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Chapter 10: PPE part 1

What is Property, Plant, and Equipment (PPE)?

1. Acquired for use and not resale.


(They do not become part of a product held for resale.)

2. Long-lived in nature and subject to depreciation


(except for land).

3. Possess physical substance (tangible assets)

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Acquisition of PPE

Usual valuation method is historical cost. Which is


the cash or cash equivalent of obtaining asset and
getting it ready for its intended use.

Land: if purchased to construct a building, then all


net costs up to excavation for building. Special
assessments (streets, drainage) for relatively
permanent improvements are included in the land
account. Improvements (parking lots, fences) are
recorded in Land Improvements account and
depreciated over estimated lives.

Land held as an investment should be recorded in


an investment account.
Land held by a real estate company for resale
should be classified as inventory.

Buildings: all costs related to acq. and construction


are capitalized (from excavation till completion).

Equipment: all costs to prepare for intended use


includes cost for trial runs and training.

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Self-constructed assets: Assignment of overhead
portion of all OH versus no fixed OHformer
preferred.

Disposition of PPE

Depreciation should be updated to date of disposal.


All accounts should be relieved of the cost and A/D
related to the asset being disposed.
Gains/losses from disposal are shown in the
appropriate income account.
Assets may be retired by: sales, exchange,
involuntary conversion, or abandonment.

The basic J.E.:

Cash $1,000
A/D 3,700
*Loss on disposal 5,300
Machinery $10,000

* a plug figure, would have been a gain if a credit


entry.

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Fully depreciated assets that are still in service
remain on the books at historical cost minus A/D.
GAAP requires that the amount of fully
depreciated assets in service be disclosed in notes
to F/S.

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Valuation of PPE when fair value is obscured by the
form of the transaction.

Cash discountsgross versus net method, both


are allowed, net preferred.
Deferred payment(1) use fair value at time of
purchase or (2) record at present value of pmts.
Lump-sum purchasesallocate (prorate) cost
among basket of assets based on their relative
fair values.
Issuance of stock for assetuse market value of
stock not par value.

Some exceptions to historical cost valuation:

1. Fair value is used for Donated assetsgains to


other revenue.
2. Prudent cost can be used if self-constructed
assets cost exceed fair value or if you were
ignorant about price and paid too much for an
asset originally.
3. Non-monetary exchanges assets considered
non-commercial and gain indicatedasset is
recorded at amount that balances the entry.

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Costs Subsequent to Acquisition

General rule is that costs that achieve greater future


benefits are capitalized and costs that only
maintain a given level of service should be
expensed in the period incurred.

Greater future benefits are defined as one or more of


the following:
(1) Increase the useful life of an asset.
(2) Increase the quantity (throughput) of units
produced. Or decrease the cost/unit.
(3) Enhance the quality of units produced.

Firms have limits on capitalization (materiality) and


expense all small expenditures.

Repairs are expensede.g., oil change in trucks.

Costs for: Additions, Improvements, Replacements,


Rearrangements, Reinstallation, and Major
repairs that benefit several periods are
capitalized. Three approaches are possible to
capitalize: (1) substitute, (2) capitalize new cost,
(3) debit A/Dused when useful life is extended.

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Chapter 10 Part 2:
CONSTRUCTION PERIOD INTEREST COSTS

Interest costs during construction of assetsit is a


financing cost? In which case, it should be expensed.
Or, is it a cost needed to bring an asset to usable
condition and location? In which case, it should be
capitalized with cost of asset. GAAP generally is
consistent with capitalizing interest during the
construction period of a qualified asset.

Qualifying Assetsrequire a period of time to


prepare for intended use (either self use or discrete
project for sale or lease.)

Period of capitalizationbegins with the first


expenditure of the project and ends when asset is
substantially complete and ready for its intended use
or when interest ends which ever is first.

Interest can be from specific (or non-specific) project


borrowings, but interest does not include a cost for
equitythere must be actual interest expense.

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Average accumulated expenditures (AAE)---
Maximum interest expense (capitalizable) cannot
exceed the actual construction expenditures during a
period. You have to determine the time-weighted
average amount of construction expenditures during
the period. If expenses occurred evenly throughout
the period, a simple average (total/2) would be
adequate.
FAS34 defines expenditures as: capitalized expenditures (net of progress
payment collections) for the qualifying asset that have required the payment of cash,
the transfer of other assets, or the incurring of a liability on which interest is
recognized (in contrast to liabilities, such as trade payables, accruals, and retainers
on which interest is not recognized). However, reasonable approximations of net
capitalized expenditures may be used. For example, capitalized costs for an asset
may be used as a reasonable approximation of capitalized expenditures unless the
difference is material.

Disclosure:
FAS34 requires that:
a. For an accounting period in which no interest
cost is capitalized, the amount of interest cost
incurred and charged to expense during the
period.
b. For an accounting period in which some
interest cost is capitalized, the total amount of
interest cost incurred during the period and the
amount thereof that has been capitalized.

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Interest rateSpecific Interest Method
If a specific loan was taken out for the construction
project and if it was equal to or greater than AAE,
Max. interest capitalized (MIC) = rate for specific
loan*AAE.

If AAE exceeds specific loan amount, then use the


weighted-average rate on all other borrowings times
the AAE in excess of specific construction loan to
calculate MIC. In this case:
MIC = rate for specific loan * AAE (up to amount of
loan) + weighted average rate on other borrowings *
AAE in excess of specific loan amount.

When there are no specific borrowings for specific


projects, the Weighted-Average Method is used to
calculate the appropriate interest rate to use. This is a
minor variation to the above. You would use the
weighted-average of all borrowings and apply to the
total of AAE.

