Financial Accounting Theory and

Analysis Text and Cases 12th Edition

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 CHAPTER 9

Case 9-1

a. Under FASB ASC 958-605, the land would be recorded at fair value. The inflow is
considered revenue. The land would be reported in the balance sheet at $100,000. A
corresponding amount of revenue would appear in the income statement.

b. i. FASB ASC 958-605 defines a donation as a nonreciprocal transfer. Recording

the land at fair value is consistent with the full disclosure principle. It is also
consistent with the Conceptual Framework's qualitative criterion, relevance. If
users wish to value the firm, fair value of firm assets is relevant to their decision
models.

The primary defense of recording a donated asset at fair value is that fair value
represents the cash equivalent value of the asset. If cash had been received,
instead, the dollars would have been recorded. Then the dollars received could
have been used to purchase the asset at fair value.

Recording the inflow as revenue is consistent with the Conceptual Framework's

definition of earnings, as the change in net assets from nonowner sources. The
asset was received from a third party, not an owner. Its inflow adds value to the
firm.

ii. Recording the donated asset at fair value is inconsistent with the cost principle.
According to the cost principle, the recorded cost of an asset is equivalent to the
consideration given in return. Because a donation is a nonreciprocal transfer,
nothing was given in return, hence, no cost can be recorded.

A second, though less convincing argument, would be that fair value may be too
subjective to be reliable.

It can also be argued that if fair value is the appropriate and relevant
measurement for a donated asset, then the credit should be considered a gain, not
a revenue. The Conceptual Framework defines revenues as inflows from the
production or delivery of goods and services. A donated asset does not result
from the production or delivery of goods or services. Rather it is more like a
gain - resulting from peripheral or incidental transactions.

c. Under previous practice, the credit for fair value of the donated asset would have
been to donated capital. Because the credit to revenue required under FASB ASC

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 958-605 is closed to retained earnings, the composition of stockholders' equity would
differ but total stockholders' equity is unaffected by the SFAS No. 116 requirements.
Comparative balance sheets containing summary information would appear the same
as before, as follows:

ASSETS LIABILITIES
Liabilities $350,000
($800,000 + 100,000) $900,000 S/E 550,000

Hence, balance sheet ratios such as debt/equity are not affected.

Placing the inflow of fair value on the income statement would increase income from
continuing operations, net income and EPS.

Case 9-2

a. Postponing the purchase of the equipment until the next year will have the following
financial statement impacts assuming that the equipment will be placed into use when
it is purchased:

Balance Sheet:

Plant assets will be less by

Cost $400,000
Less Accumulated Depr 20,000 $380,000
((400,000/10) x 1/2)

Notes Payable will be less by $400,000

Interest Payable will be less by 10,000

((400,000/10) x 1/4)

Deferred Tax Liability will be less by

Accumulated Depr - tax $57,143
(400,000 x 2/7 x 1/2)
Accumulated Depr - books 20,000
Temporary difference $ 37,143x tax rate

Income Statement:

Interest Expense will be less by $10,000

Depreciation Expense will be less by $20,000

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 Income Tax Expense will be more by the tax rate times lost interest and depreciation
tax shield (tax rate x ($10,000 + 57,143)) and less by the change in the deferred tax
liability (tax rate x $37,143).

Statement of Cash Flows:

The inflow from Operating Activities will be affected by the tax savings on the
interest and depreciation taken on the tax return.

The supplemental schedule disclosing financing and investing activities not affecting
cash will include the purchase of the machine with the note.

According to the efficient market theory, the only impact that postponing the
purchase would have on stock price would result from cash flow impacts. These are
described in part b.

Finance theory on capital structure would suggest that the lower debt to equity ratio
that would result from the postponement would imply less risk, because the debt to
equity ratio is thought to be correlated with the firm's beta. If the debt to equity ratio
is significantly affected, the market could perceive the increased risk in a negative
manner.

b. The cash flow impacts of postponing the purchase of the equipment comprise the
time value of the tax effects of the interest and depreciation tax shields which total
$77,143 ($20,000 + $57,143). Although the purchase would only be delayed three
months, the first year depreciation is taken one year earlier and one fourth of the first
year's interest is taken earlier. On the downside, the interest payments and the
payment of principal are both shifted three months earlier. However, this shift is
unlikely to have a material impact.

c. Purchasing before year-end would be more favorable to stockholders. The market

assesses the value of the firm in terms of the present value of future cash flows. The
depreciation and interest tax shields that would occur during the current year would
accelerate the tax benefits of these deductions for one year. The timing of the interest
and loan principal payment would occur three months earlier. But, the tax timing
difference would produce a more significant effect.

Case 9-3

a. The conventional concept of depreciation accounting usually is defined as a system

of accounting that aims to distribute the cost or other basic value of tangible capital
assets, less salvage (if any), over the estimated useful life of the unit (which may be a
group of assets) in a systematic and rational manner. It is a process of allocation, not

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 of valuation. Depreciation for the year is the portion of the total charge under such a
system that is allocated to the year.

b. i. This is a static concept of depreciation in which the initial cost or other value is
not changed during the life of the asset; thus total depreciation charges over the
life of the asset are equal to the initial cost or value of the asset less any salvage
value.

This concept is based upon the cost, realization and matching concept of
conventional financial accounting. Cost represents the amount that is recorded as
the value of the asset to the entity at the date of acquisition. In subsequent periods
cost less accumulated depreciation is considered to represent the minimum value
to the entity of the services to be received from the plant asset during the
remainder of its life. The realization concept requires that during the life of an
asset its valuation should not be greater than cost or cost less accumulated
depreciation; if a higher valuation were recorded, the entity would recognize
unrealized income.

ii. The matching concept requires that the portion of the cost (or value basis) of the
asset to be allocated to each accounting period should be matched with the
expected revenue or net revenue contribution of the period. Matching can take
the form of (1) adjusting depreciation charges for the effects of interest during
the entire life of the asset, (2) associating depreciation allocations with net
revenue contributions of the asset so that they are proportional to the net revenue
contributions of each period, (3) associating depreciation allocations with
nonmonetary, physical service units (e.g., input or output measures, such as
machine-hours or miles of operation or number of units produced) so that they
are proportional to the units of service provided each period or (4) associating
depreciation allocations with units of time (e.g., months or years) so that they are
equal for periods of equal length.

iii. Since this concept merely requires that the allocation be systematic and rational,
much discretion is left to management in the selection of a depreciation method.
But the requirement that the allocation be rational probably means that it should
be related to the expected benefits to be received from the asset.

c. Since the conventional accounting concept of depreciation is a process of cost

allocation, not valuation, the concern here is with determining what portion of the
cost of the computer system should be assigned to expense in a given accounting
period. The estimate of periodic depreciation is dependent upon three separate
variables:

i. Establishing the depreciation base. Since an asset may be sold before its service
value is completely consumed, the depreciation base is the cost of asset services

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 that will be used by the firm and charged to expense during its service life; this
usually is less than the original cost of the asset. The depreciation base of an asset
is its acquisition cost plus removal costs at time of retirement and minus gross
salvage value.

ii. Estimating the service life. This involves selecting the unit in which the service
life of the asset is to be measured and then estimating the total number of units of
service embodied in the asset.

Although service life usually is measured in units of time, it may be more

appropriate to use units of output or activity which usually are expressed in
physical units such as tons, gallons, miles or machine-hours.

In selecting the appropriate unit of service for each asset, consideration should be
given to the factors that decrease the service life of an asset. These factors may
be divided into two classes: (1) physical causes including casualties and (2)
economic and functional causes.

The physical causes are the physical deterioration and impaired utility of the
asset that result (1) from wear and tear that is due to operating use and (2) from
other forms of decay that are due to the action of the elements. Damage resulting
from unusual events such as accidents, earthquakes, floods, hurricanes, and
tornadoes also may reduce or end asset usefulness.

An asset that is in good physical condition may lose its economic usefulness as a
result of technological obsolescence and inadequacy (or economic obsolescence).
Technological obsolescence results from innovations and improvements that
make the existing plant obsolete. Inadequacy usually results from the effects of
growth and change in the scale of a firm's operations that reduce or terminate the
service life of assets.

iii. Choosing the method of cost apportionment. The problem here is to determine
the relative portion of services that has expired in each accounting period. This
might be approached by estimating whether all units of service are equally
valuable (and have an equal cost) or whether some service units have a higher
value and cost than others.

The two major variables to be considered in reaching the rational and systematic
solution to this problem are: (1) whether the quantity of services withdrawn from
the bundle will be equal or will vary during the periods of service life and (2)
whether the value or cost of various units of service will be equal or will vary
during the periods of service life.

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d. There are a number of systematic depreciation methods that recognize these factors
in varying degrees and could be used for the computer system; these may be
classified as follows:

i. On the basis of time--

1. A constant charge per period, i.e., the straight-line method.
2. A decreasing charge per period, i.e., a declining- balance or the sum-of-the
year’s digits method.
3. An interest (increasing charge) method in which the depreciation charges are
adjusted using the entity's average internal rate of return.

ii. On an output measure basis--

1. A charge based upon a ratio of a constant cost to net revenue contribution;
i.e., the cost allocation for each period would be a constant proportion of the
net revenue contribution of the computer system.
2. A charge based upon the expected physical services from the computer
system; i.e., the cost allocation would be in terms of hours, days or months of
operation or some other measure of input or output related to the computer
services.

