Receivables and Sales

Receivables and Sales

Chapter 10 Property, Plant, and Equipment and Intangible Assets: Acquisition and Disposition Copyright 2015 McGraw-Hill Education. All rights reserved. Types of Assets Long-lived, revenue-producing assets Property, plant, and equipment: Land, Buildings, Equipment, Machinery, Furniture, Autos, and Trucks Natural resources: Oil and Gas Deposits, Timber Tracts, and Mineral Deposits Intangible assets:

Patents Copyrights Trademarks Franchises Goodwill Illustration: Property, Plant, and Equipment Semtech Corporation Illustration: Intangible AssetsLayne Christensen Company Illustration: Property, Plant, and Equipment and Their Acquisition Costs Illustration: Intangible Assets and Their Acquisition Costs LO10-1 Costs to Be Capitalized Property, plant, and equipment and intangible assets Can be acquired by:

Purchase Donation Self-construction Business combination Exchange Lease Initial cost = Purchase price + all expenditures necessary to bring the asset to its desired condition and location for use LO10-1 Cost of Equipment Includes: Purchase price Any sales tax

Transportation costs Expenditures for installation and testing Legal fees to establish title Any other costs to bring the asset to its condition and location for use LO10-1 Illustration Initial Cost of Equipment Central Machine Tools purchased an industrial lathe to be used in its manufacturing process. The purchase price was $62,000. Central paid a freight company $1,000 to transport the machine to its plant location plus $300 shipping insurance. In addition, the machine had to be installed and mounted on a special platform built specifically for the machine at a cost of $1,200. After installation, several trial runs were made to ensure proper operation. The cost of these trials including wasted materials was $600. Purchase price Freight and handling Insurance during shipping Special foundation Trial runs

$62,000 1,000 v300 1,200 600 $65,100 Capitalized Concept Check The following expenditures relate to equipment purchased by Symington Corporation: Purchase price $48,000 Transportation costs 2,400 Installation and special wiring 1,500 Testing 6,000 What is the initial cost of the equipment purchased by Symington? a.

$51,900. b. $57,900. c. $50,800. d. $48,000. $48,000 (purchase price) + $2,400 (transportation costs) + $1,500 (installation and wiring) + $6,000 (testing) = $57,900 LO10-1 Cost of Land Costs may include: Purchase price Attorney fees

Real estate agent commissions Costs related to title and title search Recording fees Any back taxes, liens, mortgages, or other obligations Expenditures such as clearing, filling, draining, and even removing old buildings Proceeds from the sale of salvaged materials after purchase reduce the cost of land LO10-1 Illustration: Initial Cost of Land The Byers Structural Metal Company purchased a six-acre tract of land and an existing building for $500,000. The company plans to raze the old building and construct a new office building on the site. In addition to the purchase price, the company made the following expenditures at closing of the purchase: Title insurance $ 3,000 Commissions 16,000 Property taxes

6,000 Shortly after closing, the company paid a contractor $10,000 to tear down the old building and remove it from the site. An additional $5,000 was paid to grade the land. The $6,000 in property taxes included $4,000 of delinquent taxes paid by Byers on behalf of the seller and $2,000 attributable to the portion of the current LO10-1 Illustration: Initial Cost of Land (continued) Capitalized cost of land Purchase price of land Title insurance Commissions Delinquent property taxes Cost of removing old building Cost of grading $500,000 3,000 16,000

4,000 10,000 5,000 $538,000 Property taxes = $6,000 $2,000 Related to the current period LO10-1 Land Improvements Usually have useful lives that are estimable Costs: o Separately identified and capitalized o Depreciated over periods benefited by their use Examples: o Cost of parking lots, driveways, and private roads, costs of fences and lawn and garden sprinkler systems LO10-1

Cost of Buildings Cost of acquiring a building usually includes: Purchase price Realtor commissions and legal fees Reconditioning costs LO10-1 Cost of Natural Resources Natural Resources Includes timber tracts, mineral deposits, and oil and gas deposits Benefits are derived from their physical consumption Costs of Natural Resources If purchased Purchase price Any other costs necessary to bring the

asset to condition and location for use If developed Acquisition costs Exploration costs Development costs Restoration costs LO10-1 Asset Retirement Obligations An existing legal obligation associated with the disposition/retirement of a tangible, long-lived asset Recognized as a liability and measured at fair value If value can be reasonably estimated

