AF310- Intermediate Accounting I

Chapter 10
Acquisition and Disposition of
PPE

Kun Yu, Intermediate Accounting I 8-1

 Property, Plant, and Equipment
 PPE
 “Used in operations” and not for resale.
 Long-term in nature and usually depreciated.
 Possess physical substance.

 Use historical cost to measure PPE

 Cost related to the acquisition of PPE
 Cost related to getting PPE ready for use

Kun Yu, Intermediate Accounting I 8-2

 Cost of Land
 Purchase price
 Closing costs, such as title to the land,
attorney’s fees, and recording fees
 Costs of grading, filling, draining, and clearing
 Assumption of any liens, mortgages, or
encumbrances on the property
 Additional land improvements that have an
indefinite life.

Kun Yu, Intermediate Accounting I 8-3

 Cost of Buildings
 Materials, labor, and overhead costs
incurred during construction
 Professional fees and building permits

Kun Yu, Intermediate Accounting I 8-4

 Cost of Equipment
 purchase price
 freight and handling charges
 insurance on the equipment while in
transit
 cost of special foundations if required
 assembling and installation costs
 costs of conducting trial runs
Kun Yu, Intermediate Accounting I 8-5
 Self-Constructed Assets
 Materials and direct labor
 Overhead can be handled in two ways:
 Assign no fixed overhead
 Assign a portion of all overhead to the
construction process.

Kun Yu, Intermediate Accounting I 8-6

 Interest Capitalization
 Interest costs during construction need to be capitalized
 Interest costs after construction need to be expensed
 Computation of the amount to be capitalized
 Compute weighted average accumulated expenditures
 Expenditures are weighted by the amount of time that interest cost
is incurred.
 Compute avoidable interest cost and actual interest cost
 Avoidable interest cost: the amount of interest that could have
been avoided if expenditures for the asset had not been made
 Apply the interest rate on the specific borrowings for the portion
below the amount of specific borrowings
 Apply weighted average interest rate on other borrowings for the
portion above the amount of specific borrowings
 Capitalize the lesser of avoidable interest cost or actual interest
cost
Kun Yu, Intermediate Accounting I 8-7
 Interest Capitalization
Interest Capitalization Illustration: KC Corporation borrowed
$200,000 at 12% interest from State Bank on Jan. 1, 2011, for
specific purposes of constructing special-purpose equipment to be
used in its operations. Construction on the equipment began on
Jan. 1, 2011, and the following expenditures were made prior to
the project’s completion on Dec. 31, 2011:
Other general debt existing
Actual Expenditures:
on Jan. 1, 2011:
January 1, 2011 $100,000
$500,000, 14%, 10-year
April 30, 2011 150,000 bonds payable
November 1, 2011 300,000
December 31, 2011 100,000 $300,000, 10%, 5-year
Total expenditures $650,000 note payable
Kun Yu, Intermediate Accounting I 8-8
 Compute Weighted Average
Accumulated Expenditures
Weighted
Average
Actual Capitalization Accumulated
Date Expenditures Period Expenditures
Jan. 1 $ 100,000 12/12 $ 100,000
Apr. 30 150,000 8/12 100,000
Nov. 1 300,000 2/12 50,000
Dec. 31 100,000 0/12 -
$ 650,000 $ 250,000

A company weights the construction expenditures by the amount of time

(fraction of a year or accounting period) that it can incur interest cost on
the expenditure.

Kun Yu, Intermediate Accounting I 8-9

 Compute the Actual and
Avoidable Interest
Actual Interest Interest Actual
Debt Rate Interest
Weighted-average
Specific Debt $ 200,000 12% $ 24,000 interest rate on
general debt
General Debt 500,000 14% 70,000 $100,000 = 12.5%
300,000 10% 30,000 $800,000
$1,000,000 $ 124,000

Accumulated Interest Avoidable

Expenditures Rate Interest
Avoidable Interest
$ 200,000 12% $ 24,000
50,000 12.5% 6,250
$ 250,000 $ 30,250

Kun Yu, Intermediate Accounting I 8-10

 Capitalize the Lesser of Avoidable
Interest or Actual Interest

Avoidable interest $ 30,250

Actual interest 124,000

Journal entry to Capitalize Interest:

Equipment 30,250
Interest expense 30,250

Kun Yu, Intermediate Accounting I 8-11

 Valuation of PPE
 Valuation of PPE
 the fair value of the asset given up
 the fair value of the asset received

 Cash Discounts — whether taken or not — generally considered a

reduction in the cost of the asset.

 Lump-Sum Purchases — Allocate the total cost among the various

assets on the basis of their fair market values.

 Issuance of Stock — The market value of the stock issued is a fair

indication of the cost of the property acquired.

