PREVIEW OF CHAPTER 5

PROPERTY, PLANT, AND EQUIPMENT

Property, plant, and equipment are assets of a durable
nature.

Other terms commonly used are plant assets and fixed

assets.

► “Used in operations” and not Includes:

for resale.  Land,

► Long-term in nature and usually

 Building structures,

depreciated.  Equipment.

► Possess physical substance.

Acquisition of PPE
Historical cost measures the cash or cash equivalent
price of obtaining the asset and bringing it to the location
and condition necessary for its intended use.

In general, costs include:

1. Purchase price, including import duties and non-

refundable purchase taxes, less trade discounts and
rebates.

2. Costs attributable to bringing the asset to the

location and condition necessary for it to be used in a
manner intended by the company.
Acquisition of PPE
Companies value property, plant, and equipment in
subsequent periods using either the
 Cost method or
 Fair value (revaluation) method.
Acquisition of PPE
Cost of Land
All expenditures made to acquire land and ready it for use.
Costs typically include:
(1) purchase price;
(2) closing costs, such as title to the land, attorney’s
fees, and recording fees;
(3) costs of grading, filling, draining, and clearing;
(4) assumption of any liens, mortgages, or encumbrances
on the property; and
(5) additional land improvements that have an indefinite
life.
 Cont’d
 Improvements with limited lives, such as private
driveways, walks, fences, and parking lots, are
recorded as Land Improvements and depreciated.

 Land acquired and held for speculation is classified

as an investment.

 Land held by a real estate concern for resale should

be classified as inventory.
Acquisition of PPE
Cost of Buildings
Includes all expenditures related directly to acquisition
or construction. Costs include:

 materials, labor, and overhead costs incurred during

construction and

 professional fees and building permits.

Companies consider all costs incurred, from excavation

to completion, as part of the building costs.
Acquisition of PPE
Cost of Equipment
Include all expenditures incurred in acquiring the
equipment and preparing it for use. Costs include:
 purchase price,
 freight and handling charges,
 insurance on the equipment while in transit,
 cost of special foundations if required,
 assembling and installation costs, and
 costs of conducting trial runs.
Acquisition of PPE
Self-Constructed Assets
Costs include:
 Materials and direct labor
 Overhead can be handled in two ways:
1. Assign no fixed overhead.
2. Assign a portion of all overhead to the
construction process.
Companies use the second method extensively.
Acquisition of PPE
Interest Costs During Construction
Three approaches have been suggested to account for the
interest incurred in financing the construction.

$0 Increase to Cost of Asset $?

Capitalize no Capitalize
interest during Capitalize actual all costs of
construction costs incurred funds
during construction

ILLUSTRATION 5-1
IFRS
Capitalization of Interest Costs
Acquisition of PPE
Interest Costs During Construction
 IFRS requires — capitalizing actual interest (with
modification).
 Consistent with historical cost.
 Capitalization considers three items:
1. Qualifying assets.
2. Capitalization period.
3. Amount to capitalize.
Interest Costs During Construction
Qualifying Assets
Require a substantial period of time to get them
ready for their intended use or sale.
Two types of assets:
 Assets under construction for a company’s own
use.
 Assets intended for sale or lease that are
constructed or produced as discrete projects.
Interest Costs During Construction
Capitalization Period
Begins when:
1. Expenditures for the assets are being incurred.
2. Activities for readying the asset for use or sale are in
progress .
3. Interest costs are being incurred.

Ends when:
The asset is substantially complete and ready for use.
Interest Costs During Construction
Amount to Capitalize
Capitalize the lesser of:
1. Actual interest cost incurred.
2. Avoidable interest - the amount of interest cost
during the period that a company could theoretically
avoid if it had not made expenditures for the asset.
Interest Costs During Construction
 To apply the avoidable interest concept, a company
determines the potential amount of interest that
it may capitalize during an accounting period by
multiplying the appropriate interest rate(s) by the
weighted-average accumulated expenditures for
qualifying assets during the period.

