Operational Assets: Acquisition and Disposition

Operational Assets: Acquisition and Disposition
Chapter 10 Operational Assets: Acquisition and Disposition

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

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.

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

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

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

Costs to be Capitalized ---- Buildings
Purchase price Architectural fees Cost of permits Excavation costs Construction costs

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

Asset Retirement Obligations
Often encountered with natural resource extraction when the land must be restored to a useable condition. 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.

Intangible Assets Intangible Assets Lack physical substance.
Useful life is often difficult to determine. Intangible Assets Economic benefits last beyond the current period. Usually acquired for operational use.

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

Patents An exclusive right recognized by law and granted by the Canadian Intellectual Property 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.

What is Torch’s patent cost?
Patents Torch, Inc. has developed a new device. Research and development costs totalled $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.

Copyrights 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.

Trademarks 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 Canadian Intellectual Property Office and renewable indefinitely in 10-year periods.

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

Deferred Charges These include deferred development costs, preoperating and startup costs, and organization costs.

Goodwill Goodwill 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 The Smithson Corporation acquired the net assets of the Rider Corporation in exchange for $18 million cash.

Goodwill What amount of goodwill should be recorded on Eddy Company books? a. $3 b. $7 c. $5 d. $4 What amount of goodwill should be recorded on Eddy Company books? a. $100,000 b. $200,000 c. $300,000 d. $400,000

Lump-Sum Purchases Several assets are acquired for a single, lump-sum price that may be lower than the sum of the individual asset prices. 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. Asset 1 Asset 2 Asset 3

An independent business valuation report estimated the market values.
Lump-Sum Purchases The Smyrna Hand & Edge Tools Company purchased an existing factory for $2 million. The price included the land, the building, the equipment in the building, a patent, and inventories of raw materials. An independent business valuation report estimated the market values.

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

Lump-Sum Purchases

Noncash Acquisitions Deferred payments Issuance of equity securities
Donated Assets Exchanges

Deferred Payments or 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.

Deferred Payments On June 30, 2005, the Prairie Steam Gas Corporation purchased equipment. Prairie paid $10,000 on the purchase date and signed a non-interest-bearing note requiring the balance to be paid in five annual payments of $10,000 beginning June 30, The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries on June 30, 2005, and December 31, 2005 (year-end), and June 30, 2006.

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.

Deferred Payments Example

Deferred Payments On January 1, 2005, Dennison Inc. purchased a machine and signed a non-interest-bearing note. The note requires the company to make five annual payments of $20,000 beginning December 31, Dennison is not sure what interest rate reflects the time value of money. However, the machine could have been purchased for $79,854 cash. Prepare the required journal entries on January 1, 2005, and December 31, 2005 (year-end).

Deferred Payments Example

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.”

Issuance of Equity Securities
On March 31, 2005, the Elcorn Company issued 10,000 common shares in exchange for land. On the date of the transaction, the market value of the common shares was $20 per share. Prepare the required journal entries to record this transaction.

Issuance of Equity Securities Example

Donated Assets On occasion, companies acquire operational assets through donation. CICA HB requires the receiving company to Credit other contributed capital. Record the donated asset on the books at market value.

The deal created about 3,000 jobs locally.
Donated Assets On occasion, companies acquire operational assets through donation. CICA HB 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.

Government Assistance
Government assistance towards the acquisition of fixed assets should be either: deducted from the related fixed assets with any amortization calculated on the net amount (cost reduction method); or deferred and amortized to income on the same basis as the related depreciable asset are amortized (deferral method).

Government Assistance
The Elcorn Company purchased manufacturing equipment costing $500,000. The Company is entitled to government assistance of 40%. The machinery has a 10-year life with no salvage value.

Cost Reduction Method

Deferral Method - differences

Key Ratio The fixed-asset turnover ratio measures a company’s effectiveness in managing property, plant and equipment. Fixed-asset turnover ratio Net sales Average fixed assets =

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

Dispositions The Robosport Company sold for $6,000 machinery that originally cost $20,000. Amortization of $12,000 had been recorded up to the date of sale. Prepare the journal entries necessary to record the disposition of this equipment.

Dispositions Amortization has already been recorded up to the date of sale.

Dispositions Remove original cost of asset and accumulated depreciation from the books. Record the gain or loss.

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.

Exchanges

Exchanges of Dissimilar Assets
The Elcorn Company traded land it had been holding as an investment in exchange for equipment. The land had a book value of $100,000. The fair value of the land is $80,000 and $10,000 cash is given. Record the exchange on the books of Elcorn.

Elcorn The $20,000 loss recognized is the difference between the fair value and book value of the land.

The Elcorn Company traded land it had been holding as an investment in exchange for equipment. The land had a book value of $100,000. The fair value of the land is $80,000 and $10,000 cash is received. Record the exchange on the books of Elcorn.

Elcorn The $20,000 loss recognized is the difference between the fair value and book value of the land.

The Elcorn Company traded land it had been holding as an investment in exchange for equipment. The land had a book value of $100,000. The fair value of the land is $140,000 and $10,000 cash is given. Record the exchange on the books of Elcorn.

Elcorn The $40,000 gain recognized is the difference between the fair value and book value of the land.

The Elcorn Company traded land it had been holding as an investment in exchange for equipment. The land had a book value of $100,000. The fair value of the land is $140,000 and $10,000 cash is received. Record the exchange on the books of Elcorn.

Elcorn The $40,000 gain recognized is the difference between the fair value and book value of the land.

Dissimilar Assets - Summary
Recognize the difference between the fair value and the book value of the asset given up as a gain or loss. Value the asset required at the fair value of the asset given up plus (minus) and cash paid (received). If the fair value of the asset given up can not be determined, the asset received is recorded at its fair value.

