Chapter 10 - Acquisition and Disposition of PPE

Question 1

What types of assets qualify for capitalizing interest costs during construction? (2)

Answer 1

-Assets under construction for a company’s own use (including buildings, plants, and large machinery)

-Assets intended for sale or lease that are constructed or otherwise produced as discrete projects (ships, real estate developments)

Question 2

What types of assets do not qualify for capitalizing interest costs during construction? (2)

Answer 2

• Assets that are in use or ready for their intended use
• 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 (land remaining undeveloped and assets not used because of obsolescence, excess capacity, or need for repair)

Question 3

Define the Capitalization Period and its three conditions.

Answer 3

The capitalization period is the period of time during which a company must capitalize interest. It begins with the presence of three conditions:

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 capitalization continues as long as these three conditions are present. The capitalization period ends when the asset is substantially complete and ready for its intended use.

Question 4

How is the weighted-average interest rate computed?

Answer 4

Total interest/Total principal

Question 5

How is interest capitalization handled for expenditures for land?

Answer 5

When a company purchases land w/the intent of developing it for a particular use, interest costs associated with those expenditures qualify for interest capitalization.

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

If the company develops land for lot sales, it includes any capitalized interest costs as part of the acquisition cost of the developed land.

It should not capitalize interest costs involved in purchasing land held for speculation b/c the asset is ready for its intended use.

Question 6

If a company borrows money to finance the construction of assets and temporarily invests the excess borrowed funds in interest-bearing securities until they need the funds, how should it handle the interest revenue?

Answer 6

In general, companies should not net or offset interest revenue against interest costs. Companies should capitalize interest incurred on qualifying assets regardless of any interest revenue..

Question 7

How does IFRS compare to GAAP regarding interest revenue earned on specific qualified asset borrowings?

Answer 7

IFRS requires that interest revenue earned should offset interest costs capitalized. GAAP does not.

Question 8

If a company acquires property by issuing securities, how is the cost of the property acquired determined?

Answer 8

The par or stated value of such stock fails to properly measure the property cost.

The market price of the stock issued is a fair indication of the cost of the property acquired.

If the company cannot determine the market price of the stock exchanged, it establishes the fair value of the property as the basis for recording the asset and issuance of the common stock.

Question 9

Record the following journal entry:
Company A decides to purchase adjacent land for expansion of its operations. In lieu of paying cash for the land, the company issued 5,000 shares of common stock (par value $10) to the owner of the land. The common stock has a fair value of $12 per share.

Answer 9

Land (5,000 x 12) 60,000
Common Stock (5,000 x 10) 50,000
Paid-in Capital Excess of Par 10,000

Question 10

How should companies account for the exchange of nonmonetary assets such as PPE?

Answer 10

On the basis of the FV of the asset given up or the FV of the asset received, whichever is clearly more evident. Thus, companies should recognize any gains or losses immediately.

Question 11

After installing plant assets and readying them for use, a company incurs additional costs that range from ordinary repairs to significant additions. Should these costs be capitalized or expensed?

Answer 11

Costs incurred to achieve greater future benefits should be capitalized, and expenditures that maintain a given level of services should be expensed.

Question 12

After installing plant assets and readying them for use, a company incurs additional costs that range from ordinary repairs to significant additions. What conditions must be present to capitalize these costs?

Answer 12

One of three conditions must be present:
1. The useful life of the asset must be increased.
2. The quantity of units produced from the asset must be increased.
3. The quality of the units produced must be enhanced.

Question 13

When companies substitute one asset for another, what is the difference between an improvement and a replacement?

Answer 13

An improvement (betterment) is the substitution of a better asset for the one currently used. Ex. a concrete floor for a wooden floor.

A replacement is the substitution of a similar asset. Ex. a wooden floor for a wooden floor.

Question 14

If an expenditure increases the future service potential of the asset, when would the substitution approach be used to capitalize the expense? How is it used?

Answer 14

The substitution approach is used if the carrying amount of the old asset is available.

It is then a simple matter to remove the cost of the asset and replace it w/the cost of the new asset.

Question 15

Recording the following entry:

A company decides to replace the pipes in its plumbing system. A plumber suggests that the company use plastic tubing in place of the cast iron pipes and copper tubing. The old pipe and tubing have a book value of $15,000 (cost of $150,000 less accumulated depreciation of $135,000), and a scrap value of $1,000. The plastic tubing costs $125,000. If the company pays $124,000 for the new tubing after exchanging the old tubing.

Answer 15

Because the carrying amount of the old asset is available, the substitution approach is used.

Plant Assets (plumbing system) 125,000
Accumulated Dep - Plant Assets 135,000
Loss on Disposal Plant Assets 14,000
Plant Assets 150,000
Cash ($125,000 - $1,000) 124,000

Question 16

If an expenditure increases the future service potential of the asset, when would the new cost be capitalized while also keeping the carrying amount of the old asset on the books?

