Accounting Case Study Solution
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Accounting Case Study Solution
Joan Holtz Case 7-2
The concerns raised by Joan Holtz in this problem are being addressed based on the Governing Principle of calculation of arriving cost of Fixed Asset. 1.) The cost of an item of Property, Plant, or Equipment, includes all expenditures that are necessary to make the Asset ready for its intended use. When a company constructs a building or item of equipment for its own use, the amount of capitalized cost includes all the costs incurred in construction. 2.) As in the case of Product costs, these costs include the materials and labor directly associated with the project, as well as a fair share of the company’s indirect costs incurred during the construction period. 3.) FASB requires that these capitalized costs also include Interest. The amount of Interest capitalized is the amount related to borrowings made to finance the project (construction loans) if these are identifiable. 4.) If not, the company must estimate the interest cost that must have been avoided if the asset in question had not been constructed. The total amount of interest capitalized cannot exceed the company’s total interest cost for the period. The interest capitalization ends when the asset is substantially complete and ready for its intended use. 5.) If the company contracts with an outside party to build the asset and makes deposits or progress payments to the contractor, then interest costs associated with these funds are included in the capitalized cost.
Answer to Question 1:
a.) Architects’ fees: As per the above explanation, the cost needs to be included in the cost of Building as it is an expenditure which is necessary to make the Building come into existence.
b.) Cost of Snow during Removal: It is added to the cost of Building as the expenditure is necessary for the asset’s intended use.
c.) Cash discounts earned: The income should be reduced from the Total cost of the Building as it is a one-time expenditure related only to buying materials for construction bringing the asset to useful condition.
d.) Cost of building a combined construction office and toolshed that would be torn down once the factory wing had been completed: The cost needs to be capitalized as the construction of the Office and the toolshed is necessary to bring the Factory wing into complete existence.
Interest on Money borrowed to finance construction: The amount, assumed to be identifiable(as per the problem) will be capitalized and added as part of the cost of the Factory Building(Interest accrued till substantial level of construction)
f.) Local Real estate Taxes for the period of construction: Will be capitalized since it is a onetime obligation to be paid to bring the Asset into existence.
g.) Cost of Mistakes: Will not be capitalized and written-off in the year of incurrence as this does not lead to any future economic benefit.
h.) Overhead costs of maintenance department, supervision, depreciation, heat, light and power etc.: Will be capitalized as the expenses are directly attributable and identifiable to construction of Factory Building.
i.) Cost of Insurance during construction: Will not be capitalized and written-off in the year of incurrence as this does not lead to any future economic benefit.
Answer to Question 2:
a.) Since revenues are being earned from the existing buildings it is appropriate to charge depreciation on these buildings against these revenues in order to measure income. Although they are expected to be razed soon and the purpose of purchasing this building was not to earn income from the existing theatre, therefore only a portion of price should be charged.
b.) Cost of demolition of old buildings should be capitalized as the cost is necessary to bring the new building into useful existence.
c.) The net book value of the old buildings for the company in (c) would be written off when they were razed since they didn’t purchase the building and their cost was its book value. Since book values of real property are typically less than market value, the “cost” of the new buildings would be less than the cost of buildings built by the Archer Company. The construction cost and demolition costs would remain the same in both situations. Answer to Question 3:
a.) Installation of additional steel beams cost should be charged to the cost of the machine — “Cost of Installation”, because the equipment as mentioned above should be capitalized. The cost incurred to install the new machine, therefore it is a cost requirement for machine to get ready for operation b.) & c.) Strengthening of foundation, outside engineer to assist in installation and sales tax on machine can be all capitalized as they are
necessary to make the asset ready for its intended use. However the company will be intending to expense the same for initial Tax advantage. c.) The difference between the trade-in value and the depreciated value of the old machine should be treated as deduction to the cost of the new machine because accepting old machine as partial payment is like trading old asset to a similar new asset. Value of the old asset is used in calculating the acquisition cost of the new asset Answer to Question 4:
The customer is buying the computer along with the services, therefore, its paying for both. Also the revenue does not match the expenses if R&D costs are expensed. Thus, if the system is leased, these costs should be capitalized along with the hardware costs. The problem with capitalization is that the lease revenue is uncertain. Profits will be overstated if in the future they are not able to collect the revenue. However, expensing the costs as incurred better reflects the cash flows of the business. Answer to Question 5:
No, since the product is being commercially sold and they don’t have the estimated future expenditures required to meet the 65 ppm standard, they should base their depreciation expense on expenditures to date in order to meet the revenues to the related costs. Once the 65 ppm standard is achieved and the complete cost to achieve is known, the cost of the asset should be adjusted and an adjustment should be made to previous depreciation expense. If the 65 ppm standard is never achieved, the firm would have trouble allocating the expenditure made attempting to achieve that standard. Also they might lose some of their major customers. They should also be concerned about the time lag in achieving 65 ppm standard.
Joan Holtz Case 8-3
Answer to Question 1:
The bond was issued in 1883 and assuming that it was issued at Par value, the effective rate of Interest needs to be computed for the 127 years and the Principal along with the compound interest needs to be arrived at to find the redeemable value of the bond. There are calculators which can help compute the value and the same needs to be used for the redemption. However this appears to be a theoretical case where the tenure has exceeded 100 years and such a scenario wouldn’t have existed in practical scheme of things. Answer to Question 2:
a.) The effective rate of Interest when the Interest calculated Semi-annually on a Zero coupon Bond turns out to be 15% as Joan had calculated. b.) The effective after tax rate assuming Tax rate to be 40% will be 9%(0.15*(1-0.40)) c.) If company had issued 15% coupon bonds at par $1000 per bond, the after-tax effective interest rate will also be 9% after considering the tax discount on the Interest payment. Answer to Question 3:
a.) The company, if it buys back bonds from the open market directly, is liable to pay a securities transaction tax which is a major portion. By engaging an investment banker, the company can afford to forfeit the tax and pass on the burden to the investment banker. The gain for the investment banker (who is involved in such transactions all throughout), it becomes easier to make a gain in the open market by selling bonds and buying shares of the company. The swap is bound to be a Win-Win relationship for both the company and investment banker. b.) The gain should be treated as income for financial reporting purpose, as the gain is a gain on account of swap of bonds with shares, a cash flow from investing activity.
Answer to Question 4:
The Airline would ascertain, with a reasonable degree of calculation based on past trends the amount of redemption of the frequent Flyer Miles. However till such time the redemption happens, the airline would disclose the expenditure as a “Contingent Liability” based on the principle of Conservatism and Disclosure of nature of Transactions. The item would be given in the notes to the Balance sheet depending on the nature of the expenditure. Answer to Question 5: