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Chapter 10 Long-Lived Assets

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1 Chapter 10 Long-Lived Assets
Presenter’s name Presenter’s title dd Month yyyy LEARNING OUTCOMES Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred. Compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination. Explain and evaluate the effects on financial statements and ratios of capitalizing versus expensing costs in the period in which they are incurred. Describe the different depreciation methods for property, plant, and equipment and the effects of the choice of depreciation method and the assumptions concerning useful life and residual value on depreciation expense, financial statements, and ratios. Calculate depreciation expense. Describe the different amortization methods for intangible assets with finite lives and the effects of the choice of amortization method and the assumptions concerning useful life and residual value on amortization expense, financial statements, and ratios. Calculate amortization expense. Describe the revaluation model. Describe the impairment of property, plant, and equipment and intangible assets. Describe the derecognition of property, plant, and equipment and intangible assets. Explain and evaluate the effects on financial statements and ratios of impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets. Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets. Analyze and interpret the financial statement disclosures regarding property, plant, and equipment and intangible assets. Compare the financial reporting of investment property with that of property, plant, and equipment. Explain and evaluate the effects on financial statements and ratios of leasing assets instead of purchasing them. Explain and evaluate the effects on financial statements and ratios of finance leases and operating leases from the perspective of both the lessor and the lessee.

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. LOS. Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred. Pages 480–482 Long-lived assets: Also referred to as noncurrent 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, intangible, or financial assets. Examples of long-lived tangible assets, typically referred to as property, plant, and equipment (PP&E) and sometimes as fixed assets, include land, buildings, furniture and fixtures, machinery and equipment, and vehicles. Examples of long-lived intangible assets (assets lacking physical substance) include patents and trademarks. Examples of long-lived financial assets include investments in equity or debt securities issued by other companies. This presentation covers long-lived tangible and intangible assets (hereafter, referred to for simplicity as long-lived assets). When PP&E is purchased, the buyer records the asset at cost. In addition to the purchase price, the buyer also includes, as part of the cost of an asset, all the expenditures necessary to get the asset ready for its intended use. For example, freight costs borne by the purchaser to get the asset to the purchaser’s place of business, and special installation and testing costs required to make the asset usable, are included in the total cost of the asset. Subsequent expenditures related to long-lived assets are included as part of the recorded value of the assets on the balance sheet (i.e., capitalized) if they are expected to provide benefits beyond one year in the future and are expensed if they are not expected to provide benefits in future periods. Copyright © 2013 CFA Institute

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. LOS. Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred. Pages 482–483 This follows Example 10-1, page 482, in the text. The company will capitalize, as part of the cost of the machine, all costs that are necessary to get the new machine ready for its intended use: €10,900 purchase price, €200 for delivery, €300 for installation and testing, and €350 to reinforce the factory floor and ceiling joists to accommodate the machine’s weight (which was necessary to use the machine and does not increase the value of the factory). The €100 to train staff is not necessary to get the asset ready for its intended use and will be expensed. The company will capitalize the expenditure of €1,500 to repair the factory roof because the repair is expected to extend the useful life of the factory. The company will expense the €1,000 to have the exterior of the factory and adjoining offices repainted because the painting does not extend the life or alter the productive capacity of the buildings. Copyright © 2013 CFA Institute

4 Acquisition of 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. LOS. Compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination. Pages 484–487 Intangible assets are assets lacking physical substance. Intangible assets include items that involve exclusive rights, such as patents, copyrights, trademarks, and franchises. Accounting for an intangible asset depends on how it is acquired. Will consider three ways: purchased in situations other than business combinations, developed internally, and acquired in business combinations. Copyright © 2013 CFA Institute

5 Acquisition of Intangible assets
How Acquired Treatment 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. LOS. Compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination. LOS. Explain and evaluate the effects on financial statements and ratios of capitalizing versus expensing costs in the period in which they are incurred. Pages 484–487 Intangible assets purchased in situations other than business combinations (e.g., buying a patent): Same as long-lived tangible assets, recorded at their fair value when acquired, which is assumed to be equivalent to the purchase price. Intangible assets developed internally: Generally expensed when incurred, although capitalized in some situations. Examples include expenditures on R&D or advertising that develop such intangible assets as patents, copyrights, or brands. Because costs associated with internally developing intangible assets are usually expensed, a company that has internally developed such intangible assets will recognize a lower amount of assets than a company that has obtained intangible assets through external purchase. In addition, on the statement of cash flows, costs of internally developing intangible assets are classified as operating cash outflows whereas costs of acquiring intangible assets are classified as investing cash outflows. Differences in strategy (developing versus acquiring intangible assets) can thus impact financial ratios. Intangible assets acquired in a business combination: When one company acquires another company, the transaction is accounted for using the acquisition method of accounting. Under the acquisition method, the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value. If the purchase price exceeds the sum of the amounts that can be allocated to individual identifiable assets and liabilities, the excess is recorded as goodwill. Goodwill cannot be identified separately from the business as a whole. Under IFRS, the acquired individual assets include identifiable intangible assets that meet the definitional and recognition criteria. The definitional criteria are identifiability, control by the company, and expected future benefits. The recognition criteria are probable flows of the expected economic benefits to the company and measurability. Otherwise, if the item is acquired in a business combination and cannot be recognized as a tangible or identifiable intangible asset, it is recognized as goodwill. Under U.S. GAAP, there are two criteria to judge whether an intangible asset acquired in a business combination should be recognized separately from goodwill: The asset must be either an item arising from contractual or legal rights or an item that can be separated from the acquired company. Examples of intangible assets treated separately from goodwill include the intangible assets previously mentioned that involve exclusive rights (patents, copyrights, franchises, licenses), as well as such items as internet domain names and video and audiovisual materials. Copyright © 2013 CFA Institute

