PP&E
Accelerated Depreciation Sum of the years digits (SYD) These depreciation methods are illustrated using the following information in an example: -10,000 Asset Cost -4 Year Life - 2,000 Salvage Value
#year remaining X (Cost-Salvage)/Sum of the years Sum of the years: 1+2+3+4=10 4X(10,000-2000)/10=3,200 Sum of the years: 1+2+3+4=10 3X(10,000-2000)/10=2,400 2X(10,000-2000)/10=1,600
How much interest can be capitalized?
The amount capitalized is the lesser of actual interest cost incurred during the period or avoidable interest.
Valuation for a Self Constructed Asset
The capitalized cost of a self-constructed asset includes: 1. Direct Labor 2. Material 3. Overhead 4. Interest Cost (more in next lesson)
Capitalized Cost Practice Questions A corporation issued debt to purchase 10 aches of land for development purposes. Expenditures related to this purchase are as follows: Description Amount Purchase price $1,000,000 Real estate taxes in arrears $15,000 Debt issuance costs $2,000 Attorney fee - title search on land $5,000 The company should record its acquisition of the land in its financial statements at what value?
$1,020,000
Capitalized Cost Practice Questions Assume a purchase of a tract of land for a future factory site for $200,000. The old building on the property was razed and salvaged materials resulting from demolition were sold. Costs and proceeds were as follows: Demolition of old building $25,000 Legal fees for purchase contract 5,000 Title guarantee insurance 6,000 Proceeds from sale of salvaged materials 4,000 How much should be recorded for the purchase of land?
$232,000
Practice question A plant asset is purchased with $10,000 down and a 2-year non-interest bearing note with a single payment at maturity of $20,000. The PV factor of $1 for 2 years at 10% is .82645. At what value is the plant asset recorded on the date of acquired?
$26,529 PV of future payments plus the $10,000. The entry is: DR: Plant Asset 26,529 CR: Cash (10,000) CR: Note payable (16,529)
Practice Question A company purchased a machine on July 1, year 1 for $300,000. The machine has an estimated useful life of 5 years and a salvage value of $40,000. The machine is being depreciated from the date of acquisition by the 150% declining balance method. For the year ended December 31, Year 1 what should be recorded as depreciation on this machine?
$45,000 (1/5*1.50)*300000 = 90,000/2=45,000
straight line method example Assume: $10,000 asset cost, 4-year life, $2,000 salvage value
(10,000-2,000)/4 = 2,000 per year Watch out for assets placed into service during the year. In that case, the depreciation would be prorated.
What is the straight line method?
(Cost - salvage value)/number of years
What are examples of post-acquisition expenditures to be capitalized?
- Additions Improvements Rearrangements
Impairment of Assets What are the main classification of impairment of assets?
- Assets held and are in use - Asset held for disposal (sale) - Asset to be disposed of other than sale (abandonment, spin-off to shareholders, or exchange for other assets)
What are the other cost included in inventory related to natural resources?
- Direct extraction costs (material and labor) -Production costs for processing after extraction - Depreciation on equipment related to the extraction efforts. Once the natural resource inventory is sold, remove the inventory and recognized cost of goods sold.
What are the two ways payment data from AAE can be provided?
- Discrete or Continuous If you are given dates and different payments amounts go with the discrete calculation.
What are the indicators of potential impairment?
- Significant decrease in fair value - Change in the way the asset is used or physical change in asset - Legal factors/change in business climate or adverse action/assessment by regulator -Asset cost are more than planned, inflating the cost basis -Operating or cash flow losses from the asset
Held-for-Sale Criteria The following are indicators that the asset held for sale:
- There is a plan to sell the asset - The asset must be available for sale - the sale is expected to occur in one year - the asset is being actively marketed
Capitalized cost if it:
1. Extends an asset's useful life or 2. Improves the quality/quantity of an asset's service without extending its useful life.
What are the two methods to determine interest when there is more than one interest-bearing debt?
1. Specific method - use the specific construction loans first and then apply the average interest rate on remaining debt. 2.Average Method - treat all debt the same and apply the average rate on all debt.
What are the two methods allowed for exploration costs?
1. Successful efforts - only the cost of successful exploration efforts are capitalized, unsuccessful efforts are expensed. - This method reflects capitalization of costs once the asset is located. 2. Full cost - all cost of exploring are capitalized. - This method reflects matching all costs incurred to obtain the asset.
