CFA Level I - Financial Reporting and Analysis

Long-Lived Assets
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Contents
1.
2.
3.
4.
5.
6.
7.
8.

Introduction
Acquisition of Long-Lived Assets
Depreciation and Amortization of Long-Lived Assets
The Revaluation Model
Impairment of Assets
Derecognition
Presentation and Disclosures
Investment Property

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1. Introduction
Long-lived assets are defined as those assets which are expected to provide
future economic benefits extending more than one year
These assets may be tangible, intangible, or financial assets
Major questions:
What value should be shown on the balance sheet?
How should the cost be allocated over the life of the asset?

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2. Acquisition of Long-Lived Assets

Upon acquisition, long-term, tangible assets such as property, plant and equipment
are recorded on the balance sheet at cost which is typically the same as fair value.
Assets costs might include expenditures in addition to purchase price
Should these costs be expenses or capitalized?

Intangible asset valuation depends on method of acquisition

Developed internally
Purchased
Though a business acquisition

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Property, Plant, and Equipment

At acquisition, PPE is recorded at cost
Cost includes all expenditures necessary to get the asset ready for intended use
Subsequent costs are capitalized if they are expected to provide benefit beyond one year;
otherwise they are expensed

Companies might have different approaches towards expensing/capitalizing costs

An analyst should understand the impact of expensing/capitalizing decisions on

financial statements and ratios

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Effects of Capitalizing vs. Expensing

Capitalizing

Expensing

Total Assets

Equity

Income variability

Net income (1st year)

Net income (later)

CFO

CFI

D/E

Interest Coverage (1st year)

Interest Coverage (later years)

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Example
Acme Inc. purchased a machine for 10,000. In addition the following costs were
incurred:

1.
2.

200 for delivery

300 for installation
100 to train staff on using the machine
1,000 to reinforce floor to support machine
500 to have the factory painted

Which expenses will be capitalized and which will be expensed

How will the treatment of these expenditures affect the companys financial statements

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Capitalization of Interest Costs

For constructed assets interest cost during construction are
capitalized as part of the asset cost
Use rate on borrowing related to construction; if no construction
debt is outstanding interest rate is based on existing unrelated debt
Capitalized interest not reported as interest expense on I/S
IFRS: interest on short-term lending offsets capitalized costs (not
allowed in U.S. GAAP)

Capitalized interest causes:

Higher net income and greater interest coverage ratios during the
period of capitalization
Higher asset values and depreciation lead to lower net income, EBIT
and interest coverage over subsequent periods

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Example
A company borrows 2,000,000 at an interest rate of 5 percent per year on 1 January
2011 to finance construction of a factory that will have a useful life of 40 years.
Construction is completed after two years, during which time the company earns
20,000 by temporarily investing the loan proceeds.
1. How much interest will be capitalized under IFRS and U.S. GAAP?
2. Where will the capitalized borrowing cost appear on the companys financial
statements?

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Intangible Assets
Intangible assets lack physical substance. Classic examples include software, customer
lists, patents, copyrights and trademarks. Accounting for intangible asset depends on
how it is acquired.
Acquired in a business combination

Recorded at fair value; similar to long-lived tangible assets

Determination of fair value requires judgment

Purchased in situation other than business combinations

Recorded at fair value

Developed internally

Next slide

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Intangible Assets Developed Internally

Under IFRS research costs are expensed as incurred and development costs are
capitalized; U.S. GAAP requires both research and development costs to be
expensed as incurred.
Costs incurred to develop software for sale to others are expensed as incurred
until products technological feasibility has been established; subsequent costs
should be capitalized.
Under IFRS costs incurred to develop software for internal use should be
capitalized once feasibility established. U.S .GAAP: capitalize all development
costs.

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Example
Acme Inc. starts an internal software development project on 1 January 2012. It incurs
expenditures of 10,000 per month during the fiscal year ended 31 December 2012.
By 31 March it is clear that product will be developed successfully and will be used as
intended. How are the software development costs recorded before and after 31
March according to IFRS? According to U.S. GAAP?

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3. Depreciation and Amortization of Long-Lived Assets

Under the cost model of reporting long-lived assets, the capitalized cost of a
tangible (intangible) long-lived asset is expensed through a process called
depreciation (amortization)
An assets carrying amount is the amount at which the asset is reported on the
balance sheet; carrying amount is also called net book value
Carrying amount = historical cost accumulated depreciation

Depreciation methods include

Straight-line method: cost of asset allocated evenly over useful life
Accelerated methods
Units-of-production method

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Example
Consider three companies with names based on their depreciation method:
1. Straight Line (SL) Inc.
2. Double Declining Balance (DDB) Inc.
3. Units of Production (UOP) Inc.
Each company purchases identical equipment for 10,000 and makes similar assumptions: estimated
useful life = 4 years; residual value = 1,000; productive capacity = 1,000 units. Production over 4 years:
300, 300, 200, 100. Complete the table below for each company.
Beginning Net
Book Value

Depreciation
Expense

Accumulated
Depreciation

Ending Net Book

Value

Year 1
Year 2
Year 3
Year 4

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Solution
Straight Line

Double Declining
Balance

Units of Production

Beg. Net Book Value Dep. Exp.

Acc. Dep.

End Net Book Value

Year 1

10,000

2,250

2,250

7,750

Year 2

7,750

2,250

4,500

5,500

Year 3

5,500

2,250

6,750

3,250

Year 4

3,250

2,250

9,000

1,000

Beg. Net Book Value Dep. Exp.

Acc. Dep.

End Net Book Value

Year 1

10,000

5,000

5,000

5,000

Year 2

5,000

2,500

7,500

2,500

Year 3

2,500

1,250

8,750

1,250

Year 4

1,250

250

9,000

1,000

Beg. Net Book Value Dep. Exp.

