Part 8. Long-Lived Assets

Question 1

Capitalisation

Answer 1

If a firm makes an expenditure, it will capitalize the cost as an asset on the balance sheet, as it is expected to provide future economic benefits over multiple accounting periods.

• This Is initially recorded as an asset on the balance sheet at cost, with its fair value at acquisition plus any costs necessary to prepare the asset for use.
• 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).
• Once capitalised, subsequent related expenditures which provide more future economic benefit (rebuilding the asset) are also capitalised.

Question 2

Expensed

Answer 2

When a firm makes an expenditure, it can expense the cost in an income statement in the period that occurred if the future economic benefit is unlikely or highly uncertain.

• the current period pretax income is reduced by the amount of the expenditure.
• Subsequent expenditures merely sustain the usefulness of assets (e.g. regular maintenance) are expensed when incurred.

Question 3

Capitalising interest

Answer 3

This is to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset.

The interest cost is allocated to the income statement through depreciation expense (if the asset is held for use), or COGS (if asset is held for sale).

US GAAP - capitalised interest is an outflow of investing activities, while interest expense is an outflow from operating activities.

IFRS - interest expense can be operating, financing or investing cash flow.

Question 4

Intangible assets

Answer 4

A long-term asset that lacks physical substance such as patents, brand names, copyrights, and franchises.

Infinite lived - it is amortized over its useful life.
Indefinite lived - it is not amortised but tested for impairment at least annually. If impaired, the fall in value is recognised in income statements loss in period in which impairment is recognised.

Question 5

Identifiable intangible asset (IFRS)

Answer 5

• capable of being separated from firm or arise from the contractual or legal right..
• controlled by firm.
• expected to provide economic benefits.
• future economic benefits must be probable, and assets cost reliably measured.

Question 6

Unidentifiable intangible asset

Answer 6

The one that cannot be purchased separately, and may have indefinite life.

i.e. goodwill - the excess of purchase price over the fair value of identifiable asset (net of liabilities) acquired in business combination.

Question 7

Research and development costs

Answer 7

IFRS:

Research costs - expensed incurred.
Development costs - may be capitalised.

US GAAP:

Research & Development Costs - generally expensed as incurred.

• costs incurred to develop software for sale of others are expensed incurred, until products tech feasibility has been established, after which costs of developing salable product are capitalised.

Question 8

Purchased intangible assets

Answer 8

• Intangible asset purchased as part of group, the total purchase price is allocated to each asset on basis of fair value.
• The capitalising results in higher net income in 1st year, and lower net income in subsequent years.
• Assets, equity and operating cash flow are all higher when expenditures are capitalised.

Question 9

Acquisition method

Answer 9

This is used to account for business combinations, where purchase price is allocated to identifiable assets and liabilities of acquired firm on basis of fair value, remaining purchase price is recorded as goodwill.

Created goodwill - capitalised
Internal goodwill - expensed

Question 10

Net income

Answer 10

• Immediate higher net income from expenditure capitalised,
• In subsequent periods, firm will report lower net income since income statement allocation to depreciation expense.
• expensed - net income is reduced by after tax amount of expenditure, and remains.

overall: total net income is identical whether costs are capitalised or expensed, the timing of recognition is the only difference.

Question 11

Shareholders equity

Answer 11

• capitalisation = higher shareholder equity as retained earnings are higher, with a balanced A = L + E. As cost is added, the shareholder equity will reduce.
• expense - retained earnings and shareholder equity reflects entire reduction in net income in period of expenditure.

Question 12

Cash flow from operations

Answer 12

• capitalised - outflow from investing activities, resulting in higher operating cash flow and lower investing cashflow compared to expense.
• immediate expense - outflow from operating activities
  overall: with no difference in tax treatment, total cash flow will be the same, just different classification.

Question 13

Financial ratios

Answer 13

• lower debt to asset/equity ratios with capitalisation, as capitalisation results in higher assets and equity compared to expensing.
• This will initially result in higher ROA and ROE, meaning higher net income in 1st year, but subsequent years are reduced as net income is reduced by depreciation expense.
• expensing firm, ROE and ROA is lower in 1st year, and higher in subsequent years since net income is higher and assets and equity is lower initially than if capitalised expenditure.
• interest coverage ratio (EBIT/ interest expense) measuring firms ability to make required interest payments on debt, in capitalising interest results in lower interest expense in expensed, but higher if capitalised.

Question 14

Depreciation

Answer 14

A systematic allocation of an assets cost over time, a real and significant operating expense.

Question 15

Carrying (book) value

Answer 15

The net value of asset/liability on balance sheet, for property, plant and equipment carrying value equals historical cost minus accumulated depreciation.

Question 16

Historical cost

Answer 16

The original purchase price of asset including installation, and transportation cost, aka gross investment in asset.

Question 17

Straight line depreciation

Answer 17

The predominant method of computing depreciation for financial reporting.

Question 18

Accelerated depreciation

Answer 18

When more depreciation is recognised in early years of assets life and less in the later years.

Question 19

Units of production method

Answer 19

The depreciation is based on usage rather than time, where expense is higher in periods of high usage.

