Essentials of FA_Chapter 9

8/13/2019 Essentials of FA_Chapter 9

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Essent ia l s o f F inanc ia l Accoun t ing , Second Edi t ion ASISH K. BHATTACHARYYA

E SSENTIALS OF F INANCIAL ACCOUNTING

B Y ASISH K B HATTACHARYYA Second Edition

Chapter 9


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Fixed Assets: Characteristics

Entities acquire fixed assets with an intention to usethem in production of goods or services or for rentalor for administrative use.Usually, these provide economic benefits for morethan one accounting period.Major spare parts and stand-by equipment qualifyas PP&E when an entity expects to use themduring more than one period.

Similarly, insurance spares are accounted for asPP&E.Spare parts and servicing equipment which can be usedonly in connection with an item of property, plant andequipment are called insurance spares .

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RECOGNITION AND

MEASUREMENT OF PP&E

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Recognition Criteria

The cost of an item of property, plant and equipment(PP&E) is recognised as an asset if, and only if:(a) it is probable that future economic benefits associated

with the item will flow to the entity; and(b) the cost of the item can be measured reliably.

An entity evaluates under this recognition principle allits PP&E costs at the time they are incurred.

These costs include costs incurred initially to acquire or

construct an item of PP&E and costs incurredsubsequently to add to, replace part of, or service it.

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Items of PP&E may be acquired for safety orenvironmental reasons.

Such an item of PP&E qualifies for recognition as anasset.

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Initial Measurement

An item of property, plant and equipment thatqualifies for recognition as an asset should initiallybe measured at its cost.The cost of an item of PP&E comprises:

its purchase price;any cost directly attributable to bringing the asset to thelocation and condition necessary for it to be capable ofoperating in the manner intended by management; and

the initial estimate of the costs of dismantling and siterestoration.

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Purchase Price

The cost of an item of property, plant andequipment is the cash price equivalent at therecognition date.

The difference between the cash price equivalent andthe total payment is recognised as interest .If, the supplier charges a lower price for cash sales, thatlower price is the purchase price even if the entity haspurchased the asset on credit by paying a price higherthan the cash sales price.Usually, if the payment is deferred beyond six months ,the purchase price is the present value of price payableto the supplier.The present value is calculated using the market

interest rate .

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Exchange Difference

The carrying amount of the fixed asset is notadjusted for exchange difference arising fromsettlement or restatement of a liability, denominatedin a foreign currency, assumed on acquisition of theitem of PP&E.

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Directly Attributable Cost

A cost, which would have been avoided had theasset not been acquired, is directly attributable tobringing the asset to the location and workingcondition for its intended use.

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Directly Attributable Cost: Examples

Costs of employee benefits arising directly from theconstruction or acquisition of the item of PP&E;Costs of site preparation;

Initial delivery and handling costs;Installation and assembly costs;Costs of testing; andProfessional fees.

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Directly Attributable Cost: Examples of Cost NotIncluded in The Cost of PP&E

Costs of opening a new facility;Costs of introducing a new product or service(including costs of advertising and promotionalactivities);Costs of conducting business in a new location orwith a new class of customer (including costs ofstaff training); and

Administration and other general overhead costs.

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Costs Which are Not Included in the Carrying Amount of an Item of PP&E

Costs incurred while an item capable of operating inthe manner intended by management has yet to bebrought into use or is operated at less than fullcapacity;Initial operating losses, such as those incurredwhile demand for the items output builds up; and Costs of relocating or reorganising part or all of anentitys operations.

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Start-up Costs

Start-up and similar pre-production costs do notform part of the cost of an asset unless they arenecessary to bring the asset to its workingcondition.

Expenditure on start-up and commissioning incurredafter the commencement of commercial productionshould not be capitalised.Often, it is difficult to determine the date ofcommencement of commercial production, becauseenterprises usually sell goods produced during test runsand experimental production.It is a matter of judgement.

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Borrowing Costs

Borrowing costs that are directly attributable to theacquisition of PP&E are included in the cost ofproduction or construction of that item.

Borrowing costs for the period of construction orproduction should be capitalised.Capitalisation of borrowing costs should commence withcommencement of the activities related to theproduction or construction of the asset and shouldcease when the asset is substantially complete.Borrowing cost for the period during which theproduction is suspended should not be included in thecost of the asset, provided that the temporarysuspension is not normal to the production process.

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Asset Retirement Obligation

An entity should recognise a provision in thebalance sheet for the estimated expenditure ondismantling of the asset, removing the same andrestoration of the site and include the same in theacquisition cost of the asset.

The provision should be recognised at the present valueof the estimated amount that will be required to settlethe obligation.

Usually, the probability-weighted expected value of theamount to be spent is discounted by the risk-free rate.

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Asset Retirement Obligation: Unwinding ofthe Discount

The carrying amount of the provision increases ineach period to reflect the passage of time, and thisincrease is recognised a borrowing cost.Change in the provision due to any other reason,such as change in the estimated amount or thediscounting rate, should be adjusted to the carryingamount of the asset.

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Land Development Expenditure

Cost of land development that provides enduringbenefit to the business is capitalised.

In case of owned or leasehold land, the developmentexpenditure should be added to the cost of the land and

should not be shown separately.In case of lease-hold land, if the lease agreementprovides for recovery of development expenditure fromthe lessor on termination of the lease, the net cost of theland should be amortised.The net cost is the cost including land developmentexpenditure minus the recoverable amount, if any.

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Demolition Cost

Entities may purchase a land with a building whichis to be demolished to construct a new building forits intended use.

If, this be the case, the cost of the land is the total of thepurchase price for the land (with building) and the costof demolishing the building.No portion of the purchase price is allocated to thebuilding because the building is unusable.

The cost of demolishing the building should beconsidered as the cost for making the land ready foruse.

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Expenditure to Bring the Asset Ready forUse

Expenditure incurred to bring the fixed asset to itsworking condition is capitalised, provided the samewas contemplated at the time of acquisition of theasset.

The underlying principle is that if the purchase priceassumes that an additional expenditure would beincurred to make the asset ready for use, the additionalexpenditure should be a part of the acquisition cost.

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Asset Acquired Through a GovernmentGrant

When the government grant is in the form of non-monetary assets such as land or other resources,both the asset and the grant are recognised at fairvalue.

Alternatively, sometimes both the asset and the grantare recognised at a nominal amount.

If the grant meets only part of the cost of an asset,the same is recognised either as a deferred income

or by deducting the grant in arriving at the carryingamount of the asset.

If an enterprise recognises a government grant as adeferred income, it should be allocated over the usefullife of the asset on a systematic and rational basis.

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Component Accounting

Where several fixed assets are purchased for aconsolidated price, the consideration should beapportioned to the various assets on a fair basis asdetermined by a competent valuer.

An entity should allocate the cost of an item ofPP&E to its significant parts and recognise themseparately.

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Significant Component

The term significant part is not defined in theaccounting standard (IAS 16).

Usually, a component is considered significant if its costexceeds 10% of the total cost of the asset.

A significant part of an item of property, plant andequipment may have a useful life and adepreciation method that are the same as theuseful life and the depreciation method of another

significant part of that same item.Such parts may be grouped in determining thedepreciation charge.

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SELF-CONSTRUCTED ASSETS

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Fundamental Principle

The accumulation of costs commences when themanagement commits to the acquisition of the fixedasset.It ceases when the asset is substantially ready foruse.

The phrase substantially ready for use implies that thecapitalisation of cost should cease when only someadministrative work is left to be completed or the

production is complete except for some work which isnot technically essential for completion of the productionof the asset.

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Preliminary Stage Costs

Preliminary stage costs , which are in the nature ofresearch expenses , should be charged to the profitand loss account for the period in which they areincurred.

Examples of preliminary stage costs are costs ofexploration of opportunities for acquisition orconstruction of an asset, costs of feasibility studies,costs of engineering studies, and costs of designlayouts.

If the entity purchases an option to acquire a fixedasset, the payment should be capitalised.

