Analysis of

Financial Statements
Session # 9
14-Nov-2020

Today’s topics
Analysis of Long Lived Assets :
1. Capitalization Decision.
2. Analysis of Depreciation and Impairment.

1
 Part 1
Capitalization Decision

2
 Long-Lived Operating Assets
• Unlike inventory, they are not held for resale
• They are used in manufacturing, sales and administration
• They provide services for more than one year
Two issues :
1) Which costs to allocate to the Asset
2) To Expense or Capitalize

All Costs incurred till Assets are ready for use :

• Invoice price
• Taxes
• Insurance …..
3
4
5
Exercise
Misha bought a machine for £39,000/- , which she expects to have a useful life of
four years and a residual value of £4,000 at the end of that time. If depreciation is
to be provided on the straight-line basis, the Net Book Value (NBV) after two years
will be:
A. £17,500
B. £19,500.
C. £21,500.
D. £30,250.

Correct answer: C) £21,500.

Feedback:
The annual depreciation charge will be (£39,000 - £4,000)/ 4 = £8,750. NBV after two years =
£39,000 - (2 x 8,750) = £21,500.

6
To Expense or to Capitalization

The effect

7
Expense / Capitalization Effect :
Base Exp Cap
Asset 100
Debt 60
Equity 40
Income 30
ROA 30%
ROE 75%

8
Example :
The company purchased capital assets of 20 through additional equity
Asset Purchase value = 20
Depreciation Expense SL 5 years = 4 per year

It has two options

1) Expense full 20 in current year or

2) Capitalize the expense over its useful life of 5 years. i.e 20 / 5 = 4 depreciation expense
per year.

9
Capitalization Effect :
Base Exp Cap
Asset 100
The company purchased capital
assets of 20 through additional Debt 60
equity Equity 40
Income 30
• Asset Purchase value = 20
• Depreciation Expense SL 5 ROA 30%
years = 4 per year ROE 75%

It has two options

1) Expense full 20 in current year or

2) Capitalize the expense over its useful life of 5 years. i.e 20 / 5 = 4 depreciation 10
expense per year.
 Capitalization Effect :
Base Exp Cap
Asset 100 100

Debt 60 60
Equity 40 60

Income 30 10

ROA 30% 10%

ROE 75% 17%
Expense full 20 in current year
If the company choses to expense out in current year, income will drop from 30 to 10 (30 – 20
capital expense). Asset size will not increase thus ROA will be = Income / Asset = 10 / 100 = 10.
11
ROE = Income / Equity = 10 / 60 = 17%.
Capitalization Effect :
Base Exp Cap
Asset 100 100 120

Debt 60 60 60
Equity 40 60 60

Income 30 10 26

ROA 30% 10% 22%

ROE 75% 17% 43%
Capitalize the asset
If the company choses to capitalize. Income will reduce to 26 (30 – only depreciation expense of 4). Since the
company has capitalized its assets, the asset size will increase to 120. Thus ROA will be Income / Assets = 26 /
120 = 22%. Similarly ROE = Income / Equity = 26 / 60 = 43%. 12
 Exercise
For an asset owned for more than one year, the depreciation charge for the year,
calculated using the reducing-balance basis at the rate of 35%, would be arrived at as
follows:
A. 35% x cost of the asset.
B. 35% x (cost of the asset - accumulated depreciation).
C. 35% x accumulated depreciation.
D. 35% x (cost of the asset + accumulated depreciation).

Correct answer: B) 35% x (cost of the asset - accumulated depreciation).

 
Feedback:
The formula to apply if the reducing balance method of depreciation is being used is: percentage
multiplied by the net book value of the asset.

13
End of Part 1
Capitalization Decision

14
 Part 2
Depreciation and Impairment

15
Accounting Depreciation :
Is an accounting method of allocating the cost of a tangible asset over its
useful life and is used to account for decline in the asset value.

Economic Depreciation :
Decline in the value of a property due to indirect changes. Such as decline
in the quality of neighborhood or the construction or closure of roads in
the vicinity.

