Long-lived Assets 2014 Level I Financial Reporting and Analysis IFT Notes for the CFA exam
Contents 1. Introduction... 3 2. Acquisition of Long-Lived Assets... 3 3. Depreciation and Amortization of Long-Lived Tangible Assets... 9 4. Revaluation Model... 15 5. Impairment of Assets... 17 6. Derecognition... 20 7. Presentation and Disclosures... 21 8. Investment Property... 21 Summary... 22 Next Steps... 24 This document should be read in conjunction with the corresponding reading in the 2014 Level I CFA Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2013, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Irfanullah Financial Training. CFA Institute, CFA, and Chartered Financial Analyst are trademarks owned by CFA Institute. Copyright Irfanullah Financial Training. All rights reserved. Page 2
1. Introduction In the previous readings, we looked at current assets including inventories. This reading focuses on non-current assets, or long-term assets. Long-lived assets are defined as those assets which are expected to provide economic benefits over a long period of time in the future, typically more than a year. These assets may be tangible, intangible, or financial assets. Examples include land, property, plant, and equipment, building, machinery and patents etc. The kind of investment in long-term assets depends on the business. While investing in a potline/smelter may be important for an aluminum company, computer servers will be a tangible asset for an online grocery store. There are two important questions in accounting for a long-lived asset: What is the cost of the asset at the time of purchase that should be shown on the balance sheet? How should this cost be allocated over the life of an asset? 2. Acquisition of Long-Lived Assets Long term tangible assets such as property, plant and equipment are recorded on the balance sheet at cost, which is the same as fair value. An asset s cost might include expenditures in addition to purchase price. The question is how these costs should be treated expensed or capitalized? Valuation of an intangible asset depends on how the asset was acquired developed internally, purchased, or through a business acquisition? 2.1 Property, Plant, and Equipment Property, plant, and equipment are recorded at cost at acquisition. In addition to the purchase price, the cost includes all expenditures necessary to get the asset ready for intended use. For instance, readying the factory for installation of a machine is included in the cost. But, if any training is required for the staff to operate the machine, that is expensed and not capitalized. Copyright Irfanullah Financial Training. All rights reserved. Page 3
Subsequent costs are capitalized, if they are expected to provide benefit beyond one year; otherwise they are expensed. Companies might have different approaches to wards expensing/capitalizing costs. An analyst should understand the impact of expensing/capitalizing decisions financial statements and ratios. All the capitalized costs related to the long-lived assets are recorded in the balance sheet. 2.2 Effect of Capitalizing vs. Expensing When cost is capitalized: Assets on balance sheet (non-current assets) increase by the capitalized amount. Cash flow from investing activities decreases. In the subsequent periods over an asset s useful life, the capitalized amount is allocated to depreciation/amortization. This, in turn, reduces net income on the income statement and carrying value of asset on the balance sheet (non-current assets). When cost is expensed: The entire expense appears on the income statement and cash flow statement. It decreases net income and operating cash flow by the after-tax amount. No asset is recorded on the balance sheet. No depreciation/amortization amount is recorded in the subsequent periods. The following table identifies the effects of capitalizing vs. expensing on various financial statements items. Capitalizing Expensing Total Assets Higher Lower Equity Higher Lower Income variability Lower Higher Net Income (1 st year) Higher Lower Net Income (later) Lower Higher Cash flow from operating activities (CFO) Higher Lower Copyright Irfanullah Financial Training. All rights reserved. Page 4
