Download Intermediate Accounting

INTERMEDIATE
ACCOUNTING
CCOUNTING
INTERMEDIATE A
Chapter 10
Property, Plant, and Equipment: Acquisition and Subsequent
Investments
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Objectives
1. Describe the characteristics of property, plant, and
equipment.
2. Identify the costs to be included in the acquisition of
property, plant, and equipment.
3. Determine the cost of property, plant, and equipment
obtained by a nonmonetary exchange of assets.
4. Compute the cost of a self-constructed asset, including
capitalized interest.
5. Describe the accounting for expenditures incurred subsequent
to acquisition.
6. (Appendix 10.1) Explain the accounting for oil and gas
properties.
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What are the Characteristics of Property,
Plant, And Equipment? (Slide 1 of 3)
• Property, plant, and equipment (alternatively called plant assets, fixed
assets, or operational assets) are the tangible noncurrent assets that a
company uses in the normal operations of its business.
• To be included in this category, an asset must have three characteristics:
• The asset must be held for use in operations and not for investment. This
characteristic does not imply that the asset must be continuously used.
For example, the furniture and fixtures in coffee shops are included in its
property, plant, and equipment. However, the companies that sold these
items to the coffee shop would categorize them as inventory.
• The asset must have an expected life of more than one year. The asset
represents future economic benefits, or service potential, that the
company will receive over the life of the asset as it is used in the normal
course of business.
• The asset must be tangible in nature. There must be a physical substance
that can be seen and touched.
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What are the Characteristics of Property,
Plant, And Equipment? (Slide 2 of 3)
• A company initially records property, plant, and equipment
assets at acquisition, or historical, cost.
• Because the asset is expected to provide economic benefits to
the company over a period of more than one year, the
company allocates the cost of the asset as an expense to each
period in which the asset is used and the company receives
benefits.
• The use of historical cost as the basis for reporting property,
plant, and equipment provides several advantages:
• The historical cost is equal to the fair value at the date of acquisition.
• The cost provides a verifiable valuation of the asset.
• Gains from holding the asset are recognized only when realized through
a sale transaction.
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What are the Characteristics of Property,
Plant, And Equipment? (Slide 3 of 3)
• Because depreciation is a process of cost allocation rather than
of valuation, the net book value of an asset (cost minus
accumulated depreciation) does not necessarily reflect the
economic value of the asset.
• GAAP requires that a company report its property, plant, and
equipment at its depreciated cost (cost minus accumulated
depreciation).
• However, when the asset becomes impaired such that its fair
value is less than its book value, the asset must be written down to
fair value.
• Under U.S. GAAP, companies are not allowed to write up an
asset if its fair value is above its historical cost. (IFRS allows this.)
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Real Report: Starbucks’ Property, Plant,
and Equipment Disclosure (Slide 1 of 3)
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Real Report: Starbucks’ Property, Plant,
and Equipment Disclosure (Slide 2 of 3)
Questions:
1. What characteristics do these assets possess that allow
Starbucks to classify them as property, plant, and
equipment?
•
Starbucks’ property, plant, and equipment have three characteristics.
They are used in the business and have a life greater than a year. As
noted in the notes to the financial statements, the expected lives range
from 2 to 40 years. Finally, all of the fixed assets are tangible in
nature.
2. At what value does Starbucks’s report its property, plant,
and equipment?
•
Starbucks reports $2,416.5 million of NET property, plant, and
equipment… cost ($5,888.7 million) minus accumulated depreciation
($3,472.2 million).
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Real Report: Starbucks’ Property, Plant,
and Equipment Disclosure (Slide 3 of 3)
3. Why does Starbucks report both the cost of property, plant,
and equipment and accumulated depreciation instead of
only the net amount?
•
Initially, Starbucks records its property, plant, and equipment at
historical costs. GAAP requires that companies report both the
historical cost valuation of property, plant, and equipment and the
related accumulated depreciation.
4. What type of asset is work in progress?
•
Work in progress represents the cost of self-constructed property,
plant, and equipment that has not yet been completed.
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How Do We Account for the Acquisition of
Property, Plant And Equipment?
•
The major types of assets that a company includes in the category of
property, plant, and equipment are land, buildings, equipment, and
leasehold improvements.
•
•
The acquisition cost of property, plant, and equipment includes all costs
necessary to obtain the benefits to be derived from the asset.
•
•
Natural resources, such as timberlands, oil deposits, and mineral deposits, are
also included as property, plant, and equipment.
contract price; minus discounts taken; plus freight, assembly, installation, testing
costs and retirement obligation
GAAP allows a company to either
•
•
(1) include discounts not taken as part of the cost of the asset or
(2) subtract discounts not taken from the cost of the asset and report them as an
expense.
•
Most companies prefer the second approach.
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Land
• The recorded cost of land includes the following:
• contract price
• costs of closing the transaction and obtaining title, including commissions, options,
legal fees, title search, insurance, and past due taxes
• costs of surveys
• costs of preparing the land for its particular use, such as clearing, grading, and
removing old buildings (net of any proceeds from salvage) when such improvements
have an indefinite life
• government assessments for streets, sidewalks, sewers, and water lines for which the
government is responsible for the upkeep and are permanent in nature
• Because land has an indefinite economic life and its residual value is
unlikely to be less than its acquisition cost, land is not depreciated.
• If land is not currently used in operations, but purchased for future use, it is
more representationally faithful to classify it as an investment.
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Example: Land
• Trotter Company purchases a parcel of land as a site for a new warehouse
for $150,000. Trotter demolished an existing building on the property and
began construction of the warehouse. In addition to the purchase price,
Trotter incurred the following costs:
• Trotter was able to sell salvaged materials from the demolished building
for $1,000 (subtracted from cost of land).
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Land Improvements and Buildings
• A company will often make expenditures that improve the
usefulness of the property, such as landscaping, paving, and
fencing.
• Because these improvements have a limited economic life, a company
should record the costs of these improvements in a Land Improvements
account and depreciate them over their economic lives.
• The recorded cost of buildings includes the following:
•
•
•
•
•
contract price
costs of remodeling and reconditioning
costs of excavation for the specific building
architectural costs and the costs of building permits
capitalized interest costs
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Equipment
• Equipment is a broad term that includes machinery, furniture
and fixtures, office equipment, vehicles, and similar assets.
• The recorded cost of equipment includes the following:
• purchase price, minus any discounts taken, plus sales tax
• transportation costs, plus any insurance costs on the equipment while in
transit
• installation or assembly costs
• initial testing costs
• Therefore, if the cost is necessary to obtain the equipment and
prepare it for use, it should be capitalized as property, plant,
and equipment.
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Example: Equipment
• Devon Company purchases a machine with a contract price of $100,000 on
terms of 2/10, n/30. Devon pays within the discount period and incurs
transportation costs of $2,500, as well as installation and testing costs of
$3,000. Sales tax is $7,000. During the installation of the machine,
uninsured damages of $500 are incurred and paid by the company.
The cost of the machine is $110,500 ($100,000 − $2,000 + $2,500 +
$3,000 + $7,000). Devon makes the following journal entry to record these
costs:
• Note that Devon does not include the $500 of damages in the cost of the
asset because it was not a “necessary” cost.
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Leasehold Improvements
• Improvements made by the lessee to leased property that,
unless specifically exempted in the lease agreement, revert to
the lessor at the end of the lease
• Therefore, a lessee capitalizes the cost of a leasehold
improvement, such as the interior design of a retail store, and
depreciates the cost over its economic life or the life of the
lease, whichever is shorter.
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Summary: Property, Plant and Equipment
• A company’s decision to expense a cost immediately, to
capitalize it as a depreciable asset (e.g., building, equipment),
or to capitalize it as a nondepreciable asset (e.g., land) has an
impact on both the company’s income statement and balance
sheet.
• The general procedure is to determine whether incurring the
cost will provide economic benefits for the company beyond
the current period and, if so, which asset is associated with the
expected future benefits.
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Property, Plant and Equipment Ratios
• Property, plant, and equipment are often a company’s
primary productive assets.
• Analysts and managers are interested in company’s ability to
use its investment in fixed assets to generate sales.
• One measure of this efficiency is the fixed asset turnover ratio,
which computes the number of dollars of sales generated
during a period relative to the average dollars invested in
fixed assets.
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Asset Retirement Obligations
• The acquisition of some operational assets create an asset
retirement obligation—a legal obligation related to the
retirement of the asset.
• In some instances, asset retirement obligations arise from
environmental responsibilities and laws, such as the
requirement to decommission nuclear power plants at the end
of their useful lives or to reclaim the land after mining or
drilling operations have concluded.
