© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 10 Operational Assets: Acquisition and Disposition

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 10-3 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 10-4 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 10-5 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 10-6 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 10-7 Purchase price Architectural fees Cost of permits Excavation costs Construction costs Purchase price Architectural fees Cost of permits Excavation costs Construction costs Costs to be Capitalized ---- Buildings

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 10-8 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 10-9 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Intangible Assets Lack physical substance. Economic benefits last beyond the current period. Useful life is often difficult to determine. Usually acquired for operational use. Intangible Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Patents Copyrights Trademarks Franchises Organization costs Goodwill Patents Copyrights Trademarks Franchises Organization costs Goodwill Record at current cash equivalent cost, including purchase price, legal fees, and filing fees. Costs to be Capitalized ---- Intangible Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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. Internally developed costs (R&D) that result in patents 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. Internally developed costs (R&D) that result in patents are expensed in the period incurred. Patents

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Right to sell products or provide services purchased by franchisee from franchisor. Franchises

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 2Asset 1Asset 3 Portions of the lump-sum price attributable to particular assets are assigned to those assets. Allocation of the remaining lump-sum price is based on relative values of the individual assets.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Lump-Sum Purchases

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Noncash Acquisitions Deferred payments Issuance of equity securities Donated Assets Exchanges Deferred payments Issuance of equity securities Donated Assets Exchanges

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Deferred Payments The asset acquired is recorded at the Cash equivalent price (market value) or Present value of future cash payments using the prevailing market interest rate Whichever is more objective and reliable. The asset acquired is recorded at the Cash equivalent price (market value) or Present value of future cash payments using the prevailing market interest rate Whichever is more objective and reliable.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Deferred Payments On May 1, 2003, Fesler, Inc. purchased equipment paying $3,000 down and issuing a note payable. The note requires four annual payments of $2,500 with the first payment due on May 1, The note is noninterest- bearing. The prevailing market rate of interest on notes of this nature is 12%. Prepare the required journal entries on May 1, 2003, and December 31, 2003 (year-end). On May 1, 2003, Fesler, Inc. purchased equipment paying $3,000 down and issuing a note payable. The note requires four annual payments of $2,500 with the first payment due on May 1, The note is noninterest- bearing. The prevailing market rate of interest on notes of this nature is 12%. Prepare the required journal entries on May 1, 2003, and December 31, 2003 (year-end).

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Deferred Payments Since we do not know the cash equivalent price in this example, we must use the present value of the future cash payments.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Deferred Payments Example

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 objective and reliable. 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 objective and reliable. 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.”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Donated Assets On occasion, companies acquire operational assets through donation. SFAS No. 116 requires the receiving company to record revenue equal to the value of the donated asset. Record the donated asset on the books at market value. On occasion, companies acquire operational assets through donation. SFAS No. 116 requires the receiving company to record revenue equal to the value of the donated asset. Record the donated asset on the books at market value. 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.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Dispositions  Update depreciation to date of disposal.  Remove original cost of asset and accumulated depreciation from the books.  The difference between BV of the asset and the amount received is recorded as a gain or loss. Accounting Steps

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide On June 30, 2003, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 1998 at a cost of $15,000. The asset had a useful life of 10 years and no salvage value. MeLo last recorded depreciation on the equipment on December 31, 2002, its year-end. Prepare the journal entries necessary to record the disposition of this equipment. On June 30, 2003, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 1998 at a cost of $15,000. The asset had a useful life of 10 years and no salvage value. MeLo last recorded depreciation on the equipment on December 31, 2002, its year-end. Prepare the journal entries necessary to record the disposition of this equipment. Dispositions

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide  Update depreciation to date of sale. Dispositions

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide  Remove original cost of asset and accumulated depreciation from the books.  Record the gain or loss. Dispositions

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Exchanges The valuation of a nonmonetary 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 readily determinable. The valuation of a nonmonetary 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 readily determinable.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Exchanges