Cash flow from investing activities (CFI) Lower Higher Debt/Equity Lower Higher Interest Coverage (1 st year) Higher Lower Interest Coverage (later years) Lower Higher Worked Example 1: Acme Inc. purchased a machine for $ 10,000. In addition, the following costs were incurred: $200 for delivery $300 for installation $100 to train staff on using the machine $1,000 to reinforce floor to support machine $500 to paint the factory 1. Which expenses will be capitalized and which will be expensed? 2. How will the treatment of these expenditures affect the company s financial statements? Solution to 1: Expenses to be capitalized = $10,000+$200+$300+$1000 = $11,500 Expensed costs = $100 +$500 = $600 Training cost is expensed because if the trained staff leaves the company, then it doesn t provide a long term benefit to the business. Solution to 2: Balance sheet: PP&E increases by $11,500 and cash decreases by $11,500. Income statement: an expense of $600 towards training staff and painting. Also a depreciation expense spread over the useful life of the asset appears on the income statement. Cash flow statement: CFI decreases by $11,500 and CFO decreases by $600. 2.3 Capitalization of Interest Costs For long-term constructed assets, interest cost incurred during construction is capitalized as part of the asset cost. For example, assume you are constructing a building and you take a loan of Copyright Irfanullah Financial Training. All rights reserved. Page 5
$100 million at 10% interest specifically for the building s construction; the construction is expected to take 2 years to complete. Use rate on borrowing related to construction; if no construction debt is outstanding interest rate is based on existing unrelated debt. There s a small difference in how IFRS and U.S. GAAP treat interest earned by investing loan proceeds in the short term. IFRS deducts the interest earned from capitalized costs whereas U.S. GAAP does not allow netting of interest earned. Effect of capitalized interest on financial statements: Capitalized interest is reported as part of the asset s cost on the balance sheet; in the future, it is reported as part of the asset s depreciation expense in the income statement. Capitalized interest appears as part of CFI as cash outflows whereas expensed interest decreases operating cash outflow. Results in 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 ratio in the subsequent periods. EBIT will be low because depreciation is considered an operating expense. Since depreciation is high, EBIT is lower. Worked Example 2: A company borrows 2,000,000 at an interest rate of 5% per year on January 1, 2011 to finance the 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 company s a financial statements? Solution to 1: According to US GAAP, the entire interest cost is $2,000,000 *0.05*2 = $200,000 is capitalized. Copyright Irfanullah Financial Training. All rights reserved. Page 6
According to IFRS, the $20,000 the company earns by temporarily investing is deducted from the interest cost. Hence, capitalized interest cost is 200,000-20,000 = $180,000 Solution to 2: The entire capitalized cost will appear on the balance sheet initially. Once the capitalized interest is depreciated, it will appear on the income statement. 2.4 Intangible Assets Intangible assets are long-term assets of a company that do not exist physically. Examples include patents, software, goodwill, customer lists, copyrights and trademarks. Accounting for intangible assets depends on how it is acquired. Intangible assets can be acquired in the following three ways: 1) acquired in a business combination 2) purchased in situations other than business combinations and 3) developed internally. Acquired in a Business Combination This refers to a situation where one company merges with or acquires another company and in the process and in the process acquires intangible assets. Identifiable intangible assets such as patents, copyrights and trademarks are recorded at their fair value; similar to long-lived tangible assets. Determination of fair value requires judgment. Goodwill is an intangible asset that cannot be identified separately; it is recorded when one business acquires another business. If the purchase price exceeds the sum of the fair value of the individual assets and liabilities of the acquired business, the excess amount is recognized as goodwill. For example, Ta Hospitals Inc. acquires Man Equipments Inc. for $100 million. The fair value of Man Equipments net assets equal $95 million. Excess of $5 million represents goodwill. Purchased in Situations Other than Business Combinations This refers to a situation where an identifiable intangible asset is purchased The identifiable intangible asset is recorded at fair value Copyright Irfanullah Financial Training. All rights reserved. Page 7
Developed Internally For internally developed intangible assets, there are two phases: research phase and development phase. Research phase refers to the period during which commercial feasibility of an intangible asset is yet to be established. Development phase refers to the period during which the technical feasibility of completing an intangible asset has been established with the intent of either using or selling the asset. The table below summarizes how research and development costs are handled under IFRS and U.S. GAAP: IFRS vs. U.S. GAAP handling of R&D costs Type of expenditure IFRS U.S. GAAP 1. Research costs Expense as incurred Expense as incurred 2. Development costs Capitalized Expense as incurred except software development costs 3. Software for sale to others Expense as incurred until product s technological feasibility has been established; subsequent costs to be capitalized. 4. Software for internal use Capitalize once feasibility is established. Capitalize development costs Capitalize development costs Worked Example 3: Acme Inc. starts an internal software development project on January 1, 2012. It incurs expenditures of 10,000 per month during the fiscal year ended December 31, 2012. By March 31, it is clear that the product will be developed successfully and will be used as intended. How are the software development costs recorded before and after March 31 according to IFRS and U.S. GAAP? Copyright Irfanullah Financial Training. All rights reserved. Page 8