Post-acquisition expenditures Practice Question A machine with an original estimated useful life of 10 years was moved to another location in the factory after it had been serviced for 3 years. The efficiency of the machine is increased for its remaining useful life. The reinstallation costs should be capitalized if the remaining useful life of the machine is:
5 year - Yes 10 Year - Yes
Capitalization
A cost that is included in the value of the asset.
Post-acquisition expenditures Terms Expenditure
A cost that is recognized on the income statement
Non-Accelerated Depreciation Methods What is the concept behind depreciation?
A systematic and rational allocation of the cost of a fixed asset over its estimated useful life.
What are the component costs of natural resources?
Acquisition cost - the cost to acquire natural resources including full purchase price of the property or cost to lease the property. Exploration costs - the costs to locate the natural resource before development. These are the costs of drilling in search of the ore or oil.
What to do if an asset held for use impairment test?
An asset is impaired if the carrying value (CV) will not be recovered. CV is the amount reported on the balance sheet. Recoverability is determined by comparing CV to undiscounted cash flows (UCF). UCF = Gross cash inflows from an asset less outflow to obtain the net inflows. - There is an impairment when the CV>UCF. - The impairment loss is the difference between CV and fair value (FV). - The new basis is the FV if lower than CV.
How do you account for assets to be disposed of other than sale?
Assets can also be held in anticipation of the following dispositions: - Abandonment - Exchange for a similar asset - Distribution to shareholders in a spin-off
Valuation of Plant Assets What do you value the assets if the purchase price or amount paid is unknown?
At the date of acquisition, a plant asset is recorded at whichever fair value is more readily determinable and reliable: 1. the consideration given in the exchange or 2. the asset acquired After the date of acquisition, plant assets are carried at acquisition date fair value less accumulated depreciation.
A company with a June 30 fiscal year end entered into a $3,000,000 construction project on April 1 to be completed on September 30. The cumulative construction-in-progress balances at April 30, May 31, and June 30 were $500,000, $800,000, and $1,500,000, respectively. The interest rate on company debt used to finance the construction project was 5% from April 1 through June 30 and 6% from July 1 through September 30. Assuming that the asset is placed into service on October 1, what amount of interest should be capitalized to the project on June 30?
Average Expenditures = 500,000+800,000+1,500,000/3=933,333 Interest rate for 3 month period .05x3/12=.0125 Capitalized interest = $11,666 April 1 to June 30 500,000 * 3/12 = 125,000 May to June30 800,000-500,000 *2/12 = 50,000 June1 to June 30 1,500,000-800,000*1/12=58,333 Weighted avg expenditures = 233,333 Interest rate April to June = .05 Capitalized interest $11,666
What is the average accumulated expenditures?
Average accumulated expenditures (AAE) are the total expenditures during the construction period, and therefore the debt that could have been avoided. AAE is determined by using the weighted average of the actual expenditures during the year or simple average of beginning and ending AAE (AAE/2).
Average Method Example Assume that construction begins during the current period and AAE for the period is $160,000. Debt outstanding for the entire period is $170,000 and actual interest is $8,400. Interest rates and loans are as follows: - 5%, $120,000 construction loan - 6%, $20,000 note payable unrelated to construction - 4%, $30,000 note payable unrelated to construction
Average interest rate on all loans = [(.05)120,000+(.06)20,000+(.04)30,000]/(120,000+20,000+30,000)=.0494 Recall that AAE is $160,000 (less than total debt of $170,000). Therefore, interest capitalized is:{.0494($160,000)}=$7,904
How is avoidable interest calculated?
Avoidable interest is determined by multiplying the interest rate by average accumulated expenditures for the qualifying assets during the period.
What is avoidable interest?
Avoidable interest is interest that could have been avoided if expenditures for the construction had not been made.
How to allocate that cost? What are the categories of PP&E?
Buildings Machinery And Equipment - Have a finite useful life, therefore are depreciable. Land - any land that the company uses for primary business operations. This asset is the only asset in PPE that is not depreciated. Land improvements - have a finite useful life (parking lots, fencing, etc.) Natural resources - produce income and the allocation of cost is called depletion (gravel pit, coal mine, tract of timberland, etc.)
