Reading 26: Long-lived Assets

Capitalized Cost vs. Expensed Cost

Capitalized Cost

When the assets are expected to provide benefits over multiple periods.

Expensed Cost

When the assets are expected to provide benefits over only 1 periods.

Intangible Assets

Internally R&D

IFRS

Research cost (discovery of new knowledge and understanding) is expensed

Development cost (turn research findings into plan) is capitalized.

US. GAAP

Both R&D costs are expense, except for-sale softwares

Capitalization's effects
(spreading costs over the year)

First: Lower expense and higher net income, but subsequently increase.

First: Higher asset and equity, but subsequently decrease

First: Lower CFI and Higher CFO, but subsequently reverse

First: Higher ROE and ROA in initial period, and subsequently decrease.

First: Lower debt-to-asset and debt-to-equity ratios, but subsequently increase.

Depreciation Methods
Can use Calculator (check Manual)

Straight-line

Accelerated (Double-declining balance)

Unit of Production

Depreciation Expense = $\frac{Historic.Cost-Salvage.Value}{Depreciable.Life}$

Higher depreciation expense early, lower in later year

Equal expense amount each period.

$ Depreciation_{i}=\frac{2}{Depreciable.Life}\times Book.Value_{i}$

Asset revaluation, impairment & derecognition

Expense based on percentage rather than time.

$Expense_{i}=\frac{Historic.Cost-Salvage.Value}{Life_{Output.Unit}}\times Output.Unit_{i}$

Revaluation Model

GAAP vs IFRS

Asset Impairment

IFRS

Asset is impaired if its book value (historical cost - acc.depreciation) > recoverable amount.

Recoverable amount is the greater of (fair value - selling cost) and Value in use (present value of expected cash flow)

If impaired, asset is written down to the recoverable amount

Loss reversal is permitted UP TO historical cost.

GAAP
(2-step approach)

Subsequent recoveries are not allowed for assets held for use.

Asset impairment results in a loss in income statement.

No impact on cash flow until the disposal of asset.

Asset Derecognition
Discussion in MD&A

If asset is sold, the (sale proceeds - carrying value) is reported as a gain or loss in Income Statement.

If asset is abandoned, (sale proceeds = 0) the carrying value is removed from balance sheet and a loss is reported in Income Statement.

If asset is Exchanged (for another asset), the carrying value of old and new asset is compared, and a gain (loss) is recognized.

GAAP

Effects on financial statements

Impairment

Upward Re-evaluation

Devaluation can result in either a gain (increase net income and asset) or loss (reduce net income & asset)

Financial Presentation and Disclosure

What must be disclosed

Accumulated depreciation / amortization

Title restrictions and assets pledged as collateral.

(For impaired assets) the loss amount and reasons for such loss

(For revalued assets) (IFRS only) the revaluation date, how to determine fair value, and carrying value with historical cost model.

Carrying values for each asset class

Analysis

Fixed asset's Average age =$ \frac{Accumulated.Depreciation}{Annual. Depreciation.Expense}$

Total Useful Life =$ \frac{Historical.Cost}{Annual.Depreciation.Expense}$

Remaining Useful Life =$\frac{Ending.Net.PP\&E}{Annual.Depreciation.Expense}$

Investment Property

(IFRS): Investment property is property owned for renting out, or for capital appreciation, etc.

Firms account for Investment Property using

Increase in fair value of investment property above historical cost is recognized as gains in income statement.

Leasing

Capital (Finance) lease

For lessee

Lease interest payment and depreciation are recorded as expense in Income Statement.

On Cashflow Statement, the interest portion is recorded as CFO, principal portion as CFF.

Operating lease

For lessee

No asset/liability is recored on balance sheet.

Lessee treats like purchasing asset with debt: The lease is recorded in lessee's balance sheet and depreciated over its life.

For lessor

Full lease payment is reported as rental expense (Income Statement) and CFO (Cash Flow Statement).

Asset remains on lessor balance sheet.

Remove that asset from balance sheet, and replace it with Lease Receivables.

Record lease interest payment as interest income.

Record lease principal payment as the decrease in lease receivable.

Asset is added to lessee's balance sheet and depreciated overtime

Spread an asset's cost over multiple periods, creating a balance sheet asset

Take an asset's cost as an expense on the income statement in the current period

Subsequent expenditure is

Capitalized if provide benefits beyond 1 period

Expensed if provide benefits for only 1 period

Interest expense

Interest expense on funds, spent constructing a capital assets is capitalized as part of

asset's value on balance sheet (self-use)

asset's value in inventory (for sale to other)

(IFRS) Capitalized interest is reduced by any income on borrowings invested temporarily (nếu dùng phần tiền chưa giải ngân đi đầu tư đâu đó ra lãi, thì phần lãi đó bị trử vào phần interest được capitalized)