Some companies recognized the AROs gradually over the life of the asset While others did not recognize the obligations until the asset was retired or sold Example: Oil and gas exploration company might be required to restore land to its original condition after extraction is completed LO10-1 Asset Retirement Obligations (continued) Provisions of Standards to address AROs Scope Recognition Measurement Present value calculations LO10-1 Illustration: Asset Retirement Obligations The Jackson Mining Company paid $1,000,000 for the right to explore

for a coal deposit on 500 acres of land in Pennsylvania. Costs of exploring for the coal deposit totaled $800,000 and intangible development costs incurred in digging and erecting the mine shaft were $500,000. In addition, Jackson purchased new excavation equipment for the project at a cost of $600,000. After the coal is removed from the site, the equipment will be sold. Jackson is required by its contract to restore the land to a condition suitable for recreational use after it extracts the coal. The company has provided the following three cash flow possibilities (A, B, and C) for the restoration costs to be paid in three years, after extraction is completed: Cash Outflow Probability A $500,000 30% B 600,000 50% C 700,000 20% The companys credit-adjusted risk free interest rate is 8%.

LO10-1 Illustration: Asset Retirement Obligations Total capitalized cost of the coal deposit: Purchase of rights to explore Exploration costs Development costs Restoration costs Total cost of coal deposit $1,000,000 800,000 500,000 468,360 $2,768,360 Present value of expected cash outflow for restoration costs (asset retirement obligation): $500,000 30% = 600,000 50% = 700,000 20% = $150,000

300,000 140,000 $590,000 .79383 = $468,360 (.79383 is the present value of $1, n = 3, i = 8%) LO10-1 Illustration: Asset Retirement Obligations Total capitalized cost for the coal deposit: Purchase of rights to explore Exploration costs Development costs Restoration costs Total cost of coal deposit Journal Entry Coal mine Cash Asset retirement liability Excavation equipment Cash $1,000,000

800,000 500,000 468,360 $2,768,360 Debit Credit 2,768,360 2,300,000 468,360 600,000 600,000 LO10-1 Illustration: Asset Retirement Obligations Year 1 2 3

Accretion Expense 8% (468,360) = 37,469 8% (505,829) = 40,466 8% (546,295) = 43,705 Increase in Balance Asset Retirement Obligation 468,360 505,829 546,295 590,000 37,469 40,466 43,705 Journal Entry Asset retirement liability

Loss Cash Loss = $625,000 $590,000= $35,000 Debit Credit 590,000 35,000 625,000 LO10-1 Illustration: Asset Retirement Obligations Year 1 2 3 Accretion Expense

8% (468,360) = 37,469 8% (505,829) = 40,466 8% (546,295) = 43,705 Journal Entry Accretion expense Asset retirement liability Increase in Balance Asset Retirement Obligation 468,360 505,829 546,295 590,000 37,469 40,466 43,705 Debit

Credit 37,469 37,469 Concept Check The Winderl Mining Co. paid $50 million for the right to explore and extract copper from land owned by the state of Wyoming. To obtain the rights, Winderl agreed to restore the land to a suitable condition for other uses after its exploration and extraction activities. Winderl incurred exploration and development costs of $15 million on the project. The companys credit-adjusted risk free interest rate is 6%. It estimates the possible cash flows for restoring the land, three years after its extraction activities begin, as follows: Cash outflow Probability $ 5 million 40% $10 million 60% What is the initial cost of the copper mine? a.

$65,000,000. b. $73,000,000. c. $71,716,960. d. $95,000,000. Restoration costs: Expected value = $8 million ($5 million x 40% + $10 million x 60%). $8 million x .83962 (PV factor, i = 6, n = 3) = $6,716,960 Cost of mine: $50,000,000 + 15,000,000 + 6,716,960 = $71,716,960 LO10-1 Intangible Assets

Represent exclusive rights that provide benefits to the owner Lack physical substance Difficult to anticipate the timing and the existence of future benefits attributable to many intangible assets Companies can either: Amortized Purchase intangible assets from other entities Ex: Existing patent, copyright, trademark Develop intangible assets internally Ex: Develop a new product that is then patented Finite useful lives Indefinite useful lives Not Amortized LO10-1 Intangible Assets (continued)

all other costs necessary to Cost = Purchase price + bring the asset to its desired condition and location for use Intangible Assets (continued) LO10-1 Specifically identifiable Patents Copyrights Trademarks Right to Right of protection Right to display a manufacture a given to a creator of word, a slogan, a product or to use a a published work. symbol, or an process Ex: Song/film/book emblem Franchises

Exclusive right by franchisor to franchisee to use the franchisors trademark/product Granted by the Granted for the life Registered with U.S. Franchisor U.S. Patent Office of the creator plus Patent Office for a grants it for a for a period of 20 70 years period of 10 years specified years period of time to the franchisee Cost includes Costs includes Cost includes Initial payment plus purchase price, purchase price, legal purchase price, legal periodic payments legal fees, filing fees, filing fees, not fees, filing fees, not over the life of the

fees, not including including internal including internal franchise internal research research & research & agreement & development development development LO10-1 Goodwill Represents the unique value of a company as a whole over and above its identifiable tangible and intangible assets Goodwill can emerge from a companys: Clientele and reputation Trained employees and management team Favorable business location

