Accounting 330 Exam 3 (Chapter 10)

Historical Cost

measures the cash or cash equivalent price of obtaining the asset and bringing it to the location and condition necessary for its intended use

Under IFRS, what happens if funds are borrowed before they are needed?

The accumulated interest revenue is subtracted from the cost. Only the net amount is capitalized.

How much interest can you actually capitalize? Is there a limit?

Yes. The cap is the smaller of actual interest accrued or avoidable interest.

How do you calculate a gain or loss on the exchange of PPE?

You compare the Fair Value (MV-what we can sell it for) of the old asset with the carrying value (BV-HC-accum. depreciation) of the old asset; Subtract the carrying value from the fair value.

If there is a loss on exchanging PPE, what do you do?

You record it immediately.

What subsequent costs can be capitalized? What kinds cannot? Which are always capitalized? Which are never?

Ordinary repairs cannot be capitalized. For example, changing the oil in a car. These are period costs. Major repairs, like installing a new engine, can be capitalized. Additions are ALWAYS capitalized. Improvements and replacements are treated like purchasing a new asset.

Finding the Historical Cost on a new machine about to be exchanged

Sum of: Cash paid for new machine + Fair value of new machine Cash paid for new machine is calculated by: Given market price of new machine - Trade-in value.

Capitalizing Interest under IFRS requires that...

Interest revenue earned on specific borrowings should be used to offset interest costs that are capitalized.

Writing-DOWN PPE

Write-down PPE when the fair value of the asset is LESS than its carrying value. Occurs when the asset is impaired or being held for sale.

Steps to Capitalizing Avoidable Interest (U.S. GAAP)

1. Calculate the total weighted average accumulated expenditures (= Amount * Capitalization period) 2. Break payments up into financed and unfinanced. Based on the total WAAE, distribute the construction loan amount to financed and the rest to unfinanced. 3. Calculate the total principle and the interest expense, using the amounts (principle) and interest rates from debt not used for construction. 4. Divide the total interest expense by total principle to calculate the Weighted Average Interest Rate. 5. Go back to breakdown of financed and unfinanced payments. Use the construction loan amount and interest rate to calculate the financed interest expense; Use the unfinanced payment amount and the weighted average interest rate to calculate the unfinanced interest expense. 6. Sum the two. This is total avoidable interest. Compare that to total interest expense accrued, and capitalize the smaller of the two.

Capitalization Period requirements

1. Expenditures for the asset have been made. 2. Activities necessary to get the asset ready for use are in progress. 3. Interest cost is being incurred.

Exchanging PPE: What are the two questions you have to ask?

1. Is there a gain or a loss? 2. If there is a gain, does the gain have commercial substance?

Actual interest calculation (IFRS, construction loan)

= Construction loan amount * const. interest %

Total Avoidable Interest calculation (IFRS, construction loan)

= Total WA Expenditure * Const. loan interest %

Assignment/Allocation of Costs and Expenses to Self-Constructed Assets under U.S. GAAP

Allocate a portion of OH costs to the construction process. This approach is called the "full-costing approach".

Capitalization Rate (IFRS, non-construction loan)

Avoidable interest is calculated using ONLY the Weighted Average Interest Rate on outstanding debt. No attempt is made to offset interest revenues. The max amount that can be capitalized is the total interest accrued.

Capitalization Rate (IFRS, construction loan)

Avoidable interest is calculated using ONLY the interest rate on the construction loan. The max that can be capitalized is the total interest on the construction loan.

Under IFRS, what is the different requirement to determine the capitalization period?

Borrowing costs must start to acquire. Also, avoidable interest is put into borrowing costs.

When to capitalize?

Capitalize costs incurred after acquisition of the asset such as improvements, renovations, additions, etc. if they provide future service potential.

What is commercial substance?

Commercial substance substantially changes the nature of a business.

Borrowing Cost Differences under IFRS

Companies can include exchanges from foreign borrowings; Discounts and premiums can be amortized; Can include lease charges when determining avoidable interest.

