CHAPTER 10 Acquisition and Disposition of Property, Plant, and Equipment ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC) Topics Questions Brief Exercises Exercises Problems Concepts for Analysis 1, 2, 3, 4, 5, 13 1, 2, 3, 1, 6, Valuation and classification of land, buildings, and equipment 1, 2, 3, 4, 6, 7, 12, 13, 21 Self-constructed assets, capitalization of overhead 5, 8, 20, 21 4, 6, 12, 16 Capitalization of interest 8, 9, 10, 11, 2, 3, 13, 21 4, 5, 7, 8, 9, 10, 16 1, 5, 6, 3, 4 Exchanges of assets 12, 16, 17 8, 9, 10, 11, 12 3, 11, 16, 17, 18, 19, 20 4, 8, 9, 10, 11 5 Lump-sum purchases, issuance of stock, deferredpayment contracts 12, 14, 15 5, 6, 3, 6, 11, 12, 1, 2, 3, 11 13, 14, 15, 16 Costs subsequent to acquisition 18, 19, 21 13 21, 22, 23 Alternative valuations 22 Disposition of assets 23 14, 15 24, 25 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-1 ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE) Learning Objectives Brief Exercises Exercises Problems 1, 2, 3, 4, 5, 11, 12, 13 1, 2, 3, 4, 5, 6, 11 4, 5, 6, 11, 12 Describe property, plant, and equipment Identify the costs to include in initial valuation of property, plant, and equipment Describe the accounting problems associated with self-constructed assets Describe the accounting problems associated with interest capitalization 2, 3, 5, 6, 7, 8, 9, 10 5, 6, Understand accounting issues related to acquiring and valuing plant assets 5, 6, 7, 8, 9, 10, 11, 12 11, 12, 13, 14, 15, 16, 17, 18, 19, 20 3, 4, 8, 9, 10, 11 Describe the accounting treatment for costs subsequent to acquisition 13 21, 22, 23 Describe the accounting treatment for the disposal of property, plant, and equipment 14, 15 24, 25 10-2 2, Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ASSIGNMENT CHARACTERISTICS TABLE Description It e m Level of Difficu lty Time (minut es) E10-1 E10-2 E10-3 E10-4 E10-5 E10-6 E10-7 E10-8 E10-9 E10-10 E10-11 E10-12 E10-13 E10-14 E10-15 E10-16 E10-17 E10-18 E10-19 E10-20 E10-21 E10-22 E10-23 E10-24 E10-25 Acquisition costs of realty Acquisition costs of realty Acquisition costs of trucks Purchase and self-constructed cost of assets Treatment of various costs Correction of improper cost entries Capitalization of interest Capitalization of interest Capitalization of interest Capitalization of interest Entries for equipment acquisitions Entries for asset acquisition, including self-construction Entries for acquisition of assets Purchase of equipment with zero-interest-bearing debt Purchase of computer with zero-interest-bearing debt Asset acquisition Nonmonetary exchange Nonmonetary exchange Nonmonetary exchange Nonmonetary exchange Analysis of subsequent expenditures Analysis of subsequent expenditures Analysis of subsequent expenditures Entries for disposition of assets Disposition of assets Moderate Simple Simple Moderate Moderate Moderate Moderate Moderate Moderate Moderate Simple Simple Simple Moderate Moderate Moderate Simple Moderate Moderate Moderate Moderate Simple Simple Moderate Simple 15–20 10–15 10–15 20–25 30–40 15–20 20–25 20–25 20–25 20–25 10–15 15–20 20–25 15–20 15–20 25–35 10–15 20–25 15–20 15–20 20–25 15–20 10–15 20–25 15–20 P10-1 P10-2 P10-3 P10-4 Classification of acquisition and other asset costs Classification of acquisition costs Classification of land and building costs Dispositions, including condemnation, demolition, and trade-in Classification of costs and interest capitalization Interest during construction Capitalization of interest Nonmonetary exchanges Nonmonetary exchanges Nonmonetary exchanges Purchases by deferred payment, lump-sum, and Moderate Moderate Moderate Moderate 35–40 40–55 35–45 35–40 Moderate Moderate Moderate Moderate Moderate Moderate Moderate 20–30 25–35 20–30 35–45 30–40 30–40 35–45 P10-5 P10-6 P10-7 P10-8 P10-9 P10-10 P10-11 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-3 nonmonetary exchanges 10-4 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ASSIGNMENT CHARACTERISTICS TABLE (Continued) It e m Description Level of Difficu lty Time (minut es) CA10-1 CA10-2 Acquisition, improvements, and sale of realty Accounting for self-constructed assets Moderate Moderate 20–25 20–25 CA10-3 CA10-4 CA10-5 CA10-6 Capitalization of interest Nonmonetary exchanges Costs of acquisition Cost of land vs building—ethics Simple Moderate Simple Moderate 20–25 30–40 20–25 20–25 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-5 LEARNING OBJECTIVES 10-6 Describe property, plant, and equipment Identify the costs to include in initial valuation of property, plant, and equipment Describe the accounting problems associated with self-constructed assets Describe the accounting problems associated with interest capitalization Understand accounting issues related to acquiring and valuing plant assets Describe the accounting treatment for costs subsequent to acquisition Describe the accounting treatment for the disposal of property, plant, and equipment Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) CHAPTER REVIEW Chapter 10 presents a discussion of the basic accounting problems associated with the incurrence of costs related to property, plant, and equipment; and