The evolution of the circulating and noncirculating capital distinction of assets and liabilities into

the working capital concept has been accompanied by the separate classification and disclosure
of long-term assets. In this chapter we examine one of the categories of long-term assets: property,
plant, and equipment. Long-term investments and intangibles are discussed in Chapter 10.

Property, Plant, and Equipment

The items of property, plant, and equipment generally are a major source of future service
potential to the enterprise. These assets represent a significant commitment of economic resources
for companies in capital-intensive industries, such as Ford in the automobile manufacturing
industry, Boeing in the airplane manufacturing industry, and ExxonMobil in the oil exploration
and refining industry. Such companies can have as much as 75 percent of their total assets
invested in property, plant, and equipment. The valuation of property, plant, and equipment assets
is of interest to users of financial statements because it indicates the physical resources available
to the firm and can also give some indication of future liquidity and cash flows. These valuations
are particularly important in capital-intensive industries because property, plant, and equipment
constitutes a major component of the company's total assets. The objectives of plant and
equipment accounting are as follows:

1. Reporting to investors on stewardship

2. Accounting for the use and deterioration of plant and equipment
3. Planning for new acquisitions, through budgeting
4. Supplying information for taxing authorities
5. Supplying rate-making information for regulated industries

Accounting for Cost

Many businesses commit substantial corporate resources to acquire property, plant, and
equipment. Investors, creditors, and other users rely on accountants to report the extent of
corporate investment in these assets. The initial investment, or cost to the enterprise, represents
the sacrifice of resources given up in the past to accomplish future objectives. Traditionally,
accountants have placed a great deal of emphasis on the principle of objective evidence to
determine the initial valuation of long-term assets. Cost (the economic sacrifice incurred) is the
preferred valuation method used to account for the acquisition of property, plant, and equipment
because, as discussed in Chapter 5, cost is more reliable and verifiable than other valuation
methods such as discounted present value, replacement cost, or net realizable value. There is also
a presumption that the agreed-upon purchase price represents the future service potential of the
asset to the buyer in an arm's-length transaction.
Despite the reliability and verifiability of the purchase price as the basis for initially recording
property, plant, and equipment, the assignment of cost to individual assets is not always as
uncomplicated as might be expected. When assets are acquired in groups, when they are self-
constructed, when they are acquired in nonmonetary exchanges, when property contains assets
that are to be removed, or when there are expected future costs associated with decommissioning
an asset, certain accounting issues arise. These issues are discussed in the following sections.

GROUP PURCHASES
When a group of assets is acquired for a lump-sum purchase price, such as the purchase of land,
buildings, and equipment for a single purchase price, the total acquisition cost must be allocated
to the individual assets so that an appropriate amount of cost can be charged to expense as the
service potential of the individual assets expires. The most common, though arbitrary, solution to
this allocation problem has been to assign the acquisition cost to the various assets on the basis
of the weighted average of their respective appraisal values. Where appraisal values are not
available, the cost assignment may be based on the relative carrying values on the seller's books.
Because no evidence exists that either of these values is the relative value to the purchaser,
assignment by either of these procedures would seem to violate the objectivity principle, but the
use of these methods is usually justified on the basis of expediency and the lack of acceptable
alternative methods.

SELF-CONSTRUCTED ASSETS
Self-constructed assets give rise to questions about the proper components of cost. Although it is
generally agreed that all expenses directly associated with the construction process should be
included in the recorded cost of the asset (material, direct labor, etc.), there are controversial
issues regarding the assignment of fixed overhead and the capitalization of interest. The fixed-
overhead issue has two aspects: (1) should any fixed overhead be allocated? and (2) if so, how
much fixed overhead should be allocated? This problem has further ramifications. If a plant is
operating at less than full capacity and fixed overhead is assigned to a self-constructed asset,
charging the asset with a portion of the fixed overhead will cause the profit margin on all other
products to increase during the period of construction. Three approaches are available to resolve
this issue:

1. Allocate no fixed overhead to the self-construction project.

2. Allocate only incremental fixed overhead to the project.
3. Allocate fixed overhead to the project on the same basis as it is allocated to other
products.

Some accountants favor the first approach. They argue that the allocation of fixed overhead is
arbitrary and therefore only direct costs should be considered. Nevertheless, the prevailing opinion
is that the construction of the asset required the use of some amount of fixed overhead; thus, fixed
overhead is a proper component of cost. Consequently, no allocation is seen as a violation of the
historical cost principle.
When the production of other products has been discontinued to produce a self-constructed
asset, allocation of the entire amount of fixed overhead to the remaining products will cause
reported profits on these products to decrease. (The same amount of overhead is allocated to fewer
products.) Under these circumstances, the third approach seems most appropriate. On the other
hand, it seems unlikely that an enterprise would discontinue operations of a profitable product to
construct productive facilities except in unusual circumstances.
When operations are at less than full capacity, the second approach is the most logical. The
decision to build the asset was probably connected with the availability of idle facilities.
Increasing the profit margin on existing products by allocating a portion of the fixed overhead to
the self-construction project will distort reported profits.
A corollary to the question of fixed overhead allocation is the issue of the capitalization of
interest charges during the period of the construction of the asset. During the construction period,
extra financing for materials and supplies will undoubtedly be required, and these funds are often
obtained from external sources. The central question is the advisability of capitalizing the cost
associated with the use of these funds. Some accountants have argued that interest is a financing
rather than an operating charge and should not be charged against the asset. Others have noted
that if the asset were acquired from outsiders, interest charges would undoubtedly be part of the
cost basis to the seller and would be included in the sales price. In addition, public utilities
normally capitalize both actual and implicit interest (when their own funds are used) on
construction projects because future rates are based on the costs of services. Charging existing
products for the expenses associated with a separate decision results in an improper matching of
costs and revenues. Therefore, a more logical approach is to capitalize incremental interest charges
during the construction period. Once the new asset is placed in service, interest is charged against
operations.
The misapplication of this theory resulted in abuses during the early 1970s, when many
companies adopted the policy of capitalizing all interest costs. However, in 1974 the SEC
established a rule preventing this practice.1 In 1979, the FASB issued SFAS No. 34, “Capitalization
of Interest Costs”2 (see FASB ASC 835-20). In this release, the FASB maintained that interest
should be capitalized only when an asset requires a period of time to be prepared for its intended
use.
The primary objective of the guidance contained at FASB ASC 835-20 is to recognize interest
cost as a significant part of the historical cost of acquiring an asset. The criteria for determining
whether an asset qualifies for interest capitalization are that the asset must not yet be ready for its
intended purpose, and it must be undergoing activities necessary to get it ready. Qualified assets
are defined as (1) assets that are constructed or otherwise produced for an enterprise's own use
and (2) assets intended for sale or lease that are constructed or otherwise produced as discrete
projects. The FASB ASC 835-20-15-6 guidance excludes interest capitalization for inventories
that are routinely manufactured or otherwise produced in large quantities on a repetitive basis.
Assets that are in use or are not being readied for use are also excluded.
An additional issue addressed is the determination of the proper amount of interest to capitalize.
The FASB ASC 835-20-30 guidance indicates that the amount of interest to be capitalized is the
amount that could have been avoided if the asset had not been constructed. Two interest rates may
be used: the weighted average rate of interest charges during the period and the interest charge on
a specific debt instrument issued to finance the project. The amount of avoidable interest is
determined by applying the appropriate interest rate to the average amount of accumulated
expenditures for the asset during the construction period. The specific interest is applied first;
then, if there are additional average accumulated expenditures, the average rate is applied to the
balance. The capitalized amount is the lesser of the calculated “avoidable” interest and the actual
interest incurred. In addition, only actual interest costs on present obligations may be capitalized,
not imputed interest on equity funds.

REMOVAL OF EXISTING ASSETS

When a firm acquires property containing existing structures that are to be removed, a question
arises concerning the proper treatment of the cost of removing these structures. Current practice
is to assign removal costs less any proceeds received from the sale of the assets to the land,
because these costs are necessary to put the site in a state of readiness for construction.

ASSETS ACQUIRED IN NONCASH TRANSACTIONS

In addition to cash transactions, assets may also be acquired by trading equity securities, or one
asset may be exchanged in partial or full payment for another (trade-in). When equity securities
are exchanged for assets, the cost principle dictates that the recorded value of the asset is the
amount of consideration given. This amount is usually the market value of the securities
exchanged. If the market value of the securities is not determinable, cost should be assigned to
the property on the basis of its fair market value. This procedure is a departure from the cost
principle and can be viewed as an example of the use of replacement cost in current practice.
When assets are exchanged—for example, in trade-ins—additional complications arise.
Accountants have long argued the relative merits of using the fair market value versus the book
value of the exchanged asset. In 1973, the APB released Opinion No. 29, “Accounting for
Nonmonetary Transactions” (see FASB ASC 845), which maintains that fair value should
(generally) be used as the basis of accountability.3 Therefore the cost of an asset acquired in a
straight exchange for another asset is the fair market value of the surrendered asset.
This general rule was originally subject to one exception. The original APB guidance stated
that exchanges should be recorded at the book value of the asset given up when the exchange is
not the culmination of the earning process. Two examples of exchanges that do not result in the
culmination of the earning process were defined as follows:

1. Exchange of a product or property held for sale in the ordinary course of business
(inventory) for a product or property to be sold in the same line of business to
facilitate sales to customers other than parties to the exchange
2. Exchange of a productive asset not held for sale in the ordinary course of business for a
similar productive asset or an equivalent interest in the same or similar productive
asset4

That is, if the exchanged assets were dissimilar, the presumption was to be that the earning
process was complete, and the acquired asset was recorded at the fair value of the asset exchanged
including any gain or loss. This requirement existed for straight exchanges and for exchanges
accompanied by cash payments (also known as boot). For example, if Company G exchanges cash
of $2,000, and an asset with a book value of $10,000 and a fair market value of $13,000, for a
dissimilar asset, a gain of $3,000 should be recognized ($13,000 − $10,000), and the new asset is
recorded at $15,000.
On the other hand, accounting for the exchange of similar productive assets originally took a
somewhat different form. According to the original provisions of APB Opinion No. 29, losses on
the exchange of similar productive assets are always recognized in their entirety whether or not
boot (cash) is involved. However, gains were never recognized unless boot was received. In 2004,
the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets—An Amendment of APB
Opinion No. 29”5 (see FASB ASC 845-10). This amendment eliminated the exception for
nonmonetary exchanges of similar productive assets and replaced it with a general exception for
exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary
exchange has commercial substance if the future cash flows of the entity are expected to change
significantly as a result of the exchange. For these exchanges, the book value of the asset
exchanged is to be used to measure the asset acquired in the exchange. Thus, no gains are to be
recognized; however, a loss should be recognized if the fair value of the asset exchanged is less
than its book value (i.e., an impairment is evident). The resulting amount initially recorded for the
acquired asset is equal to the book value of the exchanged asset (adjusted to its fair value, when
there is an apparent impairment) plus or minus any cash (boot) paid or received.

DONATED AND DISCOVERY VALUES

Corporations sometimes acquire assets as gifts from municipalities, local citizens' groups, or
stockholders as inducements to locate facilities in certain areas. For example, in 1992 the BMW
automobile company announced it would build a plant in the Greenville–Spartanburg area of
South Carolina after the state offered several incentives, including $70.7 million in reduced
property taxes, $25 million to buy land for the plant and lease it to BMW for $1 per year, and $40
million to lengthen the local airport runway so that it could accommodate wide-body cargo
aircraft. The cost principle holds that the recorded values of assets should be equal to the
consideration given in return, but because donations are nonreciprocal transfers, strict adherence
to this principle will result in a failure to record donated assets at all. On the other hand, failure
to report values for these assets on the balance sheet is inconsistent with the full-disclosure
principle.
Previous practice required donated assets to be recorded at their fair market values, with a
corresponding increase in an equity account termed donated capital. Recording donated assets at
fair market values is defended on the grounds that if the donation had been in cash, the amount
received would have been recorded as donated capital, and the cash could have been used to
purchase the asset at its fair market value.
SFAS No. 116 (see FASB ASC 605-10-15-3) requires that the inflow of assets from a donation
be considered revenue (not donated capital).6 If so, the fair market value of the assets received
represents the appropriate measurement. However, the characterization of donations as revenues
may be flawed. According to SFAC No. 6, revenues arise from the delivery or production of goods
and the rendering of services. If the contribution is a nonreciprocal transfer, then it is difficult to
see how revenue has been earned. Alternatively, it may be argued that the inflow represents a gain.
This latter argument is consistent with the conceptual framework definition of a gain as resulting
from peripheral or incidental transactions and with the definition of comprehensive income as the
change in net assets resulting from nonowner transactions. Under this approach, the asset and gain
would be recorded at the fair market value of the asset received, thereby allowing full disclosure
of the asset in the balance sheet.
 Similarly, valuable natural resources may be discovered on property subsequent to its
acquisition, and the original cost might not provide all relevant information about the nature of
the property. In such cases, the cost principle is modified to account for the appraisal increase in
the property. A corresponding increase is reported as an unrealized gain in accumulated other
comprehensive income. An alternative practice consistent with the conceptual framework
definition of comprehensive income would be to recognize the appraisal increase as a gain.

Financial Analysis of Property, Plant, and Equipment

In Chapter 6 we discussed analyzing a company's profitability by computing the return-on-assets
(ROA) ratio. The sustainability of earnings is a major consideration in this process. For capital-
intensive companies, a large portion of their asset base is investments in property, plant, and
equipment, and a major question for investors analyzing such companies concerns their asset
replacement policy. A company that has a large investment in property, plant, and equipment and
that fails to systematically replace those assets generally reports an increasing return on assets
over the useful life of its asset base. This occurs because the ROA denominator decreases by the
amount of the company's annual depreciation expense, resulting in an increasing return
percentage for stable amounts of earnings. In addition, the general pattern of rising prices tends
to increase the selling price of the company's product, resulting in a further upward bias for the
ROA percentage.
An examination of a company's investing activity helps in analyzing the earnings sustainability
of its ROA percentage. For example, Hershey's statement of cash flows, contained in Chapter 7,
reveals that the company acquired $323,961,000 and $179,538,000 of property, plant, and
equipment assets in 2011 and 2010, respectively. These amounts are 9.0 percent and 5.3 percent,
respectively, of the gross property, plant, and equipment assets. Tootsie Roll's statement of cash
flows reveals that the company acquired approximately $16,351,000 and $12,813,000 of property,
plant, and equipment assets in 2011 and 2010, respectively, amounting to 3.3 percent and 2.9
percent of the purchase price of its property, plant, and equipment assets. Both of these
computations provide evidence that the companies' ROA percentages are not being distorted by a
failure to systematically replace their long-term assets.

Cost Allocation
Capitalizing the cost of an asset implies that the asset has future service potential. Future service
potential indicates that the asset is expected to generate or be associated with future resource
flows. As those flows materialize, the matching concept (discussed in Chapter 5) dictates that
certain costs no longer have future service potential and should be charged to expense during the
period the associated revenues are earned. Because the cost of property, plant, and equipment is
incurred to benefit future periods, it must be spread, or allocated, to the periods benefited. The
process of recognizing, or spreading, cost over multiple periods is termed cost allocation. For
items of property, plant, and equipment, cost allocation is referred to as depreciation. As the asset
is depreciated, the cost is said to expire—that is, it is expensed (see Chapter 5 for a discussion of
the process of cost expiration).
As discussed earlier, balance sheet measurements should theoretically reflect the future service
potential of assets at a moment in time. Accountants generally agree that cost reflects future
service potential at acquisition. However, in subsequent periods, expectations about future
resource flows can change. Also, the discount rate used to measure the present value of the future
service potential can change. As a result, the asset may still be useful, but because of technological
changes, its future service potential at the end of any given period might differ from what was
originally anticipated. Systematic cost allocation methods do not attempt to measure changes in
expectations or discount rates. Consequently, no systematic cost-allocation method can provide
balance sheet measures that consistently reflect future service potential.
The historical cost-accounting model currently dominant in accounting practice requires that
the costs incurred be allocated in a systematic and rational manner. Thomas, who conducted an
extensive study of cost allocation, concluded that all allocation is based on arbitrary assumptions
and that no one method of cost allocation is superior to another.7 At the same time, it cannot be
concluded that the present accounting model provides information that is not useful for investor
decision making. A number of studies document an association between accounting income
numbers and stock returns. This evidence implies that historical cost-based accounting income,
which employs cost-allocation methods, has information content (see Chapter 4 for further
discussion of this issue).

