CH 10 - INT

Gain (non-monetary exchange)

"Gain on exchange of assets"

Loss (non-monetary exchange)

"Loss on exchange of assets"

Noncash Acquisitions

- deferred payments (notes payable) - issuance of equity securities - donated assets - exchanges of nonmonetary assets for other assets

Interest is capitalized during the construction period for (a) assets built for a company's own use as well as for-- SELF-CONSTRUCTED ASSETS (b) assets constructed as discrete (non-routine "think back to COST" projects for sale or lease.

-Interest is not capitalized on inventories that are routinely manufactured in large quantities on a repetitive basis. (Interest would be capitalized for discrete projects -Only interest incurred during the construction period is eligible for capitalization. The interest capitalization period begins when construction begins and the first expenditure is made as long as interest costs are actually being incurred.

The cost of a natural resource includes

-More frequently, though, the company will develop these assets which will include acquisition costs for the use of land and the exploration and development costs incurred before production begins, and restoration costs incurred during or at the end of extraction. -Sometimes a company buys natural resources from another company. In that case, initial valuation is simply the purchase price plus any other costs necessary to bring the asset to the condition and location for use.

Deferred Payments

-The initial valuation of the asset is, again, quite simple as long as the note payable explicitly requires the payment of interest at a realistic interest rate. -Assets acquired in exchange for a deferred payment contract are valued at the fair value of the items exchanged, either: 1. The fair value of the note payable by computing the present value of the cash payments at the appropriate interest rate. (The economic essence of a transaction should prevail over its outward appearance -- "NON-INTEREST BEARING NOTES: some of the note actually is interest") ----The note is also recorded at fair value through a contra-asset account "Discounts on Notes Payable" which records the difference between the face amount (to be paid in the future) and its present value 2. The fair value of the asset acquired.

Natural Resources vs. PPE

-They can be distinguished from other assets by the fact that their benefits are derived from their physical consumption. -On the contrary, equipment, land, and buildings produce benefits for a company through their use in the production of goods and services. Unlike those of natural resources, their physical characteristics usually remain unchanged during their useful lives.

A trademark, also called tradename, is an

-exclusive right to display a word, a slogan, a symbol, or an emblem that distinctively identifies a company, product, or a service. -The firm can register its trademark with the U.S. Patent and Trademark Office to protect it from use by others for a period of 10 years. The registration can be renewed for an indefinite number of 10-year periods, so a trademark is an example of an intangible asset whose useful life can be indefinite.

The cost of buildings usually includes realtor commissions and legal fees in addition to the purchase price.

-realtor commissions and legal fees in addition to the purchase price. -Quite often a building must be refurbished, remodeled, or otherwise modified to suit the needs of the new owner. These reconditioning costs are part of the building's acquisition cost. --When a building is constructed rather than purchased, unique accounting issues are raised.

We've just discussed that U.S. GAAP requires R&D costs to be expensed immediately. There are three types of costs related to R&D, however, that are capitalized (recorded as an asset). These exceptions are shown below:

1) Development costs for software that has reached the point of technological feasibility 2) R&D performed by the company for sale to others 3) R&D purchased in a business acquisition

The costs of cloud computing arrangements are treated as the purchase of intangible assets if both:

1- The customer has a contractual right to take possession of the software without significant penalty, and 2- The customer could run the software on its own or with an unrelated vendor. If either of these criteria is not met, the arrangement is treated as a service contract, and costs are expensed as incurred. Any implementation costs incurred during the application development phase (integration with the company's own software, coding, and configuration or customization) are capitalized. Interestingly, even if the arrangement itself does not qualify for capitalization as an intangible asset (because one of the two criteria above is not met), implementation costs still can be capitalized. Any costs related to preliminary planning or the post-implementation operation, however, would be expensed as incurred.

For financial reporting purposes, long-lived, revenue-producing assets typically are classified in two categories.

1. Plant, Property, and Equipment Assets (including Natural Resources) 2. Intangible Assets

Companies acquire intangible assets in two ways:

1. They purchase intangible assets like patents, copyrights, trademarks, or franchise rights from other companies. 2.They develop intangible assets internally, for instance, by developing a new product or process and obtaining a protective patent.

