R30 Long Lived Assets

CFA® Level I - Financial Reporting and Analysis

Long-Lived Assets

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Contents

1. Introduction

2. Acquisition of Long-Lived Assets

3. Depreciation and Amortization of Long-Lived Assets

4. The Revaluation Model

5. Impairment of Assets

6. Derecognition

7. Presentation and Disclosures

8. Investment Property

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1. Introduction

• Long-lived assets are defined as those assets which are expected to provide future economic benefits extending more than one year

• These assets may be tangible, intangible, or financial assets

• Major questions: What value should be shown on the balance sheet?

How should the cost be allocated over the life of the asset?

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2. Acquisition of Long-Lived Assets

• Upon acquisition, long-term, tangible assets such as property, plant and equipment are recorded on the balance sheet at cost which is typically the same as fair value. Asset’s costs might include expenditures in addition to purchase price

Should these costs be expenses or capitalized?

• Intangible asset valuation depends on method of acquisition Developed internally

Purchased

Though a business acquisition

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Property, Plant, and Equipment

• At acquisition, PPE is recorded at cost Cost includes all expenditures necessary to get the asset ready for intended use

Subsequent costs are capitalized if they are expected to provide benefit beyond one year; otherwise they are expensed

• Companies might have different approaches towards expensing/capitalizing costs

• An analyst should understand the impact of expensing/capitalizing decisions on financial statements and ratios

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Effects of Capitalizing vs. Expensing

Capitalizing Expensing

Total Assets H L

Equity H L

Income variability L H

Net income (1st year) H L

Net income (later) L H

CFO H L

CFI L H

D/E L H

Interest Coverage (1st year) H L

Interest Coverage (later years) L H

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ExampleAcme Inc. purchased a machine for 10,000. In addition the following costs were incurred:

200 for delivery

300 for installation

100 to train staff on using the machine

1,000 to reinforce floor to support machine

500 to have the factory painted

1. Which expenses will be capitalized and which will be expensed

2. How will the treatment of these expenditures affect the company’s financial statements

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Capitalization of Interest Costs

• For constructed assets interest cost during construction are capitalized as part of the asset cost Use rate on borrowing related to construction; if no construction

debt is outstanding interest rate is based on existing unrelated debt

Capitalized interest not reported as interest expense on I/S

IFRS: interest on short-term lending offsets capitalized costs (not allowed in U.S. GAAP)

• Capitalized interest causes: Higher net income and greater interest coverage ratios during the

period of capitalization

Higher asset values and depreciation lead to lower net income, EBIT and interest coverage over subsequent periods

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ExampleA company borrows 2,000,000 at an interest rate of 5 percent per year on 1 January 2011 to finance construction of a factory that will have a useful life of 40 years. Construction is completed after two years, during which time the company earns 20,000 by temporarily investing the loan proceeds.

1. How much interest will be capitalized under IFRS and U.S. GAAP?

2. Where will the capitalized borrowing cost appear on the company’s financial statements?

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Intangible AssetsIntangible assets lack physical substance. Classic examples include software, customer lists, patents, copyrights and trademarks. Accounting for intangible asset depends on how it is acquired.

Acquired in a business combination Recorded at fair value; similar to long-lived tangible assets

Determination of fair value requires judgment

Purchased in situation other than business combinations Recorded at fair value

Developed internally Next slide

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Intangible Assets Developed Internally

• Under IFRS research costs are expensed as incurred and development costs are capitalized; U.S. GAAP requires both research and development costs to be expensed as incurred.

• Costs incurred to develop software for sale to others are expensed as incurred until product’s technological feasibility has been established; subsequent costs should be capitalized.

• Under IFRS costs incurred to develop software for internal use should be capitalized once feasibility established. U.S .GAAP: capitalize all development costs.


ExampleAcme Inc. starts an internal software development project on 1 January 2012. It incurs expenditures of 10,000 per month during the fiscal year ended 31 December 2012. By 31 March it is clear that product will be developed successfully and will be used as intended. How are the software development costs recorded before and after 31 March according to IFRS? According to U.S. GAAP?


3. Depreciation and Amortization of Long-Lived Assets

• Under the cost model of reporting long-lived assets, the capitalized cost of a tangible (intangible) long-lived asset is expensed through a process called depreciation (amortization)

• An asset’s carrying amount is the amount at which the asset is reported on the balance sheet; carrying amount is also called net book value Carrying amount = historical cost – accumulated depreciation

• Depreciation methods include Straight-line method: cost of asset allocated evenly over useful life

Accelerated methods

Units-of-production method


Example

Consider three companies with names based on their depreciation method:

1. Straight Line (SL) Inc.

2. Double Declining Balance (DDB) Inc.

3. Units of Production (UOP) Inc.

Each company purchases identical equipment for 10,000 and makes similar assumptions: estimated useful life = 4 years; residual value = 1,000; productive capacity = 1,000 units. Production over 4 years: 300, 300, 200, 100. Complete the table below for each company.


Beginning Net Book Value

Depreciation Expense

Accumulated Depreciation

Ending Net Book Value

Year 1

Year 2

Year 3

Year 4

Solution


Beg. Net Book Value Dep. Exp. Acc. Dep. End Net Book Value

Year 1 10,000 2,250 2,250 7,750

Year 2 7,750 2,250 4,500 5,500

Year 3 5,500 2,250 6,750 3,250

Year 4 3,250 2,250 9,000 1,000


Year 1 10,000 5,000 5,000 5,000

Year 2 5,000 2,500 7,500 2,500

Year 3 2,500 1,250 8,750 1,250

Year 4 1,250 250 9,000 1,000


Year 1 10,000 3,000 3,000 7,000

Year 2 7,000 3,000 6,000 4,000

Year 3 4,000 2,000 8,000 2,000

Year 4 2,000 1,000 9,000 1,000

Straight Line

Double DecliningBalance

Units of Production

Example (Continued)


Sales Op. Ex. (excluding depreciation)

Carrying Amount of total assets (excluding equipment)

Year 1 400,000 300,000 30,000

Year 2 400,000 300,000 30,000

Year 3 400,000 300,000 30,000

Year 4 400,000 300,000 30,000

Given the data below, compute the asset turnover ratio, operating profit margin and operating return on assets for SLD and DDB.

