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16/12/2020 08:15:06 AM

Accounting for valuation and disposition of property plant, and equipment in U.S

ACCOUNTING FOR VALUATION AND DISPOSITION OF PROPERTY PLANT, AND EQUIPMENT IN U.S

Nguyễn Thị Kim Hương

1. Valuation of Property, Plant, and Equipment

1.1 Cash Discounts

When a company purchases plant assets subject to cash discounts for prompt payment, how should it report the discount? If it takes the discount, the company should consider the discount as a reduction in the purchase price of the asset. But should the company reduce the asset cost even if it does not take the discount?

Two points of view exist on this question. One approach considers the discount— whether taken or not—as a reduction in the cost of the asset. The rationale for this approach is that the real cost of the asset is the cash or cash equivalent price of the asset.

In addition, some argue that the terms of cash discounts are so attractive that failure to take them indicates management error or inefficiency. Proponents of the other approach argue that failure to take the discount should not always be considered a loss. The terms may be unfavorable, or it might not be prudent for the company to take the discount. At present, companies use both methods, though most prefer the former method.

1.2 Deferred-Payment Contracts

Companies frequently purchase plant assets on long-term credit contracts, using notes, mortgages, bonds, or equipment obligations. To properly reflect cost, companies account for assets purchased on long-term credit contracts at the present value of the consideration exchanged between the contracting parties at the date of the transaction.

For example, Greathouse Company purchases an asset today in exchange for a $10,000 zero-interest-bearing note payable four years from now. The company would not record the asset at $10,000. Instead, the present value of the $10,000 note establishes the exchange price of the transaction (the purchase price of the asset). Assuming an appropriate interest rate of 9 percent at which to discount this single payment of $10,000 due four years from now, Greathouse records this asset at $7,084.30 ($10,000 _ .70843).

When no interest rate is stated, or if the specified rate is unreasonable, the company imputes an appropriate interest rate. The objective is to approximate the interest rate that the buyer and seller would negotiate at arm’s length in a similar borrowing transaction. In imputing an interest rate, companies consider such factors as the borrower’s credit rating, the amount and maturity date of the note, and prevailing interest rates.

The company uses the cash exchange price of the asset acquired (if determinable) as the basis for recording the asset and measuring the interest element.

To illustrate, Sutter Company purchases a specially built robot spray painter for its production line. The company issues a $100,000, five-year, zero-interest-bearing note to Wrigley Robotics, Inc. for the new equipment. The prevailing market rate of interest for obligations of this nature is 10 percent. Sutter is to pay off the note in five $20,000 installments, made at the end of each year. Sutter cannot readily determine the fair value of this specially built robot. Therefore Sutter approximates the robot’s value by establishing the fair value (present value) of the note. Entries for the date of purchase and dates of payments, plus computation of the present value of the note, are as follows.

Date of Purchase

Equipment 75,816*

Discount on Notes Payable 24,184

Notes Payable 100,000

*Present value of note      = $20,000 (PVF-OA5,10%)

= $20,000 (3.79079)

= $75,816

End of First Year

Interest Expense 7,582

Notes Payable 20,000

Cash 20,000

Discount on Notes Payable 7,582

Interest expense in the first year under the effective-interest approach is $7,582 [($100,000 _ $24,184) _ 10%]. The entry at the end of the second year to record interest and principal payment is as follows.

End of Second Year

Interest Expense 6,340

Notes Payable 20,000

Cash 20,000

Discount on Notes Payable 6,340

Interest expense in the second year under the effective-interest approach is $6,340 [($100,000 _ $24,184) _ ($20,000 _ $7,582)] _ 10%. If Sutter did not impute an interest rate for deferred-payment contracts, it would record the asset at an amount greater than its fair value. In addition, Sutter would understate interest expense in the income statement for all periods involved.

1.3 Lump-Sum Purchases

A special problem of valuing fixed assets arises when a company purchases a group of plant assets at a single lump-sum price. When this common situation occurs, the company allocates the total cost among the various assets on the basis of their relative fair values. The assumption is that costs will vary in direct proportion to fair value.

This is the same principle that companies apply to allocate a lump-sum cost among different inventory items. To determine fair value, a company should use valuation techniques that are appropriate in the circumstances. In some cases, a single valuation technique will be appropriate. In other cases, multiple valuation approaches might have to be used.

1.4 Issuance of Stock

When companies acquire property by issuing securities, such as common stock, the par or stated value of such stock fails to properly measure the property cost. If trading of the stock is active, the market value of the stock issued is a fair indication of the cost of the property acquired. The stock is a good measure of the current cash equivalent price.

