Chapter 10 Long lived assets o Operating assets expected to yield their economic benefits over a period longer than one year o Significant of total assets in industries such as oil automobiles and steel Assets single entity o Generates future economic benefits and is under exclusive control of a Measurement of the Carrying Amount of Long Lived Assets o Long lived assets could be measured on the balance sheet in 2 ways 1 Assets could be measured at their estimated value in an output market where the asset is sold This is called expected benefit approach 2 Assets could be measured at their estimated cost in an input market a market where assets are purchased This is called economic sacrifice approach Expected benefit approach Recognizes that assets are valuable because of the future cash flows they are expected to generate o Discounted Present Value The value of an item of manufacturing equipment is measured by estimating the discounted present value of the stream of the future net operating cash inflows it is expected to generate over its operating life o Net Realizable Value The amount that would be received if the assets were sold in the used asset market o Under both approaches the income statement effect is the change in the value of the asset Economic Sacrifice Approach Focus on the amount of resource expenditure needed to acquire it o Historical Cost o Replacement Cost The historical amount spent to buy the asset constitutes the past sacrifice incurred to bring the asset into the firm Assets are carried at their current purchase cost the expenditure needed today to buy the asset o Under both approaches depreciation expense is recognized on the income statement however only under replacement cost are other comprehensive income holding gains The Approach Used by GAAP o GAAP uses historical cost to measure long lived assets in almost all o Parties whose transactions are explicitly or implicitly tied to accounting numbers expect them to be reliable circumstances Reliability Numbers must not be prone to manipulation If numbers were not reliable they could be manipulated easily by one party to the contract this would circumvent the contract terms o Auditors prefer financial statements to be verifiable Verifiability Numbers should arise from readily observable corroborative facts rather than subjective beliefs Verifiability reduces the risk of a lawsuit for auditors o The only long lived asset measurement method that survives the dual screens of reliability and verifiability is historical cost Long Lived Asset Measurement Rules Illustrated o Two rules 1 All costs necessary to acquire the asset and make it ready to use are included in the asset account meaning they are capitalized costs Other costs are expensed to income Capitalized Price paid for land Cost of clearing land Expensed Monthly equipment rental Cost to repair damaged equipment 2 Joint costs incurred in acquiring more than one asset are apportioned among the acquired assets GAAP requires capitalizing avoidable interest payments Avoidable interest payments o Interest that could have been avoided if expenditures for the assets had not been made o To qualify the interest doesn t have to arise from borrowing that is directly linked to a construction loan As long as some debt was outstanding during the construction period a portion of the interest was avoidable and qualifies for capitalization This is because if the asset had not been built that cash could have been used to retire debt thereby lowering interest costs Computing Avoidable Interest o Interest can also be capitalized for borrowings that are outstanding when the assets are being constructed for others inventory added for sale and lease To qualify for interest capitalization the inventory being constructed must be an identifiable discrete project a 2 year contract to construct two skyscrapers for Donald Trump o Avoidable interest is the product of cumulative weighted average expenditures on the constructed asset X the interest rate o Authoritative accounting literature requires capitalization of avoidable interest payments on self constructed assets Interest paid to lenders during the construction period is considered to be a cost necessary to prepare the asset for its intended use If the interest rate is 10 you multiply Cumulative Weighted Average Expenditures by 10 to get the avoidable interest The journal entry is DR Construction in progress CR Interest expense o GAAP limits the amount of interest that can be capitalized to the LOWER of 1 Interest actually incurred or 2 Avoidable interest Cum Weight Avg Expend X 10 Cum Weight Avg Expend X 10 For example if Chubby s interest incurred had been 1 000 000 and the avoidable interest came out to be 500 000 the capitalized amount would be equal to 500 000 o Capitalization is restricted to interest arising from actual borrowings from outsiders o The way construction is financed can alter the cost capitalized under GAAP when a company initially has no outstanding debt o GAAP does not recognize the imputed cost associated with capital provided by stockholders resulting in the cost of equity capital being ignored under GAAP in both income determination and asset costing Taxes versus Financial Reporting Incentives o The way incurred costs are allocated between land and buildings affects the amount of income that will be reported in future periods o For financial reporting and tax purposes the allocation is guided by which one the land or the building generated the cost Financial reporting purposes Manner in which costs are allocated between land and building is guided by which one generated the cost Tax purposes Different because firms try to minimize tax payments not to correctly allocate costs Higher the costs allocated to land for tax purposes the higher the future taxable income becomes because land cannot be depreciated Capitalization Criteria o GAAP capitalizes costs incurred after the asset has been placed in use as long as the expenditure Increases its productive capacity Increases its production efficiency Extends the asset s useful life Or increases the asset s other economic benefits o If there is no increase in economic benefits or future service potential the expenditure is charged to income as an expense o Example Suppose that in November 2011 Chubby s spends an additional 10 000 on a machine The total expenditure consisted of 2000 for ordinary repairs and maintenance required every several years 8 000 for