FAR CPA Practice Questions: Calculating the Gross Balance of PP&E

Calculating the Gross Balance of PP&E

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In this video, we walk through 5 FAR practice questions teaching about calculating calculating the gross balance of PP&E. These questions are from FAR content area 2 on the AICPA CPA exam blueprints: Select Balance Sheet Accounts.

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Calculating the Gross Balance of PP&E

When it comes to accounting for Property, Plant, and Equipment (PP&E), it’s essential to understand the various components that make up the gross value of these long-term assets. Not only does this value include the purchase price of the asset, but also any additional expenditures necessary to bring the asset to its intended use. One of the more intricate areas involves capitalized interest, a topic that often presents challenges when determining how much should be included in the gross amount of PP&E. We’ll break down the key concepts to help clarify how costs are capitalized, apportioned, and treated in the case of interest during asset construction.

Costs Included in the Gross Value of PP&E

The gross value of PP&E represents more than just the purchase price of the asset. Any cost directly attributable to preparing the asset for its intended use is included. This typically includes:

  • Purchase price: The amount paid to acquire the asset, whether land, building, or equipment.
  • Legal and title fees: Costs related to legal work or title searches needed to acquire the asset.
  • Demolition or site preparation costs: If a company buys land with an old building that needs to be demolished, the cost of demolition is capitalized, as it’s required to prepare the site.
  • Construction or renovation costs: Expenses incurred to renovate or construct an asset, such as materials, labor, and permits.

For example, if a company purchases a plot of land for $500,000 and spends $20,000 to demolish an old structure and $10,000 on legal fees, the total amount to be capitalized as part of the land’s value would be $530,000 ($500,000 + $20,000 + $10,000).

Apportioning the Cost of Lump-Sum Purchases

Often, companies purchase multiple assets in a lump-sum transaction, such as buying land, buildings, and equipment together. In this case, the total cost must be apportioned among the assets based on their relative fair values. This ensures that each asset is capitalized appropriately, and future depreciation calculations will be correct.

Example:
Suppose a company buys land, a building, and equipment in a lump-sum transaction for $900,000. The fair values of the individual assets are:

  • Land: $250,000
  • Building: $600,000
  • Equipment: $150,000

To apportion the total purchase price, we first determine the proportionate share of each asset.

  • Total fair value: $250,000 + $600,000 + $150,000 = $1,000,000
  • Apportioned value for land: ($250,000 / $1,000,000) × $900,000 = $225,000
  • Apportioned value for building: ($600,000 / $1,000,000) × $900,000 = $540,000
  • Apportioned value for equipment: ($150,000 / $1,000,000) × $900,000 = $135,000

These apportioned amounts ensure that the company capitalizes the correct amount for each asset.

Capitalized Interest: What It Is and How It Works

One of the more complex aspects of PP&E accounting is the capitalization of interest. When a company takes out a loan to finance the construction of an asset, the interest incurred during the construction period can be capitalized. This means the interest is added to the cost of the asset rather than expensed in the period it’s incurred.

Key Concept:
Capitalized interest is only applicable while the asset is under construction. Once the asset is complete, any further interest incurred is expensed, not capitalized.

How to Calculate Capitalized Interest

The amount of interest that can be capitalized is determined based on the weighted average of accumulated expenditures over the construction period. The longer an expenditure has been outstanding, the more interest it will accumulate.

Example Calculation:
A company begins constructing a warehouse on March 1, Year 1, with the following costs:

  • March 1: $500,000
  • June 1: $400,000
  • September 1: $300,000

The company takes out a $1,000,000 loan at 10% interest. To calculate the weighted average accumulated expenditures, we need to weight each cost by the number of months it was outstanding until construction was completed on October 31.

  • March 1 expenditure ($500,000) was outstanding for 8 months (March to October):
    $500,000 × (8/12) = $333,333
  • June 1 expenditure ($400,000) was outstanding for 5 months (June to October):
    $400,000 × (5/12) = $166,667
  • September 1 expenditure ($300,000) was outstanding for 2 months (September to October):
    $300,000 × (2/12) = $50,000

Total weighted average accumulated expenditures = $333,333 + $166,667 + $50,000 = $550,000.

Next, we calculate the interest that should be capitalized:

  • Capitalized interest = $550,000 × 10% = $55,000

However, the total interest that can be capitalized is limited by the total interest on the loan, which is calculated as:

  • Loan interest = $1,000,000 × 10% = $100,000

Since the loan interest exceeds the capitalized amount, the full $55,000 is capitalized.

When Interest Cannot Be Capitalized

One important caveat is that interest can only be capitalized while the project is in progress. If a project is completed but not placed in service immediately, the interest incurred after the completion date cannot be capitalized.

Example:
A company completes the construction of a new facility on October 31, Year 1, but the facility isn’t placed into service until December 31, Year 1. The interest incurred in November and December cannot be capitalized, even though the company hasn’t yet used the facility.

Conclusion

Understanding what costs are included in the gross value of PP&E, how to apportion costs from a lump-sum transaction, and how to handle capitalized interest during construction is crucial for the FAR CPA exam. Interest capitalization rules ensure that companies properly match the cost of long-term assets to their future economic benefits.

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