Chapter 10: PPE part 1
What is Property, Plant, and Equipment (PPE)?
1. Acquired for use and not resale.
(They do not become part of a product held for resale.)
2. Long-lived in nature and subject to depreciation (except for land).
3. Possess physical substance (tangible assets)
Acquisition of PPE
Usual valuation method is historical cost. Which is the cash or cash equivalent of obtaining asset and getting it ready for its intended use.
Land: if purchased to construct a building, then all net costs up to excavation for building. Special assessments (streets, drainage) for relatively permanent improvements are included in the land account. Improvements (parking lots, fences) are recorded in Land Improvements account and depreciated over estimated lives.
Land held as an investment should be recorded in an investment account.
Land held by a real estate company for resale should be classified as inventory.
Buildings: all costs related to acq. and construction are capitalized (from excavation till completion).
Equipment: all costs to prepare for intended use—includes cost for trial runs and training.
Self-constructed assets: Assignment of overhead—portion of all OH versus no fixed OH—former preferred.
Disposition of PPE
Depreciation should be updated to date of disposal.
All accounts should be relieved of the cost and A/D related to the asset being disposed.
Gains/losses from disposal are shown in the appropriate income account.
Assets may be retired by: sales, exchange, involuntary conversion, or abandonment.
The basic J.E.:
Cash$1,000
A/D3,700
*Loss on disposal5,300
Machinery $10,000
* a plug figure, would have been a gain if a credit entry.
Fully depreciated assets that are still in service remain on the books at historical cost minus A/D. GAAP requires that the amount of fully depreciated assets in service be disclosed in notes to F/S.
Valuation of PPE when fair value is obscured by the form of the transaction.
Cash discounts—gross versus net method, both are allowed, net preferred.
Deferred payment—(1) use fair value at time of purchase or (2) record at present value of pmts.
Lump-sum purchases—allocate (prorate) cost among “basket” of assets based on their relative fair values.
Issuance of stock for asset—use market value of stock not par value.
Some exceptions to historical cost valuation:
1. Fair value is used for Donated assets—gains to other revenue.
2. Prudent cost can be used if self-constructed assets cost exceed fair value or if you were ignorant about price and paid too much for an asset originally.
3. Non-monetary exchanges assets considered non-commercial and gain indicated—asset is recorded at amount that balances the entry.
Costs Subsequent to Acquisition
General rule is that costs that achieve greater future benefits are capitalized and costs that only maintain a given level of service should be expensed in the period incurred.
Greater future benefits are defined as one or more of the following:
(1) Increase the useful life of an asset.
(2) Increase the quantity (throughput) of units produced. Or decrease the cost/unit.
(3) Enhance the quality of units produced.
Firms have limits on capitalization (materiality) and expense all small expenditures.
Repairs are expensed—e.g., oil change in trucks.
Costs for: Additions, Improvements, Replacements, Rearrangements, Reinstallation, and Major repairs that benefit several periods are capitalized. Three approaches are possible to capitalize: (1) substitute, (2) capitalize new cost, (3) debit A/D—used when useful life is extended.
Chapter 10 Part 2:
CONSTRUCTION PERIOD INTEREST COSTS
Interest costs during construction of assets—it is a financing cost? In which case, it should be expensed. Or, is it a cost needed to bring an asset to usable condition and location? In which case, it should be capitalized with cost of asset. GAAP generally is consistent with capitalizing interest during the construction period of a qualified asset.
Qualifying Assets—require a period of time to prepare for intended use (either self use or discrete project for sale or lease.)
Period of capitalization—begins with the first expenditure of the project and ends when asset is substantially complete and ready for its intended use or when interest ends which ever is first.
Interest can be from specific (or non-specific) project borrowings, but interest does not include a cost for equity—there must be actual interest expense.
Average accumulated expenditures (AAE)---
Maximum interest expense (capitalizable) cannot exceed the actual construction expenditures during a period. You have to determine the time-weighted average amount of construction expenditures during the period. If expenses occurred evenly throughout the period, a simple average (total/2) would be adequate.
FAS34 defines expenditures as: “…capitalized expenditures (net of progress payment collections) for the qualifying asset that have required the payment of cash, the transfer of other assets, or the incurring of a liability on which interest is recognized (in contrast to liabilities, such as trade payables, accruals, and retainers on which interest is not recognized). However, reasonable approximations of net capitalized expenditures may be used. For example, capitalized costs for an asset may be used as a reasonable approximation of capitalized expenditures unless the difference is material.”
Disclosure:
FAS34 requires that:
a. For an accounting period in which no interest cost is capitalized, the amount of interest cost incurred and charged to expense during the period.
b. For an accounting period in which some interest cost is capitalized, the total amount of interest cost incurred during the period and the amount thereof that has been capitalized.
Interest rate—Specific Interest Method
If a specific loan was taken out for the construction project and if it was equal to or greater than AAE,
Max. interest capitalized (MIC) = rate for specific loan*AAE.
If AAE exceeds specific loan amount, then use the weighted-average rate on all other borrowings times the AAE in excess of specific construction loan to calculate MIC. In this case:
MIC = rate for specific loan * AAE (up to amount of loan) + weighted average rate on other borrowings * AAE in excess of specific loan amount.
