Ifsa Chapter9

CHAPTER 9
LONG-LIVED ASSETS
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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.
Copyright 2013 CFA Institute
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 machines 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.
ACQUISITION OF INTANGIBLE ASSETS

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.
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 longlived 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.
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.
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?
Jan Feb Mar

Apr May
Jun
Jul Aug Sep
Oct Nov Dec

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?
Expense 1,000
Asset 11,000
Jan Feb Mar

Expense 11,000
Asset 1,000
Apr May
Jun
Jul Aug Sep
Oct Nov Dec

8
CAPITALIZE VERSUS EXPENSE:

EFFECT ON FINANCIAL STATEMENTS
Item
Income
Statement
Statement of
Cash Flow
Increase
assets
Investing cash
outflow
Expensed via
depreciation
Immediately
reduce net
income
Balance Sheet
Costs that are capitalized

At acquisition
Subsequently
Costs that are expensed
when incurred
Operating cash
outflow
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.
DEPRECIATION METHODS
Accelerated
Straight-Line
Depreciation
Expense ($)
10
Useful Life of Asset

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.
10
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?
11

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.
Year 1
Year 2
Year 3
Year 4
Beginning Net Depreciation

Book Value
Expense
$2,300
$550
1,750
550
1,200
550
650
550
Accumulated
Year-End
Ending Net
Depreciation Book Value
$550
$1,750
1,100
1,200
1,650
650
2,200
100
12

$2,300.
expenses?
(Cost Residual
value)/Useful life
Year 1
Year 2
Year 3
Year 4
Beginning
Net Book
Value
$2,300
1,750
1,200
650
Depreciation
Expense
$550
550
550
550
Accumulated
Year-End
Ending Net
Depreciation Book Value
$550
$1,750
1,100
1,200
1,650
650
2,200
100
13

$2,300.
expenses?
Accumulated
depreciation +
Expense for year
Year 1
Year 2
Year 3
Year 4
Beginning
Net Book
Depreciation Accumulated Year- Ending Net
Value
Expense
End Depreciation Book Value
$2,300
$550
$550
$1,750
1,750
550
1,100
1,200
1,200
550
1,650
650
650
550
2,200
100
14

$2,300.
expenses?
Cost
Accumulated
depreciation
Year 1
Year 2
Year 3
Year 4
Beginning Net Depreciation

Book Value
Expense
$2,300
$550
1,750
550
1,200
550
650
550
Accumulated
Year-End
Depreciation
$550
1,100
1,650
2,200
Ending Net
Book Value
$1,750
1,200
650
100
15
CALCULATE DEPRECIATION EXPENSE: DOUBLEDECLINING BALANCE METHOD EXAMPLE

$2,300.
expenses? Year 1: Cost.
Thereafter: Prior
year ending book
value
Year 1
Year 2
Year 3
Year 4
Beginning Net
Depreciation
Book Value
Expense
$2,300
$1,150
1,150
575
575
288
287
187
Accumulated
Year-End
Ending Net
Depreciation
Book Value
$1,150
$1,150
1,725
575
2,013
287
2,200
100
16

$2,300.
expenses?
Beginning net
book value
Depreciation
rate until
Year 1
Year 2
Year 3
Year 4
Beginning Net
Book Value
$2,300
1,150
575
287
Depreciation
Expense
$1,150
575
288
187
Accumulated
Year-End
Ending Net
Depreciation
Book Value
$1,150
$1,150
1,725
575
2,013
287
2,200
100
17

$2,300.
expense?
Accumulated
depreciation +
Expense for year
Year 1
Year 2
Year 3
Year 4
Beginning
Net Book
Value
$2,300
1,150
575
287
Depreciation
Accumulated Year- Ending Net
Expense
End Depreciation Book Value
$1,150
$1,150
$1,150
575
1,725
575
288
2,013
287
187
2,200
100
18

$2,300.
expense?
Cost
Accumulated
depreciation
SOONER, Beginning Net Depreciation
Inc.
Book Value
Expense
Year 1
$2,300
$1,150
Year 2
1,150
575
Year 3
575
288
Year 4
287
187
Accumulated
Year-End
Ending Net Book
Depreciation
Value
$1,150
$1,150
1,725
575
2,013
287
2,200
100
19

UNITS-OF-PRODUCTION METHOD EXAMPLE
$2,300.
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
Year 1
Year 2
Year 3
Year 4
Beginning Net Book Depreciation

Value
Expense
$2,300
$550
1,750
825
925
550
375
275
Accumulated
Year-End
Ending Net
Depreciation
Book Value
$550
$1,750
1,375
925
1,925
375
2,200
100
20

$2,300.
Production in Years 1, 2, 3, 4: 200, 300, 200, and 100 boxes.
Actual units
produced Per
unit cost
Year 1
Year 2
Year 3
Year 4
Beginning Net
Book Value
$2,300
1,750
925
375
Depreciation
Expense
$550
825
550
275
Accumulated
Year-End
Ending Net
Depreciation
Book Value
$550
$1,750
1,375
925
1,925
375
2,200
100
21

$2,300.
Accumulated
depreciation +
Expense for year
Year 1
Year 2
Year 3
Year 4
Beginning
Net Book
Value
$2,300
1,750
925
375
Depreciation
Expense
$550
825
550
275
Accumulated YearEnding Net

