Level I - Financial Reporting and Analysis

Long-Lived Assets

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 Contents
1. Introduction
2. Acquisition of Long-Lived Assets
3. Depreciation and Amortization of Long-Lived Assets
4. The Revaluation Model
5. Impairment of Assets
6. Derecognition
7. Presentation and Disclosures
8. Investment Property
9. Leasing

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 1. Introduction

• Long-lived assets are defined as those assets which are expected to provide
future economic benefits extending more than one year

• These assets may be tangible, intangible, or financial assets

• Major questions:
 What value should be shown on the balance sheet?
 How should the cost be allocated over the life of the asset?

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 2. Acquisition of Long-Lived Assets
• Upon acquisition, long-term, tangible assets such as property, plant and equipment
are recorded on the balance sheet at cost which is typically the same as fair value.
 Asset’s costs might include expenditures in addition to purchase price
 Should these costs be expenses or capitalized?

• Intangible asset valuation depends on method of acquisition

 Developed internally
 Purchased
 Though a business acquisition

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 Property, Plant, and Equipment
• At acquisition, PPE is recorded at cost
 Cost includes all expenditures necessary to get the asset ready for intended use
 Subsequent costs are capitalized if they are expected to provide benefit beyond one year;
otherwise they are expensed

• Companies might have different approaches towards expensing/capitalizing costs

• An analyst should understand the impact of expensing/capitalizing decisions on

financial statements and ratios

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 Example
Acme Inc. purchased a machine for 10,000. In addition the following costs were
incurred:
 200 for delivery
 300 for installation
 100 to train staff on using the machine
 1,000 to reinforce floor to support machine
 500 to have the factory painted

1. Which expenses will be capitalized and which will be expensed

2. How will the treatment of these expenditures affect the company’s financial statements

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 Capitalization of Interest Costs
• For constructed assets interest cost during construction are
capitalized as part of the asset cost
 Use rate on borrowing related to construction; if no construction
debt is outstanding interest rate is based on existing unrelated debt
 Capitalized interest not reported as interest expense on I/S
 IFRS: interest on short-term lending offsets capitalized costs (not
allowed in U.S. GAAP)

• Capitalized interest causes:

 Higher net income and greater interest coverage ratios during the
period of capitalization
 Higher asset values and depreciation lead to lower net income, EBIT
and interest coverage over subsequent periods

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 Example
A company borrows 2,000,000 at an interest rate of 5 percent per year on 1 January
2011 to finance construction of a factory that will have a useful life of 40 years.
Construction is completed after two years, during which time the company earns
20,000 by temporarily investing the loan proceeds.
1. How much interest will be capitalized under IFRS and U.S. GAAP?
2. Where will the capitalized borrowing cost appear on the company’s financial
statements?

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 Intangible Assets
Intangible assets lack physical substance. Classic examples include software, customer
lists, patents, copyrights and trademarks. Accounting for intangible asset depends on
how it is acquired.

Acquired in a business combination

 Recorded at fair value; similar to long-lived tangible assets
 Determination of fair value requires judgment

Purchased in situation other than business combinations

 Recorded at fair value

Developed internally
 Next slide

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 Intangible Assets Developed Internally
• Under IFRS research costs are expensed as incurred and development costs are
capitalized; U.S. GAAP requires both research and development costs to be
expensed as incurred.

• Costs incurred to develop software for sale to others are expensed as incurred
until product’s technological feasibility has been established; subsequent costs
should be capitalized.

• Under IFRS costs incurred to develop software for internal use should be
capitalized once feasibility established. U.S .GAAP: capitalize all development
costs.

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 Example
Acme Inc. starts an internal software development project on 1 January 2012. It incurs
expenditures of 10,000 per month during the fiscal year ended 31 December 2012.
By 31 March it is clear that product will be developed successfully and will be used as
intended. How are the software development costs recorded before and after 31
March according to IFRS? According to U.S. GAAP?

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Capitalising versus Expensing: Impact on Financial Statements and Ratios

Capitalising Expensing A=L+E

Total Assets H L Capitalising versus
Equity H L expensing does not
Income variability L H impact liabilities. If
assets are higher
Net income (1st year) H L
equity will be higher
Net income (later) L H
CFO H L
CFI L H
D/E L H
Interest Coverage (Initially) H L
Interest Coverage (later) L H
ROA and ROE in (Initially) H L
ROA and ROE (later) L H

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 Example 4: Impact of Capitalising vs. Expensing

 CAP and NOW start with 1,000 cash and 1,000 equity
 Revenue = 1,500
 Equipment Purchase = 900
 Other expenses = 500
 CAP does straight line depreciation over 3 years
 Tax rate = 30%

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1. Which company reports higher net income over the three years? Total cash flow? Cash from operations?

