Recognition of Land Improvements

Question: Land is not subjected to the recording of depreciation expense because it has an infinite life. Often, though, a parking lot, fence, sidewalk, or the like will be attached to land. Those assets do have finite lives. How are attachments to land—such as a sidewalk—reported in financial accounting? Is that cost added to the land account or is some other reporting more appropriate? Should these assets be depreciated?

 

Answer: Any asset that is attached to land but has a finite life is recorded in a separate account, frequently referred to as land improvementsAssets attached to land with a finite life such as a parking lot or sidewalk.. This cost is then depreciated over the estimated life in the same way as equipment or machinery. The cost of a parking lot or sidewalk, for example, is capitalized and then reclassified to expense in a systematical and rational manner.

In some cases, a distinction between land and improvements is difficult to draw. Accounting rules do not always provide clear guidance for every possible situation. Judgment is occasionally necessary. For example, trees, shrubbery, and sewer systems might be viewed as normal and necessary costs to get land into the condition and position to generate revenues rather than serving as separate assets. Is a sewer system a cost incurred so that land can be utilized or is it truly a distinct asset? U.S. GAAP does not provide absolute rules. Such costs may be carried within the land account and not depreciated or reported as land improvements subject to depreciation. Such flexibility in accounting is more prevalent than might be imagined.

Property and Equipment with Impaired Value

Question: Property and equipment acquisitions are recorded at historical cost, a figure which is depreciated over the asset’s anticipated useful life. Land is an exception because it will last forever. These assets are eventually sold, traded, consumed, or disposed of in some other manner. While in use, their value may decline rather rapidly if adverse conditions arise. The economy as a whole or the local business environment might suffer a recession that reduces the worth of a wide array of assets. Or, some unexpected action could create a drop in the value of a specific asset.

In financial reporting, increases in the fair value of property and equipment are ignored because of the conservative nature of accounting, but what about decreases? If the value of property and equipment becomes impaired, is any accounting recognition made of that loss prior to disposal? Is historical cost always the basis for reporting such assets regardless of their worth? For example, as discussed previously, inventory is reported at the lower of cost or market whenever a decline in value has occurred. Is a similar treatment required in reporting property and equipment?

To illustrate, assume that a company constructs a plant for $3 million to manufacture widgets. Shortly thereafter, the global market for widgets falls precipitously so that the owner of this structure has little use for it. Furthermore, no one else wants to own a manufacturing plant for widgets. Does historical cost continue to be reported for this asset even if the value has been damaged significantly?

 

Answer: Accounting is influenced by conservatism. Concern should always arise when any piece of property or equipment is thought to be worth less than its normal net book value. Because temporary swings in value can happen frequently and often have no long-term impact, they do not require accounting modification. Historical cost remains the reporting basis.

Permanent declines in the worth of an asset, though, are a problem for the owner that needs to be recognized in some appropriate manner. Consequently, two tests have been created by FASB to determine if the value of property or equipment has been impaired in such a serious fashion that a loss must be recognized.

If a possible impairment of the value of property or equipment is suspected, the owner must estimate the total amount of cash that will be generated by the asset during its remaining life. The resulting cash figure is then compared with the asset’s current net book value (cost less accumulated depreciation). A reporting problem exists if the company does not anticipate receiving even enough cash to recover the net book value of the asset. At that point, the asset is a detriment to the company rather than a benefit. This recoverability testA test used to determine whether the value of a long-lived asset has been impaired; if expected future cash flows are less than present net book value, a fair value test is then performed to determine the amount of impairment. highlights situations that are so dire that immediate recognition of a loss must be considered.

If expected future cash flows exceed the current net book value of a piece of property or equipment, no reporting is necessary. The asset can still be used to recover its net book value. No permanent impairment has occurred according to the rules of U.S. GAAP.

Conversely, if an asset cannot even generate sufficient cash to recover its own net book value, the accountant performs a second test (the fair value testA test to determine the amount, if any, by which the value of a long-lived asset has been impaired; if fair value is less than present net book value, this fair value becomes the new basis for reporting and an impairment loss is recorded.) to determine the amount of loss, if any, to be reported. Net book value is compared to present fair value, the amount for which the asset could be sold. For property and equipment, the lower of these two figures is then reported on the balance sheet. Any reduction in the reported asset balance creates a loss to be recognized on the income statement.Mechanically, an impairment loss for property and equipment could be calculated in any one of several ways. FASB established these two tests. Thus, according to U.S. GAAP, the recoverability test and the fair value test must be used when impairment is suspected. Some might argue that this process is not the best method for determining an impairment loss. Standardization, though, helps to better ensure universal understanding of the figures being reported.

The recoverability test illustrated. Assume that the $3.0 million building in the previous example has been used for a short time so that it now has a net book value of $2.8 million. Also assume that because of the change in demand for its product, this building is now expected to generate a net positive cash flow of only $200,000 during each of the next five years or a total of $1.0 million. No amount of cash is expected after that time. This amount is far below the net book value of $2.8 million. The company will not be able to recover the asset’s net book value through these cash flows. Thus, the building has failed the recoverability test. The fair value test must now be applied to see if a reported loss is necessary.

The fair value test illustrated. Assuming that a real estate appraiser believes this building could be sold for only $760,000, fair value is below net book value ($2.8 million is obviously greater than $760,000). Therefore, the asset account is reduced to this lower figure creating a reported loss of $2,040,000 ($2.8 million less $760,000).