• In other settings, asset retirement obligations can arise from
legal arrangements related to the use of an asset.
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Example: Asset Retirement Obligations
• Reed Company spent $100,000 in the interior redesign of a retail store
that it had acquired through a 10-year lease. The lease requires Reed to
restore the leased building to its original condition upon termination of the
lease. Reed estimates that in 10 years the restoration costs will be
$31,125. Based on Reed’s 10% interest rate, the present value of these
future restoration costs at the time of the redesign is $12,000. The following
journal entry is made to record the leasehold improvement and the
associated asset retirement obligation:
• In subsequent periods, the asset is depreciated over its useful life. In
addition, the company recognizes accretion expense, which is classified as
an operating expense and represents the increase of the asset retirement
obligation each year that the asset is used.
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Lump-Sum Purchase
• A company may acquire several fixed assets for a single lump-sum
purchase price. To account for the assets on an individual basis, the total
purchase price must be allocated among the individual assets.
• A company allocates the acquisition price in a lump-sum purchase based on
the relative fair values of the individual assets. If only part of the purchase
price can be identified with a specific asset, the specifically identified cost
should be assigned to that asset with the remainder allocated among the
remaining assets based on their relative fair values.
• Evidence of fair value can be obtained from independent sources such as
appraisals, assessed values for property taxes, or other reasonably
accurate approximations of the assets’ market values.
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Example: Lump Sum Purchase
• Sample Company pays $120,000 for land and a building. An appraisal of
the land and building indicates values of $50,000 and $75,000,
respectively. Sample allocates the lump-sum purchase price as follows:
• Sample records the land at a cost of $48,000 and the building at a cost of
$72,000. If the cost of obtaining an appraisal is material, the company
should add it to the purchase price so it is allocated to the respective assets.
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Deferred (Future) Payments
• When a company acquires property, plant, and equipment in
exchange for making future payments, such as by issuing notes
or bonds or assuming a mortgage, it records the asset at its
fair value or the fair value of the liability on the date of the
transaction, whichever is more clearly evident.
• Note that GAAP’s fair value hierarchy allows a company to
measure fair value as the present value of the future payments
when observable market values are not available.
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Examples: Deferred Payments
• Note with a Stated Interest Rate: Antush Company purchases equipment by
issuing a $7,500, 5-year note with a stated interest rate of 12%, which is
equivalent to the market rate of interest. Antush would record the
acquisition as follows:
• Non-Interest Bearing Rate: Antush Company purchases equipment by
issuing a $10,000 non-interest-bearing 5-year note, when the market rate
for obligations of this type is 12%. The note will be paid off at the rate of
$2,000 at the end of each year. Because neither the fair value of the
equipment nor the note is observable, Antush values the equipment at the
present value of the payments, which is $7,210 ($2,000 × 3.604776, the
factor from Table 4 of the Time Value of Money Module for 5 years and a
12% rate). Antush records the acquisition of the equipment as follows:
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Issuance of Securities
• When a company acquires property, plant, and equipment by issuing
securities such as common stock or preferred stock, the company records the
exchange at the fair value of the asset acquired or of the stock issued,
whichever is more clearly evident and representationally faithful.
• Normally the two fair value measures would be very similar, but if they are
materially different, it is necessary to select one. In some situations, one of
the values may be considered more representationally faithful because it is
quoted in an active market.
• Alternatively, if the stock is not actively traded but the asset is one that is
commonly traded, the asset’s fair value would be the better choice.
• If neither of the two fair values is readily observable, the company must
assign the value that it believes to be the most faithful representation of the
transaction (a level 3 input in the FASB’s fair value hierarchy).
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Example: Issuance of Securities
• Barrett Company issued 10,000 shares of $1 par common
stock in exchange for land. Barrett’s common stock, as
evidenced by recent activity on a stock exchange, has a fair
value of $15 per share. Barrett records this transaction as
follows:
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Assets Acquired by Donation
• In certain circumstances, when a company acquires property,
plant, and equipment through donation, it is a nonreciprocal
transfer of nonmonetary assets.
• In general, GAAP requires that a donated asset should be recorded at
its fair value with a corresponding increase in either revenue or gain,
depending on whether the transaction was part of the company’s
ongoing operations or was a peripheral or incidental transaction.
