978-1259722660 Chapter 10 Lecture Note Part 1

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CHAPTER 10

PROPERTY, PLANT, AND EQUIPMENT AND INTANGIBLE ASSETS:

ACQUISITION

Overview

This chapter and the one that follows address the measurement and reporting issues involving

property, plant, and equipment and intangible assets, the tangible and intangible long-lived assets

that are used in the production of goods and services. This chapter covers the valuation at date of

acquisition. In Chapter 11, we discuss the allocation of the cost of property, plant, and equipment and

intangible assets to the periods benefited by their use, the treatment of expenditures made over the

life of these assets to maintain and improve them, impairment, and disposition.

Learning Objectives

LO10–1 Identify the various costs included in the initial cost of property, plant, and equipment,

natural resources, and intangible assets.

LO10–2 Determine the initial cost of individual property, plant, and equipment and intangible assets

acquired as a group for a lump-sum purchase price.

LO10–3 Determine the initial cost of property, plant, and equipment and intangible assets acquired

in exchange for a deferred payment contract.

LO10–4 Determine the initial cost of property, plant, and equipment and intangible assets acquired

in exchange for equity securities or through donation.

LO10–5 Calculate the fixed-asset turnover ratio used by analysts to measure how effectively

managers use property, plant, and equipment.

LO10–6 Determine the initial cost of property, plant, and equipment and intangible assets acquired

in exchange for other nonmonetary assets.

LO10–7 Identify the items included in the cost of a self-constructed asset and determine the amount

of capitalized interest.

LO10–8 Explain the difference in the accounting treatment of costs incurred to purchase intangible

assets versus the costs incurred to internally develop intangible assets.

LO10–9 Discuss the primary differences between U.S. GAAP and IFRS with respect to the

acquisition of property, plant, and equipment and intangible assets.

Lecture Outline

Part A: Valuation at Acquisition

I. Types of Assets

A. For financial reporting purposes, long-lived, revenue-producing assets typically are

classified in two categories:

1. Property, plant, and equipment (including natural resources).

2. Intangible assets.

B. In practice, some companies report intangible assets as part of property, plant, and

equipment, and others include them with the other assets category.

II. Costs to Be Capitalized

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A. Property, plant, and equipment and intangible assets can be acquired through purchase,

exchange, lease, donation, self-construction, or a business combination.

B. The initial cost of an asset includes all necessary costs to bring the asset to its condition

and location for use.

C. Costs are capitalized, rather than expensed, if they are expected to produce benefits

beyond the current period.

D. Property, plant, and equipment can be acquired through purchase.

1. The cost of equipment (machinery, computers and other office equipment, vehicles,

furniture, and fixtures) includes the purchase price plus any sales tax, transportation

costs, expenditures for installation, testing, legal fees to establish title, and any other

cost of bringing the asset to its condition and location for use.

2. The cost of land includes the purchase price plus closing costs such as fees for the

attorney, title and title search, and recording. In addition, any expenditures needed to

prepare the land for its intended use are included as part of the cost of land.

3. The cost of land improvements (parking lots, driveways, private roads, fences, lawns,

and sprinkler systems) must be separated from the cost of land because land has an

indefinite life and land improvements usually do not.

4. The cost of buildings usually includes realtor commissions and legal fees in addition

to the purchase price.

5. The cost of a natural resource includes the acquisition costs for the use of land and

the exploration and development costs incurred before production begins, and

restoration costs incurred during or at the end of extraction.

6. Restoration costs are one example of asset retirement obligations (AROs). An asset

retirement obligation is measured at fair value and is recognized as a liability and

corresponding increase in asset valuation.

7. GAAP recommends the use of the expected cash flow approach when estimating the

fair value of an ARO by calculating the present value of estimated future cash

outflows.

E. Intangible assets generally represent exclusive rights that provide benefits to the owner.

Intangible assets with finite useful lives are amortized; intangible assets with indefinite

useful lives are not amortized.

1. 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.

2. A patent is an exclusive right to manufacture a product or to use a process.

3. A copyright is an exclusive right of protection given to a creator of a published work

such as a song, film, painting, photograph, or book.

