1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Operational Assets: Acquisition and Disposition 10 Insert Book Cover Picture

2. 10-2 Actively Used in Operations Tangible Property, Plant, Equipment & Natural Resources Tangible Property, Plant, Equipment & Natural Resources Intangible No Physical Substance Intangible No Physical Substance Types of Operational Assets Expected to Benefit Future Periods

3. 10-3 Learning Objectives Identify the various costs included in the initial cost of property, plant, and equipment, natural resources, and intangible assets.

4. 10-4 Costs to be Capitalized General Rule 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.

5. 10-5  Net purchase price  Taxes  Transportation costs  Installation costs  Modification to building necessary to install equipment  Testing and trial runs  Net purchase price  Taxes  Transportation costs  Installation costs  Modification to building necessary to install equipment  Testing and trial runs Costs to be Capitalized Equipment

6. 10-6 Land is not depreciable.  Purchase price  Real estate commissions  Attorney’s fees  Title search  Title transfer fees  Title insurance premiums  Removing old buildings  Purchase price  Real estate commissions  Attorney’s fees  Title search  Title transfer fees  Title insurance premiums  Removing old buildings Costs to be Capitalized Land

7. 10-7 Separately identifiable costs of Driveways Parking lots Fencing Landscaping Private roads Separately identifiable costs of Driveways Parking lots Fencing Landscaping Private roads Costs to be Capitalized Land Improvements

8. 10-8  Purchase price  Attorney’s fees  Commissions  Reconditioning  Purchase price  Attorney’s fees  Commissions  Reconditioning Costs to be Capitalized Buildings

9. 10-9 Purchase price, exploration and development costs of:  Timber  Mineral deposits  Oil and gas reserves Purchase price, exploration and development costs of:  Timber  Mineral deposits  Oil and gas reserves Costs to be Capitalized Natural Resources

10. 10-10 Asset Retirement Obligations Recognize as a liability and a corresponding increase in the related asset. Record at fair value, usually the present value of future cash outflows associated with the reclamation or restoration. Often encountered with natural resource extraction when the land must be restored to a useable condition.

11. 10-11 Intangible Assets Lack physical substance. Future benefits less certain than tangible assets. Exclusive Rights. Usually acquired for operational use. Intangible Assets

12. 10-12  Patents  Copyrights  Trademarks  Franchises  Goodwill  Patents  Copyrights  Trademarks  Franchises  Goodwill Record at current cash equivalent cost, including purchase price, legal fees, and filing fees. Costs to be Capitalized Intangible Assets

13. 10-13  An exclusive right recognized by law and granted by the US Patent Office for 20 years.  Holder has the right to use, manufacture, or sell the patented product or process without interference or infringement by others.  R & D costs that lead to an internally developed patent are expensed in the period incurred.  An exclusive right recognized by law and granted by the US Patent Office for 20 years.  Holder has the right to use, manufacture, or sell the patented product or process without interference or infringement by others.  R & D costs that lead to an internally developed patent are expensed in the period incurred. Patents

14. 10-14 Torch, Inc. has developed a new device. Research and development costs totaled $30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. What is Torch’s patent cost? Torch, Inc. has developed a new device. Research and development costs totaled $30,000. Patent registration costs consisted of $2,000 in attorney fees and $1,000 in federal registration fees. What is Torch’s patent cost? Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as incurred. Patents

15. 10-15  A form of protection given by law to authors of literary, musical, artistic, and similar works.  Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work.  Generally, the legal life of a copyright is the life of the author plus 70 years.  A form of protection given by law to authors of literary, musical, artistic, and similar works.  Copyright owners have exclusive rights to print, reprint, copy, sell or distribute, perform and record the work.  Generally, the legal life of a copyright is the life of the author plus 70 years. Copyrights

