Connect

Close
Skip to eBook contentSkip to Chapter linksSkip to Content links for this ChapterSkip to eBook links

Chapter10: Property, Plant, and Equipment and Intangible Assets: Acquisition and Disposition

Self-Constructed Assets

A company might decide to construct an asset for its own use rather than buy an existing one. For example, a retailer like Nordstrom might decide to build its own store rather than purchase an existing building. A manufacturing company like Intel could construct its own manufacturing facility. In fact, Nordstrom and Intel are just two of the many companies that self-construct assets. Other recognizable examples include Walt Disney, Sears, and Caterpillar. Quite often these companies act as the main contractor and then subcontract most of the actual construction work.

 LO7

   The critical accounting issue in these instances is identifying the cost of the self-constructed asset. The task is more difficult than for purchased assets because there is no external transaction to establish an exchange price. Actually, two difficulties arise in connection with assigning costs to self-constructed assets: (1) determining the amount of the company's indirect manufacturing costs (overhead) to be allocated to the construction and (2) deciding on the proper treatment of interest (actual or implicit) incurred during construction.

p. 522

Overhead Allocation

One difficulty of associating costs with self-constructed assets is the same difficulty encountered when determining cost of goods manufactured for sale. The costs of material and direct labor usually are easily identified with a particular construction project and are included in cost. However, the treatment of manufacturing overhead cost and its allocation between construction projects and normal production is a controversial issue.

   Some accountants advocate the inclusion of only the incremental overhead costs in the total cost of construction. That is, the asset's cost would include only those additional costs that are incurred because of the decision to construct the asset. This would exclude such indirect costs as depreciation and the salaries of supervisors that would be incurred whether or not the construction project is undertaken. If, however, a new construction supervisor was hired specifically to work on the project, then that salary would be included in asset cost.

The cost of a selfconstructed asset includes identifiable materials and labor and a portion of the company’s manufacturing overhead costs.

   Others advocate assigning overhead on the same basis that is used for a regular manufacturing process. That is, all overhead costs are allocated both to production and to self- constructed assets based on the relative amount of a chosen cost driver (for example, labor hours) incurred. This is known as the full-cost approach and is the generally accepted method used to determine the cost of a self-constructed asset.

Interest Capitalization

To reiterate, the cost of an asset includes all costs necessary to get the asset ready for its intended use. Unlike one purchased from another company, a self-constructed asset requires time to create it. During this construction period, the project must be financed in some way. This suggests the question as to whether interest costs during the construction period are one of the costs of acquiring the asset itself or simply costs of financing the asset. On the one hand, we might point to interest charges to finance inventories during their period of manufacture or to finance the purchase of plant assets from others and argue that construction period interest charges are merely costs of financing the asset that should be expensed as incurred like all other interest costs. On the other hand, we might argue that self-constructed assets are different in that during the construction period, they are not yet ready for their intended use for producing revenues. And, so, in keeping with both the historical cost principle and the matching concept, all costs during this period, including interest, should be capitalized and then allocated as depreciation during later periods when the assets are providing benefits.

 
FINANCIAL
Reporting Case

Q3, p.501

QUALIFYING ASSETS.   Generally accepted accounting principles are consistent with the second argument. Specifically, interest is capitalized during the construction period for (a) assets built for a company's own use as well as for (b) assets constructed as discrete projects for sale or lease (a ship or a real estate development, for example). This excludes from interest capitalization consideration inventories that are routinely manufactured in large quantities on a repetitive basis and assets that already are in use or are ready for their intended use.19 Interest costs incurred during the productive life of the asset are expensed as incurred.

PERIOD OF CAPITALIZATION.   The capitalization period for a self-constructed asset starts with the first expenditure (materials, labor, or overhead) and ends either when the asset is substantially complete and ready for use or when interest costs no longer are being incurred. Interest costs incurred can pertain to borrowings other than those obtained specifically for the construction project. However, interest costs can't be imputed; actual interest costs must be incurred.