Solution: IFRS: As per the 4 th condition in the table given above, under IFRS all costs are expensed until feasibility is established if the software is developed for internal use. So, $30,000 (period from January 1 to March 31, 2012) is expensed and $90,000 is capitalized (from April 1 to December 31, 2012). U.S GAAP: The entire cost of $120,000 should be capitalized. 3. Depreciation and Amortization of Long-Lived Tangible Assets All tangible and intangible assets except goodwill have an estimated useful life. Useful life is the period over which an asset is used or depreciated. The costs of tangible assets are depreciated (i.e. costs are allocated to the income statement as depreciation expense) and intangible assets are amortized over the asset s useful life under the cost-model of reporting long-lived assets. An asset s carrying amount is historical cost accumulated depreciation. It is the amount at which the asset is reported on the balance sheet; carrying amount is also the net book value. 3.1 Three Types of Depreciation Methods 1. Straight Line The cost of an asset is distributed evenly over the asset s useful life. 2. Accelerated methods. A commonly used accelerated method is the Double Declining Balance method in which cost allocated is greater in the earlier years. 3. Units of Production The allocation of cost is equal to the actual use of an asset in a particular period. Carrying amount = historical cost accumulated depreciation Depreciable cost = historical cost estimated residual value Straight line : depreciation expense = depreciable cost / estimated useful life Double declining balance : depreciation expense = 2 * straight-line rate * beginning book value Units of Production: depreciation expense per unit = depreciable cost/useful life in units Copyright Irfanullah Financial Training. All rights reserved. Page 9
Worked Example 4: 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 is 300, 300, 200, and 100 respectively. Complete the table below for each company. Beginning Net Book Depreciation Accumulated Ending Net Book Value Expense Depreciation Value Year 1 Year 2 Year 3 Year 4 Solution: Some more useful formulae to fill the table: Beginning net book value = purchase price in year 1 Beginning book value in following years = ending net book value of the previous year Ending book value = beginning book value depreciation expense for the year (or) Ending book value = original cost accumulated year end depreciation Accumulated depreciation = accumulated depreciation for previous year + depreciation expense Straight-Line depreciation expense = 10000-1000/4 = 2250 Straight-Line Method Beginning Net Book Depreciation Accumulated Ending Net Book Value Expense Depreciation Value Copyright Irfanullah Financial Training. All rights reserved. Page 10
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 The rate of depreciation in double-declining method (DDM) is twice that of straight-line method. It is 25% for straight-line method (100% in 4 years = 25%). The rate of decline for DDM is 50%. Depreciation expense for first year = 0.25*2 *10,000= 5,000. And so on for the subsequent years. Double-Declining Balance Method Beginning Net Book Depreciation Accumulated Ending Net Book Value Expense Depreciation 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 Depreciation expense in first year = (10000/1000)*300 = 3000. Or simply put, the rate of depreciation for first year is 30% (300 units produced of a total capacity of 1000 units) Units of Production Method Beginning Net Book Depreciation Accumulated Ending Net Book Value Expense Depreciation 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 Some points to be noted: Copyright Irfanullah Financial Training. All rights reserved. Page 11
