Reading 18: Long-lived Assets

Question 1

Explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios.

Answer 1

Capitalize: depreciating across as useful life, IF there is a future benefit

Expensing: future benefit is unlikely or highly uncertain

Effects: see attached picture

• Capitalizing Interest Expense: analysts typically treat capitalized interest as an expense.
• Internal Development Costs

Question 2

Explain and evaluate how the different depreciation methods for porperty, plant and equipment affect financial statements and ratios.

Answer 2

DEPRECIATION METHODS

1. Straight-Line: equal amount of expense, often used in financial reporting
2. Accelerated (DDB): higher in the early years and lower in the later years
3. Units-of-production: Expense is based on usage rather than time

Change in estimate = no restatement, disclosed in footnotes

Change in method = no restatement, disclosed in footnotes

Question 3

Explain and evaluate how impairment and revaluation of property, plant and equipment, and intangible assets affect financial statements and ratios.

Answer 3

IMPACT ON STATEMENTS

• BS: reduces assets, liabilities (deferred taxes), and stockholders equity
• IS: decreases current net income; and increases net income later (due to lower depreciation)
• CF: Unaffected

IMPACT ON RATIOS

• increase to fixed asset and total asset turnover
• increases debt to equity
• decreases current year ROA and ROE
• increases future ROA and ROE

Question 4

Analyze and interpret financial statement disclosures regarding long-lived assets

Answer 4

1. How old are company assets?
   
   • HC / Annual Depr = Estimated Useful Life
2. Are major capital investments needed?
   
   • Accum Depr / Annual Depr = Estimated Age
3. Is the firms earnings inflated by using old equipment (low depreciation)?
   
   • Net PPE / Annual Depr = Estimated remaining life

Question 5

Explain and evaluate how leasing assets instead of purchasing them affects financial statements and ratios.

Answer 5

TREATMENT OF FINANCE LEASE

• Lower of fair value or PV of future lease payments (as an Asset and Liability)
• Depreciate over time
• Interest expense is recognized on liability
• Each payment is part interest (CFO) and part principal (CFF)

Question 6

Explain and evaluate how finance leases and operating leases affect financial statements and ratios from the perspective of both the lessor and the lessee.

Answer 6

LESEES ARE REQUIRED TO DISCLOSE:

• Lease payments for each of the next five years
• Aggregated payments beyond five years
• IFRS: 1, 2-5, beyond

PROBLEM: Interest rate disclosure is not required

• Implicit interest rate can be estimated by calculating the IRR of the finance lease payments
• Implice rate can then be used to calculate the PV ofthe operating lease payments

SALES TYPE or DIRECT FINANCING LEASE