AVERAGE ACCUMULATED EXPENDITURES.   Because we consider interest to be a necessary cost of getting a self-constructed asset ready for use, the amount capitalized is only that portion of interest cost incurred during the construction period that could have been avoided if expenditures for the asset had not been made. In other words, if construction had not been undertaken, debt incurred for the project would not have been necessary and/or other interest-bearing debt could have been liquidated or employed elsewhere.

Only assets that are constructed as discrete projects qualify for interest capitalization.

Only interest incurred during the construction period is eligible for capitalization.

The interest capitalization period begins when construction begins and the first expenditure is made as long as interest costs are actually being incurred.

Average accumulated expenditures approximates the average debt necessary for construction.

p. 523

   As a result, interest should be determined for only the construction expenditures actually incurred during the capitalization period. And unless all expenditures are made at the outset of the period, it's necessary to determine the average amount outstanding during the period. This is the amount of debt that would be required to finance the expenditures and thus the amount on which interest would accrue. For instance, if a company accumulated $1,500,000 of construction expenditures fairly evenly throughout the construction period, the average expenditures would be:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg523_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   At the beginning of the period, no expenditures have accumulated, so no interest has accrued (on the equivalent amount of debt). But, by the end of the period interest is accruing on the total amount, $1,500,000. On average, then, interest accrues on half the total or $750,000.

   If expenditures are not incurred evenly throughout the period, a simple average is insufficient. In that case, a weighted average is determined by time-weighting individual expenditures or groups of expenditures by the number of months from their incurrence to the end of the construction period. This is demonstrated in Illustration 10-13.

ILLUSTRATION 10-13
Interest Capitalization

On January 1, 2011, the Mills Conveying Equipment Company began construction of a building to be used as its office headquarters. The building was completed on June 30, 2012. Expenditures on the project, mainly payments to subcontractors, were as follows:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg523_2.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

On January 2, 2011, the company obtained a $1 million construction loan with an 8% interest rate. The loan was outstanding during the entire construction period. The company's other interest-bearing debt included two long-term notes of $2,000,000 and $4,000,000 with interest rates of 6% and 12%, respectively. Both notes were outstanding during the entire construction period.

Average accumulated expenditures is determined by timeweighting individual expenditures made during the construction period.

   The weighted-average accumulated expenditures by the end of 2011 are:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg523_3.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

 
FINANCIAL
Reporting Case

Q4, p. 501

   Again notice that the average accumulated expenditures are less than the total accumulated expenditures of $1,500,000. If Mills had borrowed exactly the amount necessary to finance the project, it would not have incurred interest on a loan of $1,500,000 for the whole year but only on an average loan of $950,000. The next step is to determine the interest to be capitalized for the average accumulated expenditures.

STEP 1: Determine the average accumulated expenditures.

INTEREST RATES.   In this situation, debt financing was obtained specifically for the construction project, and the amount borrowed is sufficient to cover the average accumulated expenditures. To determine the interest capitalized, then, we simply multiply the construction loan rate of 8% by the average accumulated expenditures.

p. 524

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1005.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

STEP 2: Calculate the amount of interest to be capitalized.

   Notice that this is the same answer we would get by assuming separate 8% construction loans were made for each expenditure at the time each expenditure was made:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg524_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

The amount of interest capitalized is determined by multiplying an interest rate by the average accumulated expenditures.

   The interest of $76,000 is added to the cost of the building, bringing accumulated expenditures at December 31, 2011, to $1,576,000 ($1,500,000 + 76,000). The remaining interest cost incurred but not capitalized is expensed.

   It should be emphasized that interest capitalization does not require that funds actually be borrowed for this specific purpose, only that the company does have outstanding debt. The presumption is that even if the company doesn't borrow specifically for the project, funds from other borrowings must be diverted to finance the construction. Either way—directly or indirectly—interest costs are incurred. In our illustration, for instance, even without the construction loan, interest would be capitalized because other debt was outstanding. The capitalized interest would be the average accumulated expenditures multiplied by the weighted-average rate on these other loans. The weighted-average interest rate on all debt other than the construction loan would be 10%, calculated as follows:20

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1006.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   This is a weighted average because total interest is $600,000 on total debt of $6,000,000.

