Joan Holtz (C)

c a s e r e p o r t

\

Prepared by

MBAxii G7

Mohamad Nizam Jaafar

Farithal B Sahari

Mizwan Mohamad Shahimin

Mohaini Ahmad Basri

Submitted to

Dr Nik Nazli Nik Ahmad

On

18^th August 2002

TABLE OF CONTENTS

	CONTENTS	PAGE NO.
	Abstract of the case	3
	Scenario 1 : On self-constructed building	4
	Scenario 2 : On purchase land and building	6
	Scenario 3 : On purchase of a new machine	8
	Scenario 4 : On leased assets	11
	Scenario 5 : On Income Tax Credit	13
	Scenario 6 : On Upgrading an Equipment	14
	Questions & Answers	16
	Conclusion	19
	Appendices :	20
1	Further Information on Lease	i
2	Further Information on Research & Development Costs	ii
3	Further Information on Basket Purchase	iii
4	Copy of Original Case Question	iv
5	Copy of Oral Presentation Handouts	v
6	Copy of Oral Presentation Slides	vi
	Main References	23

ABSTRACT OF THE CASE

To be or not to be…that’s the question.

To capitalize or to expense, that’s the main theme of the case.

Joan asked her professor on how to determine which expenditure is to be capitalized, and which to be expensed. She posed several situations to her professor.

Basically, for each scenario given, capitalization of expenditure determined based on:

1. Necessity

2. Future benefits

Nevertheless, difficulties arise in some at some situations, such that expenditures associated with leasing, taxes and R&D. In those cases, several factors or criteria outlined per accounting guidelines / standards should be referred.

However, it to be understood that all capitalized expenditure would over period is allocated over time according to its usage. Such allocation would be in term of:

depreciation (for tangibles),

amortization (for intangibles),

or depletion (for natural resources).

SCENARIO NO. 1 : ON SELF-CONSTRUCTED BUILDING

Brief Information

Bruce Manufacturing Company used its own maintenance crew to build additional wing to its existing factory and incurred the followings:

§ Architect fee

§ Cost of removing snow for clearing construction site

§ Cash discount on construction material purchased

§ Cost of construction office & tool shed that to be torn down once construction completed

§ Local real estate taxes

§ Interest on money borrowed to finance the construction

§ Cost of mistakes during construction

§ Overhead cost of the maintenance department

§ Cost of insurance during construction

§ Cost of losses/injuries not covered by the insurance

Argument For Discussion

Which of the costs are to be capitalized?

Solution & Analysis

Based on the general guideline in IAS 16 (Property, Plant & Equipment), the cost of a self constructed asset “should comprise those costs which relate directly to the specific asset and those that are attributable to the construction activity in general and can be allocated to the specific asset.”

EXPENDITURES	CAPITALIZED?	JUSTIFICATION
Architect Fee	Capitalized	These are all ‘one-time costs’ incurred for making the place ready for construction hence, to be capitalized.
Snow clearance	Capitalized
Cash discount	Capitalized
Construction office	Capitalized
Real estate taxes	Capitalized
Interest on money borrowed to finance the construction	Capitalized	According to MASB 27 (Borrowing Costs), the benchmark treatment is to recognize the interest as expense in the period incurred (expensed). However, interest cost on construction of qualified asset allowed to be capitalized as part of the construction costs. Yet, interest capitalized cannot exceed the company’s total interest cost for the period.
Mistakes	Expensed
Maintenance overhead	Capitalized	The share of these costs attributed directly to the construction are to be capitalized to the construction.
Insurance	Capitalized
Losses/injuries	Expensed

SCENARIO NO. 2 : ON PURCHASED LAND & BUILDING

Brief Information

1. Archer Company purchased a land (that come together with buildings on it).

Archer demolished the existing structures & builds a combined office & hotel building on the land.

2. Suppose the owner of the old building & land wanted to build a

combined office & hotel over the old premises.

