Chapter 10 Operational Assets: Acquisition and Disposition 1 Question 10-1 The term operational asset is used to describe the broad category of long-lived assets that are used in the production of goods and services. The difference between tangible and intangible assets is that intangible assets lack physical substance and they primarily refer to the ownership of rights. Question 10-2 The cost of an operational asset includes the purchase price (less any discounts received from the seller), transportation costs paid by the buyer to transport the asset to the location in which it will be used, expenditures for installation, testing, legal fees to establish title, and any other costs of bringing the asset to its condition and location for use. Question 10-3 The cost of a developed natural resource includes the acquisition costs for the use of land, the exploration and development costs incurred before production begins, and the restoration costs incurred during or at the end of extraction. Question 10-4 Purchased intangibles are valued at their original cost to include the purchase price and all other necessary costs to bring the asset to condition and location for use. Research and development costs incurred to internally develop an intangible asset are expensed in the period incurred. Filing and legal costs for both purchased and developed intangibles are capitalized. Question 10-5 Goodwill represents the unique value of the company as a whole over and above all identifiable tangible and intangible assets. This value results from a company’s clientele and reputation, its trained employees and management team, its unique business location, and any other unique features of the company that can’t be associated with a specific asset. Because goodwill can’t be separated from a company, it is not possible for a buyer to acquire it without also acquiring the whole company or a substantial portion of it. Goodwill will appear as an asset in a balance sheet only when it was paid for in connection with the acquisition of another company. The capitalized cost of goodwill equals the purchase price of the acquired company less the market value of the net assets acquired. The market value of the net assets equals the market value of all identifiable tangible and intangible assets less the market value of any liabilities of the selling company assumed by the buyer. Chapter 10 Operational Assets: Acquisition and Disposition QUESTIONS FOR REVIEW OF KEY TOPICS 2 Answers to Questions (continued) Question 10-6 A lump-sum purchase price generally is allocated based on the relative market values of the individual assets. The relative market value percentages are multiplied by the lump-sum purchase price to arrive at the initial valuation of each of the separate assets. Question 10-7 Assets acquired in exchange for deferred payment contracts are valued at their fair value or the present value of payments using a realistic interest rate. Theoretically, both alternatives should lead to the same valuation. Question 10-8 Assets acquired through the issuance of equity securities are valued at the fair value of the securities if known; if not known, the fair value of the assets received is used. Question 10-9 Donated assets are valued at their fair values. Question 10-10 When an operational asset is sold, a gain or loss is recognized for the difference between the consideration received and the asset’s book value. Retirements and abandonments are handled in a similar fashion. The only difference is that there will be no monetary consideration received. A loss is recorded for the remaining book value of the asset. Question 10-11 The basic principle used to value assets acquired in a nonmonetary exchange is to use the fair value of asset(s) given up plus (minus) monetary consideration - cash - paid (received). Question 10-12 The two exceptions are (1) when fair value is not determinable, and (2) when the exchange lacks commercial substance. Question 10-13 GAAP require the capitalization of interest incurred during the construction of assets for a company’s own use as well as for assets constructed for sale or lease. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Only assets that are constructed as discrete projects qualify for interest capitalization. 3 Answers to Questions (continued) Question 10-14 Average accumulated expenditures for a period is an approximation of the average amount of debt the company would have had outstanding if it borrowed all of the funds necessary for construction. If construction expenditures are incurred equally throughout the period, the average accumulated expenditures for the period can be estimated by adding the accumulated expenditures at the beginning of the period to the accumulated expenditures at the end of the period and dividing by two. If expenditures on the project are unequal throughout the period, individual expenditures, perhaps expenditures grouped by month, should be weighted by the amount of time outstanding until the end of the construction period or the end of the company’s fiscal year, whichever comes first. Question 10-15 Applying the specific interest method, the interest rate on any construction related debt is used up to the amount of the construction debt and any excess average accumulated expenditures is multiplied by a weighted-average interest rate of all other debt. The weighted-average method multiplies average accumulated expenditures by the weighted-average interest rate of all debt, including any construction-related debt. Question 10-16 SFAS 2 defines research and development as follows: Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process. Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. Question 10-17 SFAS 2 specifically excludes from current R&D expense the cost of operational assets that have “alternative future uses” beyond the current R&D project. However, the depreciation or amortization of these assets will be included as R&D expenses in the future periods the assets are used for R&D activities. If the equipment has no alternative future use, its cost is expensed as R&D immediately. Question 10-18 GAAP require the capitalization of software development costs incurred after technological feasibility is established. Technological feasibility is established “when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements.” Costs incurred after technological feasibility but before the product is available for general release to customers are capitalized as an intangible asset. These costs include coding and testing costs and the production of product masters. Similar to SFAS 2, costs incurred after commercial production begins usually are not R&D expenditures. 4 Answers to Questions (concluded) Question 10-19 The cost of developed technology is capitalized and expensed over its expected useful life. The cost of in-process R&D is expensed in the period of the acquisition. Developed technology relates to those projects that have reached technological feasibility. Question 10-20 The successful efforts method allows companies to capitalize only exploration costs resulting in successful wells. The full-cost method allows companies to capitalize all exploration costs incurred within a geographical area. 5 Brief Exercise 10-1 Capitalized cost of the machine: Purchase price $35,000 Freight 1,500 Installation 3,000 Testing 2,000 Total cost $41,500 Note: Personal property taxes on the machine for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred. Brief Exercise 10-2 Capitalized cost of land: Purchase price $600,000 Broker’s commission 30,000 Title insurance 3,000 Miscellaneous closing costs 6,000 Demolition of old building 18,000 Total cost $657,000 All of the expenditures, including the costs to demolish the old building, are included in the initial cost of the land. Brief Exercise 10-3 BRIEF EXERCISES 6 Cost of land and building: Purchase price $600,000 Broker’s commission 30,000 Title insurance 3,000 Miscellaneous closing costs 6,000 Total cost $639,000 The total must be allocated to the land and building based on their relative market values: Asset Market Value Percent of Total Market Value Initial Valuation (Percent x $639,000) Land $420,000 60% $383,400 Building 280,000 40 255,600 $700,000 100% $639,000 Brief Exercise 10-4 Cost of silver mine: Acquisition, exploration, and development $5,600,000 Restoration costs 429,675 † $6,029,675 † $500,000 x 20% = $100,000 550,000 x 45% = 247,500 650,000 x 35% = 227,500 $575,000 x .74726* = $429,675 *Present value of $1, n = 5, i = 6% (from Table 2) Brief Exercise 10-5 7 After one year, the liability will increase to $455,456. ($429,675† + ($429,675 x 6%) = $455,456) † $500,000 x 20% = $100,000 550,000 x 45% = 247,500 650,000 x 35% = 227,500 $575,000 x .74726* = $429,675 *Present value of $1, n = 5, i = 6% (from Table 2) Actual restoration costs $596,000 Less: Asset retirement liability (575,000) Loss on retirement $ (21,000) Brief Exercise 10-6 Calculation of goodwill: Purchase price $14,000,000 Less fair value of net assets: Book value of assets $8,300,000 Plus: Excess of fair value over book value of intangible assets 2,500,000 (10,800,000) Goodwill $ 3,200,000 Brief Exercise 10-7 The initial value of machinery and note will be the present value of the note payment: PV = $60,000 (.85734* ) = $51,440 8 * Present value of $1: n = 2, i = 8% (from Table 2) Interest expense for 2006: $51,440 x 8% x 6/12 = $2,058 Brief Exercise 10-8 The cost of the patent equals the market value of the stock given in exchange: 50,000 x $22 = $1,100,000 Brief Exercise 10-9 Average PP&E for 2006 = ($740,000 + 940,000) ÷ 2 = $840,000 Net sales ÷ Average PP&E = Fixed-asset turnover ratio ? ÷ $840,000 = 3.25 Average PP&E x Fixed-asset turnover ratio = Net sales $840,000 x 3.25 = $2,730,000 Brief Exercise 10-10 Proceeds $16,000 Less book value: $80,000 (71,000) 9,000 Gain on sale of equipment $ 7,000 Journal entry (not required): 9 Cash ................................................................................ 16,000 Accumulated depreciation (account balance) .................... 71,000 Gain (difference) ........................................................... 7,000 Equipment (account balance) .......................................... 80,000 Brief Exercise 10-11 Pickup trucks = Fair value of machinery less cash received $17,000 – 8,000 = $9,000 Loss on exchange = $20,000 (book value) – 17,000 (fair value) = $3,000 Journal entry (not required): Cash ................................................................................ 8,000 Pickup trucks (determined above) ...................................... 9,000 Accumulated depreciation (account balance) .................... 45,000 Loss (difference) ................................................................ 3,000 Machinery (account balance) .......................................... 65,000 10 Brief Exercise 10-12 Pickup trucks = Fair value of machinery less cash received $24,000 – 8,000 = $16,000 Gain on exchange = $24,000 (fair value) – 20,000 (book value ) = $4,000 Journal entry (not required): Cash ................................................................................ 8,000 Pickup trucks (determined above) ...................................... 16,000 Accumulated depreciation (account balance) .................... 45,000 Gain (difference) ........................................................... 4,000 Machinery (account balance) .......................................... 65,000 Brief Exercise 10-13 Pickup trucks = Book value of machinery less cash received $20,000 – 8,000 = $12,000 No gain is recognized in this situation. Journal entry (not required): Cash ................................................................................ 8,000 Pickup trucks (determined above) ...................................... 12,000 Accumulated depreciation (account balance) .................... 45,000 Machinery (account balance) .......................................... 65,000 11 Brief Exercise 10-14 Average accumulated expenditures: January 2, 2006 $500,000 x 12/12 = $ 500,000 March 31, 2006 600,000 x 9/12 = 450,000 June 30, 2006 400,000 x 6/12 = 200,000 October 30, 2006 600,000 x 2/12 = 100,000 $1,250,000 Interest capitalized: $1,250,000 - 700,000 x 7% = $49,000 $ 550,000 x 6.75%* = 37,125 $ 86,125 = interest capitalized * Weighted-average rate of all other debt: $3,000,000 x 8% = $240,000 5,000,000 x 6% = 300,000 $8,000,000 $540,000 $540,000 = 6.75% weighted average $8,000,000 12 Brief Exercise 10-15 Average accumulated expenditures: January 2, 2006 $500,000 x 12/12 = $ 500,000 March 31, 2006 600,000 x 9/12 = 450,000 June 30, 2006 400,000 x 6/12 = 200,000 October 30, 2006 600,000 x 2/12 = 100,000 $1,250,000 Interest capitalized: $1,250,000 x 6.77%* = $84,625 * Weighted-average rate of all other debt: $ 700,000 x 7% = $ 49,000 3,000,000 x 8% = 240,000 5,000,000 x 6% = 300,000 $8,700,000 $589,000 $589,000 = 6.77% weighted average $8,700,000 Brief Exercise 10-16 Research and development: Salaries $220,000 Depreciation on R & D facilities and equipment 125,000 Utilities and other direct costs 66,000 Payment to another company 120,000 Total R & D expense $531,000 Note: The patent filing and related legal costs and the costs of adapting the product to a particular customer’s needs are not included as research and development expense. 13 Exercise 10-1 Capitalized cost of land: Purchase price $60,000 Demolition of old building $4,000 Less: Sale of materials (2,000) 2,000 Legal fees for title investigation 2,000 Total cost of land $64,000 Capitalized cost of building: Construction costs $500,000 Architect's fees 12,000 Interest on construction loan 5,000 Total cost of building $517,000 Note: Property taxes on the land for the period after acquisition are not part of acquisition cost. They are expensed in the period incurred. Exercise 10-2 To record the purchase of a machine. Machine ($45,000 + + 2,200 + 700 + 1,000) ......................... 48,900 Accounts payable ........................................................ 47,200 Cash ............................................................................ 1,700 To record prepaid insurance for the machine. Prepaid insurance ............................................................ 900 Cash ............................................................................ 900 EXERCISES 14 Exercise 10-3 Requirement 1 Cost of copper mine: Mining site $1,000,000 Development costs 600,000 Restoration costs 303,939 † $1,903,939 † $300,000 x 25% = $ 75,000 400,000 x 40% = 160,000 600,000 x 35% = 210,000 $445,000 x .68301* = $303,939 *Present value of $1, n = 4, i = 10% Requirement 2 Copper mine (determined above) ..................................... 1,903,939 Cash ($1,000,000 + 600,000) ........................................ 1,600,000 Asset retirement liability (determined above) ............. 303,939 Equipment (cost) ........................................................... 120,000 Cash ......................................................................... 120,000 15 Exercise 10-4 Organization cost expense ($12,000 + 3,000) .................... 15,000 Patent ($20,000 + 2,000) .................................................... 22,000 Pre-opening expenses .................................................... 40,000 Furniture ......................................................................... 30,000 Cash ............................................................................ 