Chapter 10 Operational Assets: Acquisition and Disposition

Chapter 10 Operational Assets: Acquisition and Disposition

Questions for Review of Key Topics

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 and the exploration and development costs incurred before production begins.

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 cannot be associated with a specific asset.

Because goodwill cannot 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 on 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.

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.

Answers to Questions (continued)

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

The gain or loss is computed by crediting the operational asset account with the amount of the original cost, debiting the related accumulated amortization to-date, debiting cash or accounts receivable and the difference is gain or loss.

In other word, first you record the amortization up-to-date, take the proceeds less net book value of the asset. Net book value is cost less accumulated amortization.

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 three exceptions are (1) when fair value is not determinable, (2) exchanges of similar assets, no monetary consideration is received and a gain is indicated, and (3) exchanges of similar assets, some monetary consideration is received and a gain is indicated.

Question 10-13

GAAP allows 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.

Answers to Questions (continued)

Question 10-14

Weighted 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 weighted 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

CICA Handbook Section 3450 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

CICA Handbook Section 3450 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 commercial production of the product begins are capitalized as an intangible asset. These costs include coding and testing costs and the production of product masters. Similar to CICA Handbook Section 3450, costs incurred after commercial production begins usually are not R&D expenditures.

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. In February of 1999, the FASB announced a proposed standard that would eliminate the immediate write-off of the value of in-process R&D. The standard would force companies to capitalize these costs as intangible assets and expense them over time. In July of 1999, the FASB announced that they would delay any decision on the issue for approximately three years. At the time this text was published, the issue had not been resolved.

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.

exercises

Exercise 10-1

Capitalized cost of land:

Purchase price $50,000

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 $54,000

Capitalized cost of building:

Construction costs $500,000

Architect's fees 10,000

Interest on construction loan 5,000

Total cost of building $515,000

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 ($40,000 + 700 + 1,000) 41,700

Accounts payable 40,000

Cash 1,700

To record prepaid insurance for the machine.

Prepaid insurance 800

Cash 800

Exercise 10-3

Requirement 1

Purchase of mining site $1,000,000

Development costs 500,000

Restoration costs 280,034

Total costs of copper mine $1,780,034

*Present value of expected cash outflow for restoration costs (asset retirement obligation)

$300,000 x 25% = $ 75,000

$400,000 x 40% = 160,000

$500,000 x 35% = 175,000

$410,000 x 0.68301** = $280,034.10

** Present value of $1, n=4, I=10%

Requirement 2

Journal entries:

Copper mine (determined in 1)…………………………1,780,034

Cash ($1,000,000 + 500,000)……………………… 1,500,000

Asset retirement liability (determined in 1)………. 280,034

Excavation equipment…………………………………. 120,000

Cash (cost)…………………………………………… 120,000

Exercise 10-4

Requirement 1

Cost $80,000 (2,000 shares x $40) which is the market value of the consideration given up. In a noncash acquisition, cost is determined by market value of the consideration given or the asset received, whichever is more clearly evident. Appraised value is not as conclusive as a measure of value as the cash offer. Where there is a substantial difference between the market value of the asset received, doubt is cast on the existence of arm’s length bargaining. The $2,000 difference does not appear to be substantial. Also, the timing of the offer to sell for $78,000 is not clear.

Requirement 2

Cost $115,000. The difference between the appraised value of the land and the Market Value of the shares is material. The market value per share is questionable as a cost basis, in view of the small number of shares involved in the recent transaction, that “established” the market value of $10 per share. To record the cost of $5,000 over the appraised value would be to violate the cost principle.

Requirement 3

Cost is $79,550 ($75,000 + 3,000 +3,100/2). Cost is measured by cash paid plus liabilities assumed. Taxes for the current year should prorated between asset and expense.

Requirement 4

The cost is $29,400, which is the market value of the consideration given up. In a noncash acquisition, under the cost principle, cost is measured by the market value of the consideration given or property received, whichever is more clearly evident. The value of the consideration given should be used because (a) it is the preferable conceptual choice and (b) it appears to be objectively measurable. The value is more objective than in the prior question, where there was only one transaction.

Exercise 10-5

Organization costs ($12,000 + 3,000) 15,000

Patent ($20,000 + 2,000) 22,000

Furniture 30,000

Cash 67,000

Exercise 10-6

Requirement 1

Patent…………………………………….$80,000

Trademarks ……………………………. 14,000

Total intangible assets…………………... $94,000

Requirement 2

Deposit with advertising agency for ads to promote the company’s professional image: $50,000

This would be treated as a prepaid expense.

Discount on bonds payable: $13,000 is a contra account reported with the bonds payable to give the net book value.

Cost of equipment acquired for research & development projects, with an alternate future use: $120,000.

This cost of equipment would be capitalized and annual amortization would be expensed to R.& D.

Cost of developing a new product that is not expected to be marketed for another 5 years: $43,000

This cost would be expenses because it does not meet all of the criteria to be deferred.

Exercise 10-7

Calculation of goodwill:

Purchase price $16,000,000

Less fair value of net assets:

Assets $23,000,000

Less: Liabilities assumed (9,500,000) (13,500,000)

Goodwill $ 2,500,000

Exercise 10-8

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:

Capital assets 1,200,000

Intangible assets 1,000,000

Less: Book value in excess of fair value:

Receivables (200,000) 9,800,000

Goodwill $ 1,200,000

Exercise 10-9

1. b

2. a

3. a

4. b

5. c

Exercise 10-10

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

Exercise 10-11

Asset Appraised Value % of total Initial Valuation

(Percent x $130,000)

Machinery $95,000 95/145= 65.5% $85,150

Office equipment 25,000 25/145 = 17.25% 22,425

Van 25,000 25/145 = 17.25 22,425

$145,000 100% $130,000

Exercise 10-12

Requirement 1

Tractor ($5,000 cash + 18,954 present value of note) 23,954

Cash 5,000

Note payable (determined below) 18,954

Present value of note payments:

PV = $5,000 (3.79079) = $18,954

Present value of an ordinary annuity of $1: n=5, i=10% (from Table 5B-4)

Requirement 2

Interest expense ($18,954 x 10%) 1,895

Note payable (difference) 3,105

Cash 5,000

Exercise 10-12 (continued)

Requirement 3

Interest expense [($18,954 - 3,105) x 10%] 1,585

Note payable (difference) 3,415

Cash 5,000

Exercise 10-13

To record the acquisition of land in exchange for common stock.

February 1, 2005

Land 90,000

Common shares (5,000 shares x $18) 90,000

To record the acquisition of a building through purchase and donation.

November 2, 2005

Building 600,000

Cash 400,000

Revenue - donation of asset (difference) 200,000

Exercise 10-14

Requirement 1

Journal entry:

2005

Cash………………………………………………… 6,000

Accumulated amortization………………………….. 22,000

Loss on disposal of tractor………………………….. 2,000