Longlived assets

1
Long-lived assets

• Buy it
• Basic acquisitions
• Self-constructed assets (interest
  capitalization)
• Time goes by
• Depreciate (Cost allocation)
• Improvements/Repairs
• Changes in value (Impairments)
• Dispose of it
• Sales
• Exchanges
• FC v. Successful efforts

2
Basic structure
Buy it Basic acquisitions Self-constructed
assets (interest capitalization) Time goes
by Depreciate (Cost allocation) Improvements/Re
pairs????? Changes in value (Impairments) Dispose
of it Sales Exchanges
3
Hilton Hotels Balance sheet
4
Hilton Hotels, footnote
NOTES Total amounts on the B/S Illustrates
two of the required disclosures Cost basis by
major class A/D in total Construction in
progress is in the total, but a separate
non-depreciating component
5
Basic acquisitions

• Land or PPE
• Cash
• Depreciation expense
• Accumulated depreciation (XA)

6
Notes on acquisitions

• What is included in acquisition cost?
• Purchase price
• Costs to prepare for intended use
• transportation costs
• installation costs
• specific employee training costs
• Example land acquisition
• surveys
• legal fees
• title fees
• realtors commissions
• If pay for purchase over time, record at PV of
  cash flows (FV)
• If lump sum purchase
• Allocate purchase price to acquired assets based
  on their fair values
• If acquire with a stock issue

7
Special case Capitalize interest costson
self-constructed assets

• For self-constructed assets, the acquisition
  cost is
• direct materials
• direct labor
• indirect construction costs

Adjusting entry at year end interest costs
during construction General idea If the firm
were to purchase an asset, the cost of financing
during the construction period would be passed
from the construction company to the
firm Eventually Depreciated so interest cost
hits I/S as depr. expense
8
Summary of rules

• What assets under construction qualify?
• for an enterprises own use (e.g., buildings,
  plants, and large machinery)
• Assets that will not be used in earning
  activities (e.g., excess capacity) do not qualify
• Over what period?
• Start capitalizing interest when expenditure for
  the long-lived asset has been made and interest
  costs are incurred.
• End capitalizing interest when construction is
  complete.
• How much to capitalize?
• See example

9
Example

• Given
• INFO RE ASSET
• Average accumulated expenditure on constructed
  asset 10,000,000
• INFO RE FINANCING
• Construction loan 6,000,000 _at_ 10
• Other loans 5,000,000 _at_ 12 and 4,000,000 _at_
  9
• Thus
• Total interest charges for the year 600,000
  960,000 1,560,000.
• Weighted average rate on other loans
  960,000/9,000,000 10.67
• What does the 10 mm represent?
• PICTURE THE T-account for the asset

8 mm financed all year 8.0 1 mm financed for
0.75 of year .75 2 mm financed for 0.5 of
year 1 1 mm financed for 0.25 of year
.25 10
10
How much to capitalize?

• First key point re calculation
• Some interest rate 10,000,000
• Second key point What interest rate?
• Best estimate is 10
• Because it is on construction debt
• But only for 6 mm
• For the remaining 4 mm (10 mm from above - 6
  mm)
• Use 10.67
• Total hypothetical (avoidable) interest
• 6mm 10 600,000
• 4mm 10.67 426,800
• 1,026,800

11
The journal entries

• Remember The entry to capitalize interest is an
  adjusting entry at year end. You cant compute
  the amount until you know construction costs.
• During the year (as incurred)
• Dr. Interest expense 1,560,000
• Cr. Cash (or interest payable) 1,560,000
• Adjusting entry
• Dr. Assets under construction (CIP) 1,026,800
• Cr. Interest expense 1,026,800
• Interest expense on the income statement will be
  1,560,000 - 1,026,800 433,200
• Thus
• Balance sheet (Assets) increase by 1,026,800
• Income statement (pretax net income) increase by
  1,026,800

12
Final notes on interest capitalization

• When construction complete
• Move Assets under construction balance to PPE
• Dr. PPE
• Cr. CIP
• Start depreciating
• Could compute
• avoidable interest amount gt interest cost for the
  year
• Remember the calculation from before
• Total hypothetical (avoidable) interest
• 6mm 10 600,000
• 4mm 10.67 426,800
• 1,026,800
• Cant capitalize more than interest cost

