1. Operational Assets: acquisition and disposition
Chapter 10
Operational Assets: acquisition and disposition
Chapter 10: Operational Assets: Acquisition and Disposition.

2. Types of Operational Assets
Actively Used in Operations
Expected to Benefit Future Periods
Intangible
No Physical Substance
Tangible
Property, Plant, Equipment & Natural Resources
Part I.
Operational assets are assets that are used actively in the operations of the business, and that are expected to benefit the operations into the future.
There are two major categories of operational assets. Tangible operational assets have physical substance. Included in this category are land, buildings, equipment, machinery, vehicles, and natural resources such as oil, gas, and mineral deposits. Intangible assets are operational assets without physical substance. Included in this category are patents, copyrights, trademarks, franchises, and goodwill.
Part II.
Operational assets may be acquired in a number of ways. Regardless of the method of acquisition, the assets are recorded at their original cost. The recorded cost includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.
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.

3. Costs to be Capitalized
Equipment
Net purchase price
Taxes
Transportation costs
Installation costs
Modification to building necessary to install equipment
Testing and trial runs
Land (not depreciable)
Purchase price
Real estate commissions
Attorney’s fees
Title search
Title transfer fees
Title insurance premiums
Removing old buildings
Part I.
The costs to be capitalized for equipment include:
the net purchase price, less discounts,
taxes,
transportation costs,
installation costs,
modification to a building necessary to install the equipment,
testing and trial runs.
Part II.
The cost of land includes:
the purchase price,
real estate commissions,
attorney’s fees,
title search,
title transfer fees,
title insurance premiums,
the cost of making the land ready for its intended use, including the cost of removing old buildings.
Unlike other operational assets in the property, plant and equipment category, land is not depreciated.

4. Costs to be Capitalized
Land Improvements
Separately identifiable costs of
Driveways
Parking lots
Fencing
Landscaping
Private roads
Buildings
Purchase price
Attorney’s fees
Commissions
Reconditioning
Part I.
Land improvements are enhancements to property such as driveways, parking lots, fencing, landscaping, and private roads. These are separately identifiable costs that are recorded in the land improvement asset account rather than in the land account. Unlike land, land improvements are depreciated.
Part II.
The cost of buildings includes:
the purchase price,
real estate commissions,
attorney’s fees,
reconditioning costs to get the building ready for use.

5. Costs to be Capitalized
Natural Resources
Acquisition costs
Exploration costs
Development costs
Restoration costs
Intangible Assets
Patents
Copyrights
Trademarks
Franchises
Goodwill
The initial cost of an intangible asset includes the purchase price and all other costs necessary to bring it to condition and location for use, such as legal and filing fees.
Part I.
The capitalized cost of natural resources includes the initial acquisition costs, exploration costs, development costs, and restoration costs.
Part II.
Intangible assets include patents, copyrights, trademarks, franchises, and goodwill. The initial cost of an intangible asset includes the purchase price and all other costs necessary to bring it to condition and location for use, such as legal and filing fees.

6. Asset Retirement Obligations
Often encountered with natural resource extraction when the land must be restored to a useable condition.
Recognize the restoration costs as a liability and a corresponding increase in the related asset.
Asset retirement obligations are often encountered with natural resource extraction when a company is required to restore the land to the original condition or to a useable condition. An asset retirement obligation is recorded as a liability and a corresponding increase in the related asset. The amount recorded is the present value of future cash flows expected to be incurred for the reclamation or restoration.
Record at fair value, usually the present value of future cash outflows associated with the reclamation or restoration.

7. Intangible Assets Intangible Assets Lack physical substance.
Exclusive Rights.
Intangible Assets
Intangible assets are operational assets without physical substance that provide the owner with exclusive rights that benefit the production of goods and services. The future benefits attributed to intangible assets usually are much less certain than those attributed to tangible operational assets.
Future benefits less certain than tangible assets.

