10-1

1. The acquisition cost of noncurrent operating assets

2. Account for noncurrent operating asset acquisitions

3. Costs expensed vs. capitalized and issues related

to research & development and oil & gas

4. Recognize intangible assets

5. The pros and cons of recording noncurrent

operating assets at their fair values

6. Efficiency analysis of a company’s property, plant,

and equipment

Chapter 10 Investments in Noncurrent

Operating Assets-Acquisitions

10-2 10-2

10-3

What Costs Are Included in Acquisition Cost?

• Noncurrent operating assets are recorded initially at cost—the original bargained or cash sales price.

• The cost of property includes not only the original purchase price or equivalent value but also any other expenditures required in obtaining and preparing the asset for its intended use.

• Any taxes, freight, installation, and other expenditures related to the acquisition should be included in the asset’s cost.

1. Identify those costs to be included in the

acquisition cost of different types of

noncurrent operating assets

10-4 10-4

10-5 10-5

10-6

Land

• Costs assigned to land should be those costs that

directly relate to the land’s unlimited life.

• Purchase price, commissions, legal fees, escrow

fees, surveying fees, and government assessments

for water lines, sewers, and roads are charged to

Land.

• Clearing and grading costs, including the removal of

unwanted structures, are also part of the cost of land.

Five Largest Land Accounts 2006 (in millions) Five Largest Land Accounts 2006 (in millions)

Wal-Mart $18,612

Home Depot 8,355

MGM Mirage 7,905

Peabody Energy 7,127

Lowe’s 5,496

10-7

Buildings

• If the structure is purchased ready to use, charge

Buildings for:

Purchase price

Commissions, legal fees, escrow fees, and

reconditioning costs

• If newly constructed by an outsider:

Contract price

Legal fees

Five Largest Building Accounts 2006 (in millions) Five Largest Building Accounts 2006 (in millions)

Wal-Mart $64,052

AES 23,977

McDonald’s 21,682

Verizon 19,207

Target 16,110

10-8

Equipment

• The purchase price

• Taxes, freight, and insurance during shipping and

installation

• Special foundations or reinforcing of floors

• Reconditioning and testing costs

Equipment costs include:

Five Largest Equipment Accounts 2006 (in millions) Five Largest Equipment Accounts 2006 (in millions)

Verizon $176,369

Qwest Communication 40,249

Dow Chemical 33,457

Intel 29,482

IBM 27,585

10-9

Intangible Assets

• Intangible assets are those assets (not including

financial assets) that lack physical substance.

• The most important distinction in intangible assets

for accounting purposes is between those that are

internally generated and those that are externally

purchased.

Five Largest Total Intangible Asset Accounts 2006

(in millions)

Five Largest Total Intangible Asset Accounts 2006

(in millions)

AT&T $127,397

Time Warner 92,806

Proctor & Gamble 89,027

General Electric 83,928

Bank of America 78,129

10-10

Trademark

• A trademark is a distinctive name, symbol,

or slogan that distinguishes a product or

service from similar products or services.

• The cost of a trademark includes the purchase price, filing and registry fees, and the cost of subsequent litigation to protect rights. It does not include internal research and development costs.

10-11

Franchises

• A franchise is the right received (usually

purchased) by a business or individual to

perform certain functions or sell certain

products or services.

• The cost of a franchise includes expenditures

made to purchase the franchise, legal fees,

and other costs incurred in obtaining the

franchise.

10-12

Order Backlog

• The order backlog is the amount of orders the

company has received for equipment that has not yet

been produced or delivered.

• These orders do not constitute sales because they do

not satisfy the revenue recognition requirement that

the product be completed and shipped. In its 2009 10-K filing, Boeing reported the following about its

order backlog:

10-13

Goodwill

• Goodwill represents the business contracts,

reputation, functioning systems, staff

camaraderie, and industry experience that

makes the company more than just a

collection of assets.

• Goodwill is a residual number, the value of all of the synergies of a functioning business that cannot be specifically identified with any other intangible factor.

10-14

Basket Purchase

• A number of assets may be acquired in a

basket purchase for one lump sum.

• When part of a purchase can be clearly

identified with specific assets, such a cost

assignment should be made and the

balance allocated among the remaining

assets.

