Advanced Accounting: Capitalization, Valuation, and Government Grants

Capitalized Borrowing Cost

• When a project is funded by general debt, additional calculations are required.

General Debt Funding

• Example: Shalla funds a project using general debt.
  • Debt obligations:
    1. 10%, $1,000,000$, five-year note payable, dated December 31, 2021, interest payable annually on December 31.
    2. 12%, $1,500,000$, 10-year bonds issued December 31, 2020, interest payable annually on December 31.

Average Carrying Amount

• Calculate the average carrying amount of the project during the period.
  • Formula: Illustration 9.3

• The capitalization period is the number of months between when the expenditure is made and the end of the project or the end of the year, whichever comes first.

Weighted-Average Borrowing Cost (Capitalization Rate)

• Calculate the weighted-average borrowing cost when using general debt.
  • Formula:
    [.10 × ($1,000,000 ÷ $2,500,000)] + [.12 × ($1,500,000 ÷ 2,500,000)] = 11.2\%

Borrowing Cost Capitalization

• Combine average carrying amount and capitalization rate to find the amount of borrowing cost available for capitalization.
  • Calculation:
    $820,000 x .112 = $91,840

Constraint on Capitalization

• The amount capitalized cannot exceed the actual borrowing costs incurred during the period.
• Example: In 2025, total borrowing costs were $280,000 (($1,000,000 x .10) + ($1,500,000 x .12)).
• Capitalize the lower of actual borrowing costs or the calculated amount.
  • In Shalla's case, capitalize $91,840.

Journal Entry

• Journal entries for capitalized borrowing costs:

Blend of Specific and General Debt

• When a project is funded by a blend of specific debt and general debt, expenditures are first allocated to the specific debt to the extent possible, and the remainder is allocated to general debt.
• Illustration 9.4: Allocation of Expenditures

Borrowing Costs of Specific Debt

• Calculate the borrowing costs of specific debt.
  • Example: $750,000$ x .15 = $112,500 (borrowing costs) less $40,000 (investment income) = $72,500.

Capitalization Rate on General Debt

• Calculate the capitalization rate on the general debt.
  • Formula:
    {[(.10 x $500,000 ÷ $2,000,000)] + [.12 × ($1,500,000 ÷ $2,000,000)]} = 11.5\%. This results in a potential amount of borrowing costs to be capitalized of $23,000 ($200,000 x .115$).

Total Amount to be Capitalized

• Determine the total amount to be capitalized, considering both specific and general debt.
• Capitalize $23,000 from the general borrowings since this amount is lower than the actual borrowing costs of the general debt of $230,000 (($500,000 × .10)+ ($1,500,000 x .12)).
• Illustration 9.5: Summary of Borrowing Costs

Journal Entry at December 31

Disclosures

• For each period, disclose the amount of borrowing costs capitalized and the capitalization rate used.
• Illustration 9.6: Example from Royal Dutch Shell's financial statements.

Valuation of Property, Plant, and Equipment

• Record property, plant, and equipment at the fair value of what is given up or the fair value of the asset received, whichever is more evident.

Cash Discounts

• If a company takes a cash discount, consider the discount as a reduction in the purchase price of the asset.
• Two views on cash discounts:
  1. The discount should be considered a reduction in the cost of the asset, whether taken or not.
  2. Failure to take the discount should not always be considered a loss.
• For homework purposes, treat the discount, whether taken or not, as a reduction in the cost of the asset.

Deferred-Payment Contracts

• Account for assets purchased on long-term credit contracts at the present value of the consideration exchanged.
• Example: Greathouse Company purchases an asset for a $10,000$ zero-interest-bearing note payable in four years.
  • Asset recorded at $7,084.30$ ($10,000 x .70843$) using a 9% interest rate.
  • Formula: PV = $10,000 (PVF_{4,9\%})
• When no interest rate is stated or if the specified rate is unreasonable, impute an appropriate interest rate.

Sutter AG Example

• Sutter AG purchases a robot spray painter for €$100,000$, five-year, zero-interest-bearing note.
• Prevailing market rate of interest is 10%.
• Note is paid off in five €$20,000$ installments.

Date of Purchase

End of First Year

End of Second Year

• If Sutter did not impute an interest rate, it would record the asset at an amount greater than its fair value and understate interest expense.

Lump-Sum Purchases

• Allocate the total cost among the various assets on the basis of their relative fair values.
• The assumption is that costs will vary in direct proportion to fair value.

Norduct Homes, Inc. Example

• Norduct Homes purchases assets of Comfort Heating for $80,000.

Allocation of Purchase Price

• Inventory: (25,000 ÷ $100,000) x 80,000 = $20,000
• Land: (25,000 ÷ $100,000) x 80,000 = $20,000
• Building: (50,000 ÷ $100,000) x 80,000 = $40,000

Issuance of Shares

• If trading of the shares is active, the market price of the shares issued is a fair indication of the cost of the property acquired.

Upgrade Living Co. Example

• Upgrade Living Co. issues 5,000 ordinary shares (par value $10$) with a market price of $12$ per share for land.

Exchanges of Non-Monetary Assets

• Account for exchanges based on the fair value of the asset given up or received, recognizing a gain or loss.
• Rationale: most transactions have commercial substance.