8. Intangible Assets ─ Patents
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.
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?
Part I.
A patent is an exclusive right to manufacture a product or to use a process that is granted by the United States Patent Office for a period of 20 years. The holder of the patent essentially has a monopoly right to use, manufacture, or sell the patented product or process without interference or infringement by others. Purchased patents are recorded at acquisition cost. Research and development costs that lead to an internally developed patent are expensed in the period incurred. Let’s consider an example dealing with patent costs.
Part II.
Torch, Incorporated 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 that will be recorded in the asset account?
Part III.
Torch’s cost for the new patent is $3,000. The $30,000 of research and development cost is expensed as incurred.
Torch’s cost for the new patent is $3,000. The $30,000 R & D cost is expensed as incurred.

9. Intangible Assets Copyrights Trademarks
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 U.S. Patent Office and renewable indefinitely in 10-year periods.
Part I.
A copyright is an exclusive right of protection given to a creator of a published work such as 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 creator plus 70 years.
Part II.
A trademark is a symbol, design, or logo that distinctively identifies a company, product, or service. If internally developed, trademarks have no recorded asset cost. If purchased, a trademark is recorded at acquisition cost. Trademarks are registered with the United States Patent Office and are renewable indefinitely in 10-year periods.

10. Intangible Assets Franchise Goodwill
A contractual arrangement where the franchisor grants the franchisee exclusive rights to use the franchisor’s trademark within a certain area for a specified period of time.
Franchise
The amount by which the consideration given price exceeds the fair value of net assets acquired.
Goodwill
Occurs when one company buys another company.
Only purchased goodwill is an intangible asset.
Part I.
A franchise is a contractual arrangement under which the franchisor grants the franchisee exclusive rights to use the franchisor’s trademark within a geographical area for a specified period of time. The franchisee usually makes an initial payment to the franchisor that is capitalized as an intangible asset along with any legal and license fees. Annual payments from operations to the franchisor are expensed.
Part II.
Unlike other intangible assets, goodwill cannot be associated with any specific right. It does not exist separate from the company itself. It represents the value of a company as a whole, over and above its identifiable net assets. Goodwill may be attributed to many factors, including good reputation, superior employees and management, good clientele, and good business location.
Only purchased goodwill is recognized. Purchased goodwill results when one company buys another company for a price that exceeds the fair value of the separate identifiable net assets acquired.

11. What amount of goodwill should be recorded in Eddy Company books?
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.
What amount of goodwill should be recorded in Eddy Company books?
a. $100,000
b. $200,000
c. $300,000
d. $400,000
Part I.
Let’s look at an example illustrating how we determine the amount of goodwill in company acquisition.
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. What amount of goodwill should be recorded in Eddy Company books? Part II.
The correct answer is choice c, $300,000, computed as follows:
We compute the $700,000 fair value of the net assets acquired by subtracting the $200,000 of liabilities assumed from the $900,000 fair value of the assets. The $1,000,000 consideration given less the $700,000 fair value of the net assets acquired results in $300,000 of goodwill.

12. Lump-Sum Purchases Asset 1 Asset 2 Asset 3
Several assets are acquired for a single price that may be lower than the sum of the individual asset prices.
Allocation of the lump-sum price is based on relative fair values of the individual assets.
Asset 1
Asset 2
Asset 3
Part I.
Lump-sum purchases occur when a group of assets is acquired for a single purchase price.
Part II.
The lump-sum purchase price is allocated to assets based on relative fair values of the individual assets.
Part III.
Let’s look at an example of a lump-sum purchase involving land and a building.
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?

13. Lump-Sum Purchases The building will be apportioned $130,000
of the total purchase price of $200,000.
Part I.
First, we calculate the allocation percentages by dividing the appraised value of each asset by the total of the appraised values. For example, the total of the building appraisal of $162,500 and the land appraisal of $87,500 is $250,000. Dividing $162,500 by $250,000 gives us an allocation percentage of 65 percent for the building.
We multiply the allocation percentage times the lump-sum purchase price to obtain the amount allocated to each asset. For the building, 65 percent of the $200,000 purchase price is $130,000 dollars.
Part II.
The entry to record the lump-sum purchase results in a debit to land for $70,000, a debit to building for $130,000, and a credit to cash for $200,000.