When there are no specific borrowings for specific projects, the Weighted-Average Method is used to calculate the appropriate interest rate to use. This is a minor variation to the above. You would use the weighted-average of all borrowings and apply to the total of AAE.
IC has to be less than or equal to actual interest!
IC cannot be greater then AAE!
Any interest not capitalized must be expensed for the period.
In class problem::::
ACE Construction started the building of a new corporate headquarters on Feb 1, 2000. The building was ready for use on July 1, 2002. The expenditures for the project were:
Feb. 1, 2000$1,000,000
Apr. 1, 20002,500,000
Aug. 1, 20003,200,000
Dec. 1, 20005,000,000
Jan. 1 through
Dec. 31, 2001 (evenly)12,000,000
Apr. 1, 2002750,000
July 1, 20022,300,000
During the entire period 1/1/2000 to 12/31/2002, ACE had debt outstanding consisting of 6%, $10M bond issue and a 5%, $7M bond issue. On July 1, 2000, ACE obtained a $10M, 10% construction loan for the project. How much interest should ACE capitalize and expense for 2000, 2001, and 2002? Assume that ACE paid off the construction loan on Sept. 1, 2002 and all other debt is outstanding as of 1/1/2003.
NONMONETARY EXCHANGES
Wow, in 2004,FASB revised/amended APB No. 29 with FASB No. 153.
We thought that the revision would greatly simplify the complicated rules, but the only big change was to drop the determination of similar/dissimilar assets and add “commercial substance”. The intent is that more exchanges will be classified as having commercial substance than in the past (some similar asset exchanges can have commercial substance).
In other words, more exchanges will now recognize fully the gains/losses on exchange.
An asset acquired in a non-monetary exchange generally is recorded at the cash equivalent value of the assets exchanged:
1. Fair value of assets given up, or
2. Fair value of the assets received,whichever is clearly more evident (easier to determine).
If we can't determine the fair value of either asset in the exchange, the asset received is valued at the book value of the asset given (no gain or loss on exchange).
Gain/loss recognition depends upon whether the exchange has commercial substance.
Commercial Substance
* Future cash flows change as a result of the exchange. Exchange of similar assets can have commercial substance.
Is the risk, timing, and amount of cash flow for the asset received different from the cash flow associated with the asset given up?
or—Are cash flows affected by the exchange?
Another way to ask this is:
Has our economic position changed?
Yes or no determination.
If yes, then recognize the full gain/loss on the exchange.
Accounting for Exchanges
Type of Exchange / Accounting for Asset Received / Accounting for gain/lossCommercial
substance / Recognize at fair value / Recognize gain/loss fully
Lacks commercial
substance / either (a) at fair value or it is a (b) plug. / (a) Recognize loss,
(b)prorate gain based on ratio of cash received to FMV of all assets received.
Remember that assets are never recognized at greater than their cash equivalent price (fair value). Therefore, do not value new assets at their list price or book value of assets given up if this means that the new assets will be recognized at an amount that exceeds their fair value!
[If cash (boot) exchanged is 25% or more of FV of all assets received, then the exchange is considered a monetary exchange and all gains/losses on exchange are recognized by both parties.]
The AL Company traded land it had been holding as an investment in exchange for equipment. The land had a book value of $100,000. In addition to the land, AL gave up $10,000 cash. This exchange is considered to have commercial substance.
The new asset is simply recorded at its fair value. The difference between that amount and the book value of the old asset, plus cash paid (or less cash received), reflects a loss or gain on the exchange.
Situation 1:
The fair value of the land is $80,000.
Equipment ($80,000 + 10,000) $90,000
Loss ($100,000 - 80,000) 20,000
Cash (amount paid) 10,000
Land (book value) 100,000
Situation 2:
The fair value of the land is $140,000.
Equipment ($140,000 + 10,000) $150,000
Cash (amount paid) 10,000
Land (book value) 100,000
Gain ($140,000 - 100,000) 40,000
The AL Company traded land it had been holding as an investment in exchange for other land. AL’s land had a book value of $100,000. In addition to the land, AL gave up $10,000 cash. Assume that this exchange is considered to LACK commercial substance.
The new asset is simply recorded at the book value of the assets given up. There is NO gainrecognized on exchange (no cash was received).
Situation 3:
The fair value of the new land is $120,000.
New Land(plug) $110,000
Cash (amount paid) 10,000
OldLand(book value) 100,000
Situation 4:
The fair value of the new land is $50,000. Recognize the loss immediately.
New Land(fair value) $50,000
Loss on exchange 60,000
Cash (amount paid) 10,000
OldLand(book value) 100,000
The AL Company traded land it had been holding as an investment in exchange for other land. AL’s land had a book value of $100,000. In addition to the land, ALreceived $10,000 cash. Assume that this exchange is considered to LACK commercial substance.
Now AL can recognize part of the full gain.
Make a trial entry to calculate the “full gain” ($30,000), then prorate it by 10/130 = 0.076923
Situation 5:
The fair value of the new land is $120,000.
New Land (plug) $92,308
Cash (amount received) 10,000
Gain on exchange 2,308
OldLand(book value) 100,000
Situation 6:
The fair value of the new land is $50,000. Recognize the loss immediately.
New Land (fair value) $50,000
Loss on exchange 40,000
Cash (amount received) 10,000
OldLand(book value) 100,000
Accounting 302 Chapter 10 - 1 -