FR&A - Long-Lived Assets

Start 12:30 pm

Long-Lived Assets

Capitalized Interest

• Accrues while a company constructs an asset for its own use
• Objective is to accurately measure the cost of the asset
• Treatment is required by both GAAP and IFRS
• Interest rate used to capitalize interest is based on debt directly related to asset
• If no specific construction debt, based on existing unrelated borrowings
• Interest costs on general corporate debt beyond project construction costs are expenses
• Capitalized interest is NOT expensed
• Eventually goes to depreciation or to COGS
• Capitalized interest is reported as an outflow from investing activities
• Normal interest is reported as an outflow in operating activities

Effects of capitalizing (vs. expensing) on various accounts

• Net income
• Delays recognition of expense.  Higher NI in short term, lower in long term.
• Reduces variability of NI because cost is spread over time
• Total net income is unaffected (does this hold with taxes?)
• Shareholders eq
• Higher net income = higher equity (retained earnings)
• As cost is allocated in future, lower NI = lower equity
• Cash from Operations
• Cap ex is usually reported under investing section
• If expensed, it will fall under operating
• Capitalizing therefore leads to higher op cash flow and lower investing cash flow as compared to expensing
• Assuming not taxes, total cash flow is same
• Remember, when capitalized, depreciation is recognized in subsequent pds - depreciation is noncash and aside from taxes does not affect cash from operations
• Financial ratios
• Capitalizing causes higher assets and equity
• ROA and ROE will initially be higher due to Net Income increase but then lower
• Interest coverage
• Higher when capitalized - Higher EBIT, and less interest expense
• Smaller after year 1
• For expanding firms, this may continue for some time because capitalized interest exceeds depreciation from previously capitalized interest

Analyst implications

• May want to add capitalized interest to total interest expense - many bond ratings agencies do this
• Be aware of how debt covenants are calculated
• Interest capitalized during the year should be added to interest expense
• Allocation of interest capitalized in previous years should be removed from depreciation expense
• Reclassify capitalized interest from investing to operating

Intangible assets - long term assets that lack physical substance (patents etc.)

• Value based on rights/privileges granted to the firm over the useful life
• Cost is amortized over useful life
• Not always reported on balance sheet
• An unidentifiable intangible asset cannot be purchased separately and may have an indefinite life
• Most common is goodwill

Intangibles created internally

• With few exceptions, these costs are expensed as incurred - R&D, software e.g.
• GAAP - both are expensed
• IFRS - Research expensed, development capitalized
• For software, costs expensed until product's feasibility has been established
• Under GAAP, capitalize subsequent expenses
• Costs for developing own internal software are also capitalized

Intangibles purchased externally

• Initially recorded at cost

Obtained in business acquisition

• Purchase method - purchase price is allocated to 'identifiable' assets and liabilities at fair value
• Any remaining excess is goodwill (unidentifiable)
• Only goodwill from business acquisition is capitalized; internally generated goodwill is not
• US GAAP
• Must calculate fair value of a firm's in-process R&D
• Expensed in the period incurred (is this the amount invested, or yet to be invested?)
• Usually not a recurring item - analysts add back
• IFRS
• IPR&D is not immediately expensed
• Firm may report as a separate finite-lived asset
• Can alternatively be included as part of goodwill
• NB CHECK TO SEE IF THIS STANDARD STILL APPLIES IN CFAI MATERIALS

Economic depreciation - actual decline in fair value of the asset over time

Depreciation methods

• Straightline = (original cost - salvage value) / useful life
• Accelerated DDB = (2 / asset life in yrs) * beginning book value
• Remember, may switch to straight line later
• No more expense charged once salvage value is reached
• Units of Production
• Depreciation = (original cost - salvage value) / total number of units it will produce ever * units produced that period
• Choice of Method
• US GAAP - may use different depreciation for tax and for financial reporting
• Many countries do NOT allow this
• US also allows MACRS

For a firm using straightline for reporting and accelerated for tax:

• Income tax expense does NOT change
• The difference between tax expense and taxes payable is added to deferred tax liability
• In later years, there will be more taxes payable than tax expense
• TOTAL depreciation expense is the same under all three methods
• NB - for DDB method, how do you know when to switch to straight line?

