Question

Joe mason acquired land on which he will construct a new restaurant. A chemical plan had once occupied the site. Government regulations require Mason to clean up the chemical residue before building. The cost of clean-up is material.

Required:

a. Under current US GAAP, an asset is charged with historical cost, which includes the purchase price and all costs incident to getting the asset ready for its intended use. Defend the historical cost principles. Use the conceptual framework concepts and definitions in your defense.

b. How should Joe treat the cost of clean-up? Is it land cost, a building cost, or an expense? Explain.

Answer 1

ANSWER:

a.         Historical cost is the amount of cash, or its equivalent, paid to acquire an asset. It includes the purchase price and all cost necessary to acquire the asset and get it ready for its intended use. Use of historical cost presents the economic facts as they actually occurred. Thus, it is relevant and reliable. It is relevant because accountants are stewards to owners. The stewardship role implies that accountants must report how moneys invested are spent. This information is disclosed by historical prices paid to acquire assets. Historical cost is reliable because it is objective and verifiable. Historical exchange prices are objectively determinable and verifiable because they are based on evidence that an exchange has taken place and amounts are typically supported by a paper trail, e.g., invoices. Hence, they these measurements represent what they purport to represent and as such are represenationally faithful and neutral.

An asset is defined as an economic resource that has future benefit to the entity and results from prior transactions and events. The prior transaction resulting in its existence is the exchange that occurred when the asset was acquired. Those moneys were invested in the asset to provide economic benefit to the company. So long as the asset is in use, cost provides benefit. Hence, cost is a relevant attribute to report to investors, creditors, and other users.

b.         Under the present accounting model, the cost of cleanup would be considered cost of land. The cost of land includes its acquisition price and all costs incurred to get it ready for its intended use. In this example the intended use to have a building built on it. Since, the cleanup is necessary before building can begin, the cost of cleanup is a cost to get the land ready for its intended use and should be capitalized as land. Under this scenario the presumption is that the cleanup cost was necessary to acquire the asset, hence it provides future benefit. The cleanup itself provides value because without it the land is not usable as a building site, and would presumable be worth less. Hence, this expenditure fits the definition of an asset.