Reading 23: Long-Lived Assets Flashcards
Identify and contrast costs that are capitalised and costs that are expensed in the period in which they are incurred.
When an asset is expected to provide benefits for only the current period, its cost is expensed on the income statement for the period. If an asset is expected to provide benefits over multiple periods, it is capitalized rather than expensed.
Compare the financial reporting of the following types of intangible assets: purchased, internally developed, acquired in a business combination.
The cost of a purchased 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. The cost of internally developed intangible assets is expensed.
Under IFRS, research costs are expensed but development costs may be capitalized. Under U.S. GAAP, both research and development costs are expensed as incurred, except in the case of software created for sale to others.
The acquisition method is used to account for assets acquired in a business combination. The purchase price is allocated to the fair value of identifiable assets of the acquired firm less its liabilities. Any excess of the purchase price above the fair value of the acquired firm’s net assets is recorded as goodwill, an unidentifiable intangible asset that cannot be separated from the business itself.
Explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios.
With capitalization, the asset value is put on the balance sheet and the cost is expensed through the income statement over the asset’s useful life through either depreciation or amortization. Compared to expensing the asset cost, capitalization results in:
* Lower expense and higher net income in period of acquisition, higher expense (depreciation or amortization) and lower net income in each of the remaining years of the asset’s life.
* Higher assets and equity.
* Lower CFI and higher CFO because the cost of a capitalized asset is classified as an investing cash outflow.
* Higher ROE and ROA in the initial period, and lower ROE and ROA in subsequent periods because net income is lower and both assets and equity are higher.
* Lower debt-to-assets and debt-to-equity ratios because assets and equity are higher.
Describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense.
Depreciation methods:
* Straight-line: Equal amount of expense each period.
* Accelerated (declining balance): Higher depreciation expense in the early years and lower depreciation expense in the later years of an asset’s life.
* Units-of-production: Expense based on percentage usage rather than time.
IFRS requires component depreciation, in which significant parts of an asset are identified and depreciated separately.
Describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios.
In the early years of an asset’s life, accelerated depreciation results in higher depreciation expense, lower net income, and lower ROA and ROE compared to straight-line depreciation. Cash flow is the same assuming tax depreciation is unaffected by the choice of method for financial reporting.
Firms can reduce depreciation expense and increase net income by using longer useful lives and higher salvage values.
Describe the different amortisation methods for intangible assets with finite lives and calculate amortisation expense.
Amortization methods for intangible assets with finite lives are the same as those for depreciation: straight line, accelerated, or units of production. Calculation of amortization expense for such assets is the same as with depreciation expense.
Describe how the choice of amortisation method and assumptions concerning useful life and residual value affect amortisation expense, financial statements, and ratios.
The choice of amortization method will affect expenses, assets, equity, and financial ratios in exactly the same way that the choice of depreciation method will. Just as with the depreciation of tangible assets, increasing either the estimate of an asset’s useful life or the estimate of its residual value will reduce annual amortization expense, which will increase net income, assets, ROE, and ROA for a typical firm.
Describe the revaluation model.
Under IFRS, firms have the option to revalue assets based on fair value under the revaluation model. U.S. GAAP does not permit revaluation.
The impact of revaluation on the income statement depends on whether the initial revaluation resulted in a gain or loss. If the initial revaluation resulted in a loss (decrease in carrying value), the initial loss would be recognized in the income statement and any subsequent gain would be recognized in the income statement only to the extent of the previously reported loss. Revaluation gains beyond the initial loss bypass the income statement and are recognized in shareholders’ equity as a revaluation surplus.
If the initial revaluation resulted in a gain (increase in carrying value), the initial gain would bypass the income statement and be reported as a revaluation surplus. Later revaluation losses would first reduce the revaluation surplus.
Explain the impairment of property, plant, and equipment and intangible assets.
Under IFRS, an asset is impaired when its carrying value exceeds the recoverable amount. The recoverable amount is the greater of fair value less selling costs and the value in use (present value of expected cash flows). If impaired, the asset is written down to the recoverable amount. Loss recoveries are permitted, but not above historical cost.
Under U.S. GAAP, an asset is impaired if its carrying value is greater than the asset’s undiscounted future cash flows. If impaired, the asset is written down to fair value. Subsequent recoveries are not allowed for assets held for use.
Asset impairments result in losses in the income statement. Impairments have no impact on cash flow as they have no tax or other cash flow effects until disposal of the asset.
Explain the derecognition of property, plant, and equipment and intangible assets.
When a long-lived asset is sold, the difference between the sale proceeds and the carrying (book) value of the asset is reported as a gain or loss in the income statement.
When a long-lived asset is abandoned, the carrying value is removed from the balance sheet and a loss is recognized in that amount.
If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing the carrying value of the old asset with fair value of the old asset (or fair value of the new asset if more clearly evident).
Explain and evaluate how impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets affect financial statements and ratios.
Impairment charges decrease net income, assets, and equity, which results in lower ROA and ROE and higher debt-to-equity and debt-to-assets ratios for a typical firm.
Upward revaluation increases assets and equity, and thereby decreases debt-to-assets and debt-to-equity ratios. A downward revaluation has opposite effects. The effect on net income and related ratios depends on whether the revaluation is to a value above or below cost.
Derecognition of assets can result in either a gain or loss on the income statement. A loss will reduce net income and assets, while a gain will increase net income and assets.
Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets.
There are many differences in the disclosure requirements for tangible and intangible assets under IFRS and U.S. GAAP. However, firms are generally required to disclose:
* Carrying values for each class of asset.
* Accumulated depreciation and amortization.
* Title restrictions and assets pledged as collateral.
* For impaired assets, the loss amount and the circumstances that caused the loss.
* For revalued assets (IFRS only), the revaluation date, how fair value was determined, and the carrying value using the historical cost model.
Analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets.
Analysts can use disclosures of the historical cost, accumulated depreciation (amortization), and annual depreciation (amortization) expense to estimate average age of assets, total useful life of assets, and remaining useful life of assets. These estimates are more accurate for firms that use straight-line depreciation.
Compare the financial reporting of investment property with that of property, plant, and equipment.
Under IFRS (but not U.S. GAAP), investment property is defined as property owned for the purpose of earning rent, capital appreciation, or both. Firms can account for investment property using the cost model or the fair value model. Unlike the revaluation model for property, plant, and equipment, increases in the fair value of investment property above its historical cost are recognized as gains on the income statement if the firm uses the fair value model.