14. Noncash Acquisitions Issuance of equity securities Deferred payments
Donated Assets
Exchanges
The asset acquired is recorded at
the fair value of the consideration given or
the fair value of the asset acquired,
whichever is more clearly evident.
Part I.
Companies sometimes acquire operational assets without paying cash. Assets may be acquired by issuing debt or equity securities, by receiving donated assets, or by exchanging other assets.
Part II.
In any noncash acquisition, the components of the transaction should be recorded at their fair values. The first indication of fair value is the fair value of the consideration given to acquire the asset. Sometimes the fair value of the asset received is used when that fair value is more clearly evident than the fair value of the consideration given.

15. Deferred Payments 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.
Part I
A deferred payment contract is usually a note payable. If the note includes a realistic interest rate (market rate), the asset acquired is recorded at the face amount of the note. If the note includes an unrealistically low interest rate or is a noninterest bearing note, the asset is recorded at the present value of the future cash payments. The interest rate used for the present values computations should be a current market rate of interest.
Part II.
Let’s consider an example where we must compute the present value of a noninterest-bearing note.
Let’s consider an example where we must compute the present value of a noninterest-bearing note.

16. Deferred Payments
On January 2, 2009, Midwestern Corporation purchased equipment by signing a noninterest-bearing note requiring $50,000 to be paid on December 31, The prevailing market rate of interest on notes of this nature is 10%.
Prepare the required journal entries for Midwestern on January 2, 2009; December 31, 2009 (year-end), and December 31, 2010 (year-end).
We do not know the cash equivalent price, so we must use the present value of the future cash payment.
Part I.
On January 2, 2009, Midwestern Corporation purchased equipment by signing a noninterest-bearing note requiring $50,000 to be paid on December 31, The prevailing market rate of interest on notes of this nature is 10%. Prepare the required journal entries for Midwestern on January 2, 2009, December 31, 2009 (year-end), and December 31, 2010 (year-end).
Part II.
Since we do not know the cash equivalent price in this example, we must compute the present value of the future cash payment by multiplying the $50,000 face amount of the note times the present value of a dollar interest factor for two years and 10 percent. The present value is $41,323.
Now, we are ready to make the journal entry for January 2, 2009.

17. Deferred Payments Part I.
On January 2, 2009, we record the equipment acquisition with a debit to equipment for $41,323, a debit to discount on note payable for $8,677, and a credit to note payable for the face amount of $50,000. The discount is computed by subtracting the $41,323 present value from the $50,000 face amount of the note payable.
Part II.
On December 31 of each year, we record interest expense for the year. Interest expense is computed by multiplying the carrying value of the note (note payable less the discount on note payable) times the interest rate. On December 31, 2009, interest expense is equal to the $41,323 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,132. This process is referred to as amortizing the discount to interest expense. As a result, the carrying value of the note in the next period will be greater because the discount is smaller.
On December 31, 2010, the carrying value of the note is increased by the amount of the discount amortized to interest expense on December 31, The new carrying value equals $41,323 plus $4,132, or $45,455. On December 31, 2009, interest expense is equal to the $45,455 carrying value of the note times 10 percent. To record the interest, we debit interest expense and credit discount on note payable for $4,545.
Finally, on December 31, 2010, we record the cash payment at maturity by debiting note payable and crediting cash for $50,000. At the maturity date, the discount on note payable has a zero balance because it has been fully amortized to interest expense.

18. Issuance of Equity Securities
Asset acquired is recorded at the fair 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.”
Donated Assets
On occasion, companies acquire operational assets through donation.
SFAS No. 116 requires the receiving company to
Record the donated asset at fair value.
Record revenue equal to the fair value of the donated asset.
Part I.
When an asset is acquired with the issuance of equity securities, it is recorded at the fair 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, the board of directors assigns a reasonable value to the asset acquired.
Part II.
On occasion, companies acquire operational assets through donation. The donation usually is an enticement to get the company to do something that benefits the donor.
The donated asset should be recorded at fair value with a debit on the recipient company’s books. What should be credited? It depends on the nature of the donor.
If the donor was another company, the Financial Accounting Standards Board Statement of Financial Accounting Standards number 116 requires that the credit be to a revenue account equal to the fair value of the donated asset.
However, donations are often made by cities or states to entice a company to locate within the city or state. The Financial Accounting Standards Board Statement does not apply to donations from governmental units. In the interest of consistency, a donation from a governmental unit should be recorded as revenue, but it may be recorded as a credit to an equity account.

