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long term assets

Page history last edited by Brian D Butler 13 years, 7 months ago

 

 

 

 

 

 

 

Long Term Assets

 

How you account for long term assets can have a big impact on the earnings statement. Management has considerable opportunities to manage earnings with respect to long-lived assets. They must make estimates of the service lives and salvage values. They must also decide how much to include in the purchase price, and what to expense. They must choose the depreciation method and speed, and decide how to deal with changes in market values (imparements). At the end of the life of the asset, they make decisions that will cause either a gain or a loss, which goes directly onto the earnings statement. All of these factors can be used by managment to manipulate the reported earnings in a particular term.

 

Note: Tangible assets such as land, buildings and equipment are often called PPE. Other intangible assets might include patents, trademarks, and so on.

 

 

Table of Contents:


 

 

 

 

 

Key issues:

1. When spending money on things with long term potential benefits…should you treat them as assets (on the balance sheet)? Or, should you expense them (on the income statement)?

2. For capitalized assets….what value should you use? Market? What should be included?

3. If depreciate / amortize…what period of time should you use?

4. If depreciate/ amortize…what to do if there is a change in expected useful life or salvage value?

5. What should you do if the assets significantly looses value because competitors introduce new technology?

6. When you finally dispose of the asset…what impact will that have on earnings?

 

These questions are especially important and difficult to answer for intangibles

financial statement analysis of earnings will be different depending on how you answer these questions.

 

 

 

1. Capitalization vs. Expensing?

Either way, is a DEBIT account (Debit Asset to increase, or Debit Retained Earnings expense to increase). Depreciation of factory buildings and equipment used for production will not be expensed immediately. Instead, it will be added to the WIP and finished goods inventories.

 

Remember…all assets have future benefits, but not all future benefits are assets.

In order to be considered an asset, you must

1. have previously acquired rights to use it in the future

2. be able to accurately estimate future benefits. This second aspect is sometimes difficult to determine for intangible assets with any degree of precision.

 

 

 

2. What value to include in Asset?

 

If you buy land and equipment on the market, then the independent market exchange sets the minimum value of the expected future benefits of those assets.

 

If you build the building yourself instead of purchasing it from someone, you can still capitalize that cost. All expenditures made during the construction should be capitalized as assets. If they build themselves, and at the end, the cost of building exceeds the market value (that they could have purchased it for), then they can write down the difference as a loss (expensing). But if they build it cheaper than market value (BV

 

Patents & Trademarks – if you purchase from someone else, then you can capitalize as asset. But if you develop it yourself internally, then you can not. The exchange with the buyer / seller on an independent market sets the minimum future benefits. Without that exchange, accountants think the value is too unknown, and should not be on the balance sheet. McDonalds, for example, does not have the value of their brand name anywhere on their books. But if someone were to purchase them, then that company would.

 

Goodwill – is an asset that is acquired during acquisition. If McDonalds were to sell, then the acquiring firm would capitalize the brand name as goodwill on the balance sheet. The arms-length transaction in the market establishes the value. Note: goodwill does not get amortized. But you should check every year to see if there is a loss in value…impairment.

 

Research – not capitalized if internally done by company. Because its too difficult to calculate the exact future benefit from research. Some of it might not bring any benefit at all. All R&D should be expensed.

 

Note that internally developed TANGIBLE goods are capitalized as assets, but internally developed INTANGIBLE goods are expensed. The physical TANGIBLE assets are evidence that an asset exists. Unless proven otherwise, you use the market value of the asset.

 

Technological Feasibility test – at some point in time, your R&D, or product development, will lead to a product that is ready to market. Once you pass that point, any additional improvements or adaptations can be capitalized. Once the product has passed the technological feasibility test, then you can capitalize.

 

If you purchase a firm that is doing R&D, then you have to expense all of the technologies that are not yet a completed resource. These are called in-process technologies, and you have to expense them, even if you purchased them from another company (establishing a market price). Again, the future benefits are too uncertain.

 

 

 

 

 

 

Measuring acquisition cost

 

For an asset – need to include all costs getting it ready for service, including transportation, installation, warehousing, lawyers costs, taxes, etc. But you have to subtract any discounts from the invoice price.

 

When purchasing a new building, the salaries of the management during the search for the site and the negotiation of the purchase can and should be capitalized in the value of the asset.

 

When purchasing both land + building, you have to add all of the common costs together, and then distribute the total costs based on their relative market value %. For example, if the total costs to be capitalized is $1.5 million, and the land has $1m market value and the building has 250,000 market value… then you distribute 25% of the 1.5 million to the building, and the rest to the land.

 

Opportunity cost is not included.

 

Capitalize Interest paid during Construction if you build your own building instead of purchasing it from someone else, then you will have to finance that construction. All of the interest payments during construction are capitalized as asset (added to value of asset) and not expensed. Once construction is done, however, then all remaining interest payments must be expensed. The interest is treated just like labor and materials needed for construction. You could have avoided these interest charges if you hadn’t done the construction.