DEPRECIATION
Once the appropriate cost of an asset has been determined, the reporting entity must decide how
to allocate its cost. At one extreme, the entire cost of the asset could be expensed when the asset
is acquired; at the other extreme, cost could be retained in the accounting records until disposal
of the asset, when the entire cost would be expensed. However, neither of these approaches
provides a satisfactory measure of periodic income, because cost expiration would not be
allocated to the periods in which the asset is in use and thus would not satisfy the matching
principle. Thus the concept of depreciation was devised in an effort to satisfy the need to allocate
the cost of property, plant, and equipment over the periods that receive benefit from use of long-
term assets.
The desire of financial statement users to receive periodic reports on the result of operations
necessitated allocating asset cost to the periods receiving benefit from the use of assets classified
as property, plant, and equipment. Because depreciation is a form of cost allocation, all
depreciation concepts are related to some view of income measurement. A strict interpretation of
the FASB's comprehensive income concept would require that changes in service potential be
recorded in income. Economic depreciation has been defined as the change in the discounted
present value of the items of property, plant, and equipment during a period. If the discounted
present value measures the service potential of the asset at a point in time, the change in service
potential interpretation is consistent with the economic concept of income.
As discussed in Chapter 5, recording cost expirations by the change in service potential is a
difficult concept to operationalize. Consequently, accountants have adopted a transactions view
of income determination, in which they see income as the end result of revenue recognition
according to certain criteria, coupled with the appropriate matching of expenses with those
revenues. Thus most depreciation methods emphasize the matching concept, and little attention is
directed to balance sheet valuation. Depreciation is typically described as a process of systematic
and rational cost allocation that is not intended to result in the presentation of asset fair value on
the balance sheet. This point was first emphasized by the Committee on Terminology of the
AICPA as follows:
Depreciation accounting is a system of accounting which aims to distribute the cost or
other basic value of tangible capital assets, less salvage value (if any), over the estimated
 useful life of the unit (which may be a group of assets) in a systematic and rational manner.
It is a process of allocation, not valuation.8 [See FASB ASC 360-10-35-4.]
The AICPA's view of depreciation is particularly important to an understanding of the
difference between accounting and economic concepts of income, and it also provides insight into
many misunderstandings about accounting depreciation. Economists see depreciation as the
decline in the real value of assets. Other individuals believe that depreciation charges and the
resulting accumulated depreciation provide the source of funds for future replacement of assets.
Still others have suggested that business investment decisions are influenced by the portion of the
original asset cost that has been previously allocated. Accordingly, new investments cannot be
made, because the old asset has not been fully depreciated. These views are not consistent with
the stated objective of depreciation for accounting purposes. Moreover, we do not support the
view that business decisions should be affected by accounting rules. In the following section, we
examine the accounting concept of depreciation more closely.

THE DEPRECIATION PROCESS

The depreciation process for long-term assets comprises three separate factors:

1. Establishing the depreciation base

2. Estimating the useful service life
3. Choosing a cost-apportionment method

Depreciation Base The depreciation base is the portion of the cost of the asset that should be
charged to expense over its expected useful life. Because cost represents the future service
potential of the asset embodied in future resource flows, the theoretical depreciation base is the
present value of all resource flows over the life of the asset, until disposition of the asset. Hence,
it should be cost minus the present value of the salvage value. In practice, salvage value is not
discounted, and as a practical matter, it is typically ignored. Proper accounting treatment requires
that salvage value be taken into consideration. For example, rental car agencies normally use
automobiles for only a short period; the expected value of these automobiles at the time they are
retired from service would be material and should be considered in establishing the depreciation
base.
Useful Service Life The useful service life of an asset is the period of time the asset is expected
to function efficiently. Consequently, an asset's useful service life may be less than its physical
life, and factors other than wear and tear should be examined to establish the useful service life.
Various authors have suggested possible obsolescence, inadequacy, supersession, and changes
in the social environment as factors to be considered in establishing the expected service life. For
example, jet airplanes have replaced most of the airlines' propeller-driven planes, and ecological
factors have caused changes in manufacturing processes in the steel industry. Estimating such
factors requires a certain amount of clairvoyance—a quality difficult to acquire.
Depreciation Methods Most of the controversy in depreciation accounting revolves around the
question of the appropriate method that should be used to allocate the depreciation base over its
estimated service life. Theoretically, the expired cost of the asset should be related to the value
received from the asset in each period; however, it is extremely difficult to measure these
amounts. Accountants have, therefore, attempted to estimate expired costs by other methods—
namely, straight line, accelerated, and units of activity.
Straight Line The straight-line method allocates an equal portion of the depreciable cost of an
asset to each period the asset is used. Straight-line depreciation is often justified on the basis of
the lack of evidence to support other methods. Because it is difficult to establish evidence that
links the value received from an asset to any particular period, the advocates of straight-line
depreciation accounting argue that other methods are arbitrary and therefore inappropriate. Use
of the straight-line method implies that the asset is declining in service potential in equal amounts
over its estimated service life.
Accelerated The sum-of-the-year's-digits and the fixed-percentage-of-declining-base (declining
balance) are the most commonly encountered methods of accelerated depreciation.9 These
methods result in larger charges to expense in the earlier years of asset use, although little
evidence supports the notion that assets actually decline in service potential in the manner
suggested by these methods. Advocates contend that accelerated depreciation is preferred to
straight-line depreciation, because as the asset ages, the smaller depreciation charges are
associated with higher maintenance charges. The resulting combined expense pattern provides a
better matching against the associated revenue stream. Accelerated depreciation, methods
probably give balance sheet valuations that are closer to the actual value of the assets in question
than straight-line methods do, because most assets lose their value more rapidly during the earlier
years of use. But because depreciation accounting is not intended to be a method of asset
valuation, this factor should not be viewed as an advantage of using accelerated depreciation
methods.
Units of Activity When assets (e.g., machinery) are used in the actual production process, it may
be possible to determine an activity level, such as the total expected output to be obtained from
these assets. Depreciation may then be based on the number of units of output produced during
an accounting period. The activity measures of depreciation assume that each product produced
during the asset's existence receives the same amount of benefit from the asset. This assumption
may or may not be realistic. In addition, care must be exercised in establishing a direct relationship
between the measurement unit and the asset. For example, when direct labor hours are used as a
measure of the units of output, a decline in productive efficiency in the later years of the asset's
use can cause the addition of more direct labor hours per product, which would result in charging
more cost per unit.

DISCLOSURE OF DEPRECIATION METHODS

Most U.S. companies use straight-line depreciation, as shown by the 2010 edition of Accounting
Trends and Techniques, which reported that 488 of the 600 firms surveyed used straight-line
depreciation for at least some of their assets.10 Both Hershey and Tootsie Roll use straight-line
depreciation for financial reporting purposes. The following is excerpted from Tootsie Roll's
summary of significant accounting policies:

PROPERTY, PLANT AND EQUIPMENT:

Depreciation is computed for financial reporting purposes by use of the straight-line
method based on useful lives of 20 to 35 years for buildings and 5 to 20 years for
 machinery and equipment. Depreciation expense was $19,229, $18,279 and $17,862 in
2011, 2010 and 2009, respectively ($000 omitted).

Capital and Revenue Expenditures

The initial purchase and installation of plant and equipment does not necessarily eliminate
additional expenditures associated with these assets. Almost all productive facilities require
periodic maintenance that should be charged to current expense. The cost of the asset to the
enterprise includes the initial cost plus all costs associated with keeping the asset in working
order. However, if additional expenditures give rise to an increase in future service potential,
these expenditures should not be charged to current operations. Expenditures that increase future
service potential should be added to the remaining unexpired cost of the asset and be charged to
expense over the estimated remaining period of benefit.
In most cases, the decision to expense or capitalize plant and equipment expenditures
subsequent to acquisition is fairly simple and is based on whether the cost incurred is “ordinary
and necessary” or “prolongs future life.” But often this decision becomes more complicated, and
additional rules have been formulated that assist in determining whether an expenditure should be
recorded as a capital improvement. If the asset's life is increased, the efficiency provided is
increased, or if output is increased, its service potential has increased, and the cost of an
expenditure should be capitalized and written off over the expected period of benefit. All other
expenditures made subsequent to acquisition should be expensed as incurred.

