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CHAPTER 10 LONG-LIVED ASSETS Presenter’s name Presenter’s title dd Month yyyy.

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1 CHAPTER 10 LONG-LIVED ASSETS Presenter’s name Presenter’s title dd Month yyyy

2 COSTS THAT ARE CAPITALIZED AND COSTS THAT ARE EXPENSED WHEN INCURRED Long-lived assets (noncurrent assets or long-term assets) -Assets that are expected to provide economic benefits over a future period of time, typically greater than one year. -May be tangible (plant, property, and equipment, or PP&E), intangible, or financial assets. At acquisition, capitalize -purchase price and -expenditures necessary to prepare asset for intended use. Subsequent expenditures are -capitalized if expected to provide benefits beyond one year (extend life or capacity). -expensed otherwise. Copyright © 2013 CFA Institute 2

3 ACQUISITION OF PP&E: EXAMPLE Which of the following expenditures are capitalized? Related to purchase of towel and tissue roll machine: -€10,900 purchase price including taxes -€200 for delivery of the machine -€300 for installation and testing of the machine -€100 to train staff on maintaining the machine -€350 paid to a construction team to reinforce the factory floor and ceiling joists to accommodate the machine’s weight Maintenance: -€1,500 for roof repair; expected to extend useful life of the factory by 5 years. -€1,000 for repainting exterior of the factory and adjoining offices; repainting neither extends the life of factory and offices nor improves their usability. Copyright © 2013 CFA Institute 3

4 ACQUISITION OF INTANGIBLE ASSETS Intangible assets: -Assets lacking physical substance. -Include items that involve exclusive rights, such as patents, copyrights, trademarks, and franchises. Accounting for an intangible asset depends on how it is acquired. We will consider three ways: -Purchased in situations other than business combinations, -Developed internally, and -Acquired in business combinations. Copyright © 2013 CFA Institute 4

5 ACQUISITION OF INTANGIBLE ASSETS How AcquiredTreatment at Acquisition Intangible assets purchased in situations other than business combinations. Recorded at fair value, which is assumed to be equivalent to the purchase price (same as long- lived tangible assets). Intangible assets developed internally. Generally expensed when incurred, although capitalized in some situations. Intangible assets acquired in a business combination. Identifiable assets are recorded at fair value. If acquisition price exceeds the sum of amounts allocable to individual identifiable assets and liabilities, the excess is recorded as goodwill. Copyright © 2013 CFA Institute 5

6 INTANGIBLE ASSETS DEVELOPED INTERNALLY Generally expensed when incurred, although capitalized in some situations. IFRS -Expenditures on research are expensed. -Expenditures on development are capitalized. U.S. GAAP -Generally, both research and development costs are expensed. -For costs related to software development: -Products for sale: Both research and development expenditures are expensed until technology feasibility is established; they are subsequently capitalized. -Software for internal use: Both research and development expenditures are expensed until probable completion is demonstrated; they are subsequently capitalized. Copyright © 2013 CFA Institute 6

7 INTANGIBLE ASSETS DEVELOPED INTERNALLY: EXAMPLE Assume REH AG, a hypothetical company, incurs expenditures of €1,000 per month during the fiscal year ended 31 December 2009 to develop software for internal use. Question: What is the accounting impact of the company being able to demonstrate that the software met the criteria for recognition as an intangible asset on 1 February versus 1 December? Copyright © 2013 CFA Institute 7 JanFebMarAprMayJunJulAugSepOctNovDec

8 INTANGIBLE ASSETS DEVELOPED INTERNALLY: EXAMPLE Assume REH AG, a hypothetical company, incurs expenditures of €1,000 per month during the fiscal year ended 31 December 2009 to develop software for internal use. Question: What is the accounting impact of the company being able to demonstrate that the software met the criteria for recognition as an intangible asset on 1 February versus 1 December? Copyright © 2013 CFA Institute 8 JanFebMarAprMayJunJulAugSepOctNovDec Expense €1,000 Asset €11,000 Expense €11,000 Asset €1,000

9 CAPITALIZE VERSUS EXPENSE: EFFECT ON FINANCIAL STATEMENTS Copyright © 2013 CFA Institute 9 ItemBalance Sheet Income Statement Statement of Cash Flow Costs that are capitalized At acquisition Increase assets −−−− Investing cash outflow Subsequently −−−− Expensed via depreciation −−−− Costs that are expensed when incurred −−−− Immediately reduce net income Operating cash outflow All else being equal, Capitalizing results in higher profitability ratios (return on equity and net profit margin) in the first year and lower profitability ratios in subsequent years. Expensing will give the appearance of greater subsequent growth in profits.

