Chapters 7 and 8 Long-term Assets

Long-Term Assets Long-term assets mainly consist of property, plant, and equipment (PPE). These assets often makeup the largest asset amounts. Future expenses arising from these long- term assets often makeup the larger expense amounts—typically reflected in depreciation expense and asset write- downs.

What is Included in Cost?  All expenditures necessary to make asset ready for its intended use.

Postacquisition Expenditures: Betterments or Maintenance? Betterments:  Increase asset’s useful life  Improve quality of asset’s output  Increase quantity of asset’s output  Reduce asset’s operating costs Accounting treatment  Betterments are capitalized  Maintenance expenditures are expensed

Depreciation Factors and Process Depreciation requires the following estimates: 1. Useful life – period of time over which the asset is expected to generate cash inflows 2. Salvage value – Expected disposal amount for the asset at the end of its useful life 3. Depreciation rate – an estimate of how the asset will be used up over its useful life.

Variance in Depreciation A company can depreciate different assets using different depreciation rates (and different useful lives). Whatever depreciation rate is chosen, however, it must generally be used throughout the useful life of that asset. Changes to depreciation rates can be made, but they must be justified as providing “better quality” financial reports.

Depreciation Methods Depreciation Methods: 1. Straight-line method 2. Accelerated Methods (Double-declining- balance method)

Straight-line Method Straight-line method: Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset. Consider the following example An asset (machine) with the following details: (1) cost of $100,000 (2) salvage value of $10,000 (3) useful life of 5 years

Straight-line Depreciation Example For the straight-line method, we use our illustrative asset to assign the following amounts to the depreciation formula:

SL Example For the asset’s first year of usage, $18,000 ($90,000 * 20%) of depreciation expense is reported in the income statement. At the end of that first year the asset is reported on the balance sheet as follows: Net book value (NBV) is cost less accumulated depreciation. At the end of year 2, the net book value will be reduced by another $18,000 to $64,000.

Double-declining-balance method Double-declining-balance method. For the double-declining-balance (DDB) method, we use our illustrative asset to assign the following amounts to the depreciation formula: (2 x BV) / Useful Life

Double-declining-balance method The asset is reported on the balance sheet as follows: In the second year, $24,000 ($60,000  40%) of depreciation expense is recorded in the income statement and the NBV of the asset on the balance sheet follows:

DDB Depreciation Schedule

Comparison of Depreciation Methods

Asset Sales

Asset Impairments Impairment of plant assets is determined by comparing the sum of the expected future (undiscounted) cash flows generated by the asset with its net book value. Companies must recognize a loss if the asset is deemed to be impaired. When a company takes an impairment charge, assets are reduced by the amount of the write-down and the loss is recognized in the income statement, which reduces current period income.

Accumulated Depreciation Does not represent the accumulation of any tangible thing. Sum of the original cost that has been expensed. Funding the purchase of new assets is usually unrelated to depreciation. Can distort ROA calculations!

Analysis of Useful life and Percent Used Up Estimated useful life = Percent used up =

Intangibles Goodwill  What is it?  Impairment test R&D  Patents, copyrights Marketing

Natural Resources Depletion

Equity Securities What is an equity investment? Why would a firm invest in the equity of another firm?

Accounting for Investments GAAP identifies three levels of influence/control:  Passive  Significant influence  Control

Passive Passive. In this case the purchasing company is merely an investor and cannot exert any influence over the investee company. Its goal for the investment is to realize dividend and capital gain income. Generally, passive investor status is presumed if the investor company owns less than 20% of the outstanding voting stock of the investee company.

Significant influence Significant influence. In certain circumstances, a company can exert significant influence over, but not control, the activities of the investee company. Generally, significant influence is presumed if the investor company owns 20-50% of the voting stock of the investee company.

Control  Control. When a company has control over another, it has the ability to elect a majority of the board of directors and, as a result, the ability to affect its strategic direction and hiring of executive management. Control is generally presumed if the investor company owns more than 50% of the outstanding voting stock of the investee company.