  
ADDITIONAL CONSIDERATION

The weighted-average rate isn't used for 2011 in our illustration because the specific construction loan is sufficient to cover the average accumulated expenditures. If the specific construction loan had been insufficient to cover the average accumulated expenditures, its 8% interest rate would be applied to the average accumulated expenditures up to the amount of the specific borrowing, and any remaining average accumulated expenditures in excess of specific borrowings would be multiplied by the weighted-average rate on all other outstanding interest-bearing debt. Suppose, for illustration, that the 8% construction loan had been only $500,000 rather than $1,000,000. We would calculate capitalized interest using both the specific rate and the weighted-average rate:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg524_2.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   In our illustration, it's necessary to use this approach in 2012.

  

p. 525

   It's possible that the amount of interest calculated to be capitalized exceeds the amount of interest actually incurred. If that's the case, we limit the interest capitalized to the actual interest incurred. In our illustration, total interest cost incurred during 2011 far exceeds the $76,000 of capitalized interest calculated, so it's not necessary to limit the capitalized amount.

Interest capitalized is limited to interest incurred.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg525_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

STEP 3: Compare calculated interest with actual interest incurred.

   Continuing the example based on the information in Illustration 10-13, let's determine the amount of interest capitalized during 2012 for the building. The total accumulated expenditures by the end of the project are:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg525_2.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   The weighted-average accumulated expenditures by the end of the project are:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg525_3.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

STEP 1: Determine the average accumulated expenditures.

   Notice that the 2012 expenditures are weighted relative to the construction period of six months because the project was finished on June 30, 2012. Interest capitalized for 2012 would be $98,800, calculated as follows:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg525_4.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

STEP 2: Calculate the amount of interest to be capitalized.

   Multiplying by six-twelfths reflects the fact that the interest rates are annual rates (12-month rates) and the construction period is only 6 months.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg525_5.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

STEP 3: Compare calculated interest with actual interest incurred.

p. 526

  
ADDITIONAL CONSIDERATION

To illustrate how the actual interest limitation might come into play, let's assume the nonspecific borrowings in our illustration were $200,000 and $400,000 (instead of $2,000,000 and $4,000,000). Our comparison would change as follows:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg526_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

  

   For the first six months of 2012, $98,800 of interest would be capitalized, bringing the total capitalized cost of the building to $2,574,800 ($2,476,000 + 98,800), and $241,200 in interest would be expensed ($340,000 − 98,800).

   The method of determining interest to capitalize that we've discussed is called the specific interest method for interest capitalization, rates from specific construction loans to the extent of specific borrowings are used before using the average rate of other debt. because we use rates from specific construction loans to the extent of specific borrowings before using the average rate of other debt. Sometimes, though, it's difficult to associate specific borrowings with projects. In these situations, it's acceptable to just use the weighted-average rate on all interest-bearing debt, including all construction loans. This is known as the weighted-average method for interest capitalization, weighted-average rate on all interest-bearing debt, including all construction loans, is used.. In our illustration, for example, if the $1,000,000, 8% loan had not been specifically related to construction, we would calculate a single weighted-average rate as shown below.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg526_2.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

Weighted-average method

   If we were using the weighted-average method rather than the specific interest method, we would simply multiply this single rate times the average accumulated expenditures to determine capitalizable interest.

DISCLOSURE.   For an accounting period in which interest costs are capitalized, both the total amount of interest costs incurred and the amount that has been capitalized should be disclosed. Graphic 10-5 shows an interest capitalization disclosure note that was included in a recent annual report of Walmart Stores, Inc., the world's largest retailer.

GRAPHIC 10-5
Capitalized Interest Disclosure—Walmart Stores, Inc.

Real World Financials

Capitalized Interest

Interest costs capitalized on construction projects were $88 million, $150 million, and $182 million in fiscal 2009, 2008, and 2007, respectively.

If material, the amount of interest capitalized during the period must be disclosed.