107,000 Exercise 10-5 Calculation of goodwill: Purchase price $17,000,000 Less fair value of net assets: Assets $23,000,000 Less: Liabilities assumed (9,500,000) (13,500,000) Goodwill $ 3,500,000 Exercise 10-6 Calculation of goodwill: Purchase price $11,000,000 Less fair value of net assets: Book value of net assets $7,800,000 Plus: Fair value in excess of book value: Property, plant, and equipment 1,400,000 Intangible assets 1,000,000 Less: Book value in excess of fair value: Receivables (200,000) 10,000,000 Goodwill $ 1,000,000 16 Exercise 10-7 1. a 2. d 3. c Exercise 10-8 Asset Market Value Percent of Total Market Value Initial Valuation (Percent x $900,000) Land ................ $ 300,000 30% $270,000 Building A ....... 450,000 45 405,000 Building B ....... 250,000 25 225,000 $1,000,000 100% $900,000 17 Exercise 10-9 Requirement 1 Tractor ($5,000 cash + 18,783† present value of note) ............. 23,783 Discount on note payable (difference) ............................. 6,217 Cash ............................................................................ 5,000 Note payable (face amount) ........................................... 25,000 † Present value of note payment: PV = $25,000 (.75131* ) = $18,783 * Present value of $1: n = 3, i = 10% (from Table 2) Requirement 2 2006: Interest expense ($18,783 x 10%) = $1,878 2007: Interest expense [($18,783 + 1,878) x 10%] = 2,066 Requirement 3 2006: $25,000 – ($6,217 – 1,878) = $20,661 2007: $25,000 – ($6,217 – 1,878 – 2,066) = 22,727 18 Exercise 10-10 To record the acquisition of land in exchange for common stock. February 1, 2006 Land ................................................................................ 90,000 Common stock (5,000 shares x $18) ............................... 90,000 To record the acquisition of a building through purchase and donation. November 2, 2006 Building .......................................................................... 600,000 Cash ........................................................................... 400,000 Revenue - donation of asset (difference) ....................... 200,000 Exercise 10-11 Requirement 1 ($ in millions) Average PP&E for 2004 = ($15,768 + 16,661) ÷ 2 = $16,214.5 Net sales ÷ Average PP&E = Fixed-asset turnover ratio $34,209 ÷ $16,214.5 = 2.11 Requirement 2 The fixed-asset turnover ratio indicates the level of sales generated by the company’s investment in fixed assets. Intel is able to generate $2.11 in sales for every $1 invested in property, plant, and equipment. 19 Exercise 10-12 Requirement 1 Cash ................................................................................ 3,000 Accumulated depreciation - tractor (balance)................... 26,000 Loss on sale of tractor (difference) ................................... 1,000 Tractor (balance) ........................................................... 30,000 Requirement 2 Cash ................................................................................ 10,000 Accumulated depreciation - tractor (balance)................... 26,000 Tractor (balance) ........................................................... 30,000 Gain on sale of tractor (difference) ............................... 6,000 Exercise 10-13 Equipment - new ($200,000 + 60,000) ............................... 260,000 Accumulated depreciation (balance) ................................ 220,000 Cash ............................................................................ 60,000 Equipment - old (balance) ............................................ 400,000 Gain ($200,000 - 180,000) .............................................. 20,000 20 Exercise 10-14 Equipment - new ($170,000 + 60,000) ................................ 230,000 Loss ($180,000 - 170,000) ................................................... 10,000 Accumulated depreciation (balance) ................................ 220,000 Cash ............................................................................ 60,000 Equipment - old (balance) ............................................ 400,000 21 Exercise 10-15 Requirement 1 Fair value of land + Cash given = Fair value of patent $150,000 + 10,000 = $160,000 Requirement 2 Patent ($150,000 + 10,000) ................................................. 160,000 Cash ............................................................................ 10,000 Land (book value) .......................................................... 120,000 Gain ($150,000 - 120,000) ............................................... 30,000 Exercise 10-16 Requirement 1 Fair value of land - Cash received = Fair value of patent $150,000 - 10,000 = $140,000 Requirement 2 Patent ($150,000 - 10,000) .................................................. 140,000 Cash ................................................................................ 10,000 Land (book value) .......................................................... 120,000 Gain ($150,000 - 120,000) .............................................. 30,000 22 Exercise 10-17 Requirement 1 Fair value of old land + Cash given = Fair value of new land $72,000 + 14,000 = $86,000 Requirement 2 Land–new ($72,000 + 14,000) ............................................ 86,000 Cash ............................................................................ 14,000 Land - old (book value) ................................................. 30,000 Gain ($72,000 – 30,000) ................................................. 42,000 Requirement 3 Land–new ($30,000 + 14,000) ............................................ 44,000 Cash ............................................................................ 14,000 Land - old (book value) ................................................. 30,000 23 Exercise 10-18 1. To record the purchase of equipment on account. Equipment ($25,000 x 98%) ............................................... 24,500 Accounts payable ........................................................ 24,500 2. To record the acquisition of equipment in exchange for a note. Equipment (determined below) ........................................... 24,545 Discount on note payable (difference) .............................. 2,455 Note payable (face amount) ........................................... 27,000 PV = $27,000 (.90909* ) = $24,545 * Present value of $1: n=1, i=10% (from Table 2) 3. To record the exchange of old equipment for new equipment. Equipment - new ($2,500 + 22,000) ................................... 24,500 Loss ($6,000 - 2,500) ......................................................... 3,500 Accumulated depreciation ............................................. 8,000 Cash ............................................................................ 22,000 Equipment - old .......................................................... 14,000 4. To record the acquisition of equipment by the issuance of stock. Equipment ....................................................................... 24,000 Common stock ............................................................ 24,000 24 Exercise 10-19 Average accumulated expenditures: $6,000,000 = $3,000,000 2 Interest capitalized: $3,000,000 - 1,500,000 x 10% = $150,000 1,500,000 x 7%* = 105,000 $255,000 = interest capitalized * Weighted-average rate of all other debt: $2,000,000 x 9% = $180,000 4,000,000 x 6% = 240,000 $6,000,000 $420,000 $420,000 = 7% $6,000,000 Exercise 10-20 Average accumulated expenditures for 2006: January 2, 2006 $500,000 x 12/12 = $ 500,000 March 1, 2006 600,000 x 10/12 = 500,000 July 31, 2006 480,000 x 5/12 = 200,000 September 30, 2006 600,000 x 3/12 = 150,000 December 31, 2006 300,000 x 0/12 = - 0 - $1,350,000 Interest capitalized: $1,350,000 x 8% = $108,000 25 Exercise 10-21 Average accumulated expenditures for 2006: January 2, 2006 $ 600,000 x 12/12 = $ 600,000 March 31, 2006 1,200,000 x 9/12 = 900,000 June 30, 2006 800,000 x 6/12 = 400,000 September 30, 2006 600,000 x 3/12 = 150,000 December 31, 2006 400,000 x 0/12 = - 0 - $2,050,000 Interest capitalized: $2,050,000 - 1,500,000 x 8.0% = $120,000 550,000 x 10.5%* = 57,750 $177,750 = interest capitalized * Weighted-average rate of all other debt: $5,000,000 x 12% = $600,000 3,000,000 x 8% = 240,000 $8,000,000 $840,000 $840,000 = 10.5% $8,000,000 26 Exercise 10-22 To expense R&D costs incorrectly capitalized. Research and development expense (below) .................... 