2. Properly account for noncurrent operating

asset acquisitions using various special

arrangements, including deferred payment,

self-construction, and acquisition of an

entire company

10-15

$56,000/$200,000 $160,000 = $ 44,800

$120,000/$200,000 $160,000 = 96,000

$24,000/$200,000 $160,000 = 19,200

$160,000

Land $ 56,000

Buildings 120,000

Equipment 24,000

$200,000

Allocated Based on Appraised Values Allocated Based on Appraised Values

Basket Purchase

• When no part of the purchase price can be

related to specific assets, the entire amount must

be allocated among the different assets acquired.

10-16

Land 44,800

Buildings 96,000

Equipment 19,200

Cash 160,000

This cost allocation is important because

depreciable assets may have different useful

lives and some assets are nondepreciable.

Basket Purchase

The entry to record this acquisition,

assuming a cash purchase, is as follows:

10-17

Deferred Payment

• The acquisition of real estate or other property

frequently involves deferred payment of all or

part of the purchase price.

• Land is acquired on January 2, 2013, for

$100,000; $35,000 is paid at the time of

purchase, and the balance is to be paid in

semiannual installments of $5,000 plus interest

on the unpaid principal at an annual rate of

10%.

10-18

June 30, 2013—Made first payment.

Interest Expense 3,250

Notes Payable 5,000

Cash 8,250

Jan. 2, 2013—Purchased land for $100,000, paying

$35,000 down, the balance to be paid in semiannual

payments of $5,000 plus interest at 10%.

Land 100,000

Cash 35,000

Notes Payable 65,000

$65,000 0.05

Deferred Payment

10-19

On January 2, 2013, equipment with a cash

price of $50,000 is acquired under a deferred

payment contract. The contract specifies a

down payment of $15,000 plus seven annual

payments of $7,189 each, or a total cost of

$65,323. The present value of the seven

payments at the implicit effective interest rate of

10 percent is $35,000.

Deferred Payment

10-20

On January 2, 2013, purchased equipment with

a cash price of $50,000 for $15,000 down plus

seven annual payments of $7,189 each.

Equipment 50,000

Discount on Notes Payable 15,323

Notes Payable 50,323

Cash 15,000

Deferred Payment

Made first payment of $7,189 on December 31, 2013.

Calculations for amortization of debt discount are as

follows: $50,323 – $15,323 = $35,000; $35,000 10% = $3,500 Notes Payable 7,189

Cash 7,189

Interest Expense 3,500

Discount on Notes Payable 3,500

10-21

Made the second payment of $7,189 and

amortized debt discount on December 31, 2014.

Notes Payable 7,189

Cash 7,189

Interest Expense* 3,131

Discount on Notes Payable 3,131

*$50,323 $7,189 = $43,134 Notes payable

$15,323 $3,500 = 11,823 Discount on notes payable

$31,311 Present value of notes payable

at the end of first year

$31,311 0.10 = $3,131

Deferred Payment

10-22

Leasing

• A lease is a contract whereby one party (the

lessee) is granted a right to use property owned

by another party (the lessor) for a specified

period of time for a specified periodic cost.

• Rental leases are operating leases and

arrangements that are equivalent to a sale of

leased assets are capital leases.

• Capital leases are recorded on the acquiring

company’s records as assets, with a related

liability at the present value of the future lease

payments.

10-23

Exchange of Nonmonetary Assets

• In some cases, an enterprise acquires a new

asset by exchanging or trading existing

nonmonetary assets.

• Monetary assets are those assets whose

amounts are fixed in terms of currency, by

contract, or otherwise (cash, accounts

receivable).

• Nonmonetary assets include all the other

assets (inventories, land).

10-24

A company issues 1,000 shares of $1 par common

stock in acquiring land; the stock has a current

market price of $45 per share. The entry should be

recorded as follows: Land 45,000

Common Stock 1,000

Paid-in Capital in Excess

of Par 44,000

Acquisition by Issuing Securities

• When a fair value for the securities can be

determined, that value is assigned to the asset

acquired. • In the absence of a fair value for the securities,

the fair value of the asset acquired is used.

10-25

Self-Construction

• Like purchased assets, self-constructed

assets are recorded at cost, including all

expenditures incurred to build the asset and

make it ready for its intended use.