Case 9-4

a. A firm may wish to construct its own fixed assets rather than acquire them from
outsiders to utilize idle facilities and/or personnel. In some cases, fixed assets may be
self-constructed to effect an expected cost savings. In other cases, the requirements
for the asset demand special knowledge, skills, and talents not readily available
outside the firm. Also, the firm may want to keep the manufacturing process for a
particular product as a trade secret.

b. Costs which should be capitalized for a self-constructed fixed asset include all direct
and indirect material and labor costs identifiable with the construction. All direct
overhead costs identifiable with the asset being constructed should also be
capitalized. Examples of costs elements which should be capitalized during the
construction period include charges for licenses, permits and fees, depreciation of
equipment used in the construction, taxes, insurance, and similar charges related to
the assets being constructed.

c. i. The increase in overhead caused by the self-construction of fixed assets should

be capitalized. These costs would not have been incurred if the assets had not
been constructed. This proposition holds regardless of whether or not the plant is
operating at full capacity. It is improper to increase the cost of finished goods
with costs which were not incurred in their manufacture and which would not
have been incurred if fixed assets had not been produced. However, if the total
construction costs on self-constructed fixed assets were substantially in excess of
their business and economic usefulness, the excess cost should not be capitalized
but should instead be recorded as a loss.

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 ii. It is clear that the capitalized costs of self-constructed assets should include a
proportionate share of overhead on the same basis as that applied to goods
manufactured for sale when the plant is operating at full capacity at the time the
fixed asset in constructed. Under these circumstances costs of finished goods
produced should not be increased for overhead for goods for which production
was foregone. The activity replacing the production of goods for sale should be
charged with the related overhead.

When idle plant capacity is used for the construction of a fixed asset, opinion
varies as to the propriety of capitalizing a share of general factory overhead
allocated on the same basis as that applied to goods manufactured for sale. The
arguments to allocate overhead maintain that constructed fixed assets should be
accorded the same treatment as inventory, new products, or joint products. It is
maintained that this procedure is necessary, or special favors or exemptions from
undercosting of fixed assets will cause a consequent overcosting of inventory
assets.

Those arguing against allocating overhead to fixed assets where the assets are
constructed when idle capacity exists maintain that since normal production will
not be affected or overhead increased, capitalization will result in increased
reported income for the period resulting from construction rather than production
of goods for sale. It is also sometimes maintained that the full cost of the
constructed asset should not include overhead that would be incurred in the
absence of such construction.

d. The $90,000 cost by which initial machines exceeded the cost of the subsequent
machines should be capitalized. Without question there are substantial future benefits
expected from the use of this machine. Because future periods will benefit from the
extra outlays required to develop the initial machine, all development costs should be
capitalized and subsequently associated with the related revenue produced by the sale
of products manufactured. If, however, it can be determined that the excess cost of
producing the first machine was the result of inefficiencies or failures which did not
contribute to the machine's successful development, these costs should be reported as
a separate item of income from counting operations according to the provisions of
Accounting Standards Update 2015-01.

Capitalizing the excess costs as a cost of the initial machine can be justified under the
general rules of asset valuation. That is, an asset acquired should be charged with all
costs incurred in obtaining the asset and placing it in productive use. A case could
also be made for prorating the excess cost of developing the first machine equally to
all four machines on the grounds that these costs were necessary in order to obtain
the four machines. In this case, the acquisition of the four machines is analogous to a
"basket" purchase where proration is acceptable.

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 Although less supportable, another alternative treatment of the excess costs of
developing the initial machine is to treat the costs as research and development.
Under current GAAP costs of research and development are expensed as incurred.

Case 9-5

a. The fair market value of the acquired site, as evidenced by the contract price, is
$60,000. It is the amount that represents the actual bargained price of the land in a
cash transaction. To charge any portion of the option costs to the land account is to
disregard the bargained price of the acquired site and, further, implies that the land is
more valuable because of the options.

The purchase of the options enabled the client to delay his/her selection of a site until
the advantages and disadvantages of each were carefully weighted. The benefits to be
derived from the net advantage of the selected site over the rejected sites will accrue
to the operations of the contemplated plant facility. The cost of the options should
therefore be separately capitalized and allocated to the periods benefited.

It may also be argued that the cost of the options represents management's failure to
plan for the acquisition of a site. Such a contention leads to the conclusion that the
cost of the option is a loss and should be expensed immediately, and it supports the
recording of the cost of the acquired site at $60.000.

b. The actual cost of the selected site is the sum of the contract price plus the cost of the
option which was exercised to purchase the land. All costs incurred to secure title to
the land are properly includable as part of its cost. However, to capitalize the cost of
the options that were allowed to lapse would be inappropriate. They have no bearing
on the acquisition of effective title to the selected site and should be treated as a loss.

c. The options were purchased with full knowledge that, after the relative advantages of
the three locations were investigated, only one of the options would be exercised.
Because the intent was to purchase only one of the three sites, the options should be
viewed as an integrated plan for acquiring the site which was ultimately selected.
Thus, the cost of all three options should be capitalized as a part of the cost of
acquiring the selected site.