Useful lives and salvage values

• Longer life = lower annual depreciation
• Higher salvage = lower annual depreciation
• In excess both will overstate income
• Management tricks:
• Overestimating useful life, and then writing it down in a restructuring process
• Write down and take immediate charge, record less future depreciation 
• Life and or salvage might be overstated, thus increasing profit but then increasing loss once the asset is retired
• Under IFRS, you may increase OR decrease the estimated residual value when new info arises
• Under GAAP, you can revise down but not up
• Depreciation can be allocated between COGS and SG&A - affects gross margin but not overall margin

Calculating average age of a firm's assets

• Helps identify older/less efficient assets which may make firm less competitive
• Can help estimate when major capex will be needed and therefore financing required
• Average age:
• Age = accumulated depreciation / annual depreciation expense
• Average depreciable life = ending gross investment / annual depreciation expense
• Gross is original cost of asset (i.e. does not include accumulated depr OR impairment charges)
• Remaining useful life = ending net investment / annual depreciation expense
• OR average depreciable life - age
• Another useful measure is capex / depreciation

Intangible amortization

• Finite lives - expense should match benefit of ownership over life of asset
• Indefinite lives - no amortization, no expense unless impairment applies

Asset Retirement Obligations (environmental charges)

• When plant closure also requires returning environment to original condition etc.
• ARO = liability reported at NPV with discount based on firm's credit standing
• Same amount is added to carrying value of the specific asset
• This keeps accounting in balance
• ARO is then depreciated over remaining life of the asset
• Accretion expense - increase in liability due to passage of time
• At maturity, ARO liability is equal to full amount of the obligation and asset is fully depreciated
• At this point, obligation has been fully recognized on the income statement

Ratio effect of ARO

• Increases both assets and liabilities by same amount
• Earnings will be lower - you have depreciation plus ARO accretion effect
• You should treat ARO as debt on balance sheet and in calculating ratios
• Accretion expense should be treated as interest

ARO's are a bit confusing - maybe come back to these later

Sales, exchanges, abandonments

• Sale
• Difference between carrying (book) value and sale proceeds is recorded as a gain/loss on the income statement
• Usually part of continuing operations
• Remove from cash flow from operations (should be under investing)
• If it was a 'component' of the business, report below income as a discontinued operation
• Component = cash flows can be clearly distinguished from rest of firm
• Reported net of tax, below net income from continuing operations
• Abandoned
• Similar to sale, but no proceeds
• Carrying value removed from balance sheet, loss of that amount in income statement
• Exchanged
• Gain or loss computed by comparing carrying value of old and fair value of new
• Carrying value of old is removed, fair value of new is put on balance sheet
• For analytical purposes, excluding gains/losses from asset dispositions is recommended

Impairments

• US GAAP: Recoverability and Loss Measurement
• Recoverability
• Asset is impaired if carrying value is greater than asset's future UNDISCOUNTED cash flows
• Loss measurement
• If impaired: loss = excess of carrying value over fair value of asset
• If fair value not known, use DISCOUNTED value of future cash flows 

Impairment of intangibles

• For finite lived, essentially the same as for tangible assets
• For infinite lived - do not amortize, but test annually for impairment
• Goodwill is hard to measure though
• Goodwill is therefore measured at the reporting unit level
• GAAP: Two step test for goodwill
• If carrying value of the reporting unit (including goodwill) > fair value of reporting unit, impairment exists
• Loss is measured as difference between carrying value of goodwill and implied value of goodwill
• IFRS: Similar but done in a single step
• Carrying value of asset is compared to recoverable amount (either by sale or fair value)
• Difference recorded as an asset impairment

Long-lived assets held for sale

• When firm decides to sell, asset is no longer depreciated
• Immediately test for impairment

Reversing an impairment loss

• US GAAP - can reverse on assets held for sale, but not on assets in use or goodwill
• Recoveries reported as component of continuing operations
• Held for use, new value becomes basis for depreciation, but no recoveries are permitted
• IFRS - recoveries are allowed for both

Analytic impact

• Impairment is a reduction of equity and assets
• In year of impairment ROA and ROE both decrease (lower earnings)
• After, ROA and ROE will increase due to higher earnings and lower assets/equity
• Asset turnover will increase (lower assets)
• No impact on cash flow
• No tax savings until sold - decrease in deferred tax liabilities
• Impairment in short means a firm has overstated earnings
• There is considerable discretion in judging impairments

Effect of revaluations on ratios

• Revaluing asset upward will result in:
• Higher total assets/equity
• lower leverage
• Higher earnings in period revaluation occurs
• Higher depreciation (and ergo lower earnings) in periods after
• Lower ROA and ROE in periods after

End

2:30 pm

2 hours