Research and Development (R&D)

Prior to 1974, the practice was to allow companies to either expense or capitalize R&D costs, but GAAP now requires all research and development costs to be charged to expense when incurred.21 This was a controversial change opposed by many companies that preferred delaying the recognition of these expenses until later years when presumably the expenditures bear fruit.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/818573/wh_b.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a> LO8

p. 527

   A company undertakes an R&D project because it believes the project will eventually provide benefits that exceed the current expenditures. Unfortunately, though, it's difficult to predict which individual research and development projects will ultimately provide benefits. In fact, only 1 in 10 actually reach commercial production. Moreover, even for those projects that pan out, a direct relationship between research and development costs and specific future revenue is difficult to establish. In other words, even if R&D costs do lead to future benefits, it's difficult to objectively determine the size of the benefits and in which periods the costs should be expensed if they are capitalized. These are the issues that prompted the FASB to require immediate expensing.

   The FASB's approach is certain in most cases to understate assets and overstate current expense because at least some of the R&D expenditures will likely produce future benefits.

DETERMINING R&D COSTS.   GAAP distinguishes research and development as follows:


Research is planned search or critical investigation aimed at discovery of new knowledge with the hope that such knowledge will be useful in developing a new product or service or a new process or technique or in bringing about a significant improvement to an existing product or process.

Development is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use.22


Most R&D costs are expensed in the periods incurred.

R&D costs entail a high degree of uncertainty of future benefits and are difficult to match with future revenues.

   R&D costs include salaries, wages, and other labor costs of personnel engaged in R&D activities, the costs of materials consumed, equipment, facilities, and intangibles used in R&D projects, the costs of services performed by others in connection with R&D activities, and a reasonable allocation of indirect costs related to those activities. General and administrative costs should not be included unless they are clearly related to the R&D activity.

   If an asset is purchased specifically for a single R&D project, its cost is considered R&D and expensed immediately even though the asset's useful life extends beyond the current year. However, the cost of an asset that has an alternative future use beyond the current R&D project is not a current R&D expense. Instead, the depreciation or amortization of these alternative-use assets is included as R&D expenses in the current and future periods the assets are used for R&D activities.

   In general, R&D costs pertain to activities that occur prior to the start of commercial production, and costs of starting commercial production and beyond are not R&D costs. Graphic 10-6 captures this concept with a time line beginning with the start of an R&D project and ending with the ultimate sale of a developed product or the use of a developed process. The graphic also provides examples of activities typically included as R&D and examples of activities typically excluded from R&D.23

R&D expense includes the depreciation and amortization of assets used in R&D activities.

   Costs incurred before the start of commercial production are all expensed as R&D. The costs incurred after commercial production begins would be either expensed or treated as manufacturing overhead and included in the cost of inventory. Let's look at an example in Illustration 10-14.

   The salaries and wages, supplies consumed, and payments to others for R&D services are expensed in 2011 as R&D. The equipment is capitalized and the 2011 depreciation is expensed as R&D. Even though the costs to develop the patented product are expensed, the filing and legal costs for the patent are capitalized and amortized in future periods just as similar costs are capitalized for purchased intangibles. Amortization of the patent is discussed in Chapter 11.

Filing and legal costs for patents, copyrights, and other developed intangibles are capitalized and amortized in future periods.

p. 528

GRAPHIC 10-6

Research and Development Expenditures

Costs incurred before the start of commercial production are all expensed as R&D.

Costs incurred after commercial production begins would be either expensed or included in the cost of inventory.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_1006.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

ILLUSTRATION 10-14
Research and Development Costs

The Askew Company made the following cash expenditures during 2011 related to the development of a new industrial plastic:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg528_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   The project resulted in a new product to be manufactured in 2012. A patent was filed with the U.S. Patent Office. The equipment purchased will be employed in other projects. Depreciation on the equipment for 2011 was $500,000.