Argument for Discussion

How would (1) the buyer and (2) the owner treat the portion of purchase price of old building and the costs of its demolishing?

Solution & Analysis

1. In Archer’s accounts (BUYER),

Portion of Purchase Price of Old Premise

The buyer should first differentiate the price paid for the building and that for the land. In this case, the portion of purchase price in respect to the old building shall be reflected separately from the costs of the land (Please refer to appendix 3 for detailed analysis).

Cost of Demolishing the Old Premise

Cost of demolishing the old building is to be capitalized in the cost of construction of the new building because it is necessarily incurred in making the site ready for construction.

2. As for the OWNER itself,

Portion of Purchase of Old Premise

Purchase price in owner book would be the original cost of the building. This cost is recorded less its accumulated depreciation in owner’s balance sheet. As the owner want to demolish the premise, the old building cost and accumulated depreciation would be removed from the balance sheet and any loss or gain on the old building would be recognized.

Cost of Demolishing the Old Premise

Similar to the buyer’s treatment cost of demolishing old structure would be capitalized in the cost of construction of the new building.

SCENARIO NO. 3 : ON PURCHASE OF A NEW MACHINE

Brief Information

Midland Company purchased a new machine. In the course of acquisition, it incurred the followings:

• Invoice price
• Transportation cost
• Sale tax on purchase
• Trade in difference (amount allowed as trade in > depreciated value of old machine)

Immediately after the purchase (during installation of the machine) Midlands has to further paid for the following:

• Cost of additional steel beam
• Cost of outside engineer
• Cost of material spoiled

in order to put the machine in its working condition.

Argument for Discussion

How would the buyer treat each of the above costs?

Solution & Analysis:

To purchase the new machine, Midland needs to pay for

INITIAL COSTS which are defined in MASB 15 & IAS 16 - Property, Plant & Equipment as:

“…its purchase price and any directly attributable costs of bringing the asset to working condition for its intended use”

Which are:

Invoice price – The purchase price or the ‘original’ value of the new machine. This cost will be regarded as the cost of the machine (CAPITALIZED).

Transportation costs – Necessarily incurred to put bring the machine to its intended site of operation (CAPITALIZED).

Sale tax on purchase – The company paid the tax in relation to its purchase of the machine (directly attributed to the machine - CAPITALIZED).

However, in paying for the new machine, Midland is allowed to trade in its old machine. Hence,

Purchase Consideration = Money paid + trade in (i.e. allowed trade in value)

If,

USED MACHINE

- Costs – RM14000

- Accumulated Depreciation – RM11000

- Thus, Current Depreciated / Book Value – RM3000

- Market Value – RM3900

NEW MACHINE

- Price – RM18900

- Purchase consideration = Cash + Market value (old machine)

- RM18900 = RM15000 + RM3900

GAIN ON EXCHANGE

- RM3900 market value – RM3000 book value = RM900

The above gain (assuming exchange is of similar assets), would not be recognized. Instead the new machine will be recorded at RM18000 (RM3000 of old machine book value plus RM15000 cash paid)

Accounting journal entries for this would be,

DR New Machine RM18000

DR Accumulated Depreciation (old machine) RM11000

CR Used Machine RM14000

CR Cash/Bank RM15000

Exchange used van plus RM15000 cash in return for new machine.

Thus,

The difference between,

Trade in value allowed – Depreciated value of old machine (the gain)

RM3900 – RM3000 = RM900 is to be ignored.

There is no account treatment necessary for this difference.

Subsequent to purchase, Midland has to incurred some installation costs in order to put the machine into its working / intended condition.

Cost of putting ADDITIONAL STEEL BEAMS

- is to be CAPITALIZED

- because a one time cost needed to enable the machine operating

Cost of OUTSIDE ENGINEER & HIS RELATED EXPENSES

- is to be CAPITALIZED

- due to the reason that it is necessary for ensuring the machine functioning properly.

