CHAPTER 10 LONG-LIVED ASSETS Presenter’s name Presenter’s title dd Month yyyy.

CHAPTER 10LONG-LIVED ASSETS

Presenter’s namePresenter’s titledd Month yyyy

Copyright © 2013 CFA Institute 2

COSTS THAT ARE CAPITALIZED AND COSTS THAT ARE EXPENSED WHEN INCURRED

• Long-lived assets (noncurrent assets or long-term assets)

- Assets that are expected to provide economic benefits over a future period of time, typically greater than one year.

- May be tangible (plant, property, and equipment, or PP&E), intangible, or financial assets.

• At acquisition, capitalize

- purchase price and

- expenditures necessary to prepare asset for intended use.

• Subsequent expenditures are

- capitalized if expected to provide benefits beyond one year (extend life or capacity).

- expensed otherwise.


ACQUISITION OF PP&E: EXAMPLE

Which of the following expenditures are capitalized?

• Related to purchase of towel and tissue roll machine: - €10,900 purchase price including taxes - €200 for delivery of the machine- €300 for installation and testing of the machine - €100 to train staff on maintaining the machine - €350 paid to a construction team to reinforce the factory floor and

ceiling joists to accommodate the machine’s weight

• Maintenance:- €1,500 for roof repair; expected to extend useful life of the factory by

5 years.- €1,000 for repainting exterior of the factory and adjoining offices;

repainting neither extends the life of factory and offices nor improves their usability.


ACQUISITION OF INTANGIBLE ASSETS

• Intangible assets:

- Assets lacking physical substance.

- Include items that involve exclusive rights, such as patents, copyrights, trademarks, and franchises.

• Accounting for an intangible asset depends on how it is acquired. We will consider three ways:

- Purchased in situations other than business combinations,

- Developed internally, and

- Acquired in business combinations.


ACQUISITION OF INTANGIBLE ASSETS

How Acquired Treatment at Acquisition

Intangible assets purchased in situations other than business combinations.

Recorded at fair value, which is assumed to be equivalent to the purchase price (same as long-lived tangible assets).

Intangible assets developed internally.

Generally expensed when incurred, although capitalized in some situations.

Intangible assets acquired in a business combination.

Identifiable assets are recorded at fair value.If acquisition price exceeds the sum of amounts allocable to individual identifiable assets and liabilities, the excess is recorded as goodwill.


INTANGIBLE ASSETS DEVELOPED INTERNALLY• Generally expensed when incurred, although capitalized in some

situations.

• IFRS

- Expenditures on research are expensed.

- Expenditures on development are capitalized.

• U.S. GAAP

- Generally, both research and development costs are expensed.

- For costs related to software development:

- Products for sale: Both research and development expenditures are expensed until technology feasibility is established; they are subsequently capitalized.

- Software for internal use: Both research and development expenditures are expensed until probable completion is demonstrated; they are subsequently capitalized.


INTANGIBLE ASSETS DEVELOPED INTERNALLY: EXAMPLE

Assume REH AG, a hypothetical company, incurs expenditures of €1,000 per month during the fiscal year ended 31 December 2009 to develop software for internal use.

Question: What is the accounting impact of the company being able to demonstrate that the software met the criteria for recognition as an intangible asset on 1 February versus 1 December?

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec


INTANGIBLE ASSETS DEVELOPED INTERNALLY: EXAMPLE

Assume REH AG, a hypothetical company, incurs expenditures of €1,000 per month during the fiscal year ended 31 December 2009 to develop software for internal use.

Question: What is the accounting impact of the company being able to demonstrate that the software met the criteria for recognition as an intangible asset on 1 February versus 1 December?

Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Expense €1,000Asset €11,000

Expense €11,000Asset €1,000


CAPITALIZE VERSUS EXPENSE: EFFECT ON FINANCIAL STATEMENTS

Item Balance SheetIncome

StatementStatement of Cash Flow

Costs that are capitalized

•At acquisition Increase assets

−−−−Investing cash

outflow

• Subsequently−−−− Expensed via

depreciation−−−−

Costs that are expensed when incurred

−−−−Immediately reduce net

incomeOperating cash

outflow

All else being equal,• Capitalizing results in higher profitability ratios (return on equity and net profit

margin) in the first year and lower profitability ratios in subsequent years. • Expensing will give the appearance of greater subsequent growth in profits.


DEPRECIATION METHODS

• Straight-line method: When the cost of the asset is allocated to expense evenly over its useful life.

