SM ch12

CHAPTER 12
QUESTIONS
1. a. The cost of land includes the original
purchase price; brokers commissions;
legal fees; title, recording, and escrow
fees;
surveying
costs;
local
government special assessment taxes;
cost of clearing or grading; and other
costs that permanently improve the
land or prepare it for use. Expenditures
for land improvements that have a
limited life, such as paving, fencing,
and landscaping, may be separately
summarized as land improvements
and depreciated over their estimated
useful lives.
b. The cost of buildings includes the
original purchase price, brokers
commissions, legal fees, title and
escrow fees, reconditioning costs,
alteration and improvement costs, and
any other costs that improve the
buildings and hence benefit future
periods.
c. The cost of equipment includes the
original purchase price, taxes and
duties on purchases, freight charges,
insurance while in transit, installation
charges and other costs in preparing
the asset for use, subsequent
improvements or additions, and any
other expenditures that will improve the
equipment and thus benefit more than
one period.
2. a. A copyright, when purchased, is
recorded at its purchase price. When
internally developed, all costs of legally
establishing the copyright are included
as costs of the copyright.
b. The cost of purchasing a franchise and
all other sums paid specifically for a
franchise including legal fees are
considered the franchise cost. Property
improvements required under the
franchise also are recorded as part of
the franchise cost.
c. The cost of a trademark includes all
expenditures required to establish the
trademark, such as filing and
registration fees, as well as legal
expenses for the defense of the
3.
4.
5.
6.
63
trademark. Purchased trademarks are

recorded at the purchase price.
Accountants frequently are required to
allocate costs among two or more
accounts. The principal method of
allocation is based on relative market
values of the individual assets, if they can
be determined. A ratio of each individual
assets market value to the sum of the
market values for all assets involved in the
purchase is used to determine cost for
each individual asset. If market values, or
some approximation of market values,
cannot be obtained for all assets in the
basket purchase, allocation can be made to
those assets where market values are
available, and any remaining balance can
be allocated, on some systematic basis, to
remaining assets.
When equipment is purchased on a
deferred payment contract, care must be
taken to exclude the stated or implicit
interest from the purchase price. The asset
should be recorded at its equivalent cash
price. Interest on the unpaid contract
balance should be recognized as interest
expense over the life of the contract.
a. Sales practice for some products
consistently inflates the list price that is
initially assigned. Because most buyers
are aware of this practice, considerable
negotiations take place between buyers
and sellers before a market price is
established. If accountants use the list
price without careful evaluation, values
could be inflated.
b. The goal of accounting for the
acquisition of property and equipment
is to record the acquisition at the
equivalent cash price or the closest
approximation to cash that can be
obtained. This is especially important
when trade-ins are involved.
a. In constructing a new building for its
own use, Gaylen Corp. will charge the
building with all costs incurred in
connection with the construction
activities. These costs will include
building costs in the form of direct
labor,
direct
materials,
factory
overhead, and any other expenditures
that can be identified with the
construction of the asset.
b. When a company constructs its own
assets, there are two positions that
may be taken in assigning general
overhead to the cost of the asset: (1)
Overhead may be assigned to special
construction just as it is assigned to
normal activities on the grounds that
both activities benefit from the
overhead; this would mean that
construction would be charged with the
increase in overhead arising from
construction activities as well as a pro
rata share of the companys fixed
overhead. (2) Only the increase in
overhead may be charged to
construction on the grounds that
management decides to construct its
own
assets
after
giving
due
consideration to the differential or
additional costs involved. An equitable
allocation of the fixed overhead
between regular operations and
construction affords no special favor to
construction activities; on the other
hand, a charge to construction for only
the increase in total overhead grants
no special concessions to regular
activities during the construction
period.
recognized by debits to asset accounts

and a credit to a revenue account in
terms of the fair
7. Before interest charges are capitalized, a

construction project should be a discrete
project. Interest should not be capitalized
for inventories manufactured or produced
on a repetitive basis, for assets that are
currently being used, or for assets that are
idle and not undergoing activities to
prepare them for use.
8. a. If the donation of the property by the
philanthropist is unconditional, the
presidents
position
cannot
be
defended. If the donation is not
recognized, both assets and income
will be understated. Furthermore,
subsequent income will be overstated
through the failure to recognize
depreciation, and this misstatement will
be accompanied by misrepresentations
of earnings-to-assets and earnings-toowners-equity relationships reflected
on the financial statements. Properties
unconditionally transferred should be
64
market values of the properties

acquired, and depreciation should be
recognized in using such properties.
b. If the donation of the property is
contingent upon certain conditions, the
presidents position relative to the
nonrecognition of the asset is proper
until the time the conditions are met.
Until the conditions are met, the fair
value
of the conditional gift, along with a
description of the conditions, should be
disclosed in the notes to the financial
statements.
for
succeeding
years,
but
by
successively decreasing amounts until
the charge has been fully written off.
Net income will be overstated for the
first year by the difference between the
9. An asset retirement obligation is a legal

obligation a company has to restore the
site of a piece of property or equipment
when the asset is retired. The estimated
fair value of the asset retirement obligation
is recognized as a liability and is added to
the cost of the asset when it is acquired.
10. Many companies establish a minimum
monetary
amount
for
recording
expenditures as assets, even though the
item purchased meets the definition of an
asset. The principal reasons for this are
materiality and the cost involved in
recording an asset and depreciating it over
its estimated life. It is more expedient to
expense these smaller capital expenditures
immediately,
thus
avoiding
the
recordkeeping associated with assets.
11. a. The cost of a depreciable asset
incorrectly recorded as an expense will
understate assets and owners equity
for the current year and for succeeding
years, but by successively decreasing
amounts until the asset no longer
makes a contribution to periodic
revenue.
Net
income
will
be
understated in the first year by the
excess of the expenditure over
depreciation for the current period; net
income in succeeding years will be
overstated
by
the
amount
of
depreciation charges applicable to the
asset that should be charged off as
expense.
b. An expense expenditure incorrectly
recorded as an addition to the cost of a
depreciable asset will overstate assets
and owners equity for the first year and
65
recognized depreciation for the current

period and the amount of the
expenditure; net income for succeeding
12.
years will be understated by the

depreciation charges recognized in
such periods.
a.
b.
c.
d.
e.
f.
Expenditure
Cost of installing machinery.........................................
Cost of unsuccessful litigation to protect patent..........
Extensive repairs as a result of fire.............................
Cost of grading land.....................................................
Insurance on machinery in transit................................
Interest incurred during construction period.................
g.
h.
i.
j.
k.
Cost of replacing a major machinery component........

New safety guards on machinery.................................
Commission on purchase of real estate.......................
Special tax assessment for street improvements........
Cost of repainting offices.............................................
13. The remaining net book value of a

component that is replaced is added to
depreciation expense for the period.
Classification
Asset
Expense
Expense
Asset
Asset
Asset (if interest added to construction
cost)
Expense (if interest charged to
expense)
Asset
Asset
Asset
Asset
Expense
15. With the full cost method of accounting for

oil and gas exploration costs, the cost of
drilling dry holes is capitalized and
amortized. With the successful efforts
method, only the exploratory costs
associated with successful wells are
capitalized; the cost of dry holes is
expensed as incurred.
14. a. Research activities are those used to

discover new knowledge that will be
useful in developing new products,
services, or processes, or significantly
improve an existing product or process.
Development activities seek to apply
research findings to develop a plan or
design for new or improved products
and processes. Development activities
include the formulation, design, and
testing of products, construction of
prototypes, and operation of pilot
plants.
16. In general, the cost of internally generated

intangibles is expensed as incurred.
17. The five general categories of intangible
assets are as follows:
1. Marketing related.
2. Customer related.
3. Artistic related.
4. Contract based.
5. Technology based.
b. Research and development costs are

generally expensed in the period
incurred. An exception is when the
expenditure is for equipment and
facilities that have alternate future uses
beyond the specific current research
project. This exception permits the
deferral of costs incurred for materials,
equipment, facilities, and intangibles
purchased, but only if the alternative
future use can be specifically
identified.
In
addition,
software
development costs are capitalized if
they are incurred after technological
feasibility has been established.
18. The two approaches used in estimating fair

values using present value computations
are the traditional approach and the
expected cash flow approach. In the
traditional approach, which is often used in
situations in which the amount and timing
of the future cash flows is determined by
contract, the present value is computed
using a risk-adjusted interest rate that
incorporates expectations about the
uncertainty of receipt of the future
contractual cash flows.
66
In the expected cash flow approach, a range of

possible outcomes is identified, the
present value of the cash flows in each
possible outcome is computed (using
the risk-free interest rate), and a
weighted-average present value is
computed by summing the present
value of the cash flows in each
outcome, multiplied by the estimated
probability of that outcome.
judgment of professional appraisers who

estimate the current value of long-term
assets.
22. Under the provisions of IFRS 16, the credit
entry is to a revaluation equity account
when noncurrent operating assets are
written up to reflect an increase in market
value. (The important point is that the
revaluation amount is not to be reported as
a gain in the income statement.)
19. a. Goodwill may be reported properly as

an asset only when it is purchased or
otherwise established by a transaction
between independent parties.
b. Expenditures for advertising should not
be capitalized as goodwill. Some
advertising expenditures may be
deferred if the costs applicable to
future benefits from such advertising
can
be
determined
objectively.
Normally, however, it is advisable to
expense such expenditures because of
the short-lived nature of the benefits
and because future benefits may be
difficult to estimate.
23. The fixed asset turnover ratio is computed

as sales divided by average property, plant,
and equipment (fixed assets); it is
interpreted as the number of dollars in sales
generated by each dollar of fixed assets.
24. As with all ratios, the fixed asset turnover
ratio must be used carefully to ensure that
erroneous conclusions are not made. For
example, fixed asset turnover ratio values
for two companies in different industries
cannot be meaningfully compared. Another
difficulty in comparing values for the fixed
asset turnover ratio among different
companies is that the reported amount for
property, plant, and equipment can be a
poor indicator of the actual fair value of the
fixed assets being used by a company.
Another complication with the fixed asset
turnover ratio is caused by leasing. Many
companies lease the bulk of their fixed
assets in such a way that the assets are not
included in the balance sheet. This practice
biases the fixed asset turnover ratio for
these companies upward because the sales
generated
by
the leased assets are included in the
numerator of the ratio but the leased assets
generating the sales are not included in the
denominator.
20. Contract-based and separately tradable

intangibles are recognized in both a basket
purchase and in a business combination.
Intangibles that are neither of these, but
that are still relevant and reliably
measurable, are recognized in a basket
purchase but are not separately recognized
when
acquired as part of a business
combination.
21. Recording noncurrent operating assets at
their current values represents a trade-off
between relevance and reliability. In the
United States, reliability concerns have
resulted in the prohibition of asset write-ups.
In many countries around the world,
accountants have learned to rely on the
67
PRACTICE EXERCISES
PRACTICE 121
1.
2.
CATEGORIES OF TANGIBLE NONCURRENT OPERATING ASSETS
Land
Cost to purchase land
Cost to purchase land
Cost to prepare land for use
Total
$100,000
50,000
10,000
$160,000
Cost to construct building
$125,000
Buildings
3.
Equipment
4.
Land Improvements
Cost to construct parking lot and sidewalks $10,000
Cost to purchase equipment

