Reading 26: Long-Lived Assets

Question 1

Describe the effects on financial statements initially when the cost is capitalized.

Answer 1

Noncurrent assets increase.

Cash flow from investing activities decreases.

Question 2

Identify the circumstances under which analysts should be wary when companies account for the differences in the companies’ expenditure capitalizing policies.

Answer 2

Inflate reported cash flow from operations by capitalizing expenditures that should be expensed.

Inflate profits to meet earnings targets by capitalizing costs that should be expensed.

Depress current-period income by expensing costs that should be capitalized, in order to be able to exhibit impressive profitability growth going forward without any real improvement in operating performance.

Question 3

Give examples of intangible assets with finite useful lives.

Answer 3

An acquired patent or copyright with a specific expiration date.

Customer lists acquired by a direct mail marketing company that are expected to provide future economic benefits.

An acquired license with a specific expiration date with no associated right to renew the license.

An acquired trademark for a product that a company plans to phase out over a specific number of years.

Question 4

List the details disclosed in the notes to the financial statements for depreciation methods used.

Answer 4

Acquisition costs.

Depreciation and amortization expenses.

Accumulated depreciation and amortization.

Depreciation and amortization methods used.

Information on assumptions used to depreciate and amortize long-lived assets.

Question 5

When an asset is exchanged for another asset, how is the carrying amount addressed?

Answer 5

The asset given up is removed from the company’s balance sheet and replaced by the fair value for the asset acquired. Any difference between the carrying amount and the fair value is recognized as a gain or loss on the income statement.

Question 6

When must companies capitalize interest associated with financing the acquisition or construction of an asset?

Answer 6

When it requires a long period of time to ready the asset for its intended use.

Question 7

List the effects of impairment recognition on a company’s financial statements.

Answer 7

The carrying value of the asset decreases.

The impairment charge reduces net income.

Impairment does not affect cash flows, because it is a noncash charge.

Question 8

Explain a key difference between the revaluation and the cost model.

Answer 8

Revaluation allows for the reported (fair) value of the asset to be higher than its historical cost. Under the cost model, by contrast, the reported value of an asset can never exceed its historical cost.

Question 9

Identify the issues analysts should consider related to capitalization of interest costs.

Answer 9

Capitalized interest costs reduce investing cash flow; expensed interest costs reduce operating cash flow.

Use the entire amount of interest expense for the period, whether capitalized or expensed, in the denominator. If depreciating interest was capitalized in previous years, adjust net income to remove the effect of depreciation of capitalized interest.

Treat any interest costs capitalized in the current period as interest expense. Net income should be reduced by the amount of interest capitalized in the current period.

Question 10

Describe the acquisition of tangible and intangible assets.

Answer 10

Upon acquisition, tangible assets with an economic life of longer than one year and intended to be held for the company’s own use are recorded on the balance sheet at cost, which is typically the same as their fair value.

Accounting for an intangible asset depends on how the asset is acquired.

Question 11

Explain intangible assets that are developed internally.

Answer 11

A company that develops intangible assets internally will expense costs of development and recognize no related assets, whereas a firm that acquires intangible assets will recognize them as assets.

A company that develops intangible assets internally will classify development-related cash outflows under operating activities on the cash flow statement, whereas an acquiring firm will classify these costs under investing activities.

Question 12

Differentiate between the finite live and infinite lives of intangible assets.

Answer 12

The cost of an intangible asset with a finite life is amortized over its useful life.

The cost of an intangible asset with an indefinite life is not amortized; instead, the asset is tested (at least annually) for impairment. If deemed impaired, the asset’s balance sheet value is reduced, and a loss is recognized on the income statement.

Question 13

What occurs if a revaluation initially increases the carrying amount of an asset?

Answer 13

The increase in value bypasses the income statement and goes directly to equity through the revaluation surplus account. Later, if the value of the asset class decreases:
The decrease reduces the revaluation surplus to the extent of the gain previously recognized in the revaluation surplus against the same asset class.

Any decrease in value beyond the reversal amount will be recognized as a loss on the income statement.

Question 14

What results if there is an assumption of a longer useful life and a higher expected residual value?

Answer 14

Lower annual depreciation expense compared to assumptions of a shorter useful life and a lower salvage value. The subjective nature of these assumptions allows management to manipulate earnings.

Question 15

Explain the units-of-production method.

Answer 15

The amount of depreciation expense for a period is based on the proportion of the asset’s production during the period compared with the total estimated productive capacity of the asset over its useful life.