10 DEPRECIATION METHODS Straight-line method: When the cost of the asset is allocated to expense evenly over its useful life. Accelerated method: When the allocation of cost is greater in earlier years. Units-of-production method: When the allocation of cost corresponds to the actual use of an asset in a particular period. Copyright © 2013 CFA Institute 10 Depreciation Expense ($) Useful Life of Asset Accelerated Straight-Line

11 CALCULATE DEPRECIATION EXPENSE: EXAMPLE At the beginning of Year 1, the company buys box manufacturing equipment for $2,300. Estimated residual value: $100. Estimated useful life: 4 years. For each year, what are the beginning and ending net book value (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses? Copyright © 2013 CFA Institute 11

12 CALCULATE DEPRECIATION EXPENSE: STRAIGHT-LINE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses? Copyright © 2013 CFA Institute 12 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, ,1001,200 Year 31, , Year , Year 1: Cost. Thereafter: Prior year ending book value.

13 CALCULATE DEPRECIATION EXPENSE: STRAIGHT-LINE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses? Copyright © 2013 CFA Institute 13 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, ,1001,200 Year 31, , Year , (Cost – Residual value)/Useful life

14 CALCULATE DEPRECIATION EXPENSE: STRAIGHT-LINE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses? Copyright © 2013 CFA Institute 14 Beginning Net Book Value Depreciation Expense Accumulated Year- End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, ,1001,200 Year 31, , Year , Accumulated depreciation + Expense for year

15 CALCULATE DEPRECIATION EXPENSE: STRAIGHT-LINE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses? Copyright © 2013 CFA Institute 15 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, ,1001,200 Year 31, , Year , Cost – Accumulated depreciation

16 CALCULATE DEPRECIATION EXPENSE: DOUBLE- DECLINING BALANCE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses? Copyright © 2013 CFA Institute 16 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$1,150 Year 21, , Year , Year , Year 1: Cost. Thereafter: Prior year ending book value

17 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$1,150 Year 21, , Year , Year , CALCULATE DEPRECIATION EXPENSE: DOUBLE- DECLINING BALANCE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expenses? Copyright © 2013 CFA Institute 17 Beginning net book value × Depreciation rate until…

18 Beginning Net Book Value Depreciation Expense Accumulated Year- End Depreciation Ending Net Book Value Year 1$2,300$1,150 Year 21, , Year , Year , CALCULATE DEPRECIATION EXPENSE: DOUBLE- DECLINING BALANCE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expense? Copyright © 2013 CFA Institute 18 Accumulated depreciation + Expense for year

19 SOONER, Inc. Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$1,150 Year 21, , Year , Year , CALCULATE DEPRECIATION EXPENSE: DOUBLE- DECLINING BALANCE METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. For each year, what are the beginning and ending net book values (carrying amount), end-of-year accumulated depreciation, and annual depreciation expense? Copyright © 2013 CFA Institute 19 Cost – Accumulated depreciation

20 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, , Year , Year , CALCULATE DEPRECIATION EXPENSE: UNITS-OF-PRODUCTION METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. Total estimated productive capacity: 800 boxes. Production in Years 1, 2, 3, 4: 200, 300, 200, and 100 boxes Copyright © 2013 CFA Institute 20 Year 1: Cost. Thereafter: Prior year ending book value

