USCPA (FAR) – (15) PPE&E

I would like to record about the key points of the US CPA exam content.

<Create and note the points based on mainly Becker’s workbook>

Capitalization of Interest

• Under US GAAP, interest incurred during the preparation period of certain assets, such as construction or manufacturing projects, can be included in the cost of the asset. This process, known as capitalization, delays the expensing of the cost until the asset starts to generate profits.
• Start of Interest Capitalization: Interest capitalization is limited to periods during which the asset is actually under construction, expenditures are being made, and interest costs are being incurred.
• Calculation of Weighted-Average Accumulated Expenditures: To reflect the average level of expenditures during the construction period, the weighted-average accumulated expenditures are calculated. This is determined by averaging the total expenditures incurred over the period. For example, if expenditures occur evenly throughout the year, the average of the beginning ($0) and end ($250,000) expenditure amounts is taken.
• Actual Interest and Avoidable Interest: Calculate both the actual interest (total interest based on loans) and the capitalizable interest (avoidable interest). Avoidable interest refers to the interest costs incurred on the average expenditures actually used in construction. This amount can be capitalized as long as it does not exceed the actual interest paid. The amount of avoidable interest is the interest that would not have been incurred if the construction project had not taken place:
• Limitation on Interest Capitalization: The interest to be capitalized is limited to the lesser of the actual interest paid or the interest calculated on the weighted-average accumulated expenditures (avoidable interest). If the avoidable interest does not exceed the actual interest, the full amount can be capitalized. If it exceeds, only up to the actual interest paid is capitalized.
• Treatment of Excess Interest: If the capitalized interest is less than the actual interest, the difference is expensed.
• Construction period interest is capitalized based on the weighted average of accumulated construction expenditures. The interest rate paid on borrowings specifically for asset construction is used first to determine the amount of interest cost capitalized. If the average accumulated expenditures outstanding exceed the amount of the specific new borrowing, interest on the excess is computed based on the interest rate for other borrowings of the company. => Firstly, calculate the weighted average interest rate on other borrowings, and then, interest on other borrowings used for construction.

Cost of land

• Cost of land includes all costs necessary to put the land in place and condition for construction of the plant. Any proceeds from the sale of any existing buildings (or standing timber, or soil) or scrap are deducted from the cost of the land.
•  Any usual and necessary cost to clear and grade the land is properly included in the Land account. Interest should only be capitalized in connection with a “discrete manufacturing activity,” so interest incurred to acquire land should be expensed when incurred.
• The purchase cost of the land, costs for razing the old building, and title insurance and legal fees are considered costs necessary to make the land usable. These are included in the cost of the land and are capitalized at the time of purchase. Since the land itself is not depreciated, these costs are also not depreciated, but their capitalization as costs directly related to the acquisition and preparation of the land accurately reflects the acquisition cost of the land.
• The cost of land includes purchase price, brokers’ commissions, title and recording fees, legal fees, clearing brush and trees, site development, cost of demolition of existing building, less any proceeds from the sale of existing building, timber, etc. Land improvements such as costs incurred to grade and pave driveways and parling logs lawn and garden sprinkler systems for the property and borrowing to finance the construction are excluded from the cost of land as they are depreciable assets and land is not.
• Treatment of Interest Incurred in Land Acquisition: However, it is not recommended to capitalize interest related to land acquisition. Unlike manufacturing or construction activities, land itself does not depreciate and the interest associated with its purchase should be expensed immediately upon occurrence. This is because land is not considered an “activity” that normally warrants the capitalization of interest.
• Debt issuance costs are presented on the balance sheet as a direct reduction to the carrying amount of the bond and should not be included in the cost of the land.

The capitalization of facility, Machine and warehouse

• These costs include invoice price less discounts, freight in, installation charges, sales, excise taxes and interest, and remodeling related interest costs during construction period.
• not include the finance charges on purchase loan.
• The net gain from the sale of a warehouse and purchase of a new warehouse will fall under continuing operations on the income statement, under “other” revenues and gains. The fact that the proceeds exceeded the carrying amount of the warehouse sold would not serve to reduce the cost basis of the new warehouse.
• According to the shipping terms of FOB destination, title does not pass until the machine is received at its destination by the company.
• The $250,000 spent on the project was spent uniformly (or evenly) during Year 3. The average amount is (0 + 250,000)/2 = 125,000.
• Avoidable interest is compared, not to interest on specific borrowings, but to total interest cost incurred for any purpose.

VAT treatment

• If recoverable (VAT can be deducted): If VAT is recoverable, it is usually not recognized as an expense and is instead deducted from the amount of tax the company owes. Consequently, VAT is not included in the acquisition cost of the equipment and is accounted for separately.
• If non-recoverable (VAT cannot be deducted): If VAT is non-recoverable, it is recognized as a final cost and included in the acquisition cost of the equipment. In this case, VAT is recorded as part of the acquisition cost.

