30. LOng-lived assets
A. Distinguish between costs that are capitalized and costs that are expensed :
When a firm makes an expenditure, it can either capitalize the cost as an asset on the balance sheet or expense the cost in the income statement in the period incurred. As a general rule, an expenditure that is expected to provide future economic benefits over multiple accounting periods is capitalized; however, if the future economic benefit is unlikely or uncertain, the expenditure is expensed in the period incurred.
An expenditure that is capitalized is initially recorded as an asset on the balance sheet at cost, typically its fair value at acquisition plus any costs necessary to prepare the asset for use. Except for land and intangible assets with indefinite lives (such as goodwill), the cost is then allocated to the income statement over the life of the asset as depreciation expense (for tangible assets) or amortization (for intangible assets).
Alternatively, if an expenditure is immediately expensed, current period pretax income is reduced by the amount of the expenditure.
Once an asset is capitalized, subsequent related expenditures that provide more future economic benefits (rebuilding the asset) are also capitalized. Subsequent expenditures that merely sustain the usefulness of the asset (regular maintenance, training costs) are expensed when incurred.
Although it may make no operational difference, the choice between capitalizing costs and expensing them will affect net income, shareholders’ equity, total assets, cash flow from operations, cash flow from investing and numerous financial ratios.
Net income :
In the period that an expenditure is capitalized, the firm will report higher net income compared to immediately expensing. In the subsequent periods, the firm will report lower net income compared to expensing, as the capitalized expenditure is allocated to the income statement through depreciation expense.
Over the life of an asset, total net income is identical whether the asset’s cost is capitalized or expensed.
Shareholders’ equity :
Because capitalization results in higher net income in the period of the expenditure compared to expensing, it also results in higher shareholders’ equity because retained earnings are greater.
Cash flow form Operations :
A capitalized expenditure is usually reported in the cash flow statement as an outflow from investing activities. If immediately expensed, the expenditure is reported as an outflow from operating activities. Thus, capitalizing an expenditure will result in higher operating cash flow and lower investing cash flow compared to expensing. Assuming no differences in tax treatment, total cash flow will be the same.
Financial ratios :
Capitalizing an expenditure initially results in higher assets and higher equity compared to expensing. Thus, both the debt-to-assets ratio and the debt-to-equity ratio are lower with capitalization.
Capitalizing an expenditure will initially result in higher return on assets (ROA) and higher return on equity (ROE). In subsequent years, ROA and ROE will be lower for a capitalization firm because net income is reduced by the depreciation expense.
Capitalized interest :
When a firm constructs an asset for its own use or, in limited circumstances, for resale, the interest that accrues during the construction period is capitalized as a part of the asset’s cost. The reasons for capitalizing interest are to accurately measure the cost of the asset and to better match the cost with the revenues generated by the constructed asset. The treatment of construction interest is similar under U.S. GAAP and IFRS.
The interest rate used to capitalize interest is based on debt specifically related to the construction of the asset. If no construction debt is outstanding, the interest rate is based on existing unrelated borrowings. Only interest on the construction cost is capitalized.
Under IFRS, income earned by temporarily investing borrowed funds reduces the interest that is eligible for capitalization. There is no such reduction of capitalized interest under U.S. GAAP.
Capitalized interest is not reported in the income statement as interest expense. Once construction interest is capitalized, the interest cost is allocated to the income statement through depreciation expense (if the asset is held for use), or COGS (if the asset is held for sale).
Generally, capitalized interest is reported in the cash flow statements as an outflow from investing activities, while interest expense is reported as an outflow from operating activities.
B. Compare the financial reporting of the following classifications if intangible assets :
Intangible assets are long-term assets that lack physical substance (patents, brand names, copyrights...). Some intangible assets have finite lives while others have indefinite lives.
The cost of a finite-lived intangible asset is amortized over its useful life. Indefinite-lived intangible assets are not amortized, but are tested for impairment at least annually. If impaired, the reduction in value is recognized in the income statement as a loss in the period in which the impairment is recognized.
Intangible are also considered either identifiable or unidentifiable. Under IFRS, an identifiable intangible asset must be :
- Capable of being separated from the firm or arise from a contractual or legal right.