The first step in the capitalization procedure is to determine weighted-average accumulated expenditures. This amount approximates the average debt necessary for construction.

A) If expenditures are made fairly evenly throughout the construction period, the weighted-average accumulated expenditures can be determined as a simple average of accumulated expenditures at the beginning and end of the period. B) If expenditures are not incurred evenly throughout the period, a weighted average is determined by time weighting individual expenditures or groups of expenditures by the number of months from their incurrence to the end of the construction period or the end of the reporting period, whichever comes first.

The second step is to calculate the amount of interest to be capitalized by multiplying an interest rate or rates by the weighted-average accumulated expenditures.

A) The specific interest method uses rates from specific construction loans to the extent of specific borrowings and then applies the weighted-average rate on all other debt to any excess of average accumulated expenditures over specific construction borrowings. B) By the weighted-average method, the weighted-average interest rate on all debt, including construction-specific borrowings, is multiplied by average accumulated expenditures. Interest capitalized is limited to interest incurred.

costs associated with Natural Resources explained

Acquisition costs are the amounts paid to acquire the rights to explore for undiscovered natural resources or to extract proven natural resources. Exploration costs are expenditures such as drilling a well, or excavating a mine, or any other costs of searching for natural resources. Development costs are incurred after the resource has been discovered but before production begins. They include a variety of costs such as expenditures for tunnels, wells, and shafts. Restoration costs include costs to restore land or other property to its original condition after extraction of the natural resource ends. Because restoration expenditures occur later—after production begins—they initially represent an obligation incurred in conjunction with an asset retirement. Restoration costs are one example of asset retirement obligations, the topic of the next subsection.

Software Development Costs (EXTERNAL)

Any software costs incurred from initial development activity until technological feasibility of the software are treated like all other R&D costs (expensed as incurred). Technological feasibility refers to the point in time "when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements." Costs incurred after technological feasibility but before the software is available for general release to customers are capitalized as an intangible asset. These costs include items such as further coding and testing and the production of product masters. Any costs incurred after the software release date generally are expensed but not as part of R&D.

R&D Purchased in Business Acquisitions

Any time a company buys another, it values the tangible and intangible assets acquired at fair value. When part of the acquisition price involves technology, we distinguish between 1- Developed technology. 2- In-process research and development.

Issuance of Equity Securities

Assets acquired by issuing common stock are valued at the fair value of the securities or the fair value of the assets, whichever is more clearly evident. (If the fair value of the common stock had not been reliably determinable, the value of the land as determined through an independent appraisal would be used as the cost of the land and the value of the common stock.) Because the common shares are not publicly traded, it's difficult to determine their fair value. In that case, the fair value of the assets received by the corporation is probably the better indicator of the transaction's exchange value. In other situations, particularly those involving corporations whose stock is actively traded, the market value of the shares is the best indication of fair value.

How are non-cash acquisitions recorded?

Assets acquired in noncash transactions are valued at the fair value of the assets given or the fair value of the assets received, whichever is more clearly evident.

ASSET RETIREMENT OBLIGATIONS

COME BACK! -Restoration costs are one example of asset retirement obligations (AROs). An asset retirement obligation is measured at fair value and is recognized as a liability and corresponding increase in asset valuation. -GAAP recommends the use of the expected cash flow approach when estimating the fair value of an ARO by calculating the present value of estimated future cash outflows.

The third step in the procedure is to compare calculated capitalized interest with the actual interest incurred during the period.

Choose the lower of the two (min. of Actual vs. Calculated)

How is interest recorded using Deferred Payments and "Discounts on Notes Payable"?

DEBIT: Interest Expense CREDIT: Discounts on Notes Payable *NOTE: Interest expense is not actually being paid until the end with cash

Donated Assets

Donated assets are valued at their fair values and revenue is recorded at an amount equal to the value of the donated asset(s). The rationale is that the company receiving the donation is performing a service for the donor in exchange for the asset donated. This should not be considered a departure from historical cost valuation. Instead, it is equivalent to the donor contributing cash to the company and the company using the cash to acquire the asset.