the accounting methods used to retire or dispose of these costs These assets, also referred to as fixed assets, are of a durable nature and include land, building structures, and equipment Fixed assets are an important part of the operations of most business organizations They provide the major means of support for the production and/or distribution of a company’s product or service (L.O 1) Property, plant, and equipment possess certain characteristics that distinguish them from other assets owned by a business enterprise These characteristics may be expressed as follows: (a) acquired for use in operations and not for resale, (b) long-term in nature and usually depreciated, and (c) possess physical substance An asset must be used in the normal business operations to be classified as a fixed asset These assets last for a number of years and their costs must be allocated to the periods which benefit from their use Acquisition of Property, Plant, and Equipment (L.O 2) Property, plant and equipment are valued in the accounts by most companies at their historical cost Historical cost is measured by the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use Thus, charges associated with freight costs and installation are considered a part of the asset’s cost The topic of depreciation is presented in Chapter 11 Subsequent to acquisition, companies should not write up property, plant, and equipment to reflect fair value when it is above cost because (a) historical cost involves actual, not hypothetical transactions and so is the most reliable, and (b) gains and losses should not be anticipated, but should be recognized only when the asset is sold The assets normally classified on the balance sheet as property, plant, and equipment include land, buildings, and various kinds of machinery and equipment The cost of each item includes the acquisition price plus those expenditures incurred in getting the asset ready for its intended use The cost of land, cost typically includes (a) purchase price (b) closing costs such as title to the land, attorneys’ fees, and recording fees (c) costs of grading, filling, draining, and clearing the property (d) assumption of any liens, mortgages, or encumbrances on the property (e) any additional land improvements that have an indefinite life (f) costs of removing an old building from land purchased for the purpose of constructing a new building When improvements that have a limited life (fences, driveways, etc.) are made to the land they should be set up in a separate Land Improvements account so they can be depreciated over their estimated useful life Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-7 Building costs include materials, labor, and overhead costs incurred during construction Any fees such as those incurred for building permits or the services of attorneys and architects are included in acquisition cost In general, all costs incurred from excavation of the site to the completion of the building are considered part of the building costs With respect to equipment, cost includes the purchase price plus all expenditures related to the purchase that occur subsequent to acquisition but prior to actual use These related costs would include such items as freight charges, insurance charges on the asset while in transit, assembly and installation, special preparation of facilities, and asset testing costs Self-Constructed Assets (L.O 3) When machinery and equipment to be used by a company are constructed rather than purchased, a problem exists concerning the allocation of overhead costs These costs may be handled in one of two ways: (a) assign no fixed overhead to the cost of the constructed asset, or (b) assign a portion of all overhead to the construction process The second method called a full-costing approach appears preferable because of its consistency with the historical cost principle It should be noted that the cost recorded for a constructed asset can never exceed the price charged by an outside producer Interest Costs During Construction 10 (L.O 4) Capitalization of interest costs incurred in connection with financing the construction or acquisition of property, plant, and equipment generally follows the rule of capitalizing only the actual interest costs incurred during construction While some modification to this general rule occurs, its adoption is consistent with the concept that the historical cost of acquiring an asset includes all costs incurred to bring the asset to the condition and location necessary for its intended use 11 To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use Assets that qualify for interest cost capitalization include assets under construction for a company’s own use (such as buildings, plants, and machinery) and assets intended for sale or lease that are constructed or otherwise produced as discrete projects (like ships or real estate developments) The period during which interest must be capitalized begins when three conditions are present: (a) expenditures for the asset have been made; (b) activities that are necessary to get the asset ready for its intended use are in progress; and (c) interest