- Controlled by the firm.
- Expected to provide future economic benefits.
An unidentifiable intangible asset is one that cannot be purchased separately and may have an indefinite life. The most common example of an unidentifiable intangible asset is goodwill.
Not all intangible assets are reported on the balance sheet. Accounting for an intangible asset depends on whether the asset was created internally, purchased externally, or obtained as part of a business combination.
Intangible assets created internally :
With some exceptions, costs to create intangible assets are expensed as incurred. Important exceptions are research and development costs (under IFRS) and software development costs.
Research and development (R&D) costs. Under IFRS, research costs, which are costs aimed at the discovery of new scientific or technical knowledge and understanding, are expensed as incurred. However, development costs are capitalized. Under U.S. GAAP, both R&D costs are generally expensed as incurred. One exception is software development costs.
Software development costs. Costs incurred to develop software for sale to others are expensed as incurred until the product’s technological feasibility has been established, after which costs are capitalized under both IFRS and U.S. GAAP. Judgment is involved in determining technological feasibility.
Under IFRS, treatment is the same whether the software is developed for sale or for a firm’s own use. Under U.S. GAAP, all research and development costs are capitalized when a firm develops software for its own use.
Purchased intangible assets :
Like tangible assets, an intangible asset purchased from another party is initially recorded on the balance sheet at cost, typically its fair value at acquisition.
Intangible assets obtained in a business combination :
The acquisition method is used to account for business combinations. Under the acquisition method, the purchase price is allocated to the identifiable assets and liabilities of the acquired firm on the basis of faire value. Any remaining amount of the purchase price is recorded as goodwill.
Only goodwill created in a business combination is capitalized on the balance sheet. The costs of any internally generated “goodwill” are expensed in the period incurred.
C. Different depreciation methods for tangible assets and effect on financial statements :
Depreciation is the systematic allocation of an asset’s cost over time. Two important terms are :
- Carrying (book) value. The net value of an asset or liability on the balance sheet. For PP&E, carrying value equals historical cost minus accumulated depreciation.
- Historical cost. The original purchase price of the asset including installation and transportation costs. Historical cost is also known as gross investment in the asset.
The analyst must decide whether the reported depreciation expense is more or less than economic depreciation, which is the actual decline in the value of the asset over the period.
Depreciation methods :
Straight-line depreciation is the predominant method of computing depreciation for financial reporting. Depreciation is the same amount each year over the asset’s estimated life :
With an accelerated depreciation method, more expense is recognized in the early years of an asset’s life and less depreciation expense in the later years. One often-used accelerated depreciation method is the double-declining balance (DDB) method :
Note that salvage value is not in the formula for DDB depreciation. However, once the carrying (book) value of the asset reaches the salvage value, no additional depreciation expense is recognized.
Depreciation under the units-of-production method is based on usage rather than time. Depreciation is higher in periods of high usage.
Depreciation under the units-of-production method is based on usage rather than time. Depreciation is higher in periods of high usage.
Useful lives and salvage values :
Calculating depreciation expense requires estimating an asset’s useful life and its salvage value. Firms can manipulate depreciation expense, and therefore net income, by increasing or decreasing either of these estimates.
A change in accounting estimates, such as useful life or salvage value, is put into effect in the current period and prospectively. That is, the change in estimate is applied to the asset’s carrying (book) value and depreciation is calculated going forward using the new estimate. The previous periods are not affected by the change.
IFRS requires firms to depreciate the components of an asset separately, thereby requiring useful life estimates for each component. For example, a building is made up of a roof, walls, flooring, electrical systems, plumbing... Under component depreciation, the useful life of each component is estimated and depreciation expense is computed separately for each. Component depreciation is allowed under U.S. GAAP but is seldom used.
E. Different amortization methods for intangible assets with finite lives, the effect on the financial statements :
Only intangible assets with finite lives are amortized over their useful lives. Amortization is identical to the depreciation of tangible assets. The same methods, straight-line, accelerated, and units-of-production, are permitted.
G. Description of the revaluation model :
Under U.S. GAAP, most long-lived assets are reported on the balance sheet at depreciated cost. There is no fair value alternative for asset reporting under U.S. GAAP.