13
Example disclosure related to interest
capitalization
Third required disclosure
14
Understanding the income statement when interest
is capitalized
1999 interest cost associated with debt on the
B/S 237 7
15
What about the balance sheet?
Unadjusted balance Interest capitalized Ending
balance
16
Long-lived assets

• Buy it
• Basic acquisitions ?
• Self-constructed assets and interest
  capitalization ?
• Time goes by
• Depreciate (Cost allocation)
• Improvements/Repairs
• Changes in value (Impairments)
• Dispose of it
• Sales
• Exchanges
• Full cost v. Successful efforts

17
Depreciation

• The concept of depreciation
• Depreciation is an allocation process, not a
  valuation process
• Dr. Depreciation expense (or WIP inventory)
• Cr. Accumulated depreciation
• Amortization, depletion, and depreciation are
  similar
• Amortization intangibles
• Depletion natural resources
• Depreciation for other tangible assets
• Methods of calculation for tangible assets
• Straight-line, SYD, Double declining balance
  (A101)
• Must know how to compute, but they are just
  formulas
• BOOK METHODS ? TAX METHODS (MACRS)

18
Depletion of Natural Resources

• Depletion is an allocation of cost (like
  depreciation)
• Nature of assets (e.g., petroleum, minerals, and
  timber) differs
• Units-of-Production (activity) method
• Foster Corporation, a major copper producer,
  incurred costs of 2 million in connection with
  property acquisition, exploration and development
  of an open-pit copper mine. Foster expects that
  the property can be sold for 500,000 after it
  has depleted the copper and spends 320,000 to
  restore the property. The fair value of the
  restoration obligation is 300,000. The total
  estimated recoverable units in the property are 1
  million tons of copper ore. Foster Corporation
  extracts 300,000 tons and sells 200,000 tons
  during the first year.
• Depletion base
• 2,000,000 300,000 500,000 1,800,000
• Per unit material cost
• 1.8/ton
• 12/31/Year1 inventory
• 1.8 X 100,000 tons 180,000
• Cost of goods sold Year 1
• 1.8 X 200,000 tons 360,000

19
Current method v. old method

• Foster Corporation, a major copper producer,
  incurred costs of 2 million in connection with
  property acquisition, exploration and development
  of an open-pit copper mine. Foster expects that
  the property can be sold for 500,000 after it
  has depleted the copper and spends 320,000 to
  restore the property. The fair value of the
  restoration obligation is 300,000. The total
  estimated recoverable units in the property are 1
  million tons of copper ore. Foster Corporation
  extracts 300,000 tons and sells 200,000 tons
  during the first year.
• Current valuation system
• Long-lived asset
• 2,000,000 300,000
• Restoration obligation
• 300,000
• Must be legal asset retirement obligation
  chapter 13
• Old rules
• Long-lived asset
• 2,000,000
• No restoration obligation
• Would have used 320 to compute depletion rate
  (negative salvage value)
• Depletion base 2,000,000 - (500,000-320,000)
  1,820,000
• Per unit material cost 1.82/ton

20
Improvements/Repairs/Maintenance

• Issue
• Capitalize v. expense the cost?
• Should
• Capitalize an improvement
• Expense maintenance
• But, lots of subjectivity
• A consistent (sensible) policy is important
• Worldcom???

21
Changes in Asset Value Subsequent to Acquisition

• Increases in value
• NOnot in US
• Decreases in value (Impairments)
• Two step test
• Compare NBV of asset to undiscounted cash flows
  of the asset in its assumed use
• WHEN TO TEST When circumstances indicate might
  be impaired
• If impaired, write down to fair value
• Cannot be recovered!
• Journal entry
• Dr. Loss (on Income statement) never
  extraordinary
• Cr. Accumulated depreciation