16. 10-16  A symbol, design, or logo associated with a business.  If internally developed, trademarks have no recorded asset cost.  If purchased, a trademark is recorded at cost.  Registered with U.S. Patent Office and renewable indefinitely in 10- year periods.  A symbol, design, or logo associated with a business.  If internally developed, trademarks have no recorded asset cost.  If purchased, a trademark is recorded at cost.  Registered with U.S. Patent Office and renewable indefinitely in 10- year periods. Trademarks

17. 10-17 Right to sell products or provide services purchased by franchisee from franchisor. Franchises

18. 10-18 Occurs when one company buys another company. The amount by which the purchase price exceeds the fair market value of net assets acquired. Only purchased goodwill is an intangible asset. Goodwill

19. 10-19 Eddy Company paid $1,000,000 to purchase all of James Company’s assets and assumed James Company’s liabilities of $200,000. James Company’s assets were appraised at a fair value of $900,000. Goodwill

20. 10-20 What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 Goodwill

21. 10-21 What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 What amount of goodwill should be recorded on Eddy Company books? a.$100,000 b.$200,000 c.$300,000 d.$400,000 Goodwill

22. 10-22 Learning Objectives Determine the initial cost of individual operational assets acquired as a group for a lump-sum purchase price.

23. 10-23 Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices. Lump-Sum Purchases Asset 2 Asset 1Asset 3 Allocation of the lump-sum price is based on relative values of the individual assets.

24. 10-24 On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500. How much of the $200,000 purchase price will be charged to the building account? On May 13, we purchase land and building for $200,000 cash. The appraised value of the building is $162,500, and the land is appraised at $87,500. How much of the $200,000 purchase price will be charged to the building account? Lump-Sum Purchases

25. 10-25 The building will be apportioned $130,000 of the total purchase price of $200,000. The building will be apportioned $130,000 of the total purchase price of $200,000. Lump-Sum Purchases Prepare the journal entry to record the purchase.

26. 10-26 Lump-Sum Purchases

27. 10-27 Noncash Acquisitions  Issuance of equity securities  Deferred payments  Donated Assets  Exchanges  Issuance of equity securities  Deferred payments  Donated Assets  Exchanges

28. 10-28 The asset acquired is recorded at The fair value of the consideration given or The fair value of the asset acquired Whichever is more objective and reliable. The asset acquired is recorded at The fair value of the consideration given or The fair value of the asset acquired Whichever is more objective and reliable. Noncash Acquisitions

29. 10-29 Learning Objectives Determine the initial cost of an operational asset acquired in exchange for a deferred payment contract.

30. 10-30 Deferred Payments Let’s consider an example where we must compute the present value of a noninterest-bearing note. Note payable Market interest rate Record asset at face value of note Less than market rate or noninterest bearing Record asset at present value of future cash flows.

31. 10-31 Deferred Payments On January 2, 2006, Midwestern Corporation purchased equipment by signing a noninterest-bearing requiring $50,000 to be paid on December 31, 2007. The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2006; December 31, 2006 (year-end), and December 31, 2007 (year-end). On January 2, 2006, Midwestern Corporation purchased equipment by signing a noninterest-bearing requiring $50,000 to be paid on December 31, 2007. The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2006; December 31, 2006 (year-end), and December 31, 2007 (year-end).

32. 10-32 Deferred Payments Since we do not know the cash equivalent price in this example, we must use the present value of the future cash payment.

33. 10-33 Deferred Payments

34. 10-34 Learning Objectives Determine the initial cost of operational asses acquired in exchange for equity securities or through donation.

35. 10-35 Issuance of Equity Securities  Asset acquired is recorded at the market value of the asset or the market value of the securities, whichever is more clearly evident.  If the securities are actively traded, market value can be easily determined.  If no objective and reliable value can be determined, board of directors assigns a “reasonable value.”  Asset acquired is recorded at the market value of the asset or the market value of the securities, whichever is more clearly evident.  If the securities are actively traded, market value can be easily determined.  If no objective and reliable value can be determined, board of directors assigns a “reasonable value.”