Under IFRS, most long-lived assets are also reported at depreciated cost (the cost model). IFRS provides an alternative, the revaluation model, that permits long-lived assets to be reported at their fair values, as long as an active market exist for the assets so their fair value can be reliably estimated. Firms must choose the same treatment for similar assets so they cannot revalue only specific assets that are more likely to increase than decrease in value. The revaluation model is rarely used in practice by IFRS reporting firms.
Revaluation under IFRS can result from either an increase or decrease in fair value from one period to the next. An initial revaluation to fair value below historical cost results in a loss that is reported on the income statement, decreasing net income and shareholders’ equity. A subsequent upward revaluation to reflect an increase in fair value is reported as a gain in the income statement to the extent that it reverses a previously reported loss from revaluation to fair value. Regardless of prior revaluations, any increase in an asset’s value above historical cost is not reported as a gain in the income statement, but is reported as a component of shareholders’ equity in an account called revaluation surplus. Subsequent declines in an asset’s value first reduce this surplus, then result in a loss reported on the income statement to the extent that an asset’s fair value decreases below its historical cost.
Revaluing an asset’s value upward will result in :
H. Impairment of PP&E and intangible assets :
Both IFRS and U.S. GAAP require firms to write down impaired assets by recognizing a loss in the income statement. However, there are differences in applying the standards.
Tangible and intangible long-lived assets with finite lives :
Impairment under IFRS. The firm must annually assess whether events or circumstances indicate an impairment of an asset’s value has occurred. An asset is impaired when its carrying (book) value exceeds the recoverable amount. The recoverable amount is the greater of its fair value less any selling costs and its value in use. The value in use is the present value of its future cash flow stream from continued use.
If impaired, the asset’s value must be written down on the balance sheet to the recoverable amount. An impairment loss, equal to the excess of carrying value over the recoverable amount, is recognized in the income statement.
Under IFRS, the loss can be reversed if the value of the impaired asset recovers in the future. However, the loss reversal is limited to the original impairment loss.
Impairment under U.S. GAAP. An asset is tested for impairment only when events and circumstances indicate the firm may not be able to recover the carrying value through future use.
Determining an impairment and calculating the loss potentially involves two steps : recoverability and loss measurement.
Recoverability. An asset is considered impaired if the carrying (book) value is greater than the asset’s future undiscounted cash flow stream. Because the recoverability test is based on estimates of future undiscounted cash flows, tests for impairment involve considerable management discretion.
Loss measurement. If impaired, the asset’s value is written down to fair value on the balance sheet and a loss, equal to the excess of carrying value over the fair value of the asset, is recognized in the income statement.
Intangible assets with indefinite lives :
Intangible assets with indefinite lives are not amortized; rather, they are tested for impairment at least annually. As impairment loss is recognized when the carrying amount exceeds fair value.
Long-lived assets held for sale :
If a firm reclassifies a long-lived asset from held for use to held for sale because management intends to sell it, the asset is tested for impairment. At this point, the asset is no longer depreciated or amortized. The held-for-sale asset is impaired if its carrying value exceeds its net realizable value. If impaired, the asset is written down to net realizable value and the loss is recognized in the income statement.
For long-lived assets held for sale, the loss can be reversed under IFRS and U.S. GAAP if the value of the asset recovers in the future. However, the loss reversal is limited to the original impairment loss.
I. Derecognition of PP&E, and intangible assets :
Eventually, long-lived assets are removed from the balance sheet. Derecognition occurs when assets are sold, exchanged, or abandoned.
When a long-lived asset is sold, the asset is removed from the balance sheet and the difference between the sale proceeds and the carrying value of the asset is reported as a gain or loss in the income statement.
If a long-lived asset is abandoned, the treatment is similar to a sale, except there are no proceeds. In this case, the carrying value oh the asset is removed from the balance sheet and a loss of that amount is recognized in the income statement.
If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing the carrying value of the old asset with fair value of the old asset (or the fair value of the new asset if that value is clearly more evident). The carrying value of the old asset is removed from the balance sheet and the new asset is recorded at its fair value.