4. A trademark, also called tradename, is an exclusive right to display a word, a slogan,

a symbol, or an emblem that distinctively identifies a company, product, or a service.

5. A franchise is a contractual agreement under which the franchisor grants the

franchisee the exclusive right to use the franchisor’s trademark or tradename within a

geographical area usually for a specified period of time.

6. Goodwill is a unique intangible asset in that it can only be purchased through the

acquisition of another company. Goodwill is the excess of the consideration exchanged

(purchase price) over the fair value of the identifiable net assets acquired.

III. Lump-Sum Purchases

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A. If a group of assets that are indistinguishable is acquired for a single sum, valuation is

obvious.

B. However, if the lump-sum purchase involves different assets, the purchase price must be

allocated usually in proportion to the individual assets’ relative market values.

Part B: Noncash Acquisitions

I. Deferred Payments

A. Assets acquired in noncash transactions generally are valued at the fair value of the assets

given or the fair value of the assets received, whichever is more clearly evident.

B. Assets acquired in exchange for a deferred payment contract are valued at the fair value of

the items exchanged, either:

1. The fair value of the note payable by computing the present value of the cash

payments at the appropriate interest rate.

2. The fair value of the asset acquired.

II. Issuance of Equity Securities

A. Assets acquired by issuing equity securities are valued at the fair value of the securities or

the fair value of the assets, whichever is more clearly evident.

III. Donated Assets

A. Donated assets are valued at their fair values and revenue is recorded at an amount equal

to the value of the donated asset(s).

B. For government grants, unlike U.S. GAAP, donated assets are not recorded as revenue

under IFRS. IAS No. 20 requires that government grants be recognized in income over the

periods necessary to match them on a systematic basis with the related costs that they are

intended to compensate.

Decision Makers’ Perspective

A. The property, plant, and equipment and intangible asset acquisition decision, often referred

to as a capital budgeting decision, is among the most significant decisions that

management must make.

B. The fixed-asset turnover ratio, calculated by dividing net sales by average fixed assets,

measures a company’s effectiveness in managing property, plant, and equipment.

IV. Exchanges

A. An asset acquired in a nonmonetary exchange generally is recorded at the cash equivalent

value of the assets exchanged.

1. 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.

2. In exchanges that lack commercial substance, the acquired asset is valued at the book

value of the asset given.

Part C: Self-Constructed Assets and Research and Development

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I. Self-Constructed Assets

A. The cost of a self-constructed asset includes identifiable materials and labor and a portion

of the company’s manufacturing overhead.

1. The incremental approach to overhead allocation includes only those additional costs

that are incurred because of the decision to construct the asset.

2. By the full-cost approach, all overhead costs are allocated both to production and to

self-constructed assets based on the relative amount of a chosen cost driver incurred.

This is the generally accepted approach.

B. Interest is capitalized during the construction period for (a) assets built for a company’s

own use as well as for (b) assets constructed as discrete projects for sale or lease.

1. Interest is not capitalized on inventories that are routinely manufactured in large

quantities on a repetitive basis.

2. Only interest incurred during the construction period is eligible for capitalization.

3. The interest capitalization period begins when construction begins and the first

expenditure is made as long as interest costs are actually being incurred.

4. The first step in the capitalization procedure is to determine weighted–average

accumulated expenditures. This amount approximates the average debt necessary for

construction.

a. If expenditures are made fairly evenly throughout the construction period, the

weighted-average accumulated expenditures can be determined as a simple average

of accumulated expenditures at the beginning and end of the period.

b. If expenditures are not incurred evenly throughout the period, a weighted average

is determined by time weighting individual expenditures or groups of expenditures

by the number of months from their incurrence to the end of the construction

period or the end of the reporting period, whichever comes first.

5. The second step is to calculate the amount of interest to be capitalized by multiplying

an interest rate or rates by the weighted-average accumulated expenditures.

a. The specific interest method uses rates from specific construction loans to the

extent of specific borrowings and then applies the weighted-average rate on all

other debt to any excess of average accumulated expenditures over specific

construction borrowings.

b. By the weighted-average method, the weighted-average interest rate on all debt,

including construction-specific borrowings, is multiplied by average accumulated

expenditures.