3,180,000 Patent .......................................................................... 3,180,000 Research and development expenditures: Basic research to develop the technology $2,000,000 Engineering design work 680,000 Development of a prototype 300,000 Testing and modification of the prototype 200,000 Total $3,180,000 To capitalize cost of equipment incorrectly capitalized as patent. Equipment ....................................................................... 60,000 Patent .......................................................................... 60,000 To record depreciation on equipment used in R&D projects. Research and development expense ............................... 10,000 Accumulated depreciation - equipment ...................... 10,000 27 Exercise 10-23 Research and development expense: Salaries and wages for lab research $ 400,000 Materials used in R&D projects 200,000 Fees paid to outsiders for R&D projects 320,000 Depreciation on R&D equipment 120,000 Total $1,040,000 The patent filing and legal costs are capitalized as the cost of the patent. The salaries, wages, and supplies for R&D performed for another company are included as inventory and expensed as cost of goods sold using either the completed contract or percentage-of-completion method. Exercise 10-24 1. a 2. d 3. d 4. b 28 Exercise 10-25 List A List B f 1. Depreciation a. Exclusive right to display a word, a symbol, or an emblem. d 2. Depletion b. Exclusive right to benefit from a creative work. i 3. Amortization c. Operational assets that represent rights. g 4. Average accumulated d. The allocation of cost for natural resources. expenditures h 5. Revenue - donation of asset e. Purchase price less fair market value of net identifiable assets. j 6. Nonmonetary exchange f. The allocation of cost for plant and equipment. k 7. Natural resources g. Approximation of average amount of debt if all construction funds were borrowed. c 8. Intangible assets h. Account credited when assets are donated to a corporation. b 9. Copyright i. The allocation of cost for intangible assets. a 10. Trademark j. Basic principle is to value assets acquired using fair value of assets given. e 11. Goodwill k. Wasting assets. 29 Exercise 10-26 Requirement 1 ($ in millions) Research and development expense ............................... 4 Software development costs ........................................... 2 Cash ............................................................................ 6 Requirement 2 (1) Percentage-of-revenue method: $4,000,000 = 40% x $2,000,000 = $800,000 $10,000,000 (2) Straight-line method: 1/5 or 20 % x $2,000,000 = $400,000. The percentage-of-revenue method is used since it produces the greater amortization, $800,000. Requirement 3 Software development costs $2,000,000 Less: Amortization to date (800,000) Net $1,200,000 30 Exercise 10-27 1. a. The costs of fixed assets (plant and equipment) are all costs necessary to acquire these assets and to bring them to the condition and location required for their intended use. These costs include shipping, installation, pre-use testing, sales taxes, interest, capitalization, etc. The original cost of the machinery to be recorded in the books is the sum of the purchase price, installation, and delivery charges. 2. d. SFAS No. 153, Exchanges of Nonmonetary Assets – an amendment of APB Opinion No. 29, states that the basic principle to be followed in these exchanges is to value the asset received at fair value and to recognize gain or loss (the difference between the fair value and the book value of the asset given up). Harper’s used machine has a book value of $64,000 ($162,500 cost - $98,500 accumulated depreciation). The fair value of the used machine is $80,000 resulting in a gain of $16,000 ($80,000 – 64,000). The only exceptions to using fair value are (1) when fair value is not determinable and (2) when the exchange lacks commercial substance. In these cases, book value is used to value the new asset and the gain would not be recognized. 3. c. The answer is the same as question 2. 31 Exercise 10-28 Requirement 1 Oil wells ......................................................................... 450,000 Cash ............................................................................ 450,000 Requirement 2 Oil wells ($50,000 + 60,000 + 80,000) ................................. 190,000 Exploration expense ........................................................ 260,000 Cash ............................................................................ 450,000 32 Problem 10-1 1. To record the acquisition of land and building. Land (determined below) ........................................................................ 62,500 Building (determined below) .............................................. 37,500 Cash ............................................................................ 100,000 Asset Market Value Percent of Total Market Value Initial Valuation (Percent x $100,000) Land $ 75,000 62.5% $ 62,500 Building 45,000 37.5 37,500 $120,000 100.0% $100,000 2. To record the acquisition of equipment for cash and a note. Equipment (determined below) ........................................... 37,037 Discount on note payable (difference) .............................. 2,963 Note payable (face amount) ........................................... 40,000 Present value of note payments: PV = $40,000 (.92593* ) = $37,037 * Present value of $1: n = 1, i=8% (from Table 2) 3. To record the acquisition of a truck by donation. Truck ............................................................................... 2,500 Revenue - donation of asset ........................................ 2,500 PROBLEMS 33 Problem 10-1 (concluded) 4. To capitalize organization costs. Organization cost expense .............................................. 3,000 Cash ............................................................................ 3,000 5. To record the purchase of machinery. Machinery ($15,000 + 500) ................................................ 15,500 Cash ............................................................................ 15,500 6. To record the acquisition of office equipment by the issuance of common stock. Office equipment ............................................................ 5,500 Common stock ............................................................ 5,500 7. To record the acquisition of land in exchange for cash and a note. Land ................................................................................ 20,000 Cash ............................................................................ 2,000 Note payable ............................................................... 