19. 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 =
= 15.4
$57,420
($2,409 + $1,993)/2
= 26
$24,006
($1,832 + $1,281)/2
Part I.
The fixed-asset turnover ratio measures how effectively a company manages its fixed assets to generate revenue. It is computed by dividing net sales by average fixed assets. Consider the following example comparing two computer manufacturing companies, Dell and Apple.
Part II.
Dell’s fixed-asset turnover ratio for 2007 is 26.
Part III.
Apple’s fixed asset ratio for 2007 is We can conclude that Dell generates nearly two times more sales dollars for each dollar invested in fixed assets than Apple does.
Dell generates nearly two times more sales dollars for each dollar invested in fixed assets than Apple does.

20. 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.
On June 30, 2009, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2004 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, 2008, its year-end.
Prepare the journal entries necessary to record the disposition of this equipment.
Part I.
After using operational assets, companies dispose of them by sale, retirement, or exchanging them for other assets. Three accounting steps are involved in dispositions:
 update depreciation to the date of disposal.
 remove the original cost of the asset and its accumulated depreciation from the books.
 record a gain or loss for the difference between the book value of the asset and the amount received.
Consider the following example where an asset is sold for cash.
Part II.
On June 30, 2009, MeLo, Inc. sold equipment for $6,350 cash. The equipment was purchased on January 1, 2004 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, 2008, its year-end.
Prepare the journal entries necessary to record the disposition of this equipment.

21. Dispositions Update depreciation to date of sale.
Remove original asset cost and accumulated depreciation.
Record the gain or loss.
Part I.
Our first step is to update the depreciation to the date of sale. It has been six months since the last depreciation entry. Since there was no salvage value, depreciation for one year is the $15,000 purchase price divided by 10 years, resulting in $1,500. For the six months of 2006, the depreciation is one-half of $1,500, or $750.
We debit depreciation expense for $750 and credit accumulated depreciation for $750 to update the depreciation to June 30.
Part II.
Our second and third steps are to remove the original cost and the related accumulated depreciation from the books, and to record any gain or loss on the sale.
Since the asset was acquired on January 1, 2004, and sold on June 30, 2009, it has been used for a total of five and one-half years. The accumulated depreciation balance on June 30 is $8,250, an amount obtained by multiplying 5 ½ years times $1,500 of depreciation per year.
The book value at the date of sale is $6,750 dollars computed by subtracting the $8,250 of accumulated depreciation from the $15,000 cost of the asset. Since the book value of $6,750 exceeds the cash sale price of $6,350 by $400, we recognize a $400 loss on the sale.
To record the entry, we debit accumulated depreciation for $8,250, debit cash for $6,350, debit loss on sale for $400, and credit equipment for $15,000.

22. Exchanges
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
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.
Part I.
Operational assets are sometimes acquired in exchanges for other operational assets. Trade-ins of old assets in exchange for new assets is probably the most frequent type of exchange. Cash is involved in the transactions to equalize fair values. The general principle to be followed is that the cost of the asset acquired is:
equal to the fair value of asset given up plus cash paid or minus cash received, or
equal to the fair value of asset acquired, if that is more clearly evident.
A gain or loss is recognized for the difference between the fair value of the asset given up and its book value.
Part II.
We follow the general principle based on fair value in the exchange of operational assets 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. Let’s look at an example where fair value cannot be determined.
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.