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. LOS. Compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination. Page 485 IFRS require that expenditures on research (or during the research phase of an internal project) be expensed rather than capitalized as an intangible asset. Research is defined as “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.” The “research phase of an internal project” refers to the period during which a company cannot demonstrate that an intangible asset is being created—for example, the search for alternative materials or systems to use in a production process. IFRS allow companies to recognize an intangible asset arising from development (or the development phase of an internal project) if certain criteria are met, including a demonstration of the technical feasibility of completing the intangible asset and the intent to use or sell the asset. Development is defined as “the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.” IAS 38 Intangible Assets. Generally, U.S. GAAP require that both research and development costs be expensed as incurred but require capitalization of certain costs related to software development. Costs incurred to develop a software product for sale are expensed until the product’s technological feasibility is established and are capitalized thereafter. Similarly, costs related to the development of software for internal use are expensed until it is probable that the project will be completed and that the software will be used as intended. Thereafter, development costs are capitalized. The probability that the project will be completed is easier to demonstrate than is technological feasibility. The capitalized costs, related directly to developing software for sale or internal use, include the costs of employees who help build and test the software. The treatment of software development costs under U.S. GAAP is similar to the treatment of all costs of internally developed intangible assets under IFRS. Copyright © 2013 CFA Institute

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? LOS. Compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination. Pages 485–487 The slide follows Example 10-3, page 486, in text. Under IFRS, the company must treat the expenditures as an expense until the software meets the criteria for recognition as an intangible asset, after which time the expenditures can be capitalized as an intangible asset. Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Copyright © 2013 CFA Institute

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? Expense €1,000 Asset €11,000 Expense €11,000 Asset €1,000 LOS. Compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination. Pages 485–487 The slide follows Example 10-3, page 486, in text. Under IFRS, the company must treat the expenditures as an expense until the software meets the criteria for recognition as an intangible asset, after which time the expenditures can be capitalized as an intangible asset. Answer: If the company is able to demonstrate that the software met the criteria for recognition as an intangible asset on 1 February, the company would recognize €1,000 of expense (on the income statement) during the fiscal year ended 31 December The other €11,000 of expenditures would be recognized as an intangible asset (on the balance sheet). Alternatively, if the company is not able to demonstrate that the software met the criteria for recognition as an intangible asset until 1 December, the company would recognize €11,000 of expense during the fiscal year ended 31 December 2009, with the other €1,000 of expenditures recognized as an intangible asset. Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Copyright © 2013 CFA Institute

9 Capitalize versus expense: Effect on Financial statements
Item Balance 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 LOS. Explain and evaluate the effects on financial statements and ratios of capitalizing versus expensing costs in the period in which they are incurred. Pages 487–492 An expenditure that is capitalized: In the period of the expenditure, Increases the amount of assets on the balance sheet and Appears as an investing cash outflow on the statement of cash flows. In subsequent periods, The capitalized amount is allocated over the asset’s useful life as depreciation or amortization expense (except assets that are not depreciated—e.g., land—or amortized—e.g., intangible assets with indefinite lives). Because depreciation and amortization are noncash expenses, apart from their effects on taxable income and taxes payable, they have no impact on the cash flow statement. In the section of the statement of cash flows that reconciles net income to operating cash flow, depreciation and amortization expenses are added back to net income. An expenditure that is expensed in the period incurred reduces net income by the after-tax amount of the expenditure. No asset is recorded on the balance sheet and thus no depreciation or amortization occurs in subsequent periods. The lower amount of net income is reflected in lower retained earnings on the balance sheet. The expenditure appears as an operating cash outflow in the period it is made. There is no effect on the financial statements of subsequent periods. 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. Copyright © 2013 CFA Institute