LO10-1 Goodwill (continued) Because goodwill cant be separated from a company, its not possible for a buyer to acquire it without also acquiring the whole company or a portion of it Capitalized Cost of Goodwill: Fair value of the consideration exchanged (acquisition price) for the company Fair value of the net assets acquired The fair value of all identifiable tangible and intangible assets (less) The fair value of any liabilities of the selling company assumed

LO10-1 Illustration: Goodwill The Smithson Corporation acquired all of the outstanding common stock of the Rider Corporation in exchange for $18 million cash. Smithson assumed all of Riders long-term debts which have a fair value of $12 million at the date of acquisition. The fair values of all identifiable assets of Rider amounted to $25 million (which includes receivables of $5 million, inventory of $7 million, property, plant, and equipment of $9 million, and patent of $4 million). The cost of the goodwill resulting from the acquisition Fair value of consideration exchanged Less: Fair value of net assets acquired Assets Less: Fair value of liabilities assumed Goodwill $18 $25 (12) (13)

$ 5 LO10-1 Illustration Goodwill (continued) The Smithson Corporation acquired all of the outstanding common stock of the Rider Corporation in exchange for $18 million cash. Smithson assumed all of Riders long-term debts which have a fair value of $12 million at the date of acquisition. The fair values of all identifiable assets of Rider amounted to $25 million (which includes receivables of $5 million, inventory of $7 million, property, plant, and equipment of $9 million, and patent of $4 million). Difference Journal Entry Receivables Inventory Property, plant, and equipment Patent Goodwill Liabilities Cash

Debit 5 7 9 4 5 Credit 12 18 Concept Check The Deardon Golf Ball Company acquired all of the outstanding common stock of Sanderson Golf for $1,750,000. The book values and fair values of Sanderson's assets and liabilities on the date of purchase were as follows: Book Value Fair Value Current assets $ 430,000 $ 415,000 Property, plant, and equipment 1,1500,000 1,470,000 Liabilities 300,000

300,000 Deardon should record goodwill of: a. $165,000. b. $470,000. c. $170,000. d. $0. $1,750,000 ($415,000 + 1,470,000 - 300,000) = $165,000 LO10-2 Lump-Sum Purchases

Refers to the acquisition of group of assets for a single sum Valuation of these assets differs when: Each asset is indistinguishable Example: 1. 10 identical delivery trucks purchased for a lump-sum price of $150,000. Assets have different characteristics and different useful lives : Allocate the lump-sum acquisition price among the Example: separate items 1. Acquisition of a factory that includes assets that are significantly different such as land, building, and equipment. LO10-2 Illustration Lump-Sum Purchase The Smyrna Hand & Edge Tools Company purchased an existing factory for a single sum of $2,000,000. The price included title to the land, the factory building, and the manufacturing equipment in the building, a patent on a process the equipment uses, and inventories of raw materials. An independent appraisal estimated the fair values

of the assets (if purchased separately) at $330,000 for the land, $550,000 for the building, $660,000 for the equipment, $440,000 for the patent, and $220,000 for the inventories. Fair Values Land Building Equipment Patent Inventories Total $$330,000 330,000 $550,000 550,000 660,000 440,000 220,000 $2,200,000 15% 25 30

20 10 100% LO10-2 Illustration Lump-Sum Purchase (continued) The Smyrna Hand & Edge Tools Company purchased an existing factory for a single sum of $2,000,000. The price included title to the land, the factory building, and the manufacturing equipment in the building, a patent on a process the equipment uses, and inventories of raw materials. An independent appraisal estimated the fair values of the assets (if purchased separately) at $330,000 for the land, $550,000 for the building, $660,000 for the equipment, $440,000 for the patent, and $220,000 for the inventories. Initial Valuation of Each Asset Consideration Price Land Building

Equipment Patent Inventories Total $2,000,000 15% 25 30 20 10 100% = = = = = $ 300,000 500,000

600,000 400,000 200,000 $2,000,000 LO10-2 Illustration: Lump-Sum Purchase (continued) Initial Valuation of Each Asset Consideration Price Land Building Equipment Patent Inventories Total $2,000,000

Journal Entry Land Building Equipment Patent Inventories Cash 15% 25 30 20 10 100% = = = = = $ 300,000