cost is being incurred 12 The amount of interest to capitalize is limited to the lower of (a) actual interest cost incurred during the period or (b) the amount of interest cost incurred during the period that theoretically could have been avoided if the expenditure for the asset had not been made (avoidable interest) The potential amount of interest that may be capitalized during an accounting period is determined by multiplying interest rate(s) by the weighted-average amount of accumulated expenditures for qualifying assets during the period 10-8 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 13 A comprehensive illustration of interest capitalization is shown on pages 544–546 This illustration includes both the computations and the related journal entries that should be made in a situation when an asset is constructed and capitalizable interest is a part of the transaction 14 Two special issues relate to interest capitalization If a company purchases land as a site for a plant, interest costs capitalized during the period of construction are part of the cost of the plant, not the land In addition, companies should generally not net or offset interest revenue against interest cost, even when construction funds are temporarily invested Acquisition and Valuation 15 (L.O 5) In general, an asset should be recorded at the fair value of what is given up to acquire it or at the fair value of the asset received, whichever is more clearly evident Determining fair value is not always as easy as it might appear Some problems that may be encountered in determining proper valuation follow 16 The purchase of a plant asset is often accompanied by a cash discount for prompt payment If the discount is taken, it results in a reduction in the purchase price of the asset However, when the discount is allowed to lapse, should a loss be recorded or should the asset be recorded at a higher purchase price? Currently, while the “loss approach” is preferred, both methods are employed in practice 17 Plant assets purchased on deferred payment contracts should be accounted for at the present value of the consideration exchanged on the date of purchase When the obligation stipulates no interest rate, or the rate is unreasonable, an imputed rate of interest must be determined for use in calculating the present value Factors to be considered in imputing an interest rate are the borrower’s credit rating, the amount and maturity date of the note, and prevailing interest rates If determinable, the cash exchange price of the asset acquired should be used as the basis for recording the asset and measuring the interest element 18 In some instances a company may purchase a group of plant assets at a single lump sum purchase price The best way to allocate the purchase price of the assets to the individual items is to base the allocation on the relative fair values of the assets acquired To determine fair value, a company should use valuation techniques that are appropriate in the circumstances 19 When assets are acquired in exchange for a company’s own stock, the best measure of cost is the fair (market) value of the stock issued Exchanges of Nonmonetary Assets 20 Nonmonetary assets such as inventory or property, plant, and equipment are items whose price may change over time Controversy exists in regard to the accounting for these assets when one nonmonetary asset is exchanged for another nonmonetary asset 21 Ordinarily, companies account for the exchange of nonmonetary assets on the basis of the fair value of the asset given up or the fair value of the asset received, whichever is clearly more evident Companies should recognize immediately any gains or losses on the exchange The rationale for immediate recognition is that most transactions have Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-9 commercial substance and therefore, should be recognized at the completion of the earnings process An exchange has commercial substance if the future cash flows change as a result of the transaction An exchange of trucks with different useful lives might have commercial substance, while an exchange of trucks with no significant difference in useful lives would probably not 22 When a transaction involves an exchange of nonmonetary assets, losses are always recognized Accounting for gains depends on whether the exchange has commercial substance If the exchange has commercial substance, the company recognizes any gain immediately Gains are deferred (not immediately recognized) if the exchange has no commercial substance, unless cash or some other form of monetary consideration is received, in which case a partial gain is recognized The portion to be recognized is equal to the ratio of the cash received to the total consideration received times the total gain indicated 23 A gain or loss on the exchange on nonmonetary assets is computed by comparing the book value of the asset given up with the fair value of that same asset The examples shown below demonstrate the various situations where exchanges of nonmonetary assets are included Exchange with Commercial Substance Al Company exchanged a used machine with a book