18,000 34 Problem 10-2 Requirement 1 Blackstone Corporation LAND ACCOUNT (Site Number 11) As of September 30, 2007 Acquisition cost $600,000 Real estate broker’s commission 36,000 Legal fees 6,000 Title insurance 18,000 Cost of razing existing building 75,000 Balance, September 30, 2007 $735,000 Requirement 2 Blackstone Corporation CAPITALIZED COST OF OFFICE BUILDING As of September 30, 2007 Contract cost $3,000,000 Plans, specifications, and blueprints 12,000 Architects’ fees for design and supervision 95,000 Capitalized interest for 2006: $900,000 x 14% x 10/12 105,000 Capitalized interest for 2007: $2,300,000 x 14% x 9/12 241,500 Total capitalized cost, September 30, 2007 $3,453,500 35 Problem 10-3 Requirement 1 Pell Corporation ANALYSIS OF CHANGES IN PLANT ASSETS For the Year Ended December 31, 2006 Balance Balance 12/31/05 Increase Decrease 12/31/06 Land $ 350,000 $438,000 [1] $ 788,000 Land improvements 180,000 180,000 Building 1,500,000 1,500,000 Machinery and equipment 1,158,000 287,000 [2] $58,000 1,387,000 Automobiles 150,000 19,000 [3] 18,000 151,000 Totals $3,338,000 $744,000 $76,000 $4,006,000 Explanation of Amounts: [1] Cost of land acquired 11/1/06: Pell stock exchanged (10,000 shares x $38) $380,000 Legal fees and title insurance 23,000 Razing existing building 35,000 $438,000 [2] Cost of machinery and equipment purchased 1/2/06: Invoice cost $260,000 Installation cost 27,000 $287,000 [3] Cost recorded for new automobile 12/31/06: Market value of trade-in $ 3,750 Cash paid 15,250 $ 19,000 36 Problem 10-3 (concluded) Requirement 2 Pell Corporation GAIN OR LOSS FROM PLANT ASSET DISPOSALS For the Year Ended December 31, 2006 Sale of machine on 3/31/06: Selling price $36,500 Less: Book value of machine ($58,000 - 24,650) (33,350) Gain on sale of machine $ 3,150 Trade-in of automobile on 12/31/06: Book value of trade-in ($18,000 - 13,500) $ 4,500 Less: Market value of trade-in (3,750) Loss on trade-in $ 750 37 Problem 10-4 To reclassify various expenditures incorrectly charged to the intangible asset account. Organization cost expense .............................................. 7,000 Prepaid insurance ............................................................ 6,000 Copyright ........................................................................ 20,000 Research and development expense ............................... 40,000 Patent ($3,000 + 12,000) ..................................................... 15,000 Franchise ......................................................................... 40,000 Advertising expense ........................................................ 16,000 Intangible asset ........................................................... 144,000 To reclassify amount paid for Stiltz Corp. incorrectly charged to the intangible asset account. Receivables ..................................................................... 100,000 Equipment ....................................................................... 350,000 Patent .............................................................................. 150,000 Goodwill (determined below) ............................................. 120,000 Note payable ............................................................... 220,000 Intangible asset ........................................................... 500,000 Calculation of goodwill: Purchase price $500,000 Less: Market value of net assets (380,000) Goodwill $120,000 38 Problem 10-5 1. To expense R&D costs. Research and development expense ............................... 12,000 Cash ............................................................................ 12,000 2. To expense legal fees for unsuccessful defense of patent. Legal fees expense .......................................................... 7,500 Cash ............................................................................ 7,500 3. To capitalize the cost of equipment. Equipment (cash price) ...................................................... 23,000 Discount on note payable (difference) .............................. 1,000 Cash (amount paid) ........................................................ 6,000 Note payable (face amount) ........................................... 18,000 4. To capitalize cost of the sprinkler system. Building - sprinkler system ............................................. 28,000 Cash ............................................................................ 28,000 5. To capitalize legal fees for successful defense of patent. Patent .............................................................................. 12,000 Cash ............................................................................ 12,000 39 Problem 10-5 (concluded) 6. To record the trade-in of an old machine for a new machine. Machine - new ($2,000* + 8,000) ....................................... 10,000 Accumulated depreciation - machine ($7,400 - 3,000) ...... 4,400 Loss on trade-in ($3,000 – 2,000*) ..................................... 1,000 Cash ............................................................................ 8,000 Machine - old .............................................................. 7,400 *Fair value of old machine (Fair value of new machine - Cash given): $10,000 - 8,000 = $2,000 40 Problem 10-6 Southern Company: Cash ................................................................................ 140,000 Building - new ($1,400,000 - 140,000) ................................ 1,260,000 Accumulated depreciation - building (balance) ................ 1,200,000 Building - old (balance) ................................................ 2,000,000 Gain ($1,400,000 – 800,000) ........................................... 600,000 Eastern Company: The fair value of Eastern’s building is $1,260,000 ($1,400,000 fair value of Southern’s building less $140,000 cash given). Building - new ($1,260,000 + 140,000) ............................... 1,400,000 Accumulated depreciation - building (balance) ................ 650,000 Cash ............................................................................ 140,000 Building - old (balance) ................................................ 1,600,000 Gain on exchange of buildings ($1,260,000 – 950,000) .. 310,000 41 Problem 10-7 Robers: Cash ................................................................................ 5,000 New asset ($75,000 - 5,000)................................................ 70,000 Accumulated depreciation - old asset (balance) ............... 55,000 Old asset (balance) ........................................................ 120,000 Gain on exchange of assets ($75,000 – 65,000) ............. 10,000 Phifer: New asset ($70,000 + 5,000) .............................................. 75,000 Accumulated depreciation - old asset (balance) ............... 63,000 Loss ($77,000 – 70,000) .............................................................. 7,000 Cash ............................................................................ 5,000 Old asset (balance) ........................................................ 140,000 42 Problem 10-8 Requirement 1 2006: Expenditures for 2006: January 3, 2006 $1,000,000 x 12/12 = $1,000,000 March 1, 2006 600,000 x 10/12 = 500,000 June 30, 2006 800,000 x 6/12 = 400,000 October 1, 2006 600,000 x 3/12 = 150,000 Accumulated expenditures (before interest) - $3,000,000 Average accumulated expenditures - $2,050,000 Interest capitalized: $2,050,000 x 10% = $205,000 = Interest capitalized in 2006 2007: January 1, 2007 ($3,000,000 + 205,000) $3,205,000 x 9/9 = $3,205,000 January 31, 2007 270,000 x 8/9 = 240,000 April 30, 2007 585,000 x 5/9 = 325,000 August 31, 2007 900,000 x 1/9 = 100,000 Accumulated expenditures (before interest) - $4,960,000 Average accumulated expenditures - $3,870,000 Interest capitalized: $3,870,000 - 3,000,000 x 10.0% x 9/12 = $225,000 870,000 x 7.2%* x 9/12 = 46,980 $271,980 = Interest capitalized in 2007 * Weighted-average rate of all other debt: $ 4,000,000 x 6% = $240,000 $720,000 6,000,000 x 8% = 480,000 = 7.2% $10,000,000 $720,000 $10,000,000 43 Problem 10-8 (concluded) Requirement 2 Accumulated expenditures 9/30/07 before interest capitalization (above) $4,960,000 2007 interest capitalized (above) 271,980 Total cost of building $5,231,980 Requirement 3 2006 $3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 6,000,000 x 8% = 480,000 Total interest incurred 1,020,000 Less: Interest capitalized (205,000) 2006 interest expense $ 815,000 2007 Total interest incurred $1,020,000 Less: Interest capitalized (271,980) 2007 interest expense $ 748,020 44 Problem 10-9 Requirement 1 2006 Expenditures for 2006 January 3, 2006 1,000,000 x 12/12 = $1,000,000 March 1, 2006 600,000 x 10/12 = 500,000 June 30, 2006 800,000 x 6/12 = 400,000 October 1, 2006 600,000 x 3/12 = 150,000 Accumulated expenditures (before interest) — $3,000,000 Average accumulated expenditures - $2,050,000 Interest capitalized: $2,050,000 x 7.85%* = $160,925 = Interest capitalized in 2006 * Weighted-average rate of all debt: $ 3,000,000 x 10% = $ 300,000 $1,020,000 4,000,000 x 6% = 240,000 = 7.85% (rounded) 6,000,000 x 8% = 480,000 $13,000,000 $13,000,000 $1,020,000 2007: January 1, 2007 ($3,000,000 + 160,925) $3,160,925 x 9/9 = $3,160,925 January 31, 2007 270,000 x 8/9 = 240,000 April 30, 2007 585,000 x 5/9 = 325,000 August 31, 2007 900,000 x 1/9 = 100,000 Accumulated expenditures (before interest) — $4,915,925 Average accumulated expenditures - $3,825,925 Interest capitalized: $3,825,925 x 7.85% x 9/12 =$225,251 = Interest capitalized in 2007 45 Problem 10-9 (concluded) Requirement 2 Accumulated expenditures 9/30/07, before interest capitalization (above) $4,915,925 2007 interest capitalized (above) 225,251 Total cost of building $5,141,176 Requirement 3 2006: $3,000,000 x 10% = $ 300,000 4,000,000 x 6% = 240,000 6,000,000 x 8% = 480,000 Total interest incurred 1,020,000 Less: Interest capitalized (160,925) 2006 interest expense $ 859,075 2007: Total interest incurred $1,020,000 Less: Interest capitalized (225,251) 2007 interest expense $ 794,749 46 Problem 10-10 To capitalize the cost of equipment to be used on future projects incorrectly charged to R&D expense. Equipment ....................................................................... 400,000 Research and development expense ........................... 400,000 To record depreciation on equipment used in R&D projects. $400,000 ÷ 5 years = $80,000 Research and development expense ............................... 80,000 Accumulated depreciation - equipment ...................... 80,000 To capitalize filing and legal fees for patent incorrectly charged to R&D expense. Patent .............................................................................. 40,000 Research and development expense ........................... 40,000 To reclassify the expenditures made for quality control during commercial production. Inventory* ....................................................................... 20,000 Research and development expense ........................... 20,000 *Quality control costs would either be treated as manufacturing overhead and included in the cost of inventory (as in this journal entry), or expensed in the period incurred. 47 Judgment Case 10-1 Requirement 1 All costs necessary to bring the land to its condition for use should be capitalized as the cost of the land. This should include the following costs : Purchase price. Title insurance. Escrow fees. Delinquent property taxes. Cost of removing old building. Cost of grading and other land preparation costs. Requirement 2 Assets acquired in exchange for deferred payment contracts are valued at their fair market value or the present value of payments using a realistic interest rate. Requirement 3 In general, operational assets received in exchange for other nonmonetary assets should be valued at the fair value of the nonmonetary assets given up plus (minus) monetary consideration given (received). There are certain exceptions when the assets received are valued at the book value of the nonmonetary assets given up plus (minus) monetary consideration given (received). The new machine acquired by exchanging an older, similar machine generally would be valued at the fair value of the old machine plus (minus) any cash given (received). However, if fair value cannot be determined or if the exchange lacks commercial substance, then the new machine would be valued at the book value of the old machine plus (minus) any cash given (received). CASES 48 Research Case 10-2 Requirement 1 SFAS No. 143, “Accounting for Asset Retirement Obligations,” requires that an existing legal obligation associated with the retirement of a tangible, long-lived asset be recognized as a liability and measured at fair value. When the liability is credited, the offsetting debit is to the related operational asset. Usually, the fair value is estimated by calculating the present value of estimated future cash outflows. Traditionally, the way uncertainty has been considered in present value calculations has been by discounting the “best estimate” of future cash flows applying a discount rate that has been adjusted to reflect the uncertainty or risk of those cash flows. That's not the approach taken here. Instead, we follow the approach described in the FASB’s Concept Statement No. 7 which is to adjust the cash flows, not the discount rate, for the uncertainty or risk of those cash flows. This expected cash flow approach incorporates specific probabilities of cash flows into the analysis. We use a discount rate equal to the credit-adjusted risk free rate. The higher a company’s credit risk, the higher will be the discount rate. Requirement 2 The cost of the coal mine is $24,513,419 determined as follows: Mining site $15,000,000 Development costs 6,000,000 Restoration costs 3,513,419 † $24,513,419 † $3 million x 20% = $ 600,000 4 million x 30% = 1,200,000 5 million x 25% = 1,250,000 6 million x 25% = 1,500,000 $4,550,000 x .77218* = $3,513,419 *Present value of $1, n = 3, i = 9% Requirement 3 Coal mine (determined above) ......................................... 24,513,419 Cash ($15,000,000 + 6,000,000) ................................... 21,000,000 49 Asset retirement liability (determined above) ............. 3,513,419 50 Case 10-2 (concluded) Requirement 4 $3,513,419 x 9% = $316,208 x 6/12 = $158,104 Requirement 5 If the actual restoration costs are more (less) than the recorded liability at the retirement date, a loss (gain) on retirement of the obligation is recognized for the difference. Asset retirement liability (maturity amount) ................... 4,550,000 Loss (difference) ............................................................. 150,000 Cash ........................................................................ 4,700,000 Requirement 6 An entity shall disclose the following information about its asset retirement obligations: a. A general description of the asset retirement obligations and the associated long-lived assets. b. The fair value of assets that are legally restricted for purposes of settling asset retirement obligations. c. A reconciliation of the beginning and ending aggregate carrying amount (book value) of asset retirement obligations showing separately the changes attributable to (1) liabilities incurred in the current period, (2) liabilities settled in the current period, (3) accretion expense (interest expense), and (4) revisions in estimated cash flows, whenever there is a significant change in one or more of those four components during the reporting period. If the fair value of an asset retirement obligation cannot be reasonably estimated, that fact and the reasons therefor shall be disclosed. 51 Judgment Case 10-3 Requirement 1 The cost of a self-constructed asset includes identifiable materials and labor and a portion of the company's manufacturing overhead costs. Requirement 2 The treatment of manufacturing overhead cost and its allocation between construction projects and normal production is a difficult issue. One alternative is to include only the incremental overhead costs in the total cost of construction. That is, only those additional costs that are incurred because of the decision to construct the asset should be added to the cost of the asset. This would exclude such indirect costs as depreciation and the salaries of supervisors that would be incurred whether or not the construction project is undertaken. If, however, a new construction supervisor were hired specifically to work on the project, then that salary would be included in asset cost. A second alternative is to assign overhead on the same basis that is used for the regular manufacturing process. For example, all overhead costs might be allocated both to production and to self-constructed assets based on the relative amount of labor hours incurred. This is known as the full-cost approach and is the generally accepted method used to determine the cost of a self-constructed asset. Requirement 3 Generally accepted accounting principles provide specific guidelines for the treatment of interest costs incurred during construction. These guidelines pertain to the construction of assets for a company’s own use as well as for assets constructed for sale or lease. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Only assets that are constructed as discrete projects qualify for interest capitalization. The construction of equipment by the Chilton Company appears to qualify for interest capitalization. The cost of the equipment would include interest if, during the construction period, interest costs were actually being incurred. 52 Judgment Case 10-4 Requirement 1 Only assets that are constructed as discrete projects qualify for interest capitalization. Assets qualifying for capitalization exclude inventories that are routinely manufactured in large quantities on a repetitive basis and assets that are in use or ready for their intended purpose. Requirement 2 The capitalization period for a self-constructed asset starts when (1) expenditures (materials, labor and overhead) have been made and (2) interest cost is being incurred. The interest cost incurred does not have to pertain to specific borrowings related to the construction project. The capitalization period ends either when the asset is substantially complete and ready for use or when interest costs are no longer incurred. Requirement 3 Average accumulated expenditures is an approximation of the average amount of debt that the company would have had outstanding during the period if every dollar spent on the project was borrowed. If construction expenditures are incurred equally throughout the period, the average accumulated expenditures for the period can be estimated by adding the accumulated expenditures at the beginning of the period to the accumulated expenditures at the end of the period and dividing by two. If expenditures on the project are unequal throughout the period, individual expenditures, perhaps expenditures grouped by month, should be weighted by the amount of time outstanding until the end of the construction period or the end of the company’s fiscal year, whichever comes first. Requirement 4 One method that could be used to determine the appropriate interest rate(s) to be used in capitalizing interest is the specific interest method. If debt financing has been obtained specifically for the construction project, its interest rate is applied to the average accumulated expenditures up to the amount of the specific borrowing. Any remaining average accumulated expenditures in excess of specific borrowings is multiplied by the weighted-average rate on all other outstanding interest-bearing debt. Sometimes it is difficult to associate specific borrowings with projects. In these situations, it is easier to just use the weighted-average rate on all interest- bearing debt, including all construction loans. This is the weighted-average method. 53 Case 10-4 (concluded) Requirement 5 The three steps used to determine the amount of interest capitalized during a period are: 1. Determine the average accumulated expenditures for the period. 2. Multiply average accumulated expenditures by the appropriate interest rate(s). 3. Compare interest capitalized with total interest cost incurred. Interest capitalized can’t exceed interest cost incurred. Research Case 10-5 (Note: This case requires the student to reference a journal article.] Requirement 2 The FASB has tentatively decided that purchased goodwill does meet the criteria in Concepts Statement 5 for initial recognition as an asset. Goodwill does represent “future economic benefits” that are in the “control” of the enterprise and that have arisen from a “past transaction or event.” Requirement 3 Some believe that goodwill is not an asset because of concerns about 1) equating costs and assets, 2) exchangeability of goodwill, and 3) controllability. 54 Real World Case 10-6 ($ in millions) Decrease in property, plant and equipment, net ($6,097 – 6,091) $(6) Decrease in intangible assets, net ($981 – 702) (279) Net decrease (285) Add: Depreciation and amortization for the year 893 Less: Additions to property, plant and equipment (755) Book value of equipment sold * (147) Proceeds from sale of equipment 341 Gain on sale of equipment $194 *OR, Book value of property, plant and equipment and intangibles, beginning of the year $7,078 Add: additions 755 Less: depreciation and amortization (893) Less: book value of property, plant and equipment and intangibles, end of the year (6,793) Book value of equipment sold $ 147 55 Judgment Case 10-7 Requirement 1 Goodwill represents the unique value of a company as a whole over and above all identifiable tangible and intangible assets. This value results from a company’s clientele and reputation, its trained employees and management team, its unique business location, and any other unique features of the company that can’t be associated with a specific asset. Requirement 2 The controller would be correct in her valuation of goodwill only if the total fair value of all of the identifiable net assets (assets less liabilities) of Georgia, Inc. equals the total book value of Georgia’s net assets ($2,800,000). Goodwill, by definition, is the excess of purchase price over the fair value of net assets, not the book value of net assets. 56 Judgment Case 10-8 Requirement 1 A company undertakes an R&D project because it believes the project will eventually provide benefits that exceed the current expenditures. Unfortunately, though, it’s difficult to predict which individual research and development projects will ultimately provide benefits. In fact, only one in ten actually reach commercial production. Moreover, even for those projects that pan out, a direct relationship between research and development costs and specific future revenue is difficult to establish. In other words, even if R&D costs do lead to future benefits, it’s difficult to objectively determine the size of the benefits and in which periods the costs should be expensed if they are capitalized. These are the issues that prompted the FASB to require immediate expensing. Requirement 2 Possible reasons include: 1. The larger a firm is, the more likely it is to prefer income-reducing accounting methods (e.g., expense R&D). This is particularly true in politically sensitive industries where excessive profits could trigger intervention into a firm's activities by government, unions, and other special interest groups. 2. Large firms may tend to have more R&D activities occurring simultaneously, creating a portfolio effect. That is, the number of successful R&D projects relative to total projects may be fairly stable from year to year in large firms. There may be much more variability in smaller firms creating larger variability in income if R&D is expensed. 3. Earnings-based management compensation schemes may be more prevalent in smaller R&D companies, thus creating a preference for accounting methods that can be more easily manipulated (e.g., capitalize R&D). 4. Smaller companies may be more dependent on debt financing. Debt covenants (contractual limitations on debt) could create a preference for accounting methods that can be more easily manipulated (e.g., capitalize R&D). 