Chapter 4Asset Analysis

Importance of Financial Analysis in Asset values

1. According to accounting principles, assets should be valued on historical exchange price. This is not because of practicability but because of verifiability. So, the financial analysts make efforts to arrive at the real price of the assets.

2. Conservatism principle some times contradicts historical concept. It refers to: i. Lower of cost or market value for valuing inventories.ii. Estimation of expected receivable losses from uncollectible accounts.

Asset reporting challenges

• Criteria for Recognizing assets and Implementation challenges

First Criterion Resources are owned by the firm

Second Criterion Resources are expected to provide future benefits sufficient to recover their cost

Third CriterionThe future economic benefits are measurable with reasonable degree of certainty

Record an asset

Challenging transactions:

• Ownership of the resource is uncertain

• Future benefits from outlays are uncertain or difficult to measure

• Resources values have changed

Asset Reporting Challenges

• First Criteria: Resources are owned by the firm. The problem is that ownership of the resources are sometimes uncertain. For example, in case of lease who is the owner? Lessee or lesser? In case of training program, should this be viewed as an asset and amortized over the employees’ expected life with the firm or should they be expensed immediately? Accounting often suggests the later.

• Second Criteria: Resources are expected to provide future economic benefits sufficient to recover the cost. The problem is to estimate the future benefits of capital outlays which are uncertain. Uncertainty comes from technological change, strategy of competitors, as well as the change in customers’ choice. For example, receivable are net of uncollectible, future residual values, valuation of marketing and R&D, valuation of goodwill, patent etc.

• Third Criteria: Even if the future economic benefits are measurable with reasonable degree of certainty, the problem is that the resource value may have changed. Like valuation of financial resources and assets.

Challenge One: Ownership of Resources is uncertain

Example of Lease: Nature and Implication of operating and capital lease

Operating Leasei. For operating lease the rental value is expense in the income

statement. There is no implication in balance sheet. • Thus the profit figure goes down.

2. For capital Lease:i. Show the present value of all future payments as asset as well as

liability. ii. The interest amount of the liability becomes the expense in income

statement.iii. The depreciation of the asset becomes the expense in the income

statement• Thus the profit figure increases.

Case Study (p.4-3): In 1998, American Airlines to report as much as 42 percent of its fleet of aircraft as leased. The motivation is that management can write the lease terms in such a way that a transaction satisfies the definition of either an operating lease or capital lease.

Factors determining capital lease Under SFAS

(Statement of Financial Accounting Standard)

• Ownership of the asset is transferred to lessee at the end of lease term

• The lessee has the option to purchase at the bargaining price at the end of the lease term

• The lease term is 75% or more of the asset’s expected useful life, and

• The present value of the lease payments is 90% or more of the fair value of the asset.

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Problem: leaseGiven,• Annual Lease rental =$10,000• Lease Term = 5 years• Lessor’s implicit interest rate =8%• Lessee’s interest rate =8.25%• Useful life of asset =5 years• Residual value = removal costSolution to problem• The lease term is greater than 75% of the useful life of the asset,

and therefore, the lessee must capitalize the lease• The discount rate is 8% (the lower of the lessee’s interest rate and

lessor’s implicit interest rate)• The amount to be capitalized at inception of the lease is the present

value of 5 annual payments of $10,000, discounted at 8%.

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Journal entries of leaseThe following accounting entry is made at the inception:1/1/xx Capitalized lease properties (asset)

Capitalized lease obligation (liability)$39,930

$39,930At the end of the first year, the lessee will record an amortization (depreciation) expense of $7,986 ($39,930 divided by 5). The following accounting entry is made:12/31/xx Amortization (depreciation) expense

Capitalized lease properties (asset)$7,986

$7,986At the end of the first year, the lessee will have paid $10,000 to the lessor. The interest expense recorded equals the beginning of the year liability balance multiplied by the interest rate ($39,930x8%). The remainder of the $10,000 is recorded as a reduction in the liability.12/31/xx Interest expense

Lease liability Cash

$3,194.40$6,805.60

$10,000Notice that for capitalized leases, the interest payment will decrease each year as the liability balance decreases. The table below gives the amortization schedule.

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Amortization Schedule

Year Rental Payment

Interest Paid @8%

Principal Payment

Liability Balance Due

0 $39,930.00

1 $10,000 (39930*.08)

$3,194.40

(10000-3194.4)

$6,805.60

(39930-6805.6)

33,124.40

2 $10,000 (33124.4*.08)

2,649.95

(10000-2649.95)

7,350.05

(33124.4-7350.05)

25,774.35

3 $10,000 (25774*.08)

2,061.95

(10000-2061.95)

7.938.05

(25774.35-7938.05)

17,836.30

4 $10,000 (17836*.08)

1,426.90

(10000-1426.90)

8,573.10

(17836.3-8573.1)

9,263.20

5 $10,000 (9263*.08)

736.80

(10000-736.80)

9,263.20

(9263.20-9263.20)

0.00

Total $50,000 $10,070.00 $39,930.00

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Differences between operating and capital lease in expenses charged in the income statement

Operating Lease

expense

Capital Lease Expense

Year (Rental expense)

Amortization/Depreciation

Interest Total

amount

1 $10,000 $7,986 $3,194.40 $11,180.40

2 $10,000 7,986 2,649.95 10,635.95

3 $10,000 7,986 2,061.95 10,047.95

4 $10,000 7,986 1,426.90 9,412.90

5 $10,000 7,986 736.80 8,722.80

Total $50,000 $39,930 $10,070.00 $50,000.00

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Balance Sheet Effect of Lease Capitalization