Practice Question A company donated computer equipment to a university (a nonreciprocal transfer). The fair value of the computer equipment was determinable. The difference between the fair value of the asset transferred and its recorded amount at the date of the donation should be recognized in the income statement when the difference result in a: Gain Loss
B. Yes and Yes Entry DR Contribution Expense FV DR Accum Depreciation BV CR Computer (BV) DR Loss Plug CR Gain (Plug) The difference between fair value and book value is a loss or gain (BV>FV Loss; BV<FV Gain)
Practice Question A machine with a 4-year estimated useful life and an estimated 10% salvage value was acquired on January 1, year1. The depreciation expense for the year 3 using the double declining balance method would be original cost multiplied by?
B.50*.50*.50
How do you account for an asset disposal of other than sale?
Continue to classify the asset as held for use until disposal occurs. Continue Depreciation Apply impairment standards for assets in use. Not treated as assets for sale because the disposition is not considered a sale.
What are capitalized costs?
Costs are those that are included in the asset rather than expensed and fall into two categories: 1. The cost to get the asset ready for use (all cost to get the asset to the correct condition and location are capitalized example sales tax, cost to set up equipment, cost to test equipment, title fees attorney fees, costs in building and construction). 2. Costs to extend the assets' useful life to improve productivity.
How is actual interest cost calculated?
Debt outstanding times the interest rate times time
Accelerated Depreciation Double Declining Balance (DDB) These depreciation methods are illustrated using the following information in an example: -10,000 Asset Cost -4 Year Life ( the straight line rate is 1*4 or 25%*2=50%) - 2,000 Salvage Value
Double Declining Balance is twice the straight line rate. The rate is applied to NBV(Cost-Accumulated Depreciation) at the beginning of each year. Note that salvage value is not deducted from depreciation base, but depreciation is not taken below salvage value. Year 1: (2*25%)*10,000=$5,000 Year 2: (2*.25)*(10000-5000)=$2,500 Year 3: 2,500-2000 = $500 Can not depreciate below salvage value
Practice Question A company determined that there was a significant decrease in the value of equipment. At year end, the company compiled the following information: Original cost of the equipment $500,000 Accumulated depreciation 300,000 Expected net future cash inflows (undiscounted) 175,000 Fair value of the equipment 125,000 What is the impairment loss reported on the income statement for the year end?
Dr: Impairment loss $75,000 Cr: Accumulated depreciation ($75,000) What if the fair value of the equipment increases to $140,000 next period? The loss cannot be recovered.
Asset held for use - Impairment Test
First determine if the cost of asset is recoverable. 1. if UCF = $100 per year x 10 years = $1,000 and CV = $900 Asset not impaired. Has more cash flow than on the value on the balance sheet. 2. Assume UCF = $100 per year x 10 years = $1,000 and CV = $1,900 Asset is impaired. Cash flows are less than the value on the books. To measure the impaired loss, compare the assets FV to the CV. Credit accumulated depreciation by the amount of the loss. Assume FV = $1,500; CV=$1,900. This means $400 loss. DR: Impairment loss $400 CR: Accumulated Depreciation $400 Impairment loss is part of income from continuing operations. Restoration of previously recognized impairment losses is prohibited.
What does systematic mean?
Formula or plan
What is the impairment test for asset held-for-sale?
If CV>NRV then recognize a loss If CV<NRV then recognize a gain (limited to previously recognized losses). Depreciation is no longer taken The asset can be written up or down, but not above original carrying value. Subsequent gains cannot exceed the amount of the initial impairment loss
What costs are expensed instead of capitalized?
If an expenditure simply maintains the asset so that its service can be used over the original estimated useful life, then the expenditure is an expense in the period incurred (usually as repairs and maintenance expense).
What is modification?
Improvement, replacement or rearrangement follows the same rules as an addition.
Capitalized of Interest
Interest can be capitalized when an entity constructs plant assets for sale, lease, or for their own use. - interest is not capitalized on inventory or other routinely produced assets. Is part of the asset's basis in addition to materials, labor, and overhead associated with construction - The firm capitalizing interest need not actually do the construction. At the end of the year, the interest expense is transferred to the asset under construction.