Capitalized vs. Expensed

For example, the cost of a major improvement to a delivery truck that extends its useful life generally would be capitalized. On the other hand, the cost of an engine tune-up for the delivery truck simply allows the truck to continue its productive activity but does not increase future benefits. These maintenance costs would be expensed.

To distinguish these two types of technology acquired, we borrow a criterion used in accounting for software development costs, and determine whether technological feasibility has been achieved. If it has, the technology is considered "developed," and we capitalize its fair value (record it as an asset) and amortize that amount over its useful life just like any other finite-life intangible asset.

For in-process R&D (technology that has not reached the feasibility stage), GAAP also requires capitalization of its fair value. However, unlike developed technology, we view in-process R&D as an indefinite-life intangible asset we don't amortize indefinite-life intangibles. Instead, we monitor these assets and test them for impairment (a permanent reduction in the value of an asset to less than its carrying value.) when required by GAAP.

R&D costs entail a high degree of uncertainty of future benefits and are difficult to match with future revenues.

For these reasons, the FASB takes a conservative approach and requires R&D costs to be expensed immediately.

How is goodwill calculated?

Goodwill is the excess of the consideration exchanged (purchase price) over the fair value of the identifiable net assets acquired. It represents the unique value of a company as a whole over and above its identifiable tangible and intangible assets. In that case, the capitalized cost of goodwill equals the fair value of the consideration given in exchange for the company (the acquisition price) less the fair value of the identifiable net assets acquired. The fair value of the identifiable net assets equals the fair value of all identifiable tangible and intangible assets less the fair value of any liabilities of the selling company assumed by the buyer. Goodwill is a residual asset; it's the amount left after other assets are identified and valued.

If an asset is purchased specifically for a single R&D project, its cost is considered R&D and expensed immediately even though the asset's useful life extends beyond the current year.

However, the cost of an asset that has an alternative future use beyond the current R&D project is not a current R&D expense. Instead, the depreciation or amortization of these alternative-use assets is included as R&D expenses in the current and future periods the assets are used for R&D activities.

A patent is an exclusive right to manufacture a product or to use a process.

If a patent is purchased from an inventor or another individual or company, the amount paid is its initial valuation. The cost might also include such other costs as legal and filing fees to secure the patent. Holders of patents often need to defend a patent in court against infringement. Any attorney fees and other costs of successfully defending a patent are added to the patent account. The U.S. Patent and Trademark Office grants this right for a period of 20 years. In essence, the holder of a patent has a monopoly on the use, manufacture, or sale of the product or process.

Lump-Sum Purchases

If these assets are indistinguishable, for example 10 identical delivery trucks purchased for a lump-sum price of $150,000, valuation is obvious. Each of the trucks would be valued at $15,000 ($150,000 ÷ 10). However, if the lump-sum purchase involves different assets, it's necessary to allocate the lump-sum acquisition price among the separate items. The assets acquired may have different characteristics and different useful lives. The allocation is made in proportion to the individual assets' relative fair values.

Fair Value Not Determinable

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. The new equipment is recorded at the book value of the old equipment ($100,000) plus the cash given ($430,000). No gain or loss is recognized on an exchange when fair value is not determinable.

R&D costs include labor costs, materials, depreciation and amortization of assets used in R&D activities, and a reasonable allocation of indirect costs related to those activities.

In general, costs incurred before the start of commercial production are all expensed as R&D. Any costs incurred after the start of commercial production are not classified R&D costs. These costs would be either expensed or treated as manufacturing overhead and included in the cost of inventory.

In a business combination, an intangible asset must be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or is separable.

In keeping with that goal, GAAP provides guidelines for determining which intangibles should be separately recognized and valued. Specifically, an intangible should be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or is capable of being separated from the acquired entity. Possibilities are patents, trademarks, copyrights, and franchise agreements, and such items as customer lists, license agreements, order backlogs, employment contracts, and noncompetition agreements.9 In past years, some of these intangibles, if present in a business combination, often were included in the cost of goodwill.