• There is a difference of opinion regarding the

amount of overhead properly assignable to

construction activity.

10-26

Savings or Loss on Self-Construction

• When the cost of self-construction of an asset is

less than the cost to acquire it through purchase

or construction from outsiders, the difference is

not a profit, but a savings.

• When the cost is greater than the cost to acquire

it through purchase or construction from

outsiders, the asset should be recorded at cost

(with some exceptions).

10-27

Interest During Period of Construction

• Capitalization of interest is required for

assets, such as buildings and equipment, that

are being self-constructed for an enterprise’s

own use and for assets that are intended to

be leased or sold to others that can be

identified as discrete projects.

• Interest should not be capitalized for

inventories manufactured or produced on a

repetitive basis.

10-28

1. Interest charges begin when the first

expenditures are made on the project and

continue as long as work continues and until

the asset is completed and actually ready for

use.

2. The amount of interest to be capitalized is

computed using the accumulated

expenditure for the project, weighted based

on when the expenditures were made during

the year.

Interest During Period of Construction

The following basic guidelines govern the

computation of capitalized interest:

10-29

3. The interest rate to be used in calculating the

amount of interest to capitalize are, in the

following order:

a) Interest rate incurred for any debt

specifically incurred for funds used on the

project.

b) Weighted-average interest rate from all

other enterprise borrowings regardless of

the use of funds.

Interest During Period of Construction

10-30

Interest During Period of Construction

4. If the construction period covers more than

one fiscal period, accumulated expenditures

include prior years’ capitalized interest.

The results provided by the four steps is the

maximum interest that can be capitalized for the year.

10-31

• Construction will take about 18 months.

• Construction costs are estimated at $6.4 million

(excluding capitalized interest).

• A 12%, $2 million loan is obtained and will

become effective on January 1, 2013, at the

beginning of construction.

Cutler Industries, Inc. has decided to construct

a new computerized assembly plant.

Interest During Period of Construction

10-32

Cutler Industries, Inc.’s other debts are:

5-year notes payable, 11% interest $3,000,000

Mortgage on other plant, 9% interest 4,800,000

The weighted-average interest rate on the

general nonconstruction debt is computed as

follows:

Interest During Period of Construction

10-33

The following expenditures were incurred on the

project during 2013.

January 1, 2013 $1,200,000

October 1, 2013 1,800,000

In the previous slide we noted that the

weighted-average rate was 9.8% (rounded).

Interest During Period of Construction

10-34

Computation of the amount of interest to be

capitalized for 2013 follows:

In Slide 10-32, the

weighted-average rate was

determined to be 9.8%

The firm borrowed

$1,800,000 on October 1

(continued)

Interest During Period of Construction

10-35

The amount of interest capitalized cannot exceed

total interest incurred during the year. Total

interest during 2013 was as follows:

Interest During Period of Construction

10-36

The actual interest was $1,002,000 and the

calculated interest was $192,500. Thus, the

entry is as follows:

Construction in Progress 192,500

Interest Expense 809,500

Cash 1,002,000

$1,002,000 $192,500

Interest During Period of Construction

10-37

Assume that additional construction

expenditures of $3,200,000 were made on

February 1, 2014, and the project was

completed on May 31, 2014. The amount of

interest to be capitalized for 2014 follows.

Interest During Period of Construction

10-38

• Avoidable interest in 2014 includes interest on

all loans that could have been repaid with the

construction expenditures made in 2013.

• These expenditures total $3,193,500

($1,200,000 + $1,800,000 + $192,500) and

include interest capitalized in 2013.

• Interest is capitalized until construction is

completed on May 31 and the building is ready

for use.

Interest During Period of Construction

10-39

• Because $253,227 is less than the actual

annual interest of $1,002,000, the entire

$253,227 is capitalized in 2014.

• The total building cost is $6,645,727, which

includes $192,500 of interest capitalized in

2013 and $253,227 in 2014.

• FASB ASC Subtopic 835-20 requires

disclosure of the total interest expense for the

year and the amount capitalized.

Interest During Period of Construction

10-40

Interest During Period of Construction

10-41 10-41

10-42

IASB on Interest Capitalization

• In 2007 the IASB revised IAS 23 to require,

starting on January 1, 2009, that all companies

capitalize “borrowing costs” incurred in the

construction of a long-term asset.

• The international standard requires that

companies capitalize the net amount of

interest incurred rather than the gross

amount.

10-43

Acquisition by Donation or Discovery

• When property is received through donation,

there is no cost that can be used as a basis for

its valuation.

• Property acquired through donation should be

appraised and recorded at its fair value.

• A donation is recognized as a gain in the

period in which it is received.

Netty’s Ice Cream Parlor is given a donation of land and a building by an eccentric ice cream lover. The entry, using appraised values, is as follows:

Land 400,000

Buildings 1,500,000

Revenue or Gain 1,900,000

10-44

Acquisition by Donation or Discovery

• FASB ASC paragraph 845-10-S99-1 requires

that when a corporation receives nonmonetary

assets as an investment by a shareholder, the

assets are recorded by the company at the

shareholder’s historical cost.

• Depreciation of an asset acquired by gift

should be recoded in the usual manner, the

value assigned to the asset providing the basis

for the depreciation charge.

10-45

Acquisition by Donation or Discovery

• If a gift is contingent upon some act to be

performed by the recipient, no asset should be

reported until the conditions of the gift have

been met.

• A discovery that greatly increases the value

of the property is commonly ignored in the

accounting in the U.S. This also applies to

accretion values, such as growing timber or

aging wine.

10-46

• To illustrate the initial recognition of an asset

retirement obligation, assume that Bryan

Beach Company purchases and erects an oil

platform at a total cost of $750,000.

• At the end of ten years, the platform must be

dismantled and removed from the site at an

estimated cost of $100,000. Using an 8%

interest rate, the present value of $100,000

for ten years is $46,319.

Asset with Significant Restoration Costs at

Retirement

10-47

Oil Platform 750,000

Cash 750,000

The journal entries to record the purchase and

the asset retirement obligation follow:

Oil Platform 46,319

Asset Retirement

Obligation 46,319

Asset with Significant Restoration Costs at

Retirement

10-48

• Homer Company constructs and commences

operation of a nuclear power plant. Total

construction cost is $400,000.

• The cost of cleaning up the routine

contamination is estimated to be $500,000;

this cost will be incurred in 30 years when the

plant is decommissioned. Additional annual

contamination cleanup cost $40,000. Assume

an interest rate of 9%.

Asset with Significant Restoration Costs at

Retirement

10-49

Nuclear Plant 400,000

Cash 400,000

Initial Acquisition

Nuclear Plant 37,686

Asset Retirement

Obligation 37,686

Asset with Significant Restoration Costs at

Retirement

FV = $500,000; I = 9%; N =

30 years $37,686

After One Year

Nuclear Plant 3, 286

Asset Retirement

Obligation 3,286 FV = $40,000; I = 9%;

N = 29 years $3,286

10-50

3. Separate costs into those that should be

expensed immediately and those that should

be capitalized, and understand the accounting

standards for research and development and

oil and gas exploration costs

10-51

Postacquisition Expenditures

• A component is a portion of a property, plant,

or equipment item that is separately identifiable

and for which a separate useful life can be

estimated (i.e., a building’s heating and cooling

system).

• Expenditures to maintain plant assets in good

operating condition are referred to as

maintenance.

• Expenditures to restore assets to good

operating condition upon their breakdown or to

restore and replace broken parts are referred to

as repairs. • Maintenance and repairs are charged to expense

accounts immediately.

10-52 10-52

10-53

• Expenditures for overhauling plant assets are

frequently referred to as renewals. They

should be expensed immediately.

• Substitution of parts or entire units are

referred to as replacements. If a part is

removed and replaced with a different part,

the cost and accumulated depreciation

related to the replaced part should be treated

like any removed plant asset.

Renewals and Replacements

10-54

Roof 40,000

Accumulated Depreciation—

Buildings (old roof) 15,000

Depreciation Expense 5,000

Buildings (old roof) 20,000

Cash 40,000

$20,000 3/4

$20,000 $15,000

Renewals and Replacements

Mendon Fireworks Company replaces the roof of its

manufacturing plant for $40,000. The original cost of the

building was $1,600,000, and it is three-fourths

depreciated. The original roof cost $20,000 and the new

roof is recorded as a separate component.

10-55

Additions and Betterments

• Enlargements and extensions of existing

facilities are referred to as additions.