   The various expenditures would be recorded as follows:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg528.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

p. 529

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/pg529_1.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   GAAP requires that total R&D expense incurred must be disclosed either as a line item in the income statement or in a disclosure note. For example, Microsoft reported $9,010 million of R&D expense on the face of its 2009 income statement. In our illustration, total R&D expense disclosed in 2011 would be $14,700,000 ($14,200,000 in expenditures and $500,000 in depreciation). Note that if Askew later sells this patent to another company for, say, $15 million, the buyer would capitalize the entire purchase price rather than only the filing and legal costs. Once again, the reason for the apparent inconsistency in accounting treatment of internally generated intangibles and externally purchased intangibles is the difficulty of associating costs and benefits.

GAAP requires disclosure of total R&D expense incurred during the period.

R&D PERFORMED FOR OTHERS.   The principle requiring the immediate expensing of R&D does not apply to companies that perform R&D for other companies under contract. In these situations, the R&D costs are capitalized as inventory and carried forward into future years until the project is completed. Of course, justification is that the benefits of these expenditures are the contract fees that are determinable and are earned over the term of the project. Income from these contracts can be recognized using either the percentage-of-completion or completed contract method. We discussed these alternatives in Chapter 5.

   Another exception pertains to a company that develops computer software. Expenditures made after the software is determined to be technologically feasible but before it is ready for commercial production are capitalized. Costs incurred before technological feasibility is established are expensed as incurred. We discuss software development costs below.

START-UP COSTS.   For the fiscal year ended January 31, 2009, Barnes & Noble Inc., opened 35 new stores. The company incurred a variety of one-time preopening costs for salaries of employees supervising construction, training, travel, and relocation of employees totaling $12.8 million. In fact, whenever a company introduces a new product or service, or commences business in a new territory or with a new customer, it incurs similar start-up costs. whenever a company introduces a new product or service, or commences business in a new territory or with a new customer, it incurs one-time costs that are expensed in the period incurred. As with R&D expenditures, a company must expense all the costs related to a company's start-up activities in the period incurred, rather than capitalize those costs as an asset. Start-up costs also include organization costs related to organizing a new entity, such as legal fees and state filing fees to incorporate.24

Start-up costs are expensed in the period incurred.

  
ADDITIONAL CONSIDERATION

Development Stage Enterprises

A development stage enterprise is a new business that has either not commenced its principal operations or has begun its principal operations but has not generated significant revenues. Prior to 1975, many of these companies recorded an asset for the normal operating costs incurred during the development stage. This asset was then expensed over a period of time beginning with the commencement of operations.

   GAAP now requires that these enterprises comply with the same generally accepted accounting principles that apply to established operating companies in determining whether a cost is to be charged to expense when incurred or capitalized and expensed in future periods.25 Therefore, normal operating costs incurred during the development stage are expensed, not capitalized. Development stage enterprises are allowed to provide items of supplemental information to help financial statement readers more readily assess their future cash flows.

  

p. 530

SOFTWARE DEVELOPMENT COSTS.   The computer software industry has become a large and important U.S. business over the last two decades. Relative newcomers such as Microsoft and Adobe Systems, as well as traditional hardware companies like IBM, are leaders in this multibillion dollar industry. A significant expenditure for these companies is the cost of developing software. Prior to 1985, some companies were capitalizing software development costs and expensing them in future periods and others were expensing these costs in the period incurred.

   Now GAAP requires that companies record R&D as an expense, until technological feasibility established when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements. of the software has been established, for costs they incur to develop or purchase computer software to be sold, leased, or otherwise marketed.26 We account for the costs incurred to develop computer software to be used internally in a similar manner. Costs incurred during the preliminary project stage are expensed as R&D. After the application development stage is reached (for example, at the coding stage or installation stage), we capitalize any further costs.27 We generally capitalize the costs of computer software purchased for internal use.

GAAP requires the capitalization of software development costs incurred after technological feasibility is established.

   Technological feasibility is established “when the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features, and technical performance requirements.”28 Costs incurred after technological feasibility but before the software is available for general release to customers are capitalized as an intangible asset. These costs include coding and testing costs and the production of product masters. Costs incurred after the software release date usually are not R&D expenditures. Graphic 10-7 shows the R&D time line introduced earlier in the chapter modified to include the point at which technological feasibility is established. Only the costs incurred between technological feasibility and the software release date are capitalized.

