Property, plant, and equipment and intangible assets can be acquired through purchase, exchange, lease, donation, self-construction, or a business combination. We address acquisitions through leasing in Chapter 15 and acquisitions through business combinations later in this chapter and in Chapter 12.
The initial valuation of property, plant, and equipment and intangible assets usually is quite simple. We know from prior study that assets are valued on the basis of their original costs. In Chapter 8 we introduced the concept of condition and location in determining the cost of inventory. For example, if Thompson Company purchased inventory for $42,000 and incurred $1,000 in freight costs to have the inventory shipped to its location, the initial cost of the inventory is $43,000. This concept applies to the valuation of property, plant, and equipment and intangible assets as well. The initial cost of these assets includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use. We discuss these additional expenditures in the next section.
Q1, p. 501
Our objective in identifying the costs of an asset is to distinguish the expenditures that produce future benefits from those that produce benefits only in the current period. The costs in the second group are recorded as expenses, but those in the first group are capitalized; that is, they are recorded as an asset and expensed in future periods.2 For example, the cost of a major improvement to a delivery truck that extends its useful life generally would be capitalized. On the other hand, the cost of an engine tune-up for the delivery truck simply allows the truck to continue its productive activity but does not increase future benefits. These maintenance costs would be expensed. Subsequent expenditures for these assets are discussed in Chapter 11.
The distinction is not trivial. This point was unmistakably emphasized in the summer of 2002 when WorldCom, Inc., disclosed that it had improperly capitalized nearly $4 billion in expenditures related to the company's telecom network. This massive fraud resulted in one of the largest financial statement restatements in history and triggered the collapse of the once powerful corporation. Capitalizing rather than expensing these expenditures caused a substantial overstatement of reported income for 2001 and the first quarter of 2002, in fact, producing impressive profits where losses should have been reported. If the deception had not been discovered, not only would income for 2001 and 2002 have been overstated, but income for many years into the future would have been understated as the fraudulent capitalized assets were depreciated. Of course, the balance sheet also would have overstated the assets and equity of the company.
The initial cost of property, plant, and equipment and intangible assets includes the purchase price and all expenditures necessary to bring the asset to its desired condition and location for use.
Property, Plant, and Equipment
COST OF EQUIPMENT. Equipment is a broad term that encompasses machinery used in manufacturing, computers and other office equipment, vehicles, furniture, and fixtures. The cost of equipment includes the purchase price plus any sales tax (less any discounts received from the seller), transportation costs paid by the buyer to transport the asset to the location in which it will be used, expenditures for installation, testing, legal fees to establish title, and any other costs of bringing the asset to its condition and location for use. To the extent that these costs can be identified and measured, they should be included in the asset's initial valuation rather than expensed currently.
Q2, p. 501
Although most costs can be identified easily, others are more difficult. For example, the costs of training personnel to operate machinery could be considered a cost necessary to make the asset ready for use. However, because it is difficult to measure the amount of training costs associated with specific assets, these costs usually are expensed. Consider Illustration 10-1.
COST OF LAND. The cost of land also should include each expenditure needed to get the land ready for its intended use. These include the purchase price plus closing costs such as fees for the attorney, real estate agent commissions, title and title search, and recording. If the property is subject to back taxes, liens, mortgages, or other obligations, these amounts are included also. In addition, any expenditures such as clearing, filling, draining, and even removing (razing) old buildings that are needed to prepare the land for its intended use are part of the land's cost. Proceeds from the sale of salvaged materials from old buildings torn down after purchase reduce the cost of land. Illustration 10-2 provides an example.
Initial Cost of Equipment
Central Machine Tools purchased an industrial lathe to be used in its manufacturing process. The purchase price was $62,000. Central paid a freight company $1,000 to transport the machine to its plant location plus $300 shipping insurance. In addition, the machine had to be installed and mounted on a special platform built specifically for the machine at a cost of $1,200. After installation, several trial runs were made to ensure proper operation. The cost of these trials including wasted materials was $600. At what amount should Central capitalize the lathe?
Each of the expenditures described was necessary to bring the machine to its condition and location for use and should be capitalized and then expensed in the future periods in which the asset is used.
