Joan Holtz (C)* Joan Holt sid to the accounting instructor, “The gen- ral prineile for arivingat the amount ofa fixed asset that is to be capitalized is reasonably clea, bu there certainly are a great many problems in applying this principle to specific situations.” Following are some ofthe problems Joan Holtz pre- sented: |. Suppose that the Bruce Manufacturing Company ‘used its own maintenance crew to build an addi- ‘onal wing on its existing factory building. What ‘would be the proper accounting treatment of the following items? b a Architects fees. ‘The cost of snow removal during construction. Cash discounts eared for prompt payment on ‘materials purchased for construction. ‘The cost of building a combined construction ‘office and toolshed that would be torn down ‘ones the factory wing had been completed. Interest on money borrowed to finance con- struction. Local real estate taxes for the period of con- struetion on the portion of land to be occupied by the new wing. ‘The cost of mistakes made during construction. ‘The overhead costs ofthe maintenance depart: ‘ment that include supervision; depreciation on “Copyright © bythe President and Fellows of Harvard Collage: Harvard Business Scho ease 198-145. ‘buildings and equipment of maintenance de- partment shops; heat, Tight, and power for these shops; and allocations of cost for such items as the cafeteria, medical office, and persoonel department. 4. The cost of insurance during construction and the cost of damages or losses on any injuries or losses not covered by insurance. 2. Assume thatthe Archer Company bought a lage picee of land, including the buildings thereon, with ‘the intent of razing the buildings and constrocting ‘combined hotel and office building in their place, The existing buildings consisted of a theater and several stores and small apartment buildings all in active use atthe time of the purchase, & What accounting treatment should be accorded that portion ofthe purchase price considered 10 bbe the amount paid forthe buildings that are subsequently razed? b. How should the costs of demolishing the old buildings be treated? © Suppose that a single company had owned this large pice of land, including the buildings thereon, and instead! of selling to the Archer ‘Company had decided to hive the buildings rized and to have a combined hotel and office building constructed on the ste fr its own ben- fit In what respect, if any, should the account ‘ng treatment ofthe old buildings andthe cost of demolishing them differ from your recommen= dations with respect to (a) and (6) above? Why?3. Midland Manufacturing Company purehased a new ‘machine, Itis clear thatthe invoice price ofthe new ‘machine should be capitalized, and it also seems reasonable to capitalize the transportation cost 10 bring the machine to the Midland plant. 'm not so lear, however, om the following items. ‘4. The new machine is heavier than the old ma- chine it replaced; consequently, the foundation ‘under the machine has had to be strengthened by the installation of additional steel beams. ‘Should this cost be charged to the building, added tothe cost ofthe machine, or expensed? Why? 'b. The installation ofthe machine took longer and ‘as more costly than anticipated. In addition to time spent by the regular maintenance erew on insallaton, it became necessary to hire an out side engincer to assist in the installation and in “working out the bugs” to get the machine run- ring properly. His costs included not only his fee but also his transportation, hotel expense, and meals. Moreover, the foreman of the do- partment and the plant superintendent both ‘penta considerable amount of time assisting in the installation work. Before the new machine ‘was working properly large amount of mater- ial had been spoiled during trial runs. How should all ofthese costs be treated? Why? © In addition to the invoice price and transporta- tion, itwas necessary to pay a sate sales tax on ‘purchasing the machine. Is this part ofthe ma- chine's cost? Why? ‘4. In connection with payment for the new ma- chine, the machine manufacturer was willing t accept the Midland Company's old machine as partial payment. Theamount allowed asa trade- Jn was larger than the depociated vali at which the old machine was being carried inthe books ofthe Midland Company. Should the difference have boon tected as a reduction in the cost of the new machin ora gin on disposal ofthe old cone? Why? 4, A computer manufacturing company sold outright shout 25 percent of ts products (in terms of dolar volume) ad leased 75 perent. On averae,a given computer was leased forfour years. The cost of leased computers was initially recorded a an asset. and was deprecated over four years. The company fssined new customers in installing the computer ‘and in designing the related systems, These “appli cations engineering” services were furnished with ‘ont charge, and the company’s cost was reported as part of its marketing expense. Applications engi- ‘neering costs averaged about S percent ofthe sales value of a computer, but about 20 percent of the first-year rental revenue of a leased computer. Re- cently, the company’s installation of computers ‘grew rapidly. Because the applications engineering cost was such a high percentage of lease revenue, reported income did not increase at all. Research ‘and development costs must be expensed as in- curred, Doss the same principle apply to applica~ tions engineering costs, or could these costs be added 10 the asset value of leased computers and amortized over the lease period? If so, could other marketing costs related to leased computers be treated in the same way’? Why’? 5. An electronic component manufacturer announced a ‘pew product that would soon be available. This prod ‘ct a new generation component, had features highly sought by customers for their next generation of eloo- tronics products, To meet the demands of its eus- tomers, many of whom had beyun to impose quality standards on supplies, the electronics component ‘manufacturer would have to achieve aquaity standard ‘of 65 ppm, thats, 65 or fewer defective parts por mil- lion parts delivered tothe customer. ‘The equipment intended to produce the new com- ponent at the 65 ppm quality standard was custom- built by the manufacturer. Once the equipment was physically installed in the plant, the company per- formed extensive testing and debugging efforts to en- ‘sure thatthe components met the roguited standard A couple of months after installation, the new equipment ‘was producing components that, while comsnetcilly viable, did not quite meet the quality standard. A key ‘customer was eager to purchase the new componcet {or use in its own new product, however. The customer agreed to purchase the eomponent now ifthe electron jes component manufacturer would continue to push ‘to meet the quality standard. ‘Since the new manufacturing equipment was going {obeginto generate revenve, the fied aset accounting ‘manager reviewed the costs capitalized as part of this asset. The costs ofthe material, labor, and overhead r= ‘quired to fabricate and install the equipment had been capitalized. Inaddition, the debugging and testing costs incurred to attempt to bring the new manufacturing‘equipment to the 65 ppm quality standard had also been capitalized, as these costs had been required to ‘make the equipment ready for its intended use. The total costs were approximately one-half million dol- lars, and they would be amortized over the asset's pro ductive life beginning with production for the eager first customer. ‘The engineers believed that at least $50,000 of ad- ditional debugging, fine-tuning, and testing would be required for the new equipment to reach the 65 ppm quality standard. Should those costs continue to be capitalized, despite the fact that the equipment was producing components that were sold commercially? Why? If so, once the quality standard was achieved and the full cost of the asset was known, should the amount of depreciation forthe initial production peri= ‘ods be adjusted? Why? The 65 ppm standard was an extremely tough standard; the engineers who had de- signed the equipment were confident they could achieve it, although a few skeptics had expressed the ‘concern that the standard might never be achieved. ‘What implications, if any, might this have for capital- izing the cost of the asset? Explain, Question Answer the questions raised by Holtz in each of the five issues on her ist.