10 depreciation methods Accelerated Straight-Line Depreciation
Expense ($) Useful Life of Asset LOS. Describe the different depreciation methods for property, plant, and equipment and the effects of the choice of depreciation method and the assumptions concerning useful life and residual value on depreciation expense, financial statements, and ratios. Page 499 Depreciation methods include the straight-line method, in which the cost of an asset is allocated to expense evenly over its useful life; accelerated method, in which the allocation of cost is greater in earlier years; and the units-of-production method, in which the allocation of cost corresponds to the actual use of an asset in a particular period. The graph on the slide illustrates straight-line versus accelerated depreciation. Units of production would vary depending on actual use. The choice of depreciation method affects the amounts reported on the financial statements, including the amounts for reported assets and operating and net income. This, in turn, affects a variety of financial ratios. 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

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? LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. The example illustrates the straight-line method, accelerated method, and the units-of-production method. Copyright © 2013 CFA Institute

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? Year 1: Cost. Thereafter: Prior year ending book value. Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 550 1,100 1,200 Year 3 1,650 650 Year 4 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. For the straight-line method, the depreciation expense in each year equals $550, which is calculated as ($2,300 original cost – $100 residual value)/4 years. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

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? (Cost – Residual value)/Useful life Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 550 1,100 1,200 Year 3 1,650 650 Year 4 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 This slide follows Example 10-8, page 500, in text. For the straight-line method, the depreciation expense in each year equals $550, which is calculated as ($2,300 original cost – $100 residual value)/4 years. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from prior year minus depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

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? Accumulated depreciation + Expense for year Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 550 1,100 1,200 Year 3 1,650 650 Year 4 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. For the straight-line method, the depreciation expense in each year equals $550, which is calculated as ($2,300 original cost – $100 residual value)/4 years. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

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? Cost – Accumulated depreciation Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 550 1,100 1,200 Year 3 1,650 650 Year 4 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. For the straight-line method, the depreciation expense in each year equals $550, which is calculated as ($2,300 original cost – $100 residual value)/4 years. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

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? Year 1: Cost. Thereafter: Prior year ending book value Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $1,150 Year 2 1,150 575 1,725 Year 3 288 2,013 287 Year 4 187 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 This slide follows Example 10-8, page 500, in text. For the double-declining balance method, the depreciation rate is double the depreciation rate for the straight-line method. Depreciation expense = Beginning net book value × Depreciation rate (until the time period in which calculated depreciation expense would reduce book value below the residual value). The depreciation rate under the straight-line method is 25% (100% divided by 4 years). Thus, the depreciation rate for the double-declining balance method is 50% (2 times 25%). The depreciation expense for the first year is $1,150 (50% of $2,300). Note that under this method, the depreciation rate of 50% is applied to the carrying amount (net book value) of the asset, without adjustment for expected residual value. Because the carrying amount of the asset is not depreciated below its estimated residual value, however, the depreciation expense in the final year of depreciation decreases the ending net book value (carrying amount) to the estimated residual value. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

17 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? Beginning net book value × Depreciation rate until… Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $1,150 Year 2 1,150 575 1,725 Year 3 288 2,013 287 Year 4 187 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. For the double-declining balance method, the depreciation rate is double the depreciation rate for the straight-line method. Depreciation expense = Beginning net book value × depreciation rate (until the time period in which calculated depreciation expense would reduce book value below the residual value). The depreciation rate under the straight-line method is 25% (100% divided by 4 years). Thus, the depreciation rate for the double-declining balance method is 50% (2 times 25%). The depreciation expense for the first year is $1,150 (50% of $2,300). Note that under this method, the depreciation rate of 50% is applied to the carrying amount (net book value) of the asset, without adjustment for expected residual value. Because the carrying amount of the asset is not depreciated below its estimated residual value, however, the depreciation expense in the final year of depreciation decreases the ending net book value (carrying amount) to the estimated residual value. Another common approach (not required in this question) is to use an accelerated method, such as the double-declining method, for some period (a year or more) and then to change to the straight-line method for the remaining life of the asset. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of the accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

18 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? Accumulated depreciation + Expense for year Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $1,150 Year 2 1,150 575 1,725 Year 3 288 2,013 287 Year 4 187 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. For the double-declining balance method, the depreciation rate is double the depreciation rate for the straight-line method. Depreciation expense = Beginning net book value × depreciation rate (until the time period in which calculated depreciation expense would reduce book value below the residual value). The depreciation rate under the straight-line method is 25% (100% divided by 4 years). Thus, the depreciation rate for the double-declining balance method is 50% (2 times 25%). The depreciation expense for the first year is $1,150 (50% of $2,300). Note that under this method, the depreciation rate of 50% is applied to the carrying amount (net book value) of the asset, without adjustment for expected residual value. Because the carrying amount of the asset is not depreciated below its estimated residual value, however, the depreciation expense in the final year of depreciation decreases the ending net book value (carrying amount) to the estimated residual value. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

