Com 4FK3 Financial Statement Analysis Week 5, 2012 Fixed Assets

2 Introduction Questions for financial analysts in regards to fixed assets  What is the gross amount of PP&E reported?  What useful life is being used for dep’n?  What depreciation method is being used?  Can the firm recover the reported value of the fixed assets through normal productive use?

3 Why Acquisition Cost? Of major countries, only the Netherlands allows periodic revaluation to market value  Also used for tax purposes Difficulties in determining market value  no active market for many assets  difficulty in finding comparable assets  need to make assumptions about the effect of technological improvements

4 Average Age The analyst can calculate the average age of the fixed assets for a firm that uses straight line depreciation

5 Treatment of Maintenance For most maintenance and repair costs, they should be expensed in the period in which they are incurred Expenditures which increase the service potential of an asset may be capitalized Capitalization can allow for some earnings manipulation

6 Straight Line Depreciation The most common method for financial statement reporting in US and Canada The total expected decrease in value over the expected life of the asset (purchase price less any expected salvage value) divided by the expected life in years, is declared as an expense each year  A half year rule may be applied

7 Straight Line Example A new machine tool is purchased for $5m  It is expected to be used for 8 years  Salvage value at that time is estimated to be $250,000  Amount to be depreciated = $5m -$0.25m $4,750,000 ÷ 8 years = $593,750 per year in depreciation expense

8 Double Declining Balance A form of accelerated depreciation Often required for income tax accounting Depreciation expense each year equals 2 ÷ (total estimated life) x UCC UCC (undepreciated capital cost) is reduced by amount of depreciation expense declared Can be used for financial reporting if the asset’s productivity decreases over time

9 DDB Example A new machine tool is purchased for $5m, it is expected to be used for 8 years and then scrapped for $250,000  2 ÷ 8 x $5m = $1.25m depreciation expense in year 1, remaining balance = $3.75m  2 ÷ 8 x $3.75m = $937,500 in year 2  2 ÷ 8 x $2,812,500 = $703,125 in year 3 Salvage value is ignored for this calculation

10 Choice of Method Some analysts claim that accelerated depreciation creates a higher quality of earnings, though this is disputed Using the method most commonly used by other firms in the industry helps with comparability

11 Deferred Taxes When a firm uses different depreciation methods for tax and financial reporting, the difference between what the firm reports as current taxes and income tax expense is reported as deferred taxes Typically these deferred taxes are a liability, as the firm has declared more depreciation for income tax than for financial reporting

12 Converting Depreciation To figure out what depreciation would have been for tax purposes, start with the depreciation expense and add back the increase in deferred tax liability ÷ marginal tax rate This can allow comparison to firms that use accelerated depreciation on financial statements as well as for tax reporting

13 Depreciable Life How long does the company expect to use the asset in question?  Useful life  Technical obsolescence  Replacement policy  Level and type of use  Maintenance and service levels All based on management estimates

14 Depreciable Life, Taxes For income tax purposes, the management discretion on depreciable life is removed The depreciable life of all assets is specified in the tax laws Some assets are treated differently for tax purposes depending on how they are used, e.g. automobiles used as taxi cabs

15 Average Depreciable Life For companies using straight line depreciation the analyst can calculate the average depreciable life of the company’s fixed assets

16 Choice of Depreciable Life Management has wide discretion over choice of depreciable life A change in estimates can be misused to manage earnings Analysts may have difficulty identifying improper life spans, can compare to others in the same industry or note frequent gain or loss on sale of PP&E

17 Change in Estimates Due to; new information, changes in use, replacement policy, level of maintenance, or upgrades, the estimated life of an asset may be changed  straight line  DDB

18 Current Economic Values The analyst would like to know the current economic value of any given asset Usually quite different from the book value Lack of secondary market for many fixed assets make valuation difficult Can find selling prices of similar new assets and adjust for used condition

19 Impairment of Fixed Assets New technology, regulations, or other factors can reduce the value of an asset  If the undiscounted value of the future cash flows from the asset exceed its book value, the asset is impaired  An impaired asset is written down to the discounted value of the future cash flows  Recognition of impairment is somewhat discretionary

20 Intangible Assets Expenditures to create intangible assets internally, expensed in the period incurred  Why? You can’t be sure that the expenditure has created an asset Intangible assets acquired from external sources are capitalized … the purchase acknowledges the asset’s value Amortized over a reasonable time

21 Research & Development Current GAAP requires R&D expenditures to be expensed in the period incurred R&D can be a requirement to maintain earnings in the future The value of the R&D can’t be objectively determined, so it is not allowed to be added to the balance sheet

22 Software Development Costs These costs are allowed to be capitalized and amortized, but only after the research has passed a certain point when the product has been proven to be technologically feasible The Software Publishers Association advocates for treatment as a period expense

23 Goodwill Arises from the purchase of a company for more than the book value of the company Capitalized to account for the market value revealed by the transaction Argument against: may be the result of overpayment and is not consistent with the treatment of similar internally generated intangible assets

24 Expensing Intangibles Reasons given for advocating this;  Expense incurred at same time as cash flow  Expenses are incurred to replace consumed intangibles, replacement cost is often the best measure… same argument as for acc. Dep’n  Expensing reduces earnings manipulation  For a stable growth firm, immediate expensing should be similar to capitalizing and amortizing

25 Operating Lease Similar to renting,  The asset is leased for a short period of time in comparison to the useful life of the asset.  The lessor is usually responsible for insurance and upkeep.  Cancellable on short notice with no penalty. Example; a company requires a dump truck for an 18 month project.

26 Capital Lease More like secured debt than a lease.  Is for most of the asset's useful life.  Payments would fully amortize a loan.  Cannot be cancelled without a large penalty often all of the outstanding payments.  Lessee is responsible for insurance and upkeep. Effectively the lessee assumes all the risks and rewards of ownership.

27 Accounting Previous accounting practices allowed leasing to work as off-balance sheet financing. The company had the use of more assets than they reported and they also had fixed payments similar to interest payments. Since 1979 GAAP requires financial leases to be capitalized.

Capitalized Leases The asset is added to the balance sheet at PV of lease payments The PV of the lease payments is added as a liability, reduced over time Depreciation expense reported as if owned (often no salvage value) Implied interest expense is reported 28

29 Capitalized Leases Lease payments are composed of the implied interest expense and a reduction in lease liability A financial lease looks almost identical on the financial statements to an asset purchase financed with a loan

Taxes Often a capital lease is still an operating lease for tax purposes This is often the reason that it is a lease This is not required to be disclosed Different rules are used to decide if a lease counts a capital lease... usually looser for financial statement reporting 30