Chapter 10: Acquisition and Disposition of Property, Plant and Equipment

Classification of PP&E Long-term assets have a number of classifications. Assets are classified in PP&E if they possess the following characteristics: Acquired for use in operations and not for resale. For example, if land is held for resale it would either be classified in inventory or investment. Long term in nature and usually depreciated (except for land). Possess physical substance. This characteristic excludes intangibles such as patents and goodwill.

Costs to Capitalize General Rule: Capitalize (add to an asset account) the costs to acquire the asset and to prepare it for its intended use. Note: for all acquisitions, part of the cost is the purchase price, specifically the “cash equivalent” purchase price (the amount we would pay if we paid cash). This excludes any cost of financing the purchase (interest expense).

Costs to Capitalize Land purchase price, clearing costs, survey costs, accrued taxes, closing costs, brokerage fees, commissions, title insurance, etc. Note that proceeds from salvage of materials from clearing land are used to offset the cost of the land. Land improvements purchase price, for some landscaping (temporary), parking lots, sidewalks and fences.

Costs to Capitalize Machinery and equipment purchase price, taxes, freight, insurance while in transit, installation, assembly, trial runs, testing and inspection during set up (preproduction costs). Buildings purchase price (or cost to construct – material, labor, overhead), closing costs, attorney’s fees, building permits, etc.

Costs to Capitalize Note: interest is not capitalized on purchase of PP&E; it is treated as a finance charge (interest expense). If a purchase discount is offered, the asset is recorded net of the discount (cash equivalent price), even if the discount is not taken. One exception to the non-capitalization of interest: For self-constructed assets (equipment, buildings, etc), companies are allowed to capitalize interest costs (put the interest in the asset account), but only for the interest incurred during the construction period.

Interest Cost Capitalization Applicable to self-constructed assets where an extended period is required and significant expenditures are made during construction. Types of assets that qualify: Assets constructed by a company for its own use. Assets that are intended for sale or lease that are discrete projects (e.g., real estate developments). Capitalization period begins when Expenditures have been made. Construction activities are underway. Interest cost is being incurred.

Interest Cost Capitalization 1. Calculate Average Accumulated Expenditures (AAE), the amount to which interest costs will be assigned; weighted average based on time outstanding during the construction period. Example 1 (for period ending 12/31/12), assuming construction has begun by April 1, 2012: Date Payment Fraction April 1 $90,000 x 9/12 = $ 67,500 June 1 45,000 x 7/12 = 26,250 Dec. 1 12,000 x 1/12 = 1,000 Avg. Accumulated Expenditures $94,750 This is the annualized average spending for the year, and is the basis for the interest calculation.

Interest Cost Capitalization If construction ended on December 1, 2012, the numerator is changed to reflect the period outstanding through December 1: Date Payment Fraction April 1 $90,000 x 8/12 = $ 60,000 June 1 45,000 x 6/12 = 22,500 Dec. 1 12,000 x 0/12 = __0___ Avg. Accumulated Expenditures $82,500 If construction goes into the second year, the balance in the Building (Construction in Progress) account, including capitalized interest, is carried forward as the starting expenditures for the second year.

Interest Cost Capitalization 2. Calculate the avoidable interest. First: use the specific borrowing rate on any funds borrowed specifically for the project. Next: if applicable, use the weighted average borrowing rate on the remaining borrowings. If specific borrowing in Example 1 is $50,000 at a 4 percent interest rate, and the remainder of the borrowing is $200,000 at an average rate of 5%: Specific borrowing $50,000 x .04 = $2,000 Other borrowing 44,750 x .05 = 2,238 Total $94,750 $4,238 Avoidable Int. .

Interest Cost Capitalization 3. Compare avoidable interest to total interest where total interest (assuming all notes have been outstanding since January 1, 2012) is calculated as follows: 50,000 x .04 = 2,000 200,000 x .05 = 10,000 Total interest = 12,000 (greater than avoidable) So capitalize avoidable interest (cannot have negative interest expense).

Interest Cost Capitalization Chapter 10 Power Points Interest Cost Capitalization 4. Summary journal entries for 2012: (a) Actual expenditures (90,000+ 45,000+12,000) Building (CIP) 147,000 Cash 147,000 (b) Actual interest paid: Interest Expense 12,000 Cash 12,000 (c) Capitalization of avoidable interest: Building (CIP) 4,238 Interest Expense 4,238 If construction continues in 2013, the starting balance for expenditures will be $151,238.

Additional Valuation Issues Chapter 10 Power Points Additional Valuation Issues Nonmonetary Exchanges – exchange of PP&E where cash is a small part of the exchange (see handout on Nonmonetary Exchanges. Deferred Payment Contracts – even when note is “non-interest bearing” transaction to record asset purchase must separate interest component from cash equivalent price of the asset (use present value to estimate the cash equivalent price). Lump Sum Purchases – use proportional fair market value to allocate cost to specific assets. Purchase with the Issuance of Stock – if stock price known, use stock price to value asset received; if stock price not known, use fair value of asset received to value stock issued.

Costs Subsequent to Acquisition Chapter 10 Power Points Costs Subsequent to Acquisition If cost is incurred to achieve greater future benefit, the cost should be capitalized. If cost is incurred to maintain existing performance, the cost should be expensed. Capitalization requires one of the three following conditions to be met: The useful life of the asset is increased The quantity of output from the asset is increased. The quality of output must be enhanced.

Treatment of Subsequent Costs Chapter 10 Power Points Treatment of Subsequent Costs Additions – new asset is created, and the costs should be capitalized. Improvements and Replacements – Improvements (betterments) substitute a better asset for the existing asset. Replacements substitute a similar asset for the existing asset. Alternate treatments: 1. Substitution approach – remove old asset, record new asset, recognize gain or loss. 2. Capitalize new cost, and leave old asset or component on the books. 3. Reduce Accumulated Depreciation – if the cost extends the useful life.

Treatment of Subsequent Costs Chapter 10 Power Points Treatment of Subsequent Costs Rearrangement and Reinstallation – incurred to increase efficiency and to benefit future periods. Usually capitalize new costs and amortize over periods benefitted (old costs may be difficult to separate and remove). Repairs – Ordinary repairs undertaken to maintain existing conditions should be expensed in the period incurred. Major repairs often improve the asset’s performance or extend its useful life; these expenditures should be capitalized.