500,000 600,000 400,000 200,000 $2,000,000 Debit Credit 300,000 500,000 600,000 400,000 200,000 2,000,000 Concept Check Cirrus Corporation acquired a manufacturing facility on five acres of land for a lump-sum price of $32,000,000. The land included land improvements such as landscaping, a sprinkler system, and a parking lot. According to independent appraisals, the fair values were $18,000,000, $12,000,000, and $10,000,000 for the building, land, and land

improvements, respectively. The initial values of the building, land, and land improvements would be: Building a. b. c. d. Land Land improvements $18,000,000 $12,000,000 $10,000,000 $18,000,000 $12,000,000 $ 2,000,000 $14,400,000 $ 9,600,000 $ 8,000,000 All of these answer choices are =incorrect. Total fair value

$40,000,000. Building: $18,000,000 $40,000,000 = 45% x $32,000,000 = $14,400,000. Land: $12,000,000 $40,000,000 = 30% x $32,000,000 = $9,600,000. Land improvements: $10,000,000 $40,000,000 = 25% x $32,000,000 = $8,000,000. LO10-3 Noncash Acquisitions Companies can also acquire assets by: issuing debt or equity securities receiving donated assets exchanging other assets Assets acquired in noncash transactions are valued at the fair value of the assets given or the fair value of the assets received, whichever is more clearly evident LO10-3 Deferred Payments An obligation to make payment in the future

Example: A machine is acquired for $15,000 and the buyer signs a note requiring the payment of $15,000 sometime in the future plus interest at a realistic interest rate. Journal Entry Machine Note payable Debit Credit 15,000 15,000 LO10-3 Illustration: Asset Acquired with DebtPresent Value of Note Indicative of Fair Value On January 2, 2016, the Midwestern Steam Gas Corporation purchased an industrial furnace. In payment, Midwestern signed a noninterest-bearing note requiring $50,000 to be paid on December 31, 2017. If Midwestern had borrowed cash to buy the furnace, the bank would have required an interest rate of 10%. Journal Entry

Furnace Discount on note payable Note payable Debit Credit 41,323 8,677 50,000 PV = $50,000 .82645 = $41,323 (Fair value of Note) Present value of $1: n = 2, i = 10% Discount on note payable = $50,000 $41,323 = $8,677 Illustration: Asset Acquired with DebtPresent Value of Note Indicative of Fair Value (continued) Adjusting entries for Midwesterns fiscal year-ends: Journal Entry December 31, 2016 Interest expense($41,323 10%) Discount on note payable

Debit LO10-3 Credit 4,132 4,132 December 31, 2017 4,545 Interest expense ($41,323 + $4,132) 10% Discount on note payable 4,545 50,000 Note payable Cash 50,000 Note payable Discount on note payable Jan. 1, 2016 50,000 8,677 Jan. 1, 2016

50,000 Dec. 31, 2017 Dec. 31, 2016 4,132 Bal. 12/31/17 0 Dec. 31, 2017 4,545 0 Bal. 12/31/17 Illustration: Noninterest-Bearing Note - Fair Value of Asset Is Known LO10-3 On January 2, 2016, Dennison, Inc., purchased a machine and signed a noninterest-bearing note in payment. The note requires the company to pay $100,000 on December 31, 2018. Dennison is not sure what interest rate appropriately reflects the time value of money. However, price lists indicate the machine could have been purchased for cash at a price of $79,383. Journal Entry Machine (Cash price) Discount on note payable Note payable (Face amount) Debit

Credit 79,383 20,617 100,000 PV = Face amount PV Factor Implicit rate of interest PV Factor = $79,383 $100,000 = .79383 Present value of $1: n = 2, i = ? (from Table PV table, i=8%) Discount on note payable = $100,000 $79,383 = $20,617 LO10-4 Issuance of Equity Securities Occurs when small companies incorporate and the owner or owners contribute assets to the new corporation in exchange for ownership securities Transactions exchange value either: o The fair value of the assets received by the corporation or o The market value of the shares of corporations

whose stock is actively traded LO10-4 Illustration: Asset Acquired by Issuing Equity Securities On March 31, 2016, the Elcorn Company issued 10,000 shares of its nopar common stock in exchange for land. On the date of the transaction, the fair value of the common stock, evidenced by its market price, was $20 per share. Journal Entry Land Common stock Debit 200,000 10,000 Shares @ $20 per share = $200,000 Credit 200,000 LO10-4

Donated Assets The donation usually is an enticement to do something that benefits the donor Recorded at their fair values based on either an available market price or an appraisal value Revenue is credited LO10-4 Illustration: Asset Donation Elcorn Enterprises decided to relocate its office headquarters to the city of Westmont. The city agreed to pay 20% of the $20 million cost of building the headquarters in order to entice Elcorn to relocate. The building was completed on May 3, 2016. Elcorn paid its portion of the cost of the building in cash. Journal Entry Land Cash Revenuedonation of asset Credit