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Pre-acquisition Costs

The preliminary stage ends and the pre-acquisitionstage begins when the acquisition ofthe asset is probable as evidenced bymanagements authorisation and allocation of fund.Pre-acquisition stage ends when the entity obtainsownership or control of the asset.Internal and external costs incurred in the pre-acquisition stage are charged to the profit and lossaccount for the period in which they are incurredunless those are directly attributable to the specificasset.

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Expenditure During Construction Period

Indirect expenditure essential to the constructionactivity are allocated to items of PP&E constructedduring the construction period.Expenditures that are capitalised include thefollowing:

General administration and office expenditure at theconstruction siteExpenditure on running of vehicles

Expenditure in connection with temporary structure andservice facilitiesDepreciation of fixed assets used in constructionactivities

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Expenditure During Construction Period

Accumulation of costs against a specific projectshould commence from the date the managementauthorises and commits fund for the project.Often expenditures that are in the nature ofpreliminary stage expenditure are incurred in thepre-acquisition stage. For example:

After approval of the project, the project team preparesthe detailed project report, conducts surveys and

preliminary studies, and negotiates with collaborators onthe terms and conditions of collaboration.They are directly attributable to the project and arecapitalised as a part of the project cost.

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Income During Construction Period

Some operations occur in connection with theconstruction and development of an item ofproperty, plant and equipment, but are notnecessary for construction activities.The income and related expenses of incidentaloperations should be recognised as profit or loss forthe period.However, income from operations that arenecessary for construction activities should bededucted from construction cost.

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E XCHANGE T RANSACTION

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PP&E Acquired in Exchange Transaction

IAS-16 stipulates that the cost an item of PP&Eproperty, plant or equipment acquired in exchangefor non-monetary assets or a combination ofmonetary and non-monetary assets is measured atfair value .If an enterprise is able to determine reliably the fairvalue of either of the asset received or the assetgiven up, then the fair value of the asset given up

should be used to measure the cost of the assetreceived unless the fair value of the asset receivedis more clearly evident.

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PP&E Acquired in Exchange Transaction(cont.)

The asset received in exchange is measured at thecarrying amount of the asset given up if:

(a) The exchange transaction lacks commercialsubstance; or

(b) The fair value of neither the asset received nor theasset given up is reliably measurable.

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PP&E Acquired in Exchange Transaction:Commercial Substance

An exchange transaction has commercial substanceif:(a) The configuration (risks, timing and amount) of the cash

flows of the assets received differs from the

configuration of the cash flows of the asset transferred.(b) The entity- specific value of the portion of the entitys

operation affected by the transaction changes as a resultof the exchange.

(c) The difference in (a) or (b) is significant relative to thefair value of the assets exchanged.

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PP&E Acquired in Exchange Transaction:Commercial Substance (cont.)

For the purpose of determining whether anexchange transaction has commercial substance,the entity- specific value of the portion of the entitysoperation affected by the transaction shall reflectpost-tax cash flows.

An enterprise need not have to make detailedcalculations if the result of these analyses is clear.In most situations, an exchange of similar assets doesnot have a commercial substance. Therefore, inexchange of similar assets, no gain or loss isrecognised.

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SUBSEQUENT

EXPENDITURE

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General Principle

Recognition criteria for the initial recognition of anitem of PP&E should be applied in deciding whetherexpenditure on an existing item of PP&E should becapitalised.

If the expenditure fulfills the criteria, either the carryingamount of the item of the PP&E is adjusted or it isrecognised as a separate component of the asset.

An expenditure that fails to meet the recognition criteriashould be recognised as an expense in the profit andloss account for the period in which the expenditure isincurred.

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Examples of Costs That are UsuallyCapitalised

The following examples of expenditure that areusually recognised in the carrying amount of anitem of PP&E:(a) Costs of modification of an item of PP&E to extend its

remaining useful life;(b) Costs of modification of an item of PP&E to increase

its capacity;(c) Costs of upgrading machine parts to achieve a

substantial improvement in the quality of output; and(d) Costs for the development of a new production

process enabling substantial reduction in operatingcosts.

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Repair and Maintenance

The costs of the day-to-day servicing of the item ofPP&E are recognised in profit or loss as incurred.

