Long-lived Assets

What are the key testable concepts in the Long-lived assets reading?

- The effects of capitalization vs. expensing various costs on the balance sheet in the short and long term and how that affects various ratios - The impact of the different depreciation and amortization methods on the B.S. - Determining whether an asset is impaired and how to record impairment - The revaluation model under IFRS - Disclosure requirements for long-lived assets in IFRS vs. GAAP

How are costs to purchase intangible assets treated?

Just like tangible assets, Intangible assets that are purchased are added to the balance sheet at cost, which is usually fair value. Capitalizing an intangible asset vs. expensing it has the same effects as doing so with a tangible asset.

What is the revaluation model and when is it used?

Revaluation under IFRS thus occurs when FV increases/decreases in a period. An initial devaluation is reported as a loss in NI, decreasing shareholders' equity. Subsequent revaluations that increase FV are reported as a gain in the income statement. Any increase of an asset's value above its original, historical cost, is reported in shareholders' equity (not on the income statement). Upward revaluation: total assets ↑, equity ↑, dep exp ↑, profitability ↓ in subs. periods

What is the effect of capitalizing vs. expensing on shareholders' equity?

Because capitalization initially results in higher net income it will also result in higher retained earnings and thus higher shareholders' equity for the period. Both equity and liabilities increase to maintain the A= L + E accounting equation. In subsequent periods as we recognize depreciation expenses we will reduce net income, retained earnings, and shareholders' equity. Note that capitalizing results in smoother, less variable NI compared to expensing as well.

Why do we care about the age of a firm's assets and how do we estimate the average age of a firm's total assets?

Found in the footnotes of the financial statements, we use measures of asset age to analyze whether the company has old assets and will need to invest heavily in new equipment (i.e. NI is overstated & not reflective of future profitability) or if the company is losing a competitive advantage vs. a competitor who has invested heavily in new technology/equipment.

Why are the residual/salvage value and useful life estimates important?

As we've seen both the residual value and useful life of a long-lived asset forms a key part of calculating its depreciation expense. Manipulating either of them can affect depreciation expense and thus net income. Because they are considered changes in accounting estimates (not principles) there is no need to restate previous financial statements. - A longer useful life decreases annual depreciation & increases net income - A higher residual value estimate decreases depreciation & increases NI The opposite is of course also true. The age (average, relative, or average depreciable life)

What is depreciation?

Depreciation is the practice of allocating the cost of long-lived assets over the life of the asset. We use the term depreciation when talking about tangible assets, depletion for natural resources, and amortization when referencing intangible assets. - Most tangible assets are listed at carrying, or book value (cost + install/transport $) - PPE is carried on B.S. at historical cost - accumulated depreciation Depreciation is measured using either the straight-line or accelerated method. An analyst needs to understand whether the economic depreciation (actual decline in value of the asset) is higher or lower than the reported depreciation expense.

How do we calculate depreciation using the straight-line method? Compare & Contrast Straight-line and accelerated depreciation.

The accelerated depreciation method can be more appropriate when the asset generates more benefits in the early years of its economic life. The double-declining balance method (next card) is the most common example of an accelerated method. The straight-line method results in lower depreciation expense in the early years and thus higher net income. The reverse is true in the later years.

What are the declining balance and double declining methods of depreciation (DDB)? How do we calculate DDB?

The declining balance method applies a constant rate of depreciation to an asset's (shrinking) book value. The most common of the declining balance methods is the double-declining balance (DDB) method, which applies a 2x multiple of the straight-line rate to the declining balance. So if an asset's life is 20 years, the straight line rate is 1/20 5% and the DDB rate would be 2/20 = 10%.

What is the effect of capitalizing vs. expensing on cash flow from operations?

A capitalized expenditure is reported in the cash flow statement as an outflow from INVESTING activities. If we expense it, it is reported as an outflow from OPERATING activities. Total cash flow is the same. It is just the classification that changes. So: Capitalizing an expenditure results in higher operating CFs and lower investing CFs

What are long-lived assets?