21 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, , Year , Year , CALCULATE DEPRECIATION EXPENSE: UNITS-OF-PRODUCTION METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. Total estimated productive capacity: 800 boxes. Production in Years 1, 2, 3, 4: 200, 300, 200, and 100 boxes. Copyright © 2013 CFA Institute 21 Actual units produced × Per unit cost

22 Beginning Net Book Value Depreciation Expense Accumulated Year- End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, , Year , Year , CALCULATE DEPRECIATION EXPENSE: UNITS-OF-PRODUCTION METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. Total estimated productive capacity: 800 boxes. Production in Years 1, 2, 3, 4: 200, 300, 200, and 100 boxes. Copyright © 2013 CFA Institute 22 Accumulated depreciation + Expense for year

23 Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1$2,300$550 $1,750 Year 21, , Year , Year , CALCULATE DEPRECIATION EXPENSE: UNITS-OF-PRODUCTION METHOD EXAMPLE At the beginning of Year 1, a company buys box manufacturing equipment for $2,300. Estimated residual value: $100, and estimated useful life: 4 years. Total estimated productive capacity: 800 boxes. Production in Years 1, 2, 3, 4: 200, 300, 200, and 100 boxes. Copyright © 2013 CFA Institute 23 Cost – Accumulated depreciation

24 IMPACT ON RESULTS AND RATIOS Method: The accelerated method, compared with the straight-line method, will result in -Higher depreciation expense in earlier periods, so lower operating profit margin and operating return on assets (ROA) in the early periods and higher operating profit margin and operating ROA in the later periods. -Lower average total assets in earlier periods and thus higher asset turnover ratio. Assumptions: -Longer useful life compared with shorter useful life: lower annual depreciation expense. -Higher salvage value compared with lower salvage value: lower annual depreciation expense. Copyright © 2013 CFA Institute 24

25 AMORTIZATION Amortization: Allocation of the cost of an intangible asset over its useful life. An intangible asset with an indefinite useful life is not amortized. An intangible asset with a finite useful life is amortized using the same methods as depreciation. Calculating amortization requires -The original amount at which the intangible asset is recognized, -The estimated length of its useful life, and -The estimated residual value at the end of its useful life. Copyright © 2013 CFA Institute 25

26 REVALUATION MODEL: PERMITTED UNDER IFRS Revaluation model: Alternative to historical cost model permitted under IFRS. Long-lived assets measured at fair value. May be used only if the fair values of the assets can be measured reliably. Unlike historical cost, may result in increases or decreases in value of long-lived assets. May be used for some classes of assets while historical cost is used for other classes, but the same model must be applied to assets within a particular class. Permitted for intangible assets, but only if an active market for the asset exists. In practice, use of revaluation model is relatively rare for either tangible or intangible and is especially rare for intangibles. Copyright © 2013 CFA Institute 26

27 REVALUATION MODEL: EXAMPLE Assume a company has elected to use the revaluation model for an item of machinery (the company’s only long-lived asset). The machine was purchased on the first day of the fiscal period, and measurement date occurs simultaneously with the company’s fiscal period-end. Cost to purchase machine: €10,000. At the end of the first fiscal period after acquisition, assume the fair value of the machine is determined to be €11,000. How will the company’s financial statements reflect the revaluation? Answer The balance sheet shows -The asset at a value of €11,000. -A revaluation surplus (an equity component) of €1,000. Other comprehensive income: €1,000 increase in the value of the asset. No impact on profit and loss. Copyright © 2013 CFA Institute 27

28 REVALUATION MODEL: EXAMPLE The cost to purchase a machine was €10,000. Fair value at the end of the first fiscal period was €11,000. At the end of the second fiscal period after acquisition, assume the fair value of the machine is determined to be €7,500. How will the company’s financial statements reflect the revaluation (total decrease in the carrying amount of the asset is €3,500 (€11,000 – €7,500)? Answer Balance sheet -Asset at a value of €7,500. -Revaluation surplus (an equity component) of €0. Other comprehensive loss of €1,000, reversing previous increase in the value of the asset. In profit and loss (i.e., income statement), loss of €2,500. Copyright © 2013 CFA Institute 28

