Financial Analysis #17 - Long Lived Assets: Implications for Financial Statements and Ratios Flashcards
Explain the rules and effects of capitalizing vs. expensing assets
LOS 17.a
Capitalizing - asset goes to BS; depreciate/amortize to IS over asset’s useful life
rule: capitalize if there is a future economic benefit
Expensing - asset goes to IS; immediately recognize entire asset cost on IS.
rule: Expense if future benefit is unlikely or uncertain
Compare capitalizing vs. expensing effects to:
Assets, Equity, NI (1st and subsequent years), Income variability, ROA & ROE (1st and subsequent years), debt ratio & D/E, CFO, CFI
LOS 17.a
Cap Exp reasoning
Assets, Equity higher lower cap: A(++) = L + E(++)
NI - 1st yr higher lower exp: R - E(++) = NI(–)
NI - >1yr* lower higher cap: R - E(-) = NI(-)
Inc variability lower higher exp: Exp(yr1) >> Exp(yr2)
ROA/ROE - 1st yr higher lower cap: NI(-); exp: NI(–)
ROA/ROE - >1yr lower higher cap: NI(-)
D/A; D/E lower higher exp: A(–) = L + E(+)
Int coverage yr1 higher lower cap: Int exp(–)
Int coverage >1yr lower higher cap: EBIT(-)**
* fast growth firms: cap method could stay higher if new depr > old depr
** Depreciation Exp is included in COGS on the IS
Capitalized Interest:
When does a firm use it?
Justification for capitalizing interest?
GAAP vs. IFRS
What interest rate is used?
How does cap interest flow through IS/BS/CF statements?
LOS 17.a
Used when a firm constructs an asset for:
- its own use: “held for use” (Intel wafer fab)
- sale: “held for sale” (Boeing airliner)
Why capitalize? to accurately measure capital asset costs and to align them with revenues generated from use/sale.
GAAP and IFRS treat cap int similarly.
Interest rate used (in order of usage):
- project-specific debt’s interest rate
- company’s unrelated debt
Project interest is capitalized as part of the asset’s cost.
IS - Cap int is NOT reported as int on the IS but is recognized after construction is completed over time as:
- deprec exp (asset held for use), or
- COGS exp (asset held for sale)
BS - Appears as capital asset and then as accum deprec
CF - Cap int: reported as CFI
Int exp: generally reported as CFO; int exp on debt in excess of construction is immediately expensed
Effects to ratios with capitalizing interest costs vs. expensing them.
LOS 17.a
Interest coverage ratio = EBIT / Int Exp
During construction: higher interest coverage ratio (lower Int Exp)
After contruction: lower interest coverage ratio (higher deprec exp)
What are intangible assets?
List examples.
How are they expensed?
LOS 17.a
Intangible assets - long-term assets that lack physical substance.
Examples: patents, brand names, copyrights, franchises, and goodwill
With some exceptions, firm costs that lead to intangible assets are expensed as incurred. Key exceptions are internal develoment costs such as R&D and software development,
What are R&D costs and how are they treated in financial statements (IFRS and GAAP)?
LOS 17.a
Research costs - costs towards innovation discovery
Development costs - costs to transform a firm’s research findings into products and services
Under IFRS:
Research development costs: expensed as incurred.
Development costs: capitalized.
Under GAAP:
Research and development: expensed as incurred,
except for software development costs:
- SW developed for sale:
Prior to technological feasibility: expensed as incurred
After technological feasibility: capitalized
- SW developed for internal use: capitalized
Explain how different depreciation methods for PP&E affect financial statements and ratios.
LOS 17.b
Straight-line depreciation expense:
- most popular method
- depr expSL = (orig cost - salvage value) / asset life
- Depreciation amount is the same each year
Accelerated depreciation expense:
- Double-declining bal (DDB) method often used
- depr expDDB = 2 / asset life * beginning BV of year
- deprec exp: early years(+); in latter years(-)
- NI: early years(-); latter years(+)
Units of production depreciation expense:
- Lifetime depreciable value divided by estimated total unit production (depr unit) for the asset.
- depr expUoP = units produced in yr * Depr unit
Firms can change depreciation methods throughout an asset’s lifetime. How is this case treated for reporting purposes?
LOS 17.b
Treated as a change in accounting estimates. Change affects current and prospective periods. Pervious periods are not affected by the change.
Note: Most changes in accounting principles require retroactive adjustment. A change in dpreciation method is one exception.
Be able to explain how management can manipulate financial statements by using:
- asset estimates for useful life and salvage value
- allocation of depreciation to COGS and SG&A
- write-downs
LOS 17.b
overstating useful life or salvage values: +NI, then bigger write-down or loss at the end.
Take immediate write-down: -NI in first period and then +NI through rest of asset life.
COGS vs SG&A: doees not affect operating margin (R-COGS-SG&A)/R, but does affect gross margin (R-COGS)/R
What is an “impaired asset”? Give examples of asset impairment.
LOS 17.c
an asset is impaired when:
carrying (book) value > recoverable amount
cases for impairment:
- decline in asset’s market value
- decline in asset’s physical condition
How is an asset tested for impairment under IFRS?
LOS 17.c
IFRS: assets must be tested annually for impairment
Impaired when:
carrying value > recoverable amount
- carrying value = orig cost - accum deprec
- recoverable amt = max(“fair value - selling costs”, “value in use”)
- value in use = PV(future CF from continued use)
If impaired:
- asset written down on BS to the recoverable amt
- impairment loss (carry value - recoverable amt) taken on IS
An impairment loss can be reversed if asset value recovers in the future.
How is an asset tested for impairment under GAAP?
LOS 17.c
GAAP: asset is tested only when events indicate the firm may not be to recover carry value through use in the future.
- Perform recoverability test:
carrying value > future undiscounted CF stream
- carrying value = orig cost - accum deprec
2. If impaired, measure the loss: - asset written down to fair value on BS
- impairment loss to IS (carry value - fair value*)
- *or PV(future CF) if fair value is not known
An impairment loss can be reversed if asset value recovers in the future.
how do analysts use fixed asset disclosures to identify qualities of a firm?
LOS 17.d
analysts can use financial statement disclosures to estimate the average age of fixed assets and the average depreciable life of fixed assets
In order to identify:
- firms with older, inefficient assets
- need for major capital investments
- firms with inflated earnings from the use of older assets that generate less depreciation
fixed asset disclosures: equations
LOS 17.d
Est. Useful Life = Hist Cost / Annl Deprec
Est. Age = Accum Deprec / Annl Deprec
Est Remaining Life = Net PPE / Annl Deprec
Net PPE = Cost - Accum Deprec
distortions:
- assumes S/L deprec
- land (do not deprec land)
- ignores salvage values
reporting treatment of finance lease
LOS 17.f
Treat as if leased asset was purchased with debt
- finance lease consists of:
- expense = asset deprec + loan interest
- payment = int exp (CFO-out) + principal reduction (CFI-out)
- lower of fair value or PV of future lease payments is initially reported as a BS asset AND liability
- asset is depreciated over time
- interest expense is recognized on liability
- lease payments treated like amortizing debt i.e. each payment is part interest (CFO) and part principal (CFF)
