MGT 220 Chapter 11

• Examples: property, plant, and equipmentplant assetsfixed assets

• Major characteristics are:

1. acquired for use in operations and not for resale

2. long-term in nature and usually subject to amortization

3. possess physical substance

Tangible Capital Assets

Cost of Land• purchase price • closing costs such as title, attorney, and

recording fees• cost of grading, filling, draining, and clearing

the property• removal of old building on land• assumption of any encumbrances on the

property (i.e., liens)• any land improvements that have an

indefinite life

Land ImprovementsImprovements with limited lives are recorded as Land Improvements (and not as Land) and are amortized over their estimated lives

– private driveways

– walks

– fences

– parking lots

Cost of Buildings• materials, labour, and overhead costs

incurred during construction. • any fees, such as building permits or the

services of an attorney or architect, are included in acquisition cost.

• in general, all costs incurred from excavation of the site to completion of the building are considered part of the building costs.

Cost of Equipment• purchase price

• all expenditures related to the purchase that occur subsequent to acquisition but prior to actual use. – freight charges– insurance charges on the asset while in transit– assembly and installation– special preparation of facilities– trial runs

Self-Constructed Assets• These are assets constructed by the business

for use in operations

• The cost of self-constructed assets includes:– cost of direct materials – cost of direct labour – variable manufacturing overhead – a pro rata portion (i.e., reasonable amount) of

the fixed overhead – ‘interest’?

Should we capitalize interest?

1. No, (and no capitalization of equity costs)

2. Yes, plus capitalize equity costs

3. Yes, but no capitalization of equity costs

Interest Capitalization

• CICA Handbook, par. 1000.60(b) professional judgement is appropriate in determining interest to be capitalized.

• Following FASB Statement 34, three questions must be answered:

• What are the qualifying assets?

• What is the capitalization period?

• What is the amount of interest to be capitalized?

Qualifying Assets

• List includes:– assets under construction for company’s own

use– assets intended for sale or lease produced as discrete projects

• Non-qualifying assets include:– assets in use or ready for intended use– assets not be used in company’s earnings

activities

Capitalization Period

• Capitalization period begins when three conditions are present:

1. Expenditures for the asset have been made2. Activities for readying the asset are in progress3. Interest cost is being incurred

• Capitalization continues for as long as these three conditions exist

• Capitalization ends when asset is substantially complete and ready for use

Amount to Capitalize

• Amount of interest to be capitalized is the lesser of:

• the actual interest cost incurred on debt

• the avoidable interest for construction of asset

• Avoidable interest is the amount that could have been avoided, if expenditures for the asset had not been made

Shalla Corporation: ExampleGiven:• November 1, 2001 contracts with Pfeifer

Construction Co. Ltd. to construct a $1.4 million building (on land costing $100,000)

• First payment made by Shalla to Pfeifer includes the payment for the land

• Payments made in 2002:– January 1 $ 210,000 December 31 $ 450,000– March 1 $ 300,000 Total

$1,500,000– May 1 $ 540,000

• Building completed December 31, 2002

Shalla Corporation: Example

• Debt outstanding at December 31, 2002– Specific Construction Debt: $750,000

15%, three-year note– Other Debt:

10%, five-year note $550,00012%, ten-year bonds $600,000

Shalla Corporation: Example

Weighted-Average Accumulated Expenditures:

Jan. 1 $ 210,000 12/12 = $210,000Mar. 1 300,000 10/12 = 250,000May. 1 540,000 8/12 = 360,000Dec. 31 450,000 0/12 = 0WAAE $820,000

Note: The land payment is included in the WAAE.

Next step: avoidable interest and appropriateinterest rate calculation

Shalla Corporation: Example

Weighted-Average Interest Rate =Total Interest Total PrincipalDo not include Construction Specific Debt$127,000* ($550,000 + $600,000) = 11.04%

* (550,000 X .10) + (600,000 X .12)

The rates of interest for the avoidable interestCalculation are then:Construction Note: 15%All Other Amounts: 11.04%

Shalla Corporation: Example

Avoidable Interest:WAAE up to Construction Specific Debt X Rate +Any residual amount of WAAE X Rate

Avoidable Interest:$750,000 X 15% = $112,500 70,000 X 11.04% = 7,728$820,000 $120,228

This amount is then compared to the actual interest paid.

Shalla Corporation: Example

Actual Interest:$750,000 X 15% = $112,500 550,000 X 10% = 55,000 600,000 X 12% = 72,000Total Actual Interest Paid $239,500

Avoidable Interest = $120,228Actual Interest = $239,500The lesser of these two amounts is capitalizedEntry:Dr. Building 120,228Cr. Interest Expense 120,228

Special Issues Related to Interest Capitalization

• Expenditures for land

• Interest Revenue

• Significance of interest capitalization

Other Cost Issues

• Cash Discounts

• Deferred Payment Contracts– Assets, purchased through long-term credit (such as

notes payable), are recorded at the present value of the consideration exchanged

• Lump Sum Purchase– Cost of assets, acquired at a single lump sum price,

is allocated to assets on the basis of their relative fair market values

Lump sum purchase examplePay $100,000 for a building (FV=$80,000)

and Land (FV=$60,000)

Journal entry:Building 57,143Land 42,857

Cash 100,000

Formula used?

Other Cost Issues• Issuance of Shares

– Market value of publicly-traded shares serve as the cost of the acquired asset

– When shares have no determinable market value, use the market value of the acquired asset

• Nonmonetary Exchange of Assets – Transaction is nonmonetary when cash is 10%

or less of the total fair value given up or received • Dissimilar versus similar Assets

Exchange of Nonmonetary Assets• The basic rule is that the exchange must be

based on: – the fair value of the asset given up, or – the fair value of the asset received whichever is clearly more evident.

• The rules for gain / loss recognition depend upon whether the assets exchanged are: – dissimilar assets or – similar assets

Costs Subsequent to AcquisitionRule:

Post-acquisition costs are added to the asset’s cost if, and only if, they provide future benefits: An increase in the

– Useful life

– Quantity of units produced

– Quality of units produced

Otherwise, expense!

Disposition of Tangible Capital Assets

Gain (Loss) = Sales Price - Net book value

• Don’t forget to record appropriate amortization on the asset up to the time of the sale (and hence produce the correct net book value) before you calculate the gain or loss.