Meaning of Commercial Substance

• An exchange has commercial substance if the future cash flows change as a result of the transaction.
• If the two parties' economic positions change, the transaction has commercial substance.

Andrew Co. Example

• Andrew Co. exchanges equipment for land held by Roddick Inc.
• The timing and amount of cash flows will differ significantly.
• Both are in different economic positions.
• The exchange has commercial substance, and gains/losses are recognized.

Accounting for Exchanges

• Use of fair value generally results in recognizing a gain or loss.
• Determine if the transaction has commercial substance by evaluating the cash flow characteristics of the assets exchanged.

Illustration 9.8: Accounting for Exchanges

Exchanges - Loss Situation (Has Commercial Substance)

• Recognize the loss if the exchange has commercial substance; do not value assets at more than their cash equivalent price.

Information Processing SA Example

• Information Processing SA trades a used machine for a new model.
• The exchange has commercial substance.
• Used machine: Book value €$8,000$, fair value €$6,000$.
• New model lists for €$16,000$.
• Jerrod gives a trade-in allowance of €$9,000$.

Computation of Cost of New Machine

• List price of new machine: €$16,000$
• Less: Trade-in allowance: €$9,000$
• Cash payment due: €$7,000$
• Fair value of used machine: €$6,000$
• Cost of new machine: €$13,000$

Journal Entry

Computation of Loss on Disposal

• Fair value of used machine: €$6,000$
• Less: Book value of used machine: €$8,000$
• Loss on disposal: €$2,000$

Exchanges - Gain Situation (Has Commercial Substance)

*Company records the cost of a non-monetary asset acquired in exchange for another non-monetary asset at the fair value of the asset given up, and immediately recognizes a gain.

Interstate Transportation Company Example

*Interstate Transportation Company exchanged a number of used trucks plus cash for a semi-truck.
*The used trucks have a combined book value of $42,000$ (cost $64,000$ less $22,000$ accumulated depreciation).
*Interstate's purchasing agent, experienced in the secondhand market, indicates that the used trucks have a fair value of $49,000$.
*In addition to the trucks, Interstate must pay $11,000$ cash for the semi-truck.

Computation of Semi-Truck Cost

*Fair value of trucks exchanged $49,000$
*Cash paid 11,000
*Cost of semi-truck

Journal Entry

Lacks Commercial Substance

*the economic position of Interstate did not change significantly as a result of this exchange.
*we lack gain of *Formula
**Compute the total gain or loss on the transaction. This amount is equal to the difference between asset given up and the book value of the asset given up.
(a) If the exchange has commercial substance, recognize the entire gain or loss.
(b) If the exchange lacks commercial substance, no gain or loss is.

Government Grants

When companies acquire an asset such as property, plant, and equipment through a government grant, a strict cost concept dictates that the valuation of the asset should be zero. However, a departure from the historical cost principle seems justified because the only costs incurred (legal fees and other relatively minor expenditures) are not a reasonable basis of accounting for the assets acquired. To record nothing is to ignore the economic realities of an increase in wealth and assets. Therefore, most companies use the fair value of the asset to establish its value on the
books.When companies acquire an asset such as property, plant, and equipment through a government grant, a strict cost concept dictates that the valuation of the asset should be zero. However, a departure from the historical cost principle seems justified because the only costs incurred (legal fees and other relatively minor expenditures) are not a reasonable basis of accounting for the assets acquired. To record nothing is to ignore the economic realities of an increase in wealth and assets. Therefore, most companies use the fair value of the asset to establish its value on the##Approaches
Supporters of the equity approach believe the credit should go directly to equity because often no repayment of the grant is expected. In addition, these grants are an incentive by the government-they are not earned as part of normal operations and
should not offset expenses of operations on the income statement.

IFRS

IFRS requires the income approach. The general rule is that grants should be recognized in income on a systematic
basis that matches them with the related costs that they are intended to compensate. [8] This is accomplished in one
of two ways for an asset such as property, plant, and equipment:
Recording the grant as deferred grant revenue, which is recognized as income on a systematic basis over the
useful life of the asset, orDeducting the grant from the carrying amount of the assets received from the grant, in which case the grant is
recognized in income as a reduction of depreciation expense.

Example 1: Grant for Lab Equipment

*Credit Deferred Grant Revenue for the subsidy and amortize the deferred grant revenue over the five-year period. (2) Credit the lab equipment for the subsidy and
depreciate this amount over the five-year period.
If Spectrum chooses to record deferred revenue of €$500,000$, it amortizes this amount over the five-year period to
If Spectrum chooses to reduce the cost of the lab equipment, Spectrum reports the equipment at €1,500,000
but the presentation on the financial statements###Example 2: Grant for Past Losses
Flyaway Airlines has incurred substantial operating losses over the last five years. The company now has little
liquidity remaining and is considering bankruptcy. The City of Plentiville does not want to lose airline service and
feels it has some responsibility related to the airlines losses. It therefore agrees to provide a cash grant of 1,000,000$$
to the airline to pay off its creditors so that it may continue service. Because the grant is given to pay amounts owed
to creditors for past losses, Flyaway Airlines should record the income in the period it is received. The entry to record
this grant is as follows.