IC has to be less than or equal to actual interest!


IC cannot be greater then AAE!
Any interest not capitalized must be expensed for the
period.

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In class problem::::

ACE Construction started the building of a new


corporate headquarters on Feb 1, 2000. The
building was ready for use on July 1, 2002. The
expenditures for the project were:

Feb. 1, 2000 $1,000,000


Apr. 1, 2000 2,500,000
Aug. 1, 2000 3,200,000
Dec. 1, 2000 5,000,000
Jan. 1 through
Dec. 31, 2001 (evenly) 12,000,000
Apr. 1, 2002 750,000
July 1, 2002 2,300,000

During the entire period 1/1/2000 to 12/31/2002,


ACE had debt outstanding consisting of 6%,
$10M bond issue and a 5%, $7M bond issue. On
July 1, 2000, ACE obtained a $10M, 10%
construction loan for the project. How much
interest should ACE capitalize and expense for
2000, 2001, and 2002? Assume that ACE paid
off the construction loan on Sept. 1, 2002 and all
other debt is outstanding as of 1/1/2003.

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NONMONETARY EXCHANGES

Wow, in 2004, FASB revised/amended APB No.


29 with FASB No. 153.

We thought that the revision would greatly


simplify the complicated rules, but the only big
change was to drop the determination of
similar/dissimilar assets and add commercial
substance. The intent is that more exchanges
will be classified as having commercial
substance than in the past (some similar asset
exchanges can have commercial substance).

In other words, more exchanges will now


recognize fully the gains/losses on exchange.

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An asset acquired in a non-monetary exchange
generally is recorded at the cash equivalent
value of the assets exchanged:
1. Fair value of assets given up, or
2. Fair value of the assets received, whichever is
clearly more evident (easier to determine).

If we can't determine the fair value of either


asset in the exchange, the asset received is
valued at the book value of the asset given
(no gain or loss on exchange).

Gain/loss recognition depends upon whether


the exchange has commercial substance.

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Commercial Substance

* Future cash flows change as a result of the


exchange. Exchange of similar assets can
have commercial substance.

Is the risk, timing, and amount of cash flow


for the asset received different from the cash
flow associated with the asset given up?

orAre cash flows affected by the


exchange?

Another way to ask this is:


Has our economic position changed?

Yes or no determination.

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If yes, then recognize the full gain/loss on the exchange.

Accounting for Exchanges

Type of Accounting for Accounting for


Exchange Asset Received gain/loss
Commercial Recognize at fair Recognize
value gain/loss fully
substance
Lacks either (a) at fair (a) Recognize
commercial value or it is a loss,
(b) plug. (b)prorate gain
substance
based on ratio of
cash received to
FMV of all
assets received.

Remember that assets are never recognized at


greater than their cash equivalent price (fair value).
Therefore, do not value new assets at their list price
or book value of assets given up if this means that

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the new assets will be recognized at an amount that
exceeds their fair value!
[If cash (boot) exchanged is 25% or more of FV of all assets received, then the
exchange is considered a monetary exchange and all gains/losses on exchange are
recognized by both parties.]

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The AL Company traded land it had been holding as an
investment in exchange for equipment. The land had a
book value of $100,000. In addition to the land, AL
gave up $10,000 cash. This exchange is considered to
have commercial substance.

The new asset is simply recorded at its fair value. The


difference between that amount and the book value of
the old asset, plus cash paid (or less cash received),
reflects a loss or gain on the exchange.

Situation 1:
The fair value of the land is $80,000.

Equipment ($80,000 + 10,000)......................... $90,000


Loss ($100,000 - 80,000).................................... 20,000
Cash (amount paid)..................................... 10,000
Land (book value)....................................... 100,000

Situation 2:
The fair value of the land is $140,000.

Equipment ($140,000 + 10,000)....................... $150,000


Cash (amount paid)..................................... 10,000
Land (book value)....................................... 100,000

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Gain ($140,000 - 100,000)...................................... 40,000

The AL Company traded land it had been holding as an


investment in exchange for other land. ALs land had a
book value of $100,000. In addition to the land, AL
gave up $10,000 cash. Assume that this exchange is
considered to LACK commercial substance.

The new asset is simply recorded at the book value of


the assets given up. There is NO gain recognized on
exchange (no cash was received).

Situation 3:
The fair value of the new land is $120,000.

New Land (plug)........................................... $110,000


Cash (amount paid)..................................... 10,000
Old Land (book value)............................... 100,000

Situation 4:
The fair value of the new land is $50,000. Recognize the loss
immediately.

New Land (fair value)................................... $50,000


Loss on exchange.......................................... 60,000

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Cash (amount paid)..................................... 10,000
Old Land (book value)............................................................. 100,000

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The AL Company traded land it had been holding as an
investment in exchange for other land. ALs land had a
book value of $100,000. In addition to the land, AL
received $10,000 cash. Assume that this exchange is
considered to LACK commercial substance.

Now AL can recognize part of the full gain.


Make a trial entry to calculate the full gain ($30,000),
then prorate it by 10/130 = 0.076923

Situation 5:
The fair value of the new land is $120,000.

New Land (plug)........................................... $92,308


Cash (amount received).................................. 10,000
Gain on exchange......................................... 2,308
Old Land (book value)............................... 100,000

Situation 6:
The fair value of the new land is $50,000. Recognize the loss
immediately.

New Land (fair value)................................... $50,000


Loss on exchange.......................................... 40,000
Cash (amount received).................................. 10,000

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Old Land (book value)............................................................. 100,000

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