Question 20

Component depreciation

Answer 20

The useful life of each component is estimated and depreciation expense computed separately for each.

Question 21

Useful life

Answer 21

Longer estimated useful life - decreases annual depreciation, and increased reported net income

Shorter estimated useful life - increases annual depreciation, and decreases reported net income.

Question 22

Salvage values

Answer 22

higher estimated salvage - decreases annual depreciation, and increased reported net income

lower estimated salvage - increases annual depreciation, and decreases reported net income.

Question 23

Amortisation method

Answer 23

• An increase in either estimate of assets useful life or estimate of its residual value will reduce annual amortisation expense.
• The above will increase net income, assets, ROE and ROA for a typical firm.

Question 24

Revaluation model

Answer 24

An asset is carried at its deprecated cost, but at each revaluation date the balance sheet value is adjusted to fair value.

Between revaluation date, depreciation is recorded for the asset, where revolution to fair value is done sufficiently often that reported value is not significantly different to fair value.

Question 25

Revaluation surplus

Answer 25

With no prior valuations and FV < carrying value, a loss is recorded on income statement like an impairment charge.

If FV at 1st revaluation date > carrying value of asset, the difference is recorded.

Question 26

Subsequent revaluation dates

Answer 26

• FV > carrying value, any gain in previous reverse loss, if gain > prior losses not reversed then excess is reported in revaluation surplus.
• FV < CV, the difference reduce any existing balance in evaluation surplus account; any excess is reported as a loss.

Question 27

Impairment (IFRS)

Answer 27

If there is a significant decline in the market value of the asset or significant change in the assets physical condition.

Impaired if carrying value (original cost less accumulated depreciation)> recoverable amount, which is greater than its FV less any selling costs and value in use (PV of future cash flow stream from continued use).

Impaired:

• the asset value is written down on balance sheet to recoverable amount.
• loss = excess of carrying value over recoverable amount recognised on income statement.
• loss can be reversed on identifiable long-lived asset if recovers in the future; but limited to original impairment loss.

Question 28

Impairment (US GAAP)

Answer 28

• only tested for impairment when events and circumstances indicate firm may not be able to recover carrying value through future use.

2 steps:

1. The asset is tested for impairment by applying recoverability test.
2. if asset is impaired, the 2nd step involves measuring the loss.

Question 29

Recoverability

Answer 29

The asset is considered impaired if carrying value > assets future undiscounted cash flow stream.

Due to being based on estimates of future undiscounted cash flows, tests for impairment involve considerable management discretion.

Question 30

Loss measurement

Answer 30

If impaired, the assets value is written down to fair value on balance sheet and a loss equal to excess of carrying value over fair value of asset is recognised in income statement.

Question 31

Intangible assets with indefinite lives

Answer 31

These are not amortised, but rather tested for impairment at least annually.

This impairment loss is recognised when carrying amount exceeds fair value.

Question 32

Long lived assets held for sale

Answer 32

• If firm intends to sell an asset, it will be sold and reclassified from held for use to held for sale.
• This means asset is tested for impairment, and is not longer depreciated or amortised.
• If held for sale asset is impaired, its carrying value exceeds its net realisable value (if fair value is less than selling cost); where if impaired asset is written down to net realisable value and loss recognised in income statement.
• This loss can be reversed under IFRS and US GAAP if value of asset recovers in the future, but limited to original impairment loss.
• The carrying value of asset after reversal cannot exceed carrying value before impairment is recognised.

Question 33

Derecognition

Answer 33

This occurs when assets are sold, exchanged or abandoned.

1. Sold - the asset is removed from balance sheet, and difference between sale and proceeds, and carrying value for asset is reported as gain or loss in income statement. The CV = original cost - accumulated depreciation and any impairment charges.
2. Abandoned - the treatment is similar to sale, but there are no proceeds, and the carrying value of asset is removed from balance sheet, and loss of amount is recognised in income statement.
3. Exchanged - A gain or loss is computed by comparing the carrying value of old asset with fair value of the old asset (or fair value of new asset if value is clearly more evident). The CV of old asset is removed from balance sheet, and new asset recorded at its fair value.

Question 34

The effects of impairment

Answer 34

• This reduces assets carrying value on the balance sheet, where a charge is recognized as a loss in the income statement, reducing assets and equity (retained earnings).
• In the impairment year, ROA and ROE will decrease as the impairment charge reduces net income.
• In subsequent periods, net income will be higher than without impairment charge as depreciation will be lower (asset has lower depreciable value).
• Both ROA and ROE will increase in periods after impairment charge as both equity and assets will fall from impairment charge; asset turnover will increase in the period in which impairment charge is taken and subsequent periods.
• Asset impairment has no impact on cash flow as impairment does not reduce taxable income, its unrealized loss until the asset is disposed of.