 

What interest rate to use? If you borrow new funds...use that rate. If not, then use the weighted average on other borrowings from firm. But can not capitalize more than actually paid for interest in that period. So, if a firm does not need to borrow new money to build an asset, then they can take some of their other interest expenses (from long term borrowing for example), and capitalize some of them into this new asset. This will have the effect on earnings in this period (reducing an expense will increase Net Income). So income will appear higher for a firm during construction, but then later periods will show lower earnings as the firm depreciates the asset. Capitalizing the interest in the asset delays the expense to a later period. Over a long period of time, the expensed amount will be the same.

 

 

 

3.a Depreciation / Amortization issues

 

Depreciation – tangible assets

Amortization – intangible

 

Spread the acquisition cost of long term asset over life of asset. Key is to match timing of expense to timing of benefit from assets use. Note that an asset cost is what you pay for an expected series of future benefits. In that way, an asset is like a pre-payment (like paying rent in advance). When you use the asset in each month, you should recognize the expense of the service received. There is not a single correct way to do this. These depreciation expenses are the basic costs that a firm must cover in order to earn profits. Most firms amortize intangible assets using the straight-line method. Each asset class for a company may be depreciated differently. Note that depreciation does not mean a decline in economic value, instead its just a process of cost allocation for accounting only.

 

 

Depreciable basis of asset

Historical cost – salvage value

 

Salvage value is an estimate. You do not need to depreciate the salvage value, because you will get that when you sell the asset. Note: Buildings normally have zero salvage value. Many intangibles also have zero salvage value. Salvage value can be negative (nuclear power plant, for example).

 

Service Life of asset

 

Technology may become obsolete overnight.

To limit controversy, IRS made charts. MACRS for tax purposes to determine service life.

 

 

 

 

 

3.b Depreciation / Amortization schedules

 

 

The GAAP acceptable depreciation methods are:

 

-Straight-line (time) method;

-Production or use (straight-line use) method;

 

Accelerated depreciation methods:

-Declining-balance methods;

-Sum-of-the-years'-digits method.

 

 

Straight line method

 

Most commonly method is the straight-line method. It gives a uniform pattern of depreciation per year, which is important for earnings analysts. If you know the cost of removal will be $10,000, then you add that to the original cost). The calculation of the annual deprecia¬tion is:

 

 

Annual Depreciation = (Cost - Estimated Salvage Value)/ Estimated Life in Years

 

 

Straight line of usage

 

Is good for machinery or trucks, cars. You depreciate each unit used, rather than a fixed amount over time. Match expense to usage. You figure out the cost per mile (or hour / unit) by taking the total cost and dividing by the total expected usage. Then for each period that you use the asset, you multiply that $/mile ratio and figure out the monthly expense. The depreciation cost per unit of activity is:

 

 

Depreciation Cost Per Unit = (Cost - Estimated Salvage Value) / Estimated Number of Units = $ / unit

 

 

Accelerated methods

 

Give more depreciation in early years. To match usage of some assets that are useful more in the beginning, but get old.

 

Declining Balance (DB) method

 

- do not subtract the salvage value

- need to switch to straight line at some point.

- if 5 year useful life, then 1/5 = 20%...double declining balance would be = 40%

- you can choose any %. Most common is 200 DB…a 200% of declining balance

- multiplying the net book value of the asset at the start of each period (cost less accumulated depreciation) by a fixed rate.

- subtract the depreciation charge from the net book value to calculate the depre¬ciation base for the next year.

 

 

Sum of years digits (SYD) method

 

- Depreciation charge is a fraction each period

- if there are 5 periods, then 5+4+3+2+1 = 15

- first period, you depreciate (depreciable asset value) * 5/15…then in the second you * by 4/15…etc…

- unlike the DB method…in SYD you do not subtract on depreciation to find new BV

- unlike the DB method….in SYD you do subtract the salvage value to find the depreciable asset value

- each period = depreciable asset value * fraction

 

 

 

MACRS (for taxes)

 

MACRS, used for tax purposes, is an accelerated method. MACRS allows firms to ignore salvage value in calculating depreciation, which results in writing off the entire depreciable basis. Firms rarely judge MACRS appropriate for financial reporting.

 

 

 

Accounting for depreciation or amortization

 

DEBIT either asset or expense. Debit Asset to increase value of asset, or Debit Retained Earnings expense to increase expense on Income statement. Depreciation of factory buildings and equipment used for production will not be expensed immediately. Instead, it will be added to the WIP and finished goods inventories. This is strange because depreciation is actually increasing the value of an asset. The inventory value is going up because of depreciation on the building or equipment. So, while you are crediting Accumulated Depreciation of the building, you are Debiting the inventory.

 

Office furniture and equipment will be expensed as depreciation expense (Debit as well).

 

CREDIT – accumulated depreciation for Tangible assets, leaving the historical book value on record. Intangible assets, however, do not use this contra-account and instead credit directly to the intangible asset.