Exchanges of Similar Assets
Now let’s see an example with similar assets.

The Elcorn Company exchanged equipment used in the production process for new equipment to be used for a similar purpose. $10,000 cash is given up.

Elcorn Equipment received should be valued at fair value of the old equipment plus cash paid.

The Elcorn Company exchanged equipment used in the production process for new equipment to be used for a similar purpose. $10,000 cash is received.

Elcorn Equipment received should be valued at the market value of the old equipment transferred minus the cash received.

The Elcorn Company exchanged equipment used in the production process for new equipment to be used for a similar purpose. $10,000 cash is given.

Elcorn Equipment received should be valued at the fair value of the old equipment.

The Elcorn Company exchanged equipment used in the production process for new equipment to be used for a similar purpose. $15,000 cash is received.

Elcorn 10% of the fair value of the old equipment was received in cash.

Exchanges of Assets - Summary

Let’s change the subject.

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

Interest Capitalization
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.

Interest is capitalized based on Weighted Average Accumulated Expenditures (WAAE). Qualifying expenditures weighted for the number of months outstanding during the current accounting period. Examples include: Cash payments for construction Transfer of other assets Incurrence of interest-bearing liabilities

If the qualifying asset is financed through a specific new borrowing . . . If the qualifying asset is internally financed . . . . . . use the specific rate of the new borrowing as the capitalization rate. . . . use the weighted average cost of debt as the capitalization rate.

If the AAE < the amount of the specific new borrowing . . . Specific new borrowing . . . Capitalize this portion using specific borrowing rate. AAE

If the WAAE is > the amount of the specific new borrowing . . . . . . Capitalize this portion using weighted average cost of debt. Internal financing . . . Capitalize this portion using specific borrowing rate. WAAE Specific new borrowing

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.

Steps in the capitalization process Compute actual interest expense. Compute WAAE. Determine how much interest is potentially capitalizable (IPC). Capitalize the smaller of actual interest or capitalizable interest.

On January 1, 2005, the Mills Conveying Equipment Company began construction of a building. The building was completed on June 30, Expenditures were: Jan. 3, 2005, $500,000; Mar. 31, 2005, $400,000, Sept. 30, $600,000; Jan. 31, 2006, $600,000; and Apr. 30, 2006, $300,000.

On January 2, 2005, the company obtained a $1 million construction loan with an 8% interest rate. The loan was outstanding for the entire construction period. The company’s other interest-bearing debt included two long-term notes of $2 million and $4 million with interest rates of 6% and 12% respectively. Both notes were outstanding during the entire construction period.

Compute WAAE by the end of 2005:

Compute interest on the other interest bearing debt for 2005:

Compare calculated interest with actual interest incurred and use the lower amount.

Capitalize the smaller of actual interest or IPC. Actual interest ($680,000) > IPC ($76,000) Capitalize $76,000!

Compute WAAE to the end of the project:

Calculate the interest on the WAAE.

Compare calculated interest with actual interest incurred and use the lower amount.

The total capitalized cost of the building would be as follows:

Interest expensed The difference between the actual interest and the capitalized interest is expensed. In 2005 this amount would be $604,000 ($680,000 - $76,000). In 2006 it would be $241,200 ($340,000 -$98,800)

Research and Development (R&D)
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.

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.)

Development capitalization criteria Clearly defined product or process and costs can be identified. Technical feasibility established. Intend to produce and market. Clearly defined market and is useful. Have resources to complete.

R & D Example The Askew Company made the following cash expenditures during 2005 related to the development of a new industrial plastic: R&D salaries and wages $10,000,000 R&D supplies consumed during 2005 3,000,000 Purchase of R&D equipment 5,000,000 Payments to others for services performed in connection with R&D 1,200,000 Total $19,200,000

R & D Example The future market for the product is not clearly defined, and it is not certain that resources will exist to complete the project. The equipment purchased will be employed in other projects. Amortization on the equipment for 2005 was $500,000.

R & D Example

R&D Performed for Others
Section 3450 of the CICA Handbook does not apply to companies that perform R&D for other companies under contract. In these situations, the R&D costs are capitalized as inventory and carried forward into future years until the project is completed.

Software Development Costs SFAS No. 86
“Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed” 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.

Costs are Expensed as R&D Costs are Capitalized Costs are not R&D Start of R&D Activity Technological Feasibility Start of Commercial Production Sale of Product or Process

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 Example
Let’s take a look at Illustration 10-16 page Summary information is as follows: the project began in 2004, reached technological feasibility at the end of June 2005 and began commercial production in early 2006.

$1,200,000 $800,000 Costs are Expensed as R&D Costs are Capitalized Costs are not R&D Start of R&D Activity Technological Feasibility Start of Commercial Production Sale of Product or Process June 2005 Early 2006 2004

2006 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. Calculate amortization for 2006.

Percentage-of-revenue method: $3,000,000/($3,000,000+7,000,000)= 30% 30% x $800,000=$240,000 2006 Sales 2006 Sales Additional Sales Costs capitalized

2. Straight-line method: ¼ x $800,000 = $200,000 4 years

Disclosure 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.

Web Site Development Costs
CICA EIC-118 suggests that: All costs in the planning stage be expensed. All hardware and software used to operate a Web site generally should be capitalized. Costs of developing initial graphics should be capitalized. Modifications post-launch should be evaluated to determine if they represent maintenance or a betterment.

Web Site Development Costs
4. Costs to convert content from old to new systems should be expensed. 5. Costs of operating a Web site should be expensed.

End of Chapter 10 I need help!

Operational Assets: Acquisition and Disposition

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