Case 9-6

a. Relative to plant assets, a cost incurred or an expenditure made, that is assumed to

benefit only the current accounting period is called a revenue expenditure and is
charged to expense in the period believed to benefit. A capital expenditure is
similarly a cost incurred or an expenditure made but is expected to yield benefits
either in all future accounting periods (acquisition of land) or in a limited number of
accounting periods. Capital expenditures (if material in amount) are capitalized, that

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 is, recorded as assets, and, if related to assets of limited life, amortized over the
periods believed to benefit.

The distinction between capital and revenue expenditures is of significance because it

involves the timing of the recognition of expense and, consequently, the
determination of periodic earnings. It also affects the amounts reported as assets
whose costs generally have to be recouped from future periods' revenues.

If a revenue expenditure is improperly capitalized, current earnings are overstated,

assets are overstated, and future earnings are understated for all the periods to which
the improperly capitalized cost is amortized. If the cost is not amortized, future
earnings will not be affected but assets and retained earnings will continue to be
overstated for as long as the cost remains on the books. If a nonamortizable capital
expenditure is improperly expensed, current earnings are understated and assets and
retained earnings are understated for all periods for which unamortized cost should
have remained in the accounting records. If an amortizable capital expenditure is
improperly expensed, current earnings are understated, assets and retained earnings
are understated, and future earnings are overstated for all periods to which the cost
should have been amortized.

b. Depreciation is the accounting process of allocating an asset's historical cost

(recorded amount) to the accounting periods benefited by the use of the asset. It is a
process of cost allocation, not valuation. Depreciation is not intended to provide
funds for an asset's replacement; it is merely an application of the matching concept.

c. The factors relevant in determining the annual depreciation for a depreciable asset are
the initial recorded amount (cost), estimated salvage value, estimated useful life, and
depreciation method.

Assets are typically recorded at their acquisition cost, which is in most cases
objectively determinable. But cost assignments in other cases --"basket purchases"
and the selection of an implicit interest rate in asset acquisition under deferred-
payment plans--may be quite subjective involving considerable judgement.

The salvage value is an estimate of a potentially realizable when the asset is retired
from service. It is initially a judgment factor and is affected by the length of its useful
life to the enterprise.

The useful life is also a judgment factor. It involves selecting the "unit" of measure of
service life and estimating the number of such units embodied in the asset. Such units
may be measured in terms of time periods or in terms of activity (for example, years
or machine hours). When selecting the life, one should select the lower (shorter) of
the physical life or the economic life to this user. Physical life involves wear and tear

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 and casualties; economic life involves such things as technological obsolescence and
inadequacy.

Selecting the depreciation method is generally a judgment decision; but, a method

may be inherent in the definition adopted for the units of service life, as discussed
earlier. For example, if such units are machine hours, the method is a function of the
number of machine hours used during each period. A method should be selected that
will best measure the portion of services expiring each period. Once a method is
selected, it may be objectively applied by using a predetermined, objectively derived
formula.

d. Because revenue usually represents an inflow of funds, and expense usually

represents an outflow of funds, net earnings represent a net inflow of funds.
However, the revenues and expenses reported in the income statements are accrual-
based, not cash-based measures. Hence, net income must be adjusted to measure the
net cash flows from operations. Depreciation reduces reported net earnings but does
not involve an outflow of cash. Therefore, it is added back to reported net earnings to
calculate cash provided by operations. On a statement of cash flows, depreciation
should be clearly shown as an adjustment to net earnings not requiring a use of cash
rather than be shown as a source of cash. Depreciation is not a direct source of cash.
It can be considered an indirect source only through income tax savings.

Case 9-7

a. The following costs, if applicable, should be capitalized as a cost of land:

(a) Negotiated purchase price

(b) Brokers' commission
(c) Legal fees
(d) Title fees
(e) Recording fee
(f) Escrow fees
(g) Surveying fees
(h) Existing unpaid taxes, interest, or liens assumed by the buyer
(i) Clearing, grading, landscaping and subdividing
(j) Cost of removing old building (less salvage)
(k) Special assessments such as lighting or sewers if they are permanent in nature.

b. A plant asset acquired on a deferred-payment plan should be recorded at an

equivalent cash price excluding interest. If interest is not stated in the sales contract,
an imputed interest should be determined. The asset should then be recorded at its
present value, which is computed by discounting the payments at the stated or
imputed interest rate. The interest portion (stated or imputed) of the contract price
should be charged to interest expense over the life of the contract.

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a. In general, plant assets should be recorded at the fair value of the consideration given
or the fair value of the asset received, whichever is more clearly evident.
Specifically, under the criteria contained at FASB ASC 845, when exchanging an old
machine and paying cash for a new machine, the new machine should be recorded at
the amount of monetary consideration (cash paid plus the undepreciated cost of the
nonmonetary asset (old machine) surrendered if there is no indicated loss. No
indicated gain should be recognized by the party paying monetary consideration.

