
• Does the asset qualify for interest capitalization? A company is required
to capitalize interest on assets that are either constructed for its own use
(not land) or constructed as discrete projects for sale or lease to others.
Interest cannot be capitalized for inventories that are routinely
manufactured, assets that are in use or ready for their intended use, or
assets that are idle and are not undergoing the activities necessary to
get them ready for use.
• Over what period can interest be capitalized? The capitalization period
begins when (1) expenditures for the asset have begun, (2) activities that
are necessary to get the asset ready for its intended use are in
progress, and (3) interest cost is being incurred. The capitalization
period ends when the asset is substantially complete and ready for its
intended use.
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GAAP for Interest Capitalization
(Slide 2 of 2)
• What amount of interest can be capitalized? The amount of interest
capitalized for a qualifying asset is the portion of the interest cost
that could have been avoided if the construction had not occurred.
This amount is known as avoidable interest. A company determines
avoidable interest by applying an interest rate to the weighted
average accumulated expenditures for the qualifying asset during
the capitalization period. The specific steps necessary to determine
the amount of avoidable interest that can be capitalized are
described next.
• If a company suspends substantially all the activities related to
the construction of the asset, it suspends interest capitalization
until the activities are resumed.
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Interest Capitalization Procedures
(Slide 1 of 2)
Step 1: Determine the Weighted average accumulated
expenditures for the period, defined as the sum of the
construction expenditures weighted by the amount of time that
interest cost could have been incurred on those expenditures
during the construction period.
Step 2: Determine the appropriate interest rate.
• If the weighted average accumulated expenditures are less than or
equal to the funds borrowed specifically to finance the construction of a
qualifying asset, the company uses the interest rate on that specific
borrowing.
• If the weighted average expenditures on the asset are greater than the
specific borrowing or if no specific borrowing is made, the company uses
both the interest rate on the specific borrowing and a weighted average
interest rate on all other borrowings
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Interest Capitalization Procedures
(Slide 2 of 2)
Step 3: Compute avoidable interest by applying the appropriate
interest rate(s) to the weighted average accumulated
expenditures.
Step 4: Capitalize the lesser of avoidable interest or actual interest.
The total amount of interest cost that a company capitalizes
each period may not exceed the actual interest cost incurred.
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Capitalized Interest –
Multiple Accounting Periods
• It is common for the construction project to extend beyond the
end of a company’s fiscal year.
• In this situation, the procedure shown previously is repeated for
the subsequent year with one adjustment—the total
expenditures plus capitalized interest from the previous year is
considered to be an outstanding expenditure as of the first
day of the subsequent year.
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Impact of Interest Capitalization
• When a company capitalizes interest costs instead of expensing
them, it triggers two effects on the financial statements:
• The company will report higher amounts for property, plant, and
equipment due to the capitalized interest being added to the acquisition
cost of the equipment.
• The company does not report the capitalized amount of interest as
interest expense during the construction period. Therefore, the company
will report higher income than it otherwise would if it had expensed the
full amount of interest. In addition, all things being equal, the capitalized
interest will result in higher depreciation expense in future periods.
Therefore, the capitalization of interest is essentially a question of asset
valuation and timing of the expense recognition.
• GAAP requires that companies disclose both the capitalized interest
amount and the total interest cost incurred in the notes to its financial
statements.
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How Do We Account for Expenditures
Subsequent to Acquisition? (Slide 1 of 2)
• After initial acquisition, companies make various expenditures
relating to property, plant, and equipment for purposes
ranging from routine repairs to major overhauls and
improvements.
• The related accounting decision is whether to report these
expenditures as investments that enhance property, plant, and
equipment or to expense them.
• Conceptually, if the expenditure is expected to increase the future economic
benefits of the asset, it should be capitalized (recorded as an asset).
• Otherwise, it should be recorded as an expense.
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How Do We Account for Expenditures
Subsequent to Acquisition?
• An expenditure that increases the
expected future economic
benefits of the asset above those
that originally were expected is
called a capital expenditure.
• An expenditure that does not increase
the economic benefits but is incurred to
maintain the existing benefits is an
operating expenditure (revenue
expenditure) and is expensed in the
period incurred.
• The future economic benefits can
be increased by:
• Many companies establish a lower
limit, or materiality threshold, on the
amount of expenditure that will be
capitalized. Any amount below the
lower limit will be expensed,
regardless of whether it provides
future benefits or not.
• extending the life of the asset
• improving productivity of the
asset by enabling the asset to
produce more goods at the same
cost or by producing the same
quantity of goods at a lower cost
• increasing the quality of the
product
• Subsequent expenditures can be
classified as additions, improvements
and replacements, rearrangements,
and repairs and maintenance.
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Additions
• An addition involves enlarging an existing asset by adding a
new component and they are capitalized as an asset.
• When an addition involves changing an existing asset, an issue
arises as to how to account for the cost of such changes.
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Improvements and Replacements
(Slide 1 of 3)
• An improvement (betterment) is the substitution of a better
asset for the one currently used, such as the installation of a
new solar heating system in a building.
• A replacement (renewal) is the substitution of an equivalent
asset, such as a new engine in a truck. Expenditures related to
improvements and replacements are capitalized as assets.
• There are three alternative methods for a company to account
for such capitalized expenditures:
• Substitution
• Reduction of Accumulated Depreciation
• Capitalization as a New Asset
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Improvements and Replacements
(Slide 2 of 3)
• Substitution: Under this method, the book value of the old asset is removed
and a new asset is recorded. This only works if the book value of the old
asset is known. This may not happen when purchased as part of a bigger
asset, like a building.
• Reduction of Accumulated Depreciation: This method reduces accumulated
depreciation, thereby increasing the asset’s book value, for the cost of the
improvement or replacement. This method is appropriate when the
expenditure extends the service life of the asset which, in effect, restores
some of the service potential of the asset that had previously been
depreciated.
• Capitalization as a New Asset: Under this method, the expenditure is
capitalized as a new asset without removing the carrying amount of the old
asset. This method is most appropriate for additions. This method is also
appropriate for improvements and replacements, particularly if the book
value of the old asset has been sufficiently depreciated to an immaterial
amount.
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Improvements and Replacements
(Slide 3 of 3)
• Rearrangement and moving: The costs of rearranging the facilities within a
building or moving them to a new location are capitalized as assets and
depreciated over the period expected to benefit.
• If these costs are immaterial or if it’s uncertain that the costs will provide future
benefits, the company should expense such costs in the period incurred.
• Repairs and maintenance: Routine expenditures for repair and
maintenance do not increase the future economic benefits of the asset but,
instead, maintain the existing benefits provided by the asset and should be
expensed in the period incurred.
• Usually a company expenses the cost of these major repairs.
• If these repairs increase the future benefits of the asset similar to an
improvement or replacement, the cost should be capitalized.
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