Debit 20,000,000 16,000,000 4,000,000 Donation = $20,000,000 20% = $4,000,000 LO10-9 International Financial Reporting Standards U.S. GAAP IFRS Government Grants Both U.S. GAAP and IFRS require that donated assets be valued at their fair values Deduct the amount of the grant in Recorded as revenue in the determining the initial cost of the period received

asset, or Record the grant as a liability, deferred income, in the balance sheet and recognize it in the income statement systematically over the assets useful life Concept Check The County of Santa Clara gave a parcel of land to the 49ers Company as part of an agreement requiring the 49ers to construct its football stadium on the donated land. The land cost the county $12,800,000 when purchased several years ago and had an appraised value of $20,000,000 on the date it was given to the 49ers. As a result of the donation, the 49ers should record: a. A credit to retained earnings of $20,000,000. b. A debit to land of $12,800,000. c.

A credit to revenue of $20,000,000. d. All of these answer choices are incorrect. GAAP requires that if a company receives a donated asset it must record revenue at an amount equal to the fair value of that asset. LO10-5 Decision Makers Perspective Capital budgeting: Includes decisions pertaining to acquisitions of property, plant, and equipment and intangible assets Requires management to forecast all future net cash flows generated by the asset(s) Net present value model Present value of future net cash flows Initial

> acquisition cost LO10-5 Decision Makers Perspective Fixed Asset Turnover Ratio: Indicates the level of sales generated by the companys investment in fixed assets Book value, sometimes called carrying value or carrying amount (cost less accumulated depreciation and depletion) LO10-5 Decision Makers Perspective Fixed Asset Turnover Ratio ($ in millions) GAP Ross Stores 2014 2013 2014 2013 Property, plant, and equipment (net) $2,758 $2,619 $1,875 $1,493

Net sales2014 $16,148 $10,230 GAP Fixed-asset turnover ratio (2014) = $16,148 $2,688.5 ($2,758 + $2,619) 2 = $6.01 Ross Stores $10,230 $1,684 $6.07 LO10-6 Dispositions Sale Monetary consideration

(cash or a receivable) The seller recognizes a gain or loss for the difference between the consideration received and the book value of the asset sold Retirement No monetary consideration A loss is recorded for the remaining book value of the asset LO10-6 Illustration: Sale of Property, Plant, and Equipment The Robosport Company sold for $6,000 equipment that

originally cost $20,000. Depreciation of $12,000 had been recorded up to the date of sale. Journal Entry Cash Accumulated depreciation Loss on disposal of equipment Equipment Book value = ($20,000 $12,000) = $8,000 Loss = $8,000 $6,000 = $2,000 Debit 6,000 12,000 2,000 Credit 20,000 LO10-6 Exchanges Refers to the acquisition of an asset in exchange for an

asset other than cash Old asset (Fair value) Traded-in New asset acquired (Fair value) Difference Paid in cash or other asset Gain or loss is recognized in these transactions for the difference between the fair value and book value of the asset given LO10-6 Illustration: Nonmonetary Asset Exchange (Gain) The Elcorn Company traded its laser equipment for the newer air-cooled ion lasers manufactured by American Laser Corporation. The old equipment had a book value of $100,000 (cost of $500,000 less accumulated depreciation of $400,000) and a fair value of $150,000. To

equalize the fair values of the assets exchanged, in addition to the old equipment, Elcorn paid American Laser $430,000 in cash. Journal Entry Laser equipmentnew Accumulated depreciation Laser equipmentold Cash Gain Debit Credit 580,000 400,000 500,000 430,000 50,000 Fair value of new equipment = $580,000 ($150,000 + $430,000) Gain = Fair value ($150,000) Book value ($100,000) = $50,000 LO10-6

Illustration: Nonmonetary Asset Exchange (Loss) The Elcorn Company traded its laser equipment for the newer air-cooled ion lasers manufactured by American Laser Corporation. The old equipment had a book value of $100,000 (cost of $500,000 less accumulated depreciation of $400,000) and a fair value of $75,000. To equalize the fair values of the assets exchanged, in addition to the old equipment, Elcorn paid American Laser $430,000 in cash. Journal Entry Laser equipmentnew Accumulated depreciation Loss Laser equipmentold Cash Debit Credit 505,000 400,000 25,000 500,000 430,000 Fair value of new equipment = $505,000 ($75,000 + $430,000)

Loss = Fair value ($75,000) Book value ($100,000) = ($25,000) LO10-6 Nonmonetary Asset Exchange (Fair Value Not Determinable) The Elcorn Company traded its laser equipment for the newer aircooled ion lasers manufactured by American Laser Corporation. The old equipment had a book value of $100,000 (cost of $500,000 less accumulated depreciation of $400,000). The fair value of both the new and old equipment is not determinable. Elcorn paid American Laser $430,000 in cash. Journal Entry Equipmentnew Accumulated depreciation Equipmentold Cash Debit Credit 530,000 400,000 500,000 430,000