Initial Cost of Land
The Byers Structural Metal Company purchased a six-acre tract of land and an existing building for $500,000. The company plans to raze the old building and construct a new office building on the site. In addition to the purchase price, the company made the following expenditures at closing of the purchase:
Shortly after closing, the company paid a contractor $10,000 to tear down the old building and remove it from the site. An additional $5,000 was paid to grade the land. The $6,000 in property taxes included $4,000 of delinquent taxes paid by Byers on behalf of the seller and $2,000 attributable to the portion of the current fiscal year after the purchase date. What should be the capitalized cost of the land?
Two thousand dollars of the property taxes relate only to the current period and should be expensed. Other costs were necessary to acquire the land and are capitalized.
LAND IMPROVEMENTS. It's important to distinguish between the cost of land and the cost of land improvements the cost of parking lots, driveways, and private roads and the costs of fences and lawn and garden sprinkler systems. because land has an indefinite life and land improvements usually do not. Examples of land improvements include the cost of parking lots, driveways, and private roads and the costs of fences and lawn and garden sprinkler systems. Costs of these assets are separately identified and capitalized. We depreciate their cost over periods benefited by their use.
The costs of land improvements are capitalized and depreciated.
COST OF BUILDINGS. The cost of acquiring a building usually includes realtor commissions and legal fees in addition to the purchase price. Quite often a building must be refurbished, remodeled, or otherwise modified to suit the needs of the new owner. These reconditioning costs are part of the building's acquisition cost. When a building is constructed rather than purchased, unique accounting issues are raised. We discuss these in the “Self-Constructed Assets” section of this chapter.
COST OF NATURAL RESOURCES. Natural resources oil and gas deposits, timber tracts, and mineral deposits. that provide long-term benefits are reported as property, plant, and equipment. These include timber tracts, mineral deposits, and oil and gas deposits. They can be distinguished from other assets by the fact that their benefits are derived from their physical consumption. For example, mineral deposits are physically diminishing as the minerals are extracted from the ground and either sold or used in the production process.3 On the contrary, equipment, land, and buildings produce benefits for a company through their use in the production of goods and services. Unlike those of natural resources, their physical characteristics usually remain unchanged during their useful lives.
Sometimes a company buys natural resources from another company. In that case, initial valuation is simply the purchase price plus any other costs necessary to bring the asset to condition and location for use. More frequently, though, the company will develop these assets. In this situation, the initial valuation can include (a) acquisition costs, (b) exploration costs, (c) development costs, and (d) restoration costs. Acquisition costs the amounts paid to acquire the rights to explore for undiscovered natural resources or to extract proven natural resources. are the amounts paid to acquire the rights to explore for undiscovered natural resources or to extract proven natural resources. Exploration costs for natural resources, expenditures such as drilling a well, or excavating a mine, or any other costs of searching for natural resources. are expenditures such as drilling a well, or excavating a mine, or any other costs of searching for natural resources. Development costs for natural resources, costs incurred after the resource has been discovered but before production begins. are incurred after the resource has been discovered but before production begins. They include a variety of costs such as expenditures for tunnels, wells, and shafts. It is not unusual for the cost of a natural resource, either purchased or developed, also to include estimated restoration costs costs to restore land or other property to its original condition after extraction of the natural resource ends.. These are costs to restore land or other property to its original condition after extraction of the natural resource ends. Because restoration expenditures occur later—after production begins—they initially represent an obligation incurred in conjunction with an asset retirement. Restoration costs are one example of asset retirement obligations, the topic of the next subsection.
On the other hand, the costs of heavy equipment and other assets a company uses during drilling or excavation usually are not considered part of the cost of the natural resource itself. Instead, they are considered depreciable plant and equipment. However, if an asset used in the development of a natural resource cannot be moved and has no alternative use, its depreciable life is limited by the useful life of the natural resource.
The cost of a natural resource includes the acquisition costs for the use of land, the exploration and development costs incurred before production begins, and restoration costs incurred during or at the end of extraction.
ASSET RETIREMENT OBLIGATIONS. Sometimes a company incurs obligations associated with the disposition of property, plant, and equipment and natural resources, often as a result of acquiring those assets. For example, an oil and gas exploration company might be required to restore land to its original condition after extraction is completed. Before 2001, there was considerable diversity in the ways companies accounted for these obligations. Some companies recognized these asset retirement obligations obligations associated with the disposition of an operational asset. (AROs) gradually over the life of the asset while others did not recognize the obligations until the asset was retired or sold.
Generally accepted accounting principles now require that an existing legal obligation associated with the retirement of a tangible, long-lived asset be recognized as a liability and measured at fair value, if value can be reasonably estimated. When the liability is credited, the offsetting debit is to the related asset.4 These retirement obligations could arise in connection with several types of assets. We introduce the topic here because it often arises with natural resources. Let's consider some of the provisions of the standard that addresses these obligations.
Scope. AROs arise only from legal obligations associated with the retirement of a tangible long-lived asset that result from the acquisition, construction, or development and (or) normal operation of a long-lived asset.
Recognition. A retirement obligation might arise at the inception of an asset's life or during its operating life. For instance, an offshore oil-and-gas production facility typically incurs its removal obligation when it begins operating. On the other hand, a landfill or a mining operation might incur a reclamation obligation gradually over the life of the asset as space is consumed with waste or as the mine is excavated.
An asset retirement obligation (ARO) is measured at fair value and is recognized as a liability and corresponding increase in asset valuation.
Measurement. A company recognizes the fair value of an ARO in the period it's incurred. The liability increases the valuation of the related asset. Usually, the fair value is estimated by calculating the present value of estimated future cash outflows.
Present Value Calculations. Traditionally, the way uncertainty has been considered in present value calculations has been by discounting the “best estimate” of future cash flows applying a discount rate that has been adjusted to reflect the uncertainty or risk of those cash flows. That's not the approach we take here. Instead, we follow the approach described in the FASB's Concept Statement No. 75 which is to adjust the cash flows, not the discount rate, for the uncertainty or risk of those cash flows. This expected cash flow approach adjusts the cash flows, not the discount rate, for the uncertainty or risk of those cash flows. incorporates specific probabilities of cash flows into the analysis. We use a discount rate equal to the credit-adjusted risk free rate. The higher a company's credit risk, the higher will be the discount rate. All other uncertainties or risks are incorporated into the cash flow probabilities. We first considered an illustration of this approach in Chapter 6. Illustration 10-3 demonstrates the approach in connection with the acquisition of a natural resource.
As we discuss in Chapter 11, the cost of the coal mine is allocated to future periods as depletion using a depletion rate based on the estimated amount of coal discovered. The $600,000 cost of the excavation equipment, less any anticipated residual value, is allocated to future periods as depreciation.
The difference between the asset retirement liability of $468,360 and the probability weighted expected cash outflow of $590,000 is recognized as accretion expense, an additional expense that accrues as an operating expense, over the three-year excavation period. This process increases the liability to $590,000 by the end of the excavation period.
If the actual restoration costs are more (less) than the $590,000, a loss (gain) on retirement of the obligation is recognized for the difference.
St. Mary Land & Exploration Company is engaged in the exploration, development, acquisition, and production of natural gas and crude oil. For the six months ended June 30, 2009, St. Mary reported $123 million in asset retirement obligations in its balance sheet. Graphic 10-4 describes the company's policy and provides a summary of disclosure requirements.
It is important to understand that asset retirement obligations could result from the acquisition of many different types of tangible assets, not just natural resources. For example, Dow Chemical Company reported a $106 million asset retirement liability in its 2008 balance sheet related to anticipated demolition and remediation activities at its manufacturing sites in the United States, Canada, Europe, Italy, and Brazil.
Cost of Natural Resources
The Jackson Mining Company paid $1,000,000 for the right to explore for a coal deposit on 500 acres of land in Pennsylvania. Costs of exploring for the coal deposit totaled $800,000 and intangible development costs incurred in digging and erecting the mine shaft were $500,000. In addition, Jackson purchased new excavation equipment for the project at a cost of $600,000. After the coal is removed from the site, the equipment will be sold.