Intangible asset lack physical substance

Identifiable vs Unidentifiable

Identifiable intangible assets

Can be separated from, or controlled by, the firm

are expected to provide probable future benefits and their cost can be reliably measured

unidentifiable intangible assets

cannot be separated from the firm

Purchased Intangible Assets

Finite-lived intangible are amortized over their useful lives

Indefinite-lived intangibles are not amortized but tested for impairment

Software

For sale

IFRS & GAAP: expensed as incurred, until technological feasibility is established

For internal use

IFRS: same as for-sale

GAAP: capitalize all software development costs

purchased intangibles are recorded at cost

for group of assets, price paid is allocated based on fair value of each asset

assets from business acquisition are recorded at fair value

Variables

Historic cost: = purchase price + installation costs + transport costs

Accumulated depreciation = cumulative total of depreciation expensed to Income Statement

Net book value: the remaining carrying value in balance sheet

Depreciable Life is measured in years

Depreciable Life is measured in amount of Unit Output

Component Depreciation

Involves depreciating an asset based on the separate useful lives of its individual components (Example: airplane consists of interior that need to be depreciated separately)

Required under IFRS

Permitted under GAAP but seldom used

Effects on financial report
(at earlier year, situation reverses after time)

Depreciation expense: Straight-line < Accelerated

Net income: Straight-line > Accelerated

Assets: Straight-line > Accelerated

Equity: Straight-line > Accelerated

ROA: Straight-line > Accelerated

ROE: Straight-line > Accelerate

Turnover ratios: Straight-line < Accelerated

Cash-flow: SAME

Estimates

Longer useful life or higher salvage value reduces annual depreciation, thus increase net income, assets, equity

Shorter useful life or lower salvage value increases annual depreciation, thus reduce net income, assets, equity

Amortization

Spread asset's costs just as depreciation does, estimating useful lives may be more complicated

Intangibles with finite lives (e.g. patent that will expire) amortize over useful life, pattern should match consumption of benefits

Intangibles with indefinite lives (e.g. renewable trademark) No amortization, periodic impairment review

does not allow upward revaluation

Cost model (depreciated historic cost)

Revaluation model is periodic revaluation to fair value; active market for asset must exist, rarely used

Asset value is depreciated between revaluation dates, set to fair value at each revaluation date

IFRS allow firms to choose either cost model (i.e. Purchased Price - Accumulated Depreciation) or revaluation model

Asset revaluation
Remember to do double-entry

1st revaluation date

Fair value < Carrying value: loss to income statement

Fair value > Carrying value: gain to balance sheet, reported in equity as Revaluation Surplus

Subsequent revaluation dates

Fair value < Carrying value: Loss first reduces any revaluation surplus, further loss to income statement

Fair value > Carrying value: Gain first reverses any losses previously reported in income statement, further gains to equity as revaluation surplus

Annually assess indications of impairment (e.g. decline in market value or physical condition)

Assess only when there is indication that book value may not be recoverable through future use

Step 1: Identification of impairment

Asset is impaired when Book value > Asset's estimated future undiscounted cash flows

Step 2: Loss recognition

if impaired, write down asset to fair value (or discounted value of future cash flows if fair value unknown), recognize loss in income statement

Impairment of Assets Held-for-sale (IFRS & GAAP)

Asset is tested for impairment when transferred from held-to-use to held-for sale

Depreciation expense is no longer recognized

Asset is impaired if Book value > Net realizable value
Net realizable value = Fair value - selling costs

If impaired, write down asset to NRV

Loss reversals are allowed up to the original loss (IFRS and GAAP)

Assets are classified as held-for-sale once sales process commences - lower of carrying value or (fair value - sales costs)

Impacts of Derecognition

When asset is sold or exchanged

Carrying value removed from balance sheet

Cash or new asset added to balance sheet

Gain or loss reported on income statement

When asset is abandoned

Carrying value removed from balance sheet

Any loss reported on income statement

Increase assets (higher Net Book Value)

Increase Equity (revaluation gain)

No impact on net income (unless reversing a previous loss)

Decreases future net income (increased depreciation)

No impact on cash flow (revaluation is non-cash adjustment)

Ratios

Fixed-asset and total asset turnover ratios: DECREASE

Debt-to-equity ratio: DECREASE

ROA & ROE

Current year: DECREASE

Future years: DECREASE

decreases income, assets and equity;

lower current ROA and ROE (increase in future)

higher current Turnover, Debt-to-equity & Debt-to-asset ratio.

Analysis of Impairment
Analyst should recognize that

Past earnings have been overstated due to insufficient depreciation

Management has controls over timing of impairment recognition and size of impairment losses

Impairment involve judgement: potential earnings management

Cost model:

same as for PP&E (depreciated cost)

Must disclose depreciation method, useful lives, and fair value

Fair value model

Differ from revaluation model

All changes in value taken to income statement

Must disclose how fair value is determined