LO10-6 Exchange Lacks Commercial Substance Commercial Substance: Present when future cash flows change as a result of the exchange Example: Newer models of equipment can increase production or improve manufacturing efficiency causing an increase in revenue or a decrease in operating costs with a corresponding increase in future cash flows Exchange Lacks Commercial Substance Gain Situation Book value of the old asset is used to record the exchange Loss Situation

Fair value of old asset is used to record the exchange (unlikely situation) LO10-6 Illustration: Nonmonetary Asset Exchange Exchange Lacks Commercial Substance The Elcorn Company traded a tract of land to Sanchez Development for a similar tract of land. The old land had a book value of $2,500,000 and a fair value of $4,500,000. To equalize the fair values of the assets exchanged, in addition to the land, Elcorn paid Sanchez $500,000 in cash. This means that the fair value of the land acquired is $5,000,000. Journal Entry Landnew Landold Cash Credit Debit

3,000,000 2,500,000 500,000 Fair value of new land = $3,000,000 ($2,500,000 + $500,000) No gain is recognized. Concept Check Arizona Pharmaceuticals exchanged laser equipment with a book value of $70,000 and a fair value of $75,000 for the newer model of laser equipment. In addition to the old equipment, $90,000 in cash was given. Arizona should recognize: a. A loss of $5,000. b. A gain or 15,000. c. A gain or $5,000.

d. No gain or loss. A gain is recognized for the difference between the fair value of the old equipment and the equipments book value: $75,000 70,000 = $5,000 Concept Check Arizona Pharmaceuticals exchanged laser equipment with a book value of $70,000 and a fair value of $75,000 for the newer model of laser equipment. In addition to the old equipment, $90,000 in cash was given. Arizona should record the new laser equipment at: a. $ 95,000. b. $165,000. c.

$160,000. d. All of these answer choices are incorrect. The new laser equipment is recorded at an amount equal to the fair value of the old equipment plus the cash given: $75,000 + 90,000 = $165,000 LO10-7 Self-Constructed Assets A company might decide to construct an asset for its own use rather than buy an existing one Identifying the cost is difficult because there is no external transaction to establish an exchange price Two Critical Issues Determining the amount of indirect manufacturing costs (overhead) to be allocated to the construction

Deciding on the proper treatment of interest (actual or implicit) incurred during construction LO10-7 Self-Constructed Assets (continued) Overhead Allocation The treatment of manufacturing overhead cost and its allocation: 1. Inclusion of only the incremental overhead costs 2. Full-cost approach Interest Capitalization 1. Capitalized and then allocated as depreciation LO10-7 Interest Capitalization Qualifying Assets Assets that are constructed for a companys own use as well as assets constructed as discrete projects for sale or

lease Only interest incurred during the construction period is eligible for capitalization Period of Capitalization Begins when construction begins and the first expenditure is made as long as interest costs are actually being incurred Average Accumulated Expenditures Approximates the average debt necessary for construction LO10-7 Illustration: Interest Capitalization On January 1, 2016, the Mills Conveying Equipment Company began construction of a building to be used as its office headquarters. The building was completed on June 30, 2017. Expenditures on the project, mainly payments to subcontractors, were as follows: January 1, 2016 $ 500,000 March 31, 2016 400,000 September 30, 2016 600,000

Accumulated expenditures at December 31, 2016 (before interest capitalization) $ 1,500,000 January 31, 2017 600,000 April 30, 2017 300,000 On January 1, 2016, the company obtained a $1 million construction loan with an 8% interest rate. The loan was outstanding during the entire construction period. The companys other interest-bearing debt included two long-term notes of $2,000,000 and $4,000,000 with interest rates of 6% and 12%, respectively. Both notes were outstanding during the entire construction period. Illustration: Interest Capitalization (continued) LO10-7 STEP 1: Determine the average accumulated expenditures. If expenditures incurred are fairly even throughout the period, the average expenditures would be: Total accumulated expenditures incurred evenly throughout the period

Average accumulated expenditures $1,500,000 2 $ 750,000 If expenditures are not incurred evenly throughout the period, weighted average is determined: Actual Expenditures January 1, 2016 $500,000 12/12 = March 31, 2016 400,000 9/12 = September 30, 2016 600,000 3/12 = Average accumulated expenditures for 2016 = Time-Weighted Expenditures $500,000 300,000

150,000 $950,000 LO10-7 Illustration: Interest Capitalization (continued) STEP 2: Calculate the amount of interest to be capitalized. Interest capitalized for 2016 = $950,000 8% = $76,000 Accumulated expenditures at December 31, 2016 Cost of the building $1,500,000 Interest capitalized for 2016 76,000 Accumulated expenditures at December 31, 2016 $1,576,000 STEP 3: Compare the calculated interest with actual interest incurred. Loans $1,000,000 2,000,000 4,000,000 Actual