22
Impairments Surprise Inc.,

• Surprise Inc. owns a specialized oven to make
  pizza. The ovens cost basis is 18,000 and
  accumulated depreciation is 4,000 at December
  31, 2003.
• NBV 14,000
• Surprises best estimate of the expected cash
  flows generated over each of the next four years
  (undiscounted) related to its oven are
• 2004 2,000
• 2005 2,500
• 2006 3,000
• 2007 3,500
• Total 11,000
• The risk-adjusted rate for a 4-year debenture is
  10. The risk-free rate is 6.
• The fair value of the oven is 9,000 (GIVEN).
• The oven fails step 1 of the 2 part test because
  11,000 lt 14,000. Now what?
• Loss 5,000

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Impairment disclosures

• Description of the impaired asset
• Amount of loss and where it is on the I/S
• How fair value was determined (SFAS 157)
• If in a segment, which one

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(No Transcript)
25
Long-lived assets

• Buy it
• Basic acquisitions ?
• Self-constructed assets and interest
  capitalization ?
• Time goes by
• Depreciate (Cost allocation) ?
• Improvements/Repairs ?
• Changes in value (Impairments) ?
• Dispose of it
• Sales
• Exchanges
• Full cost v. Successful efforts

26
Dispositions

• Regular sale Deberg company sells machinery
  (cost, 100,000 accumulated depreciation,
  40,000) for 50,000 in cash.
• Cash 50
• A/D 40
• Loss on sale of PPE 10
• PPE 100
• Donation Kline Industries donates land that cost
  80,000 and has a fair market value of 110,000
  to the Memphis Industrial Development Corp.
• Donation expense 110
• Gain on donation of land 30
• Land 80
• Involuntary Conversion (e.g., due to flood, fire,
  theft, condemnation, etc.)
• Camel was forced to sell a plant located on
  company property that stood directly in the path
  of an interstate highway. In settlement, Camel
  received 500,000, which was substantially in
  excess of the 200,000 book value of the plant
  and land (cost of 400,000 less accumulated
  depreciation of 200,000).
• Cash 500
• A/D 200
• Gain on conversion 300 maybe extraordinary

27
Final review of Hiltons footnote
Fourth required disclosure
28
Long-lived assets

• Buy it
• Basic acquisitions ?
• Self-constructed assets and interest
  capitalization ?
• Time goes by
• Depreciate (Cost allocation) ?
• Improvements/Repairs ?
• Changes in value (Impairments) ?
• Dispose of it
• Sales ?
• Exchanges
• Full cost v. Successful efforts

29
Preview of Exchanges

• Transaction
• Firm exchanges one asset for another
• If the other asset is cash, then this is just a
  sale!
• Dr. Asset acquired in the exchange (CASH)
• Dr. A/D on asset given up
• Cr. Cost basis of asset given up in the exchange
• Dr. Loss on transaction or Cr. Gain
• If the other assets have significant cash
  component ( 25), then it is a monetary
  exchange, and treat it like a sale
• Dr. Asset acquired in the exchange (CASH)
• Dr. Asset acquired in the exchange (PPE,
  Inventory, Marketable Securities,)
• Dr. A/D on asset given up
• Cr. Cost basis of asset given up in the exchange
• Dr. Loss on transaction or Cr. Gain

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Non-monetary exchanges

• If a significant portion of the assets acquired
  are not cash, then different rules for gain/loss
  recognition
• Dr. Asset acquired in the exchange (CASH) YES
• Dr. Asset acquired in the exchange YES, but amt
  is ???
• Dr. A/D on asset given up YES
• Cr. Cost basis of asset given up in the
  exchange YES
• Dr. Loss on transaction or Cr. Gain ???
• Depends on
• Whether it generates a hypothetical gain or
  loss
• How much cash
• Fair value of assets received known or not known
• Nature of transaction (does it have economic
  substance)

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Example 1.1

• Jayco exchanges a fleet of cars (cost, 140,000
  accumulated depreciation, 60K) to Pitt Co. in
  exchange for land with a fair value of 160,000.
  Jayco also pays 50,000 to Pitt as part of the
  exchange.

Point Monetary exchange (50K/160K)
32
Example 1.2

• Assume the same facts as in 1.1 except that the
  fair value of the land is 110,000.

Point Still a monetary exchange
(50K/110K) Whether a gain or loss is irrelevant
33
Example 1.3

• Assume the same facts as in 1.1 except that the
  fair value of the land is not readily
  determinable. Jayco also is unable to determine
  a reliable estimate of the fair value of the
  cars. They are customized vehicles designed
  specifically to deliver Jaycos products.