Cost of MATERIAL SPOILED during trial run

- is also to be CAPITALIZED

- the reason is as per above

- IAS 16 , Property, Plant & Equipment states that “…start up & pre production costs do not form part of the cost of an asset unless they are necessary to bring the asset to its working condition. INITIAL OPERATING LOSSES INCURRED prior to an asset achieving planned performance are recognized as an asset (i.e. CAPITALIZED)”

SCENARIO 4 : ON LEASED ASSETS

Brief Information

This question deals with the outbound logistics process of the company whereby the products manufactured, i.e. the computers, are

1) 25% sold to customer and

2) 75% remaining are leased.

The cost of the leased computer was initially recorded as an asset and depreciated over four years. Besides selling and leasing the computers, the company also provided an ‘application engineering’ services to the customers. These services include the activity of installing the computer and designing the systems. The cost for these services was recorded by the company as marketing expense.

Argument for Discussion

Can the ‘application engineering services’ costs be added to the asset value of the leased computer and amortized over the lease period?

And could other marketing costs related to the leased computer be treated in the same way? Why?

Solution & Analysis

According to the IAS 17.8 (to determine classification of leases):

Situations that would normally lead to a lease being classified as a finance lease include the following: [IAS 17.8]

· the lease transfers ownership of the asset to the lessee by the end of the lease term;

· the lease term is for the major part of the economic life of the asset, even if title is not transferred;

The following principles should be applied in the financial statements of lessors:

· the lessor should record a finance lease in the balance sheet as a receivable, at an amount equal to the net investment in the lease; [IAS 17.28]

· the lessor should recognize finance income based on a pattern reflecting a constant periodic rate of return on the lessor's net investment outstanding in respect of the finance lease; [IAS 17.30] and

· Lease income should be recognized over the lease term on a straight-line basis, unless another systematic basis is more representative of the time pattern in which use benefit is derived from the leased asset is diminished. [IAS 17.42]

Assuming that the company follows the guideline in IAS 17.8, i.e. treating the leased computers as finance lease. It is also assumed that the cost of application engineering services contributed to the net investment of leased computer.

According to the IAS 17.42, which stated that the revenue for the leased computer should be recognized over the lease term, conforms to the argument to include the cost in the asset value and amortized over the lease period. The matching concept is assumed for the concluded conformation above.

The argument to include marketing costs in the asset value and amortized does not follow the right accounting treatment. The cost should be expensed as incurred, as it does not contribute to the net investment of the leased computer.

(Please refer to Appendix 1 for further information on lease)

SCENARIO NO. 5 : ON INCOME TAX CREDIT (ITC)

Brief Information

There are two methods for accounting treatment of the ITC.

Deferral method: Treats the ITC reduction as reduction in the original cost of the asset which spreads the tax credit over the period of the assets’ useful life.

Flow-through method: The ITC reduction is treated as tax reduction which is ‘earned’ as a result of acquiring assets which reduces the income tax expense.

Arguments for discussion

Why it is allowed to treat the ITC using those two methods? State the rationale.

Solution & Analysis

The rationale of permitting these two methods for ITC is that it allows companies to suit the governing tax law limitation and its tax liability limitation with the methods permitted to recognize the ITC.

Consider an entity that invested in Solar Application. The governing federal law has provided some guidelines on which equipment/asset that is entitled for the ITC and maximum limit on the permissible tax credit.

Usually, there is a limit on the amount that can be taken for tax reduction. General guide is that the amount of tax reduction must not exceed the total tax owned by the entity. If the amount of ITC is less than the total tax owned, the entity could use the flow-through method. On the other hand, if the amount of ITC is higher than the total tax owned, the entity is allowed to use other alternative to recognize the tax reduction, which is the deferral method.

Other than that, concerning on the period of the usage of the tax credit, if there is limitation on the entity’s tax liability, which inhibit the use of the credit partly or fully, the excess can be carried forward to the preceding years.

