CHAPTER 10
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
393
expenses for the defense of the
trademark. Purchased trademarks are
recorded at the purchase price.
3. Accountants frequently are required to
allocate costs among two or more
accounts. The principal method of
allocation is based on relative fair values of
the individual assets, if they can be
determined. A ratio of each individual
asset’s fair value to the sum of the fair
values for all assets involved in the
purchase is used to determine cost for
each individual asset. If fair values, or
some approximation of fair values, cannot
be obtained for all assets in the basket
purchase, allocation can be made to those
assets where fair values are available, and
any remaining balance can be allocated, on
some systematic basis, to remaining
assets.
4. 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.
5. 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.
6. 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 company’s fixed
overhead. (2) Only the increase in
overhead may be charged
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.
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. Under IAS 23, a company capitalizes the
net amount of interest which is the gross
amount of interest, computed as under U.S.
GAAP, less the amount of investment
income generated by borrowed
construction funds that are temporarily
invested before they are needed to pay for
construction expenditures. Accordingly, the
amount of interest capitalized under the
international standard is generally less than
the amount that would be capitalized under
the U.S. standard.
9. a. If the donation of the property
by the philanthropist is unconditional,
the president’s 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-to-
owners’-equity relationships reflected
on the financial statements. Properties
unconditionally transferred should be
recognized by debits to asset accounts
and a credit to a revenue account in
terms of the fair 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,
to the president’s 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.
10. Under IAS 41, biological assets, such as
cattle, fruit trees, and lumber forests, are
recorded in the balance sheet at their fair
value (less estimated selling costs) as of
the balance sheet date. Increases in this
fair value are recognized as gains, and
decreases are recognized as losses.
11. 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.
12. 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.
13. a. The cost of a depreciable asset
incorrectly recorded as an expense will
394
 understate assets and owners’ equity the cost of a depreciable asset will
for the current year and for succeeding overstate assets and owners’ equity for
years, but by successively decreasing the first year and for succeeding years,
amounts until the asset no longer but by successively decreasing
makes a contribution to periodic amounts until the charge has been fully
revenue. Net income will be written off. Net income will be overstated
understated in the first year by the for the first year by the difference
excess of the expenditure over between the recognized depreciation for
depreciation for the current period; net the current period and the amount of the
income in succeeding years will be expenditure; net income for succeeding
overstated by the amount of years will be understated by the
depreciation charges applicable to the depreciation charges recognized in such
asset that should be charged off as periods.
expense.
b. An expense expenditure
incorrectly recorded as an addition to
14. Expenditure Classification

a.......................................Cost of installing machinery Asset

b.........Cost of unsuccessful litigation to protect patent Expense
c.........................Extensive repairs as a result of a fire Expense
d...................................................Cost of grading land Asset
e..............................Insurance on machinery in transit Asset
.................................................................................................f. Interest incurred during construction
period Asset (if interest
added to construction cost)

Expense (if interest charged to expense)

................................................................................................g.Cost of replacing a major machinery
component................................................................................. Asset
................................................................................................h.New safety guards on machinery
..........................................................................................Asset
.................................................................................................i.Commission on purchase of real estate
................................................................................................... Asset
.................................................................................................j.Special tax assessment for street
improvements............................................................................. Asset
................................................................................................k. Cost of repainting offices
.....................................................................................Expense

15. The remaining net book value of a prototypes, and operation of pilot
component that is replaced is added to plants.
depreciation expense for the period.
b. Research and development
16. a. Research activities are those costs are generally expensed in the
used to discover new knowledge that period incurred. An exception is when
will be useful in developing new the expenditure is for equipment and
products, services, or processes, or facilities that have alternate future uses
significantly improve an existing beyond the specific current research
product or process. Development project. This exception permits the
activities seek to apply research deferral of costs incurred for materials,
findings to develop a plan or design for equipment, facilities, and intangibles
new or improved products and purchased, but only if the alternative
processes. Development activities future use can be specifically identified.
include the formulation, design, and In addition, software development costs
testing of products, construction of are capitalized if they are incurred after

