Question

Vedat Corporation acquires new equipment with a list price of $100 to expand its product line, paying $50 on delivery and agreeing to pay $25 in one year’s time and the remaining $25 in two years’ time. The company extends a portion of its factory wall in order to fit the new machine in place and then rearranges existing equipment into a more efficient layout. The new equipment is dropped on installation requiring repairs prior to use. At the end of the equipment’s useful life, Vedat Corporation is required to dismantle and dispose of it, paying a special environmental tax due to hazardous materials in its construction. Vedat is licensed to manufacture products with this equipment, and is required to pay a royalty for each unit produced.

Instructions

Discuss how the cost of the new equipment should be determined.

Answer 1

The cost of the machine shall include the following components :

Costs to be included in cost of machine :

1. 50$ should be straight away included in the cost of machine as it represents cash paid for machine on the current date.

2. 25$ each paid after a period of 1 & 2 years shall be discounted using a discount rate and then added to the value of machine. Difference between present value and original cost shall be recorded as finance cost.

For e.g Assuming discount rate to be 10%, cost to be included in cost of machine for 25$ paid after year 1 = 25*0.909 = 22.725$. Rest 25$-22.725$ = 2.275$ is to be recorded as finance cost

3. Cost on repairs required for installation of machine is also to be included as it represents expenses incurred to bring machine to it's present working condition.

4. Special environemental tax required to be paid at end of machine's life basically represents provision to be made for decommissioning/restoration which is also added in cost of machine.

Costs not to be included in cost of machine :

1. Cost to extend a portion of factory and rearranging current equipment is not to be inlcuded as it is not directly attributable to machine.

2. Royalty to be paid for each unit produced is not something which is related to machine and hence should be recorded as a separate royalty expense in Income Statement.