36. 10-36 Donated Assets  On occasion, companies acquire operational assets through donation.  SFAS No. 116 requires the receiving company to Record the donated asset on the books at fair value. Record revenue equal to the fair value of the donated asset.  On occasion, companies acquire operational assets through donation.  SFAS No. 116 requires the receiving company to Record the donated asset on the books at fair value. Record revenue equal to the fair value of the donated asset. Recently, in an effort to lure a facility for Dell Computers to Nashville, TN, the city donated land for the new facility. The deal created about 3,000 jobs locally.

37. 10-37 Learning Objectives Calculate the fixed asset turnover ratio used by analysts to measure how effectively managers use property, plant, and equipment.

38. 10-38 Fixed-Asset Turnover Ratio This ratio measures how effectively a company manages its fixed assets to generate revenue. Net sales Average fixed assets Fixed asset turnover ratio =

39. 10-39 Dell vs. Apple comparison Compute the fixed asset turnover ratio for both companies Receivables Management (All dollar amounts in millions)

40. 10-40 Receivables Management Dell $41,444 ($1,517 + $913)/2 = 34.1 Apple $8,279 ($707 + $669)/2 = 12.0 Net sales Average fixed assets Fixed asset turnover ratio = Dell generates nearly three times the sales dollars for each dollar invested in fixed assets.

41. 10-41 Learning Objectives Explain how to account for dispositions and exchanges for other nonmonetary assets.

42. 10-42 Dispositions  Update depreciation to date of disposal.  Remove original cost of asset and accumulated depreciation from the books.  The difference between book value of the asset and the amount received is recorded as a gain or loss. Accounting Steps

43. 10-43 On June 30, 2006, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2001 at a cost of $15,000. The equipment was depreciated using the straight- line method over an estimated ten-year life with zero salvage value. MeLo last recorded depreciation on the equipment on December 31, 2005, its year-end. Prepare the journal entries necessary to record the disposition of this equipment. On June 30, 2006, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2001 at a cost of $15,000. The equipment was depreciated using the straight- line method over an estimated ten-year life with zero salvage value. MeLo last recorded depreciation on the equipment on December 31, 2005, its year-end. Prepare the journal entries necessary to record the disposition of this equipment. Dispositions

44. 10-44  Update depreciation to date of sale. Dispositions

45. 10-45  Remove original cost of asset and accumulated depreciation from the books.  Record the gain or loss. Dispositions

46. 10-46 Exchanges  The valuation of an asset exchange depends on whether cash is paid or received.  General Valuation Principle (GVP): Cost of asset acquired is... Fair value of asset given up plus cash paid or minus cash received or Fair value of asset acquired, if it is more clearly evident.  The valuation of an asset exchange depends on whether cash is paid or received.  General Valuation Principle (GVP): Cost of asset acquired is... Fair value of asset given up plus cash paid or minus cash received or Fair value of asset acquired, if it is more clearly evident.

47. 10-47 Exchanges In the exchange of operational assets fair value is used except in rare situations in which the fair value cannot be determined or the exchange lacks commercial substance. When fair value cannot be determined or the exchange lacks commercial substance, the asset(s) acquired are valued at the book value of the asset(s) given up, plus (or minus) any cash exchanged. No gain is recognized.

48. 10-48 Matrix, Inc. exchanges one unique operational asset for another operational asset. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up had a cost to Matrix of $600,000, and accumulated depreciation of $400,000. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction. Matrix, Inc. exchanges one unique operational asset for another operational asset. Due to the nature of the assets exchanged, Matrix could not determine the fair value of the asset given up or received. The asset given up had a cost to Matrix of $600,000, and accumulated depreciation of $400,000. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction. Fair Value Not Determinable

49. 10-49 In addition, Matrix paid $100,000 cash to acquire the operational asset. Fair Value Not Determinable

50. 10-50 Matrix, Inc. The journal entry below shows the proper recording of the exchange. Matrix, Inc. The journal entry below shows the proper recording of the exchange. Fair Value Not Determinable

51. 10-51 Exchange Lacks Commercial Substance When exchanges are recorded at fair value, any gain or loss is recognized for the difference between the fair value and book value of the asset(s) given-up. To preclude the possibility of companies engaging in exchanges of appreciated assets solely to be able to recognize gains, fair value can only be used in legitimate exchanges that have commercial substance.