 In computing the WAAE, a company weights the

construction expenditures by the amount of time
(fraction of a year or accounting period) that it can
incur interest cost on the expenditure.
Interest Costs During Construction
Interest Costs During Construction
Illustration: Assume a company borrowed $200,000 at 12%
interest from State Bank on Jan. 1, 2015, for specific purposes
of constructing special-purpose equipment to be used in its
operations. Construction on the equipment began on Jan. 1, 2015,
and the following expenditures were made prior to the project’s
completion on Dec. 31, 2015:
Other general debt existing on
Actual Expenditures during 2015: Jan. 1, 2015:
January 1 $ 100,000
April 30 150,000 $500,000, 14%, 10-year
bonds payable
November 1 300,000
December 31 100,000
$300,000, 10%, 5-year
Total expenditures $ 650,000 note payable
Interest Costs During Construction
Step 1 - Determine which assets qualify for capitalization of
interest.
Special purpose equipment qualifies because it requires a
period of time to get ready and it will be used in the company’s
operations.

Step 2 - Determine the capitalization period.

The capitalization period is from Jan. 1, 2015 through Dec. 31,
2015, because expenditures are being made and interest costs
are being incurred during this period while construction is taking
place.
Interest Costs During Construction
Step 3 - Compute weighted-average accumulated expenditures.
Weighted
Average
Actual Capitalization Accumulated
Date Expenditures Period Expenditures
Jan. 1 $ 100,000 12/12 $ 100,000
Apr. 30 150,000 8/12 100,000
Nov. 1 300,000 2/12 50,000
Dec. 31 100,000 0/12 -
$ 650,000 $ 250,000

A company weights the construction expenditures by the amount

of time (fraction of a year or accounting period) that it can incur
interest cost on the expenditure.
Interest Costs During Construction
Step 4 - Compute the Actual and Avoidable Interest.

Selecting Appropriate Interest Rate:

1. For the portion of weighted-average accumulated

expenditures that is less than or equal to any amounts
borrowed specifically to finance construction of the assets,
use the interest rate incurred on the specific borrowings.

2. For the portion of weighted-average accumulated

expenditures that is greater than any debt incurred
specifically to finance construction of the assets, use a
weighted average of interest rates incurred on all other
outstanding debt during the period.
Interest Costs During Construction
Step 4 - Compute the Actual and Avoidable Interest.
Actual Interest Interest Actual Weighted-average
Debt Rate Interest interest rate on
Specific Debt $ 200,000 12% $ 24,000 general debt

General Debt 500,000 14% 70,000 $100,000

= 12.5%
300,000 10% 30,000 $800,000
$ 1,000,000 $ 124,000

Accumulated Interest Avoidable

Avoidable Interest Expenditures Rate Interest
$ 200,000 12% $ 24,000
50,000 12.5% 6,250
$ 250,000 $ 30,250
Interest Costs During Construction
Step 5 – Capitalize the lesser of Avoidable interest or
Actual interest.

Avoidable interest $ 30,250

Actual interest 124,000

Journal entry to Capitalize Interest:

Equipment 30,250
Interest Expense 30,250
Interest Costs During Construction
Comprehensive Illustration: On November 1, 2014, Shalla
Company contracted Pfeifer Construction Co. to construct
a building for $1,400,000 on land costing $100,000
(purchased from the contractor and included in the first
payment). Shalla made the following payments to the
construction company during 2015.
Interest Costs During Construction
Pfeifer Construction completed the building, ready for
occupancy, on December 31, 2015. Shalla had the following
debt outstanding at December 31, 2015.
Specific Construction Debt
1. 15%, 3-year note to finance purchase of land and
construction of the building, dated December 31,
2014, with interest payable annually on December 31 $750,000
Other Debt
2. 10%, 5-year note payable, dated December 31, 2011,
with interest payable annually on December 31 $550,000
3. 12%, 10-year bonds issued December 31, 2010, with
interest payable annually on December 31 $600,000
Compute weighted-average accumulated expenditures for 2015.
Interest Costs During Construction
Compute weighted-average accumulated expenditures for 2015.

ILLUSTRATION 5-4
Computation of Weighted-Average
Accumulated Expenditures
Interest Costs During Construction
Compute the avoidable interest. ILLUSTRATION 5-5
Computation of
Avoidable Interest
Interest Costs During Construction
Compute the actual interest cost, which represents the
maximum amount of interest that it may capitalize during
2015.

