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Perspective on Investing. CHAPTER 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENT Sommers – ACCT 3311.

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Presentation on theme: "Perspective on Investing. CHAPTER 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENT Sommers – ACCT 3311."— Presentation transcript:

1 Perspective on Investing

2 CHAPTER 10 ACQUISITION AND DISPOSITION OF PROPERTY, PLANT AND EQUIPMENT Sommers – ACCT 3311

3 Long-lived, Revenue-producing Assets Tangible Property, Plant, Equipment & Natural Resources Tangible Property, Plant, Equipment & Natural Resources Types of Operational Assets Expected to Benefit Future Periods General Rule for Cost Capitalization The initial cost of an operational asset includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.

4 Costs to be Capitalized Land (not depreciable) Purchase price Real estate commissions Attorney’s fees Title search Title transfer fees Title insurance premiums Removing old buildings Equipment Net purchase price Taxes Transportation costs Installation costs Modification to building necessary to install equipment Testing and trial runs

5 Costs to be Capitalized Land Improvements – Separately identifiable costs Driveways Parking lots Fencing Landscaping (limited life) Private roads Buildings Purchase price Attorney’s fees Commissions Reconditioning Natural Resources Acquisition costs Exploration costs Development costs Restoration costs Self Constructed Assets Materials Direct Labor Overhead

6 Discussion Questions Q10–4 Indicate where the following items would be shown on a balance sheet. (a) A lien that was attached to the land when purchased. Land (b) Landscaping costs. Land improvements if limited life, else land. (c) Attorney’s fees and recording fees related to purchasing land Land (d) Variable overhead related to construction of machinery. Machinery

7 Discussion Questions Q10–4 (e) A parking lot servicing employees in the building. Land Improvements (f) Cost of temporary building for workers during construction of building Building (g) Interest expense on bonds payable incurred during construction of a building. Building (h) Assessments for sidewalks that are maintained by the city. Land (i) The cost of demolishing an old building that was on the land when purchased. Land

8 Example 1: Continued Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building: Title insurance$ 16,000 Legal fees for drawing the contract 5,000 Pro-rated property taxes for period after acquisition 36,000 State transfer fees 4,000 An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping (limited life). Determine the initial valuation of each asset Semtech acquired in these transactions.

9 Example 1: Continued Purchase price$4,000,000 Title search and insurance 16,000 Legal fees 5,000 State transfer fees 4,000 Total cost$4,025,000 Fair Value% of Total Valuation Land $3,300,000 75%$3,018,750 Building 1,100,000 25% 1,006,250 $4,400, %$4,025,000 Land$3,018,750 Building 1,006,250 Land improvements: Parking lot 82,000 Landscaping 40,000

10 Example 1: Continued Semtech Manufacturing purchased land and building for $4 million. In addition to the purchase price, Semtech made the following expenditures in connection with the purchase of the land and building: Title insurance$16,000 Legal fees for drawing the contract 5,000 Pro-rated property taxes for period after acquisition 36,000 State transfer fees 4,000 An independent appraisal estimated the fair values of the land and building, if purchased separately, at $3.3 and $1.1 million, respectively. Shortly after acquisition, Semtech spent $82,000 to construct a parking lot and $40,000 for landscaping. Now assume that immediately after acquisition, Semtech demolished the building. Demolition costs were $250,000 and the salvaged materials were sold for $6,000. In addition, Semtech spent $86,000 clearing and grading the land in preparation for the construction of a new building.

11 Example 1: Continued Cost of land: Purchase price$4,000,000 Title search and insurance 16,000 Legal fees 5,000 State transfer fees 4,000 Demolition of old building$250,000 Less: Sale of materials (6,000) 244,000 Clearing and grading costs 86,000 Total cost of land$4,355,000 Land improvements: Parking lot$ 82,000 Landscaping$ 40,000

12 Asset Fair Value Percent of Total Fair Value Initial Valuation Land$ 75, %$ 62,500 Building 45, % 37,500 $120, %$100,000 Example 2 Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction. 1.On September 1, the company acquired five acres of land with a building that will be used as a warehouse. Tristar paid $100,000 in cash for the property. According to appraisals, the land had a fair value of $75,000 and the building had a fair value of $45,000. Land62,500 Building37,500 Cash100,000

13 Example 2: Continued Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction. 2.On September 1, Tristar signed a $40,000 noninterest-bearing note to purchase equipment. The $40,000 payment is due on September 1, Assume that 8% is a reasonable interest rate. Equipment 37,037 Discount on note payable 2,963 Note payable 40,000 PV(FV=40,000, PMT=0, n=1, i=8) = 37,037

14 Example 2: Continued Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction. 3.On September 15, a truck was donated to the corporation. Similar trucks were selling for $2,500. Truck2,500 Revenue - donation of asset2,500 4.On September 18, the company paid its lawyer $3,000 for organizing the corporation. Organization cost expense3,000 Cash3,000