Question 16

How is the capitalized amount in subsequent periods allocated over the asset’s useful life?

Answer 16

As depreciation expense for tangible assets or amortization expense for intangible assets with finite lives.

Question 17

Under what circumstances can goodwill be recognized on the balance sheet?

Answer 17

When it is created in a business acquisition; internally generated goodwill cannot be capitalized.

Question 18

Explain the effects on financial statements when an item is expensed.

Answer 18

Net income decreases by the entire after-tax amount of the cost.

No related asset is recorded on the balance sheet, and therefore no depreciation or amortization expense is charged in future periods.

Operating cash flow decreases.

Expensed costs have no financial statement impact in future years.

Question 19

Distinguish between the cost model and the fair value model as pertaining to investment property.

Answer 19

Cost model: This is identical to the cost model used for PP&E. If the cost model is used, the fair value of investment property must be disclosed. Fair value model: This differs from the revaluation model used for PP&E in the way net income is affected.

Under the revaluation model, the impact of the revaluation on net income depends on a previously recognized increase or decrease in the carrying amount of the asset.

Under the fair value model, all changes in the fair value of an asset impact net income.

Question 20

Explain the reversals of impairments of long-lived assets under U.S. GAAP and IFRS.

Answer 20

Under U.S. GAAP, once an impairment loss is recorded for assets held-for-use, it cannot be reversed. However, for assets held-for-sale, if the fair value of the asset increases subsequent to impairment recognition, the loss can be reversed, and the asset’s value can be revised upward.

IFRS allows reversal of impairment losses if the value of the asset increases regardless of classification of the asset. Reversal of a previously recognized impairment charge increases reported profits.

Question 21

Name the 2 primary models for reporting long-lived assets, and explain each.

Answer 21

Cost Model:

1. Required under U.S. GAAP and permitted under IFRS.
2. Cost of long-lived tangible assets (except land) and intangible assets with finite useful lives is allocated over their useful lives as depreciation and amortization expense.
3. An asset’s carrying value (also called carrying amount or net book value) equals its historical cost minus accumulated depreciation/amortization (as long as the asset has not been impaired).

Revaluation Model:

1. Permitted under IFRS, but not under U.S. GAAP.
2. Long-lived assets are reported at fair value (not at historical cost minus accumulated depreciation/amortization).

Question 22

What occurs if a revaluation initially decreases the carrying amount of an asset?

Answer 22

The decrease in value is recognized as a loss on the income statement.

Later, if the value of the asset class increases:

The increase is recognized as a gain on the income statement to the extent that it reverses a revaluation loss previously recognized on the income statement against the same asset class.

Any increase in value beyond the reversal amount will not be recognized on the income statement but will be adjusted directly to equity through the revaluation surplus account.

Question 23

Name the situations in which an intangible asset acquired in a business combination should be recognized separately from goodwill under U.S. GAAP.

Answer 23

The asset arises from legal or contractual rights, or

The item can be separated from the acquired company.

Question 24

What is the effect on financial statements in future periods when the asset is depreciated or amortized?

Answer 24

Noncurrent assets decrease.

Net income decreases.

Retained earnings decrease.

Equity decreases.

Question 25

Identify what is reported if a company uses the straight-line method to depreciate its assets.

Answer 25

A lower asset turnover ratio during the early years of the asset’s life (because a lower depreciation charge results in higher net assets).

Higher operating profit margin in the early years of the asset’s use (because lower depreciation expense results in higher operating income).

Higher operating return on assets (ROA) in the early years of the asset’s use (due to lower depreciation expense) and lower ROA in later years.

Question 26

Under what circumstances does IFRS allow the revaluation model to be used for certain classes of assets and for the cost model to be used for others?

Answer 26

As long as (1) the company applies the same model to assets in a particular class and (2) whenever a revaluation is performed, all assets in the particular class are revalued (to avoid selective revaluation).

Question 27

Distinguish between capitalization and expensing.

Answer 27

If an item is expected to provide benefits to the company for a period longer than one year, its cost is capitalized. If the item is expected to provide economic benefits in only the current period, its cost is expensed.

Question 28

Distinguish between an impaired asset under IFRS and under U.S. GAAP.

Answer 28

Under IFRS, an asset is considered impaired when its carrying amount exceeds its recoverable amount.

Under U.S. GAAP, an asset is considered impaired when its carrying value exceeds the total value of its undiscounted expected future cash flows (recoverable amount).