If cash is received, gains are not recognized; however, a loss should be recognized if
the fair value of the asset exchanged is less than its book value (i.e., an impairment is
evident). The resulting amount initially recorded for the acquired asset is equal to the
book value of the exchanged asset (adjusted to its fair value, when there is an
apparent impairment) plus or minus any cash (boot) paid or received.

Case 9-8

a. Expenditures should be capitalized when they benefit future periods. The cost to
acquire the land should be capitalized and classified as land, a nondepreciable asset.
Since tearing down the small factory is readying the land for its intended use, its cost
is part of the cost of the land and should be capitalized and classified as land. As a
result, this cost will not be depreciated as it would if. it was classified with the
capitalizable cost of the building.

Since rock blasting and removal is required for the specific purpose of erecting the
building, its cost is part of the cost of the building and should be capitalized and
classified with the capitalizable cost of the building. This cost should be depreciated
over the estimated useful life of the building.

The road is a land improvement, and its cost should be capitalized and classified
separately as a land improvement. This cost should be depreciated over its estimated
useful life.

The added four stories is an addition, and its cost should be capitalized and classified
with the capitalizable cost of the building. This cost should be depreciated over the
remaining life of the original office building because that life is shorter than the
estimated life of the addition.

b. The gain should be recognized on the sale of the land and building because income is
realized whenever the earning process has been completed and the sale has taken
place.

The net book value at the date of sale would be composed of the capitalized cost of
the land, the land improvement, and the building, as determined above, less the
accumulated depreciation on the land improvement and the building. The excess of

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 the proceeds received from the sale over the net book value at the date of the sale
would be accounted for as a gain and included in income from continuing operations
in the income statement.

Case 9-9

a. The expenditures that should be capitalized when equipment is acquired for cash
should include the invoice price of the equipment (net of discounts) plus all
incidental outlays relating to its purchase or preparation for use, such as insurance
during transit, freight, duties, ownership search, ownership registration, installation,
and breaking-in costs. Any available discounts, whether taken or not, should be
deducted from the capitalizable cost of the equipment.

b. i. When the market value of the equipment is not determinable by reference to a

similar cash purchase, the capitalizable cost of equipment purchased with bonds
having an established market price should be the market value of the bonds.

ii. When the market value of the equipment is not determinable by reference to a
similar cash purchase, and the common stock used in the exchange does not have
an established market price, the capitalizable cost of equipment should be the
equipment's estimated fair value if that is more clearly evident than the fair value
of the common stock. Independent appraisals may be used to determine the fair
values of the assets involved.

iii. When the market value of equipment acquired is not determinable by reference to
a similar cash purchase, the capitalizable cost of equipment purchased by
exchanging similar equipment having a determinable market value should be the
lower of the recorded amount of the equipment relinquished or the market value
of the equipment exchanged.

c. The factors that determine whether expenditures relating to property, plant, and
equipment already in use should be capitalized are as follows:
. Expenditures are relatively large in amount.
. They are nonrecurring in nature.
. They extend the useful life of the property, plant, and equipment.
. They increase the usefulness of the property, plant, and equipment.

d. The net book value at the date of the sale (cost of the property, plant, and equipment
less the accumulated depreciation) should be removed from the accounts. The excess
of cash from the sale over the net book value removed is accounted for as a gain on
the sale and reported on the income statement, while the excess of net book value
removed over cash from the sale is accounted for as a loss on the sale and reported on
the income statement.

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Case 9-10

a. Historical cost is the amount of cash, or its equivalent, paid to acquire an asset. It
includes the purchase price and all cost necessary to acquire the asset and get it ready
for its intended use. Use of historical cost presents the economic facts as they
actually occurred. Thus, it is relevant and reliable. It is relevant because accountants
are stewards to owners. The stewardship role implies that accountants must report
how moneys invested are spent. This information is disclosed by historical prices
paid to acquire assets. Historical cost is reliable because it is objective and verifiable.
Historical exchange prices are objectively determinable and verifiable because they
are based on evidence that an exchange has taken place and amounts are typically
supported by a paper trail, e.g., invoices. Hence, they these measurements represent
what they purport to represent and as such are represenationally faithful and neutral.

An asset is defined as an economic resource that has future benefit to the entity and
results from prior transactions and events. The prior transaction resulting in its
existence is the exchange that occurred when the asset was acquired. Those moneys
were invested in the asset to provide economic benefit to the company. So long as
the asset is in use, cost provides benefit. Hence, cost is a relevant attribute to report
to investors, creditors, and other users.

b. Under the present accounting model, the cost of cleanup would be considered cost of
land. The cost of land includes its acquisition price and all costs incurred to get it
ready for its intended use. In this example the intended use to have a building built
on it. Since, the cleanup is necessary before building can begin, the cost of cleanup is
a cost to get the land ready for its intended use and should be capitalized as land.
Under this scenario the presumption is that the cleanup cost was necessary to acquire
the asset, hence it provides future benefit. The cleanup itself provides value because
without it the land is not usable as a building site, and would presumable be worth
less. Hence, this expenditure fits the definition of an asset.