Interest Capitalization Limits Capitalized Interest
Interest capitalization adds interest to the asset basis during construction. After the asset is placed into service, interest is no longer capitalized and asset is depreciated.
Average Method Twist What if AAE had been $200,000 (more than total debt of $170,000)? Then actual interest for the period would be capitalized because total debt ($170,000) is less than $200,000.
Interest capitalized would be: (.05)120000 (.048)20000 (.048)30000 $8,400
Specific Method Twist What if AAE had been $200,000? Then actual interest for the period would be capitalized because total debt ($170,000) is less than $200,000.
Interest capitalized would be: (.05)120000 (.06)20000 (.04)30000 $8,400
What does allocation mean?
It means allocating costs - not a process of valuation
Practice Question A company issued 2,000 shares of its $10 par common stock for a tract of land. The stock had a fair value of $18 per share on this date. The last property tax bill had the land assessed at $24,000. What should be recorded as an increase in additional paid in capital.
Land 36,000 CS (20,000) APIC (16,000) Twist: what is given the appraisal value of the land and the company's stock is closely held? - Then the appraised value would be cost of land, because it would be the most reliable value.
Rationale for Capitalization
Matching - interest incurred during construction is deferred in asset under unit it generates revenue; then interest is expensed through depreciation. Avoidable interest - if the construction had not taken place, the firm could have avoided the interest.
What is the valuation of the asset if purchased on credit?
Often plant assets are acquired on a deferred payment or by issuing a note payable. The asset is recorded at the present value of future cash payments using a market rate of interest for similar financing arrangements.
What does depreciable costs mean?
Original cost of the asset less salvage value.
What type of other capitalized costs can be capitalized?
Other costs that can be capitalized if the cost: 1. extend an asset's useful life or 2. improves the quality/quantity of an asset's service without extending its useful life These expenditures are capitalized included in the book value of the asset. Examples: Additions, Improvements, replacements, and rearrangements.
What costs are capitalized? Criteria for classification of plant asset?
Plant Assets: - Are currently used in operations - Have a useful life of more than one year - Have physical substance (i.e., not an intangible asset)
Valuation if there is Issuance of Securities
Plant assets acquired through the issuance of stocks or bonds are recorded at the fair value of the security given of the fair value of the asset acquired, whichever is more clearly determinable.
What is the substitution approach/method?
Remove the old asset and accumulated depreciation, recognize a loss, and capitalize the new cost.
Post-acquisition expenditures Practice Question The following expenditures relating to the plant building were made during the year: Replacement of the old shingle roof with a fireproof tile roof 75,000 Repainted the plant building 5,000 Major improvements to the electrical wiring system 35,000 How much should be capitalized?
Replacement roof 75,000 Improvement - Elec. Wiring 35,000 Total 110,000
Valuation for a donated asset
Sometimes an asset is given, but no compensation is received (non-reciprocal transfer). Contribution expense is the fair value (FV) of the asset donated. - Remove the book value (BV) of the asset donated. - if the fair value (FV) is not determinable, use BV for the contribution expense.
Specific Method Example Assume that construction begins during the current period and AAE for the period is $160,000. Debt outstanding for the entire period is $170,000 and actual interest is $8,400. Interest rates and loans are as follows: - 5%, $120,000 construction loan - 6%, $20,000 note payable unrelated to construction - 4%, $30,000 note payable unrelated to construction
Specific Method Average interest rate on non-construction loans = [(.06)$20,000+(.04)$30,000]/($20,000+$30,000) =.048 Avoidable Interest = Interest on construction loan .05($120,000) $6,000 +Interest on other debt .048($160,000-$120,000)$1,920 Avoidable Interest $7,920 Interest capitalized $7,920
How do you account for an asset impairment?
Step 1: Are future net cash flows recoverable? - Yes - No impairment Step 2: Potential impairment - For use 1. Impairment loss = CV-FV 2. Depreciation new basis 3. No reversal of loss - For Sale 1. Impairment = CV - FV less cost to sell 2. No depreciation 3. Reversal permitted
Limitation of Self-Constructed Values
The self constructed asset cannot be recorded in excess of the assets fair value at the time of completion. If the total cost of the construction exceeds fair value of the constructed asset, a loss is recognized.
What does salvage value mean?
The value estimated to be received from the asset when it is no longer used in service. An asset can not be depreciated beyond the salvage value.
What is the debit accumulated depreciation approach?
This approach is used when expenditures increases the useful life. Reducing accumulated depreciation turns back the clock on the life of the larger asset.
What is the increase the basis of the larger asset approach?
This approach is used when productivity (versus useful life) is enhanced or when the accounting system does not have the details to remove the old components.
When can interest be capitalized?
Three conditions must exist simultaneously for interest to be capitalized: 1. Interest cost is being incurred 2. Construction activities are taking place 3. Construction expenditures are occurring
How do you determine the average accumulated expenditures?
Two Methods Weighted Average - Assume two payments for construction of $40,000 on Jan 1 and July 1. - The weighted average is ($40,000 * (12/12)) + (40000*(6/12))=$60,000. Simple Average - Assume there are small discreate payments evenly thought the year and a total of $180,000 was paid during the year. (0+180000)/2=90000
What are the capitalized interest rates determined?
Two ways : Specific Method Or Average Method - If the problem says the construction loan interest is applied first, you are being asked for the specific method.
How do determined the interest rate for capital interest?
Two ways to determine the interest rate: 1. Weighted average interest on all debt Or 2. Specific interest on construction loans - The specific interest method uses interest on construction loans first, and then remaining debt.
How are depletion of resources accounted for?
Unit of production method
AAE relative to interest-bearing debt
When AAE>interest-bearing debt, all interest costs will be capitalized and there is no interest expense because all debt could have been avoided if there was no construction. - If AAE is $10,000 and debt is $8,000, then interest on the debt (actual interest) is less than the interest on the AAE (avoidable interest). If AAE<total interest-bearing debt, then interest expense is the difference between the total interest costs and interest capitalized. -if AAE is $8,000 and debt is $10,000, the interest on the debt (actual interest) is more than the interest on the AAE (avoidable interest).
What are additions?
extensions or enlargements of an existing asset. if the addition is an integral part of the larger asset, depreciate over the shorter of its useful life or the remaining life of the larger asset.
Interest becomes part of AAE Assume an entity borrowed $2,000,000 at 6% for the construction of a warehouse. Construction began in year 1. Year 1: the entity paid $1,400,000 to contractor and capitalized $42,000 of interest in year 1. The balance in the construction account is $1,442,000.
he Year 2: the entity paid $600,000 to the contractor on April 1. AAE for year 2: {$1,442,000(12/12)+$600,000(9/12)}=$1,892,000 Avoidable interest: (6%x$1,892,000)=$113,520 Actual Interest: (6%x$2,000,000)=$120,000 The ending asset balance: ($1,442,000+$600,000+$113,520)=$2,155,520
What is an expenditure?
maintains the asset so that its service can be used over its original estimated useful life; expense in the period incurred, usually as repair and maintenance expense.
Natural Resources What are natural resources?
noncurrent assets that contain the cost associated with acquisition, exploration, and development of a natural resource deposit. Examples: mining ore, oil drilling, timberland, etc. It does not include the cost of extraction.
What does book cost mean?
original cost less accumulated depreciation (sometimes referred to as net book value or carrying value).
What does rational mean?
representational faithfulness (fits with reality)
What is depletion?
the allocation of natural resource being extracted to the inventory of the ore, mineral, or timber. Depletion is debited to inventory and credited to a contra account for the natural resource asset.
What is the amount of interest capitalization?
the lesser of avoidable interest or actual interest incurred during the period. - Avoidable interest is determined by multiplying average accumulated expenditures (AAE) by the interest rate. Interest capitalization is not limited to the construction debt.
unit of service hours method Assume: $22,000 asset cost, $2,000 salvage value, 2,500 service hours are used, and 10,000 is the total service hours.
{(22,000-2000)/10000} X 2,500 = $5,000
unit of production method Assume: $22,000 asset cost, $2,000 salvage value, 300 units produced, and 1,000 is the total units.
{(22,000-2000)/1000} x 300 = $6,000
What is the service hours method?
{(Cost-Salvage)/Total hours of service} x hours used
What is the unit of production method?
{(cost-salvage)/total units} x unites produced
Practice Question A machine costs $60,000. The Machine's total output is expected to be 500,000 units. If 100,000 units are produced in the first year, what is the depreciation?
{60,000/500000} X 100,000 = $12,000