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2. Based on ROE and net profit margin, how does the profitability of the two companies compare?

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3. Why does NOW report change in cash of €70 in Year 1?, while CAP reports total change in cash of (€110)?

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 3. Depreciation and Amortization of Long-Lived Assets
• Under the cost model of reporting long-lived assets, the capitalized cost of a
tangible (intangible) long-lived asset is expensed through a process called
depreciation (amortization)

• An asset’s carrying amount is the amount at which the asset is reported on the
balance sheet; carrying amount is also called net book value
 Carrying amount = historical cost – accumulated depreciation

• Depreciation methods include

 Straight-line method: cost of asset allocated evenly over useful life
 Accelerated methods
 Units-of-production method

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 Example
Consider three companies with names based on their depreciation method:
1. Straight Line (SL) Inc.
2. Double Declining Balance (DDB) Inc.
3. Units of Production (UOP) Inc.
Each company purchases identical equipment for 10,000 and makes similar assumptions: estimated
useful life = 4 years; residual value = 1,000; productive capacity = 1,000 units. Production over 4 years:
400, 300, 200, 100. Complete the table below for each company.
UOP Depreciation per unit = (Cost – Residual Value) / Productive Capacity

Beginning Net Depreciation Accumulated Ending Net Book

Book Value Expense Depreciation Value
Year 1
Year 2
Year 3
Year 4

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Solution Beg. Net Book Value Dep. Exp. Acc. Dep. End Net Book Value
Year 1 10,000 2,250 2,250 7,750
Straight Line Year 2 7,750 2,250 4,500 5,500
Year 3 5,500 2,250 6,750 3,250
Year 4 3,250 2,250 9,000 1,000

Beg. Net Book Value Dep. Exp. Acc. Dep. End Net Book Value
Double Declining Year 1 10,000 5,000 5,000 5,000
Balance Year 2 5,000 2,500 7,500 2,500
Year 3 2,500 1,250 8,750 1,250
Year 4 1,250 250 9,000 1,000

Beg. Net Book Value Dep. Exp. Acc. Dep. End Net Book Value
Units of Production
Year 1 10,000 3,600 3,600 6,400
Year 2 6,400 2,700 6,300 4,000
Year 3 4,000 1,800 8,100 2,000
Year 4 2,000 900
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 Compute the asset turnover ratio, operating profit margin and operating ROA for SLD and DDB. Assume sales =
400,000/year, operating expenses without depreciation = 300,000 and carrying amount of assets w/o new
machine = 300,000.

Operating
Assets Other Carrying Operating
Expenses Depreciaton Operating Total Asset Operating
Sales EBIT Than Value of Return on
without Expense Expense Assets Turnover Profit Margin
Equipment Equipment Assets
Depreciation

SLD - Y1 400,000 300,000 2,250 302,250 97,750 300,000 7,750 307,750 1.300 24.44% 31.53%

SLD - Y2 400,000 300,000 2,250 302,250 97,750 300,000 5,500 305,500 1.309 24.44% 31.76%

SLD - Y3 400,000 300,000 2,250 302,250 97,750 300,000 3,250 303,250 1.319 24.44% 32.00%

SLD - Y4 400,000 300,000 2,250 302,250 97,750 300,000 1,000 301,000 1.329 24.44% 32.23%

DDB - Y1 400,000 300,000 5,000 305,000 95,000 300,000 5,000 305,000 1.311 23.75% 30.65%

DDB - Y2 400,000 300,000 2,500 302,500 97,500 300,000 2,500 302,500 1.322 24.38% 31.97%

DDB - Y3 400,000 300,000 1,250 301,250 98,750 300,000 1,250 301,250 1.328 24.69% 32.64%
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DDB - Y4 400,000 300,000 250 300,250 99,750 300,000 1,000 301,000 1.329 24.94% 33.11%
 Financial Statement Impact Summary
The relationships indicated in the table below are for the early years of an asset’s life

Straight Line Accelerated (DDB)

Depreciation expense Lower Higher
Net income Higher Lower
Assets Higher Lower
Equity Higher Lower
Return on assets Higher Lower
Return on equity Higher Lower
Asset turnover Lower Higher
Operating profit margin Higher Lower

Above relationships reverse in the later years if the firm’s capital expenditure decline

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 Component Method of Depreciation
• IFRS requires companies to use the component method of depreciation
depreciate each component separately
• U.S. GAAP allows component depreciation but the method is seldom used in
practice
• Example: a machine has two major components. Component 1 costs $10,000 and
has an estimated useful life of 10 years. Component 2 has a cost of $3,000 and has
an estimated useful life of 3 years. What is the depreciation expense for the first
year?

