CASE 7-2. Joan Holtz(C) Joan Holtz said to the accounting instructor,” The general principal for arriving at the amount of a fixed assets that is to be capitalized is reasonably clear, but there certainly are a great many problems in applying this principle to specific situation. QUESTION 1: 1. Suppose that the Bruce Manufacturing Company used its own maintenance crew to build an additional wing on its existing factory building. What would be the proper accounting treatment for the following treatment of the following items? Question 1-a
Architects’ fees should be capitalized. Architect is employed to seek planning and building approvals from the relevant authorities before a building project can be implemented. (These are all ‘one-time costs’ incurred for making the place ready for construction hence, to be capitalized). Capital expenditures include those for building improvements or other long-term betterments, new equipment, architect’s fees even the cost of defending or perfecting title to property. Capital expenditures also include amounts paid to improve equipment or property already owned.
Examples of construction costs include, but are not limited to, building materials, architects’ fees, building permit fees, subcontract fees, rent for property, other than real property, to complete construction, operating and maintenance costs for property used in the construction, site preparation, compensation for work performed, and cost of supplies consumed in the construction. Capitalization takes place during the completion of the project. Question 1-b. Snow removal costs should be capitalized (include costs for materials, such as salt bags and calcium bags and sometimes need to use snow removal using rucks). Question 1-c. Cash discounts earned should be capitalized(consider as a reduction in the cost of the assets). Many companies automatically take advantage of these discounts as a matter of policy because of the high rate of interest earned. If didn’t accept the cash discount. The other view is that failure to take the discount should not be considered a loss, because the terms may be unfavorable or the company might not be prudent to take the discount. Question 1-d. The cost of building a combined construction office and tool shed should be capitalized in the asset account. including direct costs, labor) associated with the construction project shall be included in establishing the asset valuation). Buildings and other construction are first accounted for as construction in progress. When the construction is at least 90% complete or the construction has been certified as substantially complete, the construction is removed from construction in progress and accounted for as buildings or other. Question 1-e. Interest on money borrowed to finance construction should be capitalized.
The amount of interest capitalized is the amount related to borrowings made to finance the project. The total amount of interest capitalized cannot exceed the company’s total interest cost of the period. The interest capitalization period ends when the assets is substantially complete and ready for its intended use. Question 1-f Local real estate taxes should be capitalized and depreciated. For tax purposes, it is a cost which cannot be deducted in the year in which it is paid or incurred and must be capitalized.
The general rule is that if the acquired property’s useful life is longer than the taxable year, then the cost must be capitalized. The capital expenditure costs are then amortized or depreciated over the life of the asset in question. Question 1-g Cost of mistakes made during construction should be treated as expenses. (The share of these costs attributed directly to the construction are to be capitalized to the construction. ) Question 1-h Overhead costs of the maintenance department should be capitalized. All costs of preparing assets for use should be capitalized. Employee wages paid for the construction work.
Example, building improvements may include interior and upgrading existing facilities by installation or replacement of materials and equipment. Overhead costs for a business are the cost of resources used by an organization just to maintain its existence. Overhead costs are usually measured in monetary terms, but non-monetary overhead is possible in the form of time required to accomplish tasks. Question 1-i Cost of Insurance during construction and the cost of damages not covered by insurance should be treated as expensed (EXPENSES) So, should buy new insurance and not all existing cost will be covered.
QUESTION 2 Assume that the Archer Company bought a large piece of land, including the building thereon, with the intent of razing the buildings and constructing a combined hotel and office building in their place. The existing buildings consisted of theater and several stores and small apartment buildings, all in active use at the time purchase. Question 2-a Regarding this question the scenario would be, Archer Company’s intention is wanted to buy land plus the building thereon which the building then will be razed in order to build a combined hotel and office building.
To be more specific below are the items involved; i)Land ii)Old building iii)Demolishing old building In this case, the cost involved would be cost of acquiring the land and old building without considering the cost of demolishing the building yet. Question 2-b Next scenario would be focusing to the main subject which is building. Similar to question 2(a), Archer has bought the land together with the buildings thereon. The intention of this transaction is to have an empty piece of land to construct a new hotel and office building.
In addition, all the costs associated with getting the land ready for the construction should be capitalized as the cost of the land. Therefore, the cost of demolishing the existing buildings to have the land ready for the construction should also be capitalized as the cost of the land. Question 2-c If a single company had owned this large piece of land, the land and the buildings thereon should be separate items in the fixed assets of the company. The reason is because the buildings have a limited economic life, while the land will last indefinitely.
Hence, the buildings will be depreciated while the land is not depreciated. As can be referred in the answer of (a) and (b) above, the intention of the purchase is to have a land ready to build new buildings. Therefore, all the costs involved to have the land ready to construct new buildings are capitalized as the cost of the land In addition, as for (c), the land and the buildings are already separate assets items. Therefore, the cost of the land is not affected. The intention is to construct a new hotel and office building, and to do this, the existing buildings need to be demolished.