23. Fair Value Not Determinable
Matrix, Inc. exchanged 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 originally cost $600,000, and had an accumulated depreciation balance of $400,000 at the time of the exchange. Matrix exchanged the asset and paid $100,000 cash.
Let’s record this unusual transaction.
Part I.
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 originally cost $600,000, and had an accumulated depreciation balance of $400,000 at the time of the exchange. Matrix exchanged the asset and paid $100,000 cash. Let’s record this unusual transaction.
Part II.
First, we compute the book value of the asset given up in the exchange. Book value is equal to $200,000, determined by subtracting the $400,000 of accumulated depreciation from the $600,000 original cost.
In addition to giving up book value of $200,000, Matrix paid $100,000 to acquire the new operational asset.
The asset acquired will be recorded at the book value given up plus the cash paid. Now we are ready for the journal entry.

24. Fair Value Not Determinable
Matrix, Inc.
The journal entry below shows the proper recording of the exchange.
To record the equipment acquired, we debit equipment for $300,000, the book value given up plus the cash paid. We remove the asset given up with a credit to equipment for its cost of $600,000 and a debit to accumulated depreciation for $400,000. Finally, we credit cash for the $100,000 paid in the transaction. Since fair value is not known, Matrix did not recognize a gain or a loss on the exchange.

25. 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.
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.
Part I.
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.
Part II.
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
the expected change in cash flows is significant relative to the fair value of the assets exchanged.
If the exchange does not meet these two conditions, it lacks commercial substance and, book value is used to value the asset(s) acquired. No gain is recognized.
Let’s look at an example, first with commercial substance, and then without commercial substance.

26. Exchanges
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.
Part I.
Matrix, Inc. exchanged new equipment and $10,000 cash for equipment owned by Float, Inc. The equipment originally cost Matrix $500,000. At the date of the exchange, the equipment had accumulated depreciation of $300,000, book value of $200,000, and fair value of $205,000. Record the transaction assuming the exchange has commercial substance.
Part II.
First, we must determine the gain or loss. The fair value of the asset given up exceeds its book value by $5,000 which means there is a gain in this transaction of $5,000.
Gain = Fair Value – Book Value
Gain = $205,000 – $200,000 = $5,000

27. Exchanges
$205,000 fair value + $10,000 cash
Record the same transaction assuming the exchange lacks commercial substance.
Part I.
Since the transaction has commercial substance, we will record the asset acquired at the fair value of the asset given up plus the cash paid, and we will recognize the gain.
To record the equipment acquired, we debit equipment for the sum of the $205,000 of fair value given up plus the $10,000 cash paid. We remove the asset given up with a credit to equipment for its cost of $500,000 and a debit to accumulated depreciation for $300,000. We credit cash for the $10,000 paid in the transaction, and credit the gain of $5,000.
Part II.
Now let’s see how we would record this transaction if it lacks commercial substance.
Part III.
Since the transaction lacks commercial substance, the equipment acquired should be valued at book value of equipment given up plus the cash paid. The $5,000 gain is not recognized.
To record the equipment acquired, we debit equipment for $210,000, the book value given up plus the cash paid. We remove the asset given up with a credit to equipment for its cost of $500,000 and a debit to accumulated depreciation for $300,000. Finally, we credit cash for the $10,000 paid in the transaction
$200,000 book value + $10,000 cash

28. 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.
Part I.
There are two difficult accounting issues that must be addressed when a company is constructing assets for its own use:
determining the amount the company’s manufacturing overhead to be included in the asset’s cost.
 deciding on the proper treatment of interest incurred during the construction period. One approach to assigning overhead to self-constructed assets is the incremental approach, where actual incremental overhead costs are recorded in the asset account. However, the most commonly used method is to assign overhead using a predetermined overhead rate, based on an overhead cost driver activity, that is used to assign the company’s overhead to regular production. This approach is called the full cost approach.
Unlike purchased assets, self-constructed assets may take a long period of time to be made ready for their intended use. The construction activities during this period require construction financing. Following our general rule for the cost of an asset, all costs necessary to make the asset ready for its intended use, including interest during the construction period, should be included in the asset’s cost.
Part II.
Interest is capitalized (included in the asset’s cost) for qualifying assets. Qualifying assets are:
assets built for a company’s own use.
assets constructed as discrete projects for sale or lease. Assets in this category are large construction projects such as a real estate development built for sale or lease.
Only the portion of interest cost incurred during the construction period that could have been avoided if the construction had not been undertaken may be capitalized.
Asset constructed:
For a company’s own use.
As a discrete project for sale or lease.
Interest that could have been avoided if the asset were not constructed and the money used to retire debt.