395
 technological feasibility has been
established.
17. 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.
18. In general, the cost of internally generated
intangibles is expensed as incurred.
19. 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.
20. 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.
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.
21. 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
396
because future benefits may be difficult
to estimate.
22. The fair value of acquired in-process
research and development is recognized as
an asset when acquired as part of a
business combination but as an expense
when acquired as a basket purchase outside
a business combination.
23. 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
judgment of professional appraisers who
estimate the current value of long-term
assets.
24. Under the provisions of IAS 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.)
25. Under the provisions of IAS 40, a company
can elect to use a fair value approach in
which the investment property is reported in
the balance sheet at its fair value, and any
resulting gains or losses are reported in the
income statement.
26. 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.
27. 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 assets generating the sales are not included
generated by the leased assets are included in the denominator.
in the numerator of the ratio but the leased

397
Chapter 10 398
Chapter 10 399

PRACTICE EXERCISES

PRACTICE 10–1 CATEGORIES OF TANGIBLE NONCURRENT OPERATING

ASSETS

1. Land
Cost to purchase land...................................................... $ 100,000
Cost to purchase land...................................................... 50,000
Cost to prepare land for use........................................... 10,000
Total................................................................................... $ 160,000

2. Buildings
Cost to construct building............................................... $ 125,000

3. Equipment
Cost to purchase equipment........................................... $ 20,000
Cost to ship and install equipment................................. 1,000
Cost of testing.................................................................. 1,750
Total................................................................................... $ 22,750

4. Land Improvements
Cost to construct parking lot and sidewalks................. $ 10,000

PRACTICE 10–2 BASKET PURCHASE

Allocated
Cost
Equipment $250,000 (250,000/800,000) × $750,000 $234,375
Building 425,000 (425,000/800,000) × $750,000 398,438
Land 125,000 (125,000/800,000) × $750,000 117,187
Total $800,000 $750,000
(Note: Some rounding is necessary to ensure that the total allocated cost is
$750,000.)
Chapter 10 400

PRACTICE 10–3 DEFERRED PAYMENT

1. Equipment............................................................................... 120,696
Discount on Notes Payable.................................................... 49,304
Cash.................................................................................... 10,000
Notes Payable....................................................................
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

2. Notes Payable......................................................................... 20,000

Cash.................................................................................... 20,000
Interest Expense..................................................................... 9,963
Discount on Notes Payable.............................................. 9,963
Interest expense: ($160,000 – $49,304) × 0.09 = $9,963

PRACTICE 10–4 EXCHANGE OF NONMONETARY ASSETS

Equipment........................................................................................ 93,000
Gain on Asset Exchange........................................................ 58,000
Land......................................................................................... 35,000

PRACTICE 10–5 COST OF A SELF-CONSTRUCTED ASSET

Cost of materials........................................................................................... $
400,000
Labor cost......................................................................................................
600,000
Allocated overhead cost ($8,000,000/$4,000,000) × $600,000..................
1,200,000
Interest cost...................................................................................................
140,000
Total........................................................................................................ $
2,340,000
Chapter 10 401

PRACTICE 10–6 CAPITALIZED INTEREST: SINGLE-YEAR COMPUTATION

Applicable Months of
Interest Avoidable Capitalized
Amount Rate Interest Interest

January 1 $100,000 10% 12/12 $10,000

May 1 200,000 12 8/12 16,000
November 1 300,000 12 2/12 6,000
Total $600,000 $32,000

1. Amount of capitalized interest = $32,000

2. Cost of building = $600,000 + $32,000 = $632,000

PRACTICE 10–7 CAPITALIZED INTEREST: JOURNAL ENTRY

Building............................................................................................ 32,000
Interest Expense ($250,000 – $32,000).......................................... 218,000
Cash.........................................................................................
250,000
Total interest: ($100,000 × 0.10) + ($2,000,000 × 0.12) = $250,000

PRACTICE 10–8 CAPITALIZED INTEREST: MULTIPLE-YEAR

COMPUTATION

Applicable Months of
Interest Avoidable Capitalized
Amount Rate Interest Interest

From Year 1 $ 100,000 10% 12/12 $ 10,000

532,000 12 12/12 63,840
July 1 500,000 12 6/12 30,000
Total $1,132,000 $103,840

1. Amount of capitalized interest = $103,840

2. Cost of building = $1,132,000 + $103,840 = $1,235,840

PRACTICE 10–9 ACQUISITION BY DONATION

Land.................................................................................................. 111,000
Revenue (or Gain)...................................................................
111,000
Chapter 10 402

PRACTICE 10–10 ACCOUNTING FOR AN ASSET RETIREMENT OBLIGATION

Mining Site....................................................................................... 800,000