• Accelerated method: When the allocation of cost is greater in earlier years.

• Units-of-production method: When the allocation of cost corresponds to the actual use of an asset in a particular period.

1 2 3 4 5 6 7 8 9 10

Depreciation Expense ($)

Useful Life of Asset

Accelerated

Straight-Line


CALCULATE DEPRECIATION EXPENSE: EXAMPLE

• At the beginning of Year 1, the company buys box manufacturing equipment for $2,300.

• Estimated residual value: $100.

• Estimated useful life: 4 years.

• For each year, what are the beginning and ending net book value (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses?


CALCULATE DEPRECIATION EXPENSE: STRAIGHT-LINE METHOD EXAMPLE

• At the beginning of Year 1, a company buys box manufacturing equipment for $2,300.

• Estimated residual value: $100, and estimated useful life: 4 years.

• For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses?

Beginning Net Book Value

Depreciation Expense

Accumulated Year-End

DepreciationEnding Net Book Value

Year 1 $2,300 $550 $550 $1,750Year 2 1,750 550 1,100 1,200Year 3 1,200 550 1,650 650Year 4 650 550 2,200 100

Year 1: Cost.Thereafter: Prior year ending book value.






Beginning Net Book

ValueDepreciation

Expense




(Cost – Residual value)/Useful life






Beginning Net Book

ValueDepreciation

ExpenseAccumulated Year-End Depreciation

Ending Net Book Value


Accumulated depreciation + Expense for year











Cost – Accumulated depreciation


CALCULATE DEPRECIATION EXPENSE: DOUBLE-DECLINING BALANCE METHOD EXAMPLE








Year 1 $2,300 $1,150 $1,150 $1,150Year 2 1,150 575 1,725 575Year 3 575 288 2,013 287Year 4 287 187 2,200 100

Year 1: Cost.Thereafter: Prior year ending book value











Beginning net book value × Depreciation rate until…


Beginning Net Book

ValueDepreciation







• For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expense?



SOONER, Inc.




DepreciationEnding Net Book

ValueYear 1 $2,300 $1,150 $1,150 $1,150Year 2 1,150 575 1,725 575Year 3 575 288 2,013 287Year 4 287 187 2,200 100




• For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expense?

Cost – Accumulated depreciation






Year 1 $2,300 $550 $550 $1,750Year 2 1,750 825 1,375 925Year 3 925 550 1,925 375Year 4 375 275 2,200 100

CALCULATE DEPRECIATION EXPENSE: UNITS-OF-PRODUCTION METHOD EXAMPLE



• Total estimated productive capacity: 800 boxes.

• Production in Years 1, 2, 3, 4: 200, 300, 200, and 100 boxes

Year 1: Cost.Thereafter: Prior year ending book value











• Production in Years 1, 2, 3, 4: 200, 300, 200, and 100 boxes.

Actual units produced × Per unit cost


Beginning Net Book

ValueDepreciation











Beginning Net Book

ValueDepreciation

Expense


DepreciationEnding Net Book

ValueYear 1 $2,300 $550 $550 $1,750Year 2 1,750 825 1,375 925Year 3 925 550 1,925 375Year 4 375 275 2,200 100






Cost –Accumulated depreciation


IMPACT ON RESULTS AND RATIOS

Method: The accelerated method, compared with the straight-line method, will result in

- Higher depreciation expense in earlier periods, so lower operating profit margin and operating return on assets (ROA) in the early periods and higher operating profit margin and operating ROA in the later periods.

- Lower average total assets in earlier periods and thus higher asset turnover ratio.

Assumptions:

- Longer useful life compared with shorter useful life: lower annual depreciation expense.

- Higher salvage value compared with lower salvage value: lower annual depreciation expense.


AMORTIZATION

• Amortization: Allocation of the cost of an intangible asset over its useful life.

• An intangible asset with an indefinite useful life is not amortized.

• An intangible asset with a finite useful life is amortized using the same methods as depreciation. Calculating amortization requires

- The original amount at which the intangible asset is recognized,

- The estimated length of its useful life, and

- The estimated residual value at the end of its useful life.


REVALUATION MODEL: PERMITTED UNDER IFRS

Revaluation model:

• Alternative to historical cost model permitted under IFRS.

• Long-lived assets measured at fair value.

• May be used only if the fair values of the assets can be measured reliably.

• Unlike historical cost, may result in increases or decreases in value of long-lived assets.