Jackson is required by its contract to restore the land to a condition suitable for recreational use after it extracts the coal. The company has provided the following three cash flow possibilities (A, B and C) for the restoration costs to be paid in three years, after extraction is completed:
The company's credit-adjusted risk free interest rate is 8%.
Total capitalized cost for the coal deposit is:
Asset retirement obligations could result from the acquisition of many different types of tangible assets, not just natural resources.
Disclosure of Asset Retirement Obligations—St. Mary Land & Exploration Company
Real World Financials
Note 9—Asset Retirement Obligations (in part)
The Company recognizes an estimated liability for future costs associated with the abandonment of its oil and gas properties. A liability for the fair value of an asset retirement obligation and a corresponding increase to the carrying value of the related long-lived asset are recorded at the time a well is completed or acquired. The increase in carrying value is included in proved oil and gas properties in the consolidated balance sheets. The Company depletes the amount added to proved oil and gas property costs and recognizes accretion expense in connection with the discounted liability over the remaining estimated economic lives of the respective oil and gas properties. Cash paid to settle asset retirement obligations is included in the operating section of the Company's consolidated statement of cash flows.
The Company's estimated asset retirement obligation liability is based on historical experience in abandoning wells, estimated economic lives, estimates as to the cost to abandon the wells in the future and federal, and state regulatory requirements. The liability is discounted using a credit-adjusted risk-free rate estimated at the time the liability is incurred or revised. The credit-adjusted risk-free rates used to discount the Company's abandonment liabilities range from 6.5 percent to 12.0 percent. Revisions to the liability could occur due to changes in estimated abandonment costs or well economic lives, or if federal or state regulators enact new requirements regarding the abandonment of wells.
Sometimes, after exploration or development, it becomes apparent that continuing the project is economically infeasible. If that happens, any costs incurred are expensed rather than capitalized. An exception is in the oil and gas industry, where we have two generally accepted accounting alternatives for accounting for projects that prove unsuccessful. We discuss these alternatives in Appendix 10.
Intangible assets operational assets that lack physical substance; examples include patents, copyrights, franchises, and goodwill. include such items as patents, copyrights, trademarks, franchises, and goodwill. Despite their lack of physical substance, these assets can be extremely valuable resources for a company. For example, Interbrand Sampson, the world's leading branding consulting company, estimated the value of the Coca-Cola trademark to be $69 billion.6 In general, intangible assets refer to the ownership of exclusive rights that provide benefits to the owner in the production of goods and services.
The issues involved in accounting for intangible assets are similar to those of property, plant, and equipment. One key difference, though, is that the future benefits that we attribute to intangible assets usually are much less certain than those attributed to tangible assets. For example, will the new toy for which a company acquires a patent be accepted by the market? If so, will it be a blockbuster like Beanie Babies or Rubik's Cube, or will it be only a moderate success? Will it have lasting appeal like Barbie dolls, or will it be a short-term fad? In short, it's often very difficult to anticipate the timing, and even the existence, of future benefits attributable to many intangible assets. In fact, this uncertainty is a discriminating characteristic of intangible assets that perhaps better distinguishes them from tangible assets than their lack of physical substance. After all, other assets, too, do not exist physically but are not considered intangible assets. Accounts receivable and prepaid expenses, for example, have no physical substance and yet are reported among tangible assets.
Intangible assets generally represent exclusive rights that provide benefits to the owner.
Companies can either (1) purchase intangible assets from other entities (existing patent, copyright, trademark, or franchise rights) or (2) develop intangible assets internally (say, develop a new product or process that is then patented). In either case, we amortize its cost, unless it has an indefinite useful life.7 Also, just like property, plant, and equipment, intangibles are subject to asset impairment rules. We discuss amortization and impairment in Chapter 11. In this chapter, we consider the acquisition cost of intangible assets.
The initial valuation of purchased intangible assets usually is quite simple. We value a purchased intangible at its original cost, which includes its purchase price and all other costs necessary to bring it to condition and location for intended use. For example, if a company purchases a patent from another entity, it might pay legal fees and filing fees in addition to the purchase price. We value intangible assets acquired in exchange for stock, or for other nonmonetary assets, or with deferred payment contracts exactly as we do property, plant, and equipment. Let's look briefly at the costs of purchasing some of the more common intangible assets.
