Financial Reporting and Analysis

-Sessions 7 and 8-

Professor Raluca Ratiu, PhD

Reporting and Analyzing Long-Term Assets

-Chapter 8-
 Long-Term Operating Assets

 Two common characteristics

• Acquired for the purpose of producing and delivering
products and services that generate revenues
• Help produce revenues for multiple periods

Tangible Assets Intangible Assets

 Have physical substance  Have no physical substance
 Usually include land,  Provide the owner with
buildings, machinery, specific rights and privileges
fixtures and equipment  Include trademarks,
patents, copyrights, etc.
Airbus’s Long-Term Assets
 Tangible Assets
Capitalized Costs

 Reported as assets on the balance sheet

 Called capital expenditures
 Must include all costs necessary to acquire an asset
and prepare it for its intended use
 Includes
• Installation costs
• Taxes
• Shipping costs
• Legal fees
• Setup and calibration costs
• Asset retirement obligations
 Capital Expenditure Characteristics

Characteristics that expenditures must possess to be

capitalized:

1.It is probable that the future economic benefits

associated with the asset will flow to the entity.

2.The cost of the asset can be measured reliably.

Capitalized costs cannot exceed the expected future

benefits to be derived from the use of the asset.
 Constructed Assets

When assets are constructed by a company for its own

use, capitalized costs should include:

 All direct material and labor costs, and

 A reasonable amount of overhead costs, and

 Capitalized interest
• Interest expenses associated with debt incurred to
finance the construction- only
 Costs Subsequent to Acquisition

Additional costs incurred after an asset is placed in

service
 Improvement or betterment
• Consist of outlays that enhance the usefulness of
the asset or extend the asset’s useful life beyond
the original expectation
• Costs should be capitalized
 Routine repairs and maintenance
• Costs should be expensed in the period incurred
 Depreciation

 Cost of PPE assets is allocated systematically to

expense over the time period that the assets are
expected to help produce revenue

 Cost allocation process is known as depreciation

• Cost transferred from the balance sheet to the income
statement

Depreciation is a systematic allocation of the

cost of an asset to expense over time.
 Purchase of PPE
1) Acquiring a delivery truck for $80,000 cash.

(1) Truck (+A) 80,000  

    Cash (–A)   80,000
  Truck (A)     Cash (A)  
(1) 80,000 80,000 (1)
 Recording Depreciation

2) Recorded depreciation of $12,000 for the delivery truck

(2) Depreciation expense (+E, –SE) 12,000  

   Accumulated depreciation (+XA, –A)   12,000
  Depreciation Expense (E)   Accumulated Depreciation (XA)
(2) 12,000 12,000 (2)

Represents the total asset cost expensed since acquired

 Plant Assets on the Balance Sheet
Delivery truck, at cost $ 80,000
Less accumulated depreciation 12,000
Delivery truck, net $ 68,000
Over time, the contra asset grows while net
value declines
Accumulated Depreciation
 Contra asset account
 Represents the total cost allocated to expense since
the asset was acquired
 Offsets the balance in the corresponding asset
account
Book Value
Remaining cost that is not yet depreciated
 Depreciation

 Depreciation is used to allocate the cost of a plant

asset over the useful life
Two estimates are required to compute depreciation
Useful Life
 The period of time over which the asset is expected to
provide economic benefits to the company
 Differs from the physical life

Residual Value
 The expected realizable value of the asset at the end of
its useful life
 Also known as salvage value
 Can represent the scrap, disposal, or resale value
 Airbus’s Footnote Disclosure
Airbus reported the following disclosure for its
property and equipment for 2020 fiscal year:
 Depreciation Methods

 Three common depreciation methods

• Straight-line method- equal expense each year
• Double-declining-balance method- accelerated method
with more expense in early years of life
• Units-of-production method- based on activity instead of
time
 The nonrecoverable cost
• Amount of cost to be allocated over the useful life
• Called the depreciable base
 Straight-Line Depreciation
Example

Tanner Enterprises purchased a delivery truck for $80,000,

and estimated the useful life to be 5 years and the residual
value to be $8,000.

Depreciation Base Depreciation Rate

Cost – Salvage value 1 ÷ Estimated useful life
$80,000 – $8,000 = $72,000 1 ÷ 5 years = 20%
Depreciation expense = Depreciation base × Depreciation rate
$72,000 × 20% = $14,400
Book value at end of year 1:
$80,000 – $14,400 = $65,600
 Double-Declining-Balance Depreciation
Example

Tanner Enterprises purchased a delivery truck for

$80,000, and estimated the useful life to be 5
years and the residual value to be $8,000.