Intercorporate Investments

Some terms Mark-to-market Realized Recognized Ready market Trading security Available for sale security

Passive - No ready market Account for at cost No mark-to-market

Investment Classifications GAAP allows for two possible classification is equity investments: Available-for-sale. Investments in securities that management intends to hold for capital gains and dividend income; although it may sell them if the price is right. Trading. Investments in securities that management intends to actively trade (buy and sell) for trading profits as market prices fluctuate.

Passive - Ready market Trading or Available for sale depending on management’s intentions Both are marked-to-market For trading securities the gain/loss is recognized prior to being realized (on income statement) For available for sale securities recognition is at realization. Until then the holding gain/loss is kept in an the equity section of the balance sheet (not on income statement)

Are Changes in Asset Value Income? Changes in the carrying amount of the investment (asset) has a corresponding effect on equity: Assets  = Liabilities + Equity  The central issue in the accounting for investments is whether this change in equity is income. The answer depends on the investment classification.

Example of Trading and Available for sale 10/1/98 Buy 10 $15 each Record at cost 12/21/98 Market value rises to $18 Mark-to-market 02/20/99 Sell 10 each Gain (loss) = Sales price – Book Value

Held To Maturity Investments

Equity Method Investments Equity Method accounting is required for investments in which the investor company can exert “significant influence” over the investee. Significant influence is the ability of the investor to affect the financial or operating policies of the investee.

Equity Method Investments Ownership levels of 20-50% of the outstanding common stock of the investee company presume significant influence. Significant influence can also exist when ownership is less than 20% if, for example, the investor company is able to gain a seat on the board of directors of the investee company, or when the investor controls technical know-how or patents that are used by the investee company, or when the investor company is able to exert control by virtue of legal contracts between it and the investee company.

Accounting for Equity Method Investments Initially record investment at cost. Increase asset to reflect proportionate share of net income. Essentially treats their income as yours. Dividends decrease investment. Treated as a return of investment. They are not considered income. No mark-to-market Income recognized rarely equals either cash flow or actual change in market value.

Equity Method Accounting Assume that HP acquires a 30% interest in Mitel Networks. On the date of acquisition, Mitel reports $1,000 of stockholders’ equity, and HP purchases its 30% stake for $300. Assume that Mitel reports net income of $100 and pays dividends of $20 (30% or $6 to HP)

Equity Method Accounting Following are the balance sheet and income statement impacts for the preceding transactions:

Your turn Initially L purchases 30% of S for $9 when the book value of S = $30 1. S has income of $20 and pays total dividends of $10 2. S has a loss of $10 and pays total dividends of $20 Record L’s yearly income from S and investment in S

Equity method Why would a firm prefer using the equity method over consolidation? Blue and Yellow = Green example

Equity method cautions! Income shown on income statement is not really income. The asset shown is not at market value. Potentially liabilities are “hidden” off balance sheet.

Business Combinations (Over 50%) 2 companies brought together as single accounting entity. Results in a combination of both the investor and investment firm’s financial statements. Purchase method must be used for acquisition of another company. Prior to 2002 and outside of U.S., under certain conditions the pooling of interests method was/is used.

Investments with Control — Consolidation Accounting Accounting for business combinations (acquisitions) involves one additional step to equity method accounting. Consolidation accounting replaces the investment balance with the assets and liabilities to which it relates, and it replaces the equity income reported by the investor company with the sales and expenses of the investee company to which it relates.

Consolidation Accounting

Consolidation with Purchase Price Above Book Value

Foreign Currency Translation Many companies conduct operations, not only in countries outside of the US, but also in currencies other than $US. Many purchase assets in foreign currencies, borrow in foreign currencies, and transact business with their customers in foreign currencies. US corporations can have subsidiaries whose entire balance sheets and income statements are stated in foreign currencies.

Foreign Currency Translation Adjustment at Ford Motor Company

Income Statement Effects of Currency Swings McDonald’s: