Reading 30 LOS's Flashcards
LOS 30a: Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred
Capitalized costs are recognized as noncurrent assets on the balanc sheet. The associated cash outlfow is listed under investing activities on the statement of cash flows. In subsequent periods, the capitalized mount is allocated (expensed) over the asset’s useful life as depreciation expense (for tangible assets) or amortization expense ( intangible assets with finite lives). These expenses reduce net income and decrease the book valye of the asset
Expensed Costs reduces net income for the current period by its entire after-tax amount. This results in lower income and lower retained earnings for the related period. The associated cash outflow is classified under operating activities on the statement of cash flows
All other factors remaining the same, the decision to expense an item as opposed to capitalize it would give the impression of greater earnings growth. On the other hand the decision to capitalize instead f expensing results im higher reported operating vash flow.
If an asset is acquired in a nonmonetary exchange, the amount recognized on the balance sheet typically equals the fair value of the asset required. Accounting for such exchanges would result in a removal of the asset exchanged for the new asset, and then a gain of loss recorded based on both assets carrying value.
Costs Incurred at Acquisition
When a long-lived asset is acquired, expenses other than just the purchase price need to be considered ( Shipping, installation). These cost are also capitalized and included in the value of the asset on the balance sheet.
Subsequent expenses related to the long-lived asset may be capitalized if they are expected to provide benefits beyond one yeay, any time less is expensed.
Capitalization of Interest Cost
Companies must capitalize interest costs associated with financing the acquisition or construction of an asset that requires a long period of time to ready for its intended use. For example, if a company constructs a building for its own use, interest expense incurred to finance contruction must be capitalized.
- Under IFRS, but not US GAAP, income earned from temporarily borrowed funds that were acquried to finance the cost of the asset, must be subtracted from interest expense on borrowed funds to determine the amount that can be capitalized
Analytical Issues Relating to Capitalization of Interest Costs
- Capitalized interest costs reduce investing cash flow, while expensed interest costs reduce operating cash flow under US GAAP and operating or financing cash flow under IFRS. Therefore, analysts must examine the impact of classification on reported cash flow
- To provide a true picture of a company’s interest coverage ratio, the entire amountof interest expense, whether capitalzied or expensed, should be used in the denominator
- Interest coverage ratio = EBIT / Interest expense
- A higher ratio indicates that the company can comfortable service its debt through operating earnings
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LOS 30b: Compare the financial reporting of the following types of intangible assets: purchased, internally developed, acquired in a business combination.
Intangible assets lack physical substance and include items that involve exclusive rights such as patents, copyrights, and trademarks. Some intangible assets have finite lives, while other have indefinite lives.
- The cost of an intangible with finite life is amortized
- the cost of an intangible with infinite life is tested for impairment
Intangible assets can also be categorized as indentifiable or unidentifiable
Under IFRS to be identifiable, its must meet 3 definitional criteria, and 2 recognition criteria
Definitional:
- They must be identifiable, meaning that they should either be separable from the entity or must arise from legal rights
- The must be under the company’s control
- They must be expected to earn future economice benefits
Recognitional:
- It is probable that their expected future economic benefits will flow to the entity
- The cost of the asset can be reliably measured
Intangible Assets Squired in Situations other than Business Combinations
These assets are recorded at their fair value when acquired, where the fair value is assumed to equal the purchase price. They are recognized on the balance sheet, and costs of acquisition are classified as investing activities on the cash flow statement. Analysts will focus more on the type of asset acquired, not necessarily the price paid for the asset, as this price is made with a significant degree of judgement, and therefore not 100% reliable.
Intangible assets Developed Internally
These are generally expensed when incurred, but may be capitalized in certain situations
- A firm that develops intangible assets will expense costs of development and recognize no related assets, while a firm tha tacquires intangible assets will recognize them
- A company that develops intangible assets internally will classify development related cash outflows as operating activities on the cash flow statement, while an acquiring firm will classify these costs as investing
Research and Development costs
Generally, US GAAP required that R&D costs be expensed when incurred. However they require that certain costs related to software development be capitalized
IFRS requires that expenditures on research or during the research phase of an internal project be expensed rather than capitalized as an intangible asset. IFRS allows companies to recognize an internal asset from development or the development phase of an internal project is certain criteria are met, including a demonstrationg of the technical feasibility of finishing the prject
Intangible Assets Acquired in a Business Combination
When a company acquires another company, if the price paid to acquire exceeds the fair value of the net assets, the excess if recorded as goodwill. Goodwill is an intangible asset that cannot be identified separately from the business as a whole. Only goodwill created in a business acquisition can be recognized on the balance sheet; internally generated good will cannot be capitalized.
