Reading 18 - Long Lived Assets

Question 1

When a firm makes a capital expenditure, what are the two ways the firm can categorize the expense?

Answer 1

• Capitalize the cost as an asset on the balance sheet
• Expense the cost on the income statement in the period incurred

Question 2

What is the general rule regarding when to capitalize or expense an asset?

Answer 2

Capitalize an asset that is expected to provide a future economic benefit over multiple accounting periods

Expense an asset if the future economic benefit is unlikely or uncertain

Question 3

What happens to net income when an asset is expensed or capitalized?

Answer 3

• Expensed - 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 so net income is higher than if it were capitalized
• Capitalized - delays the recognition of the expense on the income statement. In the current period the firm will report high income than one that expenses. In subsequent periods net income will be lower than if had expensed

Question 4

How is a capitalized expenditure reported on the cash flow statement?

Answer 4

• As an outlflow from investing activities
• Will result in higher operating cash flow and lower investing cash flow as opposed to expensing

Question 5

What are the affects on financial ratios whether an asset has been capitalized or expensed?

Answer 5

• Capitalizing results in higher assets and higher equity . (D/A and D/E are lower )
• Capitalizing will initially have higher ROA and ROE. This is b/c of higher net income in the first yr… Later yrs will have lower ROA and ROE
• Expensing will have lower ROA and ROE for the opposite reason above.

Question 6

What is Capitalized Interest?

Answer 6

The interest that accrues during the construction period for an asset the firm plans to use

** the objective of capitalized interest is to accurately measure the cost of the asset & to better match the cost with the revenues generated by the constructed asset

Question 7

What is the objective of capitalizing interest?

Answer 7

To accurately measure the cost of the asset and to better match the cost with revenues generated by the constructed asset

• Not reported on the I/S
• The interest cost is allocated to the I/S throught depreciation expense (if asset is held for use) or COGS (if asset is held for sale)

Question 8

What is the interest coverage ratio?

Answer 8

It measures the firm’s ability to make required interest payments on its debt

= EBIT / Interest Expense

Question 9

Explains what happens to the interest coverage ratio under both expensing and capitalizing?

Answer 9

In the year of the expenditure

Capitalizing - results in lower interest expense and higher net income. Higher interest coverage ratio

Expensing - results in higher interest expense and lower net income. Lower interest coverage ratio

In the years following

Above will reverse because Net Income will be lower for capitalizing than expensing..

Question 10

How are R&D costs treated under IFRS ?

Answer 10

• Research costs are expensed as incurred.
• Development costs are capitalized (development means the translating of information from research into a potential business product/process)

Question 11

How are R&D costs treated under GAAP ?

Answer 11

Research and development costs are generally expensed as incurred, except for software development costs

Question 12

How are Software Development costs treated under GAAP?

Answer 12

Costs incurred to develop software for sale to others are expensed as incurred until the product’s technological feasibility has been established

If feasible, GAAP requires subsequent costs to be capitalized

Question 13

What are the 3 ways a capitalized cost may be depreciated?

Answer 13

1. Straight-line
2. Accelerated
3. Units of production

Question 14

Explain straight-line depreciation and what is the formula?

Answer 14

Depreciation is the same amount each year over the asset’s estimated life

Question 15

Explain accelerated depreciation and what is the formula?

Answer 15

More depreciation expense is recognized in the early yrs of an asset’s life.

Results in lower net income in the early yrs as opposed to straight line

Double-Declining Balance (DDB) is most common:

Question 16

Describe the units-of-production method ?

Answer 16

Is based on usage rather than time. The depreciable basis of the asset (cost-est salvage value) is divided by the # of units the asset is expected to produce over its useful life to get depreciation per unit

Question 17

How does a firm determine if an asset is impaired under IFRS ?

Answer 17

When its carrying (book) value (original cost less accumulated depreciation) exceeds the recoverable amount

** The asset is then written down on the balance sheet to recoverable amount and an impairment loss is recognized in the income statement

Question 18

How does a firm determine if an asset is impaired under GAAP ? There are 2 steps involved is a hint….