Recognition and Measurement Issues

Accounting depreciation methods are objective because they use historical cost. Moreover, once
the method is selected, the resulting depreciation charges are generally reliable. Nevertheless, all
accounting depreciation methods have similar recognition and measurement problems. Given that
fixed assets are intended to provide service potential over multiple future years, each cost-
allocation method requires estimates of salvage value and useful life, and given the rapidly
changing competitive environment, revisions of these estimates may be required each accounting
period.
One can argue that accounting depreciation methods do not provide relevant information for
users. Users desire information that is useful in predicting future cash flows. Users are also aware
that management makes a decision each period either to reinvest in available long-term assets or
to replace existing long-term assets with new ones. Consequently, a current-value approach to
depreciation may be more consistent with investors' needs.
Using a current-value balance sheet approach to report depreciation would require knowledge
of the reinvestment value of each long-term asset at the end of each accounting period. Such a
determination may be impracticable or even impossible. The assets in question may be old, or
they may be so specialized that there is no readily determinable market value. Alternative
discounted present-value techniques require estimates of future cash flows that may be unreliable,
and appraisal values may not be realistic. Hence, there is no simple answer to the determination
of the most appropriate approach to depreciation. This determination depends, to a large extent,
on an individual's perception of the necessary tradeoff between relevance and reliability.

IMPAIRMENT OF VALUE
The SFAC No. 6 definition of assets indicates that assets have future service potential and
consequently value to the reporting entity. Having future service potential implies that the asset
is expected to generate future cash flows. When the present value of future cash flows decreases,
the value of the asset to the firm declines. If the decline in value over the life of the asset is greater
than the accumulated depreciation charges, the book value of the asset is overstated, and the value
of the asset is said to be impaired. Yet accountants have been reluctant to apply the lower of cost
or market (LCM) rule to account for property, plant, and equipment.
The FASB, noting divergent practices in the recognition of impairment of long-lived assets,
originally issued SFAS No. 121,11 now superseded, which addressed the matter of when to
recognize the impairment of long-lived assets and how to measure the loss. This release ignored
current value as a determinant of impairment. Rather, it stated that impairment occurs when the
carrying amount of the asset is not recoverable. The recoverable amount is defined as the sum of
the future cash flows expected to result from use of the asset and its eventual disposal. Under this
standard, companies were required to review longlived assets (including intangibles) for
impairment whenever events or changes in circumstances indicate that book value might not be
recoverable. Examples indicating potential impairment included the following:

1. A significant decrease in the market value of an asset

2. A significant change in the extent or manner in which an asset is used
3. A significant adverse change in legal factors or in business climate that affects the
value of assets
4. An accumulation of significant costs in excess of the amount originally expended to
acquire or construct an asset
5. A projection or forecast that demonstrates a history of continuing losses associated
with the asset

Although fair value was not used to determine impairment, SFAS No. 121 required that when
an impairment occurred, a loss was to be recognized for the difference between the carrying value
of an asset and its current value less estimated cost to dispose of the asset. The resulting reduced
carrying value of the asset became its new cost basis and was to be depreciated over the remaining
useful life of the asset.
In 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-
Lived Assets”12 (see FASB ASCs 360-10-35-15 to 49). The FASB stated that the new standard
was issued because SFAS No. 121 did not address accounting for a segment of a business
accounted for as a discontinued operation, as originally required by APB Opinion 30.
Consequently, two accounting models existed for disposing of long-lived assets. The Board
decided to establish a single accounting model, based on the framework established in SFAS No.
121, for long-lived assets to be disposed of by sale.
The guidance at FASB ASC 360-10-40 applies to all dispositions of long-term assets; however,
it excludes current assets, intangibles, and financial instruments because they are covered in other
releases. According to its provisions, assets are to be classified as follows:

1. Long-term assets held and used

2. Long-lived assets to be disposed of other than by sale
3. Long-lived assets to be disposed of by sale
 Long-term assets held and used are to be tested for impairment using the original SFAS No. 121
criteria if events suggest there may have been impairment. The impairment is to be measured at
fair value by using the present-value procedures outlined in SFAC No. 7 (see Chapter 2).
To illustrate, consider the following scenario. Baxter Company owns a manufacturing facility
with a carrying value of $80 million that is tested for recoverability.13 Two courses of action are
under consideration—sell in two years, or sell at the end of its remaining useful life of 10 years.
The company develops the probability of a range of possible estimated future cash flows for each
possibility, considering various future sales levels and future economic conditions as follows.

Next, the probability of each of the courses of action must be determined. If the probability of
the first course of action is 60 percent and the second is 40 percent, the total present value is $88.2
[($82.0 × .6) + ($97.4 × .4)].
For long-term assets held and used, it might be necessary to review the original depreciation
policy to determine if the useful life is still as originally estimated. Next, the assets are grouped at
the lowest level for which identifiable cash flows are independent of cash flows from other assets
and liabilities, and losses are allocated pro rata to the assets in the group. Any losses are disclosed
in income from continuing operations.
To illustrate grouping, assume that Alvaraz Company owns a manufacturing facility that is one
of the groups of assets that is tested for recoverability. In addition to long-term assets, the asset
group includes inventory and other current liabilities not covered by FASB ASC 360. The $5.5
million aggregate carrying amount of the asset group is not fully recoverable and exceeds its fair
value by $1.2 million. How is the impairment loss allocated?
 Long-lived assets to be disposed of other than by sale, such as those to be abandoned, exchanged
for a similar productive asset, or distributed to owners in a spin-off, are to be considered held and
used until disposed of. Additionally, to resolve implementation issues, the depreciable life of a
long-lived asset to be abandoned was to be revised in accordance with the criteria originally
established in APB Opinion No. 20, “Accounting Changes” (since rescinded).
The accounting treatment for long-lived assets to be disposed of by sale is used for all long-
lived assets, whether previously held and used or newly acquired (FASB ASC 360-10-35). That
treatment retains the requirement originally outlined in SFAS No. 121 to measure a long-lived
asset classified as held for sale at the lower of its carrying amount or fair value less cost to sell
and to cease depreciation (amortization). As a result, discontinued operations are no longer
measured on the basis of net realizable value, and future operating losses are no longer recognized
before they occur.
In summary, SFAS No. 144 retained the requirements of SFAS No. 121 to recognize an
impairment loss only if the carrying amount of a long-lived asset is not recoverable from its
undiscounted cash flows. This loss is measured as the difference between the carrying amount and
fair value of the asset (see FASB ASC 360-10-35-17).