29 REVALUATION MODEL: EXAMPLE 2 Assume a company has elected to use the revaluation model for an item of machinery (the company’s only long-lived asset). The machine was purchased on the first day of the fiscal period, and the measurement date occurs simultaneously with the company’s fiscal period-end. Cost to purchase machine: €10,000. At the end of the first fiscal period after acquisition, assume the fair value of the machine is determined to be €7,500. How will the company’s financial statements reflect the revaluation? Answer Balance sheet shows the asset at a value of €7,500. Profit and loss (i.e., income statement) shows a €2,500 loss. Copyright © 2013 CFA Institute 29

30 REVALUATION MODEL: EXAMPLE 2 The cost to purchase the machine was €10,000. Fair value at the end of the first fiscal period was €7,500. At the end of the second fiscal period after acquisition, assume the fair value of the machine is determined to be €11,000. How will the company’s financial statements reflect the revaluation (total increase in the carrying amount of the asset is €3,500 (€11,000 – €7,500)? Answer Balance sheet shows -The asset at a value of €11,000. -A revaluation surplus (an equity component) of €1,000. Profit and loss (i.e., income statement): Profit of €2,500 reversing previous loss. Other comprehensive income of €1,000. Copyright © 2013 CFA Institute 30

31 IMPAIRMENT Impairment charges reflect an unanticipated decline in the value of an asset. In general, when an asset’s carrying amount is not recoverable: -The carrying amount of the impaired asset is written down, and -An impairment loss is recognized. IFRS vs. U.S. GAAP -IFRS and U.S. GAAP define recoverability differently. -Impairment reversals are permitted under IFRS but not under U.S. GAAP. Copyright © 2013 CFA Institute 31

32 IMPAIRMENT: PP&E At the end of each reporting period, a company assesses whether there are indications of asset impairment (e.g., evidence of obsolescence, decline in demand for products, or technological advancements). If no indication of impairment, no test for impairment. If there is an indication of impairment, test for impairment. Under IFRS, impairment loss is measured as the excess of carrying amount of the asset over its recoverable amount. -Recoverable amount: “The higher of its fair value less costs to sell and its value in use.” -Value in use: Discounted expected future cash flows. Under U.S. GAAP -Assess recoverability: If not recoverable (carrying amount exceeds undiscounted expected future cash flows), then measure impairment loss. -Impairment loss is measured as the excess of the carrying amount of the asset over its fair value. Copyright © 2013 CFA Institute 32

33 IMPAIRMENT OF PP&E: EXAMPLE Company has a machine used to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The following information pertains to the machine: Carrying amount £18,000 Undiscounted expected future cash flows £19,000 Present value of expected future cash flows £16,000 Fair value if sold £17,000 Costs to sell£2,000 What would the company report for the machine under IFRS versus U.S. GAAP? Copyright © 2013 CFA Institute 33

34 IMPAIRMENT OF PPE: EXAMPLE A company has a machine used to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The following information pertains to the machine: Carrying amount £18,000 Undiscounted expected future cash flows £19,000 Present value of expected future cash flows £16,000 Fair value if sold £17,000 Costs to sell£2,000 What would the company report for the machine under IFRS versus U.S. GAAP? Copyright © 2013 CFA Institute 34 Recoverable amount: Higher of value in use and fair value less cost to sell. Recoverable amount: £16,000 Carrying amount: £18,000 Impairment loss: £2,000

35 IMPAIRMENT OF PP&E: EXAMPLE A company has a machine used to produce a single product. The demand for the product has declined substantially since the introduction of a competing product. The following information pertains to the machine: Carrying amount £18,000 Undiscounted expected future cash flows £19,000 Present value of expected future cash flows £16,000 Fair value if sold £17,000 Costs to sell£2,000 What would the company report for the machine under IFRS versus U.S. GAAP? Copyright © 2013 CFA Institute 35 Recoverable? Yes, it is recoverable because the amount of undiscounted expected future cash flows exceeds the carrying amount. No impairment loss is recognized.