Answer 16

The justification for this approach is that the item is sufficiently depreciated to reduce its carrying amount almost to zero. Although this assumption may not always be true, the differences are often insignificant. Companies usually handle improvements in this manner.

Question 17

If an expenditure increases the future service potential of the asset, when would the expenses be charged to accumulated depreciation.

Answer 17

In cases when a company does not improve the quantity or quality of the asset itself but instead extends its useful life, the company debits the expenditure to Accumulated Depreciation rather than to an asset account.

The theory behind this approach is that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. The net carrying amount of the asset is the same whether debiting the asset or accumulated depreciation.

Question 18

How does a company distinguish between a PPE repair and an improvement?

Answer 18

A company makes ordinary repairs to maintain plant assets in operating condition. It charges ordinary repairs to an expense account in the period incurred, on the basis that it is the primary period benefited. Maintenance charges that occur regularly include replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning. A company treats these as ordinary operating expenses.

It is often difficult to distinguish a repair from an improvement or replacement. The major consideration is whether the expenditure benefits more than one year or one operating cycle, whichever is longer. If a major repair (such as an overhaul) occurs, several periods will benefit. A company should handle the cost as an addition, improvement, or replacement.

Question 19

If a company scraps or abandons an asset w/o cash recovery, what amount of loss is recognized?

Answer 19

The company recognizes a loss equal to the asset’s book value.

If scrap value exists, the gain or loss that occurs is the difference b/w the asset’s scrap value and it’s book value.

Question 20

How much interest during construction of PPE can be capitalized and how is it calculated?

Answer 20

The amount capitalized is the LESSER of actual interest cost incurred during the period or avoidable interest.

To calculate:
1. Compute Average Accumulated Expenditures (AAE) - make sure the expenditures qualify for capitalization.

Average accumulated expenditures (AAE) are the total expenditures during the construction period, and therefore the debt that could have been avoided.

AAE is determined by using the weighted average of the actual expenditures during the year (if uneven payments throughout the year) or simple average of beginning and ending AAE (for even payments throughout the year).

2. Apply interest rate to AAE to determine avoidable interest.
3. Calculate actual interest incurred.

Question 21

What is interest capitalization from construction PPE and what is the rationale (2)?

Answer 21

Capitalized interest is part of the asset’s basis, just like materials, labor, and overhead associated with construction.

At the end of the year, the entity is going to calculate the amount of interest that can be capitalized and its going to make a JE to classify that interest out of interest expense into the asset. (Db Asset; Cr Interest Exp) This decreases interest expense and increases the value of asset.

Rationale:
Follows the Matching Concept - interest incurred during construction is deferred in the asset until it generates revenue; then interest is expensed through depreciation.

Avoidable interest - if the construction had not taken place, the firm could have avoided the interest.

Question 22

What is Avoidable Interest and how is it calculated?

Answer 22

Avoidable interest is interest that could have been avoided if expenditures for the construction had not been made.

Avoidable interest is determined by multiplying the interest rate by the average accumulated expenditures for the qualifying assets during the period.

Question 23

What is Average Accumulated Expenditures and how is it calculated?

Answer 23

Average accumulated expenditures (AAE) are the total expenditures during the construction period, and therefore the debt that could have been avoided.

AAE is determined by using the weighted average of the actual expenditures during the year (if uneven payments throughout the year) or simple average of beginning and ending AAE (for even payments throughout the year).

Question 24

If a company determines $102,000 should be reported as capitalized interested for their PPE under construction, what is the journal entry to be made at the end of the year?

Answer 24

Construction in progress 102,000
Interest Expense 102,000

Question 25

A corporation issued debt to purchase 10 acres of land for development purposes. Expenditures related to this purchase are as follows:

Purchase Price $1,000,000
Real estate taxes in arrears $15,000
Debt issuance costs $2,000
Attorney fee - title search on land $5,000

What amounts (if any) would NOT be included in calculating the acquisition cost of the land for the financial statements?

Answer 25

Debt issuance costs - this is a financing cost and is not part of the asset

Question 26

A machine with an original estimated useful life of 10 years was moved to another location in the factory after it had been in service for 3 years. The efficiency of the machine is increased for its remaining useful life. Should the reinstallation costs be capitalized if the remaining usefule life of the machine is 5 years? 10 years?

Answer 26

Yes and Yes.

Even if the remaining useful life in the machine is decreased from 7 to 5 years, the efficiency of the machine is increased because of the relocation, so the costs should be capitalized.

Question 27

How are expenditures that extend the useful life of a plant asset without improving its quantity or quality accounted for?

A) As improvements
B) By debiting accumulated depreciation
C) By debiting the asset account
D) As additions

Answer 27

B) By debiting accumulated depreciation

If an expenditure increases the life of an asset, but does not increase the quality nor quantity, a debit to the accumulated depreciation account is needed as the useful life of the asset has been extended. an improvement typically increases the quality of the asset or the quantity of production of the asset. If the expenditure is simply to maintain the existing level of service, it is a repair expense and not capitalized.