Costs of day-to-day servicing are primarily the costs oflabour and consumables, and may include the cost of

small parts.

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Replacement of Parts

Parts of some items of PP&E may requirereplacement at regular intervals.

For example, a furnace may require relining after aspecified number of hours of use

Items of PP&E may also be acquired to make a lessfrequently recurring replacement, such as replacing theinterior walls of a building

An entity recognises in the carrying amount of an

item of PP&E, the cost of replacing part of such anitem when that cost is incurred if the recognitioncriteria are met.

The carrying amount of those parts that are replaced isderecognised.

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Inspection and Overhaul

A condition of continuing to operate an item ofproperty, plant and equipment (for example, anaircraft) may be performing regular majorinspections for faults, regardless of whether parts of

the item are replaced.When each major inspection is performed, its cost isrecognised in the carrying amount of the item of PP&Eas a replacement if the recognition criteria are satisfied.

Any remaining carrying amount of the cost of theprevious inspection (as distinct from physical parts) isderecognised.

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Relocation Costs

Cost of re-deploying or relocating an item of PP&Eshould be recognised as an expense as it isincurred.

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S UBSEQUENT MEASUREMENT

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Fundamental Principle

An entity can choose either the cost model or therevaluation model as its accounting policy.Once the choice is made, and shall apply thatpolicy to an entire class of PP&E.Most companies use the cost model for subsequentmeasurement of items off PP&E.

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Cost Model

After recognition as an asset, an item of PP&E iscarried at its cost less any accumulateddepreciation and any accumulated impairmentlosses.

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Revaluation Model

Revaluation model can be used only for those itemsof PP&E whose fair value can be measured reliably .

After recognition as an asset, an item of PP&E iscarried at a revalued amount, being its fair value atthe date of the revaluation less any subsequentaccumulated depreciation and subsequentaccumulated impairment losses.Items of PP&E should be revalued with sufficient

regularity to ensure that the carrying amount doesnot differ materially from the fair value at the end ofthe reporting period.

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Revaluation Model: Fair Value

The fair value of land and buildings is usuallydetermined from market-based evidence byappraisal that is normally undertaken byprofessionally qualified valuer.

The fair value of items of plant and equipment isusually their market value determined by appraisal.

If there is no market-based evidence of fair valuebecause of the specialised nature of the item of

property, plant and equipment, an entity estimates thefair value using an income or a depreciated replacementcost approach.

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Revaluation Model: Frequency ofRevaluation

The frequency of revaluations depends upon thechanges in fair values of the items of property, plantand equipment being revalued.

When the fair value of a revalued asset differs materially

from its carrying amount, a further revaluation isrequired.

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Revaluation: Accounting Method

If an assets carrying amount is increased as aresult of a revaluation, the increase is recognised inother comprehensive income and accumulated inequity under the heading of revaluation reserve.

However, the increase is recognised in profit or loss tothe extent that it reverses a revaluation decrease of thesame asset previously recognised in profit or loss.

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Revaluation: Accounting Method (cont.)

If an assets carrying amount is decreased as aresult of a revaluation, the decrease is recognisedin profit or loss.

However, the decrease is recognised in other

comprehensive income to the extent of any creditbalance existing in the revaluation surplus in respect ofthat asset.The decrease recognised in other comprehensiveincome reduces the amount accumulated in equityunder the heading of Revaluation Reserve.

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The revaluation reserve included in equity inrespect of an item of property, plant and equipmentmay be transferred directly to retained earningswhen the asset is derecognised.

This may involve transferring the whole of therevaluation reserve when the asset is retired ordisposed of.

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However, some of the revaluation reserve may betransferred as the asset is used by an entity.

In such a case, the amount of the surplus transferredwould be the difference between depreciation based on

the revalued carrying amount of the asset anddepreciation based on the assets original cost.Transfers from revaluation surplus to retained earningsare not made through profit or loss.

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Revaluation Reserve

Revaluation reserve represents accumulatedunrealised gain arising from revaluation of items ofPP&E.The revaluation reserve is not available fordistribution to shareholders either as dividend or asbonus shares.