Kun Yu, Intermediate Accounting I 8-12

 Examples
 UMB Purchased a equipment with list price $10,000 and
cash discount 5/10, n/30. UMB paid cash within the
discount period.
Dr. Equipment 9,500
Cr. Cash 9,500

 UMB issued 1000 shares of common stock to purchase

land. The market value of the common stock is $10 per
share, and par value is $1 per share.
Dr. Land 10,000
Cr. Common stock 1,000
APIC 9,000

Kun Yu, Intermediate Accounting I 8-13

 Accounting for Exchanges of
nonmonetary Assets
 Commercial substance
 Effect of the transaction on future cash flows
 Exchanges have commercial substance
 Recognize gains and losses immediately
 Exchanges have no commercial substance
 No cash received
 Defer gains, but recognize losses immediately
 Cash received
 Recognize partial gains, but recognize losses immediately

Kun Yu, Intermediate Accounting I 8-14

 Exchanges: Loss Situation
Illustration: Information Processing, Inc. trades its used
machine for a new model at Jerrod Business Solutions Inc. The
exchange has commercial substance. The used machine has a book
value of $8,000 (original cost $12,000 less $4,000 accumulated
depreciation) and a fair value of $6,000. The new model lists for
$16,000. Jerrod gives Information Processing a trade-in
allowance of $9,000 for the used machine. Information
Processing computes the cost of the new asset as follows.

Kun Yu, Intermediate Accounting I 8-15

 Exchanges: Loss Situation

Equipment 13,000
Accumulated Depreciation—Equipment 4,000
Loss on Disposal of Equipment 2,000
Equipment 12,000
Cash 7,000
Kun Yu, Intermediate Accounting I 8-16
 Gains With Commercial
Substance
Illustration: Interstate Transportation Company exchanged a
number of used trucks plus cash for a semi-truck. The used
trucks have a combined book value of $42,000 (cost $64,000
less $22,000 accumulated depreciation). Interstate’s
purchasing agent, experienced in the second-hand market,
indicates that the used trucks have a fair market value of
$49,000. In addition to the trucks, Interstate must pay
$11,000 cash for the semi-truck. Interstate computes the cost
of the semi-truck as follows.

Kun Yu, Intermediate Accounting I 8-17

 Gains with Commercial
Substance

Semi-truck 60,000
Accumulated Depreciation—Trucks 22,000
Trucks 64,000
Gain on disposal 7,000
Cash 11,000
Kun Yu, Intermediate Accounting I 8-18
 Gains without Commercial
Substance: No cash Received
Now assume that Interstate Transportation Company
exchange lacks commercial substance. That is, the
economic position of Interstate did not change
significantly as a result of this exchange. In this case,
Interstate defers the gain of $7,000 and reduces the
basis of the semi-truck.

Kun Yu, Intermediate Accounting I 8-19

 Gains without Commercial
Substance: No cash Received

Semi-truck 53,000
Accumulated Depreciation—Trucks 22,000
Trucks 64,000
Cash 11,000

Kun Yu, Intermediate Accounting I 8-20

 Gains without Commercial
Substance: Some cash Received
When a company receives cash (sometimes referred to as
“boot”) in an exchange that lacks commercial substance,
it may immediately recognize a portion of the gain. The
general formula for gain recognition when an exchange
includes some cash is as follows:

Kun Yu, Intermediate Accounting I 8-21

 Gains without Commercial
Substance: Some cash Received
Illustration: Queenan Corporation traded in used machinery
with a book value of $60,000 (cost $110,000 less
accumulated depreciation $50,000) and a fair value of
$100,000. It receives in exchange a machine with a fair value
of $90,000 plus cash of $10,000.

Kun Yu, Intermediate Accounting I 8-22

Exchanges without Commercial
Substance—Some Cash Received

Kun Yu, Intermediate Accounting I 8-23

 Gains without Commercial
Substance: Some cash Received

Cash 10,000
Machine 54,000
Accumulated Depreciation—Machine 50,000
Machine 110,000
Gain on disposal of machine 4,000

Kun Yu, Intermediate Accounting I 8-24

Summary of Gain and Loss
Recognition on Exchanges

Kun Yu, Intermediate Accounting I 8-25

 Cost Subsequent to Acquisition
 Capitalizing vs. expensing
 Costs incurred to achieve greater future benefits
should be capitalized (e.g., Additions, improvements
or replacements)
 Useful life of the asset must be increased.
 Quantity of units produced from asset must be increased.
 Quality of units produced must be enhanced
 Expenditures that simply maintain a given level of
services should be expensed (e.g. ordinary repairs)

 WorldCom: Capitalize a significant amount of

expenditures to report positive net income
Kun Yu, Intermediate Accounting I 8-26
 Disposal of PPE
 Gain (loss) = Selling price of PPE – Net book value of
PPE

 Eliminate all the accounts related to the sold PPE

 PPE
 Accumulated Depreciation

 E.g. Federal Express sold a small delivery truck that had

been used in the business for the last three years. The
company’s records shows the following:
 Delivery truck cost $28K
 Accumulated depreciation $23K
Kun Yu, Intermediate Accounting I 8-27
 Disposal of PPE
 Give the journal entry assuming the truck was sold for:
1. $5.2k
Dr. Cr.
Cash (+A) 5.2
Accumulated depreciation (-XA, +A) 23
Delivery truck Inventory (-A) 28
Gain (+SE) 0.2
1. $4.6K
Dr. Cr.
Cash (+A) 4.6
Accumulated depreciation (-XA, +A) 23
Loss (-SE) 0.4
Delivery truck Inventory (-A) 28

Kun Yu, Intermediate Accounting I 8-28