ILLUSTRATION 5-6 The interest cost that Shalla capitalizes is the

Computation of Actual lesser of $120,228 (avoidable interest) and
Interest Cost
$239,500 (actual interest), or $120,228.
Interest Costs During Construction
Shalla records the following journal entries during 2015:
January 1 Land 100,000
Buildings (or CIP) 110,000
Cash 210,000
March 1 Buildings 300,000
Cash 300,000
May 1 Buildings 540,000
Cash 540,000
Dec. 31 Buildings 450,000
Cash 450,000
Buildings (Capitalized Interest) 120,228
Interest Expense 119,272
Cash 239,500
Interest Costs During Construction
At December 31, 2015, Shalla discloses the amount of interest
capitalized either as part of the income statement or in the
notes accompanying the financial statements.
ILLUSTRATION 5-7
Capitalized Interest
Reported in the Income
Statement

ILLUSTRATION 5-8
Capitalized Interest
Disclosed in a Note
Interest Costs During Construction
Special Issues Related to Interest Capitalization
1. Expenditures for Land
 If land is purchased as a site for a structure, interest costs
capitalized during the period of construction are part of
the cost of the plant, not the land.
 Conversely, if the company develops land for lot sales, it
includes any capitalized interest cost as part of the
acquisition cost of the developed land.

2. Interest Revenue
 In general, companies should not offset interest revenue
against interest cost unless earned on specific borrowings.
Valuation of PPE

Companies should record property, plant, and

equipment:

 at the fair value of what they give up or

 at the fair value of the asset received,

whichever is more clearly evident.

Valuation of PPE
Cash Discounts — Discounts for prompt payment.

Deferred-Payment Contracts — Assets purchased on

long-term credit contracts are valued at the present
value of the consideration exchanged.

Lump-Sum Purchases — Allocate the total cost among

the various assets on the basis of their relative fair
market values.

Issuance of Shares — The market price of the

shares issued is a fair indication of the cost of the
property acquired.
Valuation of PPE
Exchanges of Non-Monetary Assets
Ordinarily accounted for on the basis of:
 the fair value of the asset given up or
 the fair value of the asset received,
whichever is clearly more evident.

Companies should recognize immediately any gains or

losses on the exchange when the transaction has
commercial substance.
Exchanges of Non-Monetary Assets
Meaning of Commercial Substance
Exchange has commercial substance if the future
cash flows change as a result of the transaction. That
is, if the two parties’ economic positions change, the
transaction has commercial substance.
ILLUSTRATION 5-10: Accounting for Exchanges
Exchanges of Non-Monetary Assets
Exchanges—Loss Situation
Companies recognize a loss immediately whether
the exchange has commercial substance or not.

Rationale: Companies should not value assets at

more than their cash equivalent price; if the loss
were deferred, assets would be overstated.
Exchanges of Non-Monetary Assets
Illustration: Information Processing, Inc. trades its used machine for
a new model at Jerrod Business Solutions Inc. The exchange has
commercial substance. The used machine has a book value of €8,000
(original cost €12,000 less €4,000 accumulated depreciation) and a fair
value of €6,000. The new model lists for €16,000. Jerrod gives
Information Processing a trade-in allowance of €9,000 for the used
machine. Information Processing computes the cost of the new asset as
follows.
ILLUSTRATION 5-11: Computation of Cost of New Machine
Exchanges of Non-Monetary Assets
Illustration: Information Processing records this transaction as follows:

Equipment 13,000
Accumulated Depreciation—Equipment 4,000
Loss on Disposal of Equipment 2,000
Equipment 12,000
Cash 7,000