Of course, a company can develop its own goodwill through advertising, training employees, and other efforts. In fact, most do. However, a company must expense all such costs incurred in the internal generation of goodwill. By not capitalizing these items, accountants realize that this results in an understatement of real assets because many of these expenditures do result in significant future benefits. Also, it's difficult to compare two companies when one has acquired goodwill and the other has not. But imagine how difficult it would be to associate these expenditures with any objective measure of goodwill. In essence, we have a situation where the characteristic of faithful representation overshadows relevance.

Just like for other intangible assets that have indefinite useful lives, we do not amortize goodwill. This makes it imperative that companies make every effort to identify specific intangibles other than goodwill that they acquire in a business combination since goodwill is the amount left after other assets are identified.

The fixed-asset turnover ratio measures a company's effectiveness in managing property, plant, and equipment.

Net Sales / Avg. Fixed Assets

The relative fair value percentages are multiplied by the lump-sum purchase price to determine the initial valuation of each of the separate assets.

Notice that the lump-sum purchase includes inventories. The procedure used here to allocate the purchase price in a lump-sum acquisition pertains to any type of asset mix, not just to property, plant, and equipment and intangible assets.

Gain Situation for Lack of Commercial Substance in an Exchange

On the other hand, if the land were exchanged for a tract of land that has the identical characteristics as the land given, then it is unlikely that future cash flows would change. This exchange lacks commercial substance, and the gain of $4 million cannot be recognized on the exchange. The new land is recorded at the book value of the old land plus any cash paid. The FASB's intent in including the commercial substance requirement for the use of fair value was to avoid companies' trading property for no business reason other than to recognize the gain.

If the acquired R&D project is completed successfully, we switch to the way we account for developed technology and amortize the capitalized amount over the estimated period the product or process developed will provide benefits. If the project instead is abandoned, we expense the entire balance immediately.

R&D costs incurred after the acquisition to complete the project are expensed as incurred, consistent with the treatment of usual R&D expenditures. Similarly, the purchase of R&D from third parties not associated with a business combination is expensed as incurred, just as if the company had performed the R&D activity itself. An exception is when the purchased R&D has an alternative use beyond a specific project.

Internally-developed intangible assets typically are expensed ("operating expenses").

Rather than reporting these in the balance sheet as assets, we typically expense them in the income statement in the period we incur those internal development costs. For example, the research and development (R&D) costs incurred in developing a new product or process are not recorded as an intangible asset in the balance sheet. Instead, they are expensed directly in the income statement as incurred. The reason we expense all R&D costs is the difficulty in determining the portion of R&D that benefits future periods. Conceptually, we should record as an intangible asset the portion that benefits future periods. Due to the difficulties in arriving at this estimate, current U.S. accounting rules require firms to expense all R&D costs as incurred. An exception to this rule is legal fees. The firm will record in the Patent asset account the legal and filing fees to secure a patent, even if it developed the patented item or process internally.

GAAP distinguishes research and development as follows:

Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process. Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use

International Financial Reporting Standards draw a distinction between research activities and development activities.

Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized.

The basic steps in recording non-monetary asset exchanges follow:

Step 1:Record the new asset at fair value. Fair value is determined based on the fair value of the asset(s) given up or the fair value of the asset received. In a normal exchange, we expect those two fair values to equal. Step 2:Remove the book value of the nonmonetary asset given. Book value equals the recorded cost of the old asset minus its accumulated depreciation. Step 3:Record any cash received or paid. Cash is used to equalize the fair values of the nonmonetary assets in the exchange. Step 4:Record any gain or loss. The gain or loss on the exchange equals the difference between fair value and book value of the asset given up in step 2. If fair value is greater, then a gain is recorded. If book value is greater, then a loss is recorded. The gain or loss also can be viewed as the "plug" that balances debits and credits in the journal entry.

Self-Constructed Assets

The cost of a self-constructed asset includes identifiable materials and labor and a portion of the company's manufacturing overhead.