The beginning book value is the same for all the three methods. The total depreciation over 4 years for all three companies (or under three depreciation methods) should be the same. Worked Example 5: Given the data below, compute the asset turnover ratio, operating profit margin and operating return on assets for SL and DDB. Sales Operating Expenditure (exc. Depreciation) Carrying amount of total assets (exc. 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 Solution: If you recall from the previous reading, Asset turnover ratio = total revenue / average total assets Operating profit margin = EBIT / total revenue Operating return on assets = EBIT / average total assets SL: Year 1: EBIT = Sales - (operating expenditure given in the data above + depreciation expense calculated for each company each year in Worked Example 4). EBIT for year 1 = 400,000 (300,000 +2,250) = 97,750 Total assets in year 1 = carrying value of assets other than equipment + ending net book value of equipment from worked example 4 = 37,750 Total asset turnover ratio for year 1 = 400,000/37,750 = 10.59 Operating profit margin = 97,750/400,000 = 24.4 Return on Assets = 97,750/37,750 = 258.9 Copyright Irfanullah Financial Training. All rights reserved. Page 12
Year Sales Operating expenses (excluding dep.) Dep. Exp. Operating Expense EBIT Assets other than equipment Carrying value Total Assets Asset Turnover OPM (%) ROA (%) 1 400,000 300,000 2,250 302,250 97,750 30,000 7,750 37,750 10.6 24.4 258.9 2 400,000 300,000 2,250 302,250 97,750 30,000 5,500 35,500 11.27 24.4 275.3 3 400,000 300,000 2,250 302,250 97,750 30,000 3,250 33,250 12.03 24.4 293.9 4 400,000 300,000 2,250 302,250 97,750 30,000 1,000 31,000 12.9 24.4 315.3 Similarly, compute the values for DDB. Year Sales Operating expenses (excluding dep.) Dep. Exp. Operating Expense EBIT 1 400,000 300,000 5,000 305,000 95,000 30,000 5,000 35,000 11.43 23.7 271.4 2 400,000 300,000 2,500 302,500 97,500 30,000 2,500 32,500 12.31 24.3 300.0 3 400,000 300,000 1,250 301,250 98,750 30,000 1,250 31,250 12.80 24.6 316.0 4 400,000 300,000 250 300,250 99,750 30,000 1,000 31,000 12.90 24.9 321.7 Assets other than equipment Carrying value Total Assets Asset Turnover OPM (%) ROA (%) Notice that the choice of the depreciation method (SL vs DDB) impacts financial statement elements are ratios. 3.2 Impact of depreciation methods on Financial Statements Note: This table is important from a testability perspective. The relationships indicated in the table below are for the early years of an asset s life Straight Line (SL) Accelerated (DDB) Interpretation Depreciation Expense Lower Higher Compared to SL, the rate of depreciation for DDB is double making the depreciation expense higher in the initial years. Net Income Higher Lower Compared to SL, depreciation expense is higher in initial years for DDB making net income lower. Copyright Irfanullah Financial Training. All rights reserved. Page 13
Assets Higher Lower Compared to SL, depreciation and accumulated depreciation are higher for DDB making assets lower in the initial years. Equity Higher Lower Equity = assets liabilities. Liabilities are not affected. Since assets are lower for DDB, equity is also lower. Return on Assets (NI/Assets) Return on Equity Asset Turnover Operating Profit Margin Higher Lower Compared to SL, ROA for DDB is lower in earlier years because percentage impact on the numerator (net income) more than the percentage impact on the denominator (assets). Percentage impact on assets is low because equipment is generally a small percentage of assets. Higher Lower Compared to SL, ROE for DDB is lower in earlier years because percentage impact on net income is more than the percentage impact on equity. Lower Higher Revenue is not impacted by the choice of depreciation method. Assets are lower for the DDB method making asset turnover higher. Higher Lower Revenue is not impacted. EBIT is lower for DDB in the initial years which makes operating profit margin lower. The above relationships are for the initial years of an asset. These reverse in the later years if the firm s capital expenditure declines. 3.3 Component Method of Depreciation In this method, individual components or parts of an asset are depreciated separately at different rates. For example, in an aircraft it may be prudent to depreciate engine, frame and interior furnishings separately. IFRS requires companies to use the component method of depreciation i.e. depreciate each component separately. U.S. GAAP allows component depreciation but the method is often not used in practice. Worked Example 6: Copyright Irfanullah Financial Training. All rights reserved. Page 14
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? Solution: Depreciation expense for component 1 in year 1 = 10,000/10 = $1,000 Depreciation expense for component 2 in year 1 = $3,000/3 = $1,000 Total depreciation expense for the first year = $2,000 If the company did not use component method for depreciation, the depreciation expense for year 1 would be $13,000 over 10 years = $1,300. As you can see, by not using the component method, the expense is much lower. 3.4 Amortization Methods and Calculation of Amortization Expense Amortization is to intangible assets with finite useful lives what depreciation is to tangible assets. Intangible assets with a finite useful life are expensed (amortized) over time. Some intangible assets such as goodwill and brand names have infinite useful lives and are not amortized, while those with finite lives include customer lists, patents, copyrights and trademarks. The depreciation methods are also accepted for calculating amortization. The calculation requires the original amount of the intangible asset, estimated useful life and residual value of the asset. 