Annual Interest Rate 8% = $ 80,000 6% = 120,000 12% = 480,000 $680,000 Calculated Interest Use lower amount > $76,000 LO10-7 Illustration: Interest Capitalization (continued) The same procedure is carried out for 2017. The method of determining the amount of interest to capitalize by using rates from specific loans to the

extent of specific borrowings before using the average rate of other debt is called the specific interest method The alternative is the weighted-average method Concept Check In January of 2016, the Mateo Company began construction of its own storage facility. During 2016, $13,000,000 in construction costs were incurred as follows: January 1, $2,000,000; March 31, $4,000,000; June 30, $4,000,000; October 31, $3,000,000. Mateo took out a $4,000,000, 10% construction loan at the beginning of the year. The company had $20,000,000 in other interest-bearing debt with a weighted-average interest rate of 8%. The facility was completed early in 2017. What amount of interest should Mateo capitalize in 2016 using the specific interest method? a. $600,000. b. $750,000.

c. $680,000. d. $660,000. Average accumulated expenditures = $7,500,000 ($2,000,000 x 12/12 + $4,000,000 x 9/12 + $4,000,000 x 6/12 + $3,000,000 x 2/12). Capitalized interest: $4,0000,000 x 10% + $3,500,000 x 8% = $680,000 LO10-7 Illustration: Capitalized Interest Disclosure Wal-Mart Stores, Inc. LO10-8 Research and Development (R&D) Research Planned search or

critical investigation to discover new knowledge that helps developing a new product or service or a new process or technique or improving an existing product or processes Development Translation of research findings into a plan or design for a new product or process or improving existing product or processes, whether intended for sale or use LO10-8 Determining R&D Costs Includes costs relevant to R&D projects, such as:

Salaries, wages, and other labor costs of R&D personnel Costs of materials consumed, equipment, facilities, and intangibles used in R&D projects Costs of services performed by others A reasonable allocation of indirect costs related to the R&D activities Asset purchased for single R&D project Cost is considered R&D and expensed immediately in the current year Asset purchased for more than a single R&D project Depreciation or amortization of the asset included as R&D expense in the current and future periods LO10-8

Illustration: Research and Development Expenditures Costs incurred are R&D costs Costs incurred are Non-R&D costs LO10-8 Illustration: Research and Development Costs The Askew Company made the following cash expenditures during 2016 related to the development of a new industrial plastic: R&D salaries and wages $10,000,000 R&D supplies consumed during 2016 3,000,000 Purchase of R&D equipment 5,000,000 Patent filing and legal costs 100,000 Payments to others for services performed in connection

with R&D activities 1,200,000 Total $19,300,000 The project resulted in a new product to be manufactured in 2017. A patent was filed with the U.S. Patent Office. The equipment purchased will be employed in other projects. Depreciation on the equipment for 2016 was $500,000. Journal Entry R&D expense Cash Debit Credit 14,200,000 14,200,000 LO10-8 Illustration: Research and Development Costs (continued)

The Askew Company made the following cash expenditures during 2016 related to the development of a new industrial plastic: R&D salaries and wages $10,000,000 R&D supplies consumed during 2016 3,000,000 Purchase of R&D equipment 5,000,000 Patent filing and legal costs 100,000 Payments to others for services performed in connection with R&D activities 1,200,000 Total $19,300,000 The project resulted in a new product to be manufactured in 2017. A patent was filed with the U.S. Patent Office. The equipment purchased will be employed in other projects. Depreciation on the equipment for 2016 was $500,000. Journal Entry Equipment Cash

Debit Credit 5,000,000 5,000,000 LO10-8 Illustration: Research and Development Costs (continued) The Askew Company made the following cash expenditures during 2016 related to the development of a new industrial plastic: R&D salaries and wages $10,000,000 R&D supplies consumed during 2016 3,000,000 Purchase of R&D equipment 5,000,000 Patent filing and legal costs 100,000 Payments to others for services performed in connection with R&D activities

1,200,000 Total $19,300,000 The project resulted in a new product to be manufactured in 2017. A patent was filed with the U.S. Patent Office. The equipment purchased will be employed in other projects. Depreciation on the equipment for 2016 was $500,000. Journal Entry Debit R&D expense Accumulated depreciationequipment 500,000 Credit 500,000 LO10-8 Illustration: Research and Development Costs (continued)

