Question

(Accounting for Self-Constructed Assets) Troopers Medical Labs, Inc., began operations 5 years ago producing stetrics, a new type of instrument it hoped to sell to doctors, dentists, and hospitals. The demand for stetrics far exceeded initial expectations, and the company was unable to produce enough stetrics to meet demand.

The company was manufacturing its product on equipment that it built at the start of its operations. To meet demand, more efficient equipment was needed. The company decided to design and build the equipment, because the equipment currently available on the market was unsuitable for producing stetrics.

In 2017, a section of the plant was devoted to development of the new equipment and a special staff was hired. Within 6 months, a machine developed at a cost of $714,000increasedproductiondramaticallyandreducedlaborcostssubstantially.Elatedbythesuccessofthenewmachine,thecompanybuiltthreemoremachinesofthesametypeatacostof$441,000 each.

Instructions

a. In general, what costs should be capitalized for self-constructed equipment?

b. Discuss the propriety of including in the capitalized cost of self-constructed assets:

(1) The increase in overhead caused by the self-construction of fixed assets.

(2) A proportionate share of overhead on the same basis as that applied to goods manufactured for sale.

c. Discuss the proper accounting treatment of the $273,000($714,000 − $441,000) by which the cost of the first machine exceeded the cost of the subsequent machines. This additional cost should not be considered research and development costs.

Short answer

a. The Troopers medical lab Inc. should charge materials and direct labor to the equipment account.

b. 1. Only the incremental costs should be charged.

2. Nothing should be capitalized more than the prevailing amount in the market.

c. The company should allocate the additional costs of $273,000 to all four machines.

Step-by-step solution

Meaning of Acquisition of cost

Acquisition costs areincurred to acquire new assets or a business. These costs can be incurred in three common ways: mergers and acquisitions, fixed resources, and client acquisition

(a) Explaining the cost that should be capitalized

The equipment account should be invoice for all materials and direct labor utilized in its construction. Importantly, no benefit of self-construction should be documented because this method contradicts the historical cost principle. The debate is about how indirect expenses, such as power, heat; light, insurance, and property taxes on manufacturing buildings need to be allocated. Below are the possible approaches.

(b1) Explaining the increase in overhead caused by the self-construction of fixed assets

Many pupils feel that the asset's cost should only include the variable overhead expenses that arise from the construction. This method implies that the company's fixed costs will remain the same whether the asset is built or not; hence allocating a portion of the constant overhead costs to the equipment will reduce current expenses and, as a result, overestimate current period income. As a result, only the additional expenses should be assessed.

(b2) Explaining the proportionate share of overhead on the same basis as that applied to goods manufactured for sale

Alternative (2) proponents say that such assets should be treated the same as inventory items, with all expenses allocated to them as if saleable things were being created. They argue that no special treatment should be given in cost allocation as long as appropriate information is provided to make the decision. They suggest overhead to permanent assets at regular intervals, comparable to allocating to joint goods and byproducts. Of course, no item should be capitalized at a higher rate than the current market rate.

(c) Explaining the proper accounting treatment

It might be argued that the $273,000 additional expenditures should be assigned to all four machines because development costs are typically greater on the first few units. The additional expenses should be expensed if they are related to inefficiency rather than development expenditures.