Case 9-11

a. The stewardship role of accounting implies that accountants should report on how
moneys were invested in assets and the performance resulting from making those
investments. This notion is consistent with reporting assets at historical cost. Long-
term assets provide benefits for a number of time periods. Investments are made in
fixed assets so that over the long-run revenues will be generated. Fixed asset
investments thus generate revenues over multiple accounting periods. The matching
principle implies that these revenues should be matched with the cost of generating
them. Because an element of this cost is the cost of long-term fixed assets these costs
should be matched with the revenues they generate, implying that the cost should be
allocated to those periods in which the revenues (benefits) are expected to occur.

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b. Accountants believe that cost allocation provides relevant information because it
attempts to match cost with revenue and thus provides measures of performance. On
the other hand, all allocation schemes are by their very nature arbitrary. As such,
they are not objective. Also, one could argue that cash flow is all that matters with
regard to fixed assets. In other words, purchasing a fixed asset is an investing
activity, a cash outflows. It is not an operating activity. It provides physical assets to
generate revenue, but it is a sunk cost and does not recur on an annual basis.

c. If the purpose of the balance sheet is to disclose resources and claims to resources,
historical cost once the asset has been purchased may no longer be relevant.
Historical cost does not provide a measure of the current value of the asset in use.
Each period the company in effect makes a conscious decision to keep the asset.
These decisions imply that the company is, in effect, reinvesting in the asset.
Reinvestment decisions are made based on replacement cost. Hence, replacement
cost would provide relevant measures of fixed assets.

d. Yes, a current value approach to the valuation of fixed assets would be consistent
with the physical capital maintenance concept. The concept of physical capital
maintenance is concerned with maintaining productive capacity, the operating assets
of the entity. Assets must eventually be replaced in order to maintain the current
level of productive capacity. Hence, measurement of assets at their replacement cost,
a current cost measure, is consistent with the physical capital maintenance concept.

e. The major problems associated with use of replacement cost relate to determining the
amount of replacement cost. Once purchased, the replacement cost of fixed assets
may be difficult if not practically impossible to determine. Replacement cost is the
cost to replace the assets with similar assets in similar condition. But, there may be
no ready market for the assets. In these cases, it may be necessary to obtain appraisal
values in order to approximate replacement cost. In some cases, specific price
indexes may be used, but these measures provide reasonably approximations only
when the price of the asset being measured moves in the same way as the movement
of the price index.

Moreover, relevance of replacement cost may be questionable. It can be argued that

entry values are relevant only when purchase is contemplated. For owned assets
replacement cost may be irrelevant because these assets will either be used or sold.
Hence, a better measure of current value may be net realizable value.

FASB ASC 9-1 Depreciation

FASB ASC 360-10-35 Found by searching “depreciation and property, plant and
equipment” or by accessing the Assets link and selecting Property, plant and
equipment, overall. Specifically, the definition of depreciation is contained in FASB

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 ASC 350-10-35-4. The pronouncements dealing with depreciation can be found by
accessing the Printer Friendly with sources link. .

FASB ASC 9-2 Asset Impairment

A search of “asset impairments” resulted in over 130 entries. The EITF issues can be
found by searching asset impairment and EITF.

FASB ASC 9-3 Asset Retirement Obligations

The discussion of asset retirement obligations is contained at FASB ASC 410 Found
by searching “asset retirement obligations” or through the cross reference section
using the original pronouncement number FAS 143. The EITF issues can be found by
accessing the Printer Friendly with sources link at topic 410.

FASB ASC 9-4 Disclosure of Depreciation

Found by accessing the Assets link, selecting Property, plant and equipment and
selecting disclosure.

Topic 360-10-50

FASB ASC 9-5 Overhaul Costs in the Airline Industry

Select the industry link and then choose airlines. Select Property and Equipment and
then Initial Measurement.

Topic 908-360

FASB ASC 9-6 Accounting for the Mining Extractive Industry

Select the industry link and then choose extractive industry-mining.

Topic 930-330

FASB ASC 9-7 Franchise Prematurity Period

Select the industry link and then choose franchises.

Topic 952.