End Depreciation
Book Value
$550
$1,750
1,375
925
1,925
375
2,200
100
22

$2,300.
Cost
Accumulated
depreciation
Year 1
Year 2
Year 3
Year 4
Beginning
Net Book
Value
$2,300
1,750
925
375
Depreciation
Expense
$550
825
550
275
Accumulated
Year-End
Ending Net Book
Depreciation
Value
$550
$1,750
1,375
925
1,925
375
2,200
100
23
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.
24
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.
25
REVALUATION MODEL:
PERMITTED UNDER IFRS
Revaluation model:
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.
26
REVALUATION MODEL: EXAMPLE

Assume a company has elected to use the revaluation model for an item of
machinery (the companys only long-lived asset). The machine was purchased
on the first day of the fiscal period, and measurement date occurs
simultaneously with the companys 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 companys 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.
27
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 companys 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.
28
REVALUATION MODEL: EXAMPLE 2

Assume a company has elected to use the revaluation model for an item of
machinery (the companys only long-lived asset). The machine was purchased
on the first day of the fiscal period, and the measurement date occurs
simultaneously with the companys 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 companys 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.
29
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 companys 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.
30
IMPAIRMENT
Impairment charges reflect an unanticipated decline in the value of an
asset.
In general, when an assets 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.
31
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.
32
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?
33
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
19,000
Present value of expected future cash flows 16,000

Fair value if sold
17,000
Costs to sell
2,000
Recoverable
amount: Higher
of value in use
and fair value
less cost to sell.
What would the company report for the machine under IFRS versus U.S. GAAP?
Recoverable amount: 16,000
Carrying amount:
18,000
Impairment loss:
2,000
34
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
19,000
Recoverable?
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?
Yes, it is recoverable because the amount of undiscounted
expected future cash flows exceeds the carrying amount.
No impairment loss is recognized.
35
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
36
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
37
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 companys 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 companys 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.
38
ASSET AGE RATIOS

Historical cost: $100, estimated useful life: 10 years, estimated salvage value: $0.
100
90
80
70
60
50
40
30
20
10
0
Historical cost($100)/
Annual depreciation
expense ($10) = Total
useful life (10 years)
Accumulated
depreciation ($30)/
Annual depreciation
expense ($10) =
Estimated age (3
years)
Net PP&E ($70)/

Annual depreciation
expense ($10) =
Estimated remaining
life (7 years)
39
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.
40
LEASES
Lease: Contract between the owner of an assetthe lessorand another
party seeking use of the assetthe 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.
41
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.
42

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CHAPTER 9

COSTS THAT ARE CAPITALIZED AND COSTS

ACQUISITION OF PP&E: EXAMPLE

ACQUISITION OF INTANGIBLE ASSETS

Copyright 2013 CFA Institute

ACQUISITION OF INTANGIBLE ASSETS

Recorded at fair value, which is assumed to be

Generally expensed when incurred, although

Identifiable assets are recorded at fair value.

Copyright 2013 CFA Institute

INTANGIBLE ASSETS DEVELOPED INTERNALLY

INTANGIBLE ASSETS DEVELOPED INTERNALLY:

Jan Feb Mar

Jul Aug Sep

Oct Nov Dec

INTANGIBLE ASSETS DEVELOPED INTERNALLY:

Jan Feb Mar

Jul Aug Sep

Oct Nov Dec

CAPITALIZE VERSUS EXPENSE:

Costs that are capitalized

All else being equal,

Useful Life of Asset

CALCULATE DEPRECIATION EXPENSE:

Copyright 2013 CFA Institute

CALCULATE DEPRECIATION EXPENSE:

Beginning Net Depreciation

Copyright 2013 CFA Institute

CALCULATE DEPRECIATION EXPENSE:

Copyright 2013 CFA Institute

CALCULATE DEPRECIATION EXPENSE:

Copyright 2013 CFA Institute

CALCULATE DEPRECIATION EXPENSE:

Beginning Net Depreciation

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CALCULATE DEPRECIATION EXPENSE: DOUBLEDECLINING BALANCE METHOD EXAMPLE

Copyright 2013 CFA Institute

CALCULATE DEPRECIATION EXPENSE: DOUBLEDECLINING BALANCE METHOD EXAMPLE

Copyright 2013 CFA Institute

CALCULATE DEPRECIATION EXPENSE: DOUBLEDECLINING BALANCE METHOD EXAMPLE

Copyright 2013 CFA Institute

CALCULATE DEPRECIATION EXPENSE: DOUBLEDECLINING BALANCE METHOD EXAMPLE

CALCULATE DEPRECIATION EXPENSE:

Beginning Net Book Depreciation

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CALCULATE DEPRECIATION EXPENSE:

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CALCULATE DEPRECIATION EXPENSE:

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Accumulated YearEnding Net

CALCULATE DEPRECIATION EXPENSE:

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IMPACT ON RESULTS AND RATIOS

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Copyright 2013 CFA Institute

REVALUATION MODEL: EXAMPLE

Copyright 2013 CFA Institute

REVALUATION MODEL: EXAMPLE

Copyright 2013 CFA Institute