CFA II: SS5 - Long Lived Assets
Terms in this set (31)
Capitalizing v. Expensing
If an expenditure is expected to provide a future economic benefit over multiple accounting periods it is capitalized, if not it is expenses. Cash is reduced and an Asset is created which is reduced by deprecation expense over the life of the asset. The choice of which is most appropriate here has many affects.
Affect on Net Income
Capitalizing an expenditure delays the recognition of expense in the income statement. Thus in the period it is capitalized the firm will report higher net income compared to expensing, in subsequent periods it will report lower net income. This allocation process reduces the variability of net income.
Affect on Shareholder's Equity
Because capping results in higher net income in the period of the expenditure as compared to expensing, SE is also higher initially. Total Assets are higher with Cap, and liabilities are unaffected, so the accounting equation remains balanced. (A + L + E)
Affect on Cash Flow From Operations
A cap expenditure is usually reported in the cash flow statement as an outflow from investing activities. If expensed, the expenditure is reported as an outflow from operating activities. Assuming no differences in the tax treatment, total cash flow will be exactly the same.
Remember subsequent depreciation is a non cash event and does not affect CFO.
Affect on Financial Ratios
Capitalizing an expenditure results in higher assets and equity compared to expensing. Thus both the D/A and D/E ratios will be lower.
Capitalizing will initially result in higher ROA and ROE as a result of the higher net income in the first year. In subsequent years ROA and ROE will be lower as net income is reduced by dep. expense.
The interest accrued during the construction period of an asset is capitalized as a part of the asset's cost to more accurately measure the cost. The interest rate used to capitalize interest is based on debt specifically related to the construction of the asset. It is not reported in the income statement as interest expense, it is depreciated with the rest of the asset.
Interest Coverage Ratio
The Interest Coverage Ratio (EBIT / interest expense) measures a firm's ability to make required interest payments on its debt. In the year of the expenditure, capitalizing results in lower interest expense and higher net income compared to expensing. The result is a higher interest coverage ratio when interest is capitalized. Subsequent periods will see lower ICRs.
Adjusting For Capitalized Interest
You can reverse the affects of capitalized interest by doing the following:
- Capitalized interest should be added to interest expense.
- Cap Int, net of depreciation should be removed for A & SE.
- Allocation of interest Capped in previous years should be removed from dep expense.
- Interest capped during the year should be re-classified to CFO from CFI.
- Ratios should be recalculated with the restated figures.
Internal Development Costs
Intangible Assets are Long term assets that lack physical substance (patents & brands etc). With some exceptions costs incurred by the firm to create intangible assets are expensed as incurred. Important exceptions are R&D and software development cost.
Under IFRS, research costs are expensed as incurred (costs aimed at discovery of new scientific or technical knowledge). Development costs (translation of research findings into a plan or design of a new product or process) are capitalized.
Under U.S. GAAP both R&D are expensed as incurred with some notable exceptions, namely software development.
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. Once that occurs the subsequent costs are capitalized.
Dep Expense = (original value - salvage value) / depreciable life
Accelerated or DDB Depreciation
DDB Dep in Year X = 2 / Asset Life in Years x Book Value at Beg Period X.
Change in Depreciation Accounting Method
A change in depreciation accounting method is treated like a change in accounting estimate. The change is put into effect in the current period and prospectively. The previous periods are not affected by the change.
Impairments under IFRS
Under IFRS the firm must annually assess whether events indicate an impairment on an asset has occurred. An asset is impaired when its carrying value exceeds the recoverable amount (greater of fair value - selling costs and value in use). Value in use is the PV of the future cash flow stream from continued use.
Impairment loss is recognized in the income statement, and the loss can be reversed if the value of the impaired asset is recovered.
Impairments under U.S. GAAP
Under U.S. GAAP the 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. We then first test for impairment, and if it is impaired we measure the loss.
The asset is considered impaired if the carrying value is greater than the asset's future undiscounted cash flow stream. If impaired the asset is written-down to fair value on the BS and a loss equal to the excess of carrying value over the fair value of the asset is recognized in the IS. No recoveries permitted.
Financial statement disclosure on long-lived assets.