Deprecation Method : Straight Line / Accelerated 16

Exercise
Bruno buys two motor vans costing £41,000 in total. They are depreciated on the reducing-balance
basis at the rate of 40% per annum. Which of the following statements is true?
A. The NBV of the vans after one year will be £24,600 and the depreciation charge
for year 2 will be £16,400.
B. The NBV of the vans after two years will be £14,760 and the depreciation charge
for year 2 will be £9,840
C. The NBV of the vans after one year will be £14,760 and the depreciation charge
for year 2 will be £16,400.
D. The NBV of the vans after two years will be £24,600 and the depreciation charge
for year 2 will be £9,840
Correct answer: (B)

Feedback:
NBV of the vans after 1 year = £41,000 x 60% = £24,600.
NBV of the vans after 2 years = £24,600 x 60% = £14,760.
The charge for depreciation in Year 1 = £41,000 x 40% = £16,400 and in Year 2 = £24,600 x 40% =
£9,840. 17
Three methods in changing Depreciation Method
1. Change in method applicable to newly acquired assets only (Impact is
gradual)

2. Change in method applicable to all assets (effect is greater and can be

significant in the year of switch)

3. Change in asset life or salvage value (these are considered change in

estimates and not change in accounting principles)

18
19
Assignment for next class
Review the Depreciation policy of your company and document if any
change has been reported in last two years

20
21
22
23
24
25
26
27
Impairment

28
Impairment :
• Impairment of asset occur when the market price of the asset is less
than the value in company's balance sheet.
• Accounts that are likely to be written down are the company's
goodwill, accounts receivable and long-term assets 
• Impairment losses can occur for a variety of reasons: physical damage to
the asset, a permanent reduction in market value and legal issues
against the asset.
• Upon adjusting an impaired asset’s carrying value, the loss is recognized
on the company’s income statement.
• The loss will reduce income in the income statement and reduce total
assets on the balance sheet.
29
Which of the following terms does this statement define: “the amount by
which the carrying amount of an asset exceeds its recoverable amount”?

A. Depreciation
B. Fair value
C. Impairment loss
D. Value in use

Correct answer: (C)

30
Building Cost = Rs. 25 M
Impairment example :
Accumulated Depreciation = Rs. 5 M
Book Value = Rs. 20 M (25-5)

After Damage Building’s Market Value = Rs. 12 M

Loss on Impairment = Rs. 8 M (20-12)
The journal entry to recognize the Loss on Impairment:
Title of Account Debit Credit
Loss on Impairment Rs. 8 M (Dr) Rs. 8 M
Accumulated Depreciation (Building) Rs. 5 M
Building Rs. 13 M

The Loss on Impairment for Rs. 8 M is recognized on the income statement as a reduction
to the period’s income and the asset Building is recognized at its reduced value of Rs. 12
M on the balance sheet (25 historical cost – 8 impairment loss – 5 accumulated
depreciation).
31
After the impairment, depreciation expense is calculated on : Asset’s new value
 End of Part 2
Depreciation and Impairment

32
Class Quiz :
Impact of Depreciation Method on Financial Statements
ITEM IMPACTED STRAIGHT-LINE ACCELERATED
Earnings,
H = Higher Equity, Profit
Margins
L = Lower
NI = No Impact Current Ratio

Asset Turnover

Debt-to-Equity
Ratio

33
Impact of Depreciation Method on Financial Statements
ITEM IMPACTED STRAIGHT-LINE ACCELERATED
Higher, as depreciation Lower, as depreciation
Earnings, Equity, Profit expense is lower in early expense is higher in early
Margins years. years.

No impact because the No impact because the

Current Ratio current ratio relates to short- current ratio relates to short-
term assets. term assets.

Lower, as asset values are Higher, as asset values are

Asset Turnover
higher in the early years. depreciated up front.

Higher, as equity is lowered

Lower, as equity is higher
Debt-to-Equity Ratio driven by higher earnings in in the early years with an
the early years. elevated depreciation
expense.

34
Thank you

35