Answer 18

Step 1 : The asset is tested for impairment by applying a recoverability test

Step 2 : If the asset is impaired, the second step involves measuring the loss

Question 19

How is recoverability determined under GAAP for impairment of an asset?

Answer 19

If the carrying value (original cost less accumulated depreciation) is > than the asset’s future undiscounted cash flow stream

Question 20

How is Loss Measurement determined under GAAP for impairment of an asset?

Answer 20

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

**If fair value is unknown it is estimated as the discounted value of the future cash flows

Question 21

Can impairment losses be reversed under GAAP or IFRS?

Answer 21

GAAP : No

IFRS : Yes

Question 22

How do impairment losses affect financial statements and ratios?

Answer 22

• Impairment will result in lower assets and lower equity (RE)
• In the yr of impairment, ROA and ROE will decrease since earnings are lower
• In subsequent periods ROA and ROE will be higher

Question 23

When an impairment loss is taken, what does this tell us ?

Answer 23

That the firm had not recognized enough depreciation or amortization expense and that b/c of this overstated earnings.

Question 24

What are two reasons why it is useful for analysts to know the average age of a company’s fixed assets?

Answer 24

1. It helps identify older, less efficient assets, which may make the firm less competitive.
2. An analyst can estimate when major capital expenditure will be required, helping forecast when the firm may face significant financing requirements

Question 25

What are three useful calculations regarding a firm’s fixed assets?

Answer 25

1. Average Age
2. Average Depreciable Life
3. Remaining Useful Life

Question 26

How is Average Age calculated?

Answer 26

Question 27

How is Average Depreciable Life calculated?

Answer 27

Gross Investment is the original cost of the asset. Gross investment is before deductig accumulated depreciation

Question 28

How is Remaining Useful Life calculated?

Answer 28

***Net Investment = Original Cost - Accumulated Depreciation

Question 29

What are the two types of leases?

Answer 29

1. Finance lease - essentially a purchase of an asset that is financed by with debt. Lessee will add equal amounts to both assets and liabilities on the balance sheet. Over the term, the lessee will recognize depreciation expense on the asset and interest expense on the liability
2. Operating lease - essentially a rental agreement. The periodic lease payments are simply recognized as rental expense.

Question 30

What are the benefits (5) of leasing?

Answer 30

1. Less-costly financing (ie no down payment)
2. Reduced risk of obsolescence (at the end of lease you can return it)
3. Less restrictive provisions
4. Off-balance sheet financing (no liability is reported on b/s)
5. Tax reporting advantages (in US can create a synthetic lease where the lease is treated as an ownership position for tax reporting)

Question 31

Under IFRS, when is a lease considered a finance lease?

Answer 31

if substantially all the rights and risks of ownership are transferred to the lessee

Question 32

Under GAAP, when is a lease considered a finance lease?

Answer 32

If any one of the following criteria is met :

1. If the title of the asset is transferred to the lesse at the end of the lease period
2. A bargain purchase option exists.
3. The lease period is 75% or more of the asset’s economic life
4. The PV of the lease payments is 90% of more of the fair value of the leased asset

Question 33

How does the Lessee (ie “Renter”) report an Operating Lease on its Financial Statements?

Answer 33

• At inception, no entry is made
• During the lease, rent expense is recognized in the lessee’s income statment
• In the cash flow statement, the lease payment is reported as an outflow from operating activities

Question 34

How does the Lessee (ie “Renter”) report a Finance Lease on its Financial Statements?

Answer 34

• At inception, the lower of the PV of future minimum lease payments or the fair value is recognized as an asset and liability on the b/s
• Over the term, the asset is depreciated and depreciation expense as well as interest expense is reported in the income statement.

Question 35

What types of lease disclosures are required under GAAP ?

Answer 35

• The lessee must disclose the lease payments that are due in each of the next five yrs
• Payments after 5 years can be aggregrated

Question 36

From the Lessor’s perspective, what are the two types of leases?

Answer 36

1. Sales-Type Lease: is treated as if the lessor sold the asset and provided the financing to the buyer
2. Direct Financing Lease: the lessor is simply providing a financing function to the lessee.