6. The third step in the procedure is to compare calculated capitalized interest with actual

interest incurred during the period. Capitalized interest is limited to the amount of

interest incurred.

7. If material, the amount of interest capitalized during the period must be disclosed in a

note.

II. Research and Development (R&D)

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A. Companies are willing to spend huge amounts on R&D because they believe the project

will eventually provide benefits that exceed current expenditures. The FASB takes a

conservative approach and requires R&D costs to be expensed immediately because:

1. It’s difficult to predict which individual research and development projects will

ultimately provide benefits.

2. 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.

B. 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.

1. R&D costs include labor costs, materials, depreciation and amortization of assets used

in R&D activities, and a reasonable allocation of indirect costs related to those

activities.

2. In general, costs incurred before the start of commercial production are all expensed as

R&D. Any costs incurred after the start of commercial production are not classified

R&D costs. These costs would be either expensed or treated as manufacturing

overhead and included in the cost of inventory.

C. If an asset is purchased specifically for a single R&D project, its cost is considered R&D

and expensed immediately even though the asset’s useful life extends beyond the current

year. However, the cost of an asset that has an alternative future use beyond the current

R&D project is not a current R&D expense. Instead, the depreciation or amortization of

these alternative-use assets is included as R&D expenses in the current and future periods

the assets are used for R&D activities.

D. International Financial Reporting Standards draw a distinction between research activities

and development activities. Research expenditures are expensed in the period incurred.

However, development expenditures that meet specified criteria are capitalized.

E. An exception to expensing all R&D costs exists for the computer software industry.

1. Computer software companies expense R&D costs until technological feasibility is

achieved.

2. Costs incurred after technological feasibility but before the product is available for

general release to customers are capitalized as an intangible asset.

3. The periodic amortization of capitalized computer software development costs is the

greater of (1) the ratio of current revenues to current and anticipated revenues or (2)

the straight-line percentage over the useful life of the asset.

F. Under IFRS, the U.S. approach for amortizing computer software development costs is

allowed but not required.

G. R&D costs incurred for others under contract are capitalized as inventory and carried

forward into future years until the project is complete. Income can be recognized using

either the percentage-of-completion method or the completed contract method.

H. When one company buys another, we assign fair values to the tangible and intangible

assets, as well as to developed technology and in-process research and development.

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1. The amount allocated to developed technology is capitalized and amortized as any

other intangible asset.

2. GAAP requires the capitalization of in-process R&D as an indefinite life intangible

asset. If the research project is completed successfully, the amount capitalized is

amortized over the useful life of the developed intangible. If the project is

unsuccessful, we write off the amount capitalized.

I. Start-up costs, including organization costs, are expensed in the period incurred.

Appendix 10: Oil and Gas Accounting

A. There are two generally accepted methods that companies can use to account for oil and

gas exploration costs.

1. The successful efforts method requires that exploration costs that are known not to

have resulted in the discovery of oil or gas (sometimes referred to as dry holes) be

included as expenses in the period the expenditures are made.

2. The full-cost method allows costs incurred in searching for oil and gas within a large

geographical area to be capitalized as assets and expensed in the future as oil and gas

from the successful wells are removed from that area.

B. The method used must be disclosed in a note.

PowerPoint Slides

Two PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the instructor to

intersperse in the presentation short exercises students can be asked to solve individually

or in small groups before the solution is “revealed” by the instructor. {These are available

only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being asked

to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more important

in the education marketplace. Students and instructors with disabilities use many different

assistive technologies, and McGraw-Hill Education is working to increase compatibility

and access that will not only help those with disabilities achieve better learning outcomes,

but also serve the institutions that are teaching these students. Accessible PowerPoint

allows slide content to be read by a screen reader and provides alternative text

descriptions for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture when

possible, instead of color to denote different aspects of the imagery used within the slide.

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Note: The slides are intended to provide comprehensive coverage of the chapter, but they

can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

Instructors Resource Manual 10-7

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