Point But when fair value not known, record
acquired asset at NBV of surrendered assets
34
Example 1.4

• Jayco trades its machine which it carries on its
  books at a cost of 4,000, accumulated
  depreciation of 1,600, for a machine with a fair
  value of 2,000. The machines are similar and
  the economic position of Jayco does not change.

Point Lacks commercial substance Accounting
depends on whether transaction generates a
theoretical loss or gain Theoretical
loss acquired asset at fair value
recognize the loss
35
Example 1.5

• Jayco Realty owns four acres of land, with a cost
  of 100,000 on the west side of the city and Kaan
  Realty owns three acres, with a cost of 90,000,
  on the east side of town. Both plots of land
  have a fair value of 130,000. Economic
  development consultants hired by both firms
  recommend that a strip mall be built on the east
  side of town and apartments catering to young
  adults be built on the west side of the city.
  Because Jayco has more experience building strip
  malls and Kaan has more experience building
  apartments, they swap plots of land. Their
  economic positions remain the same and there
  should not be a significant change in cash flows.

Point Lacks commercial substance Accounting
depends on whether transaction generates a
theoretical loss or gain Theoretical gain of
30K Accounting depends on extent of cash
received No cash received Recognize ZERO
portion of the gain acquired asset at book
value of surrendered asset
36
Example 1.6

• Jayco exchanges a fleet of used cars plus cash
  (10,000) for land to be used as a future plant
  site. The cars have a cost of 70,000 and
  accumulated depreciation of 40,000. Jayco
  determines that the fair value of the cars is
  35,000 and that the transaction lacks commercial
  substance.

Point Lacks commercial substance Theoretical
gain of 5K No cash received cash paid is
irrelevant Recognize ZERO portion of the
gain acquired asset at FV deferred gain
37
Example 1.7

• Jayco exchanges a used machine with a carrying
  value of 60,000 (cost 115,000 and accumulated
  depreciation of 55,000) and a fair value of
  100,000 for another machine with a fair value of
  90,000. In addition, Jayco receives cash of
  10,000. Jayco determines that the transaction
  lacks commercial substance.

Recognizable Gain Cash recd / FV of assets
exchanged 10 / 100 10 10 40K
4K Asset Fair value deferred gain 90K -
36K 54K
Point Lacks commercial substance Theoretical
gain of 40K Cash received Recognize a
portion of the gain acquired asset at FV
deferred gain
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Example 1.8Jayco sells the asset from 1.7
Earnings process complete

• Five days after the exchange in 1.7, Jayco
  (unexpectedly) sells the new machine to an
  independent third party. The fair value of the
  machine has not changed, thus, the sale price is
  90,000. Because the sale is unexpected, this
  information does not affect the assessment of the
  commercial substance of the original transaction.
  Ignore depreciation for the 5-day period.

Illustrates that the deferred gain eventually
gets recognized, because the basis of the
acquired machine (54K) is lower than it
otherwise would have been. When Jayco sells the
asset, it completes the earnings process.
39
Successful efforts v. Full cost accounting

• Calaboga Oil paid 50 million for a large oil
  field in Alaska. During 2004 Calaboga explored
  for oil throughout the field. Twenty wells were
  drilled at a total cost of 200 million, or 10
  million per well. Nineteen of the wells proved
  to be unproductive dry holes, while one was found
  to contain a considerable amount of oil. What is
  the appropriate carrying amount of the producing
  well? How much is the depreciation expense in
  2004?
• Total cost to be allocated 250
• Full cost
• Drilling expense 0
• Balance sheet carrying amount 50 200 250
• Depleted via units of production as
• oil extracted from the single productive well
• Successful efforts
• Drilling expense 237.50
• Balance sheet carrying amount 250/20 12.50

40
Final notes on FC v. SE

• FC
• Lower drilling expense early
• Higher depreciation expense later
• SE
• Higher drilling expense early
• Lower depreciation expense later
• 1977 Could use FC or SE (GAAP)
• 1977 SEC mandated SE only
• 1978 Both bad, use either
• Natural gas industry 25 use FC