• May be used for some classes of assets while historical cost is used for other classes, but the same model must be applied to assets within a particular class.

• Permitted for intangible assets, but only if an active market for the asset exists.

• In practice, use of revaluation model is relatively rare for either tangible or intangible and is especially rare for intangibles.


REVALUATION MODEL: EXAMPLE• Assume a company has elected to use the revaluation model for an item of

machinery (the company’s only long-lived asset). The machine was purchased on the first day of the fiscal period, and measurement date occurs simultaneously with the company’s fiscal period-end.

• Cost to purchase machine: €10,000.

• At the end of the first fiscal period after acquisition, assume the fair value of the machine is determined to be €11,000. How will the company’s financial statements reflect the revaluation?

Answer

• The balance sheet shows

- The asset at a value of €11,000.

- A revaluation surplus (an equity component) of €1,000.

• Other comprehensive income: €1,000 increase in the value of the asset.

• No impact on profit and loss.


REVALUATION MODEL: EXAMPLE

• The cost to purchase a machine was €10,000. Fair value at the end of the first fiscal period was €11,000.

• At the end of the second fiscal period after acquisition, assume the fair value of the machine is determined to be €7,500. How will the company’s financial statements reflect the revaluation (total decrease in the carrying amount of the asset is €3,500 (€11,000 – €7,500)?

Answer

• Balance sheet

- Asset at a value of €7,500.

- Revaluation surplus (an equity component) of €0.

• Other comprehensive loss of €1,000, reversing previous increase in the value of the asset.

• In profit and loss (i.e., income statement), loss of €2,500.


REVALUATION MODEL: EXAMPLE 2

• Assume a company has elected to use the revaluation model for an item of machinery (the company’s only long-lived asset). The machine was purchased on the first day of the fiscal period, and the measurement date occurs simultaneously with the company’s fiscal period-end.

• Cost to purchase machine: €10,000.

• At the end of the first fiscal period after acquisition, assume the fair value of the machine is determined to be €7,500. How will the company’s financial statements reflect the revaluation?

Answer

• Balance sheet shows the asset at a value of €7,500.

• Profit and loss (i.e., income statement) shows a €2,500 loss.


REVALUATION MODEL: EXAMPLE 2

• The cost to purchase the machine was €10,000. Fair value at the end of the first fiscal period was €7,500.

• At the end of the second fiscal period after acquisition, assume the fair value of the machine is determined to be €11,000. How will the company’s financial statements reflect the revaluation (total increase in the carrying amount of the asset is €3,500 (€11,000 – €7,500)?

Answer

• Balance sheet shows

- The asset at a value of €11,000.

- A revaluation surplus (an equity component) of €1,000.

• Profit and loss (i.e., income statement): Profit of €2,500 reversing previous loss.

• Other comprehensive income of €1,000.


IMPAIRMENT

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

• In general, when an asset’s carrying amount is not recoverable:

- The carrying amount of the impaired asset is written down, and

- An impairment loss is recognized.

• IFRS vs. U.S. GAAP

- IFRS and U.S. GAAP define recoverability differently.

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


IMPAIRMENT: PP&E

• At the end of each reporting period, a company assesses whether there are indications of asset impairment (e.g., evidence of obsolescence, decline in demand for products, or technological advancements).

• If no indication of impairment, no test for impairment. • If there is an indication of impairment, test for impairment.

• Under IFRS, impairment loss is measured as the excess of carrying amount of the asset over its recoverable amount. - Recoverable amount: “The higher of its fair value less costs to sell and its

value in use.” - Value in use: Discounted expected future cash flows.

• Under U.S. GAAP- Assess recoverability: If not recoverable (carrying amount exceeds

undiscounted expected future cash flows), then measure impairment loss.- Impairment loss is measured as the excess of the carrying amount of the

asset over its fair value.


IMPAIRMENT OF PP&E: EXAMPLE

• Company has a machine used to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The following information pertains to the machine:

• Carrying amount £18,000

• Undiscounted expected future cash flows £19,000

• Present value of expected future cash flows £16,000

• Fair value if sold £17,000

• Costs to sell £2,000

What would the company report for the machine under IFRS versus U.S. GAAP?


IMPAIRMENT OF PPE: EXAMPLE

• A company has a machine used to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The following information pertains to the machine:







Recoverable amount: Higher of value in use and fair value less cost to sell.

