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 Architect Fee These are all one-time costs incurred for making the place ready for construction hence, to be capitalized. Capitalized Snow clearance Capitalized CAPITALIZED? JUSTIFICATION

Cash discount Construction office Real estate taxes

Capitalized Capitalized 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 companys total interest cost for the period.

Mistakes Maintenance overhead

Expensed The share of these costsattributed directly to the construction are to be capitalized to the construction.

Capitalized 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 Archers 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 owners 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 buyers 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 DR Accumulated Depreciation (old machine) CR Used Machine CR Cash/Bank

RM18000 RM11000 RM14000 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 thedeferral method. Other than that, concerning on the period of the usage of the tax credit, if there is limitation on the entitys 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 assets lifetime. It is thus up to the entitys 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 assets 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.
a. Necessary in term of the costs incurred need to be incurred in order to put the asset into its intended use / working condition. b. 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 leasors book or the leasees ?

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 leasees book and not the leasors. 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 computers 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 shouldnt arise as it already accounted as asset in the leasees 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 leasees 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)