• Example: Hrouda Company accepts a donation of a building
worth $50,000. Hrouda records the donation as follows:
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Nonmonetary Asset Exchanges
(Slide 1 of 2)
• A nonmonetary exchange is a reciprocal transfer between a company
and another entity in which the company acquires nonmonetary assets or
services by surrendering other nonmonetary assets (Inventory, PP&E) or
services (e.g., trade-in, swap).
• In general, the cost of a nonmonetary asset acquired in exchange for
another nonmonetary asset is the fair value of the asset surrendered.
• If the fair value of the asset received is more clearly evident than the fair value
of the asset surrendered, it can be used to measure the cost of the asset
acquired.
• A gain or loss on the exchange is recognized as the difference between the
fair value of the asset surrendered and its book value.
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Nonmonetary Asset Exchanges
(Slide 2 of 2)
• When a small amount of cash, often referred to as boot, is also given or
received, the cost of the asset acquired and the gain or loss on the
nonmonetary asset surrendered is determined by these equations:
AND
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Example: Exchanges of Nonmonetary Assets
(Slide 1 of 2)
• No Cash Included in the Exchange: Arnold entered into an
agreement with Carbon to exchange one of its small buildings
for a specialized piece of equipment owned by Carbon.
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Example: Exchanges of Nonmonetary Assets
(Slide 2 of 2)
• Cash Included in Exchange:
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Exception to the General Rule to
Use Fair Value for Nonmonetary Exchanges
• The conceptual basis of valuing the acquired asset at fair value and
allowing for immediate gain or loss recognition is that, in most exchanges,
the economic position of the two companies has changed as a result of the
exchange.
• When the company’s future cash flows are expected to significantly change
as a result of the exchange, the transaction has commercial substance.
• If an exchange does not have commercial substance and results in a loss,
the general rule discussed earlier is followed. If the exchange does not
have commercial substance and results in a gain, GAAP requires the gain to
be deferred by reducing the cost of the asset.
• If a nonmonetary exchange which lacks commercial substance results in a
gain and cash is received, GAAP allows a portion of the gain to be
recognized. The recognized gain is determined based on a proportion of
the cash received to the total consideration received.
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Example: Exception to the General Rule
to Use Fair Value for Nonmonetary Exchanges
• Messenger Company owns a truck with a book value of $30,000 (cost of
$50,000 and accumulated depreciation of $20,000) and a fair value of
$33,000. Messenger exchanges the truck and $2,000 for a used truck from
Leninger Company that has a fair value of $35,000. Because the trucks are
so similar, Messenger’s cash flows are not expected to change significantly
as a result of this exchange. Messenger would record the truck it received
at $32,000, which is the fair value of the asset surrendered plus cash paid
($33,000 + 2,000) minus the $3,000 gain ($33,000 fair value of the truck
surrendered − $30,000 book value of the truck surrendered). Messenger
would record the exchange as follows:
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What Is The Cost Of Self-Constructed Assets?
• Sometimes a company constructs an item of property, plant,
and equipment that it intends to use in its operations.
• Similar to purchased assets, the cost of a self-constructed asset
includes all expenditures necessary to build the asset and put it
in operating condition.
• The costs directly related to construction—direct material and
direct labor—and should be added to the cost of the asset.
• The treatment of two other costs—overhead costs and interest costs—
have generated considerable debate.
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Overhead Costs
(Slide 1 of 2)
• There are two alternatives for a company to include overhead
costs in the cost of a self-constructed asset.
1. Allocate a portion of overhead to the self-constructed asset in the
same manner it allocates overhead to units of inventory
produced. Those in favor of this alternative argue that:
• Construction related overhead is a relevant component of the asset’s
cost and should be accounted for in the same way as regular
products, even though this means that the regular products will be
allocated less of the overhead.
• The cost of the constructed asset will be a more faithful representation
of the cost to acquire and prepare the asset for use.
• Allocating overhead to self-constructed assets enhances comparability
with the cost of an equivalent purchased asset because the seller
normally would include fixed overhead in its selling price.
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Overhead Costs
(Slide 2 of 2)
2. Include only the incremental overhead in the cost of the selfconstructed asset. Those in favor of this alternative argue that:
• To be representationally faithful, the cost of the asset should only
include the additional costs incurred to produce it.
• To be comparable, the allocation of overhead to normal operations
should not change because the overhead would have been incurred
whether or not the construction takes place.
• Common practice is to allocate both variable overhead and a
proportional share of fixed overhead to self-constructed assets.
