Chapter 7.1: Aquisition and maintenance of Property, Plant and Equipment

Question 1

What is the definition of long-lived assets in accounting?

Answer 1

Long-lived assets include property, plant, equipment, intangible assets, and goodwill held for production, rental, administrative purposes, or for the development, construction, maintenance, or repair of other assets.

They are acquired, constructed, or developed for use on a continuing basis and are not usually sold to generate revenue in the normal course of business.

Question 2

What are tangible assets, and how are they classified?

Answer 2

Tangible assets, also known as fixed assets, are assets with physical substance that can be touched. They are classified into three categories:

Land: Used in operations, it is not depreciated but may be impaired in value.

Buildings, Fixtures, and Equipment: Includes items like aircraft, package handling equipment, and vehicles.

Natural Resources: Includes mineral deposits, oil wells, and food used in operations.

Question 3

What are intangible assets, and can you provide examples?

Answer 3

Intangible assets have no physical substance and include valuable rights conferred on the business, often arising from intellectual effort.

Examples include copyrights, patents, licenses, trademarks, software, and subscription lists.

Question 4

What is goodwill, and when is it reported as an asset?

Answer 4

Goodwill has no physical substance and reflects a company’s favorable reputation with its customers.

It arises from factors like customer confidence, good service, and financial standing.

Goodwill is reported as an asset only when one business purchases another business.

Question 5

How is the fixed asset turnover ratio calculated, and what does it measure?

Answer 5

The fixed asset turnover ratio is calculated as follows:

Fixed asset turnover ratio= Average net fixed assets / Net sales (or Operating revenues)

This ratio measures the sales dollars generated by each dollar of fixed assets used in a company.

Question 6

How do creditors and security analysts use the fixed asset turnover ratio, and what does a high ratio indicate?

Answer 6

Creditors and security analysts use the fixed asset turnover ratio to assess a company’s effectiveness at generating sales from its long-lived assets.

A high ratio suggests effective management and efficient use of fixed assets.

An increasing ratio over time signals even more efficient utilization of fixed assets

Question 7

What are the cautions associated with interpreting a low or declining fixed asset turnover ratio?

Answer 7

A low or declining fixed asset turnover ratio may indicate that a company is expanding by acquiring additional productive assets in anticipation of higher future sales. It could also signal that a firm has cut back on capital expenditures, anticipating a downturn in business.

However, a detailed investigation of related activities is necessary for appropriate interpretation, as it might involve factors such as acquisitions, upgrades, or changes in business strategies.

Question 8

What does the cost principle require regarding the acquisition and maintenance of long-lived assets?

Answer 8

The cost principle mandates that all reasonable and necessary costs incurred in acquiring a long-lived asset, placing it in its operational setting, and preparing it for use must be recorded in a designated asset account.

These costs, including non-refundable taxes, legal fees, transportation costs, and installation costs, are added to the purchase price of the asset.

Interest charges associated with the purchase are recorded as expenses when incurred. These expenditures are capitalized and not recorded as expenses in the current period.

Question 9

How should a company account for the acquisition cost of land, and why is land recorded as a separate asset?

Answer 9

When a company purchases land, all incidental costs of the purchase, such as title fees, sales commissions, legal fees, title insurance, delinquent taxes, and surveying fees, should be included in its cost.

Land is recorded as a separate asset because it is not subject to depreciation.

Question 10

How are renovation and repair costs handled when a company purchases old buildings or used machinery for business operations?

Answer 10

Renovation and repair costs incurred by the purchaser prior to the asset’s use should be included as a part of its cost.

These costs are added to the acquisition cost of the asset.

Question 11

How is the acquisition cost of an asset calculated according to the cost principle, using the FedEx illustration as an example?

Answer 11

The acquisition cost, the amount recorded for the purchase, is the net cash amount paid for the asset.

When noncash assets are used as payment, it is the fair value of the asset given or received, whichever can be more clearly determined (called the cash-equivalent price).

For instance, if FedEx purchased a new aircraft with a list price of $26.8 million, received a discount of $1.8 million for signing the purchase agreement, paid $400,000 for transportation, and $600,000 for preparation costs, the acquisition cost would be calculated using these figures.

Question 12

What does the cost principle require regarding the recording of costs incurred in acquiring long-lived assets for cash?

Answer 12

The cost principle mandates that all reasonable and necessary costs incurred in acquiring a long-lived asset, including non-refundable taxes, legal fees, transportation costs, and installation costs, should be recorded in a designated asset account.

These costs are added to the purchase price of the asset when paid in cash. Interest charges associated with the purchase are recorded as expenses when incurred.

Question 13

What options do companies have for acquiring assets other than using cash, and how are these transactions recorded?

Answer 13

Companies can acquire assets through debt, leasing arrangements, equity, or other non-cash considerations.

Transactions involving debt, leases, or non-cash considerations require careful recording.

For example, if a company signs a note payable for an asset, the transaction is recorded differently from a cash purchase.

Question 14

How are leasing arrangements accounted for, and why are right-of-use assets not included in property, plant, and equipment?

Answer 14

Leases exceeding one year are classified as finance or operating leases.

Companies report right-of-use assets and lease liabilities on the statement of financial position.

Right-of-use assets are considered intangible assets and are not included in property, plant, and equipment.

Short-term leases (one year or less) provide flexibility and are not reported as liabilities and related assets.

Question 15

What is the process for accounting when non-cash consideration, such as company shares, is included in the purchase of an asset?

Answer 15

=When non-cash consideration is part of an asset purchase, the cash-equivalent cost (fair value of the asset given or received) is determined.