29. Interest Capitalization
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.
The interest capitalization period begins when the first qualifying construction expenditures are incurred for materials, labor, or overhead, and when interest costs are incurred. The interest capitalization period ends when the asset is substantially complete and ready for its intended use or when interest costs no longer are being incurred.
Consider the following example of interest incurred on a self-constructed asset.

30. Interest Capitalization
Interest is capitalized based on Average Accumulated Expenditures (AAE).
Qualifying expenditures (construction labor, material, and overhead) weighted for the number of months outstanding during the current accounting period.
If the qualifying asset is financed through a specific new borrowing
If there is no specific new borrowing, and the company has other debt
Part I.
Interest is capitalized based on average accumulated expenditures during the construction period. Average accumulated expenditures is an amount based on a weighted average computation of the qualifying expenditures times the number of months from the incurrence of the qualifying expenditures to the end of the construction period. Qualifying expenditures include labor, material, and overhead incurred on the construction project during the accounting period.
Part II.
Interest capitalization on self-constructed assets does not require the company to borrow for the specific construction project. However, if the construction is financed through a specific new borrowing, the interest rate of the new borrowing is used for the capitalization rate.
Part III.
If the construction does not require specific new borrowing, but is financed with other debt, use the weighted-average interest rate on the other debt for the capitalization rate.
. . . use the specific rate of the new borrowing as the capitalization rate.
. . . use the weighted average cost of other debt as the capitalization rate.

31. Interest Capitalization
Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec 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.
Average Accumulated Expenditures
Part I.
Welling, Inc. is constructing a building for its own use. Construction activities started on May 1 and have continued through Dec Welling made the following qualifying expenditures: May 1, $125,000; July 31, $160,000, October 1, $200,000; and December 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. How much interest should Welling capitalize on the construction project?
Part II.
First, we calculate the average accumulated expenditures by time-weighting the individual expenditures made during the eight-month construction period. For example the $125,000 expenditure made on May 1 occurs eight months from the end of the period. So the time-weighted amount of this expenditure is eight-eighths of $125,000 or $125,000. We calculate the time-weighted amounts for the other expenditures and sum them to get the average accumulated expenditures of $337,500.

32. Interest Capitalization
Since the $1,000,000 of specific borrowing is sufficient to cover the $337,500 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 × Time
Interest = $337,500 × 10% × 8/12 = $22,500
Since the $1,000,000 of specific borrowing is sufficient to cover the $337,500 of average accumulated expenditures for the year, we will use the specific borrowing rate of 10 percent to determine the amount of interest to capitalize. The loan, initiated on May 1, is outstanding for 8 months of the year. Ten percent of $337,500 multiplied by 8/12 is equal to $22,500, the amount of interest that will be capitalized.
The loan, initiated on May 1, is outstanding for 8 months of the year.

33. 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 × Time Interest = $337,500 × 12% × 8/12 = $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 rate of interest on other debt is 12 percent, the amount of interest capitalized would be 12 percent of $337,500 times 8/12, or $27,000.

34. Interest Capitalization
If specific new borrowing had been insufficient to cover the average accumulated expenditures . . .
. . . Capitalize this portion using the 12 percent weighted- average cost of debt.
Other debt
If specific new borrowing had been insufficient to cover the average accumulated expenditures for the year, the portion of the average accumulated expenditures financed with specific new borrowing is capitalized using the interest rate on the specific new borrowing, and the remainder of the average accumulated expenditures is capitalized using the weighted-average interest cost of other debt excluding the specific new borrowing. This situation exists when the construction project is partially financed with specific new borrowing and partially financed with other existing debt.
. . . Capitalize this portion using the 10 percent specific borrowing rate.
AAE
Specific new
borrowing