ILLUSTRATION 5-12: Computation of Loss on Disposal of Used Machine

Loss on
Disposal
Exchanges of Non-Monetary Assets
Exchanges—Gain Situation
Has Commercial Substance. Company usually records
the cost of a non-monetary asset acquired in exchange
for another non-monetary asset at the fair value of
the asset given up, and immediately recognizes a gain.
Exchanges of Non-Monetary Assets
Illustration: Interstate Transportation Company exchanged a
number of used trucks plus cash for a semi-truck. The used
trucks have a combined book value of $42,000 (cost $64,000
less $22,000 accumulated depreciation). Interstate’s purchasing
agent, experienced in the secondhand market, indicates that
the used trucks have a fair market value of $49,000. In
addition to the trucks, Interstate must pay $11,000 cash for
the semi-truck. Interstate computes the cost of the semi-truck
as follows. Illustration 5-13: Computation of Semi-Truck Cost
 Exchanges of Non-Monetary Assets
Illustration: Interstate records the exchange transaction as follows:
Truck (semi) 60,000
Accumulated Depreciation—Trucks 22,000
Trucks (used) 64,000
Gain on Disposal of Trucks 7,000
Cash 11,000

ILLUSTRATION 5-14: Computation of Gain on Disposal of Used Trucks

Gain on
Disposal
Exchanges of Non-Monetary Assets
Exchanges—Gain Situation
Lacks Commercial Substance. Now assume that
Interstate Transportation Company exchange lacks
commercial substance.
Interstate defers the gain of $7,000 and reduces the
basis of the semi-truck.
Exchanges of Non-Monetary Assets
Illustration: Interstate records the exchange transaction as follows:

Trucks (semi) 53,000

Accumulated Depreciation—Trucks 22,000
Trucks (used) 64,000
Cash 11,000

ILLUSTRATION 5-15: Basis of Semi-Truck—Fair Value vs. Book Value

Exchanges of Non-Monetary Assets
Summary of Gain and Loss Recognition
on Exchanges of Non-Monetary Assets ILLUSTRATION 5-16

Disclosure include
 nature of the transaction(s),
 method of accounting for the assets exchanged, and
 gains or losses recognized on the exchanges.
Valuation of PPE
Government Grants
Government Grants are assistance received from a
government in the form of transfers of resources to a
company in return for past or future compliance with
certain conditions relating to the operating activities
of the company.
IFRS requires grants to be recognized in income
(income approach) on a systematic basis that matches
them with the related costs that they are intended to
compensate.
Government Grants
Example 1: Grant for Lab Equipment. AG Company received a
€500,000 subsidy from the government to purchase lab
equipment on January 2, 2015. The lab equipment cost is
€2,000,000, has a useful life of five years, and is depreciated on
the straight-line basis.

IFRS allows AG to record this grant in one of two ways:

1. Credit Deferred Grant Revenue for the subsidy and

amortize the deferred grant revenue over the five-year
period.

2. Credit the lab equipment for the subsidy and depreciate

this amount over the five-year period.
Government Grants
Example 1: Grant for Lab Equipment. If AG chooses to record
deferred revenue of €500,000, it amortizes this amount over the
five-year period to income (€100,000 per year). The effects on
the financial statements at December 31, 2015, are:

ILLUSTRATION 5-17
Government Grant
Recorded as Deferred
Revenue
Government Grants
Example 1: Grant for Lab Equipment. If AG chooses to reduce
the cost of the lab equipment, AG reports the equipment at
€1,500,000 (€2,000,000 - €500,000) and depreciates this
amount over the five-year period. The effects on the financial
statements at December 31, 2015, are:
ILLUSTRATION 5-18
Government Grant Adjusted to Asset
Cont’d
Cont’d
Government Grants
 When a company contributes a non-monetary asset, it should
record the amount of the donation as an expense at the fair
value of the donated asset.

 If a difference exists between the fair value of the asset

and its book value, the company should recognize again or
loss.

 To illustrate, Kline Industries donates land to the City of

São Paulo for a city park. The land cost R$80,000 and has a
fair value of R$110,000. Kline records this donation as:
Costs Subsequent to Acquisition
Recognize costs subsequent to acquisition as an
asset when the costs can be measured reliably and it
is probable that the company will obtain future
economic benefits.
Evidence of future economic benefit would include
increases in
1. useful life,
2. quantity of product produced, and
3. quality of product produced.
Costs Subsequent to Acquisition
Costs Subsequent to Acquisition
Additions
 Additions should present no major accounting problems.
By definition, companies capitalize any addition to plant
assets because a new asset is created.