For example, Upgrade Living Co. decides to purchase some adjacent land for expansion of its carpeting and cabinet operation. In lieu of paying cash for the land, the company issues to Deedland Company 5,000 shares of common stock (par value $10) that have a fair market value of $12 per share. Upgrade Living Co. records the following entry.

Land (5,000 _ $12) 60,000

Common Stock                          50,000

Paid-In Capital in Excess of Par 10,000

If the company cannot determine the market value of the common stock exchanged, it establishes the fair value of the property. It then uses the value of the property as the basis for recording the asset and issuance of the common stock.

1.5 Exchanges of Nonmonetary Assets

The proper accounting for exchanges of nonmonetary assets, such as property, plant, and equipment, is controversial.5 Some argue that companies should account for these types of exchanges based on the fair value of the asset given up or the fair value of the asset received, with a gain or loss recognized. Others believe that they should account for exchanges based on the recorded amount (book value) of the asset given up, with no gain or loss recognized. Still others favor an approach that recognizes losses in all cases, but defers gains in special situations.

Ordinarily companies account for the exchange of nonmonetary assets 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. Thus, companies should recognize immediately any gains or losses on the exchange. The rationale for immediate recognition is that most transactions have commercial substance, and therefore gains and losses should be recognized.

Meaning of Commercial Substance

As indicated above, fair value is the basis for measuring an asset acquired in a nonmonetary exchange if the transaction has commercial substance. An 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.

For example, Andrew Co. exchanges some if its equipment for land held by Roddick Inc. It is likely that the timing and amount of the cash flows arising for the land will differ significantly from the cash flows arising from the equipment.

As a result, both Andrew Co. and Roddick Inc. are in different economic positions. Therefore, the exchange has commercial substance, and the companies recognize a gain or loss on the exchange.

Exchanges—Loss Situation

When a company exchanges nonmonetary assets and a loss results, the company recognizes the loss immediately. The rationale: Companies should not value assets at more than their cash equivalent price; if the loss were deferred, assets would be overstated. Therefore, companies recognize a loss immediately whether the exchange has commercial substance or not.

For example, 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.

List price of new machine $16,000

Less: Trade-in allowance for used machine 9,000

Cash payment due 7,000

Fair value of used machine 6,000

Cost of new machine $13,000

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

Exchanges—Gain Situation

Has Commercial Substance. Now let’s consider the situation in which a nonmonetary exchange has commercial substance and a gain is realized. In such a case, a company usually records the cost of a nonmonetary asset acquired in exchange for another nonmonetary asset at the fair value of the asset given up, and immediately recognizes a gain. The company should use the fair value of the asset received only if it is more clearly evident than the fair value of the asset given up.

To illustrate, 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 second-hand 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.

Interstate records the exchange transaction as follows:

Semi-truck 60,000

Accumulated Depreciation—Trucks 22,000

Trucks 64,000

Gain on Disposal of Used Trucks 7,000

Cash 11,000

Transportation Company exchange lacks commercial substance. That is, the economic position of Interstate did not change significantly as a result of this exchange. In this case, Interstate defers the gain of $7,000 and reduces the basis of the semi-truck.

Interstate records this transaction as follows:

Semi-truck 53,000

Accumulated Depreciation—Trucks 22,000

Trucks 64,000

Cash 11,000

2. Costs Subsequent to acquisition

After installing plant assets and readying them for use, a company incurs additional costs that range from ordinary repairs to significant additions. The major problem is allocating these costs to the proper time periods. In general, costs incurred to achieve greater future benefits should be capitalized, whereas expenditures that simply maintain a given level of services should be expensed. In order to capitalize costs, one of three conditions must be present:

1. The useful life of the asset must be increased.

2. The quantity of units produced from the asset must be increased.

3. The quality of the units produced must be enhanced.

For example, a company like Boeing should expense expenditures that do not increase an asset’s future benefits. That is, it expenses immediately ordinary repairs that maintain the existing condition of the asset or restore it to normal operating efficiency.

Companies expense most expenditures below an established arbitrary minimum amount, say, $100 or $500. Although, conceptually, this treatment may be incorrect, expediency demands it. Otherwise, companies would set up depreciation schedules for such items as wastepaper baskets and ashtrays.

2.1 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.

2.2 Improvements and Replacements

Companies substitute one asset for another through improvements and replacements. What is the difference between an improvement and a replacement? An improvement (betterment) is the substitution of a better asset for the one currently used (say, a concrete floor for a wooden floor). A replacement, on the other hand, is the substitution of a similar asset (a wooden floor for a wooden floor).