Cost to ship and install equipment
Cost of testing
Total
PRACTICE 122
Equipment
Building
Land
Total
$20,000
1,000
1,750
$22,750
BASKET PURCHASE
$120,000
300,000
100,000
$520,000
(120,000/520,000) 500,000
(300,000/520,000) 500,000
(100,000/520,000) 500,000
Allocated
Cost
$115,385
288,461
96,154
$500,000
(Note: Some rounding is necessary to ensure that the total allocated cost is $500,000.)
PRACTICE 123
DEFERRED PAYMENT
1.
Equipment
Discount on Notes Payable
Cash
Notes Payable
120,696
49,304
10,000
160,000
Business calculator keystrokes:

N = 8 years
I = 9%
PMT = $20,000
FV = 0 (There is no balloon payment associated with the note.)
PV = $110,696
68
2.
Notes Payable
Cash
20,000
Interest Expense
Discount on Notes Payable
20,000
9,963
9,963
Interest expense: ($160,000 $49,304) 0.09 = $9,963

PRACTICE 124
EXCHANGE OF NONMONETARY ASSETS
Equipment
Gain on Asset Exchange
Land
PRACTICE 125
93,000
58,000
35,000
COST OF A SELF-CONSTRUCTED ASSET
Cost of materials
Labor cost
Allocated overhead cost ($6,000,000/$3,000,000) $500,000
Interest cost
Total
PRACTICE 126
January 1
May 1
November 1
Total
1.
2.
$ 300,000
500,000
1,000,000
80,000
$1,880,000
CAPITALIZED INTEREST: SINGLE-YEAR COMPUTATION
Amount
$100,000
200,000
300,000
$600,000
Applicable
Interest
Rate
10%
12
12
Months of
Avoidable
Interest
12/12
8/12
2/12
Capitalized
Amount of capitalized interest = $32,000

Cost of building = $600,000 + $32,000 = $632,000
PRACTICE 127
CAPITALIZED INTEREST: JOURNAL ENTRY
Building
Interest Expense ($250,000 $32,000)
Cash
32,000
218,000
250,000
Total interest: ($100,000 0.10) + ($2,000,000 0.12) = $250,000
69
$10,000
16,000
6,000
$32,000
Interest
PRACTICE 128
CAPITALIZED INTEREST: MULTIPLE-YEAR COMPUTATION
From Year 1
Amount
$ 100,000
532,000
July 1
Total
500,000
$1,132,000
1.
2.
Applicable
Interest
Rate
10%
12
Months of
Avoidable
Interest
12/12
12/12
12
6/12
Capitalized
Interest
$ 10,000
63,840
30,000
$103,840
Amount of capitalized interest = $103,840

Cost of building = $1,132,000 + $103,840 = $1,235,840
PRACTICE 129
ACQUISITION BY DONATION
Land
100,000
Revenue (or Gain)
100,000
PRACTICE 1210 ACCOUNTING FOR AN ASSET RETIREMENT OBLIGATION

Mining Site
Cash
800,000
800,000
Mining Site
Asset Retirement Obligation
72,489
72,489
FV = $200,000; I = 7%; N = 15 years $72,489

PRACTICE 1211 RENEWALS AND REPLACEMENTS
Heating/Cooling System
180,000
Accumulated Depreciation Buildings (old system) 60,000
Depreciation Expense
40,000
Buildings (old system)
100,000
Cash
180,000
PRACTICE 1212 RESEARCH AND DEVELOPMENT
(1)
(2)
(3)
Normal: Expense all $100,000 + $120,000 = $220,000

Software: Expense amounts before technological feasibility: $100,000
International: Expense amounts before technological feasibility: $100,000
PRACTICE 1213 OIL AND GAS EXPLORATION COSTS

(1)
(2)
Successful efforts: Expense all costs of dry holes = $400,000.

Full cost: Capitalize all costs, and amortize the amount to expense in subsequent years. Accordingly,
expense for this year is $0. (Note: Because all costs were incurred on the last day of the year, there is no
amortization this year.)
PRACTICE 1214 ACCOUNTING FOR THE ACQUISITION OF AN ENTIRE COMPANY
70
Cash price
Fair value of net assets ($1,060,000 $400,000)
Goodwill
$1,000,000
660,000
$ 340,000
Cash
Accounts Receivable
Inventory
Patent
Property, Plant, and Equipment
Goodwill
Liabilities
Cash
10,000
100,000
300,000
50,000
600,000
340,000
400,000
1,000,000
PRACTICE 1215 ACCOUNTING FOR NEGATIVE GOODWILL

Cash price
Market value of net assets ($1,060,000 $400,000)
Negative goodwill
$ 500,000
660,000
$(160,000)
The $160,000 in negative goodwill is allocated proportionately to the $50,000 patent and the $600,000 property,
plant, and equipment:
Patent: $50,000 {$160,000 [$50,000/($50,000 + $600,000)]} = $37,692
PPE: $600,000 {$160,000 [$600,000/($50,000 + $600,000)]} = $452,308
Cash
Accounts Receivable
Inventory
Patent
Liabilities
Cash
10,000
100,000
300,000
37,692
452,308
400,000
500,000
PRACTICE 1216 INTANGIBLES AND A BASKET PURCHASE
Building...............................................
Operating Permit .............................
In-Process R&D...............................
Assembled Workforce....................
Estimated
Cost Allocation According to
Cost Assigned to
Fair Values
Relative Estimated Values
Individual Items
$200,000
100,000
150,000
100,000
$550,000
200,000/550,000 $500,000
100,000/550,000 $500,000
150,000/550,000 $500,000
100,000/550,000 $500,000
$181,818
90,909
136,364
90,909
$500,000
Building..............................................................................................................................................................
Operating Permit................................................................................................................................................
R&D Expense.....................................................................................................................................................
Assembled Workforce.........................................................................................................................................
Cash............................................................................................................................................................
500,000
PRACTICE 1217 INTANGIBLES AND A BUSINESS ACQUISITION
71
181,818
90,909
136,364
90,909
Cash ..................................................................................................................................................................
Inventory.............................................................................................................................................................
R&D Expense.....................................................................................................................................................
Goodwill (includes fair value of assembled workforce).....................................................................................
Liabilities....................................................................................................................................................
300,000
Cash............................................................................................................................................................
800,000
100,000
50,000
500,000
450,000
PRACTICE 1218 FIXED ASSET TURNOVER RATIO

Fixed asset turnover ratio
= Sales/Average net property, plant, and equipment

= $300,000/[($100,000 + $120,000)/2]
= 2.73
PRACTICE 1219 DANGER IN USING FIXED ASSET TURNOVER RATIO

Company B
Fixed asset turnover ratio
= Sales/Average net property, plant, and equipment

= $200,000/[($130,000 + $150,000)/2]
= 1.43
Company A using historical cost of fixed assets

Fixed asset turnover ratio = Sales/Average net property, plant, and equipment
= $300,000/[($100,000 + $120,000)/2]
= 2.73
Company A using market value of fixed assets
Fixed asset turnover ratio = Sales/Average net property, plant, and equipment
= $300,000/[($210,000 + $240,000)/2]
= 1.33
Company A is more efficient (i.e., has a higher fixed asset turnover ratio) if one uses historical cost of fixed assets
(2.73 compared to 1.43). However, Company Bs fixed assets are younger and are therefore reported at amounts
close to their market values. If we assume that the reported amounts of Company Bs fixed asset are a fair
approximation of their market values, then it appears that Company B is more efficient than is Company A (1.43
compared to 1.33).
72
EXERCISES
1220.
During the construction period, the expenditures will be charged as

follows:
Land
Land
Improvements
Building
Purchase................................................... $390,000
Land survey..............................................
5,200
Fees for search of title for land...............
600
Building permit.........................................
$
3,500
Temporary quarters for construction
crews.......................................................
10,750
Payment to tenants of old building for
vacating premises..................................
4,600
Razing old building...................................
47,000
Excavating basement...............................
10,000
Special assessment tax for street
project......................................................
2,000
Costs of construction...............................
2,900,000
Cost of paving parking lot adjoining
building....................................................
$40,000
Cost of shrubs, trees, and other
landscaping.............................................
33,000
Total......................................................$ 449,400 $73,000
$2,924,250
Dividends, $5,000, should be closed to Retained Earnings. Damages
awarded for injuries sustained in construction, $8,400, are charged to a
loss account.
1221.
Patents................................................................................. 16,200*
Cash...............................................................................
16,200
*$12,000 legal expenses + $1,700 drawings + $2,500 fees = $16,200
Research and Development Expense............................... 37,000*
Machinery............................................................................ 29,200
Cash (or other credits).................................................
66,200
*$25,000 lab expenses + $12,000 wages (40% of $30,000) = $37,000
$8,000 metal + $3,200 blueprints + $18,000 wages

(60% of $30,000) = $29,200
Patents.................................................................................
Cash...............................................................................
To record cost of defending patent.
73
17,500
17,500
1222.
Property
Land..........................
Buildings..................
Equipment................
Total........................
Appraised
Value
$ 250,000
600,000
200,000
$1,050,000
Cost
Cost Allocation
Assigned to
According to
Individual
Appraised Values
Assets
(250,000/1,050,000) $920,000 = $ 219,048
(600,000/1,050,000) $920,000 = 525,714
(200,000/1,050,000) $920,000 = 175,238
$ 920,000
1223. Land [($400,000 2/3) $400,000].............................

Building........................................................................
Patent...........................................................................
Franchise......................................................................
Cash........................................................................
To record purchase of assets for $1,150,000,
allocated on the basis of fair market value
of individual assets.
200,000
400,000
250,000
300,000*
1,150,000
*Franchise: $1,150,000 $850,000 (sum of patent,

building, and land) = $300,000
1224.
2005
July
2006
June 30
Equipment............................................................
Discount on Notes Payable................................
Notes Payable................................................
Cash................................................................
79,000
34,472
Notes Payable......................................................
Cash................................................................
12,934
Interest Expense.................................................
Discount on Notes Payable..........................
*10% ($103,472 $34,472) = $6,900
2007
June 30
Notes Payable......................................................
Cash................................................................
Interest Expense.................................................
Discount on Notes Payable..........................
*10% ($90,538 $27,572)(rounded) = $6,297
74
103,472
10,000
12,934
6,900*
6,900
12,934
12,934
6,297*
6,297
1225.
Value of the equipment considering interest at 9%

PV of $8,600 for 10 years at 9%
PVn = R(PVAF 10 9% )
= $8,600(6.4177)= $55,192 (rounded)
or with a business calculator:
PMT = $8,600; N = 10; I = 9% PV = $55,192
$86,000 $55,192 = $30,808
Correcting entry:
1226.
Discount on Notes Payable.............................................

