Applied Financial

Long Term
Analysis
z Assets
Fall 2020
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§Capitalization-deferring a cost that is incurred in the

current period, but whose benefits are expected to
extend to one or more future periods.
§ Allocation-periodically expensing a deferred cost
Long Term (asset) to one or more future expected benefit

Assets periods (depreciation, amortization, depletion)

§ Impairment-writing down the book value of the
asset when its expected cash flows are no longer
sufficient to recover the remaining cost reported on
the balance sheet.
 z Assume a company incurred the following expenditures to
purchase a towel and tissue roll machine: €10,900 purchase
price including taxes,€200 for delivery of the machine, €300 for
installation and testing of the machine. In addition, the
company paid a construction team €350 to reinforce the
factory floor and ceiling joists to accommodate the machine’s
weight. The company also paid €1,500 to repair the factory
roof (a repair expected to extend the useful life of the factory
Capital Vs by five years) and €1,000 to have the exterior of the factory

Revenue and adjoining offices repainted for maintenance reasons. The

repainting neither extends the life of factory and offices nor

Expenditure improves their usability.

1. Which of these expenditures will be capitalized and which

will be expensed?

2. How will the treatment of these expenditures affect the

company’s financial statements?

Adapted from CFA Investment Series

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Capital Vs Revenue Expenditure
Assume two identical hypothetical companies AFA and AFR start up with $1000 cash
and ordinary equity. Every year they receive total revenues of $1500 each and pay
$500 in cash expenses. At the start of operations each company purchases
equipment for $900. AFA estimates the equipment will have a useful life of three
years and capitalizes it while AFR estimates a much shorter life and expenses the
entire amount.

Assuming a tax rate of 30% answer the following questions

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

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

§ Why does AFR report a change in cash of $70 in year 1, while AFA reports total
outflow of cash of $110?

Adapted from CFA Investment Series

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AFA 1 2 3
Capital Vs Revenue 1,500 1,500 1,500
Revenue Cash expenses 500 500 500
Expenditure Depreciation 300 300 300
Income before Tax 700 700 700
Tax @30% 210 210 210
Net Income 490 490 490

Cash from 790 790 790

Operations
Cash used in (900) 00 00
investing
Total Change in (110) 790 790
Cash
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AFR 1 2 3
Revenue 1,500 1,500 1,500
Cash expenses 1400 500 500
Depreciation 0 0 0
Income before Tax 100 1000 1000
Tax @30% 30 300 300
z
Capital Vs Net Income 70 700 700
Revenue
Expenditure Cash from Operations 70 700 700
Cash used in investing 0 00 00
Total Change in Cash 70 700 700
 z

Capital Vs
Revenue AFA
Expenditure
ROE 39% 28% 22%
Net Profit 33% 33% 33%
Margin
AFR
ROE 7% 49% 33%
Net Profit 5% 47% 47%
Margin
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Capital Vs Revenue Expenditure

Expenditure is capitalized if the benefit is expected to accrue for more than one year. The decision to
capitalize or expense affects comparability with other entities and trends

Capital Expenditure
§ Increases assets

§ Increases investment outflows

§ Is depreciated/ amortised subsequently ( except for land & indefinite life intangibles)

§ Impacts cash flows indirectly via taxation

Revenue Expenditure
§ Reduces net income & retained earnings
§ Does not affect assets or subsequent periods

§ Reduces operating cash flows

z

Capitalisation of Interest Costs

Companies capitalise interest costs associated with acquiring or constructing an asset
that requires a long time to get ready for its intended use

Consequently, interest may appear as an expense in the income statement or as part of the
cost of the asset in the balance sheet. Capitalised interest is then expensed over time in the
shape of depreciation or cost of sales.

This affects cash flow subtotals and calculation of interest coverage ratios.

Including capitalised interest in coverage ratios gives a better indication of solvency.

 z

A hypothetical company, borrows €1,000,000 at an interest

rate of 10 percent per year on 1 January 2010 to finance the
construction of a factory that will have a useful life of 40
years. Construction is completed after two years, during
Capitalisation which time the company earns €20,000 by temporarily
investing the loan proceeds.
of Interest
Costs 1. What is the amount of interest that will be capitalized
under IFRS, and how would that amount differ from the
amount that would be capitalized under U.S. GAAP?

2. Where will the capitalized borrowing cost appear on the

company’s financial statements?
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Allocation
§ Depreciation varies significantly depending on the method chosen

§ The faster an asset is written off for tax purposes, the greater the tax deferral to future periods and
the more funds immediately available for operations.

§ The conceptual support for accelerated methods is the view that decreasing depreciation charges
over time compensate for

(1) increasing repair and maintenance costs,

(2) decreasing revenues and operating efficiency, and

(3) Higher uncertainty of revenues in later years of aged assets (due to obsolescence).
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Analyzing Plant Assets

§ Average total life span = Gross plant and equipment assets/Current year
depreciation expense.

§ Average age = Accumulated depreciation/Current year depreciation

expense.

§ Average remaining life = Net plant and equipment assets/Current year

depreciation expense.

§ Average total life span = Average age + Average remaining life

 z
Impairment

Impairment = Carrying Amount >

Recoverable Amount

Recoverable amount = Higher of

fair value less costs to sell and
value in use

Reversals allowed ( except for

goodwill)
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Impairment –Implications for Analysis
While impairment losses reduce net income and assets, they do not affect cash flows

Treated as non-recurring for the purposes of future projections

Historical earnings may have been overstated

Recognition and measurement of impairment charges are highly judgmental and hence
present a significant means of earnings management

§ Can be used as a means to affect trends as subsequent years will show improved profits

§ Or could be underestimated to keep earnings afloat

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Revaluations
§ Upward revaluation increases assets & equity resulting in reduced leverage

§ Upward revaluation increase depreciation, total assets & equity so profitability measures like
ROA and ROE may fall

§ Downward revaluation decreases net income resulting in reduced profitability measures in the
year of revaluation ( although assets and equity falling may result in the company appearing
more profitable in the future). Reversals may also be ‘timed’ conveniently

Fair value appraisals done by independent external sources are more reliable.
 z

Disposals of Long-Lived Assets

Gain or loss on disposal is the difference between the sale proceeds and the carrying value of the asset at
the time of sale.

During an accounting period in which a company decides to sell an asset or group of assets and
commences the process the assets are classified as held for sale.

Assets held for sale are measured at the lower of the carrying value and fair value less costs to sell and
depreciation stops.

Groups of assets that make up a significant separate component of the entity are classified as discontinued
operations

For purposes of analysis results are more comparable if the impact on the financial statements of
significant asset disposals are excluded from operating results
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Intangible Assets
Purchased ( other than in a business combination)

Recorded at fair value ( assumed to be equal to the purchase price)

If several acquired as part of a group purchase price is allocated on the basis of fair values

Internally generated

Usually expensed unless a fairly stringent criteria is met ( Research costs always expensed but
some development costs may be capitalised)

Since judgement is involved in these decisions, they can result in different capitalization practices as can
the decision to develop internally or purchase which affects the financial statements in a manner similar
to capital vs revenue expenditure choices for tangible long term assets.
 z

Intangible
Assets
Type of Expenditure IFRS US GAAP
Research Expense as incurred Expense as incurred
Development Capitalise if certain criteria Expense as incurred for
are met • Costs to develop a
software product to sell
after feasibility
• Certain costs to develop
software for internal use

In process R& D Either identify as a separate Expense immediately on

acquired in a business asset with a finite life or acquisition
combination include as part of goodwill