Expense ordinary repairs but capitalize expenditures

• Expense ordinary repairs but capitalize expenditures, which are “additions” or “benefit several periods” or “improve efficiency“.
• The cost of painting the ceiling tiles and hallways should be expensed as incurred as it is maintenance to an existing asset and is ordinary repair and maintenance expense.
• The cost of replacing the windows should be expensed as ordinary repair and maintenance expense. This is not treated as an extraordinary repair, which would be capitalized if the life of the asset is extended or the efficiency is improved.

The cost of new computers

• The cost of the new computers should be capitalized and depreciated over their useful lives consistent with the matching principle. These assets are physical assets used in a trade or business with a useful life greater than one year.

Depreciation base

• If the asset was sold in September, 9 months of depreciation are taken. One example is that the company uses straight-line depreciation starting in the month after the purchase of the asset. When the company disposes of an asset, depreciation is taken for the entire month of disposal.
• The change in the estimated useful life of the asset was determined by the end of a year and should be used to calculate the depreciation for the year.

Depreciation methods

• Straight-line depreciation method reflects that an asset’s service potential declines with the passage of time.
• Units-of-production depreciation method reflects that an asset’s service potential declines with use.
• The double-declining method of depreciation will apply a factor of 2/n(useful life) to the cost total, with representing the useful life of the asset. The salvage value is not accounted for in the calculation of this method, but must be accounted for manually to ensure that the value of the asset never falls below the salvage value.
• The half-year convention method: “The half-year convention is a method of calculating depreciation where, in the acquisition year and the year of disposal of an asset, only half of the annual depreciation expense is accounted for. This applies regardless of when during the year the asset was purchased, ensuring that the depreciation expense in the first and final years is halved. This method is primarily used for tax purposes, facilitating simpler and more consistent depreciation calculations.”

Depletion vs Depreciation

• Applicable to: Depletion: Mainly natural resources. Depreciation: Mainly tangible fixed assets.
• Cause of Decrease: Depletion: Direct consumption or extraction of resources. Depreciation: Decrease in value over time or with usage.
• Calculation Method: Depletion: Based on the actual amount of resource extracted. Depreciation: Based on the asset’s useful life and usage pattern.
• Purpose: Depletion: To accurately reflect the consumption of natural resources. Depreciation: To appropriately allocate the decrease in value of tangible fixed assets.
• Estimated restoration costs should be added to the depletable base of the natural resource. In this way, the amount of depletion charged to expense over the life of the mining operation will include the restoration costs.

Present Value of Ordinary Annuity

An ordinary annuity involves a series of equal payments made at regular intervals at the end of each period. For example, monthly, quarterly, or yearly payments made at the end of each respective period. The “Present Value of an Ordinary Annuity of $1 at 8%” refers to the current worth of a series of future $1 payments, made at the end of each period, discounted at an annual interest rate of 8%.

Impairment test

• Performance of an impairment test on fixed assets held for use and to be disposed of begins with a recoverability test, in which the sum of undiscounted future cash flows is compared with the carrying amount. If the undiscounted future cash flows are less than the carrying value, then an impairment loss would be calculated.
• The carrying amount of fixed assets should be tested for recoverability whenever events or changes in circumstances indicate the carrying amount may not be recoverable.
• A subsequent reversal of an impairment loss is prohibited under U.S. GAAP (unless the asset is held for disposal).

Methodological Differences in Goodwill Impairment Testing

• Use of Undiscounted Future Cash Flows: In the impairment testing of general long-lived assets, undiscounted future cash flows are used because these assets generate independent cash flows. By comparing undiscounted future cash flows, it can be evaluated whether the asset will continue to generate revenue.
• Goodwill Impairment Testing: The evaluation of goodwill is based on the future earning potential of the entire company or reporting unit, rather than individual assets. If undiscounted future cash flows are used, it might not accurately reflect the value that goodwill generates. Therefore, the goodwill impairment test uses the fair value of the company or reporting unit. This is a market-based perspective and is the present value of future cash flows, reflecting all the factors that market participants consider in transactions.
• Consistency and Comparability: Using fair value ensures consistent evaluation across different companies and reporting units. A market-based evaluation enhances comparability and helps users of financial statements to assess the company’s value more accurately.
• Practical Convenience:Evaluating the fair value of the entire company is more practical and efficient than calculating undiscounted future cash flows individually. Especially during mergers and acquisitions, the difference between the purchase price and the fair value is recorded as goodwill, so the same evaluation method is used for impairment testing.