Chapter # 7

Analysis of long-lived
Assets: Part – I The
Capitalization Decision
 The long-lived operating assets of a firm,
unlike inventory, are not held for resale but
are used in the firm’s manufacturing, sales and
administrative operations.

Such assets include tangible fixed assets

(plant, machinery and office facilities)

As well as intangible assets such as

computer software, patents and trademarks.
 Acquiring the asset: The
capitalization decision:
The costs of acquiring resources that
provide services over more than one
operating cycle are capitalized and carried
as assets on the balance sheet.

All costs incurred until the asset is ready for

use must be capitalized, including the
invoice price, applicable sales tax, freight and
nsurance costs incurred delivering the
quipment and any installation costs.
 Major issues:
1. Should some components of acquisition cost be
included in the capitalized cost (e.g. interest during
construction)?
2. Do some types of costs merit capitalization (e.g.
software development and research and development
costs)?
3.What accounting method should be used to
determine the amount of costs capitalized?

This choices affect the BS, IS and CFS and Ratios both
in the year the choice is made and over the life of the asset
 Capitalization Vs Expensing:
Conceptual Issues:

Financial statement effects of

capitalization on:
.Income variability.
.Profitability.
.Cash flow from operations.
.Leverage ratios
 Income variability:
Firms that capitalized costs and depreciate them
(systematically allocate them to income) over time
show smoother patterns of reported income.
Capitalized process shows higher net income.
Expense process shows lower net income. Charge
from the revenue of that year.
Profitability:
In the early years, expensing lowers profitability. If cost is
deduct at the time of expenses, then the profit will be lower.
Profitability remains lower for expensing firms as long as
the level of expenditures is increasing.
ROA and ROE are usually higher for the expensing firms
Cash flow from operations:
Cash expenditures for capitalized assets are included in
investing cash flows and never flow through CFO. But the
expensing firms include these expenditures under CFO.
Thus CFO will always be higher for capitalizing firms.

Leverage ratios:
Expensing firms report lower assets and equity
balances.
As a result, debt-to-equity and debt-to-assets
solvency ratios will appear worse for
expensing firms as compared with firms that
capitalize the same costs
Capitalization Vs Expensing:
General Issues:
•Capitalization of interest costs.
•Intangible assets.
•R &D, Patents and copy rights
•Franchises and licenses
•Brands and trademarks
•Advertising cost.
 Capitalization of interest costs
In the US, SFAS 34 requires the capitalization
of interest costs incurred during the
construction period.
Given all arguments, we believe that
expensing of interest expense is preferable.
For purpose of analysis, the income
statement capitalization of interest should be
reversed resulting in the following effects:
For purpose of analysis, therefore, the income
statement capitalization of interest should be
reversed, resulting the following effects:
1. Capitalized interest should be added back to
interest expense
2. Adding capitalized interest back to interest
expense reduces net income
3. The amount of interest capitalized should be
added back to CFI and subtracted from CFO.
4. The interest coverage ratio should be
calculated with interest expense
adjusted to add back capitalized interest.
 Intangible assets
Licenses, computer software, patents , brand
names, and copyrights (protect the
intellectual authority) are among the more
familiar examples of assets without tangible,
physical substance.

Intangible assets when acquired in an

arm’s-length transaction, the acquisition price
is assumed to equal the market value of the
assets acquired and this amount has to be
capitalized.
 Intangible assets
But if it is internally developed, difficult to
capitalized because
o The cost incurred in developing these assets
may not be easily separable.
o It is difficult to measure the amount & duration of
benefits from such expenditures.
o There may be little relationship between the cost
incurred and the value of the asset created.
 Research and development
Companies invest in R&D because they
expect the investment to produce profitable
future products.
However, absent a resultant commercial
product, these expenditures may have no value
to the firm.
Further, the value of the resulting product
may be unrelated to the amount spent on R&D.
Due to such valuation uncertainties, R&D is
generally unacceptable to creditors as security
for loans.
SFAS requires that virtually all R&D costs be
expensed in the period incurred and the amount
disclosed (made publicly available).
IAS 9 requires the expensing of research costs
but requires capitalization of development
cost when all the following criteria are met;
1. The product is clearly defined
2. Costs can be clearly identified
3. Technical feasibility has been established
4. The firm intends to produce the product
5. The market has been clearly defined
6. The firm has sufficient resource to complete the project.
Patents and copyrights:
All costs incurred in developing patents and
copyrights are expensed in conformity with the
treatment of R&D costs.

Only the legal fees incurred in registering

internally developed patents and copyrights can
capitalized.

However, the full acquisition cost is capitalized

when such assets are purchased from other
entities.
Franchise and licenses:

Franchise: not only give the technical

support, but also invest in marketing, patent,
or producing. Keep control on the firm’s
operation.

Licenses: simply give the technical expertise.

Don’t invest for marketing or production. Give
that right for some charges.

The franchisee and licensee capitalizes the

cost of purchasing these rights
BRANDS AND TRADEMARKS:
The cost of acquiring brands and trademarks
in arm’s length transactions is capitalized.

ADVERTISING COSTS:
successful advertising campaigns can
contribute to generating a customer base and
establishing brand or firm loyalty for many
years. These benefits are uncertain and
difficult to measure and advertising cost are
expensed as incurred.
 Capitalization versus expensing:
industry issues
Regulated Utilities:
Regulators allow utilities to earn profits equal
to a specified allowable rate of rate of return
on assets. Adding expenses to this allowable
profit yields the rates they can charge their
customers. Revenues are derived as follows:
Revenues are derived as follows:
Revenues = Expenses + (Rate of return X
Rate base)
Computer software development
cost:
SFAS requires that all costs incurred
to establish the technological and
economic feasibility of software be
viewed as R & D cost and expensed as
incurred. Once economic feasibility has
been established, subsequent cost can
be capitalized.
Accounting for oil and gas exploration:

Successful efforts(SE) accounting method:

The FASB required all firms to use SE
accounting method that expense all dry holes
cost and capitalize the cost of productive wells.

Full cost(FC) accounting method:

The SEC allows public limited companies to use
either SE accounting method or FC accounting
method. FC accounting method permits the
capitalization of dry holes cost.
Analytical adjustment for capitalization
and expensing

Need for analytical adjustment:

Because the choices between capitalization
and expensing discussed affect reported
corporate performance, analysts must
sometimes adjust reported data to facilitate
analysis and comparisons.
Other economic consequences:
Differences in accounting method can have
following consequences:
1. A firm’s borrowing ability may be limited
by unfavorable profitability or leverage ratios
resulting from.
2. Because of these unfavorable ratios, a firm
may curtail these expenditures,
3. Whether or not managers actually reduce
R & D, the fact that the market perceives
such a possibility can cause negative market
reaction.
Additional analysis of fixed asset data:
Changes in the balance sheet cost of fixed
assets result from four types of event:
1. Capital spending
2. Sale, impairment or retirement of fixed
assets
3. Increase in fixed assets due to acquisitions
4. Change due to effects of foreign currency
translation
Capital spending:
The capital expenditure decision provides
information to the investor as to a firm’s future
profitability and growth prospects.
Management often announces major capital
expenditure plans separately.

Sale or retirement of assets:

The sale or retirement of fixed assets removes
these assets from the balance sheet. For most
firm sale or retirement also generates gains or
losses included in reported income.