In all, both methods would take into account the ‘earned’ tax reduction. The difference is how the reduction is treated, either expensed in full in the current period or distributed over the period of asset’s lifetime. It is thus up to the entity’s accounting policy whether to attribute the ITC to the act of acquiring the asset or to the use of the asset.

SCENARIO NO. 6 : ON UPGRADING AN EQUIPMENT

Brief Information

There is an electronic product where a key customer was eager to buy the new equipment for use in its own new product if the manufacturer would continue to push to meet target of 65 ppm (65 or fewer defective part per million parts delivered to customer). Th e manufacturing equipment was going to begin to generate revenue, and all cost (material, labor and overhead) required to fabricate and installed had been capitalized. The cost is 1.5 m. The engineers believed that at least 50 K additional cost would be required to reach 65 ppm.

Argument for Discussion

Should those cost (RM50K) to be capitalized ?

Once the standard was achieved and full cost was known, should the amount of depreciation for the initial production periods be adjusted?

A few skeptics had express the concern that the standard might never be achieved. What implication of capitalizing the cost of assets (RM 1.5 M + RM 50K)?

Solution

Before we answer all these questions, we should consider some points, which lead to the way we answer the problems

1. Research and Development (R&D) costs are costs incurred for the purpose of developing new or improved product, processes or services. The purpose is to increase revenue or lower cost.

2. FASB requires that R& D cost should be treated as period cost – that is charged off as an expense of the current period as the reason, by their very nature the future benefits are highly uncertain.

3. FASB has concluded that there is no objective ways of distinguishing between projects seem reasonably assured and the unsuccessful ones.

Therefore, to the arguments,

1. The RM 50 K should not be capitalized, because for this development cost incurred where the future success of the upgrading is uncertain. Thus, it should be treated as an expense. In this sense we are taking the prudence approach, though most of criteria to capitalize the cost is fulfilled (Please refer to appendix 2 for details).

2. The depreciation cost would not be adjusted as the additional cost is not incorporated in the equipment value (not capitalized), but expensed as the period costs. However, if the development cost is capitalized, the depreciation amount at the initial production process would not be adjusted. Nevertheless, the development costs may increase the value and the life of the asset, these variables should be adjusted in calculating the asset’s depreciation once the development costs incorporated in its value.

3. The implication of capitalizing the development costs is that should the standards not achieved, would the cost remains as the capital expense ? In this case (standards not achieved), the cost has to be expensed off in the period recognizing that the cost incurred does not provide the expected future benefits to the asset.

QUESTIONS & ANSWERS

A. Question(s) related to the general principles of capitalizing expenditure

1. Question : Please explain on what it is mean to classify expenditure into asset or expense by looking at necessity and future benefit (referring to summarized chart in given class handouts – please refer to appendix 4)

Answer : In most cases the decision to expense or capitalize expenditures is moved around whether the cost incurred is ‘necessary’ and ‘prolongs future life’.

1. ‘Necessary’ – in term of the costs incurred need to be incurred in order to put the asset into its intended use / working condition.
2. ‘Future benefit’ – that costs incurred would generate future benefits, that should be allocated over the period it is consumed.

2. Question : Why costs of injuries/losses not covered by insurance be expensed ?

Answer : The costs were expensed because as if in normal situation, the occurrence of such happenings could not be determined. Hence, it is proper to write off (expense) the costs in the period incurred.

3. Question : How to value intangible asset (e.g. brand name) & how it is allocated?

Answer : Usually, it is difficult to estimate the value and the useful life of intangibles. For example, goodwill could be measured as the difference between the net value of assets and purchase consideration paid on the assets. However, for brand name, it requires valuation from a valuator in order to determine the worth of the intangible (i.e. brand name).

As for allocation, the useful life of the intangible must first be determined. Should the assets have determinable services life (e.g. patent limited to 25 years), the costs should be allocated over the service life. If no determinable service life, it depend to the company to amortize over how long, yet to comply with the maximum assumption of life stipulates in account standards (IAS 38 – not more than 20 years).

