Capitalization vs. Expense

Transcription

1 Long-Lived Assets 1 What is a capital expenditure? Capitalization difficulties Impact on financial statements Capitalization vs. Expense Other expenditures with uncertain future benefits Research and development expenditures Oil and gas exploration expenditures Direct response advertising Software development expenditures Implications for analysis Software example EMC Corporation Depreciation Age and useful life analysis Long-Lived Assets 2 Capital Expenditures: Expected to yield benefits beyond the current accounting period Get recorded as assets and amortized/depreciated as consumed Consistent with what principle of accounting? Generally subject to impairment tests

2 Long-Lived Assets 3 Capitalization Difficulties Uncertain amount and timing of future benefits What amounts should be included in capitalized cost? All costs incurred until asset is ready for use Includes interest on self-constructed assets (capitalized interest) Over time, other expenditures may be added to the carrying value When? In cases where the asset s life is extended, the capacity or efficiency of the asset is increased, or any other expenditure where the future service potential is increased Ordinary repairs and maintenance are expensed during the current period Where to draw the line? Long-Lived Assets 4 Capitalization Difficulties, continued Amount and timing of impairment charges often subjective E.g., big bath accounting Are these prior year expenses taken late or future year expenses taken early?

3 Long-Lived Assets 5 Accounting Practice on Trial Cablevision Systems Corp. offers free equipment and hook-up to new customers Cost to the company = $150 To capitalize or not to capitalize? What are the arguments? Long-Lived Assets 6 Impact of Capitalization on Financial Statements Balance sheet Assets and equity are higher Company appears more solvent (less risky?), less efficient Income statement Net income: higher in early years; even longer for growth firms ROA and ROE lower or higher Does numerator or denominator effect dominate? Generally smoother net income Perceived as less risky? However, greater likelihood of one time items

4 Long-Lived Assets 7 Impact on Financial Statements Cash flow statement No impact on net cash flow In year of acquisition: CFO higher; CFI lower In subsequent years: No difference Why? As a manager, would you prefer to capitalize or expense? Long-Lived Assets 8

5 Long-Lived Assets 9 Research and Development Expense as incurred, disclose amount Timing and amount of future benefits too uncertain Acquired in-process R&D (IPR&D) capitalized under SFAS 141(R) Long-Lived Assets 10 Oil and Gas Exploration Full cost method Capitalize cost of dry holes Justification: failure makes success possible Favored by smaller independent firms Successful efforts method Expense cost of dry holes Justification: dry holes present no future benefits Favored by larger multi-national firms

6 Long-Lived Assets 11 Direct Response Advertising Costs related to direct response advertising may be capitalized if The sales derived from the advertising are traceable directly to the advertising The advertising generates a probable future economic benefit Long-Lived Assets 12 Software Development Costs incurred to establish technological/economic feasibility Expensed as R&D Costs subsequent to establishment of feasibility Capitalized and amortized

7 Long-Lived Assets 13 Implications for Analysis Before you can compare financial statements, you must make them comparable The ultimate question is What are the future benefits of these expenditures? Long-Lived Assets 14 Table of Contents EMC CORPORATION CONSOLIDATED BALANCE SHEETS (in thousands, except per share amounts) December 31, ASSETS (As Adjusted) Current assets: Cash and cash equivalents $ 6,302,499 $ 5,843,685 Short term investments 392, ,292 Accounts and notes receivable, less allowance for doubtful accounts of $47,414 and $48,080 2,108,575 2,252,640 Inventories 886, ,803 Deferred income taxes 564, ,101 Other current assets 283, ,508 Total current assets 10,538,302 10,665,029 Long term investments 2,692,323 2,370,493 Property, plant and equipment, net 2,224,346 2,223,007 Intangible assets, net 1,185, ,616 Goodwill 9,210,376 7,046,799 Other assets, net 961, ,631 Total assets $26,812,003 $23,874,575