19 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? Cost – Accumulated depreciation SOONER, Inc. Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $1,150 Year 2 1,150 575 1,725 Year 3 288 2,013 287 Year 4 187 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. For the double-declining balance method, the depreciation rate is double the depreciation rate for the straight-line method. Depreciation expense = Beginning net book value × depreciation rate (until the time period in which calculated depreciation expense would reduce book value below the residual value). The depreciation rate under the straight-line method is 25% (100% divided by 4 years). Thus, the depreciation rate for the double-declining balance method is 50% (2 times 25%). The depreciation expense for the first year is $1,150 (50% of $2,300). Note that under this method, the depreciation rate of 50% is applied to the carrying amount (net book value) of the asset, without adjustment for expected residual value. Because the carrying amount of the asset is not depreciated below its estimated residual value, however, the depreciation expense in the final year of depreciation decreases the ending net book value (carrying amount) to the estimated residual value. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

20 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 Year 1: Cost. Thereafter: Prior year ending book value Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 825 1,375 925 Year 3 550 1,925 375 Year 4 275 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. Under the units-of-production method, depreciation expense = actual units produced times per unit cost. Dividing the equipment’s total depreciable cost by its total productive capacity gives a cost per unit of $2.75, calculated as ($2,300 original cost – $100 residual value)/800. The depreciation expense recognized each year is the number of units produced times $2.75. For Year 1, the amount of depreciation expense is $550 (200 units times $2.75). For Year 2, the amount is $825 (300 units times $2.75). For Year 3, the amount is $550. For Year 4, the amount is $275. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

21 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. Actual units produced × Per unit cost Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 825 1,375 925 Year 3 550 1,925 375 Year 4 275 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. Under the units-of-production method, depreciation expense = actual units produced times per unit cost. Dividing the equipment’s total depreciable cost by its total productive capacity gives a cost per unit of $2.75, calculated as ($2,300 original cost – $100 residual value)/800. The depreciation expense recognized each year is the number of units produced times $2.75. For Year 1, the amount of depreciation expense is $550 (200 units times $2.75). For Year 2, the amount is $825 (300 units times $2.75). For Year 3, the amount is $550. For Year 4, the amount is $275. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

22 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. Accumulated depreciation + Expense for year Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 825 1,375 925 Year 3 550 1,925 375 Year 4 275 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. Under the units-of-production method, depreciation expense = actual units produced times per unit cost. Dividing the equipment’s total depreciable cost by its total productive capacity gives a cost per unit of $2.75, calculated as ($2,300 original cost – $100 residual value)/800. The depreciation expense recognized each year is the number of units produced times $2.75. For Year 1, the amount of depreciation expense is $550 (200 units times $2.75). For Year 2, the amount is $825 (300 units times $2.75). For Year 3, the amount is $550. For Year 4, the amount is $275. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning book value is simply the ending book value from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

23 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. Cost –Accumulated depreciation Beginning Net Book Value Depreciation Expense Accumulated Year-End Depreciation Ending Net Book Value Year 1 $2,300 $550 $1,750 Year 2 1,750 825 1,375 925 Year 3 550 1,925 375 Year 4 275 2,200 100 LOS. Calculate depreciation expense. Pages 500–504 The slide follows Example 10-8, page 500, in text. Under the units-of-production method, depreciation expense = actual units produced times per-unit cost. Dividing the equipment’s total depreciable cost by its total productive capacity gives a cost per unit of $2.75, calculated as ($2,300 original cost – $100 residual value)/800. The depreciation expense recognized each year is the number of units produced times $2.75. For Year 1, the amount of depreciation expense is $550 (200 units times $2.75). For Year 2, the amount is $825 (300 units times $2.75). For Year 3, the amount is $550. For Year 4, the amount is $275. Beginning net book value: In the first year, this is the original cost to purchase the asset. In subsequent years, the beginning BV is simply the ending BV from the prior year. The accumulated depreciation equals the amount of accumulated depreciation from the prior year plus the depreciation expense for the current year. The ending net book value equals the original cost minus the accumulated depreciation. Equivalently, the ending book value equals the ending book value from the prior year minus the depreciation expense for the current year. The net book value at the end of Year 4 is the estimated residual value of $100. Copyright © 2013 CFA Institute