15 Example 2: Continued Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction. 5.On October 10, Tristar purchased machinery for cash. The purchase price was $15,000 and $500 in freight charges also were paid. Machinery15,500 Cash15,500 6.On December 2, Tristar acquired various items of office equipment. The company was short of cash and could not pay the $5,500 normal cash price. The supplier agreed to accept 200 shares of the company’s nopar common stock in exchange for the equipment. The fair value of the stock is not readily determinable. Office equipment 5,500 Common stock 5,500

16 Example 2: Continued Tristar Production Company began operations on September 1, Listed below are a number of transactions that occurred during its first four months of operations. Prepare journal entries to record each transaction. 7.On December 10, the company acquired a tract of land at a cost of $20,000. It paid $2,000 down and signed a 10% note with both principal and interest due in one year. Ten percent is an appropriate rate of interest for this note. Land20,000 Cash 2,000 Note payable18,000

17 Self-Constructed Assets When self-constructing an asset, two accounting issues must be addressed: overhead allocation to the self-constructed asset. –incremental overhead only –full-cost approach proper treatment of interest incurred during construction Under certain conditions, interest incurred on qualifying assets is capitalized. Asset constructed is for a company’s own use and is a discrete project for sale or lease. Capitalize interest that could have been avoided if the asset were not constructed and the money used to retire debt.

18 Discussion Questions Q10–9 Provide examples of assets that do not qualify for interest capitalization. (1)assets that are in use or ready for their intended use, and (2)assets that are not being used in the earnings activities of the firm.

19 Three approaches have been suggested to account for the interest incurred in financing the construction. Capitalize no interest during construction Capitalize actual costs incurred during construction Capitalize all costs of funds GAAP $ 0$ ? Increase to Cost of Asset Interest Costs During Construction

20  GAAP requires — capitalizing actual interest (with modification).  Consistent with historical cost.  Capitalization considers three items: 1.Qualifying assets. 2.Capitalization period. 3.Amount to capitalize. Interest Costs During Construction

21 Require a substantial period of time to get them ready for their intended use. Two types of assets:  Assets under construction for a company’s own use.  Assets intended for sale or lease that are constructed or produced as discrete projects. Qualifying Assets

22 Capitalization Period Begins when: 1.Expenditures for the asset have been made. 2.Activities for readying the asset are in progress. 3.Interest costs are being incurred. Ends when: The asset is substantially complete and ready for use. Capitalization Period

23 Capitalize the lesser of: 1.Actual interest costs 2.Avoidable interest - the amount of interest that could have been avoided if expenditures for the asset had not been made. Amount to Capitalize

24 Discussion Questions Q10–10 What interest rates should be used in determining the amount of interest to be capitalized? How should interest revenue from temporarily invested excess funds borrowed to finance the construction of assets be accounted for? The avoidable interest is determined by multiplying (an) interest rate(s) by the weighted-average amount of accumulated expenditures on qualifying assets. For the portion of weighted-average accumulated expenditures which is less than or equal to any amounts borrowed specifically to finance construction of the assets, the capitalization rate is the specific interest rate incurred. For the portion of weighted-average accumulated expenditures which is greater than specific debt incurred, the interest rate is a weighted average of all other interest rates incurred. The amount of interest to be capitalized is the avoidable interest, or the actual interest incurred, whichever is lower.

25 Selecting Appropriate Interest Rate: 1.For the portion of weighted-average accumulated expenditures that is less than or equal to any amounts borrowed specifically to finance construction of the assets, use the interest rate incurred on the specific borrowings. 2.For the portion of weighted-average accumulated expenditures that is greater than any debt incurred specifically to finance construction of the assets, use a weighted average of interest rates incurred on all other outstanding debt during the period. Calculating the Actual and Avoidable Interest

26 Avoidable Interest Weighted-average interest rate on general debt Actual Interest $100,000 $800,000 = 12.5% Calculating the Actual and Avoidable Interest

27 Journal entry to Capitalize Interest: Equipment 30,250 Interest expense30,250 Not crediting cash because already paid and we are transferring (capitalizing) Capitalize the lesser of Avoidable interest or Actual interest. Calculating the Actual and Avoidable Interest

28 Example 3 On January 1, 2011, the Marlee Company began construction of an office building to be used as its corporate headquarters. The building was completed early in Construction expenditures for 2011, which were incurred evenly throughout the year, totaled $6,000,000. Marlee had the following debt obligations which were outstanding during all of 2011: Construction loan, 10%$1,500,000 Long-term note, 9% 2,000,000 Long-term note, 6% 4,000,000 Calculate the amount of interest capitalized in 2011 for the building using the specific interest method.