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.

If the expenditure increases the future service potential of the asset, a company should capitalize it. The accounting is therefore handled in one of three ways, depending on the circumstances:

  1. Use the substitution approach.

Conceptually, the substitution approach is correct if the carrying amount of the ol asset is available. It is then a simple matter to removethe cost of the old asset and replace it with the cost of the new asset.

To illustrate, Instinct Enterprises decides to replace the pipes in its plumbing system. A plumber suggests that the company use plastic tubing in place of the cast iron pipes and copper tubing. The old pipe and tubing have a book value of $15,000 (cost of $150,000 less accumulated depreciation of $135,000), and a scrap value of $1,000. The plastic tubing system costs $125,000. If Instinct pays $124,000 for the new tubing after exchanging the old tubing, it makes the following entry:

Plumbing System 125,000

Accumulated Depreciation 135,000

Loss on Disposal of Plant Assets 14,000

Plumbing System 150,000

Cash ($125,000 _ $1,000) 124,000

The problem is determining the book value of the old asset. Generally, the components of a given asset depreciate at different rates. However, generally no separate accounting is made. For example, the tires, motor, and body of a truck depreciate at different rates, but most companies use one rate for the entire truck. Companies can set separate depreciation rates, but it is often impractical. If a company cannot determine the carrying amount of the old asset, it adopts one of two other approaches.

  1. Capitalize the new cost.

Another approach capitalizes the improvement and keeps the carrying amount of the old asset on the books. The justification for this approach is that the item is sufficiently depreciated to reduce its carrying amount almost to zero. Although this assumption may not always be true, the differences are often insignificant. Companies usually handle improvements in this manner.

  1. Charge to accumulated depreciation.

In cases when a company does not improve the quantity or quality of the asset itself, but instead extends its useful life, the company debits the expenditure to Accumulated Depreciation rather than to an asset account. The theory behind this approach is that the replacement extends the useful life of the asset and thereby recaptures some or all of the past depreciation. The net carrying amount of the asset is the same whether debiting the asset or accumulated depreciation.

2.3 Rearrangement and Reinstallation

Companies incur rearrangement and reinstallation costs to benefit future periods. An example is the rearrangement and reinstallation of machines to facilitate future production. If a company like Eastman Kodak can determine or estimate the original installation cost and the accumulated depreciation to date, it handles the rearrangement and reinstallation cost as a replacement. If not, which is generally the case, Eastman Kodak should capitalize the new costs (if material in amount) as an asset to be amortized over future periods expected to benefit. If these costs are immaterial, if they cannot be separated from other operating expenses, or if their future benefit is questionable, the company should immediately expense them.

2.4 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. Maintenance charges that occur regularly include replacing minor parts, lubricating and adjusting equipment, repainting, and cleaning.

A company treats these as ordinary operating expenses. 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. Acompany should handle the cost as an addition, improvement, or replacement

3. Disposition of Property, Plant, and Equipment

3.1 Sale of Plant Assets

Companies record depreciation for the period of time between the date of the last depreciation entry and the date of sale. To illustrate, assume that 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 as:

Depreciation Expense ($1,200 _ ) 600

Accumulated Depreciation—Machinery 600

The entry for the sale of the asset then is:

Cash 7,000

Accumulated Depreciation—Machinery 11,400

[($1,200 * 9) + $600]

Machinery 18,000

Gain on Disposal of Machinery 400

The book value of the machinery at the time of the sale is $6,600 ($18,000 -  $11,400). Because the machinery sold for $7,000, the amount of the gain on the sale is $400.

3.2 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. In some cases, these gains or losses may be reported as extraordinary items in the income statement, if the conditions of the disposition are unusual and infrequent in nature.

To illustrate, Camel Transport Corp. had to sell a plant located on company property that stood directly in the path of an interstate highway. For a number of years the state had sought to purchase the land on which the plant stood, but the company resisted. The state ultimately exercised its right of eminent domain, which the courts upheld. In settlement, Camel received $500,000, which substantially exceeded the $200,000 book value of the plant and land (cost of $400,000 less accumulated depreciation of $200,000). Camel made the following entry.

Cash 500,000

Accumulated Depreciation—Plant Assets 200,000

Plant Assets 400,000

Gain on Disposal of Plant Assets 300,000

If the conditions surrounding the condemnation are judged to be unusual and infrequent, Camel’s gain of $300,000 is reported as an extraordinary item.

 


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