GRAPHIC 10-7

Research and Development Expenditures—Computer Software

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_1007.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   The amortization of capitalized computer software development costs begins when the product is available for general release to customers. The periodic amortization percentage is the greater of (1) the ratio of current revenues to current and anticipated revenues (percentage-of-revenue method) or (2) the straight-line percentage over the useful life of the asset, as shown in Illustration 10-15.

   Graphic 10-8 shows the software disclosure included in a recent annual report of CA, Inc. The note provides a good summary of the accounting treatment of software development costs.

   Why do generally accepted accounting principles allow this exception to the general rule of expensing all R&D? We could attribute it to the political process. Software is a very important industry to our economy and perhaps its lobbying efforts resulted in the standard allowing software companies to capitalize certain R&D costs.

   We could also attribute the exception to the nature of the software business. Recall that R&D costs in general are expensed in the period incurred for two reasons: (1) they entail a high degree of uncertainty of future benefits, and (2) they are difficult to match with future benefits. With software, there is an important identifiable engineering milestone, technological feasibility. When this milestone is attained, the probability of the software product's success increases significantly. And because the useful life of software is fairly short (one to four years in most cases), it is much easier to determine the periods of increased revenues than for R&D projects in other industries. Compare this situation with, say, the development of a new drug. Even after the drug has been developed, it must go through extensive testing to meet FDA (Food and Drug Administration) approval, which may never be attained. If attained, the useful life of the drug could be anywhere from a few months to many years.

p. 531

ILLUSTRATION 10-15
Software Development Costs

The Astro Corporation develops computer software graphics programs for sale. A new development project begun in 2010 reached technological feasibility at the end of June 2011, and the product was available for release to customers early in 2012. Development costs incurred in 2011 prior to June 30 were $1,200,000 and costs incurred from June 30 to the product availability date were $800,000. 2012 revenues from the sale of the new product were $3,000,000 and the company anticipates an additional $7,000,000 in revenues. The economic life of the software is estimated at four years.

   Astro Corporation would expense the $1,200,000 in costs incurred prior to the establishment of technological feasibility and capitalize the $800,000 in costs incurred between technological feasibility and the product availability date. 2012 amortization of the intangible asset, software development costs, is calculated as follows:

1.

 

Percentage-of-revenue method:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1008.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

2.

 

Straight-line method:

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_eq1009.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

   The percentage-of-revenue method is used because it produces the greater amortization, $240,000.

GRAPHIC 10-8
Software Disclosure—CA, Inc.

Real World Financials

Capitalized Software Costs and Other Identified Intangible Assets (in part)

In accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed,” [FASB ASC 985–20], internally generated software development costs associated with new products and significant enhancements to existing software products are expensed as incurred until technological feasibility has been established. Internally generated software development costs of approximately $135 million, $112 million, and $85 million were capitalized during fiscal years 2009, 2008, and 2007, respectively.

   Annual amortization of capitalized software costs is the greater of the amount computed using the ratio that current gross revenues for a product bear to the total of current and anticipated future gross revenues for that product or the straight-line method over the remaining estimated economic life of the software product, generally estimated to be five years from the date the product became available for general release to customers.

PURCHASED RESEARCH AND DEVELOPMENT.   It's not unusual for one company to buy another company in order to obtain technology that the acquired company has developed or is in the process of developing. Any time a company buys another, it values the tangible and intangible assets acquired at fair value. When technology is involved, we distinguish between developed technology and in-process research and development. To do that, we borrow a criterion used in accounting for software development costs, and determine whether technological feasibility has been achieved. If so, the value of that technology is considered “developed,” and we capitalize its fair value (record it as an asset) and amortize that amount over its useful life just like any other finite-life intangible asset.