J. Financial statement presentation of and disclosures relating to PP&E and intangible assets :
IFRS disclosures :
Under IFRS, the firm must disclose the following for each class of PP&E :
The firm must also disclose :
If the revaluation (fair value) model is used, the firm must disclose :
U.S. GAAP disclosures :
Under U.S. GAAP, the PP&E disclosures include :
Under U.S. GAAP, the disclosure requirements for intangible assets are similar to those for PP&E. In addition, the firm must provide an estimate of amortization expense for the next five years.
For impaired assets, the firm must disclose :
K. Comparing financial reporting of investment property with that of PP&E :
Under IFRS, property that a firm owns for the purpose of collecting rental income, earning capital appreciation, or both, is classified as investment property. U.S. GAAP does not distinguish between investment property from other kinds of long-lived assets.
Firms can account for investment property using the cost model (accumulated depreciation) or the fair value model. Unlike the revaluation model (fair value) for PP&E, increases in the fair value of investments property above its historical cost are recognized as gains on the income statement if the firm uses the fair value model.
Calculating depreciation expense requires estimating an asset’s useful life and its salvage value. Firms can manipulate depreciation expense, and therefore net income, by increasing or decreasing either of these estimates.
A change in accounting estimates, such as useful life or salvage value, is put into effect in the current period and prospectively. That is, the change in estimate is applied to the asset’s carrying (book) value and depreciation is calculated going forward using the new estimate. The previous periods are not affected by the change.
IFRS requires firms to depreciate the components of an asset separately, thereby requiring useful life estimates for each component. For example, a building is made up of a roof, walls, flooring, electrical systems, plumbing... Under component depreciation, the useful life of each component is estimated and depreciation expense is computed separately for each. Component depreciation is allowed under U.S. GAAP but is seldom used.
E. Different amortization methods for intangible assets with finite lives, the effect on the financial statements :
Only intangible assets with finite lives are amortized over their useful lives. Amortization is identical to the depreciation of tangible assets. The same methods, straight-line, accelerated, and units-of-production, are permitted.
G. Description of the revaluation model :
Under U.S. GAAP, most long-lived assets are reported on the balance sheet at depreciated cost. There is no fair value alternative for asset reporting under U.S. GAAP.
Under IFRS, most long-lived assets are also reported at depreciated cost (the cost model). IFRS provides an alternative, the revaluation model, that permits long-lived assets to be reported at their fair values, as long as an active market exist for the assets so their fair value can be reliably estimated. Firms must choose the same treatment for similar assets so they cannot revalue only specific assets that are more likely to increase than decrease in value. The revaluation model is rarely used in practice by IFRS reporting firms.
Revaluation under IFRS can result from either an increase or decrease in fair value from one period to the next. An initial revaluation to fair value below historical cost results in a loss that is reported on the income statement, decreasing net income and shareholders’ equity. A subsequent upward revaluation to reflect an increase in fair value is reported as a gain in the income statement to the extent that it reverses a previously reported loss from revaluation to fair value. Regardless of prior revaluations, any increase in an asset’s value above historical cost is not reported as a gain in the income statement, but is reported as a component of shareholders’ equity in an account called revaluation surplus. Subsequent declines in an asset’s value first reduce this surplus, then result in a loss reported on the income statement to the extent that an asset’s fair value decreases below its historical cost.
Revaluing an asset’s value upward will result in :
- Greater total assets and greater shareholders’ equity.
- Higher depreciation expense, and thus lower profitability, in periods after revaluation.
H. Impairment of PP&E and intangible assets :
Both IFRS and U.S. GAAP require firms to write down impaired assets by recognizing a loss in the income statement. However, there are differences in applying the standards.
Tangible and intangible long-lived assets with finite lives :
Impairment under IFRS. The firm must annually assess whether events or circumstances indicate an impairment of an asset’s value has occurred. An asset is impaired when its carrying (book) value exceeds the recoverable amount. The recoverable amount is the greater of its fair value less any selling costs and its value in use. The value in use is the present value of its future cash flow stream from continued use.
If impaired, the asset’s value must be written down on the balance sheet to the recoverable amount. An impairment loss, equal to the excess of carrying value over the recoverable amount, is recognized in the income statement.