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 Amortization and Calculation of Amortization Expense
Amortization is similar in concept to depreciation. The term amortization applies to
intangible assets, and term depreciation applies to tangible assets.

Intangible assets include customer lists, copyrights, patents and trademarks.

Intangible assets with finite useful lives are amortized over their useful lives.

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 4. Revaluation Model
• The revaluation model is an alternative to the cost model for the
periodic valuation and reporting of long-lived assets.

• IFRS permit the use of either the revaluation model or the cost model

• U.S. GAAP does not allow revaluation model

• Revaluation changes the carrying amounts of classes of long-lived

assets to fair value.

• Carrying amounts are the fair values at the date of revaluation less any
subsequent accumulated depreciation or amortization

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 Example
Scenario 1: Machine costs 10,000 at the start of Period 1. At the end of Period 1 the
fair value of the machine is 12,000. At the end of Period 2 the fair value is 8,000.
Show the impact on the financial statements.

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 Example
Scenario 2: Machine costs 10,000 at the start of Period 1. At the end of Period 1 the
fair value of the machine is 8,000. At the end of Period 2 the fair value is 12,000.
Show the impact on the financial statements.

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 5. Impairment of Assets
• Impairment charges reflect an unanticipated decline in the value of an
asset.

• Both IFRS and U.S. GAAP require companies to write down the carrying
amount of impaired assets.

• Impairment reversals are permitted under IFRS but not under U.S.
GAAP.

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 Impairment Calculation
Under IFRS: Impairment loss = Carrying Value – Recoverable amount
 Recoverable amount = greater of fair value less cost to sell and value in use
 Value in use is present value of cash flow from asset

Under U.S. GAAP: First do the recoverability test to determine whether the asset is
impaired. Asset is impaired if the carrying value is greater than the asset’s future
undiscounted cash flows
 Impairment loss = Difference between fair value and carrying amount

Example 9
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 Example
Given the following data, what is the reported value under IFRS and U.S. GAAP.
• Carrying amount = 8,000
• Undiscounted expected future cash flows = 9,000
• Present value of expected future cash flows = 6,000
• Fair value if sold = 7,000
• Costs to sell = 200

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 Other Impairment Scenarios
• Impairment of Intangible Assets with a Finite Life

• Impairment of Intangibles Assets with Indefinite Lives

• Impairment of Long-lived Assets Held for Sale

• Reversals of Impairments of Long-lived Assets

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 6. Derecognition
A company derecognizes an asset (i.e., removes it from the financial statements)
when the asset is disposed of or is expected to provide no future benefits from either
use or disposal.

A company may dispose of a long-lived operating asset by selling it, exchanging it, or
abandoning it.

Gain or loss on sales = sales proceeds – carrying amount

Example 10

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 Long-Lived Assets Disposed of Other than by a Sale
• Abandoned Assets are treated like sale with 0 proceeds
 Carrying value removed from balance sheet
 Loss recognized in income statement

• Exchanged Assets
 Carrying value removed from balance sheet
 Record fair value of new asset
 Gain/loss computed by comparing carrying value of old asset with fair value of
new asset

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 7. Presentation and Disclosures
Under IFRS, for each class of property, plant and equipment, a company must disclose
the measurement bases, the depreciation method, the useful lives (or, equivalently,
the depreciation rate) used, the gross carrying amount and the accumulated
depreciation at the beginning and end of the period, and a reconciliation of the
carrying amount at the beginning and end of the period.

Under U.S. GAAP the requirements are less exhaustive. A company must disclose the
depreciation expense for the period, the balances of major classes of depreciable
assets, accumulated depreciation by major classes or in total, and a general
description of the depreciation method(s) used in computing depreciation expense
with respect to the major classes of depreciable assets.