8 Long-Lived Assets 15 Table of Contents EMC CORPORATION CONSOLIDATED INCOME STATEMENTS (in thousands, except per share amounts) For the Year Ended December 31, (As Adjusted) (As Adjusted) Revenues: Product sales $ 8,828,145 $10,071,816 $ 9,411,976 Services 5,197,765 4,804,347 3,818,229 14,025,910 14,876,163 13,230,205 Costs and expenses: Cost of product sales 4,406,187 4,663,667 4,359,041 Cost of services 1,874,824 1,990,127 1,659,836 Research and development 1,627,509 1,721,330 1,526,928 Selling, general and administrative 4,595,625 4,601,588 3,912,688 In process research and development 85,780 1,150 Restructuring and acquisition related charges 107, ,735 31,310 Operating income 1,414,275 1,568,936 1,739,252 Non operating income (expense): Investment income 140, , ,264 Interest expense (182,499) (176,355) (169,793) Other income (expense), net 2,370 (39,405) (4,677) Gain on sale of VMware stock to Cisco 148,585 Total non operating income (expense) (39,699) 31, ,379 Income before provision for income taxes 1,374,576 1,600,225 1,962,631 Income tax provision 252, , ,211 Net income 1,121,801 1,319,829 1,614,420 Less: Net income attributable to the non controlling interest in VMware, Inc. (33,724) (44,725) (15,455) Long-Lived Assets 16 Table of Contents EMC CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) For the Year Ended December 31, (As Adjusted) (As Adjusted) Cash flows from operating activities: Cash received from customers $ 14,647,691 $ 15,378,081 $ 13,333,489 Cash paid to suppliers and employees (11,032,859) (11,747,031) (10,182,600) Dividends and interest received 109, , ,062 Interest paid (73,430) (73,695) (76,025) Income taxes paid (316,542) (232,298) (202,324) Net cash provided by operating activities 3,334,385 3,565,088 3,126,602 Cash flows from investing activities: Additions to property, plant and equipment (411,579) (695,899) (699,038) Capitalized software development costs (304,520) (294,973) (232,047) Purchases of short and long term available for sale securities (5,409,540) (3,318,545) (6,204,762) Sales of short and long term available for sale securities 5,171,449 3,189,547 6,177,552 Maturities of short and long term available for sale securities 704, , ,475 Proceeds from the sale of portion of EMC s interest in VMware to Cisco 150,000 Business acquisitions, net of cash acquired (2,664,141) (725,521) (692,003) Increase in strategic and other related investments (182,994) (5,510) (12,074) Other 1,184 31,878 Net cash used in investing activities (3,095,488) (1,614,932) (1,162,897) Cash flows from financing activities: Issuance of EMC s common stock 366, , ,449 Issuance of VMware s common stock from the exercise of stock options 227, ,107 2,760 Purchase of VMware s common stock (13,259) Proceeds from the sale of VMware s common stock 1,253,533 Proceeds from securities lending 412,321 Repayments of proceeds from securities lending (412,321) Repurchase of EMC s common stock (1,489,501) (1,453,669) Excess tax benefits from stock based compensation 46,082 97,705 91,782 Payment of long term and short term obligations (20,835) (6,151) (17,178) Proceeds from long term and short term obligations 4,969 33,707 19,815 Net cash provided by (used in) financing activities 211,922 (534,011) 679,492 Effect of exchange rate changes on cash 7,995 (54,671) 10,908 Net increase in cash and cash equivalents 458,814 1,361,474 2,654,105 Cash and cash equivalents at beginning of year 5,843,685 4,482,211 1,828,106 Cash and cash equivalents at end of year $ 6,302,499 $ 5,843,685 $ 4,482,211