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. LOS. Describe the different depreciation methods for property, plant, and equipment and the effects of the choice of depreciation method and the assumptions concerning useful life and residual value on depreciation expense, financial statements, and ratios. Pages 500–504 Method: Can compare the accelerated method with the straight-line method in general. (Comparison with units of the production method is not particularly useful because units of the production method outcomes will be entirely dependent on the specific usage pattern of the asset.) Compared with the straight-line method, accelerated methods result in A higher depreciation expense in earlier periods, so—all else being equal—the company will have a lower operating profit margin and operating ROA in the early years and a higher operating profit margin and operating ROA in later periods and Lower average total assets in earlier periods and thus a higher asset turnover ratio. Assumptions also affect financial results and ratios. A longer useful life compared with a shorter useful life: A lower annual depreciation expense, which will result in higher profit margins. A higher salvage value compared with a lower salvage value: A lower annual depreciation expense, which will result in higher profit margins. Copyright © 2013 CFA Institute

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. LOS. Describe the different amortization methods for intangible assets with finite lives and the effects of the choice of amortization method and the assumptions concerning useful life and residual value on amortization expense, financial statements, and ratios. Pages 507–508 Amortization is similar in concept to depreciation. The term amortization applies to intangible assets, and the term depreciation applies to tangible assets. Both terms refer to the process of allocating the cost of an asset over the asset’s useful life. Assets assumed to have an indefinite useful life (in other words, without a finite useful life) are not amortized. An intangible asset is considered to have an indefinite useful life when there is “no foreseeable limit to the period over which the asset is expected to generate net cash inflows” for the company. Examples of intangible assets with indefinite useful lives include an acquired license that, although it has a specific expiration date, can be renewed at little or no cost and an acquired trademark that, although it has a specific expiration, can be renewed at a minimal cost and relates to a product that a company plans to continue selling for the foreseeable future. Only those intangible assets assumed to have finite useful lives are amortized over their useful lives, following the pattern in which the benefits are used up. Acceptable amortization methods are the same as the methods that are acceptable for depreciation. Examples of intangible assets with finite useful lives include an acquired customer list expected to provide benefits to a direct-mail marketing company for two to three years, an acquired patent or copyright with a specific expiration date, an acquired license with a specific expiration date and no right to renew the license, and an acquired trademark for a product that a company plans to phase out over a specific number of years. As with depreciation for a tangible asset, the calculation of amortization for an intangible asset requires the original amount at which the intangible asset is recognized and estimates of the length of its useful life and its residual value at the end of its useful life. Useful lives are estimated on the basis of the expected use of the asset, considering any factors that may limit the life of the asset, such as legal, regulatory, contractual, competitive, or economic factors. Copyright © 2013 CFA Institute

26 revaluation model: permitted under IFRS
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. LOS. Describe the revaluation model. Pages 508–512 The revaluation model is an alternative to the historical cost model for the periodic valuation and reporting of long-lived assets. IFRS permit the use of either the revaluation model or the cost model, but the revaluation model is not allowed under U.S. GAAP. Revaluation changes the carrying amounts of classes of long-lived assets to fair value (the fair value must be measured reliably). Under the cost model, carrying amounts are historical costs less accumulated depreciation or amortization. Under the revaluation model, carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortization. A key difference between the two models is that the cost model allows only decreases in the values of long-lived assets compared with historical costs but the revaluation model may result in increases in the values of long-lived assets to amounts greater than historical costs. IFRS allow a company to use the cost model for some classes of assets and the revaluation model for others, but the company must apply the same model to all assets within a particular class of assets and must revalue all items within a class to avoid selective revaluation. Examples of different classes of assets include land, land and buildings, machinery, motor vehicles, furniture and fixtures, and office equipment. The revaluation model may be used for classes of intangible assets, but only if an active market for the assets exists because the revaluation model may only be used if the fair values of the assets can be measured reliably. For practical purposes, the revaluation model is rarely used for either tangible or intangible assets, but its use is especially rare for intangible assets. Copyright © 2013 CFA Institute

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. LOS. Describe the revaluation model. Pages 508–512 The slide presents Example 10-11, page 510. Under the revaluation model, whether an asset revaluation affects earnings depends on whether the revaluation initially increases or decreases an asset class’s carrying amount. If a revaluation initially decreases the carrying amount of the asset class, the decrease is recognized in profit or loss. Later, if the carrying amount of the asset class increases, the increase is recognized in profit or loss to the extent that it reverses a revaluation decrease of the same asset class previously recognized in profit or loss. Any increase in excess of the reversal amount will not be recognized in the income statement but will be recorded directly to equity in a revaluation surplus account. If a revaluation initially increases the carrying amount of the asset class, the increase in the carrying amount of the asset class bypasses the income statement and goes directly to equity under the heading of revaluation surplus. Any subsequent decrease in the asset’s value first decreases the revaluation surplus and then goes to profit and loss. When an asset is retired or disposed of, any related amount of revaluation surplus included in equity is transferred directly to retained earnings. Copyright © 2013 CFA Institute