A long-lived or long-term asset is an asset with a useful life of more than one year. Typically these are assets used in a firm's production such as PPE or intangible assets such as goodwill.

What is the effect of capitalizing vs. expensing on net income?

Capitalizing an expenditure delays the recognition of the expense in the income statement. This will increase net income in the earlier periods but decrease net income in later periods due to depreciation expenses. Overall it will also smooth out NI. Expensing an expenditure reduces net income in that period, however, net income in future periods will be higher than if the asset had been capitalized. Total net income will be unchanged, it is just the timing of the NI that is different.

What is the effect of capitalizing vs. expensing on financial ratios?

Capitalizing an expenditure results in higher assets and equity compared to expensing. This increases the denominator and: - LOWERS Debt/Assets - LOWERS Debt/Equity Higher net income will INITIALLY result in: - HIGHER ROE - HIGHER ROA After the first period this will reverse, ROA and ROE will be higher if the firm expensed the expenditure. This bump after the first year should be interpreted with care.

What is component depreciation?

Component depreciation refers to the fact that (under IFRS) a firm must list the depreciation of each component of an asset separately. So a building's plumbing, electrical, and structure all have different depreciation estimates. On the exam: Watch out for having to separately calculate depreciation for several components (often using different methods) and then add them up to get total depreciation.

What is derecognition and how does it show up on the income statement?

Derecognition is when a firm sells or otherwise removes a long-lived asset from its balance sheet. It is thus removing these assets from continuing operations. The difference between the selling price and the carrying value of the asset is reported as a gain or loss on the income statement, usually under other gains and losses. If computing CF from operations using the indirect method we would remove this G/L as it is not expected to reoccur and are deemed an investing cash inflow.

How is Goodwill accounted for?

Goodwill occurs in an acquisition situation. Goodwill=Purchase price−FV of identifiable assets Goodwill is considered an inseparable part of a business. Note that only Goodwill created from a business combination/acquisition is capitalized on a balance sheet. The cost of any internally generated Goodwill is expensed in the period it is incurred.

What is the impact of a long-lived asset being reclassified from held-for-use to held-for-sale?

If management intends to sell a long-lived asset and reclassifies it as held for sale the asset is immediately tested for impairment. If impaired the asset is then written down to net realizable value and the loss is recorded on the income statement. Note that BOTH IFRS and GAAP permit a held for sale asset to be revalued and the loss reversed if the value of the asset recovers in the future.

When does impairment occur? What causes an asset to be impaired? How is the treatment of an impaired asset different under IFRS & GAAP?

Impairment occurs when the carrying value > recoverable amount.Where the recoverable amount = the greater of FV - selling cost or value in use (which is the PV of future CFs under IFRS and the undiscounted future CFs under GAAP). Impairment is caused by: (1) changes in regulation/business climate, (2) declines in usage rate, (3) technology changes, or (4) significant forecasted decline in long-term profitability of the asset. IFRS requires assets to be tested for impairment annually. GAAP only tests for impairment when circumstances suggest the firm may not be able to recover its value through future use. If an asset is impaired the Balance Sheet value is recorded as the recoverable amount. The loss is recorded in the income statement and usually creates a deferred tax asset. Loss reversal (revaluation) is permitted under IFRS only up to the original historical cost (i.e. only up to the amount of the loss).

What are the financial statement and ratio effects of an asset impairment?

Income statement: Current income statement will include an impairment loss in income before tax from continuing operations. Net income will also be lower. Past income statements are not restated. Future net income will be higher as there will be lower asset value, and thus a smaller depreciation expense. Balance sheet: Long-term assets are reduced by the impairment. A deferred-tax asset is usually created (if there is a deferred tax liability we reduce it instead). Stockholders' equity is reduced as a result of the impairment loss included in the income statement. Ratios - Current and future fixed-asset turnover will increase (b/c of lower fixed assets). - Debt-to-equity will be lower (since stockholders' equity goes down) - Debt-to-assets will be higher (since assets go down) - Cash flow based ratios will remain unaffected (this is all non-cash). - Future ROA and ROE will increase (less depreciation) - Past ratios that evaluated fixed assets and depreciation policy are distorted by impairment write-downs.