• Changes in asset design to provide increased or

improved services are referred to as

betterments.

• Capitalize the cost of additions and betterments.

10-56

Research and Development

• The FASB defined research activities as

those undertaken to discover new knowledge

that will be useful in developing new

products, services, or process or that will

result in significant improvements of existing

products or processes.

• Development activities involve the

application of research findings to develop a

plan or design for new or improved products

or processes.

10-57

Research and Development

Research and development costs include those

costs of:

• materials

• equipment

• facilities

• personnel

• purchased intangibles

• contract services

• a reasonable allocation of indirect cost specifically

related to research and development

Unless Research

and development

expenditures have

alternative future

uses, they are

expensed in the

period they occur.

10-58

Computer Software Development Expenditures

• Strict application of pre-Codification FASB

Statement No. 2 dictates that all development

costs be expensed.

• The Board revisited the issue in pre-

Codification FASB Statement No. 86. The

Board’s conclusions concerning software

development costs are summarized in

Exhibit 10-8, shown in Slide 10-59.

10-59 10-59

10-60

Computer Software Development

Expenditures

• All costs in developing computer software

incurred up to the point where technological

feasibility is established are expensed as

research and development (planning, design,

and testing activities).

• Testing done after the establishment of

technological feasibility and the cost to produce

masters can be capitalized.

10-61

International Accounting for R&D: IAS 38

• IAS 38 requires research costs to be

expensed and development costs to be

capitalized.

• Preliminary indications are that the general

approach to R&D accounting in IAS 38 will

be adopted by the FASB.

• Currently, U.S. GAAP requires that all R&D

costs be expensed except for post-feasibility

computer software development.

10-62

Oil and Gas Exploration Costs

• Full cost method—all exploratory costs are

capitalized.

Reasoning: The cost of drilling dry wells is part of the

cost of locating productive wells.

• Successful efforts method—exploratory costs

for dry wells are expensed, and only exploratory

costs for successful wells are capitalized.

Negative reaction: Small independent oil firms argued

that expensing costs that they have been capitalizing

would result in lower profits, depressed stock prices,

and difficulty in getting loans.

10-63 10-63

10-64

Nakamura estimated the

U.S. companies in 2001

invested approximately

$1 trillion per year in

intangible assets, and

that the value of the

existing stock of

intangibles is $5 trillion.

4. Recognize intangible assets acquired

separately, as part of a basket purchase,

and as part of a business acquisition

10-65 10-65

10-66

Intangibles Acquired in a Basket Purchase

A company pays $700,000 to purchase a

patent along with a functioning factory and

special equipment used to produce the

patented product. The estimated fair values are

allocated as follows:

10-67

Five General Categories of Intangible Assets

1. Marketing-related intangible assets such as

trademarks, brand names, and Internet domain

names.

2. Customer-related intangible assets such as

customer lists, order backlogs, and customer

relationships.

3. Artistic-related intangible assets such as

items protected by copyright.

4. Contract-based intangible assets such as

licenses, franchises, and broadcast rights.

5. Technology-based intangibles such as both

patented and unpatented technologies as well

as trade secrets.

10-68

Estimating the Fair Value of Intangibles

• The most difficult part of recording an amount

for an intangible is estimating its fair value.

• As described in Concepts Statement No. 7,

the present value of future cash flows can be

used to estimate fair value in one of two

ways, the traditional approach and the

expected cash flow approach.

10-69

Estimating the Fair Value of Intangibles

Intangible Asset A is the right to receive royalty

payments in the future of $1,000 payments at

the end of each of the next five years. The risk-

adjusted interest rate is 12%. The fair value of

the Intangible Asset A is calculated as follows:

Table Value (n = 5; I = 12) $1,000 = PV(annuity)

3.605 $1,000 = $3,605

Traditional Approach Traditional Approach

10-70

Estimating the Fair Value of Intangibles

Expected Cash Flow Approach Expected Cash Flow Approach

Intangible Asset B is a secret formula to

produce a healthy fast-food cheeseburger that

is expected to have the following associated

probabilities of happening:

Outcome 1 = 10% probability of cash flows of $5,000 at

the end of each year for 10 years

Outcome 2 = 30% probability of cash flows of $1,000 at

the end of each year for 4 years

(continued)

10-71

Outcome 3 = 60% probability of cash flows of $100 at the

end of each year for 3 years

Estimating the Fair Value of Intangibles

10-72

Acquired In-Process Research and

Development

The FASB ruled that in-process R&D is to be

recognized as an intangible asset if it is acquired

as part of a business combination but is to be

expensed if acquired as part of a basket

purchase outside of a business combination.