Overhead Allocation - Two Approaches

The incremental approach to overhead allocation includes only those additional costs that are incurred because of the decision to construct the asset. (e.g., This would exclude such indirect costs as depreciation and the salaries of supervisors that would be incurred whether or not the construction project is undertaken. If, however, a new construction supervisor was hired specifically to work on the project, then that salary would be included in asset cost.) By the full-cost approach, all overhead costs are allocated both to production and to self-constructed assets based on the relative amount of a chosen cost driver incurred. This is the generally accepted approach.

R&D performed for Others

The principle requiring the immediate expensing of R&D 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. Of course, justification is that the benefits of these expenditures are the contract revenues that will eventually be recognized. Revenue from these contracts can be recognized over time or at a point in time, depending on the specifics of the contract.

Sometimes a company will acquire a new asset by giving up an existing asset.

This is referred to as a nonmonetary asset exchange. If the values of those nonmonetary assets are not equal to one another, cash will be received or paid to equalize those values.

INTERNAL Software Development Costs

We account for the costs incurred to develop computer software to be used internally in a similar manner. Costs incurred during the preliminary project stage are expensed as R&D. After the application development stage is reached (for example, at the coding stage or installation stage), we capitalize any further costs. If, instead, we purchase computer software for internal use, those costs generally are capitalized.

Why are some R&D Costs capitalized in regards to software?

We could also attribute the exception to the nature of the software business. Recall that R&D costs in general are expensed in the period incurred for two reasons: (1) they entail a high degree of uncertainty of future benefits, and (2) they are difficult to match with future benefits. With software, there is an important identifiable engineering milestone, technological feasibility. When this milestone is attained, the probability of the software product's success increases significantly. And because the useful life of software is fairly short (one to five years in most cases), it is much easier to determine the periods of increased revenues than for R&D projects in other industries. Compare this situation with, say, the development of a new drug. Even after the drug has been developed, it must go through extensive testing to meet approval by the Food and Drug Administration (FDA), which may never be attained. If attained, the useful life of the drug could be anywhere from a few months to many years.

Exchanges Summarized

When fair value is determinable and commercial substance exists, we record the asset received at total fair value. Gains and losses are recorded for the difference between the fair value and book value of the asset given, depending on which is higher. When fair value is not determinable, fair value cannot be used to record the asset being received, and therefore we don't record a gain or loss on the asset being given. The asset received is simply recorded for the book value of the asset given, adjusted for the effects of any cash exchanged. The rules for exchanges that lack commercial substance reflect a bias toward preventing gains from being recognized unless some cash is received so that a portion of the transaction represents a monetary exchange. Losses in exchanges that lack commercial substance are fully recognized regardless of cash received or paid, just like losses when fair value is determinable.

Loss Situation for Lack of Commercial Substance in an Exchange

When the fair value of the asset given is less than its book value, we always use fair value to record the exchange.

Under IFRS, the U.S. approach for amortizing computer software development costs is

allowed but not required.

Intangible assets with finite (set) useful lives are ____; intangible assets with indefinite useful lives are not amortized.

amortized -- reduces the asset directly

Filing and legal costs for patents, copyrights, and other developed intangibles are

capitalized and amortized in future periods.

Goodwill can emerge from a company's

clientele and reputation, its trained employees and management team, its favorable business location, and any other unique features of the company that can't be associated with a specific asset.

A franchise is a

contractual agreement under which the franchisor grants the franchisee the exclusive right to use the franchisor's trademark or tradename within a geographical area usually for a specified period of time. Payments to the franchisor usually include an initial payment plus periodic payments over the life of the franchise agreement. The franchisee capitalizes as an intangible asset the initial franchise fee plus any legal costs associated with the contract agreement. The franchise asset is then amortized over the life of the franchise agreement. The periodic payments usually relate to services provided by the franchisor on a continuing basis and are expensed as incurred. Franchise operations are among the most common ways of doing business.

If material, the amount of interest capitalized during the period must be

disclosed in a note.

A copyright is an

exclusive right of protection given by the U.S. Copyright Office to the creator of a published work such as a song, film, painting, photograph, book, or computer software. Copyrights give the creator/owner the exclusive right to reproduce and sell the artistic or published work for the life of the creator plus 70 years. A copyright also allows the holder to pursue legal action against anyone who attempts to infringe the copyright. Accounting for the costs of copyrights is virtually identical to that of patents.