4. Revaluation Model What we have seen so far is the cost model of accounting where an asset is recorded originally at cost. This value is then depreciated every year. An alternative to cost model is the revaluation model. Under the revaluation model, assets are revalued periodically. The carrying value of an asset after revaluation becomes the fair value. The method is used when the fair value of an asset can be easily determined and is subject to judgment. Copyright Irfanullah Financial Training. All rights reserved. Page 15
How IFRS and U.S. GAAP treat revaluation model: IFRS permits the use of either revaluation model or the cost model. U.S. GAAP does not allow the revaluation model. Carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortization. Worked Example 7: 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 financial statements. Solution: At the end of period 1, the assets go up by $2000 to $12,000. Correspondingly, equity goes up by $2,000 under the head revaluation surplus equal to $2,000. In year 2, the value goes down to $8,000 from $12,000. Revaluation surplus is reversed which comes down by $2,000. The additional $2,000 is shown as a loss in income statement which is eventually shown in equity through retained earnings. Note: Gains do not go through income statement and instead go directly to equity under revaluation surplus. In case of loss, part of the decrease is shown as loss in income statement. Scenario 2: Machine costs $10,000 at the start of Period 1. At the end of Period 1, the fair value of machine is $8,000. At the end of Period 2, the fair value is $12,000. Show the impact on financial statements. Solution: At the end of Period 1, the asset value decreases by $2,000 which is shown as a loss on income statement. Equity also decreases by $2,000 through retained earnings. Subsequently in Period 2, when the asset value goes up by $4,000 to $12,000, the $2,000 loss recognized earlier is reversed on the income statement. The additional $2,000 is shown as a revaluation surplus under equity and does not go through the income statement. Copyright Irfanullah Financial Training. All rights reserved. Page 16
5. Impairment of Assets An asset is considered to be impaired when its carrying amount is greater than the recoverable amount. An unexpected condition can lead to a decline in an asset s value like a natural disaster or an unforeseen slump in the demand for a product. Depreciation is a planned decrease in the value of an asset whereas impairment is an unanticipated decrease. For example, assume a building is damaged because of an earthquake that decreases its value by $900,000. This loss of $900,000 due to impairment is shown on the income statement. When to test for impairment: Accounting standards do not mandate that property, plant and equipment be tested annually for impairment. However, if there is an indication of impairment, such as obsolescent inventory, significant decline in market price, continuous losses to the asset, or significant changes to its physical condition, then the asset should be tested for impairment. 5.1 Impairment Calculation IFRS and U.S. GAAP differ in the way impairment loss is calculated. 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. The following chart will help you remember how impairment loss is calculated under IFRS: Copyright Irfanullah Financial Training. All rights reserved. Page 17
Under U.S. GAAP, it is a two-step process. First, perform the recoverability test to determine whether the asset is impaired. Asset is impaired if the carrying value is greater than the asset s future undiscounted cash flows. Then, determine the impairment loss. The following chart will help you remember how impairment loss is calculated under U.S. GAAP: The formulae for both the methods are given below: IFRS: Impairment Loss = Carrying value Recoverable amount where recoverable amount = greater of fair value less cost to sell and value in use value in use = present value of cash flow from asset U.S. GAAP: Impairment Loss = Fair value Carrying amount Worked Example 8: 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 Solution: IFRS: Recoverable amount = greater of (7000-200, 6000) = 6800 Copyright Irfanullah Financial Training. All rights reserved. Page 18