value of $26,000 (cost $54,000 less $28,000 accumulated depreciation) and cash of $8,000 for a delivery truck The machine is estimated to have a fair value of $36,000 Cost of truck: Fair value of machine exchanged Cash paid Cost of truck Journal entry: Trucks Accumulated Depreciation—Machinery Machinery Gain on Disposal of Machinery Cash $36,000 8,000 $44,000 $44,000 28,000 54,000 10,000 8,000 Exchange with No Commercial Substance Al Company trades drill press A for drill press B from another company Drill Press A has a book value of $11,000 (cost $32,000 less $21,000 accumulated depreciation) and a fair value of $8,000 Drill press B has a list price of $38,000, and the seller has allowed a trade-in allowance of $15,000 on the press Cost of new machine: List price of drill press B Less trade-in allowance Cash payment due Fair value of drill press A Cost of drill press B 10-10 $38,000 15,000 23,000 8,000 $31,000 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) insurance while in transit, assembling and installation costs, the cost of conducting trial runs, and a deduction for cash discounts whether taken or not d (L.O 3) Self-Constructed Assets: Such assets may cause valuation problems because of the assignment of overhead The options are to assign a portion of all overhead costs, or assign no fixed overhead costs The first option, which is called the full-costing approach, is preferred because many believe that it results in a better matching of costs with revenues C (L.O 4) Interest Costs During Construction Basic principle: Interest cost incurred during the construction of plant assets is part of the cost of acquiring the assets and preparing them for their intended use Like other acquisition costs, interest cost should be capitalized and depreciated over the expected useful life of the assets involved Describe the computational steps involved in determining the amount of interest to be capitalized T EACHING T IP Illustration 10-1 provides a step-by-step description of interest capitalization a Determine which assets qualify for capitalization of interest b Determine the capitalization period c Compute the expenditures made during the capitalization period d Compute the weighted-average accumulated expenditures e Compute avoidable interest. Typically, this computation is difficult for students They must pay attention to the dates of construction expenditures and to the date of specific construction loans and other outstanding general debt f Compute the actual interest cost incurred g Determine the interest cost to be capitalized T EACHING T IP Illustration 10-2 provides a numerical example of interest capitalization for self-constructed special-purpose equipment Illustration 10-3 provides a flowchart diagram of the GAAP requirements on capitalization of interest Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-15 Special issues related to interest capitalization a Interest costs incurred in the purchase of land to be used for a building site are part of the building’s cost, not the land b Interest costs incurred on land being developed for lot sales, are part of the land’s cost c Interest revenue earned on funds borrowed to finance construction of assets is not netted against the interest expense incurred D (L.O 5) Acquisition and Valuation of Plant Assets Cash Discounts: The asset should be recorded at the current cash equivalent price at the date of acquisition It is preferable to exclude the cash discount from the recorded cost of the asset, whether the discount is taken or not Any discount not taken should be recorded as an expense Deferred-Payment Contracts: Assets purchased on long-term credit contracts should be accounted for at the present value of the consideration exchanged at the date of the transaction When no interest rate is stated, or if the specified rate is unreasonable, an appropriate rate should be imputed (At this point, it would be useful to review the procedure for computing the present value of a note.) Lump-Sum Purchases: Total cost should be allocated on the basis of relative fair values of the assets acquired To determine fair value, a company should use the market, income or cost valuation approach The company should assume the highest and best use of the asset in determining the fair value Issuance of Stock: The market price of stock issued is a fair indication of the cost of the property acquired If the stock’s market price is not determinable, use the fair value of the property acquired Exchanges of property, plant, and equipment (nonmonetary assets) In presenting this topic, it is important to emphasize both the basic accounting procedures and the basic accounting principles involved a Commercial substance is the basis for immediate recognition of any gain or loss on the exchange b Basic accounting procedures T EACHING T IP Illustration 10-4 provides an overview of the accounting procedures employed in the exchange of nonmonetary assets Illustration 10-5 illustrates these accounting procedures in a flowchart (1) Compute the book value of the old asset (2) Compute the total gain or loss 10-16 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) (3) Determine