Long-Lived Assets Topic 7

Alexei Alvarez, CFA, FRM

Fabricio Chala, CFA, FRM
Capitalizing vs. Expensing

Is periodically incorporated
Balance
Capitalize in the Income Statement through
Sheet
depreciation and amortization

Improvements
(increases useful Capitalize
life of the asset)
Income
Maintenance
Statement

Income
Expense
Statement
Capitalizing vs. Expensing

What is the intuition behind capitalizing?

❖ After incurring an expenditure, the firm expects a positive
economic benefit that will be received throughout multiple
periods in the future
If the future economic benefit is improbable or uncertain?
❖ Register as an expense in the income statement a incurred
What should be capitalized?
❖ Fair value at acquisition
❖ + any costs necessary to prepare the asset for use
Capitalizing Interest

When a firm constructs an asset for its own use or, in limited
circumstances, for resale, the interest that accrues during the
construction period is capitalized as part of the asset´s cost

❖ Rationale: Accurately measure the cost of the asset and to better

match the cost with the revenues generated by the constructed
asset.
❖ Generally, capitalized interest is reported in the CFI and not in the
CFO
 Intangibles

Intangibles
Lack physical substance

Identifiable Unidentifiable Finite Life Indefinite Life

- Controlled by the firm Cannot be Cost is amortized Not Amortized.
- Can be separated from purchased over the useful life Tested for
the company separately of the asset impairment at least
- Future benefits are (Goodwill) annually
expected
Intangibles

Purchased by the firm:

❖ Recorded at historical cost (BS)
❖ If bought as part of a bundle: the total purchase price is
allocated to each asset on the basis of its fair value
Intangibles obtained in a businesses combination:
❖ Acquisition Method: Purchase price is allocated to the
identifiable assets and liabilities of the acquired firm on the
basis of fair value. Any remaining amount is recorded as
goodwill.
Research & Development

IFRS:
❖ Research is registered as a expense in the income statement as
incurred
❖ Development is capitalized once the technical feasibility has
been ascertained
US GAAP:
❖ R&D is generally expensed as incurred
❖ Special Case - Software: Development may be capitalized once
technical feasibility has been reached
Effects on the Financial Statements

❖ Assume two identical companies, Long term Ltd and Right

Now Ltd. buy equipment worth $4,500 on January 2011
❖ Long Term estimates the equipment has a useful life of three
years and no residual value after that.
❖ Right Now estimates a much shorter useful life and expenses
the machinery immediately.
Effects on the Financial Statements
Net Income

7,000 6,650 6,650

6,000 5,600 5,600 5,600

5,000

4,000
3,500

3,000

2,000

1,000

0
2011 2012 2013

Net Income (Expensed) Net Income (Capitalized)

Effects on the Financial Statements
Total Equity

60,500
60,000 60,000 60,000 60,000
60,000

59,500

58,950
59,000

58,500

58,000 57,900

57,500

57,000

56,500
2011 2012 2013

Total Equity (Expensed) Total Equity (Capitalized)

Effects on the Financial Statements
Total Assets

130,500
130,000 130,000 130,000 130,000
130,000

129,500

128,950
129,000

128,500

128,000 127,900

127,500

127,000

126,500
2011 2012 2013

Assets (Expensed) Assets (Capitalized)

Effects on the Financial Statements
Cash Flow from Operations

8,000
7,100 7,100 7,100
7,000 6,650 6,650

6,000

5,000

4,000 3,500

3,000

2,000

1,000

0
2011 2012 2013

CFO (Expensed) CFO (Capitalized)

Effects on the Financial Statements
Cash Flow from Investments

0 0 0 0 0 0
2011 2012 2013
-500

-1,000

-1,500

-2,000

-2,500

-3,000

-3,500

-4,000

-4,500
-4,500
-5,000

CFI (Expensed) CFI (Capitalized)

Effects on the Financial Statements
Return on Equity

12.0% 11.4% 11.2%

10.0% 9.3% 9.3% 9.3%

8.0%

5.9%
6.0%

4.0%

2.0%

0.0%
2011 2012 2013

ROE (Expensed) ROE (Capitalized)