 For example, the addition of a wing to a hospital, or of

an air conditioning system to an office, increases the
service potential of that facility.

 Companies should capitalize such expenditures and

match them against the revenues that will result in
future periods.
Costs Subsequent to Acquisition
Improvement & Replacements
 Many times, improvements and replacements result from a
general policy to modernize or rehabilitate an older
building or piece of equipment.

 The problem is differentiating these types of

expenditures from normal repairs.

 Does the expenditure increase the future service

potential of the asset? Or, does it merely maintain the
existing level of service?

 Frequently, the answer is not clear-cut. Good judgment is

required to correctly classify these expenditures.
Costs Subsequent to Acquisition
Improvement & Replacements
 If the expenditure increases the future service
potential of the asset, a company should
capitalize it.

 The company should simply remove the cost of

the old asset and related depreciation and
recognize a loss, if any.

 It should then add the cost of the new

substituted asset.
Cont’d
Cont’d
Costs Subsequent to Acquisition
Rearrangement & Reorganizations
 A company may incur rearrangement or reorganization
costs for some of its assets.

 The question is whether the costs incurred in this

rearrangement or reorganization are capitalized or
expensed.

 IFRS indicates that the recognition of costs ceases once

the asset is in the location and condition necessary to
begin operations as management intended.

 As a result, the costs of reorganizing or rearranging existing

PPE are not capitalized but are expensed as incurred.
Costs Subsequent to Acquisition
Repairs
 A company makes ordinary repairs to maintain plant
assets in operating condition.

 It charges ordinary repairs to an expense account in the

period incurred on the basis that it is the primary period
benefited.

 Ordinary repairs include replacing minor parts, lubricating

and adjusting equipment, repainting, and cleaning.

 A company treats these as ordinary operating expenses.

Costs Subsequent to Acquisition
Repairs
 It is often difficult to distinguish a repair from an
improvement or replacement.

 The major consideration is whether the expenditure

benefits more than one year or one operating cycle,
whichever is longer.

 If a major repair (such as an overhaul) occurs,

several periods will benefit. A company should
generally handle this cost as an improvement or
replacement.
Costs Subsequent to Acquisition
ILLUSTRATION 5-21 Summary of Costs Subsequent to Acquisition
Disposition of PPE
A company may retire plant assets voluntarily or dispose of
them by:
 Sale,
 Exchange,
 Involuntary conversion, or
 Abandonment.

Depreciation must be taken up to the date of disposition.

Disposition of PPE
Sale of Plant Assets
Illustration: Barret Company recorded depreciation on a
machine costing €18,000 for nine years at the rate of
€1,200 per year. If it sells the machine in the middle of the
tenth year for €7,000, Barret records depreciation to the
date of sale as:

Depreciation Expense (€1,200 x ½) 600

Accumulated Depreciation—Machinery 600
Disposition of PPE
Illustration: Barret Company recorded depreciation on a
machine costing $18,000 for 9 years at the rate of $1,200
per year. If it sells the machine in the middle of the tenth
year for $7,000, Barret records depreciation to the date
of sale. Record the entry to record the sale of the asset:

Cash 7,000
Accumulated Depreciation—Machinery 11,400
Machinery 18,000
Gain on Disposal of Machinery 400
Disposition of PPE
Involuntary Conversion
Sometimes an asset’s service is terminated through some
type of involuntary conversion such as fire, flood, theft,
or condemnation.
Companies report the difference between the amount
recovered (e.g., from a condemnation award or insurance
recovery), if any, and the asset’s book value as a gain or
loss.
They treat these gains or losses like any other type of
disposition.
Disposition of PPE
Illustration: Camel Transport Corp. had to sell a plant
located on company property that stood directly in the path
of an interstate highway. Camel received $500,000, which
substantially exceeded the book value of the land of
$150,000 and the book value of the building of $100,000
(cost of $300,000 less accumulated depreciation of
$200,000). Camel made the following entry.

Cash 500,000
Accumulated Depreciation—Buildings 200,000
Buildings 300,000
Land 150,000
Gain on Disposal of Plant Assets 250,000
The End of Chapter 5
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