• If the allocation of overhead causes the cost of the self-constructed
asset to be greater than the fair value of the asset, the asset should
be recorded at its fair value with the excess recognized as a loss in
the current period.
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Interest During Construction
• The FASB considered three alternatives to account for interest
(whether external financing costs or internal cost of capital)
during the construction of property, plant, and equipment.
• Do not capitalize any interest during construction. Under this alternative, a
company would treat interest as a financing cost and would record the
interest as an expense during the period incurred.
• Capitalize an amount of interest (actual or imputed) for all funds used for
construction. Under this alternative, a company would assign an interest
cost to all funds used in construction, whether borrowed or not.
• Capitalize the actual interest on incremental funds borrowed for the
construction. Under this alternative, a company would treat the cost of
borrowed funds as part of the cost of constructing an asset, similar to the
treatment of materials and labor.
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GAAP for Interest Capitalization
(Slide 1 of 2)
• To implement the approach required by GAAP, a company
must address three issues:
• Does the asset qualify for interest capitalization? A company is required
to capitalize interest on assets that are either constructed for its own use
(not land) or constructed as discrete projects for sale or lease to others.
Interest cannot be capitalized for inventories that are routinely
manufactured, assets that are in use or ready for their intended use, or
assets that are idle and are not undergoing the activities necessary to
get them ready for use.
• Over what period can interest be capitalized? The capitalization period
begins when (1) expenditures for the asset have begun, (2) activities that
are necessary to get the asset ready for its intended use are in
progress, and (3) interest cost is being incurred. The capitalization
period ends when the asset is substantially complete and ready for its
intended use.
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GAAP for Interest Capitalization
(Slide 2 of 2)
• What amount of interest can be capitalized? The amount of interest
capitalized for a qualifying asset is the portion of the interest cost
that could have been avoided if the construction had not occurred.
This amount is known as avoidable interest. A company determines
avoidable interest by applying an interest rate to the weighted
average accumulated expenditures for the qualifying asset during
the capitalization period. The specific steps necessary to determine
the amount of avoidable interest that can be capitalized are
described next.
• If a company suspends substantially all the activities related to
the construction of the asset, it suspends interest capitalization
until the activities are resumed.
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Interest Capitalization Procedures
(Slide 1 of 2)
Step 1: Determine the Weighted average accumulated
expenditures for the period, defined as the sum of the
construction expenditures weighted by the amount of time that
interest cost could have been incurred on those expenditures
during the construction period.
Step 2: Determine the appropriate interest rate.
• If the weighted average accumulated expenditures are less than or
equal to the funds borrowed specifically to finance the construction of a
qualifying asset, the company uses the interest rate on that specific
borrowing.
• If the weighted average expenditures on the asset are greater than the
specific borrowing or if no specific borrowing is made, the company uses
both the interest rate on the specific borrowing and a weighted average
interest rate on all other borrowings
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Interest Capitalization Procedures
(Slide 2 of 2)
Step 3: Compute avoidable interest by applying the appropriate
interest rate(s) to the weighted average accumulated
expenditures.
Step 4: Capitalize the lesser of avoidable interest or actual interest.
The total amount of interest cost that a company capitalizes
each period may not exceed the actual interest cost incurred.
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Example: Self-Constructed Asset –
Expenditures Less Than Borrowed (Slide 1 of 3)
• On January 1, 2013, Cia Company started the construction of a building to
use as its corporate headquarters. The project was completed and ready
for occupancy on December 31, 2013. Cia incurred the following
expenditures related to construction during 2013:
Cia had a $2,000,000, 12% note payable and a $4,000,000,
13% note payable, both of which are unrelated to the construction
project, outstanding during the entire year.
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Example: Self-Constructed Asset –
Expenditures Less Than Borrowed (Slide 2 of 3)
• In order to finance construction, on January 1, 2013, Cia obtained a
$1,000,000 construction loan with a 10% interest rate. Below shows the
computation of capitalized interest related to Cia’s construction project
when weighted average accumulated expenditures are less than the
amount specifically borrowed for construction.
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Example: Self-Constructed Asset –
Expenditures Less Than Borrowed (Slide 3 of 3)
• Cia would make the following journal entry to record total
interest cost incurred, assuming that all interest was paid in
cash:
• In future periods, Cia will depreciate the capitalized interest
cost over the useful life of the building.