Debate 9-1 Capitalization of Interest

Team 1 Argue for the capitalization of interest

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 The FASB considers interest incurred during construction of the asset as an element
of historical cost. Historical cost is the amount of cash, or its equivalent, paid to
acquire an asset. It includes the purchase price and all cost necessary to acquire the
asset and get it ready for its intended use. Use of historical cost presents the
economic facts as they actually occurred. Thus, it is relevant and reliable. It is
relevant because accountants are stewards to owners. The stewardship role implies
that accountants must report how moneys invested are spent. This information is
disclosed by historical prices paid to acquire assets. Historical cost is reliable
because it is objective and verifiable. Historical exchange prices are objectively
determinable and verifiable because they are based on evidence that an exchange has
taken place and amounts are typically supported by a paper trail, e.g., invoices.
Hence, they these measurements represent what they purport to represent and as such
are representationally faithful and neutral.

An asset is defined as an economic resource that has future benefit to the entity and
results from prior transactions and events. The prior transaction resulting in its
existence is the exchange that occurred when the asset was acquired. Those moneys
were invested in the asset to provide economic benefit to the company. So long as
the asset is in use, cost provides benefit. Hence, cost is a relevant attribute to report
to investors, creditors, and other users.

According to SFAS No. 34, (See FASB ASC 835-20) interest during construction is a
cost of getting the asset ready for its intended use. Moneys were spent to construct
the asset. Debt existed so that the moneys could be available to spend on
construction costs. If the moneys had not been spent on constructing the asset, the
moneys could have been used to extinguish the debt. Hence, the interest on the debt
was avoidable. Because the interest was avoidable, its incurrence during the
construction period implies that it was directly attributable to the construction itself.
As such, it is properly classified as a construction cost, i.e., costs attach. It is a cost
of getting the asset ready for its intended use and should be capitalized along with
other construction costs.

Team 2 Argue against the capitalization of interest

Interest is the cost of debt, not the cost of an asset. Interest is a function of time. As
such it is a period cost, i.e., an expense of the accounting period. Debt is incurred to
acquire assets which will be employed to generate future cash inflows, or revenues.
The assets generate the revenue, not the debt. Hence, the assets constitute the
physical plant, the operating assets of the business enterprise. When operating assets
are used up their cost expiration is considered an expense of operations.
Alternatively, because debt is not a part of the physical plant, the cost of debt
(interest) is not considered an operating expense. Rather, it is a nonoperating cost, or
expense, of doing business.

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 According to SFAC No. 6, expenses are outflows or other using up of assets or
incurrences of liabilities from delivering or producing goods, rendering services, or
carrying out other activities that constitute the entity’s ongoing major or central
operations. Debt provides moneys to acquire assets. The assets are used to deliver or
produce goods, etc. Interest is incurred to provide debt. Thus, indirectly, the interest
is an outflow of assets, incurred in the process of delivering or producing goods,
rendering services, or carrying out other activities that constitute the entity’s ongoing
major or central operations. It is incurred during the accounting period in which
those activities take place and is a cost, or expense, of the period. It should not be
capitalized as a part of the historical cost of the constructed asset.

Finance theory is consistent with the argument that interest incurred during
construction should not be capitalized. Modern capital structure theory views
creditors as capital providers. The corporation determines how much debt versus
common stock it wants in its capital structure. In other words, moneys can be
supplied to acquire assets with debt or by issuing common stock. According to
finance theory, the interest on the debt, like dividends to common stockholders, is a
payment to capital providers, a return on their investment in the business. As such it
represents a distribution of income, not a cost incurred to acquire an asset. Under this
theory, interest would not only not be a part of the historical cost of the asset, it
would not even be considered an expense.

Debate 9-2 Donated Assets

Team 1.

Donated assets should not be reported in a company’s balance sheet. Firstly, a

donation is a non-reciprocal transfer. The company did not give up anything to
acquire donated assets. Therefore, there is no cost. According to the historical cost
principle, the cost of an asset includes all costs that were necessary to acquire an
asset and get it ready for its intended use. Since, nothing was expended to acquire
the asset or get it ready for its intended use, the historical cost principle would be
consistent with reporting no value on the company’s balance sheet.

Secondly, non-reporting of donated assets is consistent with financial capital

maintenance, noted by the FASB in the Conceptual Framework as appropriate for
financial reporting. Accordingly, financial accounting would report what was done
with the dollars invested by owners. Since no investor dollars were spent to acquire a
donated asset, there is nothing to report.

Finally, not reporting a value for donated assets is objective. Reporting fair value
would require subjective estimates that may not be unbiased, or if unbiased may not
reflect the fair value of the donated assets. If so, the reported values may not be
relevant to users.

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Team 2.

Donated assets should be reported in a company’s balance sheet at fair value. They
represent an inflow of assets to the company from non-owner sources. They meet the
definition of assets. They are probable future benefits owned or controlled by the
company that resulted from a prior transaction or event (the donation). Thus,
representational faithfulness would require that they be reported in the balance sheet
until used up as an expense.

Reporting fair value of donated assets would provide relevant information to users
regarding the financial position of the company. The company would not have a
hidden asset and the principle of full disclosure would be met.

WWW

Case 9-12

a. Under current GAAP an asset is considered impaired when the total expected future
cash inflows are less than the book value (carrying value) of the asset. That is, the
carrying value of the asset if not recoverable.

b. Under current GAAP, an impairment loss is equal to the difference between the book
value of the asset and its fair market value.

c. Less conservative. The recoverable amount is equal to the gross (total) expected cash
flows. This amount would be greater than fair value. Fair value is typically
presumed to be the present value of expected future cash flows. Hence, the loss
measured using the recoverable amount would be smaller, and income would be
higher (not conservative). Conservatism implies that when choosing between two
alternatives, the one resulting in the lower net income would be selected.

d. Current GAAP measurement of the loss would be more consistent with the economic
concept of income. The economic concept views income as the change in wealth (the
value of the company) from one period to the next, excluding investments by and
distributions to owners. Fair value is a current value measure of wealth, gross future
cash flows would not measure current value.

Case 9-13

Three approaches have been suggested to account for actual interest incurred in financing the
construction or acquisition of property, plant, and equipment.

1. Capitalize no interest during construction. Under this approach interest is considered

a cost of financing and not a cost of construction. It is contended that if the company
had used stock financing rather than debt financing, this expense would not have

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 developed. The major arguments against this approach are that an implicit interest
cost is associated with the use of cash regardless of the source.
2. Capitalize the actual interest costs. This approach relies on the historical cost concept
that only actual transactions are recorded. It is argued that interest incurred is as
much a cost of acquiring the asset as the cost of the materials, labor, and other
resources used. As a result, a company that uses debt financing will have an asset of
higher cost than an enterprise that uses stock financing. The results achieved by this
approach are held to be unsatisfactory by some because the cost of an asset should be
the same whether cash, debt financing, or stock financing is employed.
3. Charge construction with all costs of funds employed, whether identifiable or not.
This approach is an economic cost approach that maintains that one part of the cost of
construction is the cost of financing whether by debt, cash, or stock financing. An
asset should be charged with all costs necessary to get it ready for its intended use.
Interest, whether actual or imputed, is a cost of building, just as labor, materials, and
overhead are costs. A major criticism of this approach is that imputation of a cost of
equity capital is subjective and outside the framework of a historical cost system.

Current GAAP requires that the lower of actual or avoidable interest cost be capitalized as
part of the cost of acquiring an asset if a significant period of time is required to bring the
asset to a condition or location necessary for its intended use. Interest costs would be
capitalized (provided interest costs are being incurred) starting with the first expenditure
related to the asset and would continue until the asset is substantially completed and ready for
its intended use. Capitalization should occur only if the benefits exceed the costs.

Case 9-14

a. The cost of the warehouse is the cash or cash equivalent price of obtaining the asset
and bringing it to the location and condition for its intended use. For Hakie, this is:
Purchase price $20,000
Tax ($20,000 x .06) 1,200
Installation 5,200
Total cost $26,200

b. Weighted-Average Accumulated Expenditures × Interest Rate = Avoidable Interest

Or $700,000×.08 = $56,000

Since Hakie has outstanding debt incurred specifically for the construction project, in
an amount greater than the weighted-average accumulated expenditures of $700,000,
the interest rate of 8% on the borrowed funds is used for capitalization. Capitalization
ceases upon completion of the project at December 31, 2017. Therefore, the
avoidable interest is $56,000, which is less than the actual interest. The investment
revenue of $15,000 is irrelevant because such interest earned on the unexpended
portion of the loan is not allowed to be offset against the amount eligible for
capitalization.

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Case 9-15

a. An impairment loss would not be recognized because the undiscounted cash flows
exceed the carrying amount of the asset.
b. An impairment loss of $4 million would be recognized. In this case, a $400,000
decrease in the cash flow estimate, which may be based on a cash flow projection
many years in the future, would result in the recognition of a $4 million loss.
Case 9-16

Even though $1.0 million is the most likely outcome (50% chance of occurring), the
measurement of the ARO liability should be based on the probability-weighted expected cash
flow of $2.0 million

Case 9-17

a. The issues discussed in IAS No. 16 are the timing of recognition of assets, the
determination of their carrying amounts, and the associated depreciation charges to
be recognized. The revised IAS No. 16 did not change the fundamental approach to
accounting for property, plant and equipment. The Board’s purpose in revising the
standard was to provide additional guidance on selected matters.
b. IAS No. 16 indicates that items of property, plant, and equipment should be
recognized as assets when it is probable that the future economic benefit associated
with these assets will flow to the enterprise and that their cost can be reliably
measured.

Case 9-18

The solution to this case is dependent upon the companies selected by the students. A
recommended method to check their solutions is to require the downloaded company
information to be turned in along with the solution.

Financial Analysis Case

Answers will vary depending on company selected

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