Depreciation Base Depreciation Rate

Cost – Accumulated Depreciation 2 × SL rate = 2 × 20% = 40%
Book Value at Book Value at
Year Beginning of Year Depreciation Expense End of Year
1 $80,000 $80,000 × 40% = $32,000 $48,000
2 48,000 $48,000 × 40% = $19,200 28,800
3 28,800 $28,800 × 40% = $11,520 17,280
4 17,280 $17,280 × 40% = $6,912 10,368
5 10,368 $10,368 – $8,000 = $2,368 8,000

The 40% rate is not used in the last year because it would reduce
the net book value below the residual value.
 Comparing Depreciation Methods

Because double-declining balance is an accelerated

method, the expense in the early years of life is larger
than in its latter years.
Straight-Line Double-Declining Balance

Book Value at Depreciation Book Value at End

Year Depreciation Expense End of Year Expense of Year
1 $14,400 $65,600 $32,000 $ 48,000
2 14,400 51,200 19,200 28,800
3 14,400 36,800 11,520 17,280
4 14,400 22,400 6,912 10,368
5 14,400 8,000 2,368 8,000
$72,000 $ 72,000

Total depreciation over All depreciation methods yield

the asset ‘s life is the same salvage value.
identical for all methods.
 Units-of-Production Depreciation
Example
Tanner Enterprises purchased a delivery truck for
$80,000 and estimated the truck would provide 80,000
miles of service before it is sold for its residual value of
$8,000. The truck was driven 18,000 miles in year 1.
Depreciation Base Depreciation Rate
Cost – Salvage value Depreciation Base ÷ Units of Service
$80,000 – $8,000 = $72,000 $72,000 ÷ 80,000 = $0.90 per mile

Depreciation expense = Actual Units of Service × Depreciation rate

18,000 × $0.90 = $16,200

Book value at end of year 1:

$80,000 – $16,200 = $63,800
 Changes in Accounting Estimates

 Estimates of useful lives and salvage value are made

when assets are acquired
 When necessary, companies can change estimates
 Changes are applied prospectively
• i.e., only to future accounting periods

Year 1 Year 2 Year 3

 Changes in Accounting Estimate
Example

Tanner Enterprises decided to extend the useful life

of the truck from 5 to 7 years after completing 4
years of service. Straight-line depreciation is used.
Step 1. Determine the book value at the date of estimate change.
Cost – Accumulated depreciation = Book value
$80,000 – ($14,400 × 4 years) = $22,400
Step 2. Determine the new remaining useful life.
Original life – Years depreciated + additional years =
5 years – 4 years + 2 years = 3 years
Step 3. Determine depreciation expense for year 5.
Book Value – Salvage value $22,400 – $8,000
= = $4,800
Remaining estimated life 3 years
 Gains and Losses On Asset Sales

 Selling long-term assets

• Produces a gain if the proceeds are greater than the
book value of the asset
• Produces a loss if the proceeds are less than the book
value of the asset
 Any gain or loss is reported in income from
continuing operations
 Gain or Loss on Asset Sale Example

Tanner Enterprises decided to sell the $80,000 truck

for $25,000 after 4 years of straight-line depreciation.
The truck’s estimated useful life was 5 years and its
residual value was $8,000.

Book value = Cost – Accumulated depreciation

= $80,000 – ($14,400 × 4) = $22,400

Proceeds $25,000 > Book Value $22,400 = $2,600 Gain

Gains and losses are nonrecurring operating

income components.
Recording the Sale of an Operating Asset

3) Selling of the truck for $25,000

(3) Cash (+A) 25,000

Accumulated depreciation (+A, –XA) 57,600 

Truck (–A) 80,000

    Gain on the sale of truck (+R, +SE)   2,600
  Cash (A)   Accumulated Depreciation (XA)
(3) 25,000 (3) 57,600

  Truck (A)   Gain on the Sale of Truck (R)

80,000 (3) (3) 2,600 (3)
 Asset Impairments

 Companies must recognize losses on assets if

impairment happens

• When does impairment happen?

o When market values of long-term assets

decline to less than book value, and
o It can be determined that the asset’s value is
permanently impaired
 Impairment Analysis of Long-Term Assets

After an impairment write-down, depreciation

charges are reduced by the write off
 Recording an Asset Impairment

The impairment write-down reduces assets by the

amount of the write-down and a loss is recognized on
the income statement.