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Example: Self-Constructed Asset –
Expenditures More Than Borrowed (Slide 1 of 3)
• In order to finance construction, on January 1, 2013, Cia obtained a
$400,000 construction loan with a 10% interest rate. Cia will finance the
remainder of the construction with internally generated funds.
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Example: Self-Constructed Asset –
Expenditures More Than Borrowed (Slide 2 of 3)
• Cia would make the following journal entry to record total
interest cost incurred, assuming that all interest was paid in
cash:
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Example: Self-Constructed Asset –
Expenditures More Than Borrowed (Slide 3 of 3)
• Because weighted average accumulated expenditures exceed
the amount borrowed specifically for construction, the interest
rate on the specific borrowing is used to compute avoidable
interest for an amount up to the construction-related
borrowing. For the excess of weighted average accumulated
expenditures over the amount of the construction loan, a
weighted average interest rate on other borrowings is used.
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Capitalized Interest –
Multiple Accounting Periods
• It is common for the construction project to extend beyond the
end of a company’s fiscal year.
• In this situation, the procedure shown previously is repeated for
the subsequent year with one adjustment—the total
expenditures plus capitalized interest from the previous year is
considered to be an outstanding expenditure as of the first
day of the subsequent year.
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Example: Capitalized Interest –
Multiple Accounting Periods (Slide 1 of 3)
• Using the information in the previous Example, assume that
Cia’s construction project was not completed and ready for
occupancy until March 1, 2014. In order to finance
construction, on January 1, 2013, Cia obtained a $1,000,000
construction loan with a 10% interest rate. In addition to
$1,200,000 of expenditures and $58,750 of capitalized
interest in 2013, Cia incurred the following expenditures
related to construction during 2014:
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Example: Capitalized Interest –
Multiple Accounting Periods (Slide 2 of 3)
• The computation of capitalized interest for the second year of
Cia’s construction project is as follows.
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Example: Capitalized Interest –
Multiple Accounting Periods (Slide 3 of 3)
• On January 1, 2014, the expenditure amount represents the
total expenditures plus capitalized interest from 2013.
Second, because the capitalization period ends when
construction is complete (March 1, 2014), all expenditures
receive a weighting from the beginning of the year to the end
of the construction period. Cia would make the following
journal entries to record total interest cost incurred, assuming
that all interest was paid in cash:
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Impact of Interest Capitalization
• When a company capitalizes interest costs instead of expensing
them, it triggers two effects on the financial statements:
• The company will report higher amounts for property, plant, and
equipment due to the capitalized interest being added to the acquisition
cost of the equipment.
• The company does not report the capitalized amount of interest as
interest expense during the construction period. Therefore, the company
will report higher income than it otherwise would if it had expensed the
full amount of interest. In addition, all things being equal, the capitalized
interest will result in higher depreciation expense in future periods.
Therefore, the capitalization of interest is essentially a question of asset
valuation and timing of the expense recognition.
• GAAP requires that companies disclose both the capitalized interest
amount and the total interest cost incurred in the notes to its financial
statements.
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How Do We Account for Expenditures
Subsequent to Acquisition? (Slide 1 of 2)
• After initial acquisition, companies make various expenditures
relating to property, plant, and equipment for purposes
ranging from routine repairs to major overhauls and
improvements.
• The related accounting decision is whether to report these
expenditures as investments that enhance property, plant, and
equipment or to expense them.
• Conceptually, if the expenditure is expected to increase the future economic
benefits of the asset, it should be capitalized (recorded as an asset).
• Otherwise, it should be recorded as an expense.
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How Do We Account for Expenditures
Subsequent to Acquisition? (Slide 2 of 2)
• An expenditure that increases the
expected future economic
benefits of the asset above those
that originally were expected is
called a capital expenditure.
• An expenditure that does not increase
the economic benefits but is incurred to
maintain the existing benefits is an
operating expenditure (revenue
expenditure) and is expensed in the
period incurred.
• The future economic benefits can
be increased by:
• Many companies establish a lower
limit, or materiality threshold, on the
amount of expenditure that will be
capitalized. Any amount below the
lower limit will be expensed,
regardless of whether it provides
future benefits or not.
• extending the life of the asset
• improving productivity of the
asset by enabling the asset to
produce more goods at the same
cost or by producing the same
quantity of goods at a lower cost
• increasing the quality of the
product
• Subsequent expenditures can be
classified as additions, improvements
and replacements, rearrangements,
and repairs and maintenance.
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Additions
• An addition involves enlarging an existing asset by adding a
new component and they are capitalized as an asset.