35. Research and Development (R&D)
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.)
Part I.
In SFAS No. 2, research is defined as a planned search or critical investigation aimed at discovery of new knowledge with the hope that the new knowledge will result in new, or the improvement of, existing, products, services or processes.
Development is the translation of research findings into new, or the improvement of existing, products, services or processes.
Most research and development costs are expensed as incurred. The costs are incurred with the intent of future benefits, but the future benefits are uncertain, and even if the benefits materialize, it is difficult to relate the benefits to revenues of future periods.
Part II.
An exception to the immediate expensing of research and development costs is provided for work done under contract for other companies. These research and development costs are capitalized and then expensed against revenue from the contract in future periods.
If operational assets are purchased for exclusive use in research and development, the cost is expensed, regardless of the length of the assets’ useful life. If the assets have alternative future uses beyond the research and development project period, the cost should be capitalized and depreciated or amortized over the current and future periods of use.
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.

36. 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.
Costs incurred after technological feasibility is established and before the software is available for release to customers are capitalized as an intangible asset.
Costs Expensed as R&D
Costs Capitalized
Operating Costs
Part I.
All costs incurred to establish the technological feasibility of computer software products are treated as research and development costs and expensed as incurred. Costs incurred after technological feasibility is established and before the software is available for release to customers are capitalized as an intangible asset. Technological feasibility is established when all planning, designing, coding, and testing activities have been completed to determine that the software is a viable commercial product.
Consider the following timeline to illustrate these concepts.
Part II.
Costs are expensed from the start of research and development until technological feasibility is established. Costs incurred after technological feasibility is established, but before the product is released, are capitalized as an intangible asset. Costs incurred after the product is available for release to customers are treated as operating costs.
Start of R&D Activity
Technological Feasibility
Date of Product Release
Sale of Product

37. Software Development Costs SFAS No. 86
Amortization of capitalized computer software costs starts when the product begins to be marketed.
Two methods, the percentage of revenue method and the straight-line method, are compared and the method producing the largest amount of amortization is used.
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
Part I.
Amortization of capitalized computer software costs starts when the product begins to be marketed. Two methods, the percentage of revenue method and the straight-line method, are compared and the method producing the largest amount of amortization is used.
The periodic amortization percentage is the greater of:
the ratio of current revenues to current and anticipate revenues (the percentage of revenues method).
the straight-line percentage over the useful life of the asset. (the straight-line method).
Part II.
The unamortized portion of capitalized computer software cost is reported in the balance sheet as an asset. The periodic amortization expense associated with the capitalized computer software cost is reported in the income statement. The research and development expense associated with computer software development is reported in the income statement.

38. Appendix 10 ─ 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.
Appendix 10 – Oil and Gas Accounting
Part I.
There are two generally accepted methods that companies can use to account for oil and gas exploration costs. The successful efforts method requires expensing of exploration costs that result in unsuccessful wells (called dry holes). Only the exploration costs that result in successful, producing wells are capitalized. The full-cost method allows the exploration costs incurred in a wide geographical area, with many unsuccessful wells, to be capitalized if some successful wells are drilled in the area. For both methods, capitalized costs are expensed in future periods as oil and gas is removed.
Part II.
Political pressure prevented the FASB from requiring all companies to use the successful efforts method.
Political pressure prevented the FASB from requiring all companies to use the successful efforts method.

39. Oil and Gas Accounting Successful Efforts Full Cost
The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells in 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
Part I.
Let’s consider an example to illustrate the two methods of accounting of oil and gas exploration costs.
The Shannon Oil Company incurred $2,000,000 in exploration costs for each of 10 oil wells in Eight of the 10 wells were dry holes. Prepare the journal entries to record the exploration costs under both of the acceptable methods.
Part II.
Let’s start with the successful efforts method. Two of the ten (twenty percent) of the wells were successful. We debit the asset oil deposit for $4,000,000, which is 20 percent of the total exploration costs. Eighty percent of the wells were unsuccessful. We debit exploration expense for $16,000,000, which is 80 percent of the exploration costs incurred. Credit cash for $20,000,000.
Part III.
Now let’s make the entry using the full cost method. Since some of the wells were successful, we debit the asset oil deposit for $20,000,000, the entire amount of the exploration costs.
Full Cost

40. End of Chapter 10.
End of Chapter 10