Equipment...................................................................
30,808
Trademarks.......................................................................
Land ($650,000 0.20).....................................................
Buildings ..........................................................................
Franchise..........................................................................
Common Stock...........................................................
Paid-ln Capital in Excess of Par................................
145,000
130,000
520,000
115,000*
30,808
10,000
900,000
*Market value of stock..................................................... $910,000

Amount assigned on basis of known market
values:
Trademarks..............................
$145,000
Land .......................................
130,000
Buildings..................................
520,000
795,000
Value assigned to franchise...
$115,000
1227.
Buildings ...........................................................................
Premium on Bonds Payable ($300,000 0.06)..........
Bonds Payable.............................................................
Common Stock............................................................
Paid-ln Capital in Excess of Par.................................
710,000
*$710,000 (cost of building) $318,000 (market value of

bonds) = $392,000 (value assigned to common stock);
$392,000 $100,000 (par value) = $292,000 paid-in capital
in excess of par.
75
18,000
300,000
100,000
292,000*
1228.
Land ..............................................................................
Common Stock (50,000 $0.50)..............................
Paid-ln Capital in Excess of Par..............................
Cash...........................................................................
*Market value of stock: 50,000 shares $15..........
Cash paid:
Purchase price (partial)........... $80,000
Legal cost..................................
10,000
Property taxprevious year. . .
30,000
Building demolition... $21,000
Less: Salvage............
6,000
15,000
Total..........................................................................
1229.
Cost to construct special equipment:

Direct material.........................................................
Direct labor...............................................................
Variable overhead ($200,000 1.40)......................
Fixed overhead ($700,000 0.35)...........................
Total costs exclusive of interest.......................
Interest charges capitalized...................................
Total cost of self-constructed equipment...........
885,000*
25,000
725,000
135,000
$750,000
135,000
$885,000
$
320,000
200,000
280,000
245,000
$ 1,045,000
25,000*
$ 1,070,000
*Interest charge: $1,045,000 10% 3/12 year = $26,125

Limited to amount of interest paid: $500,000 10% 6/12 = $25,000
76
1230. (1)
Computation of the amount of interest to be capitalized for 2005 is as

follows:
Interest
Fraction
Capitalization of the Year
Rate
Outstanding
12.0%
Capitalized
Amount
Interest
$600,000
72,000
400,000
12.0
8/12
32,000
200,000
8.7*
8/12
11,600
November 1, 2005..............
500,000
8.7*
2/12
7,250
Total capitalized interest for 2005............................................................. $ 122,850
*Weighted-average interest rate on general bond liabilities:
Expenditure Date
January 2, 2005..................
12/12.................................$
May 1, 2005........................
Bond Issue
10-year
50,000
5-year
Principal
$ 500,000
Rate
10.0%
1,000,000
$1,500,000
8.0
8.7
Interest
Cost
80,000
$ 130,000
Weighted-average rate = $130,000 $1,500,000 = 8.7% (rounded)

(2)
Computation of the amount of interest to be capitalized for 2006 is as

follows:
Interest
Fraction
Expenditure Date
Amount
Rate
Outstanding
Accumulated in 2005......... $1,000,000
12.0%
12/12.................................$ 120,000
822,850
8.7
12/12
March 1, 2006.....................
700,000
8.7
10/12
September 1, 2006.............
400,000
8.7
4/12
December 31, 2006............
500,000
8.7
0/12
Total capitalized interest for 2006 .....................................................
Capitalized
Interest
71,588
50,750
11,600
0
$ 253,938
Interest capitalized in 2006 is restricted to the total interest incurred of $250,000

because this amount is less than the indicated amount to be capitalized of
$253,938.
1231. (a)
(b)
(c)
(d)
(e)
(f)
(g)
NC. The construction does not cover an extended period of time.

C.
NC. The equipment is produced on a repetitive basis.
NC. The construction costs are not substantial.
NC. The construction costs are not separately accumulated.
NC. The building is in use throughout the construction.
NC. The land is idle.
77
1232.
Initial Acquisition
Detoxification Facility..................................
Cash...................................................
Asset Retirement Obligation............
900,000
335,945
900,000
335,945
FV = $1,300,000; I = 7%; N = 20 years $335,945

After 1 Year
Asset Retirement Obligation............
27,651
27,651
FV = $100,000; I = 7%; N = 19 years $27,651

1233.
1234.
(a) Wall.................................................................................
Accumulated DepreciationBuildings (old wall)......
Depreciation Expense..................................................
Buildings (old wall)..................................................
Cash..........................................................................
63,000
12,500
37,500
(b) Filters .............................................................................

Accumulated Depreciation (old filters).......................
Depreciation Expense..................................................
Filters (old filters)....................................................
Cash..........................................................................
30,000
5,000
10,000
50,000
63,000
15,000
30,000
1. All $280,000 should be charged to research and development expenses.

Only expenditures for equipment that can be used on other projects can
be deferred. No such alternative uses are identified in the problem.
2. Materials and equipment, exclusive of equipment useful
on other projects................................................
$ 40,000
Personnel............................................................
100,000
Indirect costs......................................................
50,000
Equipment depreciation ($90,000 5)*............
18,000
Total..................................................................
$208,000
*The equipments useful life on other projects would be the basis for
the cost allocation to research and development expense for 2005.
78
1235. 1. (a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
2. (a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
E
C
E
E
E
E
I
I
E
C
E
C
C
C
I
I
1236. 1. Successful efforts method:

Exploration expense............................................................. $13 million
Capitalized exploration cost................................................. $3 million
2. Full cost method:
Exploration expense.............................................................
0
Capitalized exploration cost................................................. $16 million
1237. (a) Record painting of partitions as an asset. Original painting is considered
an asset expenditure. Repainting is an expense.
(b) Normally record cost of tearing down the wall as a loss. The old wall will
not benefit future periods. Some accountants justify capitalization
because all incremental costs to construct extension should be
considered cost of extension.
(c) Separate asset accounts should be maintained for the machine and the
motor because they have substantially different useful lives. When the old
motor is replaced, any remaining book value should be added to
depreciation expense for the year. The cost of the new motor is recorded
in a separate asset account.
(d) Record the cost of grading land as an asset. It is a proper addition to land.
(e) Record the assessment for street paving as an asset. It is a proper
addition to land.
(f) Record cost of tearing down the previously occupied old building in
preparation for a new one as an expense. Expense relates to the old
building, not to new construction. As in (b), some accountants justify
capitalization because cost of tearing down is necessary for new
construction.
79
1238.
1. Cash...............................................................................
5,000
Receivables................................................................... 78,000
Inventory........................................................................ 136,000
Land, Buildings, and Equipment.................................. 436,000
Goodwill......................................................................... 295,000*
Current Liabilities....................................................
80,000
Long-Term Debt.......................................................
120,000
Cash..........................................................................
750,000
*Balance of purchase price not allocated to identifiable assets.
2. Cash...............................................................................
5,000
Receivables................................................................... 78,000
Inventory........................................................................ 136,000
Land, Buildings, and Equipment.................................. 366,000*
Current Liabilities....................................................
80,000
Long-Term Debt.......................................................
120,000
Cash..........................................................................
385,000
*$70,000 reduction due to negative goodwill.
1239.
1. Accounts Receivable....................................................
Inventory........................................................................
Prepaid Insurance.........................................................
Buildings and Equipment (net)....................................
Goodwill.........................................................................
Accounts Payable....................................................
Cash..........................................................................
220,000
250,000
10,000
200,000
110,000
160,000
630,000
2. Accounts Receivable.................................................... 220,000

Inventory........................................................................ 250,000
Prepaid Insurance......................................................... 10,000
Buildings and Equipment (net)....................................
0
Extraordinary Gain..................................................
20,000
Accounts Payable....................................................
160,000
Cash..........................................................................
300,000
80
1240.
Estimated
Fair Values
Internet domain name... $ 150,000
Order backlog................ 100,000
In-process R&D............. 200,000
Operating permit...........
80,000
$530,000
Cost Allocation According to Cost Assigned to

Relative Estimated Values
Individual Items
150,000/530,000
100,000/530,000
200,000/530,000
80,000/530,000
Internet Domain Name...................................................

Order Backlog.................................................................
R&D Expense..................................................................
Operating Permit............................................................
Cash...........................................................................
Advertising Expense......................................................
Cash...........................................................................
1241.
1.
Accounts Receivable.....................................................
Inventory.........................................................................
Equipment.......................................................................
Goodwill..........................................................................
Short-Term Loan Payable.........................................
Cash...........................................................................
$500,000
$500,000
$500,000
$500,000
141,509
94,340
188,679
75,472
300,000
200,000
50,000
50,000
800,000
$141,509
94,340
188,679
75,472
$500,000
500,000
300,000
200,000
900,000
The government contacts intangible is not separately recognized because it is not

contract based nor is it separately tradable. The $100,000 fair value estimated for this
intangible is imbedded in the reported amount of goodwill.
2.
Accounts Receivable.....................................................
Inventory.........................................................................
Equipment.......................................................................
Extraordinary Gain...................................................
Short-Term Loan Payable.........................................
Cash...........................................................................
81
200,000
50,000
0
15,000
200,000
35,000
1242.
Land
Buildings
Equipment
Total fixed assets
2005
$ 200,000
600,000
300,000
$ 1,100,000
2004
$150,000
500,000
200,000
$850,000
Fixed asset turnover ratio = Sales/Average fixed assets

$2,000,000/[($850,000 + $1,100,000)/2] = 2.05
82
PROBLEMS
1243.
1.
Cost of machinery:
Raw materials................................................................
Labor..............................................................................
Installation.....................................................................
Factory overhead..........................................................
Materials spoiled in trial runs.......................................
Machinery balance........................................................
*Raw materials: $76,000 $3,000 discount = $73,000
Machine tools balance......................................................
2.
$ 73,000*
49,000
11,200
16,900
2,400
$ 152,500
$ 13,000
Correcting Entries
(a) Loss on Sale of Machinery.......................................................... 2,480*
Machinery (Job Order No. 1329).............................................
2,480
*Loss: $14,480 cost of dismantling old machine $12,000 proceeds = $2,480
(b) Purchase Discounts.....................................................................
To report cash discounts as a reduction in
machine cost.
3,000
(c) Machinery (Job Order No. 1329).................................................

Factory Overhead.....................................................................
To report excess overhead as cost of machine.
16,900
(d) Profit on Construction of Machinery..........................................

To cancel profit on self-construction; savings
were improperly recognized as profit.
24,000
(e) Machine Tools .............................................................................

To report machine tools separately.
13,000
3,000
16,900
24,000
13,000
1244.
The solution to this problem is adapted from Qs & As: Technical Hotline, Journal of
Accountancy, February 1989, p. 31.
(a) and (b)
CNCapitalize and dont depreciate.

Costs of changing the land itself should be viewed as permanent
improvements to the land and are not depreciable. These costs include
clearing away unwanted trees and shrubs, shaping the land for the tees
and greens, building sand traps, and constructing artificial lakes.
83
1244. (Concluded)
(c) and (d)
CDCapitalize and depreciate.

If the lives of the plants can be reasonably estimated, the cost of the
plants should be depreciated over those lives. However, if no
reasonable estimates exist, the cost should be capitalized but not
depreciated.
(e) and (f)
CDCapitalize and depreciate.

Land improvements that wear out over time should be capitalized and
depreciated.
(g)
EExpense.
The $50 cost of rakes is immaterial in relation to the other golf course
expenditures. The costs of estimating the life of the rakes and
maintaining a rake account in the financial records would far exceed the
value of the theoretical improvement in the records. The best approach
is to expense the cost of the rakes.
(h) and (i)
CNCapitalize and dont depreciate.