The FASB realizes that this is an

inconsistency and they intend to

revisit it in the future.

10-73

Intangibles Acquired in the

Acquisition of a Business

• Goodwill is a residual amount, the amount of

the purchase price of a business that is left

over after all other tangible and intangible

assets have been identified.

• In a basket purchase, each identifiable asset is

recorded at an amount equal to its estimated

fair market value; any residual is reported as

goodwill.

10-74

Airnational Corporation purchases the net assets

of Speedy Freight Airlines for $1,500,000 in cash.

The book value of Speedy Freight at the time of

acquisition, follows.

Intangibles Acquired in the

Acquisition of a Business

10-75

Analysis of the $732,800 difference between

the purchase price of $1,500,000 and the net

asset book value of $767,200 ($1,036,700 –

$269,500) reveals the following differences

between recorded cost and market value of the

assets:

Intangibles Acquired in the

Acquisition of a Business

10-76

The identifiable portion of the $732,800

difference amounts to $513,300 ($1,266,500 –

$753,200) and is allocation to the respective

items. The remaining difference of $219,500

($732,800 – $513,300) is recorded as goodwill.

Intangibles Acquired in the

Acquisition of a Business

10-77

Bargain Purchase

• When the amount paid for another company is

less than the fair value of the net identifiable

assets, this is a bargain purchase.

• Assume that the Speedy Freight acquisition was

for $1,000,000 instead of $1,500,000. The

acquisition would be recorded as follows:

Note that a gain is recognized

10-78

International Accounting for Intangibles:

IAS 38 and IFRS 3

• The IASB’s standard for the accounting of

intangible assets is IAS 38.

• This IASB standard is very much compatible

with U.S. GAAP.

• The most significant differences between U.S.

GAAP and IASB standards in the accounting

for intangible assets are in testing these

assets for impairment.

10-79

Valuation of Assets at Fair Values

• In IAS 16, the IASB permits the inclusion of

upward revaluations of noncurrent operating

assets in the financial statements as an

allowable alternative to reporting the historical

cost of those assets.

If a company revalues its noncurrent

operating assets to fair value, it must do so

on a regular basis and must revalue entire

classes of assets rather than just picking and

choosing certain assets.

5. Discuss the pros and cons of recording

noncurrent operating assets at their fair values

10-80

Downward revaluations are recorded as a

loss.

Upward revaluations are recorded as a debit

to the asset and a credit to a special

“revaluation” equity account.

This practice means that upward revaluations

cannot be used to boost reported income.

When the asset that has revalued upward is

subsequently sold, any associated balance in

the special revaluation equity is credited

directly to Retained Earnings.

Valuation of Assets at Fair Values

10-81

Sales

Average fixed assets

$182,515

Fixed Asset Turnover Ratio

Fixed asset turnover ratio =

General Electric’s manufacturing segments had sales

for 2008 totaled $182,515. Its beginning and ending

property, plant, and equipment balances were

$77,888 and $78,530, respectively.

= $78,209

$78,209

($77,888 + $78,530)

2 Average fixed assets =

= 2.33

6. Use the fixed asset turnover ratio as a

general measure of how efficiently a company

is using its property, plant, and equipment

10-82

Sales

Average fixed assets

$156,783 Fixed asset turnover ratio =

General Electric’s manufacturing segments had

sales for 2009 totaled $156,783. Its beginning

and ending property, plant, and equipment

balances were $78,530 and $69,212,

respectively.

= $73,871

$73,871

($78,530 + $69,212)

2 Average fixed assets =

= 2.12

Fixed Asset Turnover Ratio

10-83

Dangers in Using the Fixed Asset

Turnover Ratio

• Fixed asset turnover ratios values for two

companies in different industries cannot be

meaningfully compared.

• The reported amount for property, plant, and

equipment can be a poor indicator of the

actual fair value of fixed assets being used by

a company.