FAR-F3-M4&M5 - Cost Basis and Depreciation and Disposal

Question 1

Whenever assets are purchased requiring fixed payments extending beyond one year, the assets should be valued at PRESENT VALUE of all future payments, computed using the market rate of interest. Should we use the present value of an ordinary annuity factor or the present value of $1 factor?

Answer 1

We use the present value of an ordinary annuity factor to calculate the present value of assets purchased. The same approach for whenever assets are sold for a non-interest bearing note as a payment received and fixed payments are received thereafter. In both cases, we need to use the present value of an ordinary annuity factor for the same interest rate and the same amount of years as the problem indicates.

Question 2

Can interest be capitalized for land?

Answer 2

Interest should only be capitalized in connection with a DISCRETE MANUFACTURING ACTIVITY. Otherwise interest incurred to acquire land should be expensed when incurred.

Question 3

How should land and buildings that are purchased together be accounted for?

Answer 3

If land and building are purchased “in a basket”, then allocate the purchase price based on the ratio of appraised value of the individual properties.

Question 4

What kind of expenditures can be capitalized as equipment?

Answer 4

Costs include all expenditures related directly to the acquisition or construction of the equipment. Costs include all costs necessary to get the asset to its proper place, at the intended time and in condition for its intended use.

Question 5

How are additions, improvements and repairs to fixed assets accounted for?

Answer 5

Additions are capitalized to the fixed asset account. Improvements are likewise capitalized to the fixed asset account. Repairs are capitalized to the fixed asset account if they increase the asset’s life or they increase the usefulness of the asset. If carrying value of the old asset is not known and the asset’s life is extended, then
Dr. Accumulated depreciation and Cr. Cash/AP for the cost of the repair.

Question 6

When and how are interest costs capitalized?

Answer 6

Interest can only be capitalized when it is directly associated with a DISCRETE MANUFACTURING ACTIVITY. Construction period interest should be capitalized based on the weighted average of accumulated expenditures as part of the cost of producing fixed assets. And the interest rate to apply to the weighted average accumulated expenditures is the interest rate paid on borrowings specifically for asset construction FIRST. If the weighted average accumulated expenditures exceed the amount borrowed, then apply the interest rate for other borrowings to the excess amount. This calculated amount is considered avoidable interest. Compare the avoidable interest amount with the actual interest incurred and the lower of the 2 is considered your capitalized interest.

Question 7

How do you test for impairment of PPE?

Answer 7

UNDISCOUNTED future net cash flows
LESS net carrying value
EQUALS negative amount, then Impairment has occurred.

Fair Value or PV of future net cash flows
LESS Carrying value
EQUALS impairment loss.

In other words, if the sum of the undiscounted future cash flows is LESS than the carrying amount, an impairment loss needs to be recognized. And the impairment loss is calculated as the amount by which the carrying amount exceeds the fair value of the asset or the DISCOUNTED cash flows.

Question 8

If a fixed asset that previously impaired, experiences an increase in their NRV (fair value less costs to sell) that exceeds their current carrying value, can the carrying value of the fixed be increased?

Answer 8

Yes, a gain can be recorded but only to the extent of losses previously recorded on write downs. This is allowed ONLY for fixed assets HELD FOR SALE. It does not apply to assets held for use.

Question 9

How is straight line depreciation calculated?

Answer 9

Straight line depreciation = (Cost - salvage value) / years of useful life

Question 10

How is double declining deprecation calculated?

Answer 10

Double declining deprecation = 2 (1/N) * (Cost - accumulated depreciation), where N = the number of years of useful life.

Question 11

How is the sum of the years digits depreciation calculated?

Answer 11

Sum of the years depreciation = (cost - salvage value) * (remaining life of assets / sum of the years)

Question 12

What is composite depreciation and how is it calculated?

Answer 12

Composite depreciation is the process of averaging the economic lives of a number of property units and depreciating the entire class of assets over a single life. The formula is

total estimated cost - total salvage value = total depreciable cost.

Total annual depreciation = sum of individual annual depreciation.

Total depreciable cost / total annual depreciation = composite life. See FAR F3-M5-MCQ-05117

Question 13

What is depletion and how is it calculated?

Answer 13

Natural resources are not depreciated. They are depleted. The formula for depletion:

total depletion = unit depletion rate * (# of units sold)

Unit depletion rate = depletion base / estimated # of units that can be extracted

Depletion base = cost to purchase property * development costs to prepare the land for extraction + any estimated restoration costs - residual value of land after resources are extracted

Question 14

Are exploration costs for natural resources capitalized?

Answer 14

Exploration costs are only capitalized for successful expeditions. If not successful, then the exploration costs are expensed.

Question 15

Is land and land improvements capitalized depreciated?

Answer 15

Land is the only asset that is not depreciated. Land improvements have a finite life so they are depreciable

Question 16

Are costs to get the asset ready for use capitalized as part of PPE or expensed?

Answer 16

Costs include all expenditures related directly to the acquisition or construction of the equipment are capitalized.

Costs to get the asset ready for use are capitalized. Usually any cost necessary to bring the asset to its intended use and location, so it would include sales tax, testing costs, shipping costs etc.

Question 17

Are costs to extend the asset’s useful life or increase productivity capitalized as part of PPE or expensed?

Answer 17

Costs include all expenditures related directly to the acquisition or construction of the equipment are capitalized.

Costs to extend the asset’s useful life or increase productivity is capitalized. If a cost just maintains the asset, like an oil change, this is a regular expense and is NOT CAPITALIZED.

Question 18

Are ordinary repairs expensed or capitalized?

Answer 18

Ordinary repairs are expensed.

Question 19

Are extraordinary repairs expensed or capitalized?

Answer 19

Extraordinary repairs are capitalized.

Question 20

Leasehold improvements are capitalized and then amortized over the lessor of?

Answer 20

Leasehold improvements are capitalized and then amortized over the lessor of the life of the improvements or the remaining term of the lease.

Question 21

How are capitalized interest costs determined for the construction of a long lived asset?

Answer 21

Capitalized interest costs for a particular period are determined by applying an interest rate to the average amount of accumulated expenditures for the qualifying asset during the period (aka avoidable interest)

Question 22

when does the capitalization of interest period begin?

Answer 22

The capitalization of interest period begins when:
1. Expenditures for the asset have been made
2. Activities that are necessary to get the asset ready for its intended use are in progress.
3. Interest cost is being incurred.

Question 23

When does the capitalization of interest end?

Answer 23

Interest capitalization ends when the asset is substantially complete and ready for its intended use.

Capitalization of interest stops during intentional delays in construction but continues during ordinary construction delays.

Question 24

When a PPE item is sold, a gain or loss is recognized based on what?

Answer 24

When a PPE item is sold, a gain or loss is recognized based on the amount realized from the sale compared to the carrying amount of the Asset sold. For Example, ACB sold machinery for $100,000, ABC purchased the machinery for $200,000 and accumulated depreciation of $140,000. ABC would recognize a gain of $40,000 since the carrying value of the machinery was $60,000 ($200,000-accum. depreciation of $140,000)

JE would be:
Dr. Cash $100,000
Dr. Accumulated Depreciation $140,000
Cr. Machinery ($200,000)
Cr. Gain ($40,000)

If the sale was for $50,000, then the JE would be:
Dr. Cash $50,000
Dr. Accumulated Deprecation $140,000
Dr. Loss on sale of Equipment $10,000
Cr. Machinery ($200,000)