PATENTS. A patent exclusive right to manufacture a product or to use a process. is an exclusive right to manufacture a product or to use a process. This right is granted by the U.S. Patent Office for a period of 20 years. In essence, the holder of a patent has a monopoly on the use, manufacture, or sale of the product or process. If a patent is purchased from an inventor or another individual or company, the amount paid is its initial valuation. The cost might also include such other costs as legal and filing fees to secure the patent. Holders of patents often need to defend a patent in court against infringement. Any attorney fees and other costs of successfully defending a patent are added to the patent account.
Purchased intangible assets are valued at their original cost.
Intangible assets with finite useful lives are amortized; intangible assets with indefinite useful lives are not amortized.
When a patent is developed internally, the research and development costs of doing so are expensed as incurred. We discuss research and development in more detail in a later section. We capitalize legal and filing fees to secure the patent, even if internally developed.
COPYRIGHTS. A copyright exclusive right of protection given to a creator of a published work, such as a song, painting, photograph, or book. is an exclusive right of protection given to a creator of a published work, such as a song, film, painting, photograph, or book. Copyrights are protected by law and give the creator the exclusive right to reproduce and sell the artistic or published work for the life of the creator plus 70 years. Accounting for the costs of copyrights is virtually identical to that of patents.
TRADEMARKS. A trademark exclusive right to display a word, a slogan, a symbol, or an emblem that distinctively identifies a company, a product, or a service., also called tradename exclusive right to display a word, a slogan, a symbol, or an emblem that distinctively identifies a company, a product, or a service., is an exclusive right to display a word, a slogan, a symbol, or an emblem that distinctively identifies a company, a product, or a service. The trademark can be registered with the U.S. Patent Office which protects the trademark from use by others for a period of 10 years. The registration can be renewed for an indefinite number of 10-year periods, so a trademark is an example of an intangible asset whose useful life could be indefinite.
Trademarks or tradenames often are acquired through a business combination. As an example, in 2002, Hewlett-Packard Company (HP) acquired all of the outstanding stock of Compaq Computer Corporation for $24 billion. Of that amount, $1.4 billion was assigned to the Compaq tradename. HP stated in a disclosure note that this “… intangible asset will not be amortized because it has an indefinite remaining useful life based on many factors and considerations, including the length of time that the Compaq name has been in use, the Compaq brand awareness and market position and the plans for continued use of the Compaq brand within a portion of HP's overall product portfolio.”
Trademarks or tradenames often are considered to have indefinite useful lives.
Trademarks can be very valuable. The estimated value of $69 billion for the Coca-Cola trademark mentioned previously is a good example. Note that the cost of the trademark reported in the balance sheet is far less than the estimate of its worth to the company. The Coca-Cola Company's 2008 balance sheet disclosed trademarks at a cost of only $6 billion.
FRANCHISES. A franchise contractual arrangement under which the franchisor grants the franchisee the exclusive right to use the franchisor's trademark or tradename within a geographical area, usually for specified period of time. is a contractual arrangement under which the franchisor grants the franchisee the exclusive right to use the franchisor's trademark or tradename and may include product and formula rights, within a geographical area, usually for a specified period of time. Many popular retail businesses such as fast food outlets, automobile dealerships, and motels are franchises. For example, the last time you ordered a hamburger at McDonald's, you were probably dealing with a franchise.
Franchise operations are among the most common ways of doing business.
The owner of that McDonald's outlet paid McDonald's Corporation a fee in exchange for the exclusive right to use the McDonald's name and to sell its products within a specified geographical area. In addition, many franchisors provide other benefits to the franchisee, such as participating in the construction of the retail outlet, training of employees, and national advertising.
Payments to the franchisor usually include an initial payment plus periodic payments over the life of the franchise agreement. The franchisee capitalizes as an intangible asset the initial franchise fee plus any legal costs associated with the contract agreement. The franchise asset is then amortized over the life of the franchise agreement. The periodic payments usually relate to services provided by the franchisor on a continuing basis and are expensed as incurred.
Most purchased intangibles are specifically identifiable. That is, cost can be directly associated with a specific intangible right. An exception is goodwill, which we discuss next.