9 Long-Lived Assets 17 EMC CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Research and Development and Capitalized Software Development Costs Research and development ( R&D ) costs are expensed as incurred. R&D costs include salaries and benefits, consultants, facilities related costs, material costs, depreciation and travel. Software development costs incurred subsequent to establishing technological feasibility through the general release of the software products are capitalized. Technological feasibility is demonstrated by the completion of a detailed program design or working model, if no program design is completed. Generally accepted accounting principles require that annual amortization expense of the capitalized software development costs be the greater of the amounts computed using the ratio of gross revenue to a products total current and anticipated revenues, or the straight line method over the products remaining estimated economic life. Capitalized costs are amortized over periods ranging from eighteen months to two years which represents the products estimated economic life. Unamortized software development costs were $481.1 million and $435.0 million at December 31, 2009 and 2008, respectively, and are included in other assets, net. Amortization expense was $283.0 million, $230.3 million and $194.4 million in 2009, 2008 and 2007, respectively. Amounts capitalized were $329.1 million, $326.5 million and $239.8 million in 2009, 2008 and 2007, respectively. The amounts capitalized include stock based compensation which is not reflected in the consolidated statement of cash flow as it is a non cash item. Long-Lived Assets 18 EMC Corporation Example How much did EMC spend in 2009 on software research and development before technological feasibility was reached? How much did EMC spend in 2009 on software development after technological feasibility was reached? Total expenditures on software R&D in 2009:

10 Long-Lived Assets 19 EMC Corporation Example How did EMC s capitalized software development costs change during 2009? capitalized Capitalized SDC amortized Long-Lived Assets 20 EMC Corporation Example How would EMC s 2009 pre-tax income change if the company had always expensed all software costs as incurred? How would EMC s 2009 cash from operations change if the company had always expensed all software costs as incurred? How would EMC s assets at 12/31/09 change if the company had always expensed all software costs as incurred?

11 Long-Lived Assets 21 Depreciation After an asset is capitalized, depreciation choices also determine carrying value Expected useful life Depreciation pattern Expected salvage value Long-Lived Assets 22 Figure 10.4 ALTERNATIVE DEPRECIATION METHODS (a) Annual Depreciation Charges; and (b) Net Book Value Depreciation Expense ($) 4,500 4,000 3,500 3,000 2,500 2,000 1,500 1, Double-declining balance Sum-of-the-years digits Straight-line Year (a) Book Value ($) 9,000 8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000 Doubledeclining balance Sum-of-the-years digits Straight-line End of Year (b)

12 Long-Lived Assets 23 Useful Life and Age Straight-line depreciation expense (SL): SL = Rearranging terms yields Gross PP&E [minus salvage value] Average useful life Average useful life = Gross PP&E [minus salvage value] SL If we ignore salvage value, we can calculate average useful life for the year as Another useful formula: Average useful life = Average age of assets = Average gross PP&E SL Accumulated depreciation SL Long-Lived Assets 24 CASES Target Corporation is a general merchandise retailer. Its divisions include Target, an upscale discount chain; Mervyn s, a middle-market promotional department store; and upscale department stores in the Midwest (Dayton s, Hudson s, and Marshall Field s). Wal-Mart Stores, Inc. operates retail stores in various retailing formats in all 50 states in the United States. The company s merchandising operations serve its customers primarily through the operation of three segments: the Wal-Mart stores segment includes its discount stores, Supercenters, and Neighborhood Markets in the United States; the Sam s Club segment includes the warehouse membership clubs in the United States; the international segment includes all of its operations in Argentina, Brazil, Canada, China, Japan, Germany, Korea, Mexico, Puerto Rico, and the United Kingdom. Information taken from both firms 2003 annual reports to shareholders follows. C10 1 Target Corporation and Wal-Mart Stores: Depreciation differences and financial statement analysis

13 Long-Lived Assets 25 Target Corporation Property and Equipment February 1 February 2 ($ in millions) Land $ 3,236 $ 2,833 Buildings and improvements 11,527 10,103 Fixtures and equipment 4,983 4,290 Construction in progress 1,190 1,216 Accumulated depreciation (5,629) (4,909) Property and equipment net $15,307 $13,533 Property and equipment are recorded at cost, less accumulated depreciation. Depreciation is computed using the straight-line method over estimated useful lives. Accelerated depreciation methods are generally used for income tax purposes. Estimated useful lives by major asset category are as follows: Asset Life (in Years) Buildings and improvements 8 50 Fixtures and equipment 4 8 Computer hardware and software 4 Selected Income Statement Information Years Ended February 1 February 2 ($ in millions) Depreciation and amortization $1,212 $1,079 Earnings before income taxes and extraordinary charge 2,676 2,207 Net earnings $1,654 $1,368 Long-Lived Assets 26 Wal-Mart Corporation Property and Equipment January 31 January 31 ($ in millions) Land $11,228 $10,241 Buildings and improvements 33,750 28,527 Fixtures and equipment 15,946 14,135 Transportation equipment 1,313 1,089 Property under capital lease 4,814 4,626 Less-accumulated depreciation and amortization: Property owned (13,537) (11,436) Property under capital leases (1,610) (1,432) Total $51,904 $45,750 Depreciation and amortization for financial statement purposes are provided on the straightline method over the estimated useful lives of the various assets. For income tax purposes, accelerated methods are used with recognition of deferred income taxes for the resulting temporary differences.