The Askew Company made the following cash expenditures during 2016 related to the development of a new industrial plastic: R&D salaries and wages $10,000,000 R&D supplies consumed during 2016 3,000,000 Purchase of R&D equipment 5,000,000 Patent filing and legal costs 100,000 Payments to others for services performed in connection with R&D activities 1,200,000 Total $19,300,000 The project resulted in a new product to be manufactured in 2017. A patent was filed with the U.S. Patent Office. The equipment purchased will be employed in other projects. Depreciation on the equipment for 2016 was $500,000. Journal Entry Patent Cash

Debit Credit 100,000 100,000 LO10-8 Illustration: Research and Development Costs (continued) The Askew Company made the following cash expenditures during 2016 related to the development of a new industrial plastic: R&D salaries and wages $10,000,000 R&D supplies consumed during 2016 3,000,000 Purchase of R&D equipment 5,000,000 Patent filing and legal costs 100,000 Payments to others for services performed in connection with R&D activities

1,200,000 Total $19,300,000 The project resulted in a new product to be manufactured in 2017. A patent was filed with the U.S. Patent Office. The equipment purchased will be employed in other projects. Depreciation on the equipment for 2016 was $500,000. Expenditures reconciliation: Recorded as R&D Capitalized as equipment Capitalized as patent Total $14,200,000 5,000,000 100,000 $19,300,000 LO10-8 R&D Performed for Others and Start-Up costs R&D Performed for Others R&D costs are capitalized as inventory and carried

forward into future years until the project is completed Start-Up Costs Refers to one-time preopening costs Includes Organization costs Expensed in the period incurred LO10-8 Illustration: Software Development Costs when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements. LO10-8 Software Development Costs Amortization of capitalized software development costs begins when the product is available for general release to customers

The periodic amortization percentage: Percentage-ofrevenue method Percentage-ofrevenue method > Straight-line method < Straight-line method LO10-8 Illustration: Software Development Costs The Astro Corporation develops computer software graphics programs for sale. A new development project begun in 2015 reached technological feasibility at the end of June 2016, and the product was available for release to customers early in 2017. Development costs incurred in 2016 prior to June 30 were $1,200,000 and costs incurred from June 30 to the product

availability date were $800,000. 2017 revenues from the sale of the new product were $3,000,000 and the company anticipates an additional $7,000,000 in revenues. The economic life of the software is estimated at four years. Astro Corporation would expense the $1,200,000 in costs incurred prior to the establishment of technological feasibility and capitalize the $800,000 in costs incurred between technological feasibility and the product availability date. LO10-8 Illustration: Software Development Costs (continued) 1. Percentage-of-revenue method = = = = 2. Straight-line method =

= = $3,000,000 $3,000,000 + $7,000,000 30% 30% $800,000 $240,000 1/4 or 25% 1/4 or 25% $200,000 $800,000 Concept Check During 2016, the Ellison Software Company incurred development costs of $8,000,000 related to a new software project. Of this amount, $1,600,000 was incurred after technological feasibility was achieved. The project was completed in the middle of the year and the product was available for release to customers on July 1. Year 2016 revenues from the sale of the new software were $2,000,000 and the company anticipated future additional revenues of $18,000,000. The economic life of the software is

estimated at four years. Year 2016 amortization of the software development costs should be: a. $800,000. b. $200,000. c. $400,000. d. $160,000. Percentage-of-revenue: 10% x $1,600,000 = $160,000 Straight-line: x ($1,600,000 4) = $200,000 Amortization is the larger of the two, $200,000 LO10-8

Purchased Research and Development In case of purchased Research and Development Developed technology Capitalize its fair value as a finite-life intangible asset and amortize that amount over its useful life In-process research and development Capitalize the fair value of in-process R&D as an indefinite-life intangible asset R&D costs incurred after the acquisition are expensed as incurred

LO10-9 International Financial Reporting Standards U.S. GAAP IFRS Research and Development Expenditures All research and development Research expenditures are expensed expenditures are expensed in the in the period incurred and period incurred, except for development expenditures that meet software development costs specified criteria are capitalized as an incurred after technological intangible asset feasibility has been established APPENDIX 10 Oil and Gas Accounting Methods of accounting Successful Efforts Method Exploration costs known

not to have resulted in the discovery of oil or gas to be treated as expenses in the period the expenditures are made Full-Cost Method Exploration costs to be capitalized as assets and expensed in future as oil and gas from the successful wells are removed from that area APPENDIX 10 Illustration: Oil and Gas Accounting The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells drilled in 2016 in west Texas. Eight of the 10 wells were dry holes. 8 dry holes $2,000,000 = $16,000,000 Journal Entry

Successful Efforts Method Oil deposit Exploration expense Cash Full Cost Method Oil deposit Cash Debit Credit 4,000,000 16,000,000 20,000,000 20,000,000 20,000,000 End of Chapter 10

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