52. 10-52 Exchange Lacks Commercial Substance A nonmonetary exchange is considered to have commercial substance if the company:  expects a change in future cash flows as a result of the exchange, and  that expected change is significant relative to the fair value of the assets exchanged. A nonmonetary exchange is considered to have commercial substance if the company:  expects a change in future cash flows as a result of the exchange, and  that expected change is significant relative to the fair value of the assets exchanged.

53. 10-53 Matrix, Inc. exchanged new equipment and $10,000 cash for equipment owned by Float, Inc. Below is information about the asset exchanged by Matrix. Record the transaction assuming the exchange has commercial substance. Matrix, Inc. exchanged new equipment and $10,000 cash for equipment owned by Float, Inc. Below is information about the asset exchanged by Matrix. Record the transaction assuming the exchange has commercial substance. Exchanges

54. 10-54 Exchange Has Commercial Substance $205,000 fair value + $10,000 cash

55. 10-55 Equipment received should be valued at book value of equipment transferred plus cash paid. Exchange Does Not Have Commercial Substance $200,000 book value + $10,000 cash

56. 10-56 Learning Objectives Identify the items included in the cost of a self- constructed asset and determine the amount of capitalized interest.

57. 10-57 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 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

58. 10-58 Under certain conditions, avoidable interest incurred on qualifying assets is capitalized. Interest that could have been avoided if the asset were not constructed and the money used to retire debt. An asset constructed:  For a company’s own use.  As a discrete project for sale or lease. An asset constructed:  For a company’s own use.  As a discrete project for sale or lease. Interest Capitalization

59. 10-59 Capitalization begins when  construction begins  interest is incurred, and  qualifying expenses are incurred. Capitalization ends when...  The asset is substantially complete and ready for its intended use,  or when interest costs no longer are being incurred. Capitalization begins when  construction begins  interest is incurred, and  qualifying expenses are incurred. Capitalization ends when...  The asset is substantially complete and ready for its intended use,  or when interest costs no longer are being incurred. Interest Capitalization

60. 10-60 Interest is capitalized based on Average Accumulated Expenditures (AAE). Qualifying expenditures include labor, material and overhead incurred on the construction project during accounting period. Qualifying expenditures weighted for the number of months outstanding during the current accounting period. Interest Capitalization

61. 10-61 If the qualifying asset is financed through a specific new borrowing...... use the specific rate of the new borrowing as the capitalization rate. If there is no specific new borrowing, and the company has other debt...... use the weighted average cost of other debt as the capitalization rate. Interest Capitalization Consider the following example.

62. 10-62 Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec. 31. Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, Oct. 1, $200,000; and Dec. 1, $300,000. Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize. Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec. 31. Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, Oct. 1, $200,000; and Dec. 1, $300,000. Welling borrowed $1,000,000 on May 1, from Bub’s Bank for 10 years at 10 percent to finance the construction. The loan is related to the construction project and the company uses the specific interest method to compute the amount of interest to capitalize. Interest Capitalization

63. 10-63 Average Accumulated Expenditures Interest Capitalization

64. 10-64 Since the $1,000,000 of specific borrowing is sufficient to cover the $225,000 of average accumulated expenditures for the year, use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize. Interest = AAE × Specific Borrowing Rate Interest = $225,000 × 10% = $22,500 Since the $1,000,000 of specific borrowing is sufficient to cover the $225,000 of average accumulated expenditures for the year, use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize. Interest = AAE × Specific Borrowing Rate Interest = $225,000 × 10% = $22,500 Interest Capitalization

