Book 3 - FRA - Long-Lived Assets Flashcards
Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred.
When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement in the period incurred. As a general rule, an expenditure that is expected to provide a future economic benefit over multiple accounting periods is capitalized; however, if the future economic benefit is unlikely or highly uncertain, the expenditure is expensed in the period incurred.
An expenditure that is capitalized is initially recorded as an asset on the balance sheet at cost, typically its fair value at acquisition plus any costs necessary to prepare the asset for use. Except for land and intangible assets with indefinite lives (such as acquisition goodwill), the cost is then allocated to the income statement over the life of the asset as depreciation expense (for tangible assets) or amortization expense (for intangible assets with finite lives).
Alternatively, if an expenditure is immediately expensed, current period pretax income is reduced by the amount of the expenditure.
**Once an asset is capitalized, subsequent related expenditures that provide more future economic benefits (e.g., rebuilding the asset) are also capitalized. **
Capitalization & Net Income.
Capitalizing an expenditure delays the recognition of an expense in the income statement. Thus, in the period that an expenditure is capitalized, the firm will report higher net income compared to immediately expensing. In subsequent periods, the firm will report lower net income compared to expensing, as the capitalized expenditure is allocated to the income statement through depreciation expense. This allocation process reduces the variability of net income by spreading the expense over multiple periods.
Conversely, if a firm expenses an expenditure in the current period, net income is reduced by the after-tax amount of the expenditure. In subsequent periods, no allocation of cost is necessary. Thus, net income in future periods is higher than if the expenditure had been capitalized.
Capitalization and Shareholders’ Equity.
Because capitalization results in higher net income in the period of the expenditure compared to expensing, it also results in higher shareholders’ equity because retained earnings are greater. Total assets are greater with capitalization and liabilities are unaffected, so the accounting equation (A = L + E) remains balanced. As the cost is allocated to the income statement in subsequent periods, net income, retained earnings, and shareholders’ equity will be reduced.
If the expenditure is immediately expensed, retained earnings and shareholders’ equity will reflect the entire reduction in net income in the period of the expenditure.
Capitalization and Cash Flow From Operations.
A capitalized expenditure is usually reported in the cash flow statement as an outflow from investing activities. If immediately expensed, the expenditure is reported as an outflow from operating activities. Thus, capitalizing an expenditure will result in higher operating cash flow and lower investing cash flow compared to expensing. Assuming no differences in tax treatment, total cash flow will be the same. The classification of the cash flow is the only difference.
Recall that when an expenditure is capitalized, depreciation expense is recognized in subsequent periods. Depreciation is a noncash expense and, aside from any tax effects, does not affect operating cash flow.
Capitalization and Financial Ratios.
Capitalizing an expenditure initially results in higher assets and higher equity compared to expensing. Thus, both the debt-to-assets ratio and the debt-to-equity ratio are lower (they have larger denominators) with capitalization.
Capitalizing an expenditure will initially result in higher return on assets (ROA) and higher return on equity (ROE). This is the result of higher net income in the first year. In subsequent years, ROA and ROE will be lower for a capitalizing firm because net income is reduced by the depreciation expense.
Because an expensing firm recognizes the entire expense in the first year, ROA and ROE will be lower in the first year and higher in the subsequent years. After the first year, net income (numerator) is higher, and assets and equity (denominators) are lower, than they would be if the firm had capitalized the expenditure.
*Analysts must be careful when comparing firms because immediately expensing an expenditure gives the appearance of growth after the first year. *
Capitalized Interest.
When a firm constructs an asset for its own use or, in limited circumstances, for resale, the interest that accrues during the construction period is capitalized as a part of the asset’s cost. The reasons for capitalizing interest are to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset. The treatment of construction interest is similar under U.S. GAAP and IFRS.
The interest rate used to capitalize interest is based on debt specifically related to the construction of the asset. If no construction debt is outstanding, the interest rate is based on existing unrelated borrowings. Only interest on the construction costs is capitalized; interest costs are expensed on general corporate debt in excess of project construction costs.
Capitalized interest is not reported in the income statement as interest expense. Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use), or COGS (if the asset is held for sale).
Financial Statement Effects of Capitalizing vs. Expensing.
What are intangible assets, identifiable intangible asset and unidentifiable intangible asset?
The cost of a finite-lived intangible asset is amortized over its useful life. Indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually. If impaired, the reduction in value is recognized in the income statement as a loss in the period in which the impairment is recognized.
Intangible assets are also considered either identifiable or unidentifiable. Under IFRS, an identifiable intangible asset must be:
- Capable of being separated from the firm or arise from a contractual or legal right.
- Controlled by the firm.
- Expected to provide future economic benefits.
An unidentifiable intangible asset is one that cannot be purchased separately and may have an indefinite life. The most common example of an unidentifiable intangible asset is goodwill. Goodwill is the excess of purchase price over the fair value of the identifiable assets (net of liabilities) acquired in a business combination.
Not all intangible assets are reported on the balance sheet. Accounting for an intangible asset depends on whether the asset was created internally, purchased externally, or obtained as part of a business combination.