Under IFRS, if an intangible asset cannot be described as identifiable, it is recognized as goodwill.
Under US GAAP, an intangible asset acquired in a business combination should be recognized separately from goodwill if:
- The asset arises from legal or contractual rights
- The item can be seperated from the acquired company
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LOS 30c: Describe the different depreciation methods for property, plant, and equipment, the effect of the choice of depreciation method on the financial statements, and the effects of assumptions concerning useful life and residual value on depreciation expense.
LOS 30d: Calculate depreciation expense
There are two primary models for reporting long-lived assets
The cost model is required under US GAAP and permitted under IFRS. under this model, the cost of long-lived tangible assets (except land) and intangible assets with finite useful live is allocated over their useful lives using depreciation and amortization. Under the cost model, an asset’s carrying value equals its historical cost minus depreciation/amortization
The revaluation model is permitted under IFRS, but not under US GAAP. Under this model, long-lived assets are reported at fair value
Depreciation Methods
Straight-Line Depreciation
- Depreciation expense = (Original cost - Salvage Value)/ Depreciable LIfe
Accelerated depreciation
- DDB in Year X = (2/ depreciable life) x Book value at the beginning of year X
Units-of-Production Method
In this method, depreciation expense is based on actual use of an asset over the period. Useful life will be quoted in units of production. Simply find the percentag of life used, and deduct the amount from the carrying value
Comparison between Straight-Line and Accelerated Depreciation Methods
A company that uses straight line will report:
- A lower asset turnover ratio during the early years of the assets use
- Higher operating profit margin in the early years of the asset use
- Higher operating return on assets (ROA) in the early years of the asset’s use and lower ROA in the later years
A company that uses an accelerated depreciation method will report an improving asset turnover ration, operating profit margin, and ROA over time.
Estimates used for Calculating Depreciation
Assumptions of higher expected residual value and longer useful life will result in lower annual depreciation expense. The subjective nature of these assumptions allows management to manipulate earnings
Additional assumptions required to allocate depreciation expense between COGS and selling, general, and admin expenses (SG&A).
IFRS requries companies to use the component method of depreciation. Under this method companies depreciate different components of assets separately. US GAAP allows this, but it is not widely used.
LOS 30e: Describe the different ammortization methods for intangible assets with finite lives, the effect of the choice of amortization method on the financial statements, and the effects of assumptions concerning useful life and residual value on amortization expense
LOS 30f: Calculate amortization expense
Intangible assets with finite lives are amortized over their useful lives. Examples of these assets are:
- An acquired patent or copyright with a specific expiration date
- Customer lists acquired by a direct mail marketing compnay
- An acquired license with a specific expiration date with no associated right to renew the liscense
- An acquired trademark for a product that a company plans to phase out over a specific number of years.
Acceptable amortization methods are the same as acceptable depreciation methods. The estimate required to calculate yearly amortization expense for an intangible fixed asset with a finite life are:
- The original value of the intangible asset
- The residual value at the end of its useful life
- the length of its useful life
LOS 30g: Describe the revaluation model
Revaluation results in the carrying amount of an asset reflecting its fair value. Under this model, the carrying amount of an asset is reported at its fair value on the date of revalutaion, minus any subsequent accumulated depreciation or amortization.
A key difference between the revaluation and the cost model is that revaluation allows for the reported value of the asset to be higher than its historical cost.
US GAAP does not allow this methid. IFRS allows the revaluation model to be used for certain classes of asset and for the cost model to be used for others as long as:
- The company applies the same model to assets in a particular class
- Whenever a revaluation is performed, all assets in the particular class must be revalued
Uner the revaluation model, whether a revaluation affects earnings depends on whether the revaluation initially increases or decreases the carrying amount of the asset class:
If a revaluation initiall decreases the carrying amount:
- The decrease in value is recognized as a loss on the income statement
- Later if it increases, the increase can be recognized as a gain up to the point of the amount lost from the previous revaluation.