(1) Impairment Expense on PPE (+E, -SE) 6,000  

    Truck (–A)   6,000

Impairment Expense on PPE

  Truck (A)     (E)  
6,000 (1) (1) 6,000
 Potential Challenges of Asset Impairments

Analysis of asset write-downs present two potential

challenges:

Insufficient Write-Down Aggressive Write-Down

Assets sometimes are The “big bath” scenario can
impaired to a larger degree arise if income is currently
than is actually recognized. and severely depressed.
 Calculate PPE Turnover and
Determining Percent Depreciated
 PPE Turnover (PPET)

Measures how efficient management utilized its plant assets

Sales revenue
PPET =
Average PPE, net

Applying the PPE ratio to Aribus

2019 PPET increased from the 2018 level. Higher PPET implies a lower level of
capital investment required to achieve a given level of sales revenue. 2020
PPET was affected by a large drop in sales because of the Covid-19 Pandemic.
 Comparison of PPE Turnover
PPE Turnover at Airbus and Embraer:

Both are mature companies. They acquire assets on a continuing basis

and, as a result, they have some assets that are brand-new and others
that are reaching the end of their productive lives. The higher ratios
for Airbus indicates that it may need new investment in PPE soon.
 Percent Depreciated
Measures the percent of a company’s operating assets
that have been depreciated

Accumulated depreciation
Percent depreciated =
Cost of depreciable asset
*Portion of original cost attributable to land is removed because land is not depreciated due to its indefinite life.

Applying the PPE ratio to Airbus

Airbus’s operating assets are over 60% depreciated, likely due to the mix of new
assets and those nearing the end of their useful life.
 Percent Depreciated
Percent Depreciated for Airbus and Embraer :

Both are mature companies. They acquire assets on a continuing basis

and, as a result, they have some assets that are brand-new and others that
are reaching the end of their productive lives. The higher ratios for Airbus
indicates that it may need new investment in PPE soon.
 Intangible Assets

 Intangibles are identifiable, non-monetary assets

without physical substance
 In 2022, the value of total intangible assets was $57
trillion (55,000 companies listed on 120 stock
exchanges was represented by intangibles assets
Global Intangible Financial Tracker)
• Of those intangible assets, 65% are off-balance
sheet
 In the tech industry, more than 80% of the company
value is attributed to intangible assets
Intangible Assets
 Intangible Assets

 Separately Transferable Intangibles

• Those that are the product of contractual or
other legal rights
• Those that are not contractually or legally
defined, but can be separated from the company
and sold, transferred, or exchanged
 Not Separately Transferable Intangibles
(Goodwill)
• The excess of cost over the fair value of net
assets acquired in a business combination

® ™ ℗
 Accounting for Intangible Assets
 Can be purchased from another company or
individual, or internally developed
 Purchase cost is capitalized
 Internally developed costs are generally expensed
as incurred
 Problems with accounting for intangibles
• Benefits provided by intangibles are uncertain and difficult
to quantify
• Useful life often impossible to estimate with confidence
 Research and Development Costs (R&D)
 USGAAP requires R&D costs to be immediately recognized as an
expense
• Because of the uncertainty surrounding the benefits of R&D
• Applies to all R&D costs incurred prior to the start of commercial
production, including
o Salaries and wages of personnel engaged in R&D activities
o Cost of material and supplies used in R&D
o Cost of equipment and facilities with no alternative future use
that are used in R&D
 IFRS requires recognition of internally developed intangibles
• Development costs can be capitalized as intangible assets when
specific criteria are met
• Company must be able to complete the development process and
to produce an intangible asset that will generate future benefits
through use or sale
Airbus’s Footnote Disclosure
 Patents

 What is a patent?
• An exclusive right to produce a product or use a
technology
• Granted to protect the inventor by preventing other
companies from copying the innovation
 Accounting for costs of patents
• If purchased from another company it is capitalized
and amortized
• If developed internally, only legal costs and
registration fees are capitalized and amortized
 Copyrights