What are intangible assets? How are they treated w.r.t. to amortization? What is the difference between an identifiable intangible asset and an unidentifiable intangible asset?

Intangible assets are long-term assets that do not have any physical substance. This includes patents, brand, and copyrights. The most common example on the exam is goodwill. Intangible lives may have finite or infinite lives. We amortize the cost of a finite-lived intangible asset over its useful life. Indefinite-lived intangible assets are not amortized. Instead we test them for impairment (at least annually). If impaired the loss is recognized immediately in the income statement. An intangible asset is "identifiable if it: Can be separated from the firm Arises from a contractual/legal right Is controlled by the firm Is expected to have future economic benefits that are probable/measurable An intangible asset "unidentifiable if: Cannot be purchased separately May have an indefinite life Goodwill is prime example

What is capitalized interest and when does a firm capitalize interest?

Interest cost is capitalized when an asset is constructed for a firm's internal use (or for resale in limited circumstances). Basically the interest accrued during the construction period is added to the total cost of the asset in order to better measure the true cost of building the asset. Note ONLY interest related to that construction is capitalized, general firm-wide interest is still expensed. The interest rate used is based on the project interest rate, or on existing unrelated borrowings if no rate is available. Capitalized interest is reported in the cash flow statement as an outflow from investing activities NOT on the income statement. Interest coverage ratio (EBIT/interest expense) may need to be adjusted to include the capitalized interestt expense. IFRS only: Can apply any income earned by investing the borrowed funds against the cost of the carried interest

What is investment property and how can it be classified?

Investment property is defined as property owned for the purpose of earning income (rent), capital appreciation, or both. Investment property can be accounted for using either the historical cost method or the fair value model (but not both). Fair value model:UNLIKE the revaluation model under IFRS for non-investment property, any gains in the fair value of investment property above its historical cost ARE recognized in the income statement.

How do the different depreciation methods impact the financial statements, ratios, and taxes in the early years vs. later years?

Straight-line depreciation - Steady income stream, tax expense and ratios. ROA ↑ over time Per unit of production - Produce a variable depreciation expense and more varied net income. May be more reflective of production-to-cost (matching principle). Declining balance - Income will be lower in the first years, meaning taxes will be lower and CFO will be higher. ROA will be much higher over time.

How do we calculate depreciation using the units-of-production method?

The units of production method calculates depreciation based on asset usage instead of time. Depreciation expense is thus higher in periods where the asset is used more. One of the drawbacks of this method is that if demand for the product slows depreciation expense also decreases, which can lead to overstating reported income and asset value. Most often used when calculating the depletion rate of a natural asset.

What does it mean to capitalize vs. expense an asset? When do we use the different methods?

What: Capitalizing the cost of an asset means adding it to the balance sheet as an asset and then allocating the depreciation cost of the asset on the income statement over the life of the asset (or amortizing it for an intangible asset w/ a finite life). The exception is land and goodwill which are assumed to have indefinite lives. Once an asset is capitalized maintenance expenses are expensed whereas expenses geared towards providing future economic benefits are capitalized. Expensing an asset means recording it as an expense on the income statement in the period in which it is incurred. When: In general we capitalize an asset if it is expected to provide economic benefits over multiple accounting periods and we expense an asset if its benefit is highly uncertain or its benefit is highly uncertain.

How are costs to create intangible assets treated under IFRS/GAAP?

With a few noteworthy exceptions most costs to create an intangible asset are expensed. The exceptions relate to R&D and software development costs. Under IFRS: Research costs are expensed as incurred Development costs may be capitalized Under GAAP: Both Research and Development costs are expensed as incurred GAAP & IFRS: Exception is Software development costsCosts expensed as incurred until feasibility established then the costs may be capitalized