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Business Strategy Using Financial Statements
Chapter 4Asset analysis—long-lived
asset and depreciation
Introduction to long-lived asset Long-lived assets are resources that are
used to generate operating revenues(or reduce operating costs) for more than one period.
It includes:• Tangible assets such property, plant and
equipment.• Intangible assets such as patents,
trademarks, copyrights and goodwill.• Deferred charges such as R&D expenditure
and nature resource.
Measuring the Carrying Amount of Long-lived Assets Expected benefits approach assets would be reflected at their
estimated value in a market where asset are sold(output market).
Economic sacrifices approach assets would be measured at their
estimated cost in a market where assets are purchased(input market).
Expected benefits approach This approach recognizes that assets are
valuable because of the future cash inflows they are expected to generate.
One example of this approach is discounted present value, where the value of an asset is measured as the discounted present value of future net operating cash inflows expected to be generated from using it.
Another variant of this approach reflects long-lived assets at their net realizable value-the amount that would be received if the asset were sold in the used asset market.
Economic sacrifices approach This approach measures the amount of
resources necessary to acquire an asset. One example of this approach is historical
cost-that is, the historical amount that was expended to buy the asset.
Another variant of this approach involves measuring the current(replacement) cost of the asset.
GAAP guideline GAAP uses historical cost-an economic sacrifices
approach-for measuring long-lived assets in almost all circumstances.
All costs necessary to acquire the asset and make it ready for use are included in the asset account.
GAAP capitalizes an expenditure on a long-lived asset when the expenditure causes any of the following conditions
Useful life-extended; Capacity-increased; Efficiency-increased; Any type of increase in the
future service potential value.
Long-Lived Asset
Capitalization—process of deferring a cost that is incurred in the current period and whose benefits are expected to extend to one or more future periods For a cost to be capitalized, it must meet each of the following criteria:
• It must arise from a past transaction or event
• It must yield identifiable and reasonably probable future benefits
• It must allow owner (restrictive) control over future benefits
Capitalization—process of deferring a cost that is incurred in the current period and whose benefits are expected to extend to one or more future periods For a cost to be capitalized, it must meet each of the following criteria:
• It must arise from a past transaction or event
• It must yield identifiable and reasonably probable future benefits
• It must allow owner (restrictive) control over future benefits
Capitalization
Asset impairment
If the asset’s remaining expected future value falls below its net book value, that asset is considered to have become impaired.
Measuring impairment includes two stages: (1) If the estimated future undiscounted
net cash flows expected from the use of the asset are lower than the carrying amount of the asset, then impairment has occurred.
(2) The amount of the impairment loss is the difference between the fair value of the asset and the carrying value of the asset.
Long-lived asset
Fair value of an asset FASB defines the fair value of an asset
as the amount at which the asset could be bought or sold in a transaction between willing parties.
When market prices are not available, fair value must be estimated using techniques such as discounted present values, price of roughly similar asset, and other available information.
Asset impairment
Long-Lived Asset
Two distortions arise from impairment: • Conservative biases distort
long-lived asset valuation because assets are written down but not written up
• Large transitory effects from recognizing asset impairments distort net income while potentially increasing the usefulness of asset values in the balance sheet
Two distortions arise from impairment: • Conservative biases distort
long-lived asset valuation because assets are written down but not written up
• Large transitory effects from recognizing asset impairments distort net income while potentially increasing the usefulness of asset values in the balance sheet
Asset Impairment
Long-Lived AssetDisposal
When a long-lived asset is disposed of , the difference between its net book value and the proceeds is treated a gain or loss.
1. Net book value is historical cost minus accumulated depreciation.
2. These gains and losses are reported as nonoperating gains and losses on the income statement
Property, Plant, and Equipment
Long-lived asset
Property, Plant, and Equipment as a percent of total assets
• Property
refers to cost of real estate;
Plant
refers to building and operating structures
Equipment
refers to machinery used in operation
0
10
20
30
40
50
60
70
Intangible assets Intangible assets are rights, privileges and
benefits of ownership or control. They include patents, copyrights, leaseholds,
goodwill and trademarks. The acquired intangible asset is recorded at the
cost including purchase price, legal fees and filing fees and is amortized over its expected useful life.