All costs of getting the land ready for its intended use should be
included as part of the land cost.
1245.
1. Cost of land:
Purchase price......................................................................................... $ 120,000
Delinquent property taxes ....................................................................
35,000
Title search and insurance ....................................................................
6,500
City improvements .................................................................................
18,000
Cost of destroying buildings, net of salvage used in new building....
17,000
Total cost of land................................................................................... $ 196,500
Cost of land improvements:
Landscaping............................................................................................. $ 82,000
Sidewalks and parking lot.......................................................................
39,000
Total cost of land improvements......................................................... $ 121,000
2. Cost of building:
Building permit......................................................................................... $
8,000
Salvage material from old building........................................................
3,000
Contract cost............................................................................................ 1,650,000
Total cost of buildings.......................................................................... $1,661,000
Fire insurance premium on building is charged to expense.
84
1246.
2005:
Mar. 1 Land ($610,000 0.20)..................................................... 122,000
Buildings ($610,000 0.80)............................................. 488,000
Property Tax Expense*....................................................
18,250
Cash .............................................................................
253,250
Mortgage Payable........................................................
375,000
*Alternatively, this could be debited to Prepaid Property Taxes and
adjusted at June 30.
30 Buildings...........................................................................
29,600
Cash..............................................................................
29,600
(Note: Repairs are capitalized because they were necessary at acquisition.)
May 15 Cash..................................................................................
Buildings......................................................................
4,500
15 Buildings .........................................................................
Cash..............................................................................
67,600
15 Loss on Building Modification to Comply with Safety

Code Requirements......................................................
Cash .............................................................................
4,500
67,600
9,600
9,600
June 1 Patent................................................................................
Machinery .........................................................................
Common Stock............................................................
Paid-ln Capital in Excess of Par.................................
15,000
25,000
July 1 Franchise..........................................................................
Machinery .........................................................................
Discount on Bonds Payable...........................................
Cash..............................................................................
Bonds Payable.............................................................
20,000
45,000
3,000
Nov. 20 Land Improvements.........................................................

Cash..............................................................................
54,600
Dec. 31 Redecorating and Repairs Expense..............................

Cash..............................................................................
7,500
85
3,000
37,000
18,000
50,000
54,600
7,500
1247.
Organization Expenses..................................................
150,000*
Land, Buildings, and Equipment.............................
To record costs identified with the establishment
of company. These organization costs should be
expensed as incurred.
*Organization fees paid to state........
$ 20,000
Corporate organization costs..........
30,000
Stock promotion bonus....................
100,000
$150,000
Land.................................................................................
*Land site and old building................
$315,000
Title clearance fees...........................
18,400
Cost of razing old building...............
20,000
$353,400
353,400
Miscellaneous Revenue.................................................
Land...........................................................................
To reduce the cost of the land by proceeds
from the sale of scrap.
12,000
150,000
353,400*
12,000
Executive Salaries Expense..........................................

60,000
To record executive salaries in expense account.
60,000
Patent..............................................................................
To reclassify patent cost to separate account.
60,000
60,000
Property Tax Expense....................................................

To reclassify county real estate tax.
14,400
Buildings......................................................................... 1,750,000
To reclassify building cost to separate account.
86
14,400
1,750,000
1248.
(a) Retained Earnings..........................................................
120,000
Patents.......................................................................
To correct error debiting research and development costs of patents to patents in prior period.
(b) Patents............................................................................
Retained Earnings....................................................
To correct error debiting legal fees in
connection with the issuance of patents to
expenses in prior period.
14,280
(c) Patents............................................................................
Deferred Costs..........................................................
To debit patents with the legal costs in
connection with the successful settlement of
an infringement suit.
15,000
(d) Patents ...........................................................................

Liability for Settlement of Patent Infringement
Suit.............................................................................
Accrued Attorneys Fees..........................................
To record the settlement costs and the
additional legal fees in connection with the
successful settlement of an infringement suit.
21,260
87
120,000
14,280
15,000
20,000
1,260
1249.
1.
2005
Jan. 2
15
Apr.
May 1
July 1
Dec. 31
2.
Organization Expenses..................................................
23,300
Cash...........................................................................
23,300
To record organization cost of legal fees and
stock certificate costs.
(Note: As mentioned in the text, the AICPA has determined that organization
costs should be expensed as incurred.)
Advertising Expense......................................................
Cash...........................................................................
To record costs to hire clown and for
pamphlets and candy for promotional purposes.
1,500
Patents............................................................................
Cash...........................................................................
To record application and legal fees for patents.
49,250
1,500
49,250
Licenses..........................................................................
20,000*
Trademarks ($30,000 $20,000)....................................
10,000
Common Stock.........................................................
To record container license and trademark.
*600 $50 = $30,000 cost of both intangibles
Relative value, license to total cost: 2/3 $30,000 = $20,000
Buildings.........................................................................
Cash...........................................................................
To record cost of building to be used in future
R&D projects.
131,000
Research and Development Expense..........................

Cash...........................................................................
To record salaries of personnel involved in
R&D activities.
175,000
Intangible assets:
Patents ...................................................................
Licenses ...................................................................
Trademarks................................................................
88
30,000
131,000
175,000
$49,250
20,000
10,000
$79,250
1250.
Cost.....................................
Escrow fee..........................
Property taxes....................
Real estate commission....
Remodeling and repairs....
(1)
2005
July 1
Land
$90,000 (15%)
1,500
2,250
4,500
$98,250
Building
$510,000 (85%)
8,500
12,750
25,500
67,500
$ 624,250
Land Improvements.......................................................
Land.................................................................................
Building...........................................................................
Discount on Notes Payable...........................................
Cash ($747,500 $311,555)........................................
Notes Payable..............................................................
*Discount on notes payable:
PVn = R(PVAF n i )
PV = $25,000(Table IV
= $25,000(12.4622)
= $311,555
20 5%
Total
$600,000
10,000
15,000
30,000
67,500
$722,500
25,000
98,250
624,250
188,445*
435,945
500,000

PMT = $25,000; N = 20; I = 5% PV = $311,555
Face value...........................................
Less: Present value...........................
Discount on note................................
2.
2005
Dec. 31
2006
June 30
$500,000
311,555
$188,445
Notes Payable.................................................................
Cash..............................................................................
25,000
Interest Expense.............................................................
Discount on Notes Payable........................................
*Interest Expense: $311,555 0.05 = $15,578
Principal reduction: $25,000 $15,578 = $9,422
15,578*
Notes Payable.................................................................
Cash .............................................................................
25,000
25,000
15,578
Interest Expense.............................................................
15,107*
Discount on Notes Payable........................................
*$311,555 $9,422 = $302,133; $302,133 0.05 = $15,107
89
25,000
15,107
1251.
Betterword Company
Income Statement
For the Year Ended December 31, 2005
Sales................................................................................................
$515,000
Cost of goods sold:
Beginning inventory................................................................. $142,000
Software production costs......................................................
56,300
Amortization of capitalized software costs...........................
26,750
Goods available for sale.......................................................... $225,050
Ending inventory......................................................................
90,020
135,030*
Gross profit....................................................................................
$379,970
Expenses:
Salaries and wages of programmers..................................... $235,000
Expenses related to research period....................................
78,400
Total expenses..........................................................................
313,400
Income before income taxes.........................................................
$ 66,570
Income taxes (35%)........................................................................
23,300
Net income...................................................................................
$ 43,270
*0.60 $225,050 = $135,030
$49,500 expenses incurred after technological feasibility has been established

but before software is available for production would be capitalized and its
amortization included in the $26,750 added to cost of goods sold.
1252.
1.
Salvino Company
Analysis of Land Account
For 2005
Balance at January 1, 2005 .....................................................

Land site 653:
Acquisition cost...................................................................
Commission to real estate agent .....................................
Clearing costs.................................................... $25,000
Less: Amounts recovered.................................
20,000
Total land site 653...........................................................
Land site 654:
Land and building acquisition cost .................................
Demolition cost....................................................................
Total land site 654 .........................................................
Balance at December 31, 2005 ...............................................
90
$ 150,000
$1,600,000
90,000
5,000
1,695,000
$ 700,000
30,000
730,000
$2,575,000
1252. (Concluded)
Salvino Company
Analysis of Buildings Account
For 2005
Balance at January 1, 2005....................................................
Cost of new building constructed on land site 654:
Construction costs............................................................
Excavation fees.................................................................
Architectural design fees.................................................
Building permit fee............................................................
Balance at December 31, 2005..............................................
$ 910,000
$600,000
35,000
19,000
15,000
669,000
$1,579,000
Salvino Company
Analysis of Leasehold Improvements Account
For 2005
Balance at January 1, 2005............................................................................
Electrical work................................................................................................
Construction of extension to current work area ($80,000 1/2)................
Office space....................................................................................................
Balance at December 31, 2005......................................................................
$500,000
60,000
40,000
70,000
$670,000
Salvino Company
Analysis of Machinery and Equipment Account
For 2005
Balance at January 1, 2005...........................................................
Cost of new machines acquired:
Invoice price.............................................................................
Freight costs.............................................................................
Unloading charges...................................................................
Balance at December 31, 2005.....................................................
2.
$600,000
$90,000
2,000
2,500
94,500
$694,500
Items that were not used to determine the answer to (1) and where, or if, these
items should be included in Salvinos financial statements are as follows:
a. Imputed interest of $60,000 on funds used during construction should not be
included anywhere in Salvinos financial statements. Only actual interest
incurred can be capitalized.
b. Land site 655, which was acquired for $600,000, should be included in
Salvinos balance sheet as land held for resale.
c. Painting of ceilings for $10,000 should be included as a normal operating
expense in Salvinos income statement.
d. Royalty payments of $13,000 should be included as a normal operating
expense in Salvinos income statement.
91
1253.
Arnold Company
Analysis of Changes in Noncurrent Operating Assets
For the Year Ended December 31, 2005
Balance
Balance
Dec. 31, 2004
Increase
Decrease Dec. 31, 2005
Land.......................................... $ 175,000
$ 312,500*
$ 487,500
Land improvements................
192,000
192,000
Buildings.................................. 1,500,000
937,500*
2,437,500
Machinery and equipment...... 1,125,000
385,000
$17,000
1,493,000
Automobiles.............................
172,000
22,500
194,500
Leasehold improvements.......
216,000
216,000
$ 3,188,000
$ 1,849,500
$17,000
$ 5,020,500
COMPUTATIONS:
*Plant facility acquired from Jesco Jan. 6, 2005allocation to land and
building fair value25,000 shares of Arnold common stock at $50
per share market price.........................................................................
$1,250,000
Allocation in proportion to appraised values at the exchange date:

Amount
% of Total
Land....................................
$187,500
25%
Building..............................
562,500
75
$750,000
100%
Land ($1,250,000 0.25).....................................................
Building ($1,250,000 0.75)...............................................
$ 312,500
937,500
$1,250,000
Machinery and equipment purchased July 1, 2005:

Invoice cost...................................................................
$ 325,000
Delivery cost..................................................................
10,000
Installation cost.............................................................
50,000
Total acquisition cost...............................................
$ 385,000
(Note: The land purchased Nov. 4 would be reported as an investment, not as a
noncurrent operating asset.)
92
1254.
1. 2005 interest accrued:
12%, 5-year note ($2,000,000 0.12)...................................................
10%, 10-year bonds ($8,000,000 0.10)..............................................
13%, 3-year loan ($2,000,000 0.13)...................................................
Total interest accrued2005*........................................................
*Maximum that can be capitalized.
2.
$ 240,000
800,000
260,000
$ 1,300,000
Weighted-average interest rate, general liabilities:

Loan Amount
Rate
Interest Expense
$ 2,000,000
12%
=
$ 240,000
8,000,000
10
=
800,000
$10,000,000
$1,040,000
Weighted-average interest rate
($1,040,000 $10,000,000) = 10.4%
3.
Ship 340: Completed in October 2004. No capitalized interest in 2005.