ACCOUNTING FOR ASSET RETIREMENT OBLIGATIONS

In February 1994, Edison Electric Institute asked the FASB to add a project to its agenda to
address accounting for nuclear decommissioning and other similar costs. Later, the FASB issued
an exposure draft to include a broader project for all asset retirement obligations. This exposure
draft became SFAS No. 143, “Accounting for Asset Retirement Obligations”14 (see FASB ASC
410-20).
At the time SFAS No. 143 was issued, the FASB noted that existing practice was inconsistent;
consequently, the objective of this release was to provide accounting requirements for all
obligations associated with the removal of long-lived assets. FASB ASC 410-20 applies to all
entities that face existing legal obligations associated with the retirement of tangible long-lived
assets.
FASB ASC 410-20 provides the following definitions associated with the issue:

1. Asset retirement obligation. The liability associated with the ultimate disposal of a
long-term asset
 2. Asset retirement cost. The increase in the capitalized cost of a long-term asset that
occurs when the liability for an asset retirement obligation is recognized
3. Retirement. An other-than-temporary removal of a long-term asset from service by
sale, abandonment, or other disposal
4. Promissory estoppel. A legal concept holding that a promise made without
consideration may be enforced to prevent injustice

For each asset-retirement obligation, a company is required to initially record the fair value
(present value) of the liability to dispose of the asset when a reasonable estimate of its fair value
is available. Companies are required to use SFAC No. 7 criteria for recognition of the liability,
which is the present value of the asset at the credit-adjusted rate. This amount is defined as the
amount a third party with a comparable credit standing would charge to assume the obligation.
Subsequently, the capitalized asset-retirement cost is allocated in a systematic and rational
manner as depreciation expense over the estimated useful life of the asset. Additionally, the initial
carrying value of the liability is increased each year by use of the interest method using the credit-
adjusted rate and is classified as accretion expense and not interest expense. In the event any of
the original assumptions change, a recalculation of the obligation and the subsequent associated
expenses is to be recorded as a change in accounting estimate.
To illustrate, consider the following example.15 Gulfshores Oil Company completes
construction and places into service an offshore oil platform on January 1, 2013. The company is
legally required to dismantle and remove the platform at the end of its useful life, which is
estimated to be 10 years. FASB ASC 410-20 requires the company to recognize a liability for an
asset-retirement obligation that is capitalized as a part of the asset's cost. The company estimates
this liability by using its estimated present value and the following additional information.

1. Labor costs required to dismantle the platform are based on the best estimates of
future costs and are assigned the following probabilities:

2. Overhead is allocated at 75 percent of labor cost. This amount is based on the

company's current overhead application rate.
3. A contract for removal will include a profit to the contractor. The profit margin is
estimated to be 25 percent of labor and overhead.
4. The company wishes to contract now for the asset removal. A contractor normally
requires a risk premium to cover future uncertainties. The market risk premium for
locking in is assumed to be 5 percent of the inflation-adjusted cash flows.
5. The assumed inflation rate is 2 percent.
 6. The risk-free interest rate is 2 percent, and the adjusted credit standing rate is 4
percent.

The initial measurement of the liability is as follows:

These calculations result in Gulfshores' recording the following entry on January 1, 2013:

As a result, the company will record annual depreciation expense of $41,041 for the next 10
years, and it will increase the value of the ARO liability by 6.0 percent each year:

On December 31, 2022, Gulfshores will settle the asset-retirement obligation by using its own
workforce at a total cost of $710,000. It is necessary to compare the settlement cost with the book
value of the asset-retirement obligation on the date of retirement to determine if a gain or loss has
occurred as follows:
On the settlement date, the liability is removed from the books, the costs associated with the
restoration are recorded, and the gain is recognized.

International Accounting Standards

The IASB has issued pronouncements on the following issues affecting items of property, plant,
and equipment:

1. The overall issues associated with accounting for property, plant, and equipment
assets in a revised IAS No. 16, “Property, Plant and Equipment”
2. The capitalization of interest costs on acquired assets in IAS No. 23, “Borrowing Costs”
3. The accounting treatment for impairment of assets in IAS No. 36, “Impairment of
Assets”
4. The accounting treatment for provisions for asset retirement obligations in IAS No. 37,
“Provisions, Contingent Liabilities and Contingent Assets”
5. The accounting treatment for assets held for disposal in IFRS No. 5, “Non-Current
Assets Held for Sale and Discontinued Operations”
6. Accounting for mineral resources in IFRS No. 6, “Exploration for and Evaluation of
Mineral Resources”

IAS No. 16 was originally issued in 1982 and later revised in 2003. The stated objective of IAS
No. 16 is to prescribe the accounting treatment for property, plant, and equipment. The principal
issues discussed in IAS No. 16 are the recognition of assets, the determination of their carrying
amounts, and the depreciation charges and impairment losses to be recognized in relation to them.
The revised IAS No. 16 did not change the fundamental approach to accounting for property, plant,
and equipment. The Board's purpose in revising the original standard was to provide additional
guidance on selected matters. The revised standard also requires depreciation to be calculated in
a manner that more closely resembles the actual decline in service potential of the assets.
IAS No. 16 indicates that items of property, plant, and equipment should be recognized as assets
when it is probable that the future economic benefit associated with these assets will flow to the
enterprise and that their cost can be reliably measured. Under these circumstances, the initial
measurement of the value of the asset is defined as its cost. Subsequently, the stated preferred
treatment is to depreciate the asset's historical cost; however, an allowed alternative treatment is
to periodically revalue the asset to its fair market value. When such revaluations occur, increases
in value are to be recorded in stockholders' equity unless a previously existing reevaluation surplus
exists, whereas decreases are recorded as current-period expenses. In the event a revaluation is
undertaken, the statement requires that the entire group of assets to which the revalued asset
belongs also be revalued. Examples of groups of property, plant, and equipment assets are land,
buildings, and machinery. Finally, the required disclosures for items of property, plant, and
equipment include the measurement bases used for the assets, as well as a reconciliation of the
beginning and ending balances to include disposals and acquisitions and any revaluation
adjustments.
IAS No. 16 also requires companies to periodically review the carrying amounts of items of
property, plant, and equipment to determine whether the recoverable amount of the asset has
declined below its carrying amount. When such a decline has occurred, the carrying amount of
the asset must be reduced to the recoverable amount, and this reduction is recognized as an
expense in the current period. IAS No. 16 also requires write-ups when the circumstances or events
that led to write-downs cease to exist. This treatment contrasts to the requirements of SFAS No.
144 (see FASB ASC 360-10), which prohibits recognition of subsequent recoveries.
With respect to depreciation, IAS No. 16 indicated that the periodic charge should be allocated
in a systematic basis over the asset's useful life and that the depreciation method selected should
reflect the pattern in which the asset's economic benefits are consumed. Finally, the standard
requires periodic review of the pattern of economic benefits consumed, and when a change in the
pattern of benefits is in evidence, the method of depreciation must be changed to reflect this new
pattern of benefits. Such changes in depreciation methods are to be accounted for as changes in
accounting principles. This treatment differs substantially from U.S. GAAP, where the
depreciation method selected is required only to be systematic and rational, and changes in
depreciation methods are allowed only in unusual circumstances.
The major clarifications outlined in the revised IAS No. 16 were as follows:

1. A components approach is required for depreciation. Under a components approach,

each material component of a composite asset with different useful lives or different
patterns of depreciation is accounted for separately for the purpose of depreciation
and accounting for subsequent expenditure (including replacement and renewal).
2. The acquisition cost of property, plant, and equipment should include the amount of
an IAS No. 37 provision for the estimated cost of dismantling and removing the asset
and restoring the site, including both provisions recognized when the asset is acquired
and incremental provisions recognized while the asset is used. However, after a
provision is recognized, an increase to the provision resulting from accretion of
interest or a change in the discount rate will be charged to expense, not added to the
asset cost.
3. Accounting for incidental revenue (and related expenses) during construction or
development of an asset depends on whether the incidental revenue is a necessary
activity in bringing the asset to the location and working condition necessary for it to
be capable of operating in the manner intended by management (including those to
test whether the asset is functioning properly):
1. Net sales proceeds received during activities necessary to bring the asset to the
location and working condition necessary for it to be capable of operating
properly are deducted from the cost of the asset.
2. Revenue and related expenses should be separately recognized for operations
that occur in connection with construction or development of an asset but that
are not necessary to bring the asset to the location and working condition
necessary for it to be capable of operating properly.
4. Measurement of residual value is defined as the current prices for assets of a similar
age and condition to the estimated age and condition of the asset when it reaches the
end of its useful life.
 5. Exchanges of similar items of property, plant, and equipment will be recorded at fair
value, and gain or loss will be recognized, unless neither the fair value of the asset
given up nor the fair value of the asset acquired can be measured reliably, in which
case the cost of the acquired asset would be the carrying amount of the asset given up.
6. Subsequent expenditure is added to the carrying amount of an asset only if the
expenditure increases the asset's future economic benefits above those reflected in its
most recently assessed level of performance.

