Study Session 9: Long Lived Assets
Intangible Assets Obtained in A Business Combination
The acquisition method is used to account for business combinations. Under this method, the purchase price is allocated to the identifiable assets and liabilities of the acquired firm on the basis of fair value. Any remaining amount is recorded as Goodwill. Only Goodwill created from a business combination is capitalized on the balance sheet, the costs of any internally generated good will are expensed as incurred.
Capitalizing - Cash Flow From Operations Effect
A capitalized expenditure is usually reported as an outflow in CFI. If immediately expensed however it is reported as an outflow from operation activities. Thus capitalizing an expenditure will result in higher CFO and lower CFI. Assuming no difference in tax treatment total cash flow will be the same.
Capitalizing - Shareholder's Equity Effect
Because capitalization results in higher NI in the period of the expenditure it also results in higher shareholders' equity. As the cost is allocated to the IS in subsequent periods it lowers SE. If the expenditure is immediately expensed, RE and SE will reflect the entire reduction in net income in the period of the expenditure.
Capitalizing - Net Income Effect
Capitalizing an expenditure delays the recognition of an expense in the income statement. Thus in the period that the expenditure is capitalized, the firm will report higher NI compared to immediately expensing. In subsequent periods however it will report lower NI. This process helps reduce the variability of NI. Over the life of the asset, total NI is the same it is simply a question of timing.
Capitalizing - Financial Ratios Effect
Capitalizing an expenditure initially results in higher assets and higher equity when compared to expensing. As such both the D-to-E and D-to-Assets ratios are lower with capitalization. Capping an expenditure will initially result in higher ROA and ROE due to the higher NI in the first year. Analysts must be careful when comparing firms because immediately expensing an expenditure gives the appearance of growth after the first year.
Intangible Assets Created Internally
Costs to create intangible assets are expensed as incurred. With the exceptions of R&D and Software Development Costs.
Depreciation
Depreciation is the systematic allocation of an asset's cost over time. - Carry (Book) Value: The Net value of an asset or liability on the BS. For PP&E etc its carrying value is its historical value - accum. dep. - Historical Value: The original purchase price of the asset including installation and transportation costs. An analysts job is to decide whether the reported depreciation expense is more or less than economic depreciation, the actual decline in value over the time period.
Change in Estimate
Firms can manipulate NI through the Dep Expense. A change in accounting estimate such as useful life or salvage value is put into effect in the current period and prospectively. The previous periods are not affected by the change.
Research And Development Costs
IFRS: Under IFRS Research costs, which are costs aimed at the discovery of new scientific or technical knowledge are expensed as incurred. Development costs are capitalized. Development costs are incurred to translate research findings into a plan or design of a new product or process. US GAAP: Under U.S. GAAP both research and development costs are generally expensed as incurred. One exception is software development costs.
Long Lived Assets Held For Sale
If a firm reclassifies a LLA as Held for Sale instead of Held For Use because they intend to sell it, the asset is tested for impairment. The asset is no longer amortized or depreciated. The asset is impaired if its carrying value exceeds its Net Realizable Value (FV - Selling Costs), and an impairment expense is booked with the asset is written down. For LLA held for sale the loss can be reversed under both US GAAP and IFRS.
Intangible Assets
LT Assets that lack physical substance (patents, brands, copyrights, franchises). Some have finite loves some are indefinite. The cost of a finite lived intangible asset is amortized over its useful life. Indefinite assets are not amortized, but tested for impairment annually. Intangible Assets are also considered either identifiable or unidentifiable. Under IFRS an identifiable asset must be: - Capable of being seperated from the firm. - Controlled by the firm. - Expected to provide future economic benefits. An unidentified intangible asset is one that cannot be purchased separately and may have an indefinite life. Most common example is Goodwill.
Derecognition
Occurs when assets are sold, exchanged or abandoned. If Sold - A Gain or Loss is booked on the IS (normally in other gains and losses). If Abandoned - No proceeds so carrying value is removed from the BS and a loss of that amount is recognized in the IS. If Exchanged - A gain or loss is computed by comparing the carrying value of the old asset with the fair value of the old asset. The carrying value of the old asset is removed from the BS and the new asset is recorded at its fair value.
Intangible Asset Amortization
Only intangible assets with finite lives are amortized over their useful lives. Same methods as Dep are used (SL, DDB, UOP). Estimating useful lives however gets complicated due to legal and regulatory reasons etc. Total amortization expense will be the same it again is only down to timing. Intangible assets with indefinite lives are not amortized, only tested for impairment annually.