Internally generated intangibles such as R&D, advertising, training, it can not capitalize these costs
Noncurrent assetswithout physical
substance.
Noncurrent assetswithout physical
substance.
Useful life isoften difficultto determine.
Useful life isoften difficultto determine.
Usually acquired for operational
use.
Usually acquired for operational
use.
IntangibleAssets
Often provideexclusive rights
or privilegesbut high uncertainty.
Often provideexclusive rights
or privilegesbut high uncertainty.
Intangible Assets
Intangible AssetsAccounting for Intangible Assets
Manner of Acquisition
Purchased Developed Internally
Identifiable Capitalize Expense (with some intangible and amortize exceptions)
Unidentifiable Capitalize Expenseintangible and amortize
Amortize over shorter of economiclife or legal life, subject to a maximum of 40 years.
Use straight-line method.
Research and development costs arenormally expensed as incurred.
Intangible AssetsAccounting for Intangible Assets
Total cost,including
exploration anddevelopment,is charged to
depletion expenseover periods
benefited.
Extracted fromthe natural
environmentand reportedat cost less
accumulateddepletion.
Examples: oil, coal, gold
Plant Assets & Natural Resources
Natural Resources Natural resources (wasting assets)—rights to extract or consume natural resources
Allocation Allocation is the periodic assignment of
asset cost to expense over its expected benefit period.
Depreciation --applied to tangible fixed assets
Amortization—applied to intangible assets Depletion—applied to natural assets Three factors determine the cost
allocation amount—benefit period, salvage value and allocation method.
Depreciation is the process of allocating the cost of a plant asset to expense in the
accounting periods benefiting from its use.
Cost
AllocationAcquisition
Cost
(Unused)
Balance Sheet
(Used)
Income Statement
Expense
Depreciation
Plant Assets & Natural Resources
The calculation of depreciation requires three amounts for each
asset:
Cost.
Salvage Value.
Useful Life.
Depreciation Method
Plant Assets & Natural Resources
Factors in Computing Depreciation
Cost - Salvage Value
Useful life in periods
Depreciation
Expense per Year=
SL
Plant Assets & Natural Resources
Straight Line Depreciation Method
DepreciationPer Unit
= Cost - Salvage Value Total Units of Production
Step 1:
Step 2:
Depreciation Expense
=Depreciation
Per Unit×
Units Producedin Period
Activity (Units-of-Production) Method
Plant Assets & Natural Resources
Facts: Asset cost=$110,000; Useful life=10 years; Salvage value=$10,000
End of Accumulated BookYear Depreciation Depreciation Value
$110,0001 $ 10,000 $ 10,000 100,0002 10,000 20,000 90,000::9 10,000 90,000 20,00010 10,000 100,000 10,000
Plant Assets & Natural Resources
Straight-Line Depreciation Illustration
Step 1:
Step 2:
Double-declining-balance rate
= 2 ×Straight-line
depreciation rate
Step 3:
Depreciationexpense
=Double-declining-
balance rate×
Beginning periodbook value
Ignores salvage value
Straight-linedepreciation rate
= 100 % Useful life
Plant Assets & Natural Resources
Double-Declining-Balance Method
Depletion is calculated using theunits-of-production method.
Unit depletion rate is calculated as follows:
Total Units of Capacity
Cost – Salvage Value
Plant Assets & Natural Resources
Depletion of Natural Resources
Total depletion cost for a period is:Unit Depletion
Rate
Number of Units
Extracted in Period×
Totaldepletion
cost UnsoldInventory
Cost ofgoods sold
Plant Assets & Natural Resources
Depletion of Natural Resources
Comparing depreciation Differences in depreciation methods and
useful lives make valid comparison across firms difficult.