Interest
Fraction
Amount
Rate
Outstanding
Capitalized
Interest
Expenditures
Ship 341:
Accum. expend................... $1,150,000
April 1, 2005......................... 1,200,000
10.4%
10.4
6/12
3/12
$ 59,800
31,200
Ship 342:
Accum. expend...................
May 1, 2005..........................
1,200,000
1,600,000
10.4
10.4
9/12
5/12
93,600
69,333
750,000
1,250,000
950,000
13.0
13.0
10.4
12/12
6/12
6/12
97,500
81,250
49,400
810,000
10.4
4/12
28,080
Ship 343:
Accum. expend...................
July 1, 2005..........................
Ship 344:
Sept. 1, 2005........................
Ship 345:
Nov. 1, 2005.........................
360,000
10.4
2/12
6,240
Total capitalized interest for 2005............................................................ $516,403
93
1255.
1. Self-Constructed Equipment Cost
Stated at Full Cost
Services of consulting engineer....................................................................
Work subcontracted.......................................................................................
Materials..........................................................................................................
Production labor.............................................................................................
Maintenance labor used on self-construction.............................................
Payroll taxes and employee fringe benefits for indirect labor (30%).........
Manufacturing overhead................................................................................
Allocated executive salaries..........................................................................
Postage, telephone, supplies, and miscellaneous expenses.....................
Total............................................................................................................
$ 10,000
20,000
200,000
65,000
100,000
30,000
52,000*
22,500
10,500
$ 510,000
*Manufacturing overhead cost:

Total manufacturing overhead....................................................... $5,630,000
Less: Maintenance labor used on
self-construction............................................. $100,000
Payroll taxes and employee fringe benefits
for maintenance labor (30%) to be charged
directly to equipment......................................
30,000
130,000
Balance to be allocated.................................................................. $5,500,000
Production labor for normal products........................................... $6,810,000
Add: Production labor used on self-construction........................
65,000
Total production labor..................................................................... $6,875,000
Manufacturing overhead = 80% ($5,500,000 $6,875,000) of
production labor = 0.80 $65,000 = $52,000.
2.
Self-Constructed Equipment Cost

Stated at Incremental Cost
Services of consulting engineer..................................................................

Work subcontracted......................................................................................
Materials.........................................................................................................
Production labor............................................................................................
Variable manufacturing overhead (50% of $52,000)........................26,000
Postage, telephone, supplies, and miscellaneous expenses...................
Total........................................................................................... $331,500
94
$ 10,000
20,000
200,000
65,000
10,500
1255. (Concluded)
3.
The greatest amount that should be capitalized as the cost of equipment is

$400,000the low bid from a reputable manufacturer. This includes at least a
part of the overhead incurred other than the strictly variable overhead. Most
accounting authorities recommend that for self-constructed assets, overhead
should be allocated on the same basis as other production when a plant is not
operating at capacity. This has the effect, however, of increasing net income
because of the reduced overhead allocation to normal production. Any cost
incurred from the self-construction of an asset computed on a full cost basis that
is in excess of the cost of a comparable asset from a reputable supplier might be
considered a loss and thus charged against revenues of the current period.
1256.
Approach 1: FV = $5,000; I = 8%; N = 30 years
$497
Approach 2: FV = $100,000; I = 8%; N = 30 years
$9,938
Approach 3: FV = $1,500,000; I = 8%; N = 30 years $149,066
Present
Value
Approach 1
$
497
Approach 2
9,938
Approach 3
149,066
Total estimated fair value
Probability
0.10
0.20
0.70
Nuclear Waste Repository Site

Cash
500,000
Nuclear Waste Repository Site

Asset Retirement Obligation
106,384
95
Probability-Weighted
Present Value
$
50
1,988
104,346
$106,384
500,000
106,384
1257.
1.
Current Assets ...................................................................

Land, Buildings, and Equipment (net)..............................
Goodwill...............................................................................
Current Liabilities..........................................................
Long-Term Liabilities....................................................
Cash...............................................................................
340,000
260,000
1,085,000
25,000
160,000
1,500,000
2. The possible reasons Aurora was willing to pay an extra $1,085,000 for Payette
include
Payette has a strong organization with trained staff already in place.
Payette has an efficient production and distribution network that is up and
running.
Payette has good relationships with its banks and suppliers.
Payette sells a superior product that has a well-established market niche.
3.
4.
Current Assets ...................................................................

Cash...............................................................................
340,000
195,000
Current Assets ...................................................................

Extraordinary Gain........................................................
Cash...............................................................................
340,000
0
25,000
160,000
350,000
5,000
25,000
160,000
150,000
1258.
1.
2005:
Interest Expense.................................................................
Construction in Progress...................................................
Accrued Interest Payable...................................................
Cash...............................................................................
2004:
Interest Expense.................................................................
Construction in Progress...................................................
Accrued Interest Payable.............................................
Cash...............................................................................
96
350,000
500,000
17,000
867,000
300,000
200,000
24,000
476,000
1258. (Concluded)
2.
2005 Statement of Cash Flows:

In the Cash Flows from Operating Activities section:
Decrease in accrued interest payable...............................................
$ (17,000)
In the Cash Flows from Investing Activities section:

Increase in construction in progress.................................................
(500,000)
Supplemental Disclosure:
Cash paid during the year for interest (amount of interest paid
net of the amount capitalized)............................................................
367,000
2004 Statement of Cash Flows:

In the Cash Flows from Operating Activities section:
Increase in accrued interest payable.................................................
$ 24,000
In the Cash Flows from Investing Activities section:

Increase in construction in progress.................................................
(200,000)
Supplemental Disclosure:
Cash paid during the year for interest (amount of interest paid
net of the amount capitalized)............................................................
276,000
1259.
1.
Return on equity = Net income Stockholders equity

= $38 million ($325 million $180 million)
= 26.2%
Yes, Cole exceeded its profitability goal of 25% ROE.
2.
The following adjustments are necessary.

(a) Decrease net income and total assets by $15 million capitalized R&D.
(b) Decrease paid-in capital and total assets by $12 million to reflect market value
of the stock.
(c) The equipment should be recorded at the present value of the payment
stream.
Present value
= $1,000,000 + $3,000,000 (PVAF, n = 8, i = 12%)

= $1,000,000 + [$3,000,000 (4.9676)]
= $15,902,800

PMT = $3,000,000; N = 8; I = 12% PV = $14,902,919
$1,000,000 + $14,902,919 = $15,902,919
$25,000,000 $15,902,800 = $9,097,200
Decrease total liabilities and total assets by $9,097,200.
97
1259.
(Concluded)
(d) Decrease net income and total assets by $7 million.

After the adjustments, net income is $16 million ($38 million $15 million $7
million); total assets are $281.9028 million ($325 million $15 million $12
million $9.0972 million $7 million); total liabilities are $170.9028 million ($180
million $9.0972 million); total equity is $111 million ($145 million $15 million
$12 million $7 million).
Return on equity = $16 million $111 million
= 14.4%
After the adjustments, Cole does not meet its profitability goal. Note that item (c)
does not affect the value of ROE and that item (b) actually has the effect of
increasing ROE (by decreasing equity).
3.
The auditors should catch this kind of accounting abuse. However, even a good
audit may fail to detect such abuses when employees collude in order to bias the
accounting numbers in some way. For an example, see the article by Andy Zipser,
How Pressure to Raise Sales Led Miniscribe to Falsify Numbers, The Wall
Street Journal, September 11, 1989, p. A1.
1260.
(a) Buildings...................................................................................
329,000
Cash......................................................................................
329,000
To record cost of addition to building.
(Expenditures for additions are capitalized and are depreciated over the life of
the asset.)
(b) Loss on Removal of Wall (or Operating Expense)................
13,880
Cash......................................................................................
13,880
To record cost of removal of plant
wall$12,360 + $1,520.
(Cost to tear down old wall not considered part of new wall cost. No benefit to
future periods from old wall.)
(c) Accumulated DepreciationBuildings..................................
11,100
Cash...........................................................................................
5,930
Depreciation Expense..............................................................
9,370
Buildings ..............................................................................
26,400
To cancel book value identified with plant wall
and to record amount received from salvage.
(The removed wall will not benefit future operations and therefore should be
eliminated from the books.)
98
1260. (Concluded)
(d) Accumulated DepreciationBuildings......................................
Depreciation Expense..................................................................
Buildings ..................................................................................
To remove cost of old floor covering.
5,045
6,955
Floor Covering .............................................................................

Cash...........................................................................................
To record cost to replace flooring.
5,290
(e) Painting Expense..........................................................................

Cash...........................................................................................
To record maintenance charge for repainting.
8,290
(f) Accumulated DepreciationBuildings......................................

Buildings ..................................................................................
To remove cost of old shelving.
840
1,160
Shelving .......................................................................................
Cash...........................................................................................
To record cost of new shelving.
3,620
(g) Buildings .......................................................................................

Cash...........................................................................................
To record cost of new wiring.
(Wiring has same remaining useful life as the building.)
10,218
Accumulated DepreciationBuildings......................................
Buildings ..................................................................................
To record the removal of old wiring.
2,055
2,595
(h) Buildings.......................................................................................
Discount on Notes Payable.........................................................
Notes Payable...........................................................................
To record cost of new fixtures.
(Electrical fixtures have the same remaining useful life as the
building.)
8,580
720
Accumulated DepreciationBuildings......................................
Buildings ..................................................................................
To record the removal of old fixtures.
1,200
1,590
99
12,000
5,290
8,290
2,000
3,620
10,218
4,650
9,300
2,790
1261.
Customer List
Outcome 1: PMT = $50,000; I = 7%; N = 5 years $205,010
Outcome 2: PMT = 30,000; I = 7%; N = 4 years 101,616
Outcome 3: PMT = 10,000; I = 7%; N = 3 years 26,243
Present
Value
Outcome 1
$205,010
Outcome 2
101,616
Outcome 3
26,243
Probability
0.20
0.30
0.50
Present Value
$41,002
30,485
13,122
$84,609
Ongoing Research Project

Outcome 1: PMT =$500,000; I = 7%; N = 10 years $3,511,791
Outcome 2: PMT = 10,000; I = 7%; N = 4 years
33,872
Outcome 3: PMT =
100; I = 7%; N = 3 years
262
Present
Value
Outcome 1
$3,511,791
Outcome 2
33,872
Outcome 3
262
Probability
0.10
0.10
0.80
Present Value
$351,179
3,387
210
$354,776
Estimated Cost Allocation According to

Fair Values Relative Estimated Values
Customer list.......... $ 84,609
Ongoing research... 354,776
$439,385
84,609/439,385 $400,000
354,776/439,385 $400,000
Customer List........................................................................................
R&D Expense........................................................................................
Cash..................................................................................................
100
Cost Assigned to
Individual Items
$ 77,025
322,975
$400,000
77,025
322,975
400,000
1262.
1.
Land
Buildings
Equipment
Total fixed assets
2005
$ 300,000
800,000
400,000
$1,500,000
2004
$ 200,000
600,000
300,000
$1,100,000
Fixed asset turnover: $4,000,000/[($1,500,000 + $1,100,000)/2] = 3.08

2.
(Note: The LIFO reserves are fair value adjustments that relate to current assets
instead of long-term assets. Also, it is reasonable to assume that the fair value of
cash and accounts receivable are close to their book values.)
Fair value of fixed assets: Fair value of total assets Cash Accounts
receivable Inventory LIFO reserve
2005:
2004:
$3,500,000 $40,000 $500,000 $700,000 $100,000 = $2,160,000

$2,500,000 $30,000 $400,000 $500,000 $50,000 = $1,520,000
Fixed asset turnover: $4,000,000/[($2,160,000 + $1,520,000)/2] = 2.17