   We treat in-process R&D differently. Before 2009, we expensed the amount allocated to in-process R&D in the period of the acquisition. A new standard now requires the capitalization of the fair value of in-process R&D. But, unlike developed technology, we view it as an indefinite-life intangible asset.30 As you will learn in Chapter 11, we don't amortize indefinite-life intangibles. Instead, we test them for impairment at least annually. If the R&D project is completed successfully, we switch to the way we account for developed technology and amortize the capitalized amount over the estimated period the product or process developed will provide benefits. If the project instead is abandoned, we expense the entire balance immediately. Research and development costs incurred after the acquisition to complete the project are expensed as incurred, consistent with the treatment of any other R&D expenditure not acquired in an acquisition.

For business acquisitions made during fiscal years beginning on or after December 15, 2008, the fair value of in-process research and development is capitalized as an indefinite-life intangible asset.

p. 532

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Research and Development Expenditures. Except for software development costs incurred after technological feasibility has been established, U.S. GAAP requires all research and development expenditures to be expensed in the period incurred. IAS No. 3829 draws a distinction between research activities and development activities. Research expenditures are expensed in the period incurred. However, development expenditures that meet specified criteria are capitalized as an intangible asset. Under both U.S. GAAP and IFRS, any direct costs to secure a patent, such as legal and filing fees, are capitalized.


 LO9


IFRS requires companies to capitalize development expenditures that meet specified criteria.

   Heineken, a company based in Amsterdam, prepares its financial statements according to IFRS. The following disclosure note describes the company's adherence to IAS No. 38. The note also describes the criteria for capitalizing development expenditures as well as the types of expenditures capitalized.

      

Software, Research and Development and Other Intangible Assets (in part)

      
      

Expenditures on research activities, undertaken with the prospect of gaining new technical knowledge and understanding, is recognized in the income statement when incurred. Development activities involve a plan or design for the production of new or substantially improved products and processes. Development expenditures are capitalized only if development costs can be measured reliably, the product or process is technically and commercially feasible, future economic benefits are probable, and Heineken intends to and has sufficient resources to complete development and to use or sell the asset. The expenditures capitalized include the cost of materials, direct labor and overhead costs that are directly attributable to preparing the asset for its intended use.

Real World Financials

      

   Amortization of capitalized development costs begins when development is complete and the asset is available for use. Heineken disclosed that it amortizes its capitalized development costs using the straight-line method over an estimated 3-year useful life.


 
 

   As an example, during its fiscal year ended July 25, 2009, Cisco Systems, Inc., acquired 100% of the shares of PostPath, Inc., an e-mail and calendaring company, for $215 million. The fair values assigned included $52 million for finite-life life intangible assets (including developed technology), $152 million for goodwill, and $3 million for in-process research and development.

Real World Financials

   Cisco immediately expensed the $3 million of in-process R&D. For acquisitions that occur in the company's subsequent fiscal year, that $3 million would instead be capitalized as an indefinite-life intangible asset and accounted for subsequently as discussed above.

INTERNATIONAL FINANCIAL REPORTING STANDARDS

 

Software Development Costs. The percentage we use to amortize computer software development costs under U.S. GAAP is the greater of (1) the ratio of current revenues to current and anticipated revenues or (2) the straight-line percentage over the useful life of the software. This approach is allowed under IFRS, but not required.


 LO9


p. 533

FINANCIAL REPORTING CASE SOLUTION

1.

 

Describe to Stan what it means to capitalize an expenditure. What is the general rule for determining which costs are capitalized when property, plant, and equipment or an intangible asset is acquired? (p. 504) To capitalize an expenditure simply means to record it as an asset. All expenditures other than payments to shareholders and debt repayments are either expensed as incurred or capitalized. In general, the choice is determined by whether the expenditure benefits more than just the current period. Exceptions to this general principle are discussed in the chapter. The initial cost of an asset includes all expenditures necessary to bring the asset to its desired condition and location for use.

<a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/spi10831_p1001a.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (K)</a>

2.

 

Which costs might be included in the initial cost of equipment? (p. 504) In addition to the purchase price, the cost of equipment might include the cost of transportation, installation, testing, and legal fees to establish title.

3.