Acc. Dep.

End Net Book Value

Year 1

10,000

3,000

3,000

7,000

Year 2

7,000

3,000

6,000

4,000

Year 3

4,000

2,000

8,000

2,000

Year 4

2,000

1,000

9,000

1,000

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Example (Continued)
Given the data below, compute the asset turnover ratio, operating profit margin and operating return
on assets for SLD and DDB.
Sales

Op. Ex. (excluding Carrying Amount of total assets

depreciation)
(excluding equipment)

Year 1

400,000

300,000

30,000

Year 2

400,000

300,000

30,000

Year 3

400,000

300,000

30,000

Year 4

400,000

300,000

30,000

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Financial Statement Impact Summary

The relationships indicated in the table below are for the early years of an assets life

Straight Line

Accelerated (DDB)

Depreciation expense

Lower

Higher

Net income

Higher

Lower

Assets

Higher

Lower

Equity

Higher

Lower

Return on assets

Higher

Lower

Return on equity

Higher

Lower

Asset turnover

Lower

Higher

Operating profit margin

Higher

Lower

Above relationships reverse in the later years if the firms capital expenditure decline
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Component Method of Depreciation

IFRS requires companies to use the component method of depreciation
depreciate each component separately
U.S. GAAP allows component depreciation but the method is seldom used in
practice
Example: a machine has two major components. Component 1 costs $10,000 and
has an estimated useful life of 10 years. Component 2 has a cost of $3,000 and has
an estimated useful life of 3 years. What is the depreciation expense for the first
year?

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Amortization and Calculation of Amortization Expense

Amortization is similar in concept to depreciation. The term amortization applies to
intangible assets, and term depreciation applies to tangible assets.
Intangible assets include customer lists, copyrights, patents and trademarks.

Intangible assets with finite useful lives are amortized over their useful lives.

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4. Revaluation Model
The revaluation model is an alternative to the 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

U.S. GAAP does not allow revaluation model

Revaluation changes the carrying amounts of classes of long-lived
assets to fair value.
Carrying amounts are the fair values at the date of revaluation less any
subsequent accumulated depreciation or amortization
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Example
Scenario 1: Machine costs 10,000 at the start of Period 1. At the end of Period 1 the
fair value of the machine is 12,000. At the end of Period 2 the fair value is 8,000.
Show the impact on the financial statements.

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Example
Scenario 2: Machine costs 10,000 at the start of Period 1. At the end of Period 1 the
fair value of the machine is 8,000. At the end of Period 2 the fair value is 12,000.
Show the impact on the financial statements.

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5. Impairment of Assets
Impairment charges reflect an unanticipated decline in the value of an
asset.
Both IFRS and U.S. GAAP require companies to write down the carrying
amount of impaired assets.
Impairment reversals are permitted under IFRS but not under U.S.
GAAP.

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Impairment Calculation
Under IFRS: Impairment loss = Carrying Value Recoverable amount
Recoverable amount = greater of fair value less cost to sell and value in use
Value in use is present value of cash flow from asset

Under U.S. GAAP: First do the recoverability test to determine whether the asset is
impaired. Asset is impaired if the carrying value is greater than the assets future
undiscounted cash flows
Impairment loss = Difference between fair value and carrying amount

Example 9
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Example
Given the following data, what is the reported value under IFRS and U.S. GAAP.
Carrying amount = 8,000
Undiscounted expected future cash flows = 9,000
Present value of expected future cash flows = 6,000
Fair value if sold = 7,000
Costs to sell = 200

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Other Impairment Scenarios

Impairment of Intangible Assets with a Finite Life

Impairment of Intangibles Assets with Indefinite Lives

Impairment of Long-lived Assets Held for Sale

Reversals of Impairments of Long-lived Assets

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6. Derecognition
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.
Gain or loss on sales = sales proceeds carrying amount

Example 10

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Long-Lived Assets Disposed of Other than by a Sale

Abandoned Assets are treated like sale with 0 proceeds
Carrying value removed from balance sheet
Loss recognized in income statement

Exchanged Assets
Carrying value removed from balance sheet
Record fair value of new asset
Gain/loss computed by comparing carrying value of old asset with fair value of
new asset

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7. Presentation and Disclosures

Under IFRS, for each class of property, plant and equipment, a company must disclose
the measurement bases, the depreciation method, the useful lives (or, equivalently,
the depreciation rate) used, the gross carrying amount and the accumulated
depreciation at the beginning and end of the period, and a reconciliation of the
carrying amount at the beginning and end of the period.
Under U.S. GAAP the requirements are less exhaustive. A company must disclose the
depreciation expense for the period, the balances of major classes of depreciable
assets, accumulated depreciation by major classes or in total, and a general
description of the depreciation method(s) used in computing depreciation expense
with respect to the major classes of depreciable assets.

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8. Investment Property
Investment property is defined as property that is owned (or, in some cases, leased
under a finance lease) for the purpose of earning rentals, capital appreciation, or
both.
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, but the fair value model differs from the revaluation
model used for property, plant, and equipment. Under the fair value model, all
changes in the fair value of investment property affect net income.
Under U.S. GAAP, investment properties are generally measured using the cost model.

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Example
What is the treatment of unrealized gains and losses for AFS securities, assets valued
using revaluation model, and assets valued using the fair value model?

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Summary
Acquisition
Impact of Expense versus Capitalize Decision

Depreciation and Amortization

Impact of different methods on financial statements and ratios

Impairment

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Conclusion
Read summary
Review learning objectives

Examples
Practice problems: good but not enough
Practice questions from other sources
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