Chapter 10 Part A: Valuation at Date of Acquisition

I. Types of Operational Assets A. For financial reporting purposes, operational assets typically are classified in two categories: (T10-1) 1. Property, plant, and equipment. 2. Intangible assets. B. In practice, some companies report intangibles as part of property, plant, and equipment, and others include them with the other assets category.

II. Costs to Be Capitalized (T10-2) A. Operational assets can be acquired through purchase, exchange, lease, donation, self-construction, or a business combination. B. The initial cost of an operational asset includes all necessary cost 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 acquired through purchase 1. The cost of equipment (machinery, computers, office equipment and furniture, vehicles, 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. (T10-3) 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. (T10-4) 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. (T10-5) 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. (T10-6) 6. Restoration costs are one example of asset retirement obligations (AROs). As asset retirement obligation is measured at fair value and is recognized as a liability and corresponding increase in asset valuation. 7. In SFAS 143, the FASB recommended the use of the expected cash flow approach when estimating the fair value of an ARO by calculating the present value of estimate 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. (T10-7) 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. (T10-8) 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 purchase price over the fair value of the net assets acquired. (T10-9)

III. Lump-Sum Purchases A. If a group of operational 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. (T10-10) IV. Noncash Acquisitions 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: (T10-11) 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. C. 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. (T10-12) D. Donated assets are valued at their fair values and revenue is recorded at an amount equal to the value of the donated asset(s). (T10-13) Decision Makers Perspective

A. The operational asset acquisition decision, often referred to as capital budgeting, 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. (T10-14)

Part B: Dispositions and Exchanges

A. When an operational asset is sold, a gain or loss is recognized for the difference between the consideration received and the assets book value. (T10-15) B. An asset acquired in a nonmonetary exchange generally is recorded at the cash equivalent value of the assets exchanged. (T10-16) 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

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. (T10-17) 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 average accumulated expenditures. This amount approximates the average debt necessary for construction. a. If expenditures are made fairly evenly throughout the construction period, the 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 determine the amount of interest capitalized by multiplying an interest rate or rates by the average accumulated expenditures. a. The specific interest method uses rates from specific construction loans to the extent of specific borrowings and then applies the weightedaverage 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. (T10-18) 7. If material, the amount of interest capitalized during the period must be disclosed in a note. II. Research and Development (R&D) (T10-19) A. In 1974 the FASB issued SFAS 2 which requires all research and development costs to be charged to expense when incurred. 1. R&D costs entail a high degree of uncertainty of future benefits. 2. It is difficult to match R&D costs with future revenues. B. Research is planned search or critical investigation aimed at the discovery of new knowledge and development is the translation of research findings or other knowledge into a plan or design for a new product or process or for significant improvement to an existing product or process. 1. R&D costs include labor costs, materials, depreciation and amortization of operational assets used in R&D activities, and a reasonable allocation of indirect costs related to those activities. (T10-20) 2. In general, costs incurred before the start of commercial production are all expensed as R&D. C. GAAP require disclosure of total R&D expense incurred during the period. D. 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. Start-up costs, including organization costs, are expensed in the period incurred. An exception to expensing all R&D costs exists for the computer software industry. (T10-21) 1. Computer software companies expense R&D costs until technological feasibility is achieved.

E.

F.

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. G. When one company buys another, we allocate the purchase price to tangible and intangible assets, as well as to in-process research and development. 1. The amount allocated to developed technology is capitalized and amortized as any other intangible asset. 2. The amount allocated to in-process R&D is expensed. 3. An analyst must decide whether to consider in-process R&D expenses as transitory in nature or as a part of permanent earnings.

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. (T10-22) 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.

Chapter 11 Part A: Depreciation, Depletion, and Amortization

I. Cost AllocationAn Overview (T11-1) A. The matching principle requires that the net cost of an operational asset (cost less residual value) be allocated to the years of asset use in direct proportion to the role the asset plays in revenue production. B. Cost allocation for operational assets is known as depreciation for plant and equipment, depletion for natural resources, and amortization for intangibles. C. Depreciation, depletion, and amortization are processes of cost allocation, not valuation. D. Depreciation, depletion, and amortization for an asset used to manufacture a product is an overhead cost included in the cost of inventory.