Question 35

Impairment loss

Answer 35

• An indication that the firm has not recognised sufficient depreciation or amortisation expense, and has overstated earnings as a result.
• Judgement in determining impairment gives management discretion about timing and amount of impairment charges, plus they present an opportunity for management to manipulate earnings.
• Waiting to recognize impairment loss until the period of high earnings will tend to smooth earnings.
• Existing management may take more impairment charges in periods when earnings will be poor, due to external (macroeconomic or industry) factors.
• New management may choose to take more or greater impairment charges when they take over, resulting in low earnings that may not be perceived as ‘fault’ of management, and lower values for assets and equity give a boost to ROA and ROE going forward.

Question 36

Revaluation

Answer 36

US GAAP:

• long-lived assets reported on the balance sheet at depreciated cost using cost model (original cost less accumulated depreciation and impairment charges).
• revaluing long-lived assets upward is prohibited, with an exception to long-lived assets held for sale, for which prior impairment losses can be reversed.

IFRS:

• firms can choose to use the revaluation model, and report long-lived assets at their fair value.
• firms can choose depreciated cost for some asset classes and fair value for others.

Question 37

Revaluing assets value upward result in:

Answer 37

• Higher total assets and higher shareholder equity.
• Lower leverage ratios measured by debt ratio (total debt/total assets), and debt-to-equity ratio (higher denominators).
• Higher depreciation expense, thus lower profitability in periods after revaluation.
• Lower ROE and ROA in periods after revaluation (lower numerator and higher denominator), if an increase in asset value is the result of higher operating capacity, such as higher capacity should result in higher revenues and thus earnings.

Question 38

Derecognition of asset

Answer 38

This refers to disposal by sale, exchange for another asset, or abandonment.

• In the cost model, the carrying (book) value for the long-lived asset is its historical cost minus accumulated depreciation adjusted for impairment charges taken.
• In the revaluation model, the carrying value of an asset is its value of the last revaluation date, less any subsequent depreciation or amortization.
• Asset exchange for another, the sale price is taken to be the fair value of asset exchanged, or value of the asset acquired if the value is more readily available; no cash flows for exchange of assets, but gains and losses reported on the income statement.
• If fair values of assets cannot be reliably estimated, the price of the acquired asset is taken to be carrying the value of the exchanged asset, and no gains or losses are recorded.

Question 39

IFRS Disclosures

Answer 39

The firm must disclose the following (PP&E):

• the basis for measurement (usually historical cost)
• useful loves or depreciation rate
• gross carrying value and accumulated depreciation
• reconciliation of carrying amounts from the beginning of the period to the end of period

The firm must also disclose:

• title restrictions and assets pledged as collateral.
• agreements to acquire PP&E in the future.

If revaluation (fair value) model is used, the firm must disclose:

• the revaluation date
• how fair value was determined
• carrying value using the historical cost model

Under IFRS, the disclosure requirements for intangible assets are similar to those for PP&E, except the firm must disclose whether the useful lives are finite or indefinite.

For impaired assets, the firm must disclose:

• amount of impairment losses and reversals by asset class.
• where the losses and loss reversals are recognized in the income statement.
• circumstances that caused impairment loss or reversal.

Question 40

US GAAP Disclosures

Answer 40

The PP&E disclosures include:

• depreciation expense by period.
• balances of major classes of assets by nature and function, e.g. land, improvements, buildings, machinery, and furniture.
• accumulated depreciation by major classes or in total.
• general description of depreciation methods used.

US GAAP; the disclosure requirements for intangible assets are similar to those for PP&E, and the firm must provide an estimate of amortization expense for the next 5 years.

For impaired assets, the firm must disclose:

• a description of the impaired asset.
• circumstances that caused the impairment.
• how fair value was determined.
• the amount of loss.
• where the loss is recognised in the income statement.

Question 41

Financial statement disclosure

Answer 41

• Provide an analyst with considerable information about a company’s fixed assets and depreciation (amortization) methods, an analyst can use data to estimate the average age of a firm’s assets.

The average age is useful for 2 reasons:

• Older, less-efficient assets may make a firm less competitive.
• The average age of assets helps an analyst to estimate the timing of major capital expenditures and the firm’s future financing requirements.

Question 42

Investment property

Answer 42

• For IFRS, property that firm owns for the purpose of collecting rental income, earning capital appreciation or both.
• There is a choice of using cost model or fair value model when valuing investment property, if fair value for property can be established reliably.
• For US GAAP, this does not distinguish investment property from other kinds of long-lived assets.

Question 43

Valuation model for investment property

Answer 43

• This is the same as cost model for valuing PP&E, but fair value model is different from the revaluation model.
• The revaluation model is an increase in assets carrying value recognised as revaluation surplus in owners equity, unless it reverses previously recognised loss.
• An upward revaluation is recognised as a gain on the income statement.
• If firms required to disclose valuation model used for investment property, the firms fair value model must state how they determine fair value of investment property and reconcile beginning and ending values.
• Firms that use cost model must disclose fair value of their investment property, along with disclosures required for other types of long-lived assets (e.g. useful lives, depreciation methods used).
• A firm may change use of property such as become investment property or no longer classified as, e.g. if firm may move offices out of building it owns, begin renting space to others.
• The fair value model uses financial statement treatment of assets value depends on nature of change, but through cost model, the property’s carrying amount does not change when transferred in or out of investment property.