IAS No. 23 was first issued in 1984 and later amended in 2007. The stated purpose of IAS No.
23 is to prescribe the accounting treatment for borrowing costs, which include interest on bank
overdrafts and borrowings, amortization of discounts or premiums on borrowings, amortization
of ancillary costs incurred in the arrangement of borrowings, finance charges on finance leases,
and exchange differences on foreign currency borrowings where they are regarded as an
adjustment to interest costs.
The original standard allowed companies to choose between two methods of accounting for
borrowing costs. Under the benchmark treatment, companies were required to recognize interest
costs in the period in which they were incurred. Under the allowed alternative treatment, interest
costs that are directly attributable to the acquisition, construction, or production of a qualifying
asset are capitalized as part of that asset. The interest costs that were to be capitalized were the
costs that could be avoided if the expenditure for the qualifying asset had not been made.
In 2007, the IASB revised IAS No. 23 as a result of its joint short-term convergence project with
the FASB to reduce differences between IFRSs and U.S. GAAP. This revision removed a major
difference between the original pronouncement and SFAS No. 34. The main change in the revised
IAS No. 23 is the removal of the option of immediately recognizing all borrowing costs as an
expense, which was previously the benchmark treatment. The revised standard requires that an
entity capitalize borrowing costs directly attributable to the acquisition, construction, or
production of a qualifying asset as part of the cost of that asset, which was a permitted alternative
treatment under the original IAS No. 23.
The purpose of IAS No. 36 is to make sure that assets are carried at no more than their
recoverable amount and to define how the recoverable amount is calculated. IAS No. 36 requires
an impairment loss to be recognized whenever the recoverable amount of an asset is less than its
carrying amount (its book value). The recoverable amount of an asset is the higher of its net selling
price and its value in use. Both are based on present-value calculations.
The following definitions are of importance in applying IAS No. 36:

 Impairment: An asset is impaired when its carrying amount exceeds its recoverable
amount.
 Carrying amount: The amount at which an asset is recognized in the balance sheet
after deducting accumulated depreciation and accumulated impairment losses
 Recoverable amount: The higher of an asset's fair value less costs to sell (sometimes
called net selling price) and its value in use.
 Fair value: The amount obtainable from the sale of an asset in an arm's length
transaction between knowledgeable, willing parties.
 Value in use: The discounted present value of the future cash flows expected to arise
from
 The continuing use of an asset, and from
  Its disposal at the end of its useful life

IAS No. 36 indicates that an impairment loss should be recognized as an expense in the income
statement for assets carried at cost and treated as a revaluation decrease for assets carried at a
revalued amount. An impairment loss should be reversed (and income recognized) when there has
been a change in the estimates used to determine an asset's recoverable amount since the last
impairment loss was recognized.
In determining value in use, an enterprise should use these two methods:

1. Cash flow projections based on reasonable and supportable assumptions that reflect
the asset in its current condition and represent management's best estimate of the set
of economic conditions that will exist over the remaining useful life of the asset
(estimates of future cash flows should include all estimated future cash inflows and
cash outflows, except for cash flows from financing activities and income tax receipts
and payments)
2. A pretax discount rate that reflects current market assessments of the time value of
money and the risks specific to the asset (the discount rate should not reflect risks for
which the future cash flows have been adjusted)

If an asset does not generate cash inflows that are largely independent of the cash inflows from
other assets, an enterprise should determine the recoverable amount of the cash-generating unit to
which the asset belongs. A cash-generating unit is the smallest identifiable group of assets that
generates cash inflows that are largely independent of the cash inflows from other assets or group
of assets.
Impairment losses recognized in prior years should be reversed if, and only if, there has been a
change in the estimates used to determine recoverable amount since the last impairment loss was
recognized. However, an impairment loss should be reversed only to the extent that the reversal
does not increase the carrying amount of the asset above the carrying amount that would have
been determined for the asset (net of amortization or depreciation) had no impairment loss been
recognized. An impairment loss for goodwill should be reversed only if the specific external event
that caused the recognition of the impairment loss reverses. A reversal of an impairment loss
should be recognized as income in the income statement for assets carried at cost and treated as a
revaluation increase for assets carried at revalued amount.
IAS No. 37 outlines accounting for provisions—that is, liabilities of uncertain timing or amount,
together with contingent assets and contingent liabilities. Provisions are to be measured at the best
estimate, including risks and uncertainties, of the expenditure required to settle the present
obligation, and reflect the present value of expenditures required to settle the obligation where the
time value of money is material. The accounting requirements for provisions relating to asset
retirement obligations are similar to those outlined in SFAS No. 144. A more complete discussion
of IAS No. 37 is contained in Chapter 11.
IFRS No. 5 establishes the accounting treatment for discontinued operations and long-term
assets held for sale. IFRS No. 5 achieves substantial convergence with the accounting
requirements originally outlined in SFAS No. 144, “Accounting for the Impairment or Disposal of
Long-Lived Assets,” with respect to the definition of discontinued operations, the timing of the
classification of operations as discontinued operations and their disclosure.
 According to IFRS No. 5, a discontinued operation is a component of an entity that either has
been disposed of or is classified as held for sale, and

 Represents either a separate major line of business or a geographical area of

operations, and
 Is part of a single coordinated plan to dispose of a separate major line of business or
geographical area of operations, or
 Is a subsidiary acquired exclusively with a view to resale and the disposal involves loss
of control

Discontinued operations are disclosed as a single amount that is composed of the sum of the after-
tax profit or loss of the discontinued operation and the after-tax gain or loss recognized by
measuring the fair value of the discontinued operations assets.
Under IFRS No. 5, assets are classified as held for sale when they are available for immediate
sale and their sale is highly probable. The highly probable criterion is satisfied when

 Management is committed to a plan to sell

 The asset is available for immediate sale
 An active program to locate a buyer is initiated
 The sale is highly probable within 12 months of classification as held for sale (subject
to limited exceptions)
 The asset is being actively marketed for sale at a sales price reasonable in relation to
its fair value
 Actions required to complete the plan indicate that it is unlikely that plan will be
significantly changed or withdrawn

The following recognition and measurement principles for held-for-sale assets are contained in
IFRS No. 5:

1. At the time of classification as held for sale. Immediately before the initial
classification of the asset as held for sale, the carrying amount of the asset will be
measured in accordance with applicable IFRSs.
2. After classification as held for sale. Noncurrent assets or disposal groups that are
classified as held for sale are measured at the lower of carrying amount and fair value
less costs to sell. An impairment loss is recognized in the profit or loss for any initial
and subsequent write-down of the asset or disposal group to fair value less costs to
sell.
3. Assets carried at fair value before initial classification. For such assets, the
requirement to deduct costs to sell from fair value will result in an immediate charge
to profit or loss.
4. Subsequent increases in fair value. A gain for any subsequent increase in fair value
less costs to sell of an asset can be recognized in the profit or loss to the extent that it
is not in excess of the cumulative impairment loss that has been recognized in
accordance with IFRS No. 5 or previously in accordance with IAS No. 36.
 Assets classified as held for sale, and the assets and liabilities included within a disposal group
classified as held for sale, must be presented separately on the face of the balance sheet and are
not depreciated.
The following disclosures are required:

1. Noncurrent assets classified as held for sale and the assets of a disposal group
classified as held for sale must be disclosed separately from other assets in the balance
sheet.
2. The liabilities of a disposal group classified as held for sale must also be disclosed
separately from other liabilities in the balance sheet.
3. There are also several other additional disclosures, including a description of the
nature of assets held and the facts and circumstances surrounding the sale.