B. Question(s) related to Scenario 3 : On purchase of a new machine

4. Question : Referring to Scenario no 3, the additional beam installed should be expensed not capitalized. Please explain.

Answer : Conceptually, the costs associated directly to the machine, in order to make the machine ready for use should be capitalized and not expensed.

IAS 16 (Property, Plant & Equipment) makes it clear that initial cost includes ‘any directly attributable costs of bringing the asset to working condition for its intended use.” In this case, adding the beam is necessary in order to allow the use of the machine at the plant.

5. Question : Why the costs of the additional beam should be capitalized in the cost of the machine and not to the building?

Answer : However, the principle is clear that the additional beam should be capitalized instead of expensed. The purpose of installing the additional beams is to strengthen the base to support the new machine (to allow for the intended use of the machine). Consequently, the cost should be capitalized to the machine and not to the building.

A member of the floor also noted that based on his experience, for such cases, the tax authority requires that the costs be associated to the machine and not to the premise.

C. Question(s) related to Scenario 4 : On lease

6. Question : If there is capital allowance for a leased asset, is it to be taken into account in the leasor’s book or the leasee’s ?

Answer : According to IAS 17, in finance lease, the leasee would records the leased item as its fixed asset, whereas leasor would record it as receivable (not fixed assets). Hence, capital allowance should be accounted for in the leasee’s book and not the leasor’s. However, for income tax purpose, the lease rentals will not be allowable for the claims of capital allowances.

7. Question (4): How would the leasee treats the its leased asset at the end of the lease period ?

Answer : Assumption made for this question is that the lease is a finance lease. The assumption made based on the logic that the buyers wanted to buy computers, Yet, as they could not pay for the full amount, they finance the purchase through lease whereby at the end of the lease the computer’s ownership would be transferred to the them (the leasee). In this type of lease, although the asset is legally owned by the leasor, it would be accounted for as if owned by the leasee.

Then after, the asset is to be depreciated like other fixed assets (IAS 17). And, the liability should be reduced periodically during the lease period. Hence, the question of how the leasee treats the leased computer at the end of the lease shouldn’t arise as it already accounted as asset in the leasee’s book at the inception of the lease (strictly assuming this as finance lease where ownership is transferred). Therefore, it would be treated like other fixed assets in the leasee’s book. (Please refer to Appendix 3 for further elaboration on lease)

Question(s) related to Scenario 6 : On upgrading an equipment

8. Question (6): Why the development costs treated as expenses ?

Answer : Accounting for R&D costs is a complicated process because some costs may never result in future benefits. In this case, the upgrading of output quality of the machine could not known for certain. Hence, the additional RM 50K for debugging to upgrade the quality of the equipment to the intended standard is to be expensed in the period incurred. The reason of not capitalizing it is that achieving the expected improvement to the standard could not be ascertained for sure (highly uncertain). Should the result of not achieving be known, the cost would be avoided. But, this is not possible. Thus, though writing the cost into income statement in the period would go against the MATCHING principle, the PRUDENCE concept takes precedence over MATCHING

CONCLUSION

The answer to the question of whether expenditure should be capitalized or not lies in various factors attached to specific situation (be it building construction, purchase, lease, tax, or product development).

APPENDICES

APPENDIX 1 : FURTHER INFORMATION ON LEASE

Factors that lease is preferred over purchase:

Purchase transaction often reflects a significant cash outlay at the date of purchase, whilst leasing could minimize the amount paid initially to acquire assets, hence a stable outlay of cash.

Specifically for operating lease (simple rental agreement), the leasee does not have to report for related liability in its balance sheet. Whereas, in purchase, it has to reflect the amount due (liability) should the purchase is on credit term.