Compare the financial reporting of purchased intangible assets.
Like tangible assets, an intangible asset purchased from another party is initially recorded on the balance sheet at cost, typically its fair value at acquisition.
If the intangible asset is purchased as part of a group, the total purchase price is allocated to each asset on the basis of its fair value. For analytical purposes, an analyst is usually more interested in the type of asset acquired rather than the value assigned on the balance sheet.
The financial statement effects of capitalizing intangible assets are the same as the effects of capitalizing other expenditures. Capitalizing results in higher net income in the first year and lower net income in the subsequent years. Similarly, assets, equity, and operating cash flow are all higher when expenditures are capitalized.
Compare the financial reporting of internally created intangible assets.
Research and development costs. Under IFRS, research costs, which are costs aimed at the discovery of new scientific or technical knowledge and understanding, are expensed as incurred. However, development costs are capitalized. Development costs are incurred to translate research findings into a plan or design of a new product or process.
Under U.S. GAAP, both research and development costs are generally expensed as incurred. One exception is software development costs.
Software development costs. Costs incurred to develop software for sale to others are expensed as incurred until the product’s technological feasibility has been established, after which costs are capitalized under both IFRS and U.S. GAAP. Judgment is involved in determining technological feasibility.
Under IFRS, treatment is the same whether the software is developed for sale or for a firm’s own use. Under U.S. GAAP, all research and development costs are capitalized when a firm develops software _for its own use. _
Compare the financial reporting of intangible assets obtained in a business combination.
The acquisition method is used to account for business combinations. Under the acquisition method, the purchase price is allocated to the identifiable assets and liabilities of the acquired firm on the basis of fair value. Any remaining amount of the purchase price is recorded as goodwill. Goodwill is said to be an unidentifiable asset that cannot be separated from the business itself.
Only goodwill created in a business combination is capitalized on the balance sheet. The costs of any internally generated “goodwill” are expensed in the period incurred.
What is depreciation, book value and Historical Cost?
Depreciation is the systematic allocation of an asset’s cost over time. Two important terms are:
- Carrying (book) value. The net value of an asset or liability on the balance sheet.For property, plant, and equipment, carrying value equals historical cost minus accumulated depreciation.
- Historical cost. The original purchase price of the asset including installation and transportation costs. Historical cost is also known as gross investment in the asset.
Depreciation is a real and significant operating expense. Even though depreciation doesn’t require current cash expenditures (the cash outflow was made in the past when the asset was purchased), it is an expense nonetheless and cannot be ignored.
What is component depreciation?
IFRS requires firms to depreciate the components of an asset separately, thereby requiring useful life estimates for each component. For example, a building is made up of a roof, walls, flooring, electrical systems, plumbing, and many other components. Under component depreciation, the useful life of each component is estimated and depreciation expense is computed separately for each.
Component depreciation is allowed under U.S. GAAP but is seldom used.
Describe the different amortization methods for intangible assets with finite lives, the effect of the choice of amortization method on the financial statements, and the effects of assumptions concerning useful life and residual value on amortization expense.
Only intangible assets with finite lives are amortized over their useful lives. Amortization is identical to the depreciation of tangible assets. The same methods, straight-line, accelerated, and units-of-production, are permitted. Likewise, it is necessary to estimate useful lives and salvage values. However, estimating useful lives is complicated by many legal, regulatory, contractual, competitive, and economic factors that may limit the use of the intangible assets.
As with depreciation, the total amount of amortization is the same under all of the methods. Timing of the amortization expense in the income statement is the only difference.
Intangible assets with indefinite lives are nor amortized. Rather, they are tested for impairment at least annually. Goodwill created as a result of a business combination is a common example of an unidentifiable intangible asset with an indefinite life.
Describe the revaluation model.
Under U.S. GAAP, most long-lived assets are reported on the balance sheet at depreciated cost (original cost less accumulated depreciation and any impairment charges) .
There is no fair value alternative for asset reporting under U.S. GAAP. Under IFRS, most long-lived assets are also reported at depreciated cost (the cost model). IFRS provides an alternative, the revaluation model, that permits long-lived assets to be reported at their fair values, as long as active markets exist for the assets so their fair value can be reliably (and somewhat objectively) estimated. Firms must choose the same treatment for similar assets (e.g., land and buildings) so they cannot revalue only specific assets that are more likely to increase than decrease in value. **The revaluation model is rarely used in practice by IFRS reporting firms. **
Compare the financial reporting of investment property with that of property, plant, and equipment.
Under IFRS, property that a firm owns for the purpose of collecting rental income, earning capital appreciation, or both, is classified as investment property. U.S. GAAP does not distinguish investment property from other kinds of long-lived assets.
IFRS gives firms the choice of using a cost model or a fair value model when valuing investment property, if a fair value for the property can be established reliably.
The cost model for investment property is the same as the cost model for valuing property, plant, and equipment, but the fair value model is different from the revaluation model. Under the revaluation model, any revaluation above historical cost is recognized as revaluation surplus in owners’ equity. For investment property, however, revaluation above historical cost is recognized as a gain on the income statement.