• While firms in the same industry often use the same depreciation methods, the estimated useful lives that they use are often different.
• Analysts, by making reasonable assumption, try to undo differences in depreciable lives in order to make more meaningful comparison.
Plant Assets & Natural Resources
Analyzing Depreciation and Depletion
• Assess reasonableness of depreciable base, useful life, and allocation method
• Review any revisions of useful lives• Evaluate adequacy of depreciation—ratio of depreciation to total
assets or to another size-related factors• Analyze plant asset age—measures include
Average total life span = Gross plant and equipment assets / Current year depreciation expense. Average age = Accumulated depreciation / Current year depreciation expense. Average remaining life = Net plant and equipment assets /
Current year depreciation expense.
Average total life span = Average age + Average remaining life
Valuation emphasizes objectivity of historical cost, the conservatism principle, and accounting for the monies invested; represent a company’s capacity to produce goods and services Limitations of historical costs: • Balance sheets do not purport to reflect market values • Not especially relevant in assessing replacement values • Not comparable across companies • Collection of expenditures reflecting different purchasing power
Plant Assets & Natural Resources
Valuation Analysis
Intangible AssetsValue Analysis
When an intangible assets is purchased from another organization, few new accounting or reporting issues arise.
The acquired intangible asset is recorded at the arm-length transaction price and is amortized over the shorter of its legal or expected useful life, not to exceed 40 years
Difficult financial reporting issues arise when intangible assets are developed internally
(1) Difficulties arise from the treatment of the expenditures that ultimately create the valuable intangible
(2) FASB requires that virtually all R&D expenditures be expensed as incurred
(3) When past cash outflows successfully create assets, the outflows have already been expensed and there are usually few remaining future outflows to capitalize
Exhibit 1To illustrate, assume the asset yields a constant income of $20,000 per year before depreciation . Straight-line depreciation yields an increasing bias in the asset’s rate of return as shown here:
End of Income before Net Beginning Year Return on
Year Depreciation Depreciation Income Book Value Book Value
1 $20,000 $10,000 $10,000 $110,000 9.1%
2 20,000 10,000 10,000 100,000 10.0
3 20,000 10,000 10,000 90,000 11.1
… … … … … ...
10 20,000 10,000 10,000 10,000 100.0
While increasing maintenance costs can decrease income before depreciation, they do not negate the overall effect of an increasing return over time. Certainly, an increasing return on an aging asset is not reflective of most business.
Exhibit 2: Adjust depreciation to achieve greater comparability across
firmsThis exhibit shows information extracted from
the 1996 annual report of UAL Corporation
Fixed Assets and Depreciable LivesUSL Corporation Balance Sheet Fixed Assets December 31
($ in millions) 1996 1995Operating property and equipment
Flight equipment $8,393 $7,778
Advances on flight equipment 943 735
Other property and equipment 2,989 2,700
12,325 11,213
Less-Accumulated depreciation and amortization 5,380 5,153
6,954 6,060
Capital leases—
Flight equipment 1,775 1,362
Other property and equipment 106 102
1,881 1,464
Less—Accumulated amortization 583 503
1,289 961
$8,243 $7,021
Exhibit 2: Adjust depreciation to achieve greater comparability across firmsThis exhibit shows information extracted from the 1996 annual report of UAL Corporation(continue)
Partial Footnote on operating Property and Equipment Aircraft are depreciated to estimated salvage values, gene
rally over lives of 10 to 30 years; buildings are depreciated over lives of 25 to 45 years; and other property and equipment are depreciated over lives of 3 to 15 years.