Intangible assets generally represent ____ that provide benefits to the owner.

exclusive rights

Start-up costs, including organization costs, are

expensed in the period incurred.

A nonmonetary exchange is considered to have commercial substance if

future cash flows will change as a result of the exchange. Most exchanges are for business reasons and would not be transacted if there were no anticipated change in future cash flows. For example, newer models of equipment can increase production or improve manufacturing efficiency, causing an increase in revenue or a decrease in operating costs with a corresponding increase in future cash flows.

For government grants, unlike U.S. GAAP, donated assets are not recorded as revenue under IFRS. IAS No. 20 requires that

government grants be recognized in income over the periods necessary to match them on a systematic basis with the related costs that they are intended to compensate.

GAAP requires that total R&D expense incurred must be disclosed either as a

line item in the income statement or in a disclosure note

it's often very difficult to anticipate the timing, and even the existence, of future benefits attributable to

many intangible assets.

The cost of land improvements (parking lots, driveways, private roads, fences, lawns, and sprinkler systems)

must be separated from the cost of land because land has an indefinite life and land improvements usually do not instead improvements have useful lives that are estimable. Costs of these assets are separately identified and capitalized. We depreciate their cost over periods benefited by their use.

the costs of heavy equipment and other assets a company uses during drilling or excavation usually are

not considered part of the cost of the natural resource itself. Instead, they are considered depreciable plant and equipment. However, if an asset used in the development of a natural resource cannot be moved and has no alternative use, its depreciable life is limited by the useful life of the natural resource.

Natural resources

oil and gas deposits, timber tracts, and mineral deposits.

Intangible Assets

other than financial assets, lack physical substance, and the extent and timing of their future benefits typically are uncertain. They include items such as patents, copyrights, trademarks, franchises, and goodwill.

Costs are expensed if

produce benefits only in the current period

In practice, some companies report intangible assets as part of _____, and some companies include them with the ______.

property, plant, and equipment; other assets category

Property, plant, and equipment and intangible assets can be acquired through

purchase, exchange, lease, donation, self-construction, or a business combination.

Property, plant, and equipment

tangible, long-lived assets used in the operations of the business, such as land, land improvements, buildings, equipment, machinery, furniture, and vehicles, as well as natural resources, such as mineral mines, timber tracts, and oil wells.

Goodwill is a unique intangible asset in that it can only be purchased through

the acquisition of another company because its cost can't be directly associated with any specific identifiable right and it is not separable from the company itself. Goodwill will appear as an asset in a balance sheet only when it was purchased in connection with the acquisition of control over another company.

Capital budgeting

the process of evaluating the purchase of operational assets.

The initial cost of property, plant, and equipment and intangible assets includes

the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.

The cost of equipment (machinery, computers and other office equipment, vehicles, furniture, and fixtures) includes

the purchase price plus any sales tax, transportation costs, expenditures for installation, testing, legal fees to establish title, and any other cost of bringing the asset to its condition and location for use. For example, the costs of training personnel to operate machinery could be considered a cost necessary to make the asset ready for use. However, because it is difficult to measure the amount of training costs associated with specific assets, these costs usually are expensed.

The cost of land includes (indefinite life)

the purchase price plus closing costs such as fees for the attorney, title and title search, and recording. -If the property is subject to back taxes, liens, mortgages, or other obligations, these amounts are included also. -In addition, any expenditures such as clearing, filling, draining, and even removing (razing) old buildings that are needed to prepare the land for its intended use are part of the land's cost. -Proceeds from the sale of salvaged materials from old buildings torn down after purchase reduce the cost of land.

a new accounting standard simplified accounting for exchanges by requiring

the use of fair value except in rare situations in which the fair value can't be determined or the exchange lacks commercial substance.

Purchased intangibles are valued at

their original cost to include the purchase price and all other necessary costs to bring the asset to condition and location for use.

Costs are capitalized, rather than expensed, if

they are expected to produce benefits beyond the current period

The requirement to expense R&D immediately leads to assets being ____ and expenses being ____ in the current period.

understated; overstated