Although revaluation reserve is a component ofreserves and surplus, financial analysts, while

calculating financial ratios, reduce equity (networth) and the carrying amount of PP&E by theamount of revaluation reserve in the balance sheet.

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PP&E H ELD F OR S ALE

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Classification

An entity classifies an item of PP&E as Held forSale if its carrying amount can be recoveredprincipally through a sale transaction rather thanthrough continuing use.

The appropriate level of management must becommitted to a plan to sell the asset and an activeprogramme must have been initiated.The sale should be expected to qualify for recognitionas a completed sale within one year from the date ofclassification.

An entity continues to classify the asset as held for saleif events or circumstances that have extended theperiod to complete the sale beyond one year are notwithin the control of the entity.

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Measurement

An entity measures an item of PP&E classified asHeld for Sale at the lower of its carrying amountand fair value less costs to sell .The carrying amount immediately before theclassification should be determining applying theprinciples discussed above.The gain or loss arising from re-measurement ofthe asset at each balance sheet date should be

recognised as gain or loss in the profit and lossaccount.

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Presentation

An entity presents an item of PP&E classified asHeld for Sale separately from other assets in thebalance sheet.

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INTANGIBLE A SSETS

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Characteristics

Common examples of intangible assets arecomputer software, patents, copyrights, motionpicture, films, customer lists, mortgage servicingrights, fishing licences, import quotas, franchises,

customer or supplier relationships, customer loyalty,market share and marketing rights.

Not all the items described above meet the definition ofan intangible asset.Contemporary accounting practice does not allowrecognition of internally generated intangible assets,except software.If no intangible asset is recognised from expenditure, itis recognised as an expense when it is incurred.

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Definition

An intangible asset is an identifiable non-monetaryasset without physical substance.

The definition of an intangible asset requires anintangible asset to be identifiable to distinguish it from

goodwill.Intangible assets are fixed assets without physicalsubstance.

They provide economic benefits to the entity only incombination with other assets being used for thebusiness. They enhance the service potential of otherassets.

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Goodwill

Goodwill is an amorphous asset that an entitycreates in the course of its operation.

It arises from business connections, trade name, regularcustomers, a good reputation and efficient

management.It subsumes intangibles like corporate brand (e.g. highlyrespected company), product brand, organisationculture, knowledge, high employee morale andcustomer relationship.

It is the preeminent unidentifiable intangible asset.

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Gain from a Bargain Purchase

Occasionally, an acquirer makes a bargainpurchase, which is a business combination in whichthe amount of the purchase consideration is lessthan the fair value (net of the amount of liabilities

acquired) of identifiable assets acquired in thetransaction.The acquirer recognises the excess of the fair valueover the purchase consideration in the profit or loss

for the period in which the acquisition occurred asgain on a bargain purchase.

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Identifiability of an Intangible Asset

An intangible asset is identifiable when it:(a) is separable from goodwill; or(b) arises from contractual or other legal rights, regardless

of whether those rights are transferable or separable

from the enterprise or from other rights and obligations. An intangible asset is separable, if the entity couldrent or dispose of the asset without also disposingof the business in which it is used.

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Intangible Assets Contained in or on aPhysical Substance

Some intangible assets may be contained in or on aphysical substance, but the cost of the physicalsubstance containing the intangible asset is usuallynot significant.

Therefore, the cost is commonly treated as a part ofthe intangible asset.

Examples are compact disk, legal documentation orfilm.

In case an intangible asset is an integral part of atangible fixed asset, judgement is required onwhether such an asset should be accounted for asan item of PP&E or as an intangible asset.

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Control

Control is an important element in the definition ofan asset.Usually, the ability of an entity to control the futureeconomic benefits flows from legal rights that areenforceable in the court of law.

However, legal enforceability of a right is not anecessary condition.

In many situations, the control over assets that

could otherwise be classified as intangible assets isinsufficient.

Therefore, many intangibles do not find place in thebalance sheet as assets.