An analyst can use the data in the footnotes to calculate the average age of assets. It is useful for two reasons:
1. It helps identify older, less-efficient assets, which may make the firm less competitive.
2. An analyst can estimate when major cap expenditures will be required.
Avg. Age in years is approximated as:
Accumulated Dep / Annual Dep Exp.
This is more accurate with straight line depreciation, and can be significantly affected by the mix of assets.
Average Depreciable Life
Ending gross investment / Annual Depreciation Expense
Gross investment is the original cost of the asset. Gross investment is before deducting accumulated depreciation.
Remaining Useful LIfe
Ending Net Investment / Annual Dep. Expense
Net investment is equal to the original cost minus accumulated depreciation. Can also be calculated by subtracting the average age from average depreciable life.
Finance (Capital) Lease
A finance lease is essentially a purchase of an asset that is financed with debt. At the inception of the lease, the lessee will add equal amounts to both assets and liabilities on the balance sheet. Over the term of the lease, the lessee will recognize depreciation expense on the asset and interest expense on the liability.
Essentially a rental arrangement. No asset or liability is reported by the lessee and the periodic lease payments are simply recognized as rental expense in the income statement.
Benefits of Leasing
- Less costly financing. (normally no down payment).
- Reduced risk of obsolescence
- Less restrictive provisions
- Off Balance Sheet Financing - Operating leases don't require a liability on the BS.
- Tax Reporting Advantages
IFRS Lease Classification
If substantially all the rights and risks of ownership are transferred to the lessee, the lease is treated as a finance lease.
U.S. GAAP Lease Classification
Under US GAAP specific criteria are considered. A lessee must treat a lease as a finance (capital) lease if any one of the following criteria is met:
- Title to the leased asset is transferred to the lessee at the end of the period.
- A Bargain Purchase Option exists (you buy at a sig. lower price at a future date).
- Lease period is 75% or more of the asset's economic life.
- The PV of the lease payments is 90% or more of the FV of the leased asset.
If it meets none of these criteria it is an operating lease.
Lessee Reporting - Operating
No entry is made at the inception of the lease. During the term of the lease, rent expense, equal to the lease payment, is recognized in the lessee's income statement. In the CF statement the lease payment is reported as an outflow from operating activities.
Lessee Reporting - Finance Lease
At the inception of the lease, the lower of the PV of future minimum lease payments or the fair value is recognized as an asset and as a liability on the BS. Over the term of the lease the asset is depreciated and the dep. expense as well as interest expense is reported in the income statement. Int exp. is equal to the lease liability at the Beg of the period multiplied by the interest rate implicit in the lease.
In the CF statement the interest expense is separated into int. exp and principal. Principal portion is equal to the total payment minus the int. exp. Principal is CFI, Int. is CFO under GAAP (under IFRS int exp can be CFO or CFI)
Lease Classification - Lessor
Under U.S. GAAP if any one of the finance lease criteria for lessees is met, the collectibility of the lease payments is reasonably certain, and the lessor has substantially completed performance, the lessor must treat as a finance lease otherwise operating.
For a lessor the capital lease is treated as either a sales type lease or a direct financing lease. (IFRS does not distinguish really).
Treated as if the lessor sold the asset and provided financing to the buyer.
The lease is treated as such if the PV of the lease payments exceeds the carrying value of the asset. This will typically be the case when the lessor is a manufacturer or dealer because the cost of the leased asset will usually be less than its fair value.
At inception the lessor will recognize a sale equal to the PV of the lease payments, and COGS equal to the carrying value of the asset. Asset is removed from BS and a lease receivable equal to the PV of the payments is created. Principal reduces the A/R, interest is treated as interest revenue (treated as CFO on CF).
Direct Financing Lease
No gross profit is recognized by the lessor at the inception of the lease. The lessor is simply providing a financing function to the lessee.
Treated as such if the PV of the lease payments is equal to the carrying value of the leased asset.
At inception the lessor removes the asset from the BS and a lease receivable is created in the same amount. Principal reduces the A/R. Lessor will recognize interest income over the term of the lease. In the CF statement the interest portion is reported as an inflow from CFO.
Operating Lease - Lessor
Lease payment is recognized as rental income and the asset stays on the BS. Dep Exp is recognized over its useful life.