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Financial Statement Impact Summary

Straight Line Accelerated (DDB)

Depreciation expense Lower Higher

Net income Higher Lower

Assets Higher Lower

Equity Higher Lower

Return on assets Higher Lower

Return on equity Higher Lower

Asset turnover Lower Higher

Operating profit margin Higher Lower


The relationships indicated in the table below are for the early years of an asset’s life

Above relationships reverse in the later years if the firm’s capital expenditure decline

Component Method of Depreciation

• IFRS requires companies to use the component method of depreciationdepreciate each component separately

• U.S. GAAP allows component depreciation but the method is seldom used in practice

• Example: a machine has two major components. Component 1 costs $10,000 and has an estimated useful life of 10 years. Component 2 has a cost of $3,000 and has an estimated useful life of 3 years. What is the depreciation expense for the first year?


Amortization and Calculation of Amortization Expense

Amortization is similar in concept to depreciation. The term amortization applies to intangible assets, and term depreciation applies to tangible assets.

Intangible assets include customer lists, copyrights, patents and trademarks.

Intangible assets with finite useful lives are amortized over their useful lives.


4. Revaluation Model• The revaluation model is an alternative to the cost model for the

periodic valuation and reporting of long-lived assets.

• IFRS permit the use of either the revaluation model or the cost model

• U.S. GAAP does not allow revaluation model

• Revaluation changes the carrying amounts of classes of long-lived assets to fair value.

• Carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortization


ExampleScenario 1: Machine costs 10,000 at the start of Period 1. At the end of Period 1 the fair value of the machine is 12,000. At the end of Period 2 the fair value is 8,000. Show the impact on the financial statements.


ExampleScenario 2: Machine costs 10,000 at the start of Period 1. At the end of Period 1 the fair value of the machine is 8,000. At the end of Period 2 the fair value is 12,000. Show the impact on the financial statements.


5. Impairment of Assets

• Impairment charges reflect an unanticipated decline in the value of an asset.

• Both IFRS and U.S. GAAP require companies to write down the carrying amount of impaired assets.

• Impairment reversals are permitted under IFRS but not under U.S. GAAP.


Impairment Calculation


Under IFRS: Impairment loss = Carrying Value – Recoverable amount

Recoverable amount = greater of fair value less cost to sell and value in use

Value in use is present value of cash flow from asset

Under U.S. GAAP: First do the recoverability test to determine whether the asset is impaired. Asset is impaired if the carrying value is greater than the asset’s future undiscounted cash flows

Impairment loss = Difference between fair value and carrying amount

Example 9

ExampleGiven the following data, what is the reported value under IFRS and U.S. GAAP.

• Carrying amount = 8,000

• Undiscounted expected future cash flows = 9,000

• Present value of expected future cash flows = 6,000

• Fair value if sold = 7,000

• Costs to sell = 200


Other Impairment Scenarios


• Impairment of Intangible Assets with a Finite Life

• Impairment of Intangibles Assets with Indefinite Lives

• Impairment of Long-lived Assets Held for Sale

• Reversals of Impairments of Long-lived Assets

6. DerecognitionA company derecognizes an asset (i.e., removes it from the financial statements) when the asset is disposed of or is expected to provide no future benefits from either use or disposal.

A company may dispose of a long-lived operating asset by selling it, exchanging it, or abandoning it.

Gain or loss on sales = sales proceeds – carrying amount

Example 10


Long-Lived Assets Disposed of Other than by a Sale

• Abandoned Assets are treated like sale with 0 proceeds

Carrying value removed from balance sheet

Loss recognized in income statement

• Exchanged Assets

Carrying value removed from balance sheet

Record fair value of new asset

Gain/loss computed by comparing carrying value of old asset with fair value of new asset


7. Presentation and DisclosuresUnder IFRS, for each class of property, plant and equipment, a company must disclose the measurement bases, the depreciation method, the useful lives (or, equivalently, the depreciation rate) used, the gross carrying amount and the accumulated depreciation at the beginning and end of the period, and a reconciliation of the carrying amount at the beginning and end of the period.

Under U.S. GAAP the requirements are less exhaustive. A company must disclose the depreciation expense for the period, the balances of major classes of depreciable assets, accumulated depreciation by major classes or in total, and a general description of the depreciation method(s) used in computing depreciation expense with respect to the major classes of depreciable assets.


8. Investment Property

Investment property is defined as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rentals, capital appreciation, or both.

Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model. The cost model is identical to the cost model used for property, plant, and equipment, but the fair value model differs from the revaluation model used for property, plant, and equipment. Under the fair value model, all changes in the fair value of investment property affect net income.

Under U.S. GAAP, investment properties are generally measured using the cost model.


ExampleWhat is the treatment of unrealized gains and losses for AFS securities, assets valued using revaluation model, and assets valued using the fair value model?


Summary


• Acquisition

• Impact of Expense versus Capitalize Decision

• Depreciation and Amortization

Impact of different methods on financial statements and ratios

• Impairment

Conclusion

• Read summary

• Review learning objectives

• Examples

• Practice problems: good but not enough

• Practice questions from other sources


Documents

R30 Long Lived Assets