GOODWILL. Goodwill is a unique intangible asset in that its cost can't be directly associated with any specifically identifiable right and it is not separable from the company itself. It represents the unique value of a company as a whole over and above its identifiable tangible and intangible assets. Goodwill can emerge from a company's clientele and reputation, its trained employees and management team, its favorable business location, and any other unique features of the company that can't be associated with a specific asset.
Because goodwill can't be separated from a company, it's not possible for a buyer to acquire it without also acquiring the whole company or a portion of it. Goodwill will appear as an asset in a balance sheet only when it was purchased in connection with the acquisition of control over another company. In that case, the capitalized cost of goodwill equals the fair value of the consideration exchanged (purchase price) for the company less the fair value of the net assets acquired. The fair value of the net assets equals the fair value of all identifiable tangible and intangible assets less the fair value of any liabilities of the selling company assumed by the buyer. Goodwill is a residual asset; it's the amount left after other assets are identified and valued. Consider Illustration 10-4.
The Smithson Corporation acquired all of the outstanding common stock of the Rider Corporation in exchange for $18 million cash.* Smithson assumed all of Rider's long-term debts which have a fair value of $12 million at the date of acquisition. The fair values of all identifiable assets of Rider are as follows ($ in millions):
The cost of the goodwill resulting from the acquisition is $5 million:
The Smithson Corporation records the acquisition as follows:
|Receivables (fair value) ........................|
|Inventory (fair value)............................|
|Property, plant, and equipment (fair value) ..................|
|Patent (fair value) .................................|
|Goodwill (difference) ............................|
| Liabilities (fair value) .........................|
| Cash (purchase price) .......................|
*Determining the amount a purchaser is willing to pay for a company in excess of the identifiable net assets is a question of determining the value of a company as a whole. This question is addressed in most introductory and advanced finance textbooks.
Goodwill can only be purchased through the acquisition of another company.
Q5, p. 501
Goodwill is the excess of the fair value of the consideration exchanged over the fair value of the net assets acquired.
Of course, a company can develop its own goodwill through advertising, training, and other efforts. In fact, most do. However, a company must expense all such costs incurred in the internal generation of goodwill. By not capitalizing these items, accountants realize that the matching principle is violated because many of these expenditures do result in significant future benefits. Also, it's difficult to compare two companies when one has purchased goodwill and the other has not. But imagine how difficult it would be to associate these expenditures with any objective measure of goodwill. In essence, we have a situation where the characteristic of faithful representation overshadows relevance.
As we discussed in Chapter 1, accounting standards have significantly changed the way we account for business combinations. Before the current standard regarding accounting for goodwill, we amortized (expensed over time) goodwill just like any other intangible asset. Now, just like for other intangible assets that have indefinite useful lives, we do not amortize goodwill. This makes it imperative that companies make every effort to identify specific intangibles other than goodwill that they acquire in a business combination since goodwill is the amount left after other assets are identified.
Goodwill, along with other intangible assets with indefinite useful lives, is not amortized.
It's possible for the fair value of net assets to exceed the fair value of the consideration exchanged for those net assets. A “bargain purchase” situation could result from an acquisition involving a “forced sale” in which the seller is acting under duress. The FASB previously required this excess, deemed negative goodwill, to be allocated as a pro rata reduction of the amounts that otherwise would have been assigned to particular assets acquired. This resulted in assets acquired being recorded at amounts less than their fair values. However, current GAAP effective for acquisitions made during fiscal years beginning on or after December 15, 2008, makes it mandatory that assets and liabilities acquired in a business combination be valued at their fair values.8 Any negative goodwill is reported as a gain in the year of the combination.
In keeping with that goal, GAAP provides guidelines for determining which intangibles should be separately recognized and valued. Specifically, an intangible should be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or is capable of being separated from the acquired entity. Possibilities are patents, trademarks, copyrights, and franchise agreements, and such items as customer lists, license agreements, order backlogs, employment contracts, and noncompetition agreements.9 In past years, some of these intangibles, if present in a business combination, often were included in the cost of goodwill.10
In a business combination, an intangible asset must be recognized as an asset apart from goodwill if it arises from contractual or other legal rights or is separable.