 

 

4. Impact of new information

 

- changes in expected service life of asset

- additional expenditures to improve or maintain assets

- changes in market values of assets

 

Changes in service life or salvage value

 

- Need to re-evaluate

- Accuracy of estimates improves over time

- don’t fix back, just adjust going forward

- spread remaining book value – new salvage value over new estimate of time

 

 

Repairs vs. Improvements

 

Repairs get expensed immediately, but improvements get capitalized (added to the value of the asset), and then expensed over time through depreciation. This has an effect on the earning statements of a company depending upon how they classify repairs vs. improvements.

 

Test – does the activity either (a) extend the useful life, or (b) increase the productive capacity? If it just restores back to original expectations, then its an expense. The improvements (betterments) are treated like a new asset acquisition. The judgment must always be made where to allocate the costs, either to maintenance and repairs or to improvements. This will have an affect on earnings. If in doubt about whether to expense or capitalize, usually it’s more conservative to expense.

 

Changes in market value

 

Don’t write up value. Just recognize benefit when you later sell. But when you have definite knowledge that the Market Value (MV) of the assets has substantially decreased, and then GAAP requires that you have to write down the value, and take a loss. This is called an “impairment” loss.

 

The new fair value is either (a) market value of the asset, or (b) net present value of future cash flows. Accountants must use market value if available.

 

 

Sales of asset

 

The disposal of an asset can affect earnings because there might be either a gain or loss (on the income statement) from the sale. This is always in relation to the book value (has nothing to do with the salvage value estimate).

 

GAIN / LOSS – recorded on books as “net” value (and not at gross value). For example, you don’t record the amount received as revenue, and the remaining book value as expense. Instead, you combine these into one gain or loss, and just record the net value on the income statement. A gain means that when the firm sold the equipment, at that time, they had already charged too much depreciation, so they have to add that back to the RE account as earnings. A loss means that the firm did not charge enough depreciation over time, and that they should have charged more depreciation. So the loss makes up the difference by subtracting from earnings in this period. This basically increases the past depreciation charges at a one-time charge. NOtE: there is no gain / no loss on a trade in. One asset swaps the value with the other + the new one takes additional value for any new cash you might add. But there will not be an expense for loss on tradein.

 

If you sell the asset part way though the year, you first have to make a depreciation expense & accumulated depreciation journal entry for part of the year. Then

 

 

 

Financial statement impacts

 

Long-lived tangible assets are found on the Balance Sheet under PPE, a non-current asset.

Manufacturing firms might include depreciation in COGS expense. See discussion of inventory for more details. Different companies report this depreciation in different ways. You have to read their notes at the end of the statements to see what they are doing. Don’t compare unlike companies!

 

 

How you account for expenditures on things with potential long-term benefits has big impacts on the financial statement analysis, impacting both the balance sheet and the income statement. This is one of the most controversial topics in financial accounting. There are differences in how you should treat tangibles and intangibles, and how you treat internally developed assets from those acquired. Knowing when to expense and when to capitalize is not easy.

 

Readers of financial statements should be cautious when comparing companies with significant long term assets, especially if they are intangible assets.

 

When a firm builds their own assets (construction)…if a firm does not need to borrow new money to build an asset, then they can take some of their other interest expenses (from long term borrowing for example), and capitalize some of them into this new asset. This will have the effect on earnings in this period (reducing an expense will increase Net Income). So income will appear higher for a firm during construction, but then later periods will show lower earnings as the firm depreciates the asset. Capitalizing the interest in the asset delays the expense to a later period.

 

Management of a company estimates both the salvage value and service life of an asset. Management can manipulate those numbers to impact earnings. If they make the Salvage Value (SV) higher, then there will be less Depreciation Expense every month, making earnings on the income statement seem higher. This can have a big impact on businesses that have a lot of fixed PPE. To see this, you need to look for increasing spread between Net Income and cash flows from operations.

 

Note: since a company uses different depreciation for taxes and reporting, the use of a higher salvage value on the reporting statements does not effect the actual amount of taxes paid. They might have decreased depreciation expense on reporting statements to inflate earnings, but used an accelerated depreciation expense for taxes to decrease tax expenses.

 

If management sets a high Salvage Value (SV), and a longer useful life expectancy, then the depreciation on the financial statements will be less, and the assets will be over valued. While this might make earnings seem higher (less depreciation expenses), it will also make assets seem higher, so ROA will be affected, as will all of the turnover ratios.

 

 

Most firms chose to use straight line depreciation because for financial reporting purposes because it stays constant each period. This is in spite of the fact that accelerated depreciation is actually better at matching, but analysts’ like to see a trend in earnings. They do not like stock prices that vary up / down. So, using straight line helps to keep the earnings predictable from period to period. Note: most firms use accelerated for tax purposes. So be aware that reported tax expenses and actual tax expenses might vary.

 

 

Repairs get expensed immediately, but improvements get capitalized (added to the value of the asset), and then expensed over time through depreciation. This has an effect on the earning statements of a company depending upon how they classify repairs vs. improvements. Better service policies for assets will mean that they last longer, and improvements will be needed less frequently.

 

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