3.
It is difficult to tell whether Waystation is more or less efficient at using its fixed
assets than is Handy Corner. Based on the reported financial numbers,
Waystations fixed asset turnover is 3.08, whereas the ratio for Handy Corner is
only 2.8. However, as shown in (2), this difference may result from a difference
between book value and fair value of reported long-term assets. If Handy Corner
has relatively new fixed assets, for which the book value is quite close to the fair
value, then Waystations 2.17 fixed asset turnover ratio (based on fair values) is
worse than the 2.8 ratio value for Handy Corner.
101
DISCUSSION CASES
Discussion Case 1263
Each of the five items introduced in the case is discussed.
(a) Recorded book values on the books of the seller are irrelevant to the buyer. Market values of all
identifiable assets, both tangible and intangible, should be used to make the entry to record the
purchase. Appraisal values are one source of current values. Other possible sources include recent
sales of similar assets and engineers estimates of building costs. In this instance, the appraisal for
fire insurance purposes is recent enough that it probably could be used for purposes of recording
the purchase. The land value would be $35,000, or 1/5 of the building value. One could object to the
values in the appraisal for fire insurance coverage because of its potential bias toward higher values
to sell more insurance coverage. Evaluation of the reputation of the fire insurance company and its
appraisers would be required to determine the extent of such bias.
(b) Replacement costs of equipment can be used as a basis for determining the present worth of such
assets. Because it is easier to obtain replacement costs on new equipment than it is to determine
the market value for used equipment that exactly matches the age and condition of the assets
owned, it is common practice to use the new market price and then depreciate it to the estimated
age of the used equipment. In this instance, the new cost is estimated to be $450,000, and the
depreciated value of 50% of the cost new, $225,000, would be a reasonable estimate of the market
price of the old equipment.
(c) Franchises can be very valuable assets. As with tangible assets, the value recorded on the sellers
books is irrelevant to the buyer. Because the franchise is for an unlimited time, its value to the buyer
is unaffected by the time the seller used it. The current purchase price of similar franchises,
$120,000, can be used to record the purchase.
(d) The two research scientists who will transfer employment to Fugate represent a value to Fugate.
However, this human resource value is generally not recognized as an asset in our historical cost
system. Fugate would not own the scientists, and they could leave the company with no contract
penalties. Only in a few types of activities, such as professional sports, are contracts for human
resources capitalized and carried on the books as assets. In a business acquisition, the intangible
value of at-will employees is not recognized but is included as part of goodwill. In this case, the
researchers salaries will be charged to expense as they are paid. The accounting for human
resources is one accounting area that is certain to develop in the future.
(e) Patents are valuable assets that can be owned and transferred. The current value of the patent is
the appropriate measure of the asset value at the transaction date and the zero book balance on
Gleaves books is not relevant to Fugate.
The total current value of the assets acquired would be as follows:
Land.............................................................
$ 35,000
Building........................................................
175,000
Equipment...................................................
225,000
Franchise.....................................................
120,000
Patents.........................................................
150,000
Total..........................................................
$705,000
Because only $556,950 was paid for these assets, negative goodwill exists. The cost must be prorated to
the assets in the ratio of the total cost to the total market value, or $556,950 $705,000 = 79%. Thus,
the cost values would be 79% of each of the preceding market values. The journal entry would be as
follows:
Land.............................................................
Building........................................................
Equipment...................................................
Franchise.....................................................
Patents.........................................................
Cash......................................................
102
27,650
138,250
177,750
94,800
118,500
556,950
Note that none of the assets acquired is a current asset. Current assets would be recorded at their fair
values, even with the existence of negative goodwill.
Generally accepted accounting principles do not specify exactly what costs should be included in selfconstructed assets. Direct charges are clearly capital items, as are incremental overhead charges. FASB
Statement No. 34 requires interest to be capitalized during the construction period. Practice varies as to
normal overhead items, with the theoretical arguments favoring a charge for all overhead. This case
provides an excellent vehicle for considering both general and specific problems related to accounting
for self-constructed assets. The specific issues of the case are discussed here.
(a) Overtime premium payments should be spread to all work of the maintenance department, not just
to the construction of the machinery. Overtime hours are necessary because of the total workload in
a department, and the choice of which work is done in the overtime is purely arbitrary. To avoid
manipulating charges to specific jobs, overtime premium payments should be considered part of
general overhead.
(b) Any intracompany profit should be eliminated in the cost assigned to the machinery. Many
companies organize their operations so that different operational centers can earn a profit. Care
must be exercised to be sure remaining asset values exclude these profits.
(c) Although it is fairly well accepted that incremental overhead should be recognized as part of the
self-constructed machinery cost, there is no definite position on how the normal overhead should be
charged. A common practice is to allocate normal overhead to self-construction projects using the
same basis as is used for regular operations.
(d) The cost of machinery should include charges for testing and pilot production runs. Because the
work will be done by the production department, a charge for material, labor, and overhead should
be made by the production department to the machinery account.
(e) Because the construction time period is 1 year, the interest on money being used to construct the
machinery is a cost that should be recognized. Although the FASB has not recommended including
imputed interest on equity capital as an interest cost, including interest on outstanding debt is
required.
(f) Although the company saves money by constructing its assets, no revenue should be recognized for
this savings under the historical cost basis of accounting. It could be noted, however, that if current
cost valuation were to be adopted, the machinery might be valued at a higher market value that
would reflect the savings due to self-construction.
This case addresses the problems associated with accounting for software development costs. Strategy
wants its financial statements to present a favorable picture of the companys financial condition and
operating performance. If the owner is correct in predicting that this years research and development
costs will be recovered through sales in the following year, a strong argument could be made to defer the
costs incurred this year and match them against next years revenues. The central issue, however, is
whether the sales will actually materialize next year. The uncertainty of predicting future sales led the
FASB to conclude that until technological feasibility has been established, costs to develop software
should
be
expensed. It is unclear from this case how much of the $45,000 was related to products for which
technological feasibility had been established and how much related to new products still in the
preliminary
design and testing stages. To the extent that the costs were incurred for new products for which
technological feasibility had not been established, the CPA is correct in insisting that these costs be
expensed as required by the FASB.
103

Generally accepted accounting principles do not permit increasing the value of assets for discovery
value or for changes in values. It is true that users of the financial statements need to know this type of
information. But it is not necessary that the financial statements reflect everything that users should
know. This case demonstrates a set of circumstances that needs to be disclosed, probably by a note to
the financial statements. Information regarding the current value of assets in a case such as this could
have a significant impact on stock prices and investment decisions. To emphasize that the financial
statements report mainly cost data, a reference to the note should be inserted in the statements.
There is a wide spectrum of reporting options available to investors and creditors beyond the traditional
financial statements. Some accountants feel the profession is leaning too much toward disclosure
outside the basic financial statements, thereby failing to record events that really should be part of the
formal accounting reports. Uncertainty affects the decision of information placement. Users generally
perceive information in financial statements differently from information found in notes and
supplementary reports.
From the brief description of Arnold, it is reasonable to assume that Arnold spends a lot for research and
development (R&D) and for advertising. On theoretical grounds, both of these can be argued to be
capital expenditures. However, R&D must be expensed as incurred and advertising expenditures are
usually treated in the same way. This can result in a substantial amount of real economic assets that are
not recorded on the balance sheet. For example, assume that Arnold spends an average of $300,000 per
year on R&D and $400,000 per year on advertising and that the average economic life of the assets
created is 5 years for the R&D expenditures and 3 years for the advertising. This means that Arnold has
unrecorded assets of $2,700,000. If these assets were reported on the balance sheet, Arnolds ROA
would be about the same as that for Baker.
Other assets that are not shown on companies balance sheets include the value of asset appreciation,
key employees, favorable market position, and good reputation with suppliers, creditors, and employees.
The lack of comparability is an issue because some companies have large amounts of unrecorded
assets and others do not. For example, two companies may both have pieces of land with a current
market value of $500,000. However, one company may show the land at $100,000 because it was
purchased years ago while the other may have purchased it just recently and thus will show it at
$500,000.
A comparison of the book values of companies (total assets total liabilities) and the market values of
those companies as measured by total market value of shares outstanding illustrates that there is
considerable variability among companies, a fact that suggests companies often have large amounts of
unrecorded assets.
1.
2.
It can be argued that the asbestos removal costs are no different from any other costs incurred in
getting a building ready for use. Also, it is reasonable to think that the purchase price of the building
incorporated an adjustment for the estimated removal costs and thus was lower than it otherwise
would have been. Capitalizing the costs would cause the building to be shown at what it would really
cost to acquire it and put it into service. Those who think the removal costs should be expensed
argue that they are more like repairs, which simply return the building to its normal state.
The EITF concluded that the asbestos removal costs for buildings acquired with a known problem
should be capitalized if they are incurred within a reasonable time after the acquisition.
Because the building cannot be properly used without removing the asbestos, it can be argued that
the removal costs enhance the building. Also, the asbestos removal can be thought of as extending
the useful life of the building. If this is true, the costs should be capitalized. However, it can also be
argued that the removal costs do nothing to enhance the building or extend its useful life but are
more on the order of maintenance or repairs, which are typically expensed.
104
3.
The ElTFs decision was that the asbestos removal costs for an already owned building may be
capitalized; the removal costs are essentially treated as a betterment. For both situations (1) and
(2), the EITF emphasized that any capitalization should be subject to a test for impaired asset value
to ensure that capitalizing the removal costs would not result in reporting the building at more than
its current market value.
Answers will vary.
This solution is adapted from Recent EITF Actions, Journal of Accountancy, February 1990, p. 93.
The students reports should include the following points:
Company A will capitalize the interest on the construction loan and report total building cost of
$21,400,000 [($20,000,000 0.14 6/12) + $20,000,000]. Company B has no interest payments to
capitalize, so reported total building cost is $20,000,000.
The contractor would also need financing during the construction period and would certainly add that cost
to the price of the building. Assuming that Companies A and B were as efficient at construction as the
contractor, a reasonable price would be $21,400,000. Some might argue that the contractor, being a
specialist and thus more efficient, would be able to charge a lower price. The important point is that the
contractors price would include a charge for the interest during the period of construction.
Just as borrowing has a cost, called interest, using invested funds also has a cost. Shareholders invest in
a company and allow the board of directors to retain profits in the company because the shareholders
expect a return on their investment in the form of dividends or of an increase in the value of their shares
(capital gain). Conceptually, this return expected by shareholders is exactly analogous to the interest
expected by debt holders. The difference lies in the fact that this equity interest is implicit, whereas the
debt interest is explicit. Some have argued that the implicit interest cost associated with the use of equity
should be capitalized in the same way that debt interest is now capitalized in accordance with SFAS No.
34. See Robert Anthony, The Accounting Concepts We Need, Accounting Horizons, December 1988, p.
128.
The rule requiring firms to expense R&D outlays results in a decrease in net income for most firms. A
decrease in reported net income can impact a firm in several ways:
Managers bonuses are frequently based on reported earnings.
Loan covenants are often written in terms of reported earnings.
Some investors seem to rely on the naive use of reported earnings in picking stocks.
Accordingly, managers compensation may suffer when R&D expenditures are expensed, and those
managers may be less willing to authorize R&D projects. This is in spite of the fact that the R&D might be
beneficial for the firms long-run profitability.
It might be expected that in response to an accounting standard change, management bonus plans, loan
covenants, and investors decision rules would be adapted to allow for the change in reported earnings
brought about solely because of the accounting change. However, there is evidence that such
adjustments are not always made.
105

The estimated Gillette brand value is relevant both to outsiders who wish to value Gillette stock and to
Gillettes management who wish to monitor the impact of their actions on Gillettes most valuable asset
the brand name.
However, reading the description of the four-stage estimation process casts doubt on the reliability of the
estimate. The valuation estimate requires assumptions about the following quantities:
An appropriate sales-to-asset ratio
The baseline return on sales of a generic brand in Gillettes industry
Gillettes marginal tax rate
The brand strength multiple