 

In what situations is interest capitalized rather than expensed? (p. 522) Interest is capitalized only for assets constructed for a company's own use or for assets constructed as discrete products for sale or lease. For example, Walt Disney capitalizes interest on assets constructed for its theme parks, resorts and other property, and on theatrical and television productions in process. During the construction period, interest is considered a cost necessary to get the asset ready for its intended use.

4.

 

What is the three-step process used to determine the amount of interest capitalized? (p. 523) The first step is to determine the average accumulated expenditures for the period. The second step is to multiply the average accumulated expenditures by an appropriate interest rate or rates to determine the amount of interest capitalized. A final step compares the interest determined in step two with actual interest incurred. Interest capitalized is limited to the amount of interest incurred.

5.

 

What is goodwill and how is it measured? (p. 510) Goodwill represents the unique value of a company as a whole over and above its identifiable tangible and intangible assets. 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 controlling portion of it. Goodwill will appear as an asset in a balance sheet only when it was purchased in connection with the acquisition of another company. In that case, the capitalized cost of goodwill equals the fair value of the consideration exchanged for the company less the fair value of the net assets acquired. Goodwill is a residual asset; it's the amount left after other assets are identified and valued. Prior to the current standard for 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. <a onClick="window.open('/olcweb/cgi/pluginpop.cgi?it=jpg::::/sites/dl/premium/0077328787/student/818573/ora.jpg','popWin', 'width=NaN,height=NaN,resizable,scrollbars');" href="#"><img valign="absmiddle" height="16" width="16" border="0" src="/olcweb/styles/shared/linkicons/image.gif"> (0.0K)</a>




19 FASB ASC 835–20–25: Interest–Capitalization of Interest–Recognition (previously “Capitalization of Interest Costs,” Statement of Financial Accounting Standards No. 34 (Stamford, Conn.: FASB, 1979)).

20 The same result can be obtained simply by multiplying the individual debt interest rates by the relative amount of debt at each rate. In this case, one-third of total debt is at 6% and two-thirds of the total debt is at 12% (1/3 × 6% + 2/3 + 12% = 10%).

21 FASB ASC 730–10–25–1: Research and Development–Overall–Recognition (previously “Accounting for Research and Development Costs,” Statement of Financial Accounting Standards No. 2 (Stamford, Conn.: FASB, 1974), par. 12).

22 Ibid., section 730–10–20 (previously par. 8 of SFAS No. 2).

23 Ibid., section 730–10–55 (previously par. 9 of SFAS No. 2).

24 FASB ASC 720–15–25–1: Other Expenses–Start-Up Costs–Recognition (previously “Reporting on the Costs of Start-Up Activities,” Statement of Position 98-5 (New York: AICPA, 1998)).

25 FASB ASC 915: Development Stage Entities (previously “Accounting and Reporting by Development Stage Enterprises,” Statement of Financial Accounting Standards No. 7 (Stamford, Conn.: FASB, 1975)).

26 FASB ASC 985–20–25–1: Software–Costs of Software to be Sold, Leased, or Marketed–Recognition (previously “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed,” Statement of Financial Accounting Standards No. 86 (Stamford, Conn.: FASB, 1985)).

27 FASB ASC 350–40–25: Intangibles–Goodwill and Other–Internal-Use Software–Recognition (previously “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” Statement of Position 98-1 (New York: AICPA, 1998)).

28 FASB ASC 985–20–25–2: Software–Costs of Software to be Sold, Leased, or Marketed–Recognition (previously “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed,” Statement of Financial Accounting Standards No. 86 (Stamford, Conn.: FASB, 1985), par. 4).

29 “Intangible Assets,” International Accounting Standard No. 38 (IASCF), as amended effective January 1, 2009.

30 FASB ASC 805: Business Combinations (previously “Business Combinations,” Statement of Financial Accounting Standards No. 141 (revised) (Norwalk, Conn.: FASB, 2007)).

2011 McGraw-Hill Higher Education
Any use is subject to the Terms of Use and Privacy Notice.
McGraw-Hill Higher Education is one of the many fine businesses of The McGraw-Hill Companies.