Hence, the costs of the demolition of the existing buildings are capitalized along with the costs of the new buildings. In the beginning, purchase price of old building in owner book would be the original cost of the building. The cost is recorded less its accumulated depreciation in owner’s balance sheet. As the owner want to demolish the premise, the old building cost and accumulated depreciation would be removed from the balance sheet and any loss or gain on the building would be recognized and to be written off as expense of the period QUESTION 3:
Midland Manufacturing Company purchased a new machine. It is clear that the invoice price of the new machine should be capitalized, and it also seems reasonable to capitalize the transportation cost to bring the machine to the Midland plant. I am not so clear, however, on the following items. Question 3-a: In our case, the foundation under the new machine which has to be strengthened by the installation of additional steel beams should be charged to the cost of the machine. The cost incurred to install the new machine, therefore it is a cost requirement for machine to get ready for operation .
As it is state in the case that the equipment as mentioned above should be capitalized. So this installation cost should also be capitalized along with the cost of the new machine. Question 3-b: Regular installation maintenance crew, engineer, the foreman of the department plant superrintendent labor cost incurred and materials spoiled during the trial runs, all these cost should be charged to the cost of the machine, because all these costs incurred to get the new machine ready for operation. Question 3-c: he payment of a state sles tax on purchasing the machine and other taxes that may incur to purchase the machine would be part of the machine costs. Question 3-d: When property and equipment are disposed of by trading for new assets, the value of the old asset is used in calculating the acquisition cost of the new asset. Hence, the value of the old asset is used in calculating the cost of the new asset, and it is not treated as a gain on disposal of the old one, because an exchage or trade – in of similar assets does not result in the culmination of earnings process.
As the result, the difference between the trade-in value and the depreciated value of the old machine should be treated as deduction to the cost of the new machine because accepting Midland Company’s old machine as partial payment is trading old asset to a similar new asset. QUESTION 4 For question regarding whether these costs be added to the asset value of leased computers and amortized over the lease period?
The “application engineering” can be added to the asset value because this product release to the customer because from question already mention that this company assisted new customers in installing the computer and in designing the related systems. . As a result, annual amortization for these costs greater using the straight line method amount or the amount determined by the ratio of the year’s revenues to the total anticipated revenue for the product. Or another way is if a company thinks the leased computers as finance lease.
All costs that include in “application engineering” can be assumed contributed to the net investment of leased computer. All this guideline already stated that revenue for the leased computer should be recognized over the lease term, conforms to the argument to include the cost in the asset value and amortized over the lease period. The matching concept is assumed in this issue. Lastly, could other marketing costs related to release computers be treated in the same way? The answer is a marketing cost can’t treat as that way. It is because difficult for us to determine whether this marketing cost can contribute to success marketing activities.
In other reason such as accounting treatment, marketing costs in the asset value can’t include together with amortized. This cost actually include in term of expenses and it’s did not contribute to the net investment of the leased computer. Therefore, the marketing costs can’t be added to the asset value of leased computers. For additional information, if this computer manufacturing takes capital allowance for a leased asset, it can be classify into account in the lessor’s book or the lessee’s? The suitable answer is a lessor must record it as receivable which is not fixed asset.
It is because we assume that leased item as its fixed asset. In another area, for income tax purpose, the lease rentals will not be allowable for the claims of capital allowances. The lessee treats this issue as leased asset at the end of the lease period based on the assumption made for this question is that the lease is a finance lease. If the buyers decided to buy computers as long as they did not have ability to pay full amount. They finance the purchase through lease whereby at the end of the lease the computer’s ownership would be transferred to the lessee.
In this case, even though the main asset actually owned by the lessor but it could be accounted for as if owned but the lessee. QUESTION 5 Question 5-a The costs of $50, 000 should not continue to be capitalized because this development cost incurred, which is the future success of the upgrading is uncertainty and the benefits are obtained in the current period. Thus, it should be treated as an expense. In this situation, we can include the prudence concept, although most of criteria to capitalize the cost are fulfilled.
The development costs treated as expenses because to count R costs is not easy and need complicated process. It is because some costs may never result in future benefits. In this case, the upgrading of output quality of the machine could not know for certain. Hence, the additional $50, 000 of additional debugging to upgrade the quality of the equipment to the intended standard is to be expensed in the period incurred. The reason of not capitalizing it is achieving the expected improvement to the standard could not be ascertained for sure (highly uncertain).
Because the result of not achieving is known, the cost would be avoided. But this is not possible. Thus, though include the cost into income statement in the period would go against the matching principle; the prudence concept takes priority over matching concept. Question 5-b The amount of depreciation for the initial production periods should not be adjusted as the additional cost because it is not incorporated in the equipment value that is not capitalized but expensed as the period costs. However, if the development cost is capitalized, the depreciation amount at the initial production process would not be adjusted.
Even though, the development costs may increase the value and the life of the asset. These variables should be adjusted in calculating the depreciation of asset once the development costs incorporated in its value. Question 5-c The implication of capitalizing the cost of the asset if the standards not achieved, would the cost remains as the capital expense? In this case where is a standard not achieved, the cost has to be expensed off in the period recognizing that the cost incurred does not provide the expected future benefits to the asset.