Given the assumptions made by Financial World magazine, the computed brand value is $10.3 billion,
but slightly different estimates could result in numbers anywhere from $5 billion to $15 billion.
This may be a good example of a situation in which disclosure is better than recognition. Recognizing a
point estimate of the brand value gives an illusion of precision. Disclosing the brand value in the notes,
along with the assumptions underlying the computation, gives financial statement users a more realistic
impression of the estimated value.
1.
Appreciation in asset values is a large part of the business of a real estate firm. Because of this and
because generally accepted accounting rules require long-term assets to be depreciated, many
users of financial statements think that historical cost financial statements for real estate companies
can be particularly uninformative. For a further discussion, see Edward P. Swanson and Frederick
Niswander, Voluntary Current Value Disclosures in the Real Estate Industry, Accounting Horizons,
December 1992, p. 49.
2.
Daimler-Benz was willing to reveal the magnitude of its hidden reserves in order to comply with U.S.
GAAP as a prerequisite to listing its shares on the New York Stock Exchange.
Hidden reserves are a result of the prudence principle: the primary goal of current management is
to make sure that the firm survives into the future to the benefit of stockholders, creditors,
employees, local economies, and so on. One way to build up a financial cushion to increase the
probability of survival is to pay out small cash dividends. In many jurisdictions, the amount of cash
dividends is tied to the amount of reported income. Accordingly, the prudence principle dictates the
recording of accelerated depreciation in order to lower reported income and reduce the payment of
cash dividends.
3.
SEC dissatisfaction with asset revaluations in the 1920s and 1930s was mainly a result of unease
about the methods used to compute the revaluations, not about the notion of revaluation per se.
When there is an established market for an asset, revaluation to market value is almost as objective
and verifiable as using historical cost. An auditor is understandably wary about appraisals and
estimates; however, market values from an active market are not as subjective.
106
SOLUTIONS TO STOP & THINK

Stop & Think (p. 722): Is capitalized interest extra interest that the company has to pay? How would the
financial statements be impacted if a company were to forget to capitalize interest?
Capitalized interest is not extra interest. If a company were to forget to capitalize interest that should be
capitalized, interest expense would be overstated and long-term assets would be understated. Total cash
flow would be unaffected, but cash from operations would be understated and cash from investing
activities would be overstated.
Stop & Think (p. 745): Do you think it is likely that within the next 10 years the FASB or SEC will require
companies to recognize the current value of noncurrent operating assets? Why or why not?
It is unlikely that within the next 10 years U.S. companies will be required to recognize the current value
of property, plant, and equipment. The historical cost tradition is strong in the United States, and the
FASB is having enough trouble getting the business community to accept the recognition of the fair value
of financial instruments. Current value recognition of property, plant, and equipment is only a matter of
timethe information is very relevant and can be estimated by professional appraisers, just as the
pension liability is currently estimated by actuaries.
Stop & Think (p. 747): Why did Safeways accumulated depreciation decrease so dramatically from
1985 to 1986?
One event that reduces accumulated depreciation is the disposal of old assets. This is not what
happened to Safeway between 1985 and 1986. Instead, when Safeways assets were revalued in late
1986, the accumulated depreciation account was set to zero. It was as if Safeway had disposed of all of
its old assets and then repurchased them at their current market values.
107
SOLUTIONS TO STOP & RESEARCH

Stop & Research (p. 714): Several companies in the five largest lists are probably unfamiliar to you.
Find out what business the following companies are in: Peabody Energy, AES, and Alcan.
Peabody Energy the largest coal producer in the world
AES electricity generation and distribution; AES stands for Applied Energy Services
Alcan production of aluminum; original name was Aluminum Company of Canada
Stop & Research (p. 714): If McDonalds requires an initial cash outlay of only $175,000 for a franchise
and the value of an average McDonalds franchise is much more than $175,000, simple economics tells
us that there must be excess demand for McDonalds franchises. What additional conditions does
McDonalds impose on potential franchisees?
At http://www.mcdonalds.com, we learn the following additional requirements for McDonalds
franchisees:
Q: What business qualifications does McDonald's seek in its potential franchisees?
A: The following qualifications, among others, are essential to be considered for a McDonald's franchise:
High personal integrity

An entrepreneurial spirit and strong desire to succeed
A proven ability to motivate and train people
The ability to manage finances
A willingness to personally devote full time and best efforts to the day-to-day operation of the
restaurant as an on-premise owner-operator
A willingness to complete a comprehensive training program and become proficient in all aspects
of operating a McDonald's restaurant business
Financial resources
Q: How much does a McDonald's franchise cost?

A: Typically, new restaurant costs range from 455,000 to 768,500 USD. The size of the restaurant facility,
area of the country, pre-opening expenses, inventory, kitchen equipment, signage, and style of decor and
landscaping will affect new restaurant costs. These costs are paid to suppliers. In addition, at the time of
opening, an initial fee of 45,000 USD is paid to McDonald's Corporation for all new restaurants
Q: How much cash (or liquid assets) is required to acquire a franchise?
A: The initial cash investment is a minimum of $175,000 for a conventional purchase or $100,000 for a
Business Facilities Lease.
Q: Will McDonald's finance the remaining balance of the cost of the franchise?
A: No. McDonald's does not provide any financing. The remaining cost may be financed through a bank.
Q: May I obtain the funds to purchase a franchise from a relative, friend or associate?
A: No, because this would then involve you in a type of partnership. We do not franchise restaurants to
partners or investors. An individual must personally meet the financial qualifications and be willing to
devote his or her full time and best efforts to the day-to-day operation of the restaurant. A franchisee
must divest himself or herself of all other active business interests.
108
Stop & Research (p. 742): Another way to handle negative goodwill is to leave the recorded asset
values unchanged and report the entire amount as an extraordinary gain. In SFAS No. 141, the FASB
discussed and specifically rejected this approach. What reason did the FASB give? (Hint: Look in
Appendix B of SFAS No. 141.)
In Statement No. 141, paragraph B188, the FASB stated that the existence of negative goodwill is, in
most cases, the result of measurement error in the estimation of the fair values of the acquired assets.
Conceptually, if all of the fair values have been appropriately estimated, it would be a rare case in which
an acquirer would pay less than the aggregate fair value of the assets acquired. After setting aside the
current assets and the financial assets, for which the probability of significant measurement error is low,
the estimated fair values of the remaining noncurrent assets (and acquired R&D) are reduced
proportionately. Essentially, this procedure assumes that the unobservable measurement error is spread
proportionately throughout the remaining noncurrent assets.
109
SOLUTIONS TO NET WORK EXERCISES

Net Work Exercise (p. 709):
1.
Texas Stadium opened in 1971.
2.
The Cowboys won their first Super Bowl on January 16, 1972, beating the Miami Dolphins by a
score of 243.
Net Work Exercise (p. 726):

As of the end of 2001, ChevronTexacos worldwide net proved reserves were reported as 8,542 billion
barrels of oil and 19,410 billion cubic feet of natural gas. These reserves were estimated to have a
discounted net present value of $30.144 billion.
110
SOLUTIONS TO BOXED ITEMS

Interest Capitalization: Not Everyone Agrees (pp. 724725)
1. One practical difficulty with capitalizing the implicit interest on equity funds is that the interest rate
itself must be estimated. In addition, one must consider what the credit side of the equity interest
capitalization entry would be. Because no cash is being paid for this equity interest and because there
is no payable amount, what is the credit? Also, if this implicit equity interest is to be recognized for
companies that are engaged in the self-construction of assets, why shouldnt it be recognized for all
companies?
2. Obviously, opinions can vary on this question. One can make a good argument that interest on the
funds used to finance a self-construction project are just like any other cost of the project and should be
capitalized. This is the FASB position. On the other hand, one can argue that interest is interest, no
matter how the funds are used and that interest costs should always be expensed because they do not
benefit future periods. This is the IASB position.
Who Sets Accounting Standards in the United States? The Case of Acquired In-Process R&D
(pp. 742743)
1. It is likely that the FASB will require companies to capitalize and then amortize any costs associated
with acquired in-process R&D. This treatment makes sense because the fact that the R&D was paid for
as part of an acquisition reduces any uncertainty over whether there is probable future benefit associated
with the in-process R&D.
2. The case of acquired in-process R&D illustrates that ultimate authority for accounting standards in
the United States rests with the SEC. For the time being, the FASB has explicitly backed away from
attempting to change the practice of expensing acquired in-process R&D. However, because the SEC
has administratively discouraged the practice, the amount of acquired in-process R&D being expensed
has been reduced dramatically. When the SEC speaks about accounting standards and practice, U.S.
companies listen.
111
COMPETENCY ENHANCEMENT OPPORTUNITIES

Deciphering 121 (The Walt Disney Company)
1. Because Disney has developed its brand name itself instead of purchasing it from another company,
no value is recognized in the financial statements. However, Disney does recognize the costs of
registering and successfully defending its rights and trademarks.
2. In Note 5, Disney discloses: The Company capitalizes interest on assets constructed for its parks,
resorts and other property, and on theatrical and television productions in process. In 2001, 2000 and
1999, respectively, total interest costs incurred were $606 million, $702 million and $826 million, of
which $94 million, $132 million and $109 million were capitalized.
Supplemental cash flow information at the bottom of Disneys cash flow statement states that cash
paid for interest in 2001 was $625 million. This cash paid relates to interest reported as interest
expense, not to the capitalized interest.
If it is assumed that all the capitalized interest was paid in cash in 2001, the summary journal entry to
record interest for the year is as follows:
Projects in Progress.............................................
Interest Expense ($606 $94).............................
Interest Payable...................................................
Cash ($625 + $94)..........................................
94
512
113
719
3. Note 1 explains Disneys amortization policy for intangible assets. The following explanation is
included under the subheading Accounting Changes:
SFAS 142 addresses the financial accounting and reporting for acquired goodwill and other
intangible assets. Under the new rules, the Company is no longer required to amortize goodwill and
other intangible assets with indefinite lives, but will be subject to periodic testing for impairment.
SFAS 142 supersedes APB Opinion No. 17, Intangible Assets. Effective October 1, 2001, the
Company will adopt SFAS 142 and is evaluating the effect that such adoption may have on its
consolidated results of operations and financial position. However, the Company expects that a
substantial amount of its intangible assets will no longer be amortized.
The company policy before the issuance of SFAS 142 (described under the subheading Intangible &
Other Assets was as follows:
Intangible assets are amortized over periods ranging from two to forty years. The Company
continually reviews the recoverability of the carrying value of these assets using the methodology
prescribed in SFAS 121. The Company also reviews long-lived assets and the related intangible
assets for impairment whenever events or changes in circumstances indicate the carrying amounts
of such assets may not be recoverable. Upon such an occurrence, recoverability of these assets is
determined by comparing the forecasted undiscounted net cash flows of the operation to which the
assets relate, to the carrying amount, including associated intangible assets, of such operation. If the
operation is determined to be unable to recover the carrying amount of its assets, then intangible
assets are written down first, followed by the other long-lived assets of the operation, to fair value.
Fair value is determined based on discounted cash flows, appraised values or management's
estimates, depending upon the nature of the assets.
4. The business segment information in Note 11 states that capital expenditures for each of Disneys
operating segments were as follows in 2001 (in millions):
Media Networks........................................................
Parks and Resorts....................................................
Studio Entertainment................................................
Consumer Products..................................................
Corporate..................................................................
Total....................................................................
112
$ 207
1,278
36
70
204
$1,795
Deciphering 122 (3M: Minnesota Mining and Manufacturing)