- Any increase beyond the reveral amount will not be recognized on the income statement, but will be adjusted in the revaluation surplus account ( an equity account)
If it increases the carrying amount:
- The increase in value bypasses the income statement and goes directly to equity through the revaluation surplus account
- Later if it decreases, the revaluation surplus account decreases to the amount of the previous gain.
- Any decrease in value beyond the reversal amount is recorded as a loss on the income statement
LOS 30h; Explain the impairment of property, plant, and equipment and intangible assets
An impairment charge is made to reflect the unexpected decline in the fair value of an asset. Impairment recognition has the following effects on a company’s financial statements:
- 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
Impairment of Property, plant & equipment
Companies are required to asses whether there are indications of impairment of PP&E, and if there are, then the recoverable amount of the asset must be measured in order to test the asset for impairment.
Impairment losses reduce the carrying amount of the asset on the balance sheet and reduce net income.
Under IFRS, asn asset is considered impaired when its carrying amount exceeds its recoverable amount. The recoverable amount is the higher of “fair value less costs to sell” and “value in use”, where value in use refers to the discounted value of future cash flows expected from the asset.
Under US GAAP , determing whether an asset is impaired is different from measuring the impairment loss. An asset is considered impaired when its carrying value exceeds the total value of its undiscounted expected future cash flows. Once the carrying value is determined to be nonrecoverable, the impairment loss is measured as the difference between the asset’s carrying amount and its fair value.
Impairment of Intangible Assets with a Finite Life
These assets are not tested for impairment annually, as the are amortized. They are only tested for impairment upon the occurrence of significant adverse events.
Impairment of Intangibles with Indefinit Lives
Goodwill and other intangible assets with indefinite lives are not amortized. They are carried on the balance sheet at historical cost and tested at least annually for impairment.
Impairment of Long-Lived Assets held for Sale
A noncurrent asset is reclassified to an asset “held for sale” when it is no longer in use and management intends to sell it. These assets are tested for impairment when they are listed as held for sale.
Reversals of Impairments of Long-Lived Assets
Under US GAAP once an impairment loss is recorded for assets held for use, it cannot be reversed. If the asset is held for sale, the rule changes and it can be reversed
IFRS allows reversal of impairmetn losses if the value of the asset increases regardless of classification of the asset.
Analysts must carefully consider how impairment charges should be considered in analyzing past performance of companies and in projecting performance going forward
LOS 30i: Explain the derecognition of property, plant, and equipment and intangible assets
A company derecognizes or removes an asset from its financial statements when the asset is disposed of or is not expected to provide any future economic benefits from use or disposal.
Sale of Long-Lived Assets
Gain(loss) on asset disposal = Selling price - Carrying/book value of asset
Gains and losses on disposal of fixed assets can be found on the cash flow statement if prepared using the indirect method.
Long-Lived Assets Disposed of Other than by a Sale
Long-lived assets intended to be disposed of other than by a sale are classified as held for use until disposal
When an asset is retired or abandoned, the company does not receive any cash for it. Assets are reduced by the carrying value of the asset and a loss equal to the carrying value is recorded on the income statement
When an asset is exchanged for another asset, the gain or loss on the transaction is calculated by comparing the caryring value of the asset given up for the fair value of the asset acquired.
LOS 30j: Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets
LOS 30k: Compare the financial reporting of investment property with that of property, plant, and equipment
IFRS defines investment property as property that is owned for the purpose of earning rentals or capital appreciatoin or both. Investment property differs from long-lived tangible assets in that invesment property is not owner occupied, nor is it used for producing the company’s products and services.
Under IFRS investment property may be valued using the cost model or fair value model
- Cost Model - This is identical to cost model used for PP&E
- 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 previously recognised 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.
The following valuation issued arise when the classification of investment property changes to or from owner-occupied property or inventory
- If investment property is valued using the fair model, a move to owner-occupied property or inventory will be made at fair value. The property’s fair value will become its new cost for the purpose of ongoing accounting for the property
- If owner-occupied property is reclassified as investment property, the change in the value from depreciated cost to fair value at the time of transfer is treated like revaluation
Investment property is reported as a seperate line item on the balance sheet. Further, companies must disclose which model they have used to value the property.
US GAAP does not specifically define investnmet property. US companies that hold investmnet type property use the historical cost model.