Effects on the Financial Statements
Interest Coverage Ratio

4.0
3.7 3.7

3.5 3.3 3.3 3.3

3.0

2.4
2.5

2.0

1.5

1.0

0.5

0.0
2011 2012 2013

Interest Coverage Ratio (Expensed) Interest Coverage Ratio (Capitalized)

Effects on the Financial Statements

Capitalize Expense
Total Assets Higher Lower
Shareholders´ Equity Higher Lower
Income Variability Lower Higher
Net Income (1st Year) Higher Lower
Net Income (Subsequent Years) Lower Higher
CFO Higher Lower
CFI Lower Higher
Debt to Equity Ratio Lower Higher
Interest Coverage (1st Year) Higher Lower
Interest Coverage (Subsequent Years) Lower Higher
Effects on the Financial Statements

❖ Net Income
❖ Capitalizing an expenditure delays the recognition of an expense in the
IS.
❖ In the period that an expenditure is capitalized, the firm will report
higher NI compared to immediately expensing.
❖ Later, firm will report lower NI compared to expensing.
❖ This allocation process reduces variability of NI by spreading the
expense over multiple periods.
❖ Shareholders’ Equity
❖ If the expenditure is immediately expensed, Retained Earnings and
equity will reflect the entire reduction in NI in the period of the
expenditure.
Effects on the Financial Statements

❖ CFO
❖ A capitalized expenditure is usually reported in the cash flow
statement as an outflow from investing activities.
❖ If immediately expensed, reported as an outflow from operating
activities.
❖ Total cash flow will be the same
❖ Solvency: Initially, lower with capitalization.
❖ ROE/ROA
❖ Capitalizing will initially result in higher return on assets and on
equity.
❖ In subsequent years, ROA and ROE will be lower (NI reduced by
depreciation expense)
Depreciation Methods

Carrying amount (book value):

Historical cost – Accumulated Depreciation

Methods:
❖ Straight-line
❖ Accelerated (DDB - Double Declining Balance)
❖ Units-of-production methods
❖ Depletion: Applied to natural resources
Straight-line depreciation

❖ Recognizes an equal amount of depreciation expense each

period.
cost − residual value
SL depreciation expense =
useful life
Accelerated Depreciation

If the asset generates more benefits in the early years of its

economic life, use accelerated depreciation:
❖ Speeds up the recognition of depreciation expense in a
systematic way.
❖ The Declining balance method (DB) applies a constant rate of
depreciation to an asset’s net book value each year; the most
common one is the Double declining balance:
2
DDB depreciation= cost −accumulated depreciation
useful life
Units-of-production method

❖ Based on usage, rather than time

original cost − residual value
× output units in the period
useful life in units
Depreciation - Example

ABC purchases food processing machinery for $ 550,000. The

equipment has an estimated useful life of 5 years and an
estimated salvage value of $ 50,000. The Company expects to
produce 20,000 units of output using this machinery, with 6,000
in each of the first two years, 3,000 in the next two years and 2,000
units in the fifth year. The Company’s effective tax rate is 30%.
Revenues are 600,000 per year and expenses other than
depreciation are $ 300,000.
Calculate net income and net profit margin using the three methods to
depreciate the machinery
Change in accounting estimates

❖ A change in an accounting estimate, such as useful life or

salvage value, is put into effect in the current period and
prospectively.
Example:
ABC purchased machinery for $ 20,000 with an estimated useful
life of 5 years and a salvage value of $ 4,000. ABC uses the
straight-line depreciation method.
At the beginning of the third year, ABC reduces its salvage value
estimate to $ 1,600. Determine the depreciation expense for each year
If instead, at the beginning of the third year the firm estimates the useful
life is actually three years longer, how would your calculations change?
Amortization

❖ Applies to intangible assets with finite useful lives

❖ The same methods as depreciation can be applied
❖ Assets assumed to have an indefinite useful life are not
amortized. Why?
Impairment - IFRS

❖ Firm must annually assess whether events or circumstances

indicate an impairment of an asset’s value has occurred.
Carrying value > recoverable amount
❖ The recoverable amount is the greater of: (i) its fair value less
any selling costs, and (ii) its value in use (present value of its
future cash flows stream from continued use)