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide SAM, Co. exchanged inventory for a piece of equipment owned by Mette, Inc. The inventory has a cost basis to SAM of $125,000, and a fair value of $200,000. The equipment has a fair value of $220,000, and a cost basis to Mette of $325,000. Mette has recorded depreciation of $150,000 on the equipment. Record the exchange on the books of SAM and Mette. Exchanges of Dissimilar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide The assets exchanged are dissimilar in nature, so the implied gain should be recognized in full. Exchanges of Dissimilar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide SAM, Co. Asset acquired should be valued at the fair value of asset given up. SAM, Co. Asset acquired should be valued at the fair value of asset given up. Exchanges of Dissimilar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide The assets exchanged are dissimilar in nature, so the implied gain should be recognized in full. Exchanges of Dissimilar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Mette, Inc. Asset acquired should be valued at the fair value of asset transferred. Mette, Inc. Asset acquired should be valued at the fair value of asset transferred. Exchanges of Dissimilar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Now let’s see an example with similar assets. Exchanges of Similar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amgen, Co. exchanged similar equipment and $10,000 cash for equipment owned by Versa, Inc. Using the information below, record the exchange on the books of Amgen and Versa. Amgen, Co. exchanged similar equipment and $10,000 cash for equipment owned by Versa, Inc. Using the information below, record the exchange on the books of Amgen and Versa. Exchanges of Similar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide The assets exchanged are similar in nature, and cash is not received, so the implied gain should not be recognized. Exchanges of Similar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amgen Equipment received should be valued at the BV of equipment transferred plus cash paid. Amgen Equipment received should be valued at the BV of equipment transferred plus cash paid. Exchanges of Similar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide The assets exchanged are similar in nature. Since cash is received, a partial gain should be recognized. Exchanges of Similar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Exchanges of Similar Assets The assets exchanged are similar in nature. Since cash is received, a partial gain should be recognized.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Versa Equipment received valued at fair value less portion of gain not recognized. Versa Equipment received valued at fair value less portion of gain not recognized. Exchanges of Similar Assets

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Let’s change the subject.

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Interest is capitalized based on Average Accumulated Expenditures (AAE). Examples include: Cash payments for construction Transfer of other assets Incurrence of interest- bearing liabilities Examples include: Cash payments for construction Transfer of other assets Incurrence of interest- bearing liabilities Qualifying expenditures weighted for the number of months outstanding during the current accounting period. Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide If the qualifying asset is financed through a specific new borrowing use the specific rate of the new borrowing as the capitalization rate. If the qualifying asset is internally financed use the weighted average cost of debt as the capitalization rate. Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide If the AAE < the amount of the specific new borrowing... Specific new borrowing AAE... Capitalize this portion using specific borrowing rate. Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide If the AAE is > the amount of the specific new borrowing... Specific new borrowing AAE... Capitalize this portion using specific borrowing rate. Internal financing... Capitalize this portion using weighted average cost of debt. Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Steps in the capitalization process  Compute actual interest expense.  Compute AAE.  Determine how much interest is potentially capitalizable (IPC).  Capitalize the smaller of actual interest or capitalizable interest. Steps in the capitalization process  Compute actual interest expense.  Compute AAE.  Determine how much interest is potentially capitalizable (IPC).  Capitalize the smaller of actual interest or capitalizable interest. Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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 recorded total interest expense of $175,000 during the year, including construction borrowing of $1,000,000 on May 1, from Bub’s Bank for 10 years at 12%. 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 recorded total interest expense of $175,000 during the year, including construction borrowing of $1,000,000 on May 1, from Bub’s Bank for 10 years at 12%. Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Ê Actual interest expense is $175,000. Ë Compute AAE: Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Ì Compute the IPC: Since AAE < Specific Borrowing, use the specific borrowing interest rate of 12%. IPC = AAE × Capitalization rate IPC = $225,000 × 12% = $27,000 Ì Compute the IPC: Since AAE < Specific Borrowing, use the specific borrowing interest rate of 12%. IPC = AAE × Capitalization rate IPC = $225,000 × 12% = $27,000 Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Í Capitalize the smaller of actual interest or IPC. Actual interest ($175,000) > IPC ($27,000) Capitalize $27,000! Í Capitalize the smaller of actual interest or IPC. Actual interest ($175,000) > IPC ($27,000) Capitalize $27,000! Interest Capitalization

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide 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)

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Software Development Costs SFAS No. 86 All costs incurred to establish the technological feasibility of a computer software product are to be 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 to be 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”

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Software Development Costs SFAS No. 86 Start of R&D Activity Technological Feasibility Start of Commercial Production Sale of Product or Process Costs are Expensed as R&D Costs are Capitalized Costs are not R&D

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Amortization of capitalized computer software costs starts when the product begins to be marketed. Two methods are allowed: Revenue method Straight-line method Amortization of capitalized computer software costs starts when the product begins to be marketed. Two methods are allowed: Revenue method Straight-line method Software Development Costs SFAS No. 86

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide Balance Sheet Unamortized computer software product master cost is an asset. Income Statement Amortization expense associated with computer software cost. R&D expense associated with computer software development cost. Balance Sheet Unamortized computer software product master cost is an asset. Income Statement Amortization expense associated with computer software cost. R&D expense associated with computer software development cost. Software Development Costs SFAS No. 86 Disclosure

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Slide End of Chapter 10 I need help!