29 Example 3 Average accumulated expenditures: $6,000,000 / 2 = $3,000,000 Weighted-average rate of all other debt: $2,000,000x 9% =$180,000 4,000,000x 6% = 240,000 $6,000,000$420,000 $420,000 / $6,000,000 = 7% Interest capitalized: $3,000, ,500,000 x 10% =$150,000 1,500,000 x 7% = 105,000 $255,000 Interest capitalized

30 Example 4 On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, Expenditures on the project were as follows: January 1, 2011$1,000,000January 31, 2012$270,000 March 1, ,000April 30, ,000 June 30, ,000August 31, ,000 October 1, ,000 On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and The company’s other interest-bearing debt included two long-term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and Interest is paid annually on all debt. The company’s fiscal year-end is December Calculate the amount of interest that Mason should capitalize in 2011 and 2012 using the specific interest method. 2.What is the total cost of the building? 3.Calculate the amount of interest expense that will appear in the 2011 and 2012 income statements.

31 Example 4: Continued Expenditures for 2011: January 1, 2011$1,000,000 x 12/12 =$1,000,000 March 1, ,000 x 10/12 = 500,000 June 30, ,000 x 6/12 = 400,000 October 1, ,000 x 3/12 = 150,000 Accumulated expenditures (before interest) -$3,000,000 Average accumulated expenditures -$2,050,000 Interest capitalized: $2,050,000 x 10% = $205,000 = Interest capitalized in 2011

32 Example 4: Continued Expenditures for 2012: January 1, 2012 $3,205,000 x 9/9 = $3,205,000 January 31, ,000 x 8/9 = 240,000 April 30, ,000 x 5/9 = 325,000 August 31, ,000 x 1/9 = 100,000 Accumulated expenditures (before interest) -$4,960,000 Average accumulated expenditures - $3,870,000 Weighted-average rate of all other debt: $ 4,000,000 x 6% = $240,000$ 720,000 6,000,000 x 8% = 480,000 $10,000,000= 7.2% $10,000,000 $720,000 Interest capitalized: $3,000,000 x 10.0% x 9/12 = $225, ,000 x 7.2% x 9/12 = 46,980 $271,980 = Interest capitalized in 2012

33 Example 4: Continued Cost of Building: Expenditures in 2011$3,000,000 Interest capitalized in ,000 Expenditures in ,755,000 Interest capitalized in ,980 Total cost of building$5,231,980 Interest Expense for 2011: $3,000,000 x 10% =$ 300,000 4,000,000 x 6% = 240,000 6,000,000 x 8% = 480,000 Total interest incurred 1,020,000 Less: Capitalized (205,000) 2011 expense$ 815,000 Interest Expense for 2012: Total interest incurred$1,020,000 Less: Capitalized (271,980) 2012 expense$ 748,020

34 Example 4b: Continued On January 1, 2011, the Mason Manufacturing Company began construction of a building to be used as its office headquarters. The building was completed on September 30, Expenditures on the project were as follows: January 1, 2011$1,000,000January 31, 2012$270,000 March 1, ,000April 30, ,000 June 30, ,000August 31, ,000 October 1, ,000 On January 1, 2011, the company obtained a $3 million construction loan with a 10% interest rate. The loan was outstanding all of 2011 and The company’s other interest- bearing debt included two long- term notes of $4,000,000 and $6,000,000 with interest rates of 6% and 8%, respectively. Both notes were outstanding during all of 2011 and Interest is paid annually on all debt. The company’s fiscal year-end is December Calculate the amount of interest that Mason should capitalize in 2011 and 2012 using the weighted-average method. 2.What is the total cost of the building? 3.Calculate the amount of interest expense that will appear in the 2011 and 2012 income statements.

35 Example 4b: Continued Weighted-average rate of all debt: $ 3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000$ 1,020,000 6,000,000 x 8% = 480,000 $13,000,000= 7.85% $13,000,000 $1,020,000 Expenditures for 2011: Accumulated expenditures (before interest) -$3,000,000 Average accumulated expenditures -$2,050,000 Interest capitalized: $2,050,000 x 7.85% = $160,925 = Interest capitalized in 2011

36 Example 4b: Continued Expenditures for 2012: January 1, 2012 $3,160,925 x 9/9 = $3,160,925 January 31, ,000 x 8/9 = 240,000 April 30, ,000 x 5/9 = 325,000 August 31, ,000 x 1/9 = 100,000 Accumulated expenditures (before interest) -$4,915,925 Average accumulated expenditures - $3,825,925 Interest capitalized: $3,825,925 x 7.85% x 9/12 = $225,251 = Interest capitalized in 2012

37 Example 4b: Continued Cost of Building: Expenditures in 2011$3,000,000 Interest capitalized in ,925 Expenditures in ,755,000 Interest capitalized in ,251 Total cost of building$5,141,176 Interest Expense for 2011: Total interest incurred$1,020,000 Less: Capitalized (160,925) 2011 expense$ 859,075 Interest Expense for 2012: Total interest incurred$1,020,000 Less: Capitalized (225,251) 2012 expense$ 794,749


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