Recognized in the IS, and asset’s value is

Loss
written down to the recoverable amount (BS)

Loss can be reversed if value of impaired

Gain asset recovers in the future, but is limited to
the original impairment loss.
Impairment – US GAAP

❖ An asset is tested for impairment only when events and circumstances

indicate the firm may not be able to recover the carrying value through
future use.
❖ First step: Recoverability Test
Carrying value > Asset’s future undiscounted cash flow stream
❖ Second step: If impaired, loss measurement

Asset’s value is written down to fair value

Loss on the BS and a loss (carrying value minus
fair value), recognized in the IS

Gain Loss recoveries are not permitted

Impairment – Example

Information related to equipment owned by Rainbow S.A:

Original Cost 900,000

Accumulated Depreciation 100,000
Expected Future Cash Flows 825,000
Fair Value 790,000
Value in Use 785,000
Selling Cost 30,000

Assuming Rainbow S.A will continue to use the equipment, test the
asset for impairment under both IFRS and U.S GAAP.
Impairment – Effects on FS

❖ An impairment loss is an indication that the firm has not recognized

sufficient depreciation or amortization expense, and has overstated
earnings as a result
❖ Impairment decisions present an opportunity for management to
manipulate earnings. Waiting to recognize an impairment loss until a
period of relatively high earnings would tend to smooth earnings

Total Assets Lower

Shareholders’ Equity Lower
Net Income (1st Year) Lower
Net Income (Subsequent Years) vs. Net Income (1st Year) Higher
ROE, ROA (1st Year) Lower
ROE, ROA (Subsequent Years) Higher
Asset Turnover Higher
Sale of Long-lived Assets

𝐺𝑎𝑖𝑛 𝑜𝑟 𝑙𝑜𝑠𝑠 = 𝑆𝑎𝑙𝑒𝑠 𝑝𝑟𝑜𝑐𝑒𝑒𝑑𝑠 − 𝑐𝑎𝑟𝑟𝑦𝑖𝑛𝑔 𝑎𝑚𝑜𝑢𝑛𝑡

❖ Further detail about assets sales can be found in MD&A or
financial footnotes.
Example
❖ Pizza Planet sells 100 used pizza ovens and reports a gain of
$1.2 million. The ovens had a carrying value of $1.8 million
(original cost of $5 million less $3.2 million of accumulated
depreciation)
❖ At what price did Pizza Planet sell the ovens?
Asset Age Ratios

❖ Older, less-efficient assets may make a firm less competitive.

❖ Average age of assets helps an analyst to estimate the timing of
major capital expenditures and a firm’s future financing
requirements
❖ Because assets are often grouped by their useful lives, we can
not produce precise values, but can highlight issues for further
investigation
𝐴𝑐𝑐𝑢𝑚. 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛
Average Age
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝. 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
Total Useful Life 𝐻𝑖𝑠𝑡𝑜𝑟𝑖𝑐𝑎𝑙 𝐶𝑜𝑠𝑡
(*) If there is residual value, adjust by (1-%residual
value) 𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝. 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
𝑁𝑒𝑡 𝑃𝑃&𝐸
Remaining Useful Life
𝐴𝑛𝑛𝑢𝑎𝑙 𝐷𝑒𝑝. 𝐸𝑥𝑝𝑒𝑛𝑠𝑒
Asset Age Ratios – Example

At the end of 2016, company ABC had gross PP&E of $3 million

and accumulated depreciation of $ 1 million. During the year,
depreciation expense was $ 500,000.
What is the average age, total useful life and remaining useful life of the
Company’s PP&E?
Leasing

Contractual arrangement whereby the owner of an asset (the

lessor), allows another party (the lessee) to use the asset for a
specified period of time in return for periodic payments.

Finance Lease (IFRS) / Capital Lease (US GAAP)

❖ Purchase of an asset that is financed with debt.
❖ At inception, the lessee will add equal amounts to both assets and
liabilities (BS). Over the term of the lease, recognize depreciation
expense on the asset and interest expense on the liability.
Operating Lease
❖ Essentially a rental arrangement.
❖ No asset or liability is reported by the lessee and the periodic lease
payments are simply recognized as rental expense in the IS.
Classification of Leases (IFRS)

If substantially all the risks and rewards incidental to

ownership are transferred to the lessee  Finance lease
If one or more of this conditions are met:
❖ Transfer of ownership at the end of the lease term

❖ Bargain purchase option: purchase the asset at a cheap price

❖ Lease term is for the major part of the economic life of the asset
even if title is not transferred
❖ PV of future lease payments amounts to at least substantially all
of the leased asset’s fair value
❖ The leased assets are of a specialised nature such that only the
lessee can use them without major modifications being made
Classification of Leases (US GAAP)

If a leasing agreement meets at least one of the following 

Should be classified as a finance lease:
❖ Transfer of ownership at the end of lease term
❖ Bargain purchase option
❖ Lease term is 75% or more of the leased asset’s useful life
❖ PV of future lease payments is 90% or more of the fair value of
the leased asset (at the time the lessee signs the contract)
Leasing – Reporting by the Lessee

At inception Over the term of the lease

- No entry is made
- Rent expense (IS)
- Future obligations must
Operating Lease - Outflow of Operating
be disclosed in
Activities (CFO)
footnotes

- Asset is depreciated
- Lower of the PV of
- Interest expense (initial
future minimum lease
Finance Lease lease liability × implicit
payments or fair value
interest rate) reported
(BS)
in IS

Example: 3-year lease with 100,000-dollar yearly payments. Assume r=10%

Leasing – Reporting by the Lessee
Financial Statement Impact

Finance Operating
Total Assets Higher Lower
Liabilities Higher Lower
Net Income (in the early years) Lower Higher
Net Income (later years) Higher Lower
Total Net Income same same
Operating Income (EBIT) Higher Lower
CFO Higher Lower
CFF Lower Higher
Total Cash Flow same same
Leasing – Reporting by the Lessee
Ratio Impact
Finance Operating
Current Ratio (CA/CL) Lower Higher
Working Capital (CA - CL) Lower Higher
Asset Turnover (Revenue / Avg. Assets) Lower Higher
ROA (NI / Avg. Assets) -> Early Years Lower Higher
ROE (NI / Avg. Equity) -> Early Years Lower Higher
Debt / Assets Higher Lower
Debt / Equity Higher Lower

❖ All ratios are worse when a lease is capitalized (Finance lease)

❖ Only improvements from a Finance lease are higher EBIT, higher
CFO (principal repayment is CFF), and higher NI in the later years
of the lease. (interest + deprec. is less than the lease payment in the
later years)
Off-Balance Sheet Financing

Which type of lease could be potentially misleading, in terms of FS?

Why?
❖ Leases provide a source of financing
❖ Investor and analysts frequently adjust a lessee’s balance sheet
Leasing – Reporting by the Lessor

At inception Over the term of the lease

- Recognize depreciation
expense
Operating Lease - Keep the leased asset on BS
- Recognize lease payment as
rental income

- A sale equal to the PV of

- As lease payments are
lease payments.
received, principal portion
- COGS equal to carrying
of the payment reduces the
value of the asset
Finance Lease lease receivable.
- Asset is removed from the
- Recognize interest income
BS and a lease receivable,
(Initial lease receivable ×
equal to the PV of lease
interest rate)
payments, is created
Leasing – Reporting by the Lessor

Example:
Suppose ABC purchases an asset for $ 69,302 to lease to XYZ for
four years with an lease payment of $ 20,000 at the end of each
year. At the end of the lease, XYZ will own the asset for no
additional payment. The implied interest rate in the lease is 6%.
Determine how ABC should account for the lease payments from XYZ.
Key Concepts

❖ Depreciation ❖ Research
❖ Amortisation ❖ Development
❖ Capitalising ❖ Leasing
❖ Expensing ❖ Lessor
❖ Property, plant and ❖ Lessee
equipment ❖ Finance lease
❖ Intangible asset ❖ Operating lease
❖ Identifiable intangible asset