 What is a copyright?
• An exclusive right granted by the government to an
individual author, composer, play writer, or similar
individual
• For the life of the creator plus at least 25 years, up to
70
 Can be acquired
• Cost is capitalized and amortized over the expected
remaining economic life
 Trademarks
 What is a trademark?
• A registered name, logo, package design, image,
jingle, or slogan that is associated with a product
 Accounting for costs of trademarks
• If purchased from another company, capitalize the
cost and amortize asset
• If developed internally, expense as incurred

All advertising costs are expensed as incurred, even if the value of

a trademark is enhanced by the advertising.
 The Nike Trademark

In the early 1970’s, Carolyn Davidson, a

graduate student studying graphic design,
created the Nike swoosh for Phil Knight,
owner of Blue Ribbon Sports. Phil was
seeking a new logo and asked Carolyn to
create a design. Phil chose the now popular
‘swoosh’ logo and paid Carolyn’s invoice of
approximately $35 for her work.*

Source: Nikebiz: Company Overview: History, 1970s. “The Birth of the Nike Brand, and
Company.” http://www.nikebiz.com/company_overview/history/1970s.html
 Franchise Rights

 What is a franchise right?

• A contractual agreement that gives the right to operate a
particular business in an area for a particular period of
time
• Cost generally includes start-up costs & franchise fees

How much does it cost to open a ‘100 MONTADITOS’ franchise?*

Total Investment: Entry fee + refurbishment of premises
Initial Franchise Fee: €36,000
Royalty Fee: 7% of sales
Term of Agreement: 10 years
Renewal Fee: The current franchise fee
SOURCE: http://www.gruporestalia.com/en/franchises/100-
montaditos/
 Amortization of Intangible Assets
 Amortization for intangible assets that have a
definite life
• Capitalized cost is amortized over the expected
useful life of the intangible
• Amortization is a systematic allocation of the cost of
an intangible asset over its useful life
• Straight-line method used most often
 Amortization expense reported on the income
statement as part of operating income
• Often included with selling, general, and
administrative expenses
 Purchasing a Patent

(4) Moe’s Southwest Grill spent $80,000 at the beginning of

the year to purchase a patent.

(4) Patent (+A) 80,000 

    Cash(–A)   80,000

  Patent (A)   Cash (A)

(4) 80,000 80,000 (4)
 Recording Amortization of
Intangible Assets with a Definite Life

5) The patent has a remaining legal life of 10 years, but the

management at Moe’s believe it will provide benefits for only 5
more years.
$80,000 ÷ 5 years = $16,000

(5) Amortization expense (+E, –SE) 16,000 

    Accumulated Amortization (+XA, –A)   16,000

  Amortization Expense (E)   Accumulated Amortization (XA)

(5) 16,000 16,000 (5)
 Intangibles with Indefinite Lives
 Expected useful life of some intangibles extends
far enough into the future that it is impossible for
management to estimate
 Not amortized until the useful life can be
specified
 Must be tested for impairment annually
• Considered to be impaired if the book value of the
asset exceeds its fair market value
• Write-down equal to
 Book value – Market value
 Recording the Impairment of
Identifiable Intangible Assets
6) After 5 years of operations, changes in regulation caused
SatCo’s trademark to become permanently impaired.
Management determined the trademark’s fair market value
was $40,000 and its book value was $62,000.
$62,000 – $40,000 =
$22,000

Loss due to impairment of trademark (+E, –SE) 22,000 

  Trademark (–A)   22,000

Loss Due to Impairment (E) Trademark (A)

22,000 22,000
 Goodwill
 What is goodwill?
• The excess of the purchase price paid over the fair market
value of its identifiable net assets* to buy an entire company
• Cannot be separated from the acquired company or sold
separately
• Has an indefinite life
• Never amortized
• Subject to impairment of value

Purchase of the
Company A Net Assets Company B

*Net assets = Assets – Liabilities assumed

 Goodwill Impairment Test

 Annual impairment test required

 Impaired when the market value of the acquired
business is less than the recorded book value

 Once impaired, cannot be revalued upwards

The write-down of goodwill is usually reported by companies in income from

continuing operations.
 Airbus’ Footnote Disclosure

Excerpts from Airbus’s 2020 annual report include:

 Analysis Implications

 Hidden assets
• Internally generated intangible assets are not capitalized
• Uncapitalized assets do not appear on financial
statements
 Analysis of financial statements can be distorted
 Makes comparison of companies difficult for users

Creates an upward bias in asset turnover ratios and ROE