Problem
Cal Bikes Inc. has been experiencing growth in the demand for its products over the last several years. International road racing combined with the Olympics greatly increased the popularity of both recreational and competitive biking around the world. As a result, a sports retailing consortium entered into an agreement with Cal Bikes to purchase a full line of recreational bikes and other accessories on an increasing basis over the next 5 years.
To be able to meet the quantity commitments of this agreement, Cal Bikes had to obtain additional manufacturing capacity. A real estate firm located an available factory in close proximity to their current manufacturing facility, and Cal Bikes agreed to purchase the factory and used machinery from Walber Company on September 1, 2019. Renovations were necessary to convert the factory for Cal manufacturing use.
The terms of the agreement required Cal Bikes to pay Walber $100,000 when renovations started on January 1, 2020, with the balance to be paid as renovations were completed. The overall purchase price for the factory and machinery was $600,000. The building renovations were contracted to Bro Construction at $250,000. The payments made, as renovations progressed during 2020, are shown below. The factory was placed in service on January 1, 2021
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12/31/2020
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1/1/2020
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4/1/2020
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10/1/2020
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Walber
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$180,000
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$100,000
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$200,000
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$120,000
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Bro
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$100,000
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$100,000
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50,000
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On January 1, 2020, Cal Bikes secured a $750,000 line-of-credit with a 8% interest rate to finance the purchase cost of the factory and machinery, and the renovation costs. Cal Bikes drew down on the line-of-credit to meet the payment schedule shown above; this was Cal Bikes' only outstanding loan during 2020.
Cal Bikes will capitalize the maximum allowable interest costs for this project. Cal Bikes's policy regarding purchases of this nature is to use the appraisal value of the land for book purposes and prorate the balance of the purchase price over the remaining items. The building had originally cost Walber $200,000 and had a net book value of $120,000, while the machinery originally cost $160,000 and had a net book value of $60,000 on the date of sale. The land was recorded on Walbers' books at $50,000. An appraisal, conducted by independent appraisers at the time of acquisition, valued the land at $250,000, the building at $330,000, and the machinery at $110,000.
The company's chief engineer estimated that the renovated plant would be used for 20 years, with an estimated salvage value of $50,000. She estimated that the productive machinery would have a remaining useful life of 5 years and a salvage value of $5,000. Cal Bikes's depreciation policy specifies the 200% declining-balance method for machinery and straight-line method for the plant. One-half year's depreciation is taken in the year the plant is placed in service and one-half year is allowed when the property is disposed of or retired. Cal Bikes uses a 360-day year for calculating interest costs.
I. Determine the amounts to be recorded on the books of Cal Bikes as of December 31, 2020, for each of the following properties acquired from Trails Company. (i) Land. (ii) Buildings. (iii) Machinery.
II. Calculate Cal Bikes's 2021 depreciation expense, for book purposes, for each of the properties acquired from Trails Company.
III. Discuss the arguments for and against the capitalization of interest cost.