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FSU ACG 3171 - Chapter 10

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Chapter 10- Long-lived assetso 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- Assetso Generates future economic benefits and is under exclusive control of asingle entity- Measurement of the Carrying Amount of Long-Lived Assetso 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 lifeo 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 toacquire ito Historical Cost The historical amount spent to buy the asset constitutes the past sacrifice incurred to bring the asset into the firmo Replacement Cost Assets are carried at their current purchase cost- the expenditure needed today to buy the asseto 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 GAAPo GAAP uses historical cost to measure long-lived assets in almost all circumstances.o Parties whose transactions are explicitly or implicitly tied to accounting numbers expect them to be reliable. 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 termso 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 auditorso The only long lived asset measurement method that survives the dual screens of reliability and verifiability is historical cost- Long Lived Asset Measurement Rules Illustratedo 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 paymentso Interest that could have been avoided if expenditures for the assets had not been madeo To qualify, the interest doesn’t have to arise fromborrowing 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 qualifiesfor capitalization. This is because if the asset had not been built, that cash could have been used to retire debt, thereby lowering interest costso Interest can also be capitalized for borrowings that are outstanding when the assets are being constructed for others- inventory added forsale 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)- Computing Avoidable Interesto Avoidable interest is the product of cumulative weighted average expenditures on the constructed asset X the interest rateo 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 - Cum Weight. Avg. Expend. X 10%- CR Interest expense - Cum Weight. Avg. Expend. X 10%o GAAP limits the amount of interest that can be capitalized to the LOWER of 1. Interest actually incurred or 2. Avoidable interest.  For example if Chubby’s interest incurred had been $1,000,000and the avoidable interest came out to be $500,000, the capitalized amount would be equal to $500,000o 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 debto 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 Incentiveso 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 Criteriao GAAP capitalizes costs incurred after the asset has been placed in use as long as the expenditure: Extends the asset’s useful life Increases its productive capacity Increases its production efficiency Or, increases the asset’s other economic benefitso If there is no increase in economic benefits (or future service potential) the expenditure is charged to income as an expenseo Example: Suppose that in November 2011


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