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. LOS. Describe the revaluation model. Pages 508–512 The slide presents Example 10-11, page 510. At the end of the second fiscal period, the company’s balance sheet will show the asset at a value of €7,500. The total decrease in the carrying amount of the asset is €3,500 (€11,000 – €7,500). Of the €3,500 decrease, the first €1,000 will reduce the amount previously accumulated in equity under the heading of revaluation surplus. The other €2,500 will be shown as a loss on the income statement. Because the revaluation initially increased the carrying amount of the asset class, the increase in the carrying amount of the asset class bypassed the income statement, was treated as other comprehensive income, and was accumulated directly in equity under the heading of revaluation surplus. The subsequent decrease in the asset’s value first decreased the previously recognized revaluation surplus and then went to profit and loss. Copyright © 2013 CFA Institute

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. LOS. Describe the revaluation model. Pages 508–512 The slide presents Example page 511. If a revaluation initially decreases the carrying amount of the asset class, the decrease is recognized in profit or loss. Later, if the carrying amount of the asset class increases, the increase is recognized in profit or loss to the extent that it reverses a revaluation decrease of the same asset class previously recognized in profit or loss. Any increase in excess of the reversal amount will not be recognized on the income statement but will be recorded directly to equity in a revaluation surplus account. Here, the revaluation decreases the carrying value of the asset. The decrease is recognized in profit or loss. At the end of the first fiscal period, the company’s balance sheet will show the asset at a value of €7,500. The €2,500 decrease in the value of the asset will appear as a loss on the company’s income statement. Copyright © 2013 CFA Institute

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. LOS. Describe the revaluation model. Pages 508–512 The slide presents Example 10-12, page 511. If a revaluation initially decreases the carrying amount of the asset class, the decrease is recognized in profit or loss. Later, if the carrying amount of the asset class increases, the increase is recognized in profit or loss to the extent that it reverses a revaluation decrease of the same asset class previously recognized in profit or loss. Any increase in excess of the reversal amount will not be recognized in the income statement but will be recorded directly to equity in a revaluation surplus account. Here, the first-year revaluation decreased the carrying value of the asset, and the €2,500 decrease in the value of the asset appeared as a loss on the company’s income statement. At the end of the second fiscal period, the company’s balance sheet will show the asset at a value of €11,000. The total increase in the carrying amount of the asset is an increase of €3,500 (€11,000 – €7,500). Of the €3,500 increase, the first €2,500 reverses the previously reported loss and will be reported as a gain on the income statement. The other €1,000 will bypass profit or loss and be reported as other comprehensive income and be accumulated in equity under the heading of revaluation surplus. Copyright © 2013 CFA Institute

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. LOS. Describe the impairment of property, plant, and equipment and intangible assets. Pages 512–514 In contrast to depreciation and amortization charges, which serve to allocate the depreciable cost of a long-lived asset over its useful life, 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. However, IFRS and U.S. GAAP define recoverability differently. Impairment reversals are permitted under IFRS but not under U.S. GAAP. Copyright © 2013 CFA Institute

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. LOS. Describe the impairment of property, plant, and equipment and intangible assets. Pages 512–514 Concepts for impairment of property, plant, and equipment and intangible assets are similar. Here, we illustrate using a PP&E example. For property, plant, and equipment, at the end of each reporting period (generally, a fiscal year), a company assesses whether there are indications of asset impairment. If there is no indication of impairment, the asset is not tested for impairment. If there is an indication of impairment, such as evidence of obsolescence, decline in demand for products, or technological advancements, the recoverable amount of the asset should be measured in order to test for impairment. Under IFRS, an impairment loss is measured as the excess of the carrying amount over the recoverable amount of the asset. The recoverable amount of an asset is defined as “the higher of its fair value less costs to sell and its value in use.” Value in use is a discounted measure of expected future cash flows. Under U.S. GAAP, assessing recoverability is separate from measuring the impairment loss. An asset’s carrying amount is considered not recoverable when it exceeds the undiscounted expected future cash flows. If the asset’s carrying amount is considered not recoverable, the impairment loss is measured as the difference between the asset’s fair value and carrying amount. Copyright © 2013 CFA Institute

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? LOS. Describe the impairment of property, plant, and equipment and intangible assets. Pages 512–514 Under IFRS, an impairment loss is measured as the excess of carrying amount over the recoverable amount of the asset. The recoverable amount of an asset is defined as “the higher of its fair value less costs to sell and its value in use.” Value in use is a discounted measure of expected future cash flows. Under U.S. GAAP, assessing recoverability is separate from measuring the impairment loss. An asset’s carrying amount is considered not recoverable when it exceeds the undiscounted expected future cash flows. If the asset’s carrying amount is considered not recoverable, the impairment loss is measured as the difference between the asset’s fair value and carrying amount. Copyright © 2013 CFA Institute