the amount of gain or loss to be recognized (4) Prepare the journal entry to record the exchange T EACHING T IP Illustration 10-6 provides a numerical example of an exchange that lacks commercial substance with cash paid and received Remind students to ensure that their entry balances; this is frequently overlooked Accounting for contributions (nonreciprocal transfers) a Acquisition: The fair value of the asset should be used to record the asset on the company’s books The corresponding credit which the company will record is contribution revenue in the amount of the asset’s fair value b Disposition: When a plant asset is contributed, two types of income statement accounts may be affected (1) Contribution expense should be recorded at the fair value of the asset (2) A gain or loss should be recorded for the difference between the fair value and the book value of the asset Other Asset Valuation Methods The prudent cost concept states that it is theoretically preferable to charge a loss immediately if a company ignorantly pays too much for an asset originally E (L.O 6) Costs Subsequent to Acquisition. In general, costs incurred to achieve greater future benefits should be capitalized, but expenditures that simply maintain a given level of services should be expensed In order to capitalize costs, one of three conditions must be present: a The useful life of the asset must be increased b The quantity of units produced from the asset must be increased c The quality of the units produced must be enhanced T EACHING T IP Illustration 10-7 provides a comparative summary of costs subsequent to the acquisition of property, plant, and equipment Additions. Any additions should be capitalized because a new asset is created Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-17 Improvements and Replacements. If the expenditure increases the future service potential of the asset, a company should capitalize it If the carrying value of the old component is known, the substitution approach is used, which removes the cost of the old asset and replaces the it with the cost of the new asset If the carrying value of the old asset is unknown, the cost of the new asset is capitalized and the cost of the old asset remains in the accounting records If the new asset acquired does not improve the quantity or quality of the original asset, but instead extends the useful life, the company debits the expenditure to Accumulated Depreciation Rearrangement and Reinstallation The proper accounting treatment depends on whether the carrying value of the original installation is known (treated as a replacement) or unknown If a company can determine or estimate the original installation cost and the accumulated depreciation to date, it handles the rearrangement and reinstallation cost as a replacement If not, which is generally the case, the company should capitalize the new costs (if material in amount) as an asset to be amortized over future periods expected to benefit Repairs a Ordinary repairs should be expensed in the period incurred b Major repairs should be treated as an addition, improvement, or replacement F (L.O 7) Dispositions of Plant Assets. Depreciation up to the date of disposition must be recorded The cost and accumulated depreciation of the asset must be removed from the books, any cash received must be recorded, and a gain or loss is recognized Sale of Plant Assets Involuntary Conversion. Gains or losses are the same in any other type of disposition regardless of whether any resulting cash proceeds are going to be reinvested in replacement assets Abandonment The gain or loss is the difference between the asset’s scrap value (if any) and its book value 10-18 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 10-1 CAPITALIZATION OF INTEREST COST Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-19 ILLUSTRATION 10-2 CAPITALIZATION OF INTEREST EXAMPLE 10-20 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 10-2 (continued) Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-21 ILLUSTRATION 10-3 FLOWCHART FOR DETERMINING CAPITALIZATION OF INTEREST COST 10-22 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 10-4 ACCOUNTING FOR NONMONETARY EXCHANGES Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-23 ILLUSTRATION 10-5 NONMONETARY EXCHANGE FLOWCHART 10-24 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-25 ILLUSTRATION 10-6 EXCHANGE OF NONMONETARY ASSETS (WITH AND WITHOUT BOOT) 10-26 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 10-6 (continued) Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-27 ILLUSTRATION 10-7 SUMMARY OF COSTS SUBSEQUENT TO ACQUISITION OF PROPERTY, PLANT, AND EQUIPMENT 10-28 Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) 10-29 ... Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For... Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 10-2 (continued) Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual. .. Inc. Kieso, Intermediate Accounting, 15/e Instructor’s Manual (For Instructor Use Only) ILLUSTRATION 10-4 ACCOUNTING FOR NONMONETARY EXCHANGES Copyright © 2013 John Wiley & Sons, Inc. Kieso, Intermediate