Impairment loss = 8000-6800 = 1200 Write down the value of asset from 8000 to 6800 in the balance sheet and record a loss of 1200 in the income statement. U.S. GAAP: Is the asset impaired? No, since the carrying amount of 8,000 is less than the undiscounted future cash flows of 9,000. 5.2 Other Impairment Scenarios This section addresses other conditions under which tangible and intangible assets are tested for impairment. Impairment of Intangible Assets with Finite Lives: Intangible assets with finite lives are amortized over their period of use. Just as property, plant, and equipment are tested for impairment when significant conditions suggesting impairment arise, intangible assets should also be tested for impairment when there is a legal event or significant decrease in market price. Impairment of Intangible Assets with Indefinite Lives: Intangible assets with infinite lives such as goodwill are not amortized but they are tested annually for impairment. Impairment of Long Lived Assets Held for Sale: A long-lived asset is reclassified as heldfor-sale if the management does not intend to use it any more. For example, if a company owns a machine with the intent of using it but now intends to sell it, then it should be reclassified as held for sale. Held-for-sale assets are not depreciated or amortized. At the time of reclassification, the asset should be tested for impairment and any impairment loss should be recognized. Reversal of Impairments of Long-Lived Assets: This is based on the premise that an asset s recoverable amount can increase after an impairment loss is recognized. IFRS and U.S. GAAP differ in the treatment of reversals of impairment losses. The table below summarizes the differences: Impairment loss under IFRS U.S. GAAP Copyright Irfanullah Financial Training. All rights reserved. Page 19
Held-for-use Allows reversal Cannot be reversed Held-for-sale Allows reversal Allows reversal Revaluation to the recoverable amount if recoverable amount > previous carrying amount Not allowed 6. Derecognition Derecognition is when a company removes an asset from its financial statements when the asset is disposed of or is not expected to provide any future benefits from either use or disposal. A company may dispose of a long-living operating asset by disposing, selling or exchanging it. 6.1 Sale of Long-Lived Assets Gain/loss on long-lived assets = sales proceeds carrying amount of the asset at the time of sale where carrying amount = net book value 6.2 Long-Lived Assets Disposed of Other Than by a Sale A long-lived asset can be disposed off (not sold) by exchanging or abandoning it. Under such conditions, it is classified as held-for-use until disposal. It continues to be depreciated and tested for impairment. When an asset is abandoned: It is treated as a sale with zero proceeds. The carrying value is removed from balance sheet. The loss is recognized in the income statement. When an asset is exchanged: The carrying value is removed from balance sheet The fair value of the new asset is recorded. Copyright Irfanullah Financial Training. All rights reserved. Page 20
The gain/loss is computed by comparing the carrying value of old asset with the fair value of new asset 7. Presentation and Disclosures The guidelines for IFRS are more exhaustive than U.S. GAAP. IFRS presentation guidelines: For each class of property, plant and equipment, a company must disclose the measurement bases, the depreciation method, the useful lives, 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. Each class of intangible assets must disclose whether useful lives are finite or infinite. Impairment losses and reversal of impairment losses recognized for every asset during the period. U.S. GAAP presentation guidelines: 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 depreciating expense with respect to the major classes of depreciable assets. 8. Investment Property Investment property is a property that is owned to earn rentals or capital appreciation or both. U.S. GAAP has no specific definition for investment property and the cost model is generally used. Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model. Cost model is similar to the cost model used for property, plant and equipment. The fair value model differs from the revaluation model seen earlier. Under the fair value model, all changes in the fair value (increase/decrease) of the asset affect net income. Copyright Irfanullah Financial Training. All rights reserved. Page 21
Summary Note: This summary has been adapted from the CFA Program curriculum. Understanding the reporting of long-lived assets at inception requires distinguishing between expenditures that are capitalized (i.e., reported as long-lived assets) and those that are expensed. Once a long-lived asset is recognised, it is reported under the cost model at its historical cost less accumulated depreciation (amortization) and less any impairment and under the revaluation model at its fair value. IFRS permit the use of either the cost model or the revaluation model, whereas U.S. GAAP require the use of the cost model. Most companies reporting under IFRS use the cost model. The choice of different methods to depreciate (amortize) long-lived assets can create challenges for analysts comparing companies. Key points