The IASB has identified accounting for extractive activities as the topic for a future accounting
standard; however, no timetable for the project has been set. In the absence of a standard dealing
with this topic, there had been concern voiced that entities engaged in extractive activities and
adopting IFRSs for the first time in 2005 would encounter difficulties and uncertainty in
determining which accounting policies were acceptable using the criteria in IAS No. 8,
“Accounting Policies, Changes in Accounting Estimates and Errors.” Therefore, the principal
objective of IFRS No. 6 is to limit the need for entities to change their existing accounting policies
for exploration and evaluation assets. IFRS No. 6 permits an entity to develop an accounting policy
for recognition of exploration and evaluation expenditures as assets without specifically
considering the requirements of paragraphs 11 and 12 of IAS No. 8, “Accounting Policies,
Changes in Accounting Estimates and Errors.” Thus, an entity adopting IFRS No. 6 may continue
to use the accounting policies applied immediately before adopting the IFRS. This includes
continuing to use recognition and measurement practices that are part of those accounting policies.
Under the provisions of IFRS No. 6, exploration and evaluation assets are required to be
measured initially at cost. The expenditures to be included in the cost of these assets are
determined by the entity as a matter of accounting policy and should be applied consistently. In
making this determination, the entity should consider the degree to which the expenditures can be
associated with finding specific mineral resources. IFRS No. 6 cites the following as examples of
expenditures that might be included in the initial measurement of exploration and evaluation
assets: acquisition of rights to explore; topographical, geological, geochemical, and geophysical
studies; exploratory drilling; trenching; sampling; and activities in relation to evaluating the
technical feasibility and commercial viability of extracting a mineral resource. Where an entity
incurs obligations for removal and restoration as a consequence of having undertaken the
exploration for and evaluation of mineral resources, those obligations are to be recognized in
accordance with the requirements of IAS No. 37, “Provisions, Contingent Liabilities, and
Contingent Assets.”
After initial recognition, entities can apply either the cost model or the revaluation model to
exploration and evaluation assets. Where the revaluation model is selected, the rules of IAS No.
16 are applied to exploration and evaluation assets classified as tangible assets, and the rules of
IAS No. 38, “Intangible Assets,” are applied to those classified as intangible assets.
Additionally, because of the difficulty in obtaining the information necessary to estimate future
cash flows from exploration and evaluation assets, IFRS No. 6 modifies the rules of IAS No. 36 as
regards the circumstances in which such assets are required to be assessed for impairment. A
detailed impairment test is required in two circumstances:

1. When the technical feasibility and commercial viability of extracting a mineral

resource become demonstrable, at which point the asset falls outside the scope of IFRS
No. 6 and is reclassified in the financial statements
2. When facts and circumstances suggest that the asset's carrying amount could exceed
its recoverable amount

Companies applying this standard are required to disclose information that identifies and explains
the amounts recognized in their financial statements arising from the exploration for and
evaluation of mineral resources. Consequently, the following should be disclosed:

 the entity's accounting policies for exploration and evaluation expenditures, including
the recognition of exploration and evaluation assets; and
 the amounts of assets, liabilities, income and expense, and operating and investing
cash flows arising from the exploration for and evaluation of mineral resources.

Additionally, exploration and evaluation assets are to be treated as a separate class of assets for
disclosure purposes. The disclosures required by either IAS No. 16 or IAS No. 38 should be made,
consistent with how the assets are classified.

Cases

Case 9-1 Donated Assets

The City of Martinsville donated land to Essex Company. The fair value of the land was $100,000.
The land had cost the city $45,000.

Required:

1. Describe the current accounting treatment for the land. Include in your answer the
amount at which the land would be valued by Essex Company and any other income
statement or balance sheet effect.
2. Under the recommendations outlined in SFAS No. 116 (see FASB ASC 720), the FASB
required that donated assets be recorded at fair value and that revenue be recognized
equivalent to the amount recorded for a donation.
1. Defend the FASB's position. In your answer, refer to the conceptual framework.
2. Criticize the FASB's position. In your answer, refer to the conceptual framework.
3. Assume that immediately before the donation, Essex had assets totaling $800,000
and liabilities totaling $350,000. Compare the financial statement effects of the
FASB requirement with previous practice. For example, how would EPS or ratios
such as debt to equity be affected?

Case 9-2 Purchase of Assets

On October 10, 2013, Mason Engineering Company completed negotiations on a contract for the
purchase of new equipment. Under the terms of the agreement, the equipment may be purchased
now or Mason may wait until January 10, 2014, to make the purchase. The cost of the equipment
is $400,000. It will be financed by a note bearing interest at the market rate. Straight-line
depreciation over a 10-year life will be used for book purposes. A double-declining balance over
seven years will be used for tax purposes. (One-half year of depreciation will be taken in the year
of purchase regardless of the date of purchase.)

Required:

1. Discuss the financial statement impacts of postponing the purchase of the

equipment. Would the market price of the firm's common stock be affected by any or all of
these impacts? Do not assume in your discussion that the postponement will affect
revenues or any operating costs other than depreciation.
2. Discuss any cash flow impacts related to postponing the purchase of the equipment.
3. Efficient markets assume that stockholder wealth is affected by the amount and timing
of cash flows. Which alternative is more favorable to them: purchasing before year-
end, or waiting until January? Explain your answer.

Case 9-3 Depreciation Accounting

Depreciation continues to be one of the most controversial, difficult, and important problem areas
in accounting.

Required:

1. Explain the conventional accounting concept of depreciation accounting.

2. Discuss its conceptual merit with respect to
1. The value of the asset
2. The charge(s) to expense
3. The discretion of management in selecting the method
3. Explain the factors that should be considered when applying the conventional
concept of depreciation to the determination of how the value of a newly acquired
computer system should be assigned to expense for financial reporting purposes
(ignore income tax considerations).
4. What depreciation methods might be used for the computer system? Describe the
advantages and disadvantages of each.

Case 9-4 Self-Constructed Assets

Jay Manufacturing, Inc., began operations five years ago producing the probo, a new type of
instrument it hoped to sell to doctors, dentists, and hospitals. The demand for probos far exceeded
initial expectations, and the company was unable to produce enough probos to meet that demand.
Jay was manufacturing probos on equipment it built at the start of its operations, but it needed
more efficient equipment to meet demand. Company management decided to design and build
the equipment, because no equipment currently available on the market was suitable for
producing probos.
 In 2014, a section of the plant was devoted to development of the new equipment and a special
staff of personnel was hired. Within six months, a machine was developed at a cost of $170,000
that increased production and reduced labor cost substantially. Sparked by the success of the new
machine, the company built three more machines of the same type at a cost of $80,000 each.

Required:

1. In addition to satisfying a need that outsiders cannot meet within the desired time,
what other reasons might cause a firm to construct fixed assets for its own use?
2. In general, what costs should be capitalized for a self-constructed asset?
3. Discuss the appropriateness (give pros and cons) of including these charges in the
capitalized cost of self-constructed assets:
1. The increase in overhead caused by the self-construction of fixed assets
2. A proportionate share of overhead on the same basis as that applied to goods
manufactured for sale (consider whether the company is at full capacity)
4. Discuss the proper accounting treatment of the $90,000 ($170,000 − $80,000) by
which the cost of the first machine exceeded the cost of the subsequent machines.

Case 9-5 Accounting for Land

Your client found three suitable sites, each having certain unique advantages, for a new plant. To
thoroughly investigate the advantages and disadvantages of each site, one-year options were
purchased for an amount equal to 5 percent of the contract price of each site. The costs of the
options cannot be applied against the contracts. Before the options expire, one of the sites was
purchased at the contract price of $60,000. The option on this site had cost $3,000. The two
options not exercised had cost $3,500 each.

Required:
Present arguments in support of recording the cost of the land at each of the following amounts:

1. $60,000
2. $63,000
3. $70,000

Case 9-6 Depreciation Accounting

Property, plant, and equipment (plant assets) generally represent a material portion of the total
assets of most companies. Accounting for the acquisition and use of such assets is therefore an
important part of the financial reporting process.

Required:

1. Distinguish between revenue and capital expenditures, and explain why this
distinction is important.
2. Briefly define depreciation as used in accounting.
 3. Identify the factors that are relevant in determining the annual depreciation, and
explain whether these factors are determined objectively or whether they are based
on judgment.
4. Explain why depreciation is shown as an adjustment to cash in the operations section
on the statement of cash flows.

Case 9-7 Accounting for Land and Plant Assets

A company may acquire plant assets (among other ways) for cash, on a deferred payment plan,
by exchanging other assets, or by a combination of these ways.

Required:

1. Identify six costs that should be capitalized as the cost of the land. For your answer,
assume that land with an existing building is acquired for cash and that the existing
building is to be removed in the immediate future so that a new building can be
constructed on the site.
2. At what amount should a company capitalize a plant asset acquired on a deferred
payment plan?
3. In general, at what amount should plant assets received in exchange for other
nonmonetary assets be recorded? Specifically, at what amount should a company
record a new machine acquired by exchanging an older, similar machine and paying
cash? Would your answer be the same if cash were received?