57 Judgment Case 10-9 Requirement 1 The costs of research equipment used exclusively for Trouver would be reported as research and development expenses in the period incurred. The costs of research equipment used on both Trouver and future research projects would be capitalized and shown as equipment (less accumulated depreciation) in the balance sheet. An appropriate method of depreciation should be used. Depreciation on capitalized research equipment should be reported as a research and development expense. Requirement 2 a. Matching refers to the process of expense recognition by associating costs with revenues on a cause and effect basis. b. Research and development costs usually are expensed in the period incurred and may not be matched with revenues. This accounting treatment is justified by the high degree of uncertainty regarding the amount and timing of future benefits. A direct relationship between research and development costs and future revenues generally cannot be demonstrated. Requirement 3 Corporate headquarters’ costs allocated to research and development would be classified as general and administrative expenses in the period incurred, because they are not clearly related to research and development activities. Requirement 4 The legal expenses incurred in defending the patent should be capitalized as part of the cost of the intangible asset, patent. 58 Communication Case 10-10 You may wish to suggest to your students that they consult Appendix B of SFAS 2, Basis for Conclusions, which discusses factors deemed significant by members of the FASB in reaching their conclusion, including the various alternatives considered and reasons for accepting some and rejecting others. While SFAS 2 does dictate GAAP in this case, both views, expense and capitalize, can and often are convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than just acceptance of the standard. Each student should benefit from participating in the process, interacting first with his or her partner, and then witnessing or participating in a debate on the issue. It is important that each student actively participate in the process of arriving at a consensus argument. Domination by one individual should be discouraged. Arguments supporting the expense view should include the reasons cited by the FASB as factors they deemed significant in arriving at their conclusion. Arguments supporting the capitalize view should include reference to violations to the matching principle for successful R&D projects. Trueblood Accounting Case 10-11 A solution and extensive discussion materials accompany each case in the Deloitte & Touche Trueblood Case Study Series. 59 Communication Case 10-12 Suggested Grading Concepts and Grading Scheme: Content (70%) _____ 20 Defines research and development according to SFAS 2. _____ 30 Explains the conceptual reasons for the conclusion reached by the FASB on accounting for R&D. ____ High degree of uncertainty regarding the amount and timing of future benefits. ____ Lack of direct relationship between R&D costs and future revenues. _____ 20 Describes the treatment of equipment costs. ____ $200,000 should be expensed as R&D. ____ $300,000 should be capitalized and depreciated. ____ _____ 70 points Writing (30%) _____ 6 Terminology and tone appropriate to the audience of a company president. _____ 12 Organization permits ease of understanding. ____ Introduction that states purpose. ____ Paragraphs that separate main points. _____ 12 English ____ Sentences grammatically clear and well organized, concise. ____ Word selection. ____ Spelling. ____ Grammar and punctuation. ____ _____ 30 points 60 Ethics Case 10-13 Requirement 1 If the equipment is to be used only in the single R&D project (as is likely) the correct treatment is to expense the entire $30 million. If capitalized, only $6 million would be expensed ($30 million divided by 5 years). Therefore, Alice's treatment will increase before tax earnings by $24 million ($30 million - 6 million). Requirement 2 Discussion should include these elements. Ethical Dilemma: Is Alice's responsibility to follow GAAP by expensing the equipment purchase greater than her responsibility to assist the company in seeking new financing? Who is affected? Alice President and other managers Other employees Shareholders Potential shareholders Creditors Company auditors 61 International Case 10-14 Heineken's disclosures indicate significant differences between the Netherlands and the U.S.A. in the valuation of operational assets. The cost of goodwill is capitalized, but, unlike the U.S., it is amortized. In the area of tangible fixed assets, Heineken values these assets at replacement cost. In the U.S.A., operational assets are valued at historical cost. Analysis Case 10-15 Requirement 1 The fixed-asset turnover ratio is computed by dividing net sales by average fixed assets. A ratio of 2.87 for National indicates that they are able to generate $2.87 in net sales for each dollar invested in fixed assets (property, plant, and equipment). Requirement 2 ($ in millions) Book value of PP&E, beginning of 2004 $681 Add: purchases during 2004 215 Deduct: depreciation for 2004 (196) Book value of PP&E, end of 2004 $700 Average PP&E for 2004 = ($681 + 700) ÷ 2 = $690.5 Turnover ratio = Net sales ÷ Average PP&E 2.87 = Net sales ÷ $690.5 Net sales = $1,982 62 Judgment Case 10-16 Requirement 1 Elegant was not correct in its treatment of the software development costs. Generally accepted accounting principles require companies to expense costs incurred to develop computer software to be sold, leased or otherwise marketed as R&D costs until technological feasibility of the product or process has been established. Only those costs incurred after technological feasibility has been attained and before the product is available for general release to customers can be capitalized. Requirement 2 The amortization of capitalized computer software development costs begins with the start of commercial production. The periodic amortization percentage is the greater of (1) the ratio of current revenues to current and anticipated revenues (percentage of revenue method), or (2) the straight-line percentage over the useful life of the asset. Real World Case 10-17 Requirement 3 The following is based on Home Depot's 2004 (year ending January 30, 2004) financial statements. Answers will vary depending on the financial statement dates chosen. a. The company lists land, buildings, furniture, fixtures and equipment, leasehold improvements, construction in progress, and capital leases under Property and equipment. Goodwill (cost in excess of fair value of net assets acquired) is listed as a separate noncurrent asset. b. $3,948 million. c. Note 2 indicates that $40 million of interest was capitalized in fiscal 2004. d. Fixed-asset turnover ratio = Net sales ÷ Average PP&E ($ in millions) = $73,094 = 3.42 $21,394.5* * Average PP&E for 2004 = ($22,726 + 20,063) ÷ 2 = $21,394.5 63 Analysis Case 10-18 Requirement 1 Under the Property and equipment classification, the company lists aircraft and related equipment, package handling and ground support equipment and vehicles, computer and electronic equipment, and other. The intangible asset goodwill is included with Other assets as is a separate category of intangible assets. Requirement 2 Note 1 indicates that the company capitalized interest of $11 million in 2004. Requirement 3 The statement of cash flows reports that $1,271 million cash was used for capital expenditures in 2004. This compares with capital expenditures of $1,511 million in 2003 and $1,615 million in 2002. Requirement 4 The fixed-asset turnover ratio is computed by dividing net sales (revenues) by average fixed assets. Using 2004 data, the ratio for FedEx is 2.79, which is 15% higher than that of United Parcel Service. ($ in millions) $24,710 = 2.79 $8,868.5* * Average plant and equipment for 2004 = ($9,037 + 8,700) ÷ 2 = $8,868.5 The ratio is intended to measure a company's effectiveness in managing property, plant, and equipment. It indicates the level of sales generated by the company's investment in these assets. Like any ratio, it is but one piece of a larger puzzle and should not be interpreted in isolation. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482
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