Selected incomes statement information Year Ended December 31($ in millions) 1996 1995Depreciation and amortization $759 $724Earnings before taxes, extraordinary item and cumulative effect of accounting change $970 $621
Fix assets and Depreciable LivesSouthwest Airlines Co.Balance Sheet Fixed Assets
($ in thousands) December 31Property and equipment, at cost 1996 1995Flight equipment $3,435,304 $3,024,702Ground property and equipment 523,958 435,822Deposits on flight equipment purchase contracts 198,366 323,864 4,157,628 3,784,388Less allowance for depreciation 1,188,405 1,005,081 $2,969,223 $2,779,307Footnote on property and equipment accounting policy Depreciation is provided by the straight-line method to residual
values over periods ranging from 12 to 20 years for flight equipment and 3 to 30 years for ground property and equipment.
Fix assets and Depreciable LivesSouthwest Airlines Co.Selected Income Statement information
Year Ended December 31($ in thousands) 1996 1995Depreciation $183,470 $156,771Income before income taxes and cumulative effect of accounting changes $341,362 $305,140 Comparison Analysis• Both companies depreciate all their long-lived assets usin
g the straight line method.• Difference: useful lives: Aircraft Ground equipment United 10-30years 3-15years Southwest 12-20years 3-30years
Depreciation comparison(cont.) Straight-line depreciation expense(SL) is computed as: SL=Gross PPE(less salvage value)/Average useful lives ($ in millions) Average useful lives Uni
ted: [(13263+11942)/2)]/759=16.6 Southwest [(3959+3461)/2]/183.5=20.2 Note: 8393+2989+1775+106=13263; 3435.3+524=3959 PPE excludes deposits and advances on flight equipment If use Southwest’s longer estimated useful life assumption, Uni
ted’s 1996 depreciation would fall by $135.1 and earning would rise by the same amount. This represents a pre-tax earnings increase of 14%.
Note: 12602/20.2=623.9 759-623.9=$135.1
Chapter quiz1. On Jan. 2, 1997, Reed Co. purchased a machine
for $800,000 and established an annual depreciation charge of $100,000 over an 8-year life. During 2000, after issuing its 1999 annual financial statements, Reed concluded that (1) the machine suffered permanent impairment of its operational value,(2) $200,000 is a reasonable estimate of the machine’s market value at the time of impairment, (3) the original useful life was still appropriate. In Reed’s Dec. 31,2000 B/S,the machine should be reported at a carrying amount of: a. $0; b. $100,000; c. $160,000; d. $400,000
Chapter quiz2.On Jan. 1,1999, Crater Inc. purchased equipment h
aving an estimated salvage value equal to 20% of its original cost at the end of its 10-year life. The equipment was sold Dec. 31, 2003 for 50% of its original cost. If the equipment’s disposition resulted in a reported loss, which of the following depreciation methods did Crater use ?
a. Straight –Line b. Double declining balancec. Sum-of-years’-digits d. Composite.
Chapter quiz3. The 1989 annual report of Haas, a chemical company, contains the fo
llowing footnotes:Land, buildings and equipment are carried at cost. Assets are depreciat
ed over their estimated useful lives. Effective Jan.1,1989, the company changed its method of depreciation for newly acquired buildings and equipment to the straight-line method. Buildings and equipment acquired before that date continue to be depreciated principally by accelerated methods. Maintenance and repairs are charged to earning; replacements and betterments are capitalized.
The changes had no cumulative effect on prior years’ earnings but did increase net earnings by $9 million, or $0.14 per share in 1989.
At Dec. 31, 1989, the gross book values of assets depreciated by accelerated methods totaled $1449 million and assets depreciated by the S-L method totaled $682 million.
Chapter quiz Explain why there was no
cumulative effect for the change in depreciation method
Discuss the effect of the change in depreciation method on the trend of future depreciation expense and net income
Chapter quiz 4. A firm purchases an asset for $10,000,000. Manage
ment forecasts that the asset will have an expected life of ten years and a salvage value of 5 percent. Please answer the following questions:
(1) What are the financial statement effects from recording depreciation for this asset in the first two years of its life if financial reporting depreciation is recorded under (a) the straight-line method, and (b) the double-declining balance method?
(2) As a financial analyst, what questions would you raise with the firm’s CFO about its depreciation policy?