chapter4-long lived assets

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


The calculation of depreciation requires three amounts for each

asset:

Cost.

Salvage Value.

Useful Life.

Depreciation Method


Factors in Computing Depreciation

Cost - Salvage Value

Useful life in periods

Depreciation

Expense per Year=

SL


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


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


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


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


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


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.


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


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?

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chapter4-long lived assets