Chapter 10

Examples of assets that do not qualify for interest capitalization are

(1) assets that are in use or ready for their intended use, (2) assets that the company does not use in its earnings activities and that are not undergoing the activities necessary to get them ready for use. Examples of this second type include land remaining undeveloped and assets not used because of obsolescence, excess capacity, or need

How to assign indirect costs for self-constructed asset

1. Assign no fixed overhead to the cost of the constructed asset. To charge a portion of the overhead costs to the equipment will normally reduce current expenses and consequently overstate income of the current period. 2.Assign a portion of all overhead to the construction process. (full-costing approach) Under this approach, a company assigns a portion of all overhead to the construction process, as it would to normal production. Advocates say that failure to allocate overhead costs understates the initial cost of the asset and results in an inaccurate future allocation.

Interest Costs During Construction

1. Capitalize no interest charges during construction The major argument against this approach is that the use of cash, whatever its source, has an associated implicit interest cost, which should not be ignored. 2. Charge construction with all costs of funds employed, whether identifiable or not. Its advocates say that all costs necessary to get an asset ready for its intended use, including interest, are part of the asset's cost. 3. Capitalize only the actual interest costs incurred during construction. But this approach capitalizes only interest costs incurred through debt financing. (That is, it does not try to determine the cost of equity financing.) Under this approach, a company that uses debt financing will have an asset of higher cost than a company that uses stock financing GAAP requires the third approach—capitalizing actual interest (with modification)

Capitalization Period begins when these conditions met

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

Interest Rates for Weighted-Average Accumulated Expenditures

1. For the portion of weighted-average accumulated expenditures that is less than or equal to any amounts borrowed specifically to finance construction of the assets, use the interest rate incurred on the specific borrowings. 2. For the portion of weighted-average accumulated expenditures that is greater than any debt incurred specifically to finance construction of the assets, use a weighted average of interest rates incurred on all other outstanding debt during the period.3

Major Characteristics of Property, Plant, and Equipment

1. They are acquired for use in operations and not for resale 2. They are long-term in nature and usually depreciated. 3. They possess physical substance.

Cost of Land

1.) Purchase Price 2.) Closing Costs (title, attorney's fees, and recording fees) 3.)costs incurred in getting the land in condition for its intended use, such as grading, filling, draining, and clearing 4) assumption of any liens, mortgages, or encumbrances on the property (5) any additional land improvements that have an indefinite life.

Weighted-Average Accumulated Expenditures

A measure used in determining the amount of interest that can be capitalized. Computed by weighting construction expenditures by the amount of time (e.g., fraction of a year) that a company can incur interest cost on the expenditure.

Expenditures for Land

If it purchases land as a site for a structure (such as a plant site), interest costs capitalized during the period of construction are part of the cost of the plant, not the land.

Special Assesments for local improvements, such as pavements, street lights, sewers, and drainage systems.

It should charge these costs to the Land account because they are relatively permanent in nature. That is, after installation, they are maintained by the local government

When a company purchases plant assets subject to cash discounts for prompt payment, how should it report the discount?

One approach considers the discount—whether taken or not—as a reduction in the cost of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash equivalent price of the asset. In addition, some argue that the terms of cash discounts are so attractive that failure to take them indicates management error or inefficiency.

But how should companies account for an old building that is on the site of a newly proposed building? Is the cost of removal of the old building a cost of the land or a cost of the new building?

Recall that if a company purchases land with an old building on it, then the cost of demolition less its salvage value is a cost of getting the land ready for its intended use and relates to the land rather than to the new building.

improvements with limited lives

Such as private driveways, walks, fences, and parking lots, as Land Improvements. These costs are depreciated over their estimated lives.

Cost of Equipment

The cost of such assets includes the purchase price, freight and handling charges incurred, insurance on the equipment while in transit, cost of special foundations if required, assembling and installation costs, and costs of conducting trial runs.

What does equipment include?

The term "equipment" in accounting includes delivery equipment, office equipment, machinery, furniture and fixtures, furnishings, factory equipment, and similar fixed assets.

Cost of Buildings

These costs include (1) materials, labor, and overhead costs incurred during construction, and (2) professional fees and building permits. Generally, companies contract others to construct their buildings. Companies consider all costs incurred, from excavation to completion, as part of the building costs.

Capitalizing Interest Costs

To implement this general approach, companies consider three items: 1. Qualifying assets. 2. Capitalization period. 3. Amount to capitalize.

Qualifying Assets

To qualify for interest capitalization, assets must require a period of time to get them ready for their intended use. A company capitalizes interest costs starting with the first expenditure related to the asset. Capitalization continues until the company substantially readies the asset for its intended use.

Example Cost of Land:

When Home Depot purchases land for the purpose of constructing a building, it considers all costs incurred up to the excavation for the new building as land costs. Removal of old buildings—clearing, grading, and filling—is a land cost because this activity is necessary to get the land in condition for its intended purpose. Home Depot treats any proceeds from getting the land ready for its intended use, such as salvage receipts on the demolition of an old building or the sale of cleared timber, as reductions in the cost of the land.

To apply the avoidable interest concept

a company determines the potential amount of interest that it may capitalize during an accounting period by multiplying the interest rate(s) by the weighted-average accumulated expenditures for qualifying assets during the period.

Under international accounting standards, __________ is the benchmark (preferred) treatment for property, plant, and equipment. However, companies may also use revalued amounts. When using revaluation, companies must revalue the class of assets regularly.

historical cost

fair value

is relevant to inventory but less so for property, plant, and equipment which, consistent with the going concern assumption, are held for use in the business, not for sale like inventory.

Capitalization period

is the period of time during which a company must capitalize the interest.

Objective of Capitalizing Interest

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

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. For example, companies like Kellogg Co. consider the purchase price, freight costs, sales taxes, and installation costs of a productive asset as part of the asset's cost.

Companies should__________ property, plant, and equipment at the fair value of what they give up or at the fair value of the asset received, whichever is more clearly evident.

record

Without a purchase price or contract price, the company must allocate costs and expenses to arrive at the cost of the

self-constructed asset

Subsequent to acquisition, companies _______write up property, plant, and equipment to reflect fair value when it is above cost.

should not The main reasons for this position are as follows. 1. Historical cost involves actual, not hypothetical, transactions and so is the most reliable. 2. Companies should not anticipate gains and losses but should recognize gains and losses only when the asset is sold.

In general, companies ____________ interest revenue against interest cost.

should not net or offset

Avoidable interest

the amount of interest cost during the period that a company could theoretically avoid if it had not made expenditures for the asset. If the actual interest cost for the period is $90,000 and the avoidable interest is $80,000, the company capitalizes only $80,000. Or, if the actual interest cost is $80,000 and the avoidable interest is $90,000, it still capitalizes only $80,000.