Finance lease:

“a type of lease, regardless its legal form, where the risks and rewards incident to ownership is transferred from the leasor to the leasee” (IAS 16)

From the leasor’s perspective, the asset under finance lease is, in substance, sold to the leasee. Thus, the asset leased should be accounted for, in its book, not as a fixed asset, but as a receivable. The income effect of a finance lease is just the finance income recognized in each accounting period. There will be no depreciation charge, as no fixed asset is recorded.

In leasor’s book, at the inception of the lease, the journal entry is:

Dr Debtor / Receivable XXX

Cr Cash / P&L a/c XXX

As for leasee, at the inception of finance lease, the leased asset is to be recorded as its fixed asset. However, it must also record liability/obligation arising from the lease (which should be of the same amount with the asset).

Dr Fixed Asset under finance lease XXX

Cr Long Term Debt (Liability under finance lease) XXX

Assume that the first annual lease payment consists of YYY of interest expense and ZZZ to reduce the liability. Entry for this is:

Dr Interest expense YYY

Dr Long Term Debt (Liability under finance lease) ZZZ

Cr Cash (YYY+ZZZ)

Also, depreciation on the asset would be charged as if other asset:

Dr Depreciation Expense MMM

Cr Accumulated depreciation MMM

At the end of the lease, the value of the asset is that the depreciated value of the asset at that time.

APPENDIX 2 : FURTHER INFORMATION ON RESEARCH & DEVELOPMENT COSTS

In accounting for Research & Development activities, it is essential that an enterprise differentiate the costs into those relating to research, and those relating to development activities

Definition

Research – original & planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding

Development – the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, process, systems or services prior to the commencement of commercial production or use.

Capitalized or Expensed?

Determination of whether to capitalize or expense depends on future benefit derived.

As regards to research costs, it’s generally believed the benefits derived to be uncertain. IAS 9 requires all research costs be recognized as an expense in period in which they are incurred.

As for development costs, IAS 9 requires development cost be expensed in period incurred unless they satisfy for asset recognition criteria:

1. The product is clearly defined and its related costs can be separately identified and measured reliably
2. The technical feasibility of the product can be measured
3. The enterprise intends to produce & market the product
4. The market feasibility / usefulness of the product, has been demonstrated

The capitalized development cost, in practice classified as part of long-term intangible asset. Amortization of this cost commences when the product is available for sale / use.

A study suggested R&D costs could be classified as:

• Basic Research – Experimentation with no specific commercial objective.
• New product development – Experimental effort towards previously untried product
• Product improvement – Effort towards improving quality or functional performance of current product lines
• Cost / Capacity improvement – Development of new and improved processes, manufacturing equipment, to reduce operations costs or expand capacity
• Safety, health & convenience – Improvement of working conditions.

It is suggested that the first three categories be capitalized whilst reminders be expensed due to difficulty in determining the future periods expected to receive benefits.

APB Opinion No 17 requires the immediate expensing of such costs in order to avoid manipulation. Company could use this through capitalizing R&D costs in low-profit years and writing them off in a lump sum in high-profit years.)

APPENDIX 3 : FURTHER INFORMATION ON BASKET PURCHASE

The purchase of two or more assets acquired together at a single price.

As regards to purchase of land together with building, because there are differences in the accounting for land and building, the purchase price must be allocated between the two assets. Allocation usually based on the fair market value. As an illustration, a purchase of RM 3,600,000 of a land together with a building:

Asset	Fair Market Value	% of Total Value	Apportionment of lump-sum cost
Land	1,000,000	25%	0.25 x 3,600,000 = 900,000
Building	3000,0000	75%	0.75 x 3,600,000 = 2,700,000
Total	4,000,000	100%	3,600,000

Therefore, the journal entry in buyer’s book to record this basket purchase is:

Dr Land 900,000

Building 2,700,000

Cr Cash 3,600,000

Purchased land and building of RM 3,600,000

MAIN REFERENCES

The Accountant’s Manual Vol. 1 (MIA)

Malaysia Accounting Standard Board (Various Notes)

International Accounting Standards (Various Notes)