Under IFRS, the loss can be reversed if the value of the impaired asset recovers in the future. However, the loss reversal is limited to the original impairment loss.
Impairment under U.S. GAAP. An asset is tested for impairment only when events and circumstances indicate the firm may not be able to recover the carrying value through future use.
Determining an impairment and calculating the loss potentially involves two steps : recoverability and loss measurement.
Recoverability. An asset is considered impaired if the carrying (book) value is greater than the asset’s future undiscounted cash flow stream. Because the recoverability test is based on estimates of future undiscounted cash flows, tests for impairment involve considerable management discretion.
Loss measurement. If impaired, the asset’s value is written down to fair value on the balance sheet and a loss, equal to the excess of carrying value over the fair value of the asset, is recognized in the income statement.
Intangible assets with indefinite lives :
Intangible assets with indefinite lives are not amortized; rather, they are tested for impairment at least annually. As impairment loss is recognized when the carrying amount exceeds fair value.
Long-lived assets held for sale :
If a firm reclassifies a long-lived asset from held for use to held for sale because management intends to sell it, the asset is tested for impairment. At this point, the asset is no longer depreciated or amortized. The held-for-sale asset is impaired if its carrying value exceeds its net realizable value. If impaired, the asset is written down to net realizable value and the loss is recognized in the income statement.
For long-lived assets held for sale, the loss can be reversed under IFRS and U.S. GAAP if the value of the asset recovers in the future. However, the loss reversal is limited to the original impairment loss.
I. Derecognition of PP&E, and intangible assets :
Eventually, long-lived assets are removed from the balance sheet. Derecognition occurs when assets are sold, exchanged, or abandoned.
When a long-lived asset is sold, the asset is removed from the balance sheet and the difference between the sale proceeds and the carrying value of the asset is reported as a gain or loss in the income statement.
If a long-lived asset is abandoned, the treatment is similar to a sale, except there are no proceeds. In this case, the carrying value oh the asset is removed from the balance sheet and a loss of that amount is recognized in the income statement.
If a long-lived asset is exchanged for another asset, a gain or loss is computed by comparing the carrying value of the old asset with fair value of the old asset (or the fair value of the new asset if that value is clearly more evident). The carrying value of the old asset is removed from the balance sheet and the new asset is recorded at its fair value.
J. Financial statement presentation of and disclosures relating to PP&E and intangible assets :
IFRS disclosures :
Under IFRS, the firm must disclose the following for each class of PP&E :
- Basis for measurement.
- Useful lives or depreciation rate.
- Gross carrying value and accumulated depreciation.
- Reconciliation of carrying amounts from the beginning of the period to the end of the period.
The firm must also disclose :
- Title restrictions and assets pledged as collateral.
- Agreements to acquire PP&E in the future.
If the revaluation (fair value) model is used, the firm must disclose :
- Amounts of impairment losses and reversals by asset class.
- Where the losses and loss reversals are recognized in the income statement.
- Circumstances that caused the impairment loss or reversal.
U.S. GAAP disclosures :
Under U.S. GAAP, the PP&E disclosures include :
- Depreciation expense by period.
- Balances of major classes of assets by nature and function.
- Accumulated depreciation by major classes or in total.
- General description of depreciation methods used.
Under U.S. GAAP, the disclosure requirements for intangible assets are similar to those for PP&E. In addition, the firm must provide an estimate of amortization expense for the next five years.
For impaired assets, the firm must disclose :
- A description of the impaired asset.
- Circumstances that caused the impairment.
- How faire value was determined.
- The amount of loss.
- Where the loss is recognized in the income statement.
K. Comparing financial reporting of investment property with that of PP&E :
Under IFRS, property that a firm owns for the purpose of collecting rental income, earning capital appreciation, or both, is classified as investment property. U.S. GAAP does not distinguish between investment property from other kinds of long-lived assets.
Firms can account for investment property using the cost model (accumulated depreciation) or the fair value model. Unlike the revaluation model (fair value) for PP&E, increases in the fair value of investments property above its historical cost are recognized as gains on the income statement if the firm uses the fair value model.
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