65. 10-65 Interest Capitalization If Welling had not borrowed specifically for this construction project, it would have used the weighted-average interest method. The weighted average interest rate on other debt would have been used to compute the amount of interest to capitalize. For example, if the weighted-average interest rate on other debt is 12 percent, the amount of interest capitalized would be: Interest = AAE × Weighted-average Rate Interest = $225,000 × 12% = $27,000 If Welling had not borrowed specifically for this construction project, it would have used the weighted-average interest method. The weighted average interest rate on other debt would have been used to compute the amount of interest to capitalize. For example, if the weighted-average interest rate on other debt is 12 percent, the amount of interest capitalized would be: Interest = AAE × Weighted-average Rate Interest = $225,000 × 12% = $27,000

66. 10-66 If specific new borrowing had been insufficient to cover the average accumulated expenditures... Specific new borrowing AAE... Capitalize this portion using the 10 percent specific borrowing rate. Other debt... Capitalize this portion using the 12 percent weighted- average cost of debt. Interest Capitalization

67. 10-67 Learning Objectives Explain the difference in the accounting treatment of costs incurred to purchase intangible assets versus the costs incurred to internally develop intangible assets.

68. 10-68 Research Planned search or critical investigation aimed at discovery of new knowledge... Development The translation of research findings or other knowledge into a plan or design... Most R&D costs are expensed as incurred. (Must be disclosed if material.) Research Planned search or critical investigation aimed at discovery of new knowledge... Development The translation of research findings or other knowledge into a plan or design... Most R&D costs are expensed as incurred. (Must be disclosed if material.) Research and Development (R&D)

69. 10-69  R&D costs incurred under contract for other companies are expensed against revenue from the contract.  Operational assets used in R&D should be capitalized if they have alternative future uses.  R&D costs incurred under contract for other companies are expensed against revenue from the contract.  Operational assets used in R&D should be capitalized if they have alternative future uses. Research and Development (R&D)

70. 10-70 Software Development Costs SFAS No. 86  All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred.  Subsequent costs to obtain product masters are to be capitalized as an intangible asset.  All costs incurred to establish the technological feasibility of a computer software product are treated as R&D and expensed as incurred.  Subsequent costs to obtain product masters are to be capitalized as an intangible asset. “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed”

71. 10-71 Start of R&D Activity Technological Feasibility Date of Product Release Sale of Product Costs Expensed as R&D Costs Capitalized Operating Costs Software Development Costs SFAS No. 86

72. 10-72  Amortization of capitalized computer software costs starts when the product begins to be marketed.  Two methods are allowed:  Percentage of revenue method  Straight-line method  Amortization of capitalized computer software costs starts when the product begins to be marketed.  Two methods are allowed:  Percentage of revenue method  Straight-line method Software Development Costs SFAS No. 86

73. 10-73 Balance Sheet  The unamortized portion of capitalized computer software cost is an asset. Income Statement  Amortization expense associated with computer software cost.  R&D expense associated with computer software development cost. Balance Sheet  The unamortized portion of capitalized computer software cost is an asset. Income Statement  Amortization expense associated with computer software cost.  R&D expense associated with computer software development cost. Disclosure Software Development Costs SFAS No. 86

74. 10-74 Appendix 10 Oil and Gas Accounting

75. 10-75 Oil and Gas Accounting Two acceptable accounting alternatives Successful efforts method Full-cost method Exploration costs resulting in unsuccessful wells (dry holes) are expensed. Exploration costs resulting in unsuccessful wells may be capitalized. Political pressure has prevented the FASB from requiring all companies to use the successful efforts method.

76. 10-76 The Shannon Oil company incurred $2,000,000 in exploration costs for each of 10 oil wells in 2006. Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Successful Efforts Oil and Gas Accounting

77. 10-77 The Shannon Oil company incurred $2,000,000 in exploration costs for each of 10 oil wells in 2006. Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods. Full Cost Oil and Gas Accounting

78. 10-78 End of Chapter 10