• When an addition involves changing an existing asset, an issue
arises as to how to account for the cost of such changes.
• Example: When a company adds a new wing to a building, it
frequently makes alterations to the old building. If these
alterations are necessary to acquire and prepare the addition
for use, or if the alterations increase the economic benefits
originally anticipated for the old building, the cost of
alteration is capitalized as an asset. If the alterations do not
increase the original benefits of the old building, the cost is
expensed.
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Improvements and Replacements
(Slide 1 of 4)
• An improvement (betterment) is the substitution of a better
asset for the one currently used, such as the installation of a
new solar heating system in a building.
• A replacement (renewal) is the substitution of an equivalent
asset, such as a new engine in a truck. Expenditures related to
improvements and replacements are capitalized as assets.
• There are three alternative methods for a company to account
for such capitalized expenditures:
• Substitution
• Reduction of Accumulated Depreciation
• Capitalization as a New Asset
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Improvements and Replacements
(Slide 2 of 4)
• Substitution: Under this method, the book value of the old asset is removed
and a new asset is recorded. This only works if the book value of the old
asset is known. This may not happen when purchased as part of a bigger
asset, like a building.
• Example Pippa Company decides to replace its old oil furnace with a new
gas furnace. The oil furnace has a historical cost of $50,000 with
accumulated depreciation of $30,000. The scrap value of the old furnace is
$5,000, and the new furnace costs $70,000. Pippa records this transaction
as follows:
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Improvements and Replacements
(Slide 3 of 4)
• Reduction of Accumulated Depreciation: This method reduces accumulated
depreciation, thereby increasing the asset’s book value, for the cost of the
improvement or replacement. This method is appropriate when the
expenditure extends the service life of the asset which, in effect, restores
some of the service potential of the asset that had previously been
depreciated.
• Example Bradbury Company incurs a capital expenditure of $60,000 to
replace a roof on its factory. Bradbury had not planned to replace the
roof, but the replacement has extended the life of the factory. Bradbury
records the cost as follows:
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Improvements and Replacements
(Slide 4 of 4)
• Capitalization as a New Asset: Under this method, the expenditure is
capitalized as a new asset without removing the carrying amount of the old
asset. This method is most appropriate for additions. This method is also
appropriate for improvements and replacements, particularly if the book
value of the old asset has been sufficiently depreciated to an immaterial
amount.
• Example Heller Company records a capital expenditure of $80,000 to
enlarge a factory that increases its usefulness as follows:
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Rearrangement and Moving
• The costs of rearranging the facilities within a building or
moving them to a new location are capitalized as assets and
depreciated over the period expected to benefit.
• If these costs are immaterial or if it’s uncertain that the costs will provide
future benefits, the company should expense such costs in the period
incurred.
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Repairs and Maintenance
• Routine expenditures for repair and maintenance do not
increase the future economic benefits of the asset but, instead,
maintain the existing benefits provided by the asset and
should be expensed in the period incurred.
• Examples include expenditures such as painting, lubricating a
machine, and making periodic adjustments to equipment
• Usually a company expenses the cost of these major repairs.
• If these repairs increase the future benefits of the asset similar to an
improvement or replacement, the cost should be capitalized.
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Oil and Gas Properties
(Slide 1 of 2)
• Conceptually, any exploration costs that provide future benefits should be
capitalized.
• Differences of opinion exist as to the proper accounting for unsuccessful
exploration activities.
• Two alternative methods exist.
• Successful-efforts method—Only those exploration costs that result in the
discovery of oil and gas are capitalized as part of the oil and gas reserve and
amortized as the oil and gas is produced.
• Full-cost method—All costs incurred in the exploration and discovery of oil and
gas—even the costs associated with dry wells—are capitalized as part of cost
of the oil and gas reserves that are discovered, and amortized as the oil and
gas is produced.
• The principal difference between the two methods concerns the treatment
of the cost of dry wells.
• Both methods are used extensively.
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Oil And Gas Properties
(Slide 2 of 2)
• Regardless of the accounting policy regarding exploration
costs, GAAP requires the following disclosures:
• Estimates of quantities of proven oil and gas reserves—oil and gas
reserves which are expected to be recoverable with reasonable
certainty
• Capitalizable costs related to oil and gas activities
• Results of operations of oil- and gas-producing activities
• A standardized measure of discounted future cash flows
• Change in standardized future cash flows
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