Year 0 1 2 3 4 5

Assets

Leased assets (Gross) $39,930 $39,930 $39,930 $39,930 $39,930 $39,930

Accumulated Depreciation 0 7,986 15,972 23,958 31,944 39,930

Leased asset (Net) 39,930 31,944 23,958 15,972 7,986 0

Liability

Current portion of

lease obligation

6,806(Principal payable in year1)

7,350 (Principal payable in year 2)

7,938(Principal payable in year3)

8,573(Principal payable in year4)

9,263(Principal payable in year5)

0

Long term lease

obligation

33,124 (remaining)

25,774

(33124-7350)

17,836

(25774-7938)

9263

(17836-8573)

0 0

39,930 33,124 25,774 17,834 9,263 0

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Lessons from lease• Operating income is higher for capitalized leases than operating leases. Only

depreciation expense is deducted in capitalized leases, whereas the full rental expense is deducted for operating leases to arrive at operating income. Note that interest expense is a non-operating item.

• Net income is lower for capitalized leases than operating leases in early years and higher in later years of lease. Capitalized leases have higher expenses than operating leases in earlier years, and lower in later years as can be seen the prior table. If a company continuously enters into new leases at the same rate or an increasing rate the net income under operating leases will always be higher than under capitalized leases.

• Balance sheet implications: Capitalized leases result in the recognition of an asset and liability on the balance sheet. Operating leases do not affect the balance sheet.

• Financial Ratio Implications: Companies that capitalize leases, rather than treat them operating, will have lower liquidity, solvency and profitability ratios. The recognition of liabilities results in lower working capital and higher debt to equity ratios. The recognition of a liability also affects the interest coverage ratio – although operating income is higher for capitalizing firms their interest expense is also higher, normally resulting in lower interest coverage ratios. The higher level of assets results in lower asset turnover ratios and lower return on assets (the denominator effect dominates). Return on equity will also be lower as net income is lower in early years (numerator effect).

Challenge Two: Economic benefits are uncertain

• Valuation of goodwill becomes important in case of merger and acquisition. The problem is that the true value of goodwill is difficult to estimate and the life of goodwill to be amortized is indeed arbitrary. (Case: ABC Inc. takeover by Walt Disney in the next slide)

• Valuation of brand is difficult. Accounting likes to ignore the potential sales arising out of brand. But brand gives edge of reducing cost of marketing and higher price than competitors. (Case: Coke has a book value of equity of $8.4b against a market value of $165 billion. The difference is attributable to the value of coke’s brand.) Unlike in USA, firms have been permitted to report brand assets on their books in UK and Australia. This helps the operations of mergers and acquisitions.

• Deferred Tax Assets: Tax loss carried forward by Amazon.com in 1998 on its accumulated operating losses of $207 million gives rise to a future tax savings of $73.1 million. These carry forwards begin to expire in 2011. The challenge for financial reporting was to estimate what proportion of this asset was actually likely to be realizable.

Reporting controversy of Goodwill:Walt Disney acquisition

• Walt Disney acquired Capital Cities/ABC Inc. for $10.1 billion in cash and 155 million shares of Disney valued at $8.8 billion based on market price of stock. Disney estimated the fair value of ABC’s tangible assets at $4.0 billion and its liabilities at $4.3 billion. Should the difference between the $18.9 and the $0.3 billion of net liabilities be recorded as intangible assets on Disney’s books? If so what is the justification of the acquisition? Alternatively, should the $19.2 be written off? Prior to Disney’s offer, the market valued ABC’s equity at $9 billion. This implies that Disney paid more than 100% premium for ABC’s intangible assets. If the full acquisition price is to be shown as an assets, Disney’s management and auditors have to confident that this outlay is recoverable. But what makes ABC’s intangibles worth twice as much to Disney as they were prior to the company’s prior owners? Or did Disney overpay for Cap Cities/ABC implying that it is unlikely to recover the $19 billion in goodwill? Accounting in most of the countries require Disney to record the value of acquired tangible assets and liabilities at their fair value and show the full $19 billion of goodwill as an asset. After the acquisition, Disney is required under U.S. accounting to amortize the goodwill over maximum 40 years.

Challenge Three: Changes in Economic Benefits

• Changes in the value of operating assets. Appreciation in the values of operating assets (like receivables, inventories etc.) can not be shown according to accounting standard due to conservatism principle. The system in UK & Australia is different.

• Changes in financial instrument values: Motive is important for valuation. The motive can be: (1) Control (2) Short term investment and (3) Risk diversification. Valuation method varies depending on motives.

• Changes in values of foreign subsidiary: Asset values of the firm change with exchange rates. Such changes can be valued at historical cost or at current rate of exchange.

Valuation of Financial Instruments

1. Control

of

the

Firm

Ownership between 20% & 50%: Valuation based on equity

Ownership of more than 50% is considered a subsidiary. Assets are shown in the consolidated balance sheet. Goodwill recorded as the difference between acquisition and fair value of net assets. Subsequently amortized over 40 years.

2. Short term alternative to holding cash

1. Intend to sell: Fair value

2. Intend to hold to maturity: Cost

3. Used as a strategy to hedge changes in fair value of another item, or hedge fluctuations in expected future cash flows. Valuation: Fair value

What is the motivation for ownership of the financial assets

Common mistakes about asset accounting (Common Pitfalls)

• Since a resource has been purchased, it must be an asset – M & A, Goodwill

• The resource is not apparently paying off, so it is not an asset – accountants may be reluctant to record it as an asset or may be willing to write it off ASAP

• Resources purchased are assets, those developed are not – internally generated intangibles

• Market values are relevant only when the asset is sold – avoid economic loss by refraining from selling