Case 9-8 Acquisition and Sale of Plant Assets

George Company purchased land for use as its corporate headquarters. A small factory that was
on the land when it was purchased was torn down, and before the new building's foundation could
be constructed, a substantial amount of rock had to be blasted and removed. Because the office
building is set back on the land far from the public road, George had the contractor construct a
paved road from the public road to the parking lot of the office building.
Three years after the office building was occupied, George added four stories to the office
building. The four stories had an estimated useful life of five years more than the remaining
estimated life of the original building.
Ten years later, the land and buildings were sold at an amount more than their net book value,
and George had a new office building constructed in another state for use as its new corporate
headquarters.

Required:

1. Which of the preceding expenditures should be capitalized? How should each be

depreciated or amortized? Discuss the rationale for your answers.
2. How would the sale of the land and building be accounted for? Include in your answer
how to determine the net book value at the date of sale. Discuss the rationale for your
answer.
 Case 9-9 Accounting for Property, Plant, and Equipment
Among the principal topics related to the accounting for the property, plant, and equipment of a
company are acquisitions and retirements.

Required:

1. What expenditures should be capitalized when equipment is acquired for cash?

2. Assume the market value of equipment is not determinable by reference to a similar
purchase for cash. Describe how the acquiring company should determine the
capitalized cost of equipment purchased by exchanging it for each of the following:
1. Bonds having an established market price
2. Common stock not having an established market price
3. Similar equipment not having a determinable market price
3. Describe the factors that determine whether expenditures relating to property,
plant, and equipment already in use should be capitalized.
4. Describe how to account for the gain or loss on the sale of property, plant, or
equipment.

Case 9-10 Environmental Costs

Joe Mason acquired land on which he will construct a new restaurant. A chemical plant had once
occupied the site. Government regulations require Mason to clean up the chemical residue before
building. The cost of the cleanup is material.

Required:

1. Under current GAAP, an asset is charged with historical cost, which includes the
purchase price and all costs incident to getting the asset ready for its intended use. Defend
the historical cost principle. Use the conceptual framework concepts and definitions in
your defense.
2. How should Joe treat the cost of the cleanup? Is it a land cost, a building cost, or an
expense? Explain.

Case 9-11 Cost Allocation

Keeping an asset implies reinvestment in the asset. Finance theory is consistent with the notion
that reinvestment is at current value, or replacement cost. Such a decision is presumably based on
comparing expected future cash flows that will be generated by the asset and the cost of replacing
it with a new one that could generate the same or different cash flows.
According to the conceptual framework, the purpose of financial statements is to provide
information regarding performance. Investment or reinvestment decisions are a part of that
performance. Yet, the historical cost of fixed assets is retained and allocated over subsequent
accounting periods.

Required:
1. Present arguments in favor of cost allocation.
2. Does cost allocation provide relevant information?
3. Would a current-value approach to measurement of fixed assets be preferable? Why?
4. Would a current-value approach be consistent with the physical capital maintenance
concept? Explain.
5. What problems and limitations are associated with using replacement cost for fixed
assets?

FASB ASC Research

For each of the following research cases, search the FASB ASC database for information to
address the issues. Copy and paste the FASB paragraphs that support your responses. Then
summarize briefly what your responses are, citing the pronouncements and paragraphs used to
support your responses.

FASB ASC 9-1 Depreciation

Several pronouncements by authoritative accounting bodies deal with depreciation. List the
pronouncements dealing with depreciation. What is the FASB's current definition of
depreciation?

FASB ASC 9-2 Asset Impairment Obligations

Several FASB statements dealt with the topic of asset impairments. List the FASB statements that
dealt with asset impairments and summarize them. Several EITF documents provide additional
guidance on implementing the FASB standards. List the implementation issues discussed in the
EITF releases.

FASB ASC 9-3 Asset Retirement Obligations

SFAS No. 144 dealt with asset retirement obligations. Provide a summary of this statement.
Additionally, list the implementation issues addressed by the EITF for asset retirement
obligations.

FASB ASC 9-4 Disclosure of Depreciation

The FASB ASC requires the disclosure of certain information pertaining to depreciation. Search
the FASB ASC to find these requirements. Cite the appropriate paragraphs and summarize your
finding.

FASB ASC 9-5 Overhaul Costs in the Airline Industry

Overhaul costs are a significant aspect of accounting for property, plant, and equipment in the
airline industry. Search the FASB ASC to find a definition of overhaul cost in the airline industry.
What two methods of accounting for overhaul cost are defined in the FASB ASC? Be sure to cite
the appropriate FASB ASC paragraphs.

FASB ASC 9-6 Accounting for the Mining Extractive Industry

The FASB ASC contains guidance on the mining extractive industry.

1. Search the FASB ASC for definitions for the following terms:
1. Production phase
2. Stripping costs
2. Discuss the accounting treatment for stripping costs.

FASB ASC 9-7 Franchise Prematurity Period

The FASB ASC contains guidance on accounting for franchise assets during the prematurity
period. Search the FASB ASC for answers to the following questions:

1. How is the prematurity period defined?

2. How are franchise sizes defined during the prematurity period?
3. How is depreciation expense recorded during the prematurity period?

Room for Debate

Debate 9-1 Capitalization of Interest

According to SFAS No. 34, interest on self-constructed assets should be capitalized.

Team Debate:

Team Present arguments in favor of capitalizing interest. Tie your arguments to the concepts
1: and definitions found in the conceptual framework.

Team Criticize the provisions of SFAS No. 34. Present arguments against capitalizing
2: interest. Tie your arguments to the concepts and definitions found in the conceptual
framework. (Finance theory would say that interest is a return to the capital provider,
the lender. Finance theory might assist you in your argument.)

Debate 9-2 Donated Assets

Under current GAAP, assets that have been donated to a company are recorded at fair value.

Team Debate:

Team Argue that donated assets should not be reported in a company's balance sheet. Base
1: your arguments on the conceptual framework. You might find the historical cost
principle useful in your discussion.

Team Argue in favor of the current GAAP treatment for donated assets. Base your arguments
2: on the conceptual framework, where appropriate.
1. Accounting Series Release No. 163, “Capitalization of Interest by Companies Other Than Public
Utilities” (Washington, DC: Securities and Exchange Commission, 1974).

2. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 34,
“Capitalization of Interest Costs” (Stamford, CT: FASB, 1979), para. 9.

3. Accounting Principles Board, APB Opinion No. 29, “Accounting for Nonmonetary Transactions”
(New York: AICPA, 1973).

4. Ibid., para. 21.

5. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 153,
“Exchanges of Nonmonetary Assets an Amendment of APB Opinion No. 29” (Norwalk, CT: FASB,
2004).

6. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 116,
“Accounting for Contributions Received and Contributions Made” (Stamford, CT: FASB, 1993), para.
8.

7. Arthur L. Thomas, “The Allocation Problem in Financial Accounting Theory,” Studies in Accounting
Research No. 3 (Evanston, IL: American Accounting Association, 1969).

8. Accounting Terminology Bulletin No. 1, “Review and Resume” (New York: AICPA, 1953), ch. 9C,
para. 5.

9. Since 1954, the Internal Revenue Code has specified various accelerated depreciation methods to
be used to determine taxable income. The current acceptable method to use is termed the Modified
Accelerated Cost Recovery System. This method is not acceptable for financial reporting purposes
(see FASB ASC 360-10-35-9).

10. AICPA. Michael C Calederisi, ed., Accounting Trends and Techniques, 64th ed. (New York: AICPA,
2010).

11. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 121,
“Accounting for the Impairment of Long-Lived Assets to Be Disposed Of” (Stamford, CT: FASB, 1995).
12. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 144,
“Accounting for the Impairment or Disposal of Long-Lived Assets” (Norwalk, CT: FASB, 2001).

13. This and the following example were adapted from SFAS No. 144, Appendix A.

14. Financial Accounting Standards Board, Statement of Financial Accounting Standards No. 143,
“Accounting for Asset Retirement Obligations” (Norwalk, CT: FASB, 2001).

15. Adapted from SFAS No. 143, Appendix C.

16. This amount was rounded.