Chapter 10 Accounting
The Commercial Substance Criterion
Booking exchange transactions at fair value introduces the possibility of gains (or losses) on the transaction. GAAP requires that the transaction must possess commercial substance. An exchange transaction has commercial substance when the firm's future cash flows are expected to change significantly as a result of the exchange. A significant cash flow change exists if either: The configuration (risk, timing, and amount) of the future cash flows of the asset(s) received differs significantly from the configuration of the future cash flows of the asset(s) transferred. The entity-specific value of the asset(s) received differs from the entity-specific value of the asset(s) transferred, and the difference is significant in relation to the fair values of the assets exchanged. If both conditions are not met, the transaction must be recorded using the book value of the asset(s) relinquished. This precludes any gain recognition.
In financial reporting, the cost to be allocated to periods is the asset's original historical cost minus its expected salvage value.
Computing depreciation requires the reporting entity to estimate three things: 1. The expected useful life (in years or units) of the asset. 2.The depreciation pattern that will reflect the asset's declining service potential. 3.The expected salvage value that will exist at the time the asset is retired
Research and Development (R&D)
Difficult financial reporting issues exist when the intangible asset is developed internally instead of being purchased from another company. These difficulties arise because it is uncertain whether current expenditures will ultimately lead to valuable patents or trademarks. The recoverability of research and development (R&D) expenditures is highly uncertain at the start of a project. Consequently, the GAAP requires that virtually all R&D expenditures be charged to expense immediately.
Expected Benefit Approach
Discounted PV, Net Realizable Value Estimated value in an OUTPUT market where the asset is SOLD.
Capitalization Criteria—An Extension
GAAP capitalizes such expenditures—that is, increases the carrying amount of a long-lived asset—when the expenditure causes any of the following conditions: The useful life of the asset is extended. The capacity of the asset is increased. The efficiency of the asset is increased. There is any other type of increase in the economic benefits (or future service potential) of the asset that results as a consequence of the expenditure. When the expenditure does not meet any of these conditions, it must be treated as a period expense and be charged to income. Routine equipment maintenance is one example.
Limits on the Amount of Interest Capitalized
GAAP limits the amount of interest that can be capitalized to the lower of (1) interest actually incurred or (2) avoidable interest.
Computing Avoidable Interest
GAAP requires capitalizing what are called avoidable interest payments on self-constructed assets; this interest is defined as that "could have been avoided . . . if expenditures for the assets had not been made."
economic sacrifice approach
Historical cost, replacement cost. Estimated value in an input market where the asset is purchased.
Tax Versus Financial Reporting Incentives
How costs are allocated between land and building affects the amount of income that will be reported in future periods. For tax purposes, the incentives for allocating costs between land and building asset categories are completely different because the objective of most firms is to minimize tax payments, not to "correctly" allocate costs. The higher the costs allocated to land for tax purposes, the higher the future taxable income becomes because land cannot be depreciated. However, U.S. income tax rules generally parallel financial reporting rules and require cost allocations between land and buildings that are similar to U.S. GAAP rules. The same is true for interest capitalization.
Impairments
IAS 36, "Impairment of Assets," provides the guidelines for impairments of long-lived tangible and intangible assets other than investment property measured at fair value. For tangible assets and amortizable intangible assets: Events that require an impairment review are similar to the U.S. GAAP events mentioned in Stage A. However, Stage C differs in that an impairment loss occurs if the carrying value exceeds the recoverable amount, defined as the higher of the asset's fair value (less costs to sell) and its value in use, which is the discounted net cash flows identified in Stage B. IFRS rules also permit reversals of previously recognized impairment losses when there has been a change in the estimates that were previously used to measure the loss. The reversal increases net income. IFRS accounting for indefinite-lived intangible assets is similar to GAAP.
Indefinite-Lived Intangible Assets
Indefinite-lived intangible assets must be evaluated for impairment at least annually. •A two-step evaluation process is allowed by GAAP: 1.Firm first assesses qualitative factors to determine whether it is necessary to perform a quantitative impairment test. •If based on this qualitative evaluation, management believes that it is more likely than not that an indefinite-lived intangible asset has been impaired, then it must go to the second step. 2.Perform a quantitative assessment by calculating the fair value of the intangible asset. If the book value of the asset exceeds the fair value, then the asset is considered impaired. The firm then reduces the book value of the asset to its estimated fair value and records a loss. The book value of the asset cannot be increased later if the fair value recovers.
Financial Analysis and Depreciation Differences
Most U.S. firms use straight-line depreciation for financial reporting purposes. •Nevertheless, making valid comparisons across firms is often hindered by other depreciation assumptions, especially differences in useful lives. •To improve comparisons of profitability of firms, an analyst could standardize the average useful life used to compute depreciation expense.
Long-Lived Assets
Operating assets expected to yield their economic benefits (or service potential) over a period longer than one year are called long-lived assets.
Computer Software Products
Prior to establishing the technological feasibility of a computer software product, companies are required to expense all R&D costs incurred to develop it. After technological feasibility is established, additional costs incurred to ready the product for general release to customers are supposed to be capitalized. The capitalization of additional costs ceases when the final product is available for sale.