In its 2010 financial statements, the Ford Motor Company describes this process as follows:

We monitor our asset groups for conditions that may indicate a potential impairment of long-lived assets. These conditions include current-period operating losses combined with a history of losses and a projection of continuing losses, and significant negative industry or economic trends. When these conditions exist, we test for impairment. An impairment charge is recognized for the amount by which the carrying value of the asset group exceeds its estimated fair value…. Based upon the financial impact of rapidly-changing U.S. market conditions during the second quarter of 2008, we projected a decline in net cash flows for the Ford North America segment. As a result, in the second quarter of 2008 we tested the long-lived assets for impairment and recorded in Automotive cost of sales a pretax charge of $5.3 billion.

Capitalizing the Cost of Interest During Construction

Question: A company is considering buying a building for $1.0 million on January 1, Year One so that a retail store can be opened immediately. The company can borrow the money from a bank that requires payment of $100,000 in interest (an assumed annual rate of 10 percent) at the end of each year.

As a second possibility, the company can borrow the same $1.0 million on the first day of the current year and use it to build a similar store to be completed and opened on December 31. Again, $100,000 in interest (10 percent annual rate) must be paid every year, starting at the end of Year One. In both cases, the same amount of money is expended to acquire the structure. If money is borrowed and a building constructed, is the financial reporting the same as if the money had been spent to buy property that could be used immediately?

 

Answer: A payment of $1 million is made in both cases for a building to serve as a retail store. Although the monetary cost is the same, the interest payments are handled differently from an accounting perspective. If a building is purchased, the structure can be used immediately to generate revenue. Borrowing the money and paying the $100,000 interest for Year One allows the company to open the store and start making sales at the beginning of that year. There is no waiting. The matching principle requires this cost to be reported as interest expense for Year One. Expense is matched with the revenue it helps to create.

In contrast, if company officials choose to construct the building, no revenue is generated during Year One. Because of the decision to build rather than buy, revenues are postponed until Year Two. Without any corresponding revenues, expenses are not normally recognized. Choosing to build this structure means that the interest paid during Year One is a normal and necessary cost to get the building ready to use in Year Two. Thus, if the asset is constructed, all interest is capitalizedInterest cost incurred during the construction of a long-lived asset; the interest is added to the historical cost of the asset rather than being recorded as interest expense; it is viewed as a normal and necessary expenditure to get the asset into position and condition to generate revenues. rather than expensed until revenues are generated. The $100,000 is reported as part of the building’s historical cost. The cost is then expensed over the useful life—as depreciation—in the years when revenues are earned.

The key distinction is that buying enables the company to generate revenue right away whereas constructing the building means that no revenue will be earned during Year One.

To illustrate, assume that this building is expected to generate revenues for twenty years with no expected residual value and that the straight-method is used for depreciation purposes. Notice the difference in many of the reported figures.

 

Store Bought on January 1, Year One—Revenues Generated Immediately

• Historical cost: $1 million
• Interest expense reported for Year One: $100,000
• Interest expense reported for Year Two: $100,000
• Depreciation expense reported for Year One: $50,000 ($1 million/20 years)
• Depreciation expense reported for Year Two: $50,000
• Net book value at end of Year Two: $900,000 ($1 million less $50,000 and $50,000)

 

Store Constructed during Year One—No Revenues Generated until Year Two

• Historical cost: $1.1 million (includes Year One interest)As discussed in intermediate accounting textbooks, the full amount of interest is not actually capitalized here because the borrowed money is only tied up during the construction gradually. Until added to the project, all remaining funds can be used to generate revenues. However, for this introductory textbook, focus is on the need to capitalize interest because the decision to build defers the earning of revenue until the project is completed. Complete coverage of the rules to be applied can be obtained in an intermediate accounting textbook.
• Interest expense reported for Year One: -0- (no revenues earned)
• Interest expense reported for Year Two: $100,000
• Depreciation expense reported for Year One: Zero (no revenues earned)
• Depreciation expense reported for Year Two: $55,000 ($1.1 million/20 years)
• Net book value at end of Year Two: $1,045,000 ($1.1 million less $55,000)

Fixed Asset Turnover

Question: In previous chapters, a number of vital signs were examined in analyzing receivables and inventory. These ratios and computations are computed by decision makers to help them evaluate the operations of a reporting entity. Are there any vital signs normally studied in connection with property and equipment that a decision maker calculates in analyzing the financial health of a business?

 

Answer: Ratios and other computed amounts are not as common with noncurrent assets as has been seen with current assets. However, the fixed asset turnoverRatio calculated by dividing net sales by the average of the net fixed assets reported for the period; it indicates the efficiency by which property and equipment have been used to generate sales revenues. indicates the efficiency by which a company uses its property and equipment to generate sales revenues. If a company holds large amounts of fixed assets but fails to generate an appropriate amount of revenue, the ability of management to make good use of those assets should be questioned.

This figure is calculated by taking net sales for a period and dividing it by the average net book value of the company’s property and equipment (fixed assets). For example, assume a company reports $1 million in property and equipment on its balance sheet at the beginning of the year but $1.2 million at the end. During the year, the company generates $6.16 million in net sales. The average amount of the fixed assets for this period is $1.1 million and the fixed asset turnover is 5.6 times for the year.

net sales/average net fixed assets $6,160,000/$1,100,000 5.6 times