Capitalizing Interest under IFRS (Borrowing Differences)

Companies can include: -exchanges from foreign borrowings -discounts/premiums capitalized -lease charges when determining avoidable interest.

Journal Entry steps when recording a gain or loss on disposed PPE.

Credit asset value Debit accumulated depreciation Debit cash received Debit a loss, or credit a gain

What if the asset is premade? (Interest)

Interest costs cannot be capitalized on a premade asset.

Journal entry when abandoning PPE

Debit all accumulated depreciation Credit the entire asset Debit a loss or credit a gain on the abandonment.

What is the journal entry for capitalizing interest under GAAP?

Debit: Building Debit: Interest expense Credit: Cash Credit: Interest Payable (difference)

Self-Constructed Assets

Determining costs can be difficult; track OH and material costs to find the cost of the SC asset.

Writing-UP PPE

Do not write-up PPE to reflect fair value of the asset. Because...: -Historical cost is more relevant, and -you only recognize a gain or loss when the asset is sold.

Why should a company defer (capitalize) interest costs?

During construction, the asset is not generating revenues.

Failure to allocate OH costs (under U.S. GAAP)

Failure to allocate OH costs will understate the initial cost of the asset, and it results in an inaccurate future allocations.

Recording a gain WITHOUT commercial substance.

Historical cost = Cash paid + BV of new machine

Weighted Average Interest Rate (Under IFRS)

The construction loan is treated as a general loan. The total principle and total interest expense includes the construction loan.

Why do we capitalize subsequent costs rather than expense them right away?

The costs of repairs and improvements can be very high. If we expensed everything right away, the expenses would drop net income, therefore dropping EPS, and make our company look like we are not having such a good year.

Say you started construction in June of this year and ended in November. How would your ratios for the WA expenditure change?

The denominator (12 months) will never change. However, if you started construction June 1, the ratio for the starting date would be 7/12. If you ended November 31, the ratio would be 1/12.

Recording construction costs in excess of costs that an independent producer would charge

The excess amount is recorded as a period loss, rather than capitalizing it. This avoids capitalizing the asset at more than its probable fair value.

How do we determine a gain or loss when disposing of PPE?

The gain or loss is the difference between assets removed and any new assets received.

Recording a gain with commercial substance.

The historical cost of the new machine= Cash paid + FV of new machine; The difference with the cash paid for the new machine IS: We use the Book Value of the new machine - Trade-In Value

What happens to interest costs after construction has ended?

The interest costs must now be expensed and matched to the revenues.

Under IFRS, why are companies better off with unfinanced debt in some situations?

The maximum amount able to be capitalized is total interest expense, allowing us to capitalize more than if we used financed debt.

What are the requirements for capitalizing subsequent costs?

The useful life of the asset is increased, the quantity of assets made is increased, and the quality of the assets made is increased.

GAAP's thoughts on interest costs

They are treated just like labor and materials; interest costs are only capitalizable if the costs are incurred through debt financing.

Objective of capitalizing interest costs

To obtain a measure of acquisition cost that reflects the company's total investment in the asset, AND to charge that cost to future periods benefited.

What must we do with our books when disposing of PPE?

We have to write-off the asset entirely as well as the accumulated depreciation.

Long term Asset

When held for sale, it is measured at the LOWER of carrying value or fair value, less the costs it incurs to sell.

When does the construction period end?

When the asset is substantially complete and ready for its intended use.

Debt financing

Will have an asset of higher cost than using stock (equity) financing.

Biggest differences about capitalizing interest under GAAP and IFRS?

With GAAP, you can divide the debt into two parts: financed, specifically a construction loan, and unfinanced, all other debt, and capitalize interest from each. IFRS, however, does not allow you to do that. Instead, their directly attributable borrowing costs (construction loan) OR general loan interest costs are capitalizable. You have to pick one.

Full-Costing Approach

costs should attach to all products and assets manufactured or constructed; assigns a portion of ALL OH costs to the construction process.