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? Recoverable amount: Higher of value in use and fair value less cost to sell. LOS. Describe the impairment of property, plant, and equipment and intangible assets. Pages 512–514 Under IFRS, an impairment loss is measured as the excess of the carrying amount over the recoverable amount of the asset. The recoverable amount of an asset is defined as “the higher of its fair value less costs to sell and its value in use.” Value in use is a discounted measure of expected future cash flows. Under IFRS, the company would compare the carrying amount (£18,000) with the higher of its fair value less costs to sell (£15,000) and its value in use (£16,000). The carrying amount exceeds the value in use, the higher of the two amounts, by £2,000. The machine would be written down to the recoverable amount of £16,000, and a loss of £2,000 would be reported on the income statement. The carrying amount of the machine is now £16,000. A new depreciation schedule based on the carrying amount of £16,000 would be developed. Recoverable amount: £16,000 Carrying amount: £18,000 Impairment loss: £2,000 Copyright © 2013 CFA Institute

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? Recoverable? LOS. Describe the impairment of property, plant, and equipment and intangible assets. Pages 512–514 Under U.S. GAAP, assessing recoverability is separate from measuring the impairment loss. An asset’s carrying amount is considered not recoverable when it exceeds the undiscounted expected future cash flows. If the asset’s carrying amount is considered not recoverable, the impairment loss is measured as the difference between the asset’s fair value and carrying amount. Under U.S. GAAP, the carrying amount (£18,000) is compared with the undiscounted expected future cash flows (£19,000). The carrying amount is less than the undiscounted expected future cash flows, so the carrying amount is considered recoverable. The machine would continue to be carried at £18,000, and no loss would be reported. Yes, it is recoverable because the amount of undiscounted expected future cash flows exceeds the carrying amount. No impairment loss is recognized. Copyright © 2013 CFA Institute

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 LOS. Describe the derecognition of property, plant, and equipment and intangible assets. Pages 515–517 A company derecognizes an asset (i.e., removes it from the financial statements) when the asset is disposed of or is expected to provide no future benefits from either use or disposal. A company may dispose of a long-lived operating asset by selling it, exchanging it, or abandoning it. Noncurrent assets that are no longer in use and are to be sold are reclassified as noncurrent assets held for sale. Sale of long-lived assets: The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying amount of the asset at the time of sale. An asset’s carrying amount is typically the net book value (i.e., the historical cost minus accumulated depreciation), unless the asset’s carrying amount has been changed to reflect impairment and/or revaluation, as previously discussed. A gain or loss on the sale of an asset is disclosed on the income statement, either as a component of other gains and losses or in a separate line item when the amount is material. When an asset is exchanged, accounting for the exchange typically involves removing the carrying amount of the asset given up, adding a fair value for the asset acquired, and reporting any difference between the carrying amount and the fair value as a gain or loss. The fair value used is the fair value of the asset given up unless the fair value of the asset acquired is more clearly evident. If no reliable measure of fair value exists, the acquired asset is measured at the carrying amount of the asset given up. A gain is reported when the fair value used for the newly acquired asset exceeds the carrying amount of the asset given up. A loss is reported when the fair value used for the newly acquired asset is less than the carrying amount of the asset given up. If the acquired asset is valued at the carrying amount of the asset given up because no reliable measure of fair value exists, no gain or loss is reported. When an asset is abandoned, the accounting is similar to a sale, except that the company does not record cash proceeds. Assets are reduced by the carrying amount of the asset at the time of retirement or abandonment, and a loss equal to the asset’s carrying amount is recorded. Copyright © 2013 CFA Institute

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 LOS. Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets. LOS. Analyze and interpret the financial statement disclosures regarding property, plant, and equipment and intangible assets. Pages 517–528 Disclosures about long-lived assets appear throughout the financial statements: in the balance sheet, the income statement, the statement of cash flows, and the notes. The balance sheet reports the carrying value of the asset. For the income statement, depreciation expense may or may not appear as a separate line item. Under IFRS, whether the income statement discloses depreciation expense separately depends on whether the company is using a “nature of expense” method or a “function of expense” method. Under the nature of expense method, a company aggregates expenses “according to their nature (for example, depreciation, purchases of materials, transport costs, employee benefits, and advertising costs), and does not reallocate them among functions within the entity.” Under the function of expense method, a company classifies expenses according to the function—for example, as part of cost of sales or of SG&A (selling, general, and administrative expenses). At a minimum, a company using the function of expense method must disclose cost of sales, but the other line items vary. The statement of cash flows reflects acquisitions and disposals of fixed assets in the investing section. In addition, when prepared using the indirect method, the statement of cash flows typically shows depreciation expense (or depreciation plus amortization) as a line item in the adjustments of net income to cash flow from operations. The notes to the financial statements describe the company’s accounting method(s), the range of estimated useful lives, historical cost by main category of fixed asset, accumulated depreciation, and annual depreciation expense. Copyright © 2013 CFA Institute