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

PRACTICE 10–11 RENEWALS AND REPLACEMENTS

Heating/Cooling System................................................................. 210,000

Accumulated Depreciation—Buildings (old system)................... 128,000
Depreciation Expense..................................................................... 32,000
Buildings (old system)...........................................................
160,000
Cash.........................................................................................
210,000

PRACTICE 10–12 RESEARCH AND DEVELOPMENT

(1) Normal: Expense all—$100,000 + $120,000 = $220,000

(2) Software: Expense amounts before technological feasibility: $100,000
(3) International: Expense amounts before technological feasibility: $100,000

PRACTICE 10–13 OIL AND GAS EXPLORATION COSTS

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

(2) 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 10–14 ACCOUNTING FOR THE ACQUISITION OF AN ENTIRE

COMPANY

Cash price.................................................................................. $1,400,000

Fair value of net assets ($1,360,000 – $500,000)..................... 860,000
Goodwill...................................................................................... $ 540,000

Cash.................................................................................................. 20,000
Accounts Receivable...................................................................... 190,000
Inventory.......................................................................................... 320,000
Patent............................................................................................... 80,000
Property, Plant, and Equipment..................................................... 750,000
Goodwill........................................................................................... 540,000
Liabilities.................................................................................
500,000
Chapter 10 403

Cash.........................................................................................
1,400,000
Chapter 10 404

PRACTICE 10–15 ACCOUNTING FOR A BARGAIN PURCHASE

Cash price.................................................................................. $ 720,000

Market value of net assets ($1,360,000 – $500,000)................ 860,000
Bargain purchase amount........................................................ $(140,000)

Cash.................................................................................................. 20,000
Accounts Receivable...................................................................... 190,000
Inventory.......................................................................................... 320,000
Patent............................................................................................... 80,000
Property, Plant, and Equipment..................................................... 750,000
Gain..........................................................................................
140,000
Liabilities.................................................................................
500,000
Cash.........................................................................................
720,000

PRACTICE 10–16 INTANGIBLES AND A BASKET PURCHASE

Cost Allocation Cost

Estimated According to Assigned to
Fair Values Relative Estimated Values Individual
Items
Building.......................... $200,000 200,000/550,000 × $500,000
....................$181,818
Operating permit........... 100,000 100,000/550,000 × $500,000 90,909
In-process R&D............. 150,000 150,000/550,000 × $500,000
......................136,364
Order backlog................ 100,000 100,000/550,000 × $500,000
90,909
$550,000 $500,000

Building............................................................................................ 181,818
Operating Permit............................................................................. 90,909
R&D Expense*................................................................................. 136,364
Order Backlog.................................................................................. 90,909
Cash.........................................................................................
500,000

*The acquired in-process R&D is recognized as an expense because it has

been acquired in a basket purchase outside a business combination.

PRACTICE 10–17 INTANGIBLES AND A BUSINESS ACQUISITION

Cash.................................................................................................. 100,000
Inventory.......................................................................................... 50,000
Chapter 10 405

In-Process R&D Asset.................................................................... 500,000

Goodwill........................................................................................... 450,000
Liabilities.................................................................................
300,000
Cash.........................................................................................
800,000
Chapter 10 406

PRACTICE 10–18 FIXED ASSET TURNOVER RATIO

Fixed asset turnover ratio = Sales/Average net property, plant, and equipment
= $480,000/[($160,000 + $200,000)/2]
= 2.67

PRACTICE 10–19 DANGER IN USING FIXED ASSET TURNOVER RATIO

Company B
Fixed asset turnover ratio = Sales/Average net property, plant, and equipment
= $360,000/[($200,000 + $220,000)/2]
= 1.71
Company Ausing historical cost of fixed assets
Fixed asset turnover ratio = Sales/Average net property, plant, and equipment
= $480,000/[($160,000 + $200,000)/2]
= 2.67
Company Ausing market value of fixed assets
Fixed asset turnover ratio = Sales/Average net property, plant, and equipment
= $480,000/[($290,000 + $310,000)/2]
= 1.60
Company A is more efficient (i.e., has a higher fixed asset turnover ratio) if one
uses historical cost of fixed assets (2.67 compared to 1.71). However,
Company B’s fixed assets are younger and are therefore reported at
amounts close to their market values. If we assume that the reported
amounts of Company B’s fixed asset are a fair approximation of their market
values, then it appears that Company B is more efficient than is Company A
(1.71 compared to 1.60).
Chapter 10 407