Recoverable amount: £16,000Carrying amount: £18,000Impairment loss: £2,000


IMPAIRMENT OF PP&E: EXAMPLE

• A company has a machine used to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The following information pertains to the machine:







Recoverable?

Yes, it is recoverable because the amount of undiscounted expected future cash flows exceeds the carrying amount.

No impairment loss is recognized.


DERECOGNITION

• Derecognition of an asset: Remove it from the financial statements.

• Derecognition occurs when the asset is disposed of or is expected to provide no future benefits from either use or disposal.

• Disposal of a long-lived asset:

- Sale

- Gain or loss = Sales proceeds – Carrying amount of asset.

- Nonoperating gain or loss.

- Exchange

- Abandonment


DISCLOSURES ABOUT LONG-LIVED ASSETS

• Disclosures about long-lived assets appear throughout the financial statements.

• Balance sheet reports the carrying value of the asset.

• Income statement shows depreciation expense as a separate line item in some instances.

• Statement of cash flows:

- Acquisitions and disposals of fixed assets in the investing section

- Depreciation and amortization in the operating section

• Notes to financial statement:

- Accounting methods

- Amount of annual depreciation expense

- Range of estimated useful lives by main category of fixed asset

- Historical cost by main category of fixed asset

- Accumulated depreciation by main category of fixed asset


RATIOS USED IN ANALYZING FIXED ASSETS

• Fixed asset turnover ratio:

- Calculated as total revenue divided by average net fixed assets.

- Shows the relationship between total revenues and investment in PP&E.

- The higher this ratio, the higher the amount of sales a company is able to generate with a given amount of investment in fixed assets.

- A higher asset turnover ratio is often interpreted as an indicator of greater efficiency.

• Asset age ratios are broad indicators of a company’s need to reinvest in productive capacity.

- The average age of the asset base is estimated as the accumulated depreciation divided by the depreciation expense.

- The average remaining life of a company’s asset base is estimated as the net PP&E divided by the depreciation expense.

- The total useful life of PP&E is estimated as the total historical cost of PP&E divided by the annual depreciation expense.


ASSET AGE RATIOS

0

10

20

30

40

50

60

70

80

90

100

Historical cost($100)/Annual depreciation expense ($10) = Total useful life (10 years)

Accumulated depreciation ($30)/ Annual depreciation expense ($10) = Estimated age (3 years)

Net PP&E ($70)/ Annual depreciation expense ($10) = Estimated remaining life (7 years)

Historical cost: $100, estimated useful life: 10 years, estimated salvage value: $0.


INVESTMENT PROPERTY

IFRS

• Investment property is defined as property that is owned for the purpose of earning rentals or capital appreciation or both.

• Investment property can be valued using either a cost model or a fair value model.

- Cost model: Identical to PP&E.

- Fair value model: All changes in the fair value of the asset affect net income.

U.S. GAAP

• No specific definition of investment property.

• Most operating companies and real estate companies that hold investment-type property use the historical cost model.


LEASES

• Lease: Contract between the owner of an asset—the lessor—and another party seeking use of the asset—the lessee.

- The lessor grants the right to use the asset to the lessee.

- In exchange for the right to use the asset, the lessee makes periodic lease payments to the lessor.

• Advantages to leasing an asset compared with purchasing it:

• Leases can provide less costly financing, usually require little, if any, down payment, and are often at fixed interest rates.

• The negotiated lease contract may contain less restrictive provisions than other forms of borrowing.

• Leasing can reduce the risks of obsolescence, residual value, and disposition to the lessee.

• Certain types of leases have perceived financial reporting advantages.

• Lease accounting is currently a joint IASB/FASB project.


SUMMARY

• Expenditures related to long-lived assets are capitalized as part of the cost of assets if they are expected to provide future benefits and expensed otherwise.

• Capitalizing versus expensing an expenditure can significantly affect financial statements and ratios.

• Financial statements and ratios can be significantly affected by choice of depreciation/amortization method and by assumptions about useful life and residual value.

• IFRS (but not U.S. GAAP) permit the use of either the cost model or the revaluation model for the valuation of long-lived assets.

• Impairment charges reflect an unexpected decline in the fair value of an asset to an amount lower than its carrying amount.

• IFRS (but not U.S. GAAP) permit impairment losses to be reversed.

• Ratios used in analyzing fixed assets include the fixed asset turnover ratio and several asset age ratios.

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CHAPTER 10 LONG-LIVED ASSETS Presenter’s name Presenter’s title dd Month yyyy.

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