For example, if a company gives common shares with a market value of $10 each and pays the remaining balance in cash, the transaction is recorded based on the fair value of the shares and the cash paid.

Question 16

How are self-constructed assets accounted for, and what is capitalized interest?

Answer 16

Self-constructed assets include all direct and indirect construction costs, including interest on loans obtained for construction.

Capitalized interest reduces the company’s total interest expense annually until the facility is ready for use.

Once construction is complete, any remaining interest costs on construction loans must be expensed.

All reasonable and necessary expenditures made in acquiring and preparing an asset for its intended use should be recorded as part of the cost of the asset.

Question 17

What is a basket purchase, and why is it necessary to measure and record the cost of each asset separately in a basket purchase?

Answer 17

A basket purchase occurs when several long-lived assets are acquired in a single transaction for a single lump sum.

Each asset must be measured and recorded separately because land, buildings, and equipment are depreciated at different rates, and land is not depreciated.

The purchase price needs to be apportioned rationally among the different assets in the basket to accurately record their costs.

Question 18

How is the apportionment of the purchase price done in a basket purchase, and what criteria are used for the apportionment?

Answer 18

Accountants use the current market values of the acquired assets on the date of acquisition to apportion the lump sum to the assets in the basket.

The apportionment is based on relative market values, which are determined by the ratio of each asset’s market value to the total market value of all assets acquired in the transaction.

Question 19

Can you provide an example of how a basket purchase is apportioned among its components, and how are the costs recorded in the accounting books?

Answer 19

For instance, if FedEx paid $3,000,000 cash for a building and land, with an appraisal indicating market values of $1,890,000 for the building and $1,260,000 for the land, the total purchase price is apportioned based on these values (60% for the building and 40% for the land).

The cost of each component is calculated by multiplying the total cost by the respective ratio. Assuming a cash purchase, the accounting entry reflects these costs for each asset separately.

Question 20

What is the distinction between expenditures and expenses in accounting, and how are they recorded for assets?

Answer 20

Expenditures refer to the payment of money to acquire goods or services and can be recorded as either assets or expenses, depending on whether they benefit future periods or only the current period.

Expenses are outlays for ordinary repairs and maintenance that maintain the productive capacity of an asset during the current accounting period only.

They are recorded as expenses in the current period.

Question 21

How are ordinary repairs and maintenance expenses different from improvements in accounting?

Answer 21

Ordinary repairs and maintenance are expenditures for normal upkeep and maintenance of long-lived assets, involving relatively small amounts at each occurrence and recorded as expenses in the current period.

Improvements, on the other hand, are capital expenditures that increase the productive life, operating efficiency, or capacity of the asset.

They are added to the appropriate asset accounts and provide benefits to the company over multiple accounting periods.

Question 22

Can you provide an example of an improvement expenditure, and how is it recorded in accounting?

Answer 22

An example of an improvement expenditure could be modifying an aircraft to increase fuel efficiency.

If FedEx spent $300 million in 2023 to modify the cargo area of its aircraft, resulting in greater fuel efficiency, this expenditure would be recorded as a capital expenditure.

It enhances the asset’s economic usefulness, is added to the appropriate asset accounts, and benefits the company over multiple accounting periods.

Question 23

What challenges do accountants face in distinguishing between improvements and ordinary repairs, and how do companies handle these challenges?

Answer 23

There is often no clear line distinguishing improvements from ordinary repairs and maintenance.

Accountants must exercise professional judgment and make subjective decisions in these situations.

Many companies develop simple policies to classify expenditures, such as expensing items costing less than a certain threshold (e.g., $1,000).

These policies help in categorizing expenditures and are acceptable as immaterial amounts do not significantly impact financial statement analysis.

Question 24

What is the potential impact on financial statements when expenditures that should be recorded as current-period expenses are improperly capitalized as part of the cost of an asset?

Answer 24

Improper capitalization of expenses can inflate net earnings and cash flows, misrepresenting a company’s financial health.

This misreporting can significantly overstate earnings and make losses appear as profits, leading to a distorted view of the company’s financial position.

Question 25

What is ESG reporting, and how do companies like FedEx utilize it in their financial disclosures?

Answer 25

ESG reporting, short for Environmental, Social, and Governance reporting, involves disclosing a company’s performance in areas related to sustainability, social responsibility, and corporate governance.

Companies like FedEx release ESG information in annual reports and specific reports, providing insights into their current and anticipated effects of significant sustainability-related risks and opportunities on their value chain.

This information aids stakeholders in assessing a company’s enterprise value and understanding its focus on environmental consciousness and social responsibility.

Question 26

What internal controls should a company establish regarding long-lived assets, and why are they important?

Answer 26

To safeguard long-lived assets, companies should establish internal controls such as maintaining a registry with purchase date, serial number, acquisition date, and cost.

Tagging assets with identifying numbers and using technology like QR codes for tracking are crucial.

Policies regarding capitalization of expenditures, approved depreciation methods, and asset acquisition/disposition procedures should be in place.

These controls help prevent mismanagement, financial misrepresentation, and loss.

Question 27

Why is it essential for companies to segregate duties and establish clear procedures when disposing of fixed assets?

Answer 27

Segregating duties and establishing clear procedures during asset disposition is crucial to prevent potential losses to the company.

Different individuals should handle tasks like approving the sale, recording it in the accounting system, reconciling records, and handling cash from the sale.

This segregation of duties minimizes the risk of mismanagement, fraud, or financial discrepancies during asset disposal.