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An item that is identified as intangible asset shouldbe recognised if and only if:(a) It is probable that the future economic benefits that are

attributable to the asset will flow to the enterprise; and

(b) The cost of the asset can be measured reliably. An entity should assess the probability of the futureeconomic benefit using reasonable and supportableassumptions .

Those assumptions should represent best estimate ofthe set of economic conditions that will exist over theuseful life of the asset.

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Initial Measurement

Intangible assets acquired separately are measuredat cost.

An intangible asset acquired free of charge by wayof government grant should be recorded at the fairvalue of the asset or at a nominal value, say, at Re.1.If an intangible asset is acquired in a businesscombination, the cost of that intangible asset is its

fair value at the date of acquisition.

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Internally Generated Goodwill

Internally generated goodwill is not recognised asan asset.

Therefore, goodwill appears in the balance sheet of anentity only when it recognises goodwill in a business

combination.

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Expenditure During Research Phase

No asset is recognised from expenditure incurredduring the research phase.

Expenditure incurred during the research phase shouldbe recognised as an expense for the period in which the

expenditure is incurred.Expenditure on research includes payment to otherparties for research activities carried out on behalf of theentity.If an item of property, plant and equipment that ispurchased and used for use in research has alternativeuses, it is accounted for like any other item of PP&E.

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Expenditure During Development Phase

An entity recognises an asset from developmentphase expenditure, only if the entity demonstratesthe following:(a) The technical feasibility of completing the intangible

asset;(b) Its intention to complete the intangible asset and use

or sell it;(c) Its ability to use or sell the intangible asset;(d) The commercial viability of the intangible asset;(e) The availability of adequate technical, financial and

other resources to complete the development and touse or sell the intangible asset; and

(f) Its ability to measure the expenditure reliably

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Expenditure During Development Phase(cont.)

The accumulation of cost of an asset from theexpenditure during the development phase shouldcommence from the time when the intangible assetfirst meets the recognition criteria.

Usually, entities do not recognise asset from thedevelopment expenditure because it is often verydifficult to demonstrate that the expenditure meets therecognition criteria.

Expenditure on an intangible item that was initiallyrecognised as an expense should not berecognised as part of the cost of an intangible assetlater .

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Internally Generated Brands, etc.

Internally generated brands, mastheads, publishingtitles, customers-list and items similar in substanceshould not be recognised as intangible assets:

Expenditure on those items cannot be distinguished

from the cost of developing the business as a whole.Brands and similar assets acquired eitherindividually or with other assets should berecognised in the balance sheet.

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Software for Internal Use

Preliminary stage costs should be recognised asexpenses for the period in which those cost areincurred.

Cost capitalisation commences when an entity has

completed the conceptual formulation, design, andtesting of possible project alternatives, including theprocess of vendor selection for purchased software.

Costs incurred subsequent to the preliminaryproject stage, are capitalised if they are expected toprovide economic benefits over a number ofperiods.

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Software for Internal Use (cont.)

Costs incurred during the application developmentstage are also capitalised.These include coding and testing activities andvarious implementation costs.

These costs are limited to:(a) External direct costs;(b) Employee costs to the extent of time directly spent on

the project; and

(c) Interest cost incurred while developing internal-usesoftware.

General and administrative costs, overheads andtraining costs are expensed as incurred.

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Web Site Development Costs

An entitys own Web site that arises fromdevelopment is an internally generated intangibleasset.Development expenditure should be recognised as

an intangible asset if and only if an entity candemonstrate how its Web site will generateprobable future economic benefits.

For example, it may demonstrate that the Web site is

capable of generating revenues, including directrevenues from enabling orders to be placed.

Expenditure on developing a Web site to be usedfor promoting its own products should berecognised as an expense when incurred.

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Web Site Development Costs (cont.)

Any internal expenditure on the development andoperation of an entitys own Web site shall beaccounted for in accordance with principles foraccounting of development expenditure.

The nature of each activity for which expenditure isincurred (e.g. training employees and maintainingthe Web site) and the Web sites stage ofdevelopment or post-development should be

evaluated to determine the appropriate accountingtreatment.

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Web Site Development Costs (cont.)