Intangible Assets
Rights, privileges, and competitive advantages that result from the ownership of long-lived assets that do not possess physical substance. The category includes the following types of assets. Patents, Copyrights, Trademarks, Brand Names, Customer Lists, Licenses, Technology, Franchises, Employment Contracts
Exchanges of Nonmonetary Assets
Sometimes firms exchange one nonmonetary asset like inventory or equipment for another nonmonetary asset. Unless certain exceptions apply, the recorded cost of the acquired asset is the fair market valueof the asset given up.
Intangible Long-Lived Assets
The accounting under IAS 38 is similar to U.S. GAAP. Generally, acquired assets are carried at amortized cost. A revaluation method is allowed, but an active market must be available for the intangible. There is a difference regarding internally developed intangibles. Research is expensed. Some development expenditures may be capitalized.
The accounting for acquired intangible assets is straight-forward:
The acquired intangible asset is first recorded at the arm's length transaction price. Most acquired intangible assets are amortized (depreciated) on a straight-line basis over their expected useful economic lives and reviewed for impairment. Some intangible assets, known as indefinite-lived intangible assets, have indefinite lives and are not amortized. Instead, they are evaluated annually for impairment.
Depreciation
The costs of productive assets must be apportioned to the periods in which they provide benefits. Depreciation•Buildings•Equipment Amortization•Intangibles Depletion•Mineral deposits•Wasting assets
Depreciation: Double-Declining Balance Method
The depreciation rate for the double-declining balance (DDB) method is double the straight-line rate. Applying a constant DDB depreciation percentage to a declining balance will produce a book value at the end of the asset's economic life that is above or below the salvage value. •Apply twice the SL rate to the book value of the assets without subtracting the salvage value. •Once the DDB depreciation amount falls below what it would be with SL, a firm might use the straight-line method for the remaining years.
Long-Lived Asset Measurement Rules
The initial balance sheet carrying amount of a long-lived asset is governed by two rules: All costs necessary to acquire the asset and make it ready for use are included in the asset account; that is, they are capitalized costs. (Expenditures excluded from asset categories are "expensed" to income.) Joint costs incurred in acquiring more than one asset are apportioned among the acquired assets on a relative fair value basis or some other rational basis.
Depreciation: Straight-Line Depreciation Method
The straight-line (SL) depreciation method simply allocates cost minus salvage value evenly over the asset's expected useful life.
Depreciation: Sum=of-the-Years' Digits Method
The sum-of-the-years' digits (SYD) method is another accelerated depreciation method. It depreciates an asset to precisely its salvage value.
Depreciation: Units of Production Method
The units-of-production (UP) depreciation method allocates cost minus salvage over the expected units to be produced instead of the expected useful life.
Exchanges of Nonmonetary Assets, continued
To prevent a repeat of these abuses, the FASB issued rules that now require companies to record certain exchanges of nonmonetary assets at the existing book value of the relinquished asset if any of the following conditions apply: The fair value of neither the asset(s) received nor the asset(s) relinquished is determinable within reasonable limits. The transaction lacks commercial substance. The exchange transaction is made to facilitate sales to customers. Specifically, the transaction is an exchange of inventory or property held for sale in the ordinary course of business for other inventory or property to be sold in the same line of business.
Assets Held for Sale
When firms actively try to sell assets they own, the asset groups should be classified on the balance sheet as "held for sale". When assets are held for sale, they are reported at the lower of book value or fair market value minus costs to sell.
Disposition of Long-Lived Assets
When individual long-lived assets are disposed of before their useful lives are completed, any difference between the net book value of the asset and the disposition proceeds is treated as a gain or loss. Gain (loss) = Disposition proceeds - Book Value Gain (loss) = Disposition proceeds - (Cost - Accumulated Depreciation)
Comparison of IRFS and GAAP Long-Lived Asset Accounting
Although there are many similarities between U.S. GAAP and IFRS, numerous important differences exist. IFRS allows more choice in valuation models and has different specific guidance for issues such as depreciation and impairments. Tangible Long-Lived Assets IAS 16 allows two different models for tangible long-lived assets: Cost Method (same as U.S. GAAP)Revaluation Method - Asset is carried at a revalued amount reflecting fair market value at the revaluation date. Subsequent depreciation is based on fair value, not original cost. The amount of the write-up is credited to an owners' equity account called Revaluation Surplus (equivalent to Accumulated other comprehensive income).
Capitalization is restricted to interest arising from
actual borrowings from outsiders.
Measurement of the Carrying Amount of Long-Lived Assets
here are two ways that long-lived assets could be measured on balance sheets: Expected Benefit Approach and Economic Sacrifice Approach
Management Judgments and Impairments
•Impairment write-downs present managers another set of potential earnings management opportunities. •Auditors and other financial statement analysts should be alert to the potential use of write-offs opportunistically by managers.
•This adjustment process relies on several assumptions. •
•The salvage value proportions are roughly equivalent for all firms in the industry The useful life differences are artificial and do not reflect real differences in expected asset longevity. •The dollar breakdown within the asset categories are similar across the firms being compared.