include the following: Expenditures related to long-lived assets are capitalized as part of the cost of assets if they are expected to provide future benefits, typically beyond one year. Otherwise, expenditures related to long-lived assets are expensed as incurred. Although capitalizing expenditures, rather than expensing them, results in higher reported profitability in the initial year, it results in lower profitability in subsequent years; however, if a company continues to purchase similar or increasing amounts of assets each year, the profitability-enhancing effect of capitalization continues. Capitalizing an expenditure rather than expensing it results in a greater amount reported as cash from operations because capitalized expenditures are classified as an investing cash outflow rather than an operating cash outflow. Companies must capitalize interest costs associated with acquiring or constructing an asset that requires a long period of time to prepare for its intended use. Including capitalized interest in the calculation of interest coverage ratios provides a better assessment of a company s solvency. IFRS require research costs be expensed but allow all development costs (not only software development costs) to be capitalized under certain conditions. Generally, U.S. accounting standards require that research and development costs be expensed; however, certain costs related to software development are required to be capitalized. Copyright Irfanullah Financial Training. All rights reserved. Page 22
When one company acquires another company, the transaction is accounted for using the acquisition method of accounting in which the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value. Under acquisition accounting, if the purchase price of an acquisition exceeds the sum of the amounts that can be allocated to individual identifiable assets and liabilities, the excess is recorded as goodwill. The capitalized costs of long-lived tangible assets and of intangible assets with finite useful lives are allocated to expense in subsequent periods over their useful lives. For tangible assets, this process is referred to as depreciation, and for intangible assets, it is referred to as amortization. Long-lived tangible assets and intangible assets with finite useful lives are reviewed for impairment whenever changes in events or circumstances indicate that the carrying amount of an asset may not be recoverable. Intangible assets with an indefinite useful life are not amortized but are reviewed for impairment annually. Methods of calculating depreciation or amortization expense include the straight-line method, in which the cost of an asset is allocated to expense in equal amounts each year over its useful life; accelerated methods, in which the allocation of cost is greater in earlier years; and the units-of-production method, in which the allocation of cost corresponds to the actual use of an asset in a particular period. Estimates required for depreciation and amortization calculations include the useful life of the equipment (or its total lifetime productive capacity) and its expected residual value at the end of that useful life. A longer useful life and higher expected residual value result in a smaller amount of annual depreciation relative to a shorter useful life and lower expected residual value. IFRS permit the use of either the cost model or the revaluation model for the valuation and reporting of long-lived assets, but the revaluation model is not allowed under U.S. GAAP. Under the revaluation model, carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortization. Copyright Irfanullah Financial Training. All rights reserved. Page 23
In contrast with depreciation and amortization charges, which serve to allocate the cost of a long-lived asset over its useful life, impairment charges reflect an unexpected decline in the fair value of an asset to an amount lower than its carrying amount. IFRS permit impairment losses to be reversed, with the reversal reported in profit. U.S. GAAP do not permit the reversal of impairment losses. The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying amount of the asset at the time of sale. Long-lived assets reclassified as held for sale cease to be depreciated or amortized. Longlived assets to be disposed of other than by a sale (e.g., by abandonment, exchange for another asset, or distribution to owners in a spin-off) are classified as held for use until disposal. Thus, they continue to be depreciated and tested for impairment. 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. Next Steps Work through the examples in the curriculum. Solve the practice problems in the curriculum. Solve the IFT Practice Questions associated with this reading. Review the learning outcomes presented in the curriculum. Make sure that you can perform the implied actions. Copyright Irfanullah Financial Training. All rights reserved. Page 24