14 Long-Lived Assets 27 Estimated useful lives for financial statements purposes are as follows. Asset Life (in Years) Buildings and improvements 5 50 Fixtures and equipment 5 12 Transportation equipment 2 5 Internally developed software 3 Selected Income Statement Information January 31 January 31 ($ in millions) Depreciation and amortization $ 3,432 $ 3,290 Earnings before income taxes and minority interests 12,719 10,751 Net income $ 8,039 $ 6,671 Required: Assume a 35% tax rate. 1. Estimate the average useful life of each firm s long-lived assets. 2. Calculate a revised estimate of Wal-Mart s 2003 depreciation expense using the estimated average useful life of Target s assets. Use this amount to recalculate Wal-Mart s 2003 income before taxes and net income. 3. Calculate a revised estimate of Target s 2003 depreciation expense using the estimated average useful life of Wal-Mart s assets. Use this amount to recalculate Target s 2003 income before taxes and net income. 4. Why might a financial analyst want to make the adjustments in requirements 2 and 3? 5. What factors will affect the reliability and accuracy of the adjustments performed in requirements 2 and 3? Long-Lived Assets 28 C Target Average depreciable gross PP&E: (11, ,983) + (10, ,290) 2 Average useful life: 15, ,212 = 12.7 years Average age at 2/1/03: 5,629 1,212 = 4.6 years = 15,451.5

15 Long-Lived Assets 29 C Wal-Mart Average depreciable gross PP&E: (33, , , ,814) + (28, , , ,626) 2 = 52,100 Average useful life: 52,100 3,432 = 15.2 years Average age at 1/31/03: 15,147 3,432 = 4.4 years ( 15,147 = 13, ,610) Long-Lived Assets 30 C Wal-Mart s depreciation expense using Target s useful life: 52, = 4,102 (increase in depreciation of 4,102 3,432 = 670) Recalculated income before taxes: 12, = 12,049 Recalculated net income: 8,039 [(1.35) 670] = 7,604

16 Long-Lived Assets 31 C Target s depreciation expense using Wal-Mart s useful life: 15, = 1,017 (decrease in depreciation of 1,212 1,017 = 195) Recalculated income before taxes: 2, = 2,871 Recalculated net income: 1,654 + [(1.35) 195] = 1,781 Long-Lived Assets 32 Kmart (in $millions) 1/29/03 1/30/02 Land Buildings 1,086 1,097 Leasehold improvements 2,882 3,055 Furniture and fixtures 5,178 5,763 Construction in progress Property under capital leases 1,243 1,727 10,896 12,241 Less accumulated depreciation: Property owned (5,116) (4,977) Capital leases (888) (1,171) Total 4,892 6,093

17 Long-Lived Assets 33 Kmart Depreciation and Amortization: Depreciation and amortization, including depreciationofpropertyheldundercapitalleases,arecomputedbasedupontheestimated useful lives of the respective assets using the straight-line method for financial statement purposes and accelerated methods for tax purposes. The general range of lives are 25 to 50 years for buildings, 5 to 25 years for leasehold improvements, 3 to 17 yearsforfurnitureandfixturesand3to5yearsforcomputersystemsandequipment. (in $millions) 1/29/03 1/30/02 Depreciation and amortization Net loss (3,219) (2,446) Long-Lived Assets 34 Kmart Average depreciable gross PP&E: (1, , , ,243) + (1, , , ,727) 2 = 11,015.5 Average useful life: 11, = 14.9 years Average age at 1/29/03: 6, = 8.1 years