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. LOS. Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets. LOS. Analyze and interpret the financial statement disclosures regarding property, plant, and equipment and intangible assets. Pages 517–528 The fixed asset turnover ratio (total revenue divided by average net fixed assets) reflects 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 generally rely on the relationship between historical cost and depreciation. Asset age ratios apply primarily to PP&E reported under the cost model (not the revaluation model). The asset age and remaining useful life, two asset age ratios, are indicators of a company’s need to reinvest in productive capacity. The older the assets and the shorter the remaining life, the more a company may need to reinvest to maintain productive capacity. The average age of a company’s asset base can be estimated as the accumulated depreciation divided by the depreciation expense. The average remaining life of a company’s asset base can be estimated as the net PPE divided by the depreciation expense. The estimated total useful life of PP&E is the total historical cost of PP&E divided by the annual depreciation expense. Copyright © 2013 CFA Institute

39 Asset age ratios Historical cost: $100, estimated useful life: 10 years, estimated salvage value: $0. LOS. Analyze and interpret the financial statement disclosures regarding property, plant, and equipment and intangible assets. Pages 517–528 The application of these estimates can be illustrated by a hypothetical example of a company with a single depreciable asset. Assume the asset initially cost $100 and had an estimated useful life of 10 years and an estimated salvage value of $0. Each year, the company records a depreciation expense of $10, so accumulated depreciation will equal $10 times the number of years since the asset was acquired (when the asset is 7 years old, accumulated depreciation will be $70). Equivalently, the age of the asset will equal accumulated depreciation divided by the annual depreciation expense. In practice, such estimates are difficult to make with great precision. Companies use depreciation methods other than the straight-line method and have numerous assets with varying useful lives and salvage values, including some assets that are fully depreciated, so this approach produces an estimate only. Moreover, fixed asset disclosures are often quite general. Consequently, these estimates may be primarily useful to identify areas for further investigation. Accumulated depreciation ($30)/ Annual depreciation expense ($10) = Estimated age (3 years) Historical cost($100)/ Annual depreciation expense ($10) = Total useful life (10 years) Net PP&E ($70)/ Annual depreciation expense ($10) = Estimated remaining life (7 years) Copyright © 2013 CFA Institute

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. LOS. Compare the financial reporting of investment property with that of property, plant, and equipment. Pages 528–531 Investment property is defined under IFRS as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rentals or capital appreciation or both. An example of investment property is a building owned by a company and leased out to tenants. In contrast, other long-lived tangible assets (i.e., property considered to be property, plant, and equipment) are owner-occupied properties used for producing the company’s goods and services or for housing the company’s administrative activities. Investment properties do not include long-lived tangible assets held for sale in the ordinary course of business. For example, the houses and property owned by a housing construction company are considered to be its inventory. Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model. The cost model is identical to the cost model used for property, plant, and equipment. The fair value model, however, differs from the revaluation model used for property, plant, and equipment. Under the revaluation model, whether an asset revaluation affects net income depends on whether the revaluation initially increases or decreases the carrying amount of the asset. In contrast, under the fair value model, all changes in the fair value of the asset affect net income. To use the fair value model, a company must be able to reliably determine the property’s fair value on a continuing basis. Under U.S. GAAP, there is no specific definition of investment property. Most operating companies and real estate companies in the United States that hold investment-type property use the historical cost model. Copyright © 2013 CFA Institute

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. LOS. Explain and evaluate the effects on financial statements and ratios of leasing assets instead of purchasing them. LOS. Explain and evaluate the effects on financial statements and ratios of finance leases and operating leases from the perspective of both the lessor and the lessee. Pages 531–553 A lease is a contract between the owner of an asset—the lessor—and another party seeking use of the asset—the lessee. Through the lease, the lessor grants the right to use the asset to the lessee. The right to use the asset can be a long period, such as 20 years, or a much shorter period, such as a month. In exchange for the right to use the asset, the lessee makes periodic lease payments to the lessor. The lease versus buy decision. Advantages to leasing an asset compared with purchasing it are the following: 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. A lease can also reduce the risks of obsolescence, residual value, and disposition to the lessee because the lessee does not own the asset. The lessor may be better positioned to manage servicing the asset and to take advantage of tax benefits of ownership. As a result, leasing the asset may be less costly than owning the asset for the lessee. Leases also have perceived financial and tax reporting advantages. While providing a form of financing, certain types of leases are not reported as debt on the balance sheet. The items leased under these types of leases also do not appear as assets on the balance sheet. Therefore, no interest expense or depreciation expense is included on the income statement. Leasing is currently a joint IASB/FASB project, with an Exposure Draft expected in the 4th quarter of 2012. Copyright © 2013 CFA Institute

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


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