1.
A T-account will be used to estimate the book value of the PP&E that was sold during the year.
Property, Plant, and Equipment (net)
12/31/00
5,823
01 Purchases
980
01 Book value of
disposals
????
Depreciation expense 1,089
12/31/01
5,615
From the T-account data, the book value of the disposed assets in 2001 is $99.
2.
A T-account will be used to estimate the book value of assets disposed of during the year:
12/31/00
01 Purchases
12/31/01

14,170
980
01 Disposals
14,365
????
From the T-account data, the indicated historical cost of 2001 disposals is $785.
Accumulated Depreciation
01 Disposals
12/31/00
01 Depreciation
12/31/01
????
8,347
1,089
8,750
From the T-account data, the indicated accumulated depreciation on items disposed of in 2001 is
$686.
Estimated gain or loss on disposal:
Proceeds...................................................................
Book value ($785 $686)........................................
Estimated gain on disposal.......................................
$102
99
$ 3
Deciphering 123 (Eastman Kodak Company)

1.
Interest expense.................................................
Earnings (before taxes)......................................
Net PP&E...........................................................
Total assets........................................................
Total liabilities.....................................................
Total equity.........................................................
Net cash provided by operating activities..........
Net cash used in investing activities..................
Net cash used in financing activities..................
Interest capitalized during the year....................
113
Reported
$ 219
345
5,659
13,362
10,468
2,894
2,065
(1,047)
(808)
12
Adjust.
+12
12
12
12
0
12
12
+12
0
12
Expense
Interest
$ 231
333
5,647
13,350
10,468
2,882
2,053
(1,035)
(808)
0
2.
Interest expense.................................................
Earnings (before taxes)......................................
Net PP&E...........................................................
Total assets........................................................
Total liabilities.....................................................
Total equity.........................................................
Net cash provided by operating activities..........
Net cash used in investing activities..................
Net cash used in financing activities..................
Interest capitalized during the year....................
Expense
Interest
$ 231
333
5,647
13,350
10,468
2,882
2,053
(1,035)
(808)
0
Add Back
Depr.
0
+3
+3
+3
0
+3
0
0
0
0
Total
231
336
5,650
13,353
10,468
2,885
2,053
(1,035)
(808)
0
SAMPLE CPA EXAM QUESTIONS

1.
The correct answer is b. Capitalized interest will be based on the amount of avoidable interest
caused by the building construction. When that amount exceeds the specific funds borrowed,
interest on unrelated liabilities will be capitalized. When that amount is lower than the funds
borrowed, as is the case here, the amount to be capitalized will be the lower amount of $40,000.
2.
The correct answer is b. The only time costs are capitalized as goodwill is when a business
combination occurs and the cost of the acquisition exceeds the fair market value of the underlying
net identifiable assets acquired. Neither the cost of developing nor maintaining goodwill is
capitalized.
Writing Assignment: Is it an asset or not?

To:
Controller, Hunter Company
From:
Me
Subject: Accounting for the Finch Land Transfer
The land to be transferred from Rosalyn Finch should be recorded as an asset on the books of Hunter
Company. The title to the land is being transferred unconditionally, so there really is no question on this
issue.
The difficult issue here is how to value the land. The two major concerns are as follows:
1. Rosalyn Finch is an officer of the company, so this qualifies as a related-party transaction. The
consideration given to Finch may not be an unbiased indication of the fair value of the land. It may
be
advisable for Hunter Company to commission an external appraisal in order to determine an
independent value for the land.
2. Computing a value for the employment contract and royalty contract given to Finch in exchange for
the machine will be very difficult. Regarding the employment contract, unless it involves an
agreement to pay Finch a salary in excess of the fair value of her services, the contract should not
be accounted for any differently than any other employment contractthat is, no value should be
attached to the contract. The royalty provision is based on future sales, making the value of the
contract difficult to estimate.
For the two reasons outlined above, every attempt should be made to value the land using an
independent outside appraisal.
114
Research Project: Advertising costs: Capitalize or expense?

Concern about the diversity of practice in accounting for advertising costs led the AICPA's Accounting
Standards Executive Committee to prepare a statement of position (SOP 93-7) entitled "Reporting on
Advertising Costs." The provisions of the standard are as follows:
In general, advertising costs should be expensed because of the uncertainty of the future benefits.
In those cases in which the future benefits are more certain, advertising costs should be capitalized.
This type of advertising involves targeted advertising to customers who have purchased products in
the past. This type of advertising is characterized by the ability to estimate how many customers will
respond favorably.
The Debate: R&D accounting will bring down the U.S. economy!
Economic Consequences
The requirement that U.S. firms expense all R&D costs puts them at a competitive disadvantage to
foreign firms. Foreign firms are able to capitalize R&D costs incurred after technological feasibility has
been established. This harms U.S. firms in the following ways:
Reported R&D expenses are higher.
Reported net income is lower. Lower income means that banks are less willing to loan money and
investors are less willing to invest.
Shortage of financing causes U.S. R&D firms to cut back their research activities.
A slowdown in U.S. research activity puts U.S. firms behind foreign firms in terms of technical
advancement.
We must not allow the FASB to cripple the U.S. economy!!!!
Efficient Market
Bankers and investors, with millions of dollars on the line, do not blindly read financial statements. They
are aware of the conservative R&D accounting rule set by the FASB, and they make the correct
adjustments to their valuation and forecasting models when they use the financial statements of
companies that perform R&D. Bankers and investors are interested in the economic performance of
companies, not in accounting performance. The claim that bankers and investors will reduce financing to
firms that report low net income as a result of expensing R&D implies that bankers and investors are
completely trusting of whatever numbers accountants choose to report. This is absurd!!!!
Ethical Dilemma: Dumping costs into a landfill
The general outline of facts in this ethical dilemma matches the actual facts of the Chambers
Development case. The same audit firm had been on the Chambers engagement for a number of years,
and former audit partners from the firm were employed by Chambers.
The heroes in this case were the members of the new team of auditors who were able to overcome the
obvious pressures to cover up the wrongful capitalization of landfill costs.
This case illustrates a difficult conflict between doing what is best for the firm that employs you and doing
what will please your immediate supervisor. If the auditors on the Chambers job had just ignored the
accounting irregularities they found, their audit firm could have been liable for huge damages in
subsequent years when the truth was finally revealed. So, it was clearly in the best interests of the audit
firm for the auditors to blow the whistle. However, a staff auditor would still be reluctant to raise the issue
with a manager or partner who may have approved the fishy accounting in previous years.
The accounting announcement on March 17, 1992, was just the beginning of troubles for Chambers.
Continuing business problems eventually forced the board of directors of Chambers to put the company
up for sale. Chambers was acquired by USA Waste on June 30, 1995.
115
Articles that contain more information on the interesting Chambers Development case include:
Gabriella Stern and Laurie P. Cohen, "Chambers Development Switches Accounting Plan," The Wall
Street Journal, March 19, 1992, p. B4.
Roula Khalaf, "Fuzzy Accounting," Forbes, June 22, 1992, p. 96.
Gabriella Stern, "Audit Report Shows How Far Chambers Would Go for Profits," The Wall Street Journal,
October 21, 1992, p. A1.
Cumulative Spreadsheet Analysis
See Cumulative Spreadsheet Analysis Solutions CD-ROM, provided with this manual.
Internet Search
1.
Total revenue
R&D
Advertising
As a percentage of
revenue:
R&D
Advertising
General
Electric
$125,913
2,349
n/a
1.9%
n/a
Procter &
Gamble
$40,238
1,601
3,773
4.0%
9.4%
Microsoft
$28,365
4,310
1,270
15.2%
4.5%
General ElectricYear ended December 31, 2001

Procter & GambleYear ended June 30, 2002
MicrosoftYear ended June 30, 2002
2. a. Microsoft mentions the following four categories of intangible assets: goodwill, patents and
licenses, existing technology, and trademarks and tradenames.
b. Coca-Cola mentions the following two categories of intangible assets: trademarks and bottling and
distribution rights.
c. Intel mentions the following two categories of intangible assets: goodwill and acquisition-related
intangibles. The acquisition-related intangibles are primarily developed technology.
116

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CHAPTER 12

trademark. Purchased trademarks are

recognized by debits to asset accounts

7. Before interest charges are capitalized, a

market values of the properties

9. An asset retirement obligation is a legal

recognized depreciation for the current

years will be understated by the

Cost of replacing a major machinery component........

13. The remaining net book value of a

15. With the full cost method of accounting for

14. a. Research activities are those used to

16. In general, the cost of internally generated

b. Research and development costs are

18. The two approaches used in estimating fair

In the expected cash flow approach, a range of

judgment of professional appraisers who

19. a. Goodwill may be reported properly as

23. The fixed asset turnover ratio is computed

20. Contract-based and separately tradable

CATEGORIES OF TANGIBLE NONCURRENT OPERATING ASSETS

Cost to construct building

Cost to purchase equipment

Business calculator keystrokes:

Interest expense: ($160,000 $49,304) 0.09 = $9,963

EXCHANGE OF NONMONETARY ASSETS

COST OF A SELF-CONSTRUCTED ASSET

CAPITALIZED INTEREST: SINGLE-YEAR COMPUTATION

Amount of capitalized interest = $32,000

CAPITALIZED INTEREST: JOURNAL ENTRY

Total interest: ($100,000 0.10) + ($2,000,000 0.12) = $250,000

CAPITALIZED INTEREST: MULTIPLE-YEAR COMPUTATION

Amount of capitalized interest = $103,840

PRACTICE 1210 ACCOUNTING FOR AN ASSET RETIREMENT OBLIGATION

FV = $200,000; I = 7%; N = 15 years $72,489

Normal: Expense all $100,000 + $120,000 = $220,000

PRACTICE 1213 OIL AND GAS EXPLORATION COSTS

Successful efforts: Expense all costs of dry holes = $400,000.

PRACTICE 1215 ACCOUNTING FOR NEGATIVE GOODWILL

PRACTICE 1216 INTANGIBLES AND A BASKET PURCHASE

Cost Allocation According to

Relative Estimated Values

PRACTICE 1217 INTANGIBLES AND A BUSINESS ACQUISITION

PRACTICE 1218 FIXED ASSET TURNOVER RATIO

= Sales/Average net property, plant, and equipment

PRACTICE 1219 DANGER IN USING FIXED ASSET TURNOVER RATIO

= Sales/Average net property, plant, and equipment

Company A using historical cost of fixed assets

During the construction period, the expenditures will be charged as

*$25,000 lab expenses + $12,000 wages (40% of $30,000) = $37,000

$8,000 metal + $3,200 blueprints + $18,000 wages

1223. Land [($400,000 2/3) $400,000].............................

*Franchise: $1,150,000 $850,000 (sum of patent,

Value of the equipment considering interest at 9%

Discount on Notes Payable.............................................

*Market value of stock..................................................... $910,000

*$710,000 (cost of building) $318,000 (market value of

Cost to construct special equipment:

*Interest charge: $1,045,000 10% 3/12 year = $26,125

Computation of the amount of interest to be capitalized for 2005 is as

Weighted-average rate = $130,000 $1,500,000 = 8.7% (rounded)

Computation of the amount of interest to be capitalized for 2006 is as

Interest capitalized in 2006 is restricted to the total interest incurred of $250,000