IFRS Intangible Asset Disclosures
Similar to PP&E but firm must disclose whether the useful lives are finite or indefinite. For impaired assets the firm must also disclose: - Amount of impairment losses and reversals by asset class. - Where the losses and loss reversals are recognized in the income statement. - Circumstances that caused the impairment loss or reversal.
Software Development Costs
Software For Sale: Costs incurred to develop software for sale to others are expensed as incurred until the product's technological feasibility has been established, after which costs are capitalized under both IFRS and US GAAP. Judgement is involved in determining technological feasibility. Software For Firm Use: Under IFRS treatment is the same whether the software is developed for sale or for a firm's own use. Under US GAAP all R&D costs are capitalized when a firm develops software for its own use.
Depreciation Methods
Straight Line: Depreciation Expense = (Original Cost - Salvage Value) / Depreciable Life Double Declining Balance: DDB in year x = (2 / depreciable life in years) x book value at beg. of year x Units of Production Method: UOP Depreciation = [(orig. cost - salvage) / life output in units] x output units in the period.
Component Depreciation
Under IFRS firms are required to depreciate the components of an asset separately, requiring useful life estimates for each component. You compute Dep Expense for each individual component. This is allowed under US GAAP but rarely used.
IFRS PP&E Disclosures
Under IFRS the firm must disclose the following for each class of PP&E: - Basis for measurement (usually historical cost). - Useful lives or depreciation rate. - Gross carrying value and accum depreciation. - Reconciliation of carrying amounts from the beg. of the period to the end. Firm must also disclose: - Title restrictions and assets pledged as collateral - Agreements to acquire PP&E in the future. If Revaluation is used: - Revaluation Date - How Fair Value was determined - Carrying Value Using the Historical Cost Model
Impairments Under IFRS
Under IFRS, the firm must annually assess whether events indicate an impairment of an asset's value has occurred. As asset is impaired when its carrying value exceeds the recoverable amount. The recoverable about is the greater of its fair value (less any selling costs) and its value in use. The value in use is the PV of its future cash flow stream from continued use. If impaired the asset value is written down on the BS to the recoverable amount and an impairment loss of equal value is marked on the IS. This loss can be reversed if the asset recovers but the reversal is limited to the amount of the initial write down.
U.S. GAAP Disclosures
Under U.S. GAAP PP&E Disclosures Include: - Depreciation expenses by period. - Balances of major classes of assets by nature and function. - Accum. Depreciation by major classes or in total. - General description of dep methods used. Under U.S. GAAP the disclosure of Intangible Assets are similar to PP&E. In addition the firm must provide an estimate of amortization expense for the next 5 years. For Impaired Assets: - A description of the impaired asset - Circumstances causing impairment - How FV was determined - The amount of the loss - Where the loss is recognized in the IS.
Impairments Under US GAAP
Under US GAAP an asset is tested for impairment only when events and circumstances indicate the firm may not be able to recover the carrying value through future use. Two Steps: 1. Test for Impairment - Recoverability Test - As asset is impaired if carrying value is greater than the asset's future undiscounted cash flow stream. Based on estimates so there is considerable mgmt discretion. 2. Loss Measurement - If impaired the assets value is written down to fair value on BS (or discounted value of its future Cf if FV is not known) and an equal loss is recorded on the IS. Under US GAAP loss recoveries are not permitted.
Revaluation Model
Under US GAAP and IFRS most long-lived assets are reported on the BS at depreciated costs (original - accum. depreciation). however under IFRS there is an alternative called the revaluation model that allows long lived assets to be reported at fair values as long as active markets exist for the assets so their fair value can be reliably estimated. Rarely used in practice by IFRS firms. Gains and Losses are reported on the IS, however Gains in excess of original cost hit the shareholders equity statement under revaluation surplus.
Capitalized Interest
When a firm constructs an asset for its own use, the interest that accrues during the construction period is capitalized as a part of the asset's cost. This allows the firm to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset. The rate used to cap the interest is based on debt specifically related to the construction of the asset. If no construction debt is outstanding, the interest rate is based on existing borrowings (but only interest on the construction costs is capitalized, all interest costs in excess are simply expensed). Interest Coverage Ratio will be impacted (Increased) because capitalizing results in lower interest expense.
Capitalizing v. Expensing
When a firm makes an expenditure it can either capitalize the cost as an asset on the BS or expense the cost in the Income Statement. If the expenditure is expected to provide a future economic benefit over multiple accounting periods we capitalize it. The cost is then allocated to the IS over the life of the asset through depreciation expense. Any subsequent expenditures that add or rebuild the asset can be capitalized any thing that merely sustains its usefulness is expensed. Although it make make no operational difference, the choice between expensing and capitalizing will affect net income, shareholder's equity, total assets, cash flow and numerous financial ratios.