36 DERECOGNITION Derecognition of an asset: Remove it from the financial statements. Derecognition occurs when the asset is disposed of or is expected to provide no future benefits from either use or disposal. Disposal of a long-lived asset: -Sale -Gain or loss = Sales proceeds – Carrying amount of asset. -Nonoperating gain or loss. -Exchange -Abandonment Copyright © 2013 CFA Institute 36

37 DISCLOSURES ABOUT LONG-LIVED ASSETS Disclosures about long-lived assets appear throughout the financial statements. Balance sheet reports the carrying value of the asset. Income statement shows depreciation expense as a separate line item in some instances. Statement of cash flows: -Acquisitions and disposals of fixed assets in the investing section -Depreciation and amortization in the operating section Notes to financial statement: -Accounting methods -Amount of annual depreciation expense -Range of estimated useful lives by main category of fixed asset -Historical cost by main category of fixed asset -Accumulated depreciation by main category of fixed asset Copyright © 2013 CFA Institute 37

38 RATIOS USED IN ANALYZING FIXED ASSETS Fixed asset turnover ratio: -Calculated as total revenue divided by average net fixed assets. -Shows the relationship between total revenues and investment in PP&E. -The higher this ratio, the higher the amount of sales a company is able to generate with a given amount of investment in fixed assets. -A higher asset turnover ratio is often interpreted as an indicator of greater efficiency. Asset age ratios are broad indicators of a company’s need to reinvest in productive capacity. -The average age of the asset base is estimated as the accumulated depreciation divided by the depreciation expense. -The average remaining life of a company’s asset base is estimated as the net PP&E divided by the depreciation expense. -The total useful life of PP&E is estimated as the total historical cost of PP&E divided by the annual depreciation expense. Copyright © 2013 CFA Institute 38

39 ASSET AGE RATIOS Copyright © 2013 CFA Institute 39 Historical cost($100)/ Annual depreciation expense ($10) = Total useful life (10 years) Accumulated depreciation ($30)/ Annual depreciation expense ($10) = Estimated age (3 years) Net PP&E ($70)/ Annual depreciation expense ($10) = Estimated remaining life (7 years) Historical cost: $100, estimated useful life: 10 years, estimated salvage value: $0.

40 INVESTMENT PROPERTY IFRS Investment property is defined as property that is owned for the purpose of earning rentals or capital appreciation or both. Investment property can be valued using either a cost model or a fair value model. -Cost model: Identical to PP&E. -Fair value model: All changes in the fair value of the asset affect net income. U.S. GAAP No specific definition of investment property. Most operating companies and real estate companies that hold investment-type property use the historical cost model. Copyright © 2013 CFA Institute 40

41 LEASES Lease: Contract between the owner of an asset—the lessor—and another party seeking use of the asset—the lessee. -The lessor grants the right to use the asset to the lessee. -In exchange for the right to use the asset, the lessee makes periodic lease payments to the lessor. Advantages to leasing an asset compared with purchasing it: Leases can provide less costly financing, usually require little, if any, down payment, and are often at fixed interest rates. The negotiated lease contract may contain less restrictive provisions than other forms of borrowing. Leasing can reduce the risks of obsolescence, residual value, and disposition to the lessee. Certain types of leases have perceived financial reporting advantages. Lease accounting is currently a joint IASB/FASB project. Copyright © 2013 CFA Institute 41

42 SUMMARY Expenditures related to long-lived assets are capitalized as part of the cost of assets if they are expected to provide future benefits and expensed otherwise. Capitalizing versus expensing an expenditure can significantly affect financial statements and ratios. Financial statements and ratios can be significantly affected by choice of depreciation/amortization method and by assumptions about useful life and residual value. IFRS (but not U.S. GAAP) permit the use of either the cost model or the revaluation model for the valuation of long-lived assets. Impairment charges reflect an unexpected decline in the fair value of an asset to an amount lower than its carrying amount. IFRS (but not U.S. GAAP) permit impairment losses to be reversed. Ratios used in analyzing fixed assets include the fixed asset turnover ratio and several asset age ratios. Copyright © 2013 CFA Institute 42


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