II. Measuring Cost Allocation (T11-2) A. The process of cost allocation for an operational asset requires that three factors be established at the time the asset is put into use: (1) service life, (2) allocation base, and (3) allocation method. B. The service life, or useful life, of an operational asset is the amount of use that the company expects to obtain from the asset before disposing of it. 1. Service life can be expressed in units of time or in units of activity. 2. Expected obsolescence can shorten service life below physical life. C. Allocation base is the difference between the cost of the asset and its anticipated residual value. D. The allocation method used should be systematic and rational and correspond to the pattern of asset use. 1. Time-based methods 2. Activity-based methods III. Depreciation of Operational Assets (T11-3) A. Time-based depreciation methods allocate the depreciable base according to the passage of time. 1. The straight-line depreciation method allocates an equal amount of depreciable base to each year of the asset's service life. 2. Accelerated depreciation methods allocate more depreciable base to the earlier years of an asset's life and less to the later years. a. The sum-of-the-years'-digits method multiplies depreciable base by a declining fraction whose denominator is the constant sum of the digits from one to n where n is the number of years in the asset's service life. b. Declining balance depreciation methods multiply beginning of year book value, not depreciable base, by an annual rate that is a multiple of the straight-line rate. When 200% is used as the multiplier, the method is known as the double-declining-balance method. B. It is not uncommon for a company to switch from accelerated to straight-line approximately halfway through an asset's life. C. Activity-based depreciation methods estimate service life in terms of some measure of productivity. 1. Productivity could be measured in terms of output (for example, the number of units a machine will produce) or input (for example, the number of hours a machine will operate). 2. The units-of-production method computes a depreciation rate per measure of output and then multiplies this rate by actual output to determine periodic depreciation.

Decision Makers PerspectiveSelecting a Depreciation Method (T11-4) A. All methods provide the same total depreciation over an asset's life. B. Activity-based methods are theoretically superior to time-based methods, but often are infeasible or too costly to use. C. One possible motivation for the predominant use of straight-line is its positive effect on reported income. D. A company does not have to use the same depreciation method for both financial reporting and income tax purposes nor does it have to use the same depreciation method for different classes of assets. IV. Group and Composite Depreciation Methods A. Group and composite depreciation methods aggregate assets in order to reduce the recordkeeping costs of determining periodic depreciation. B. The group depreciation method defines the collection of assets as depreciable assets that share similar service lives and other attributes. (T11-5) 1. The group depreciation rate is determined by dividing the depreciation per year by the total cost of the group. 2. The group's average service life is calculated by dividing the depreciable base by the depreciation per year. 3. The depreciation rate is applied to the total cost of the group. 4. No gain or loss is recorded when a group asset is retired or sold. C. The composite depreciation method is used when assets are physically dissimilar but are aggregated anyway to gain the convenience of group depreciation. V. Depletion of Natural Resources (T11-6) A. Depletion of the cost of natural resources usually is determined using the unitsof-production method. B. Depletion is a product cost and is included in the cost of inventory. C. The units-of-production method often is used to determine depreciation on assets used in the extraction of natural resources.

VI. Amortization of Intangible Assets (T11-7)

A. The cost of an intangible asset with a finite useful life is amortized.

1. Most intangibles have a legal, regulatory, or contractual life that limits useful life. 2. Intangibles typically have no residual value, so the amortization base is simply cost. 3. The cost of an intangible asset usually is amortized by the straight-line method. The cost of an intangible asset with an indefinite useful life is not amortized. Goodwill is the most common intangible asset with an indefinite useful life. C. Similar to depreciation, whether amortization is a product cost or a period cost depends on the use of the asset.

B.

Part B: Additional Issues

I. Partial Periods (T11-8) A. Depreciation, depletion, and amortization in the year of acquisition and year of disposal should be determined only for the part of the year that the asset is actually used. Partial-year depreciation presents a problem only for time-based methods. B. Most companies adopt a simplifying assumption, or convention, for computing partial-year's depreciation. A common convention, known as the half-year convention, records one-half of a full year's depreciation in the year of acquisition and another half-year in the year of disposal.

II. Changes in Estimates (T11-9) A. Changes in estimates are reflected in the financial statements of the current period and future periods. B. Prior years' financial statements are not restated. C. A disclosure note describes the change in estimate and the effect of the change on income before extraordinary items, net income, and related per-share amounts. III. Change in Depreciation, Amortization, or Depletion Method (T11-10) A. Changes in depreciation, amortization, or depletion method are accounted for the same way as a change in accounting estimate. B. A disclosure note is required to provide justification for the change and to report the effect of the change on current years income. IV. Error Corrections (T11-11) A. For material errors occurring in a previous year, previous years' financial statements are retrospectively restated. B. Any account balances that are incorrect as a result of the error are corrected.

C. If retained earnings requires correction, the correction is reported as a prior period adjustment. D. A disclosure note is needed to describe the nature of the error and the impact of its correction on income before extraordinary items, net income, and earnings per share.

V. Impairment of Value

A. An operational asset held for use should be written down if there has
been a significant impairment of value. B. Tangible operational assets and finite life intangibles are tested for impairment only when events or changes in circumstances indicate book value may not be recoverable.

C. For

tangible operational assets and finite life intangibles, determining whether to record an impairment loss and actually recording the loss is a twostep process. (T11-12)

1. Step 1 - An impairment loss is required only when the undiscounted sum of future cash flows is less than book value. 2. Step 2 - The impairment loss is the excess of book value over fair value. The present value of future cash flows often is used as a measure of fair value. D. Intangible assets with indefinite useful lives should be tested for impairment at least annually. If book value exceeds fair value, an impairment loss is recognized. E. SFAS No. 142 provides guidelines for the recognition and measurement of goodwill impairment. (T11-13) 1. Step 1 A goodwill impairment loss is indicated when the fair value of the reporting unit is less than its book value. 2. Step 2 A goodwill impairment loss is measured as the excess of the book value of the goodwill over its implied fair value. 3. The implied fair value of goodwill is calculated in the same way that goodwill is determined in a business combination. That is, its a residual amount measured by subtracting the fair value of all identifiable net assets from the purchase price using the units previously determined fair value as the purchase price. 4. Similar to other intangible assets with indefinite useful lives, goodwill should be tested for impairment on an annual basis and in between annual test dates if events or circumstances indicate that the fair value of the reporting unit is below its book value. F. For operational assets held for sale, if book value exceeds fair value, an impairment loss is recognized for the difference. G. Impairment of Operational Assets A Summary (T11-14)

Part C: Subsequent Expenditures and Disposition

I.

Expenditures Subsequent to Acquisition (T11-15) A. Expenditures that are expected to produce future benefits beyond the current year are capitalized. Expenditures that simply maintain a given level of benefits are expensed in the period they are incurred. B. Many companies do not capitalize any expenditure unless it exceeds a predetermined amount that is considered material. C. Expenditures for repairs and maintenance generally are expensed when incurred. D. Additions involve adding a new major component to an existing asset and should be capitalized because future benefits are increased. E. Improvements involve the replacement of a major component of an operational asset and usually are capitalized. (T11-16) 1. By the substitution method, both the disposition of the old component and the acquisition of the new component are recorded. 2. The cost of the improvement sometimes is recorded without removing the original cost and accumulated depreciation of the original component. 3. Another way to record improvements is to reduce accumulated depreciation. F. The cost of material rearrangements should be capitalized if they clearly increase future benefits. (T11-17) G. The costs incurred to successfully defend an intangible right should be capitalized. The costs incurred to unsuccessfully defend an intangible right should be expensed. A. The federal tax code allows taxpayers to compute depreciation for their tax returns on assets acquired after 1986 using the modified accelerated cost recovery system (MACRS). BUnder MACRS, each asset is placed with a recovery period category, which determines the fixed-rate depreciation schedule. C. MACRS depreciation is equivalent to applying the double-declining-balance (DDB) method with a switch to straight-line in the year straight-line yields an equal or higher deduction than DDB and a half-year convention. D. Companies have the option to use the straight-line method.

Appendix 11A: Comparison with MACRS (Tax Depreciation) (T11-18)

Appendix 11B: Retirement and Replacement Methods of Depreciation

A. The retirement depreciation method records depreciation when assets are disposed of and measures depreciation as the difference between the proceeds received and cost. (T11-19) B. By the replacement method, depreciation is recorded when assets are replaced. (T11-20)