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Reading 26: Long-lived Assets (Depreciation Methods Can use Calculator…
Reading 26: Long-lived Assets
Capitalized Cost vs. Expensed Cost
Capitalized Cost
When the assets are expected to provide benefits over multiple periods.
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.
Spread an asset's cost over multiple periods, creating a balance sheet asset
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)
Expensed Cost
When the assets are expected to provide benefits over only 1 periods.
Take an asset's cost as an expense on the income statement in the current period
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
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
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
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
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
Depreciation Methods
Can use Calculator (check Manual)
Straight-line
Depreciation Expense = \(\frac{Historic.Cost-Salvage.Value}{Depreciable.Life}\)
Depreciable Life is measured in years
Equal expense amount each period.
Accelerated (Double-declining balance)
Higher depreciation expense early, lower in later year
\( Depreciation_{i}=\frac{2}{Depreciable.Life}\times Book.Value_{i}\)
Unit of Production
Expense based on percentage rather than time.
\(Expense_{i}=\frac{Historic.Cost-Salvage.Value}{Life_{Output.Unit}}\times Output.Unit_{i}\)
Depreciable Life is measured in amount of Unit Output
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
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
Asset revaluation, impairment & derecognition
Revaluation Model
GAAP vs IFRS
GAAP
does not allow upward revaluation
Cost model (depreciated historic cost)
IFRS allow firms to choose either cost model (i.e. Purchased Price - Accumulated Depreciation) or revaluation model
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
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
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.
Annually assess indications of impairment (e.g. decline in market value or physical condition)
GAAP
(2-step approach)
Subsequent recoveries are not allowed for assets held for use.
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
Asset impairment results in a loss in income statement.
No impact on cash flow until the disposal of asset.
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)
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.
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
Effects on financial statements
Impairment
decreases income, assets and equity;
lower current ROA and ROE (increase in future)
higher current Turnover, Debt-to-equity & Debt-to-asset ratio.
Upward Re-evaluation
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
Devaluation can result in either a gain (increase net income and asset) or loss (reduce net income & asset)
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
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
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
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.
Lessee treats like purchasing asset with debt: The lease is recorded in lessee's balance sheet and depreciated over its life.
Asset is added to lessee's balance sheet and depreciated overtime
For lessor
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.
Operating lease
For lessee
No asset/liability is recored on balance sheet.
Full lease payment is reported as rental expense (Income Statement) and CFO (Cash Flow Statement).
For lessor
Asset remains on lessor balance sheet.