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 8. Investment Property
Investment property is defined as property that is owned (or, in some cases, leased
under a finance lease) for the purpose of earning rentals, capital appreciation, or
both.

Under IFRS, companies are allowed to value investment properties using either a cost
model or a fair value model. The cost model is identical to the cost model used for
property, plant, and equipment, but the fair value model differs from the revaluation
model used for property, plant, and equipment. Under the fair value model, all
changes in the fair value of investment property affect net income.

Under U.S. GAAP, investment properties are generally measured using the cost model.

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 Example
What is the treatment of unrealized gains and losses for AFS securities, assets valued
using revaluation model, and assets valued using the fair value model?

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 9. Leasing
A lease is a contract between a lessor a lessee

• Lessor  Owner of leasing asset

• Lessee  User of leasing asset

• Lessor grants right of use of the asset to lessee; right to use could be a long period
such as 20 years or a short period such as a month
• In exchange for the right to use the asset, the user makes periodic payments to the
owner

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 The Lease versus Buy Decision
• Less costly financing

• Less restrictive provisions

• Reduced risk of obsolescence

• Off balance sheet financing

• Tax reporting advantages: in U.S firms can create a synthetic lease but treat lease
as an ownership for tax purposes.

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 Finance versus Operating Leases
• An operating lease is an agreement allowing the lessee to use the asset for a period
of time

• A finance lease is equivalent to the purchase of some asset (lease to own) by the
buyer (lessee) that is directly financed by the seller (lessor).
 IFRS: risks and rewards are transferred to the lessee
 U.S. GAAP: (1) ownership of the leased asset transfers to lessee at end of lease, (2) the lease
contains an option for the lessee to purchase the leased asset cheaply (bargain purchase
option), (3) the lease term is 75 percent or more of the useful life of the leased asset, and (4)
the present value of lease payments is 90 percent or more of the fair value of the leased asset

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 Reporting by Lessee
• Operating lease:
 No entry at inception of lease
 Rent expense equal to the lease payment recognized in
income statement during lease term

• Finance lease:
 At inception, present value of future lease payments is
recognized as an asset and as a liability on the balance
sheet
 Asset is depreciated and interest payment is recognized in
income statement over term of lease
 Interest expense = liability at the beginning of period x
interest rate

Example 19

Example 20
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 Financial Statement Impact of Lease Accounting for
Lessee
Finance Lease Operating Lease
Assets Higher Lower
Liabilities (current and long term) Higher Lower
Net income (in the early years) Lower Higher
Net income ( later years) Higher Lower
Total net income Same Same
EBIT (operating income) Higher Lower
Cash flow from operation Higher Lower
Cash flow from financing Lower Higher
Total cash flow Same Same

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 Ratio Impact of Lease Accounting
Finance Lease Operating Lease
Current ratio Lower Higher
Working capital Lower Higher
Asset turnover Lower Higher
Return on assets (early years) Lower Higher
Return on equity (early years) Lower Higher
Debt/Assets Higher Lower
Debt/Equity Higher Lower

When a company has a substantial amount of operating leases,

adjusting reported financials to include the impact of capitalising these
leases better reflects the company’s solvency position.

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 Reporting by Lessor
• Operating lease:
 Record revenue when earned
 Report leased asset on balance sheet
 Depreciation expense on income statement

• Finance lease:
 Report lease receivable
 Reduce asset by carrying amount of the asset leased
 U.S. GAAP: 1) Direct finance lease and 2) Sales type lease

• When a lessor reports a lease as a finance lease rather than an operating lease, it
usually appears more profitable in early years of the lease.

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 Two Types of Finance Leases (Lessor Perspective)

• Direct finance lease

 Present value of lease payments = carrying value of lease asset
 Lessor earns only interest revenue

• Sales type lease

 Present value of lease payments > carrying value of lease asset
 Lessor earns both interest revenue and a profit (or loss) on the sale of the leased asset

Example 21

Example 22
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 Summary
• Impact of expense versus capitalize decision on financial statements and ratios

• Impact of depreciation methods on financial statements and ratios

• Impact of impairment and revaluation on financial statements and ratios

• Financial statement disclosures regarding long-lived assets

• Impact of lease versus purchase decision on financial statements and ratios

• Finance leases versus operating leases (lessor and the lessee perspective)

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 Conclusion
• Read the summary

• Review learning objectives

• Examples

• Practice problems

• Practice questions from other sources

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