The following general guidelines may be followed:(a) Expenditure incurred in the planning stage should be

recognised as an expense.(b) Expenditure incurred in the application and

infrastructure development stage , the graphical designstage and the content development stage should beincluded in the cost of a Web site recognised as anintangible asset.

(d) Expenditure incurred in operating stage should berecognised as an expense when it is incurred.

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ANALYSTS P ERSPECTIVE

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Property, Plant and Equipment

In most cases, items of PP&E are presented in thebalance sheet at the acquisition cost less accumulated depreciation less accumulatedimpairment loss.

Therefore, the carrying amounts of PP&E in the balancesheet of comparable entities are not comparable.Consequently, financial ratios which use in thenumerator a number from the profit and loss account,and in the denominator use a number from the balancesheet are not comparable even for comparable entities.

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Property, Plant and Equipment (cont.)

Analysts prefer not to adjust balance sheet figuresfor current cost of the items of PP&E for tworeasons.

The first reason is that, as an outsider, they will have to

incur significant costs to collect information required forreplacing book values of items of PP&E for currentcosts.The second reason is that the distortion due toaccounting choice is not very significant.

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An example1

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AL (Amount in Rs.) HL (Amount in Rs.)

Year

2008

Year

200 9

Year

20 1 0

Year

2008

Year

200 9

Year

20 1 0

Sales 6 , 000 6,600 7,260 6 , 000 6,600 7,260

Earnings before int erest and tax 1,200 1,320 1,452 1,200 1,320 1,452

Interest 0 0 0 0 0 0

Income tax @ 30% 360 396 436 360 396 436

Net profit 840 924 1016 840 924 1016

Net book value of PP&E (average

of opening and closing balances)

5,500 4,500 3,500 12,750 11,250 9,750

Working capital 1500 1650 1815 1500 1650 1815

Average invested capital 7 , 000 6,150 5,315 14.250 12,900 11,565

Return on invested capital (%) 12 15.02 19.12 5.89 7.16 8.79

Asset turnover 0.86 1.03 1.37 0.42 0.51 0.63


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ConclusionsThe productivity of PP&E and other assets, in terms ofsales and net operating profit less adjusted tax(NOPLAT), is the same for both AL and HL.

However, the capital productivity of AL, in terms ofreturn on invested capital (ROIC) and asset turnover, ishigher for AL as compared to HL.Even the fair value of the items of PP&E held by ALshould be lower than the fair value of those held by HL

because the remaining useful life of items held by AL islower than those held by HL.Therefore, even if fair value is used to measure items ofPP&E, the benefit of lower investment by AL will getreflected in ROIC and asset turnover.

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Expensed Investment

GAAP does not allow recognition of any asset fromadvertising and sales promotion expenditure andalso from research expenditure.Most entities do not recognise asset from

development expenditure. Analysts consider those expenditures asinvestment.

Accordingly, they adjust financial statements before

analysis.

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Expensed Investment: Steps for


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Expensed Investment: Steps for Adjustments

The first step in capitalising the expenditure is to choosean amortisation period.The choice is guided by the product and industrycharacteristic.The choice is judgmental and hence is subjective.The next step is to take financial statements from say,five years (amortisation period) prior and makenecessary adjustments.Capitalisation of those expenditures increases the

invested capital, often without changing the reportedprofit.Income tax expense should not be adjusted becauseincome tax law allows deduction those expenditures infull for calculating the taxable income.

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Expensed Investment: Example

Advertisement expenditure Rs. 5,000 per annum; Amortisation period five years.

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Year Expenditure

(Rs.)

Amortisation

(Rs.)

Change in inves ted

capital reported in th e ba lance sheet (Rs.)

C hange in net profit

reported in the profit andloss account (Rs.)

1 5 , 000 1,000 + 4,000 + 4,000

2 5 , 000 2,000 +7,000 + 3 ,000

3 5 , 000 3,000 + 9,000 + 2,000

4 5 , 000 4,000 + 1 0 ,000 + 1,000

5 5 , 000 5,000 + 10,000 0


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END

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Essentials of FA_Chapter 9

Documents