Long-Lived Assets Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 10 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction.

Long-Lived Assets

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 10

Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Learning objectives

1. What measurement base is used for long-lived assets.

2. What kinds of costs are capitalized and how joint costs are allocated among assets.

3. How GAAP measurement rules complicate trend analysis and comparisons across companies.

4. Why the carrying values of internally developed intangibles often differ from their real values.

5. When long-lived asset impairment exists and how it is recorded.

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Learning objectives

6. How to account for asset retirement obligations and assets held for sale.

7. How different depreciation methods are computed.

8. How analysts can adjust for different depreciation assumptions and improve comparisons across companies.

9. How to account for exchanges of long-lived assets.

10.The key differences between GAAP and IFRS requirements for long-lived asset accounting.

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Long-lived operating assets

An asset generates future economic benefits and is under the exclusive control of a single entity.

This chapter concentrates on operating assets expected to yield their economic benefits (service potential) over a period longer than one year.

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Measuring the carrying amount

There are two ways that long-lived assets could be measured on balance sheets:

Expected benefit approach:

$$

• Discounted present value

• Net realizable value

Estimated value in an output market where the asset is sold

Economic sacrifice approach:

$$• Historical cost

• Replacement cost

Estimated value in an input market where the asset is purchased

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Measuring the carrying amount:Illustration of four approaches

Assume a truck originally costing $100,000, is two years old, has a remaining life of 8 years, is being depreciated on a straight-line basis, and is expected to have no salvage value.

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Initial asset measurement rules

The initial balance sheet carrying amount of a long-lived asset is governed by two rules:

1. All costs necessary to acquire the asset and make it ready to use are included in the asset account (meaning they are capitalized costs). Other costs are “expensed” to income.

$$ $$

$$ $$

Capitalized Expensed

Price paid for land

Cost of clearing land

Monthly equipment rental

Cost to repair damaged equipment

$200 delivery and installation fee

Equipment A

Equipment B

$100

$100

2. Joint costs incurred in acquiring more than one asset are apportioned among the acquired assets.

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Initial asset measurement rules:Example

Special GAAP rules apply

Purchase price

Preparation costs

Joint cost

Construction costs

Joint cost

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Initial asset measurement rules:Interest capitalization

Authoritative accounting literature requires capitalization of avoidable interest payments on self-constructed assets.

Interest paid to lenders during the construction period is considered to be a cost necessary to prepare the asset for its intended use.

Here is Canyon’s calculation of avoidable interest:

Follows from initial asset measurement rule 1.

Construction expenditures

If the interest rate is 10%, then Canyon’s avoidable interest is $715,000.

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GAAP limits the amount of interest capitalized.

Initial asset measurement rules:Interest capitalization concluded

Case 1:

$715,000

$800,000

$715,000

Avoidable interest

Actual interest

Interest capitalized

Case 2:

$715,000

$600,000

$600,000

Avoidable interest

Actual interest

Interest capitalized

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Actual interest is less in this case

Therefore only $600,000 would be capitalized

For financial reporting and tax purposes, the allocation is guided by which one (the land or the building) generated the cost.

Initial asset measurement rules:Tax versus financial reporting incentives

The way incurred costs are allocated between land and buildings affects the amount of income that will be reported in future periods.

$100

$500

• Higher depreciation

• Lower net income

• Lower taxes

Land Building

Allocation 1:

$500

$100

• Lower depreciation

• Higher net income

• Higher taxesLand Building

Allocation 2:

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Capitalization criteria:Costs incurred after initial use

GAAP capitalizes costs incurred after the asset has been placed in use as long as the expenditure:

Extends the asset’s useful life Increases its productive capacity (e.g. attainable production units) Increases its production efficiency (e.g., fewer raw materials) Or, increases the asset’s other economic benefits

If there is no increase in economic benefits (or future service potential), the expenditure is charged to income as an expense.

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Capitalization criteria:Costs incurred after initial use

Suppose that in January 2017, Winger spends an additional $8,000

$6,000 for the installation of a new component that allowed the machine to consume less raw material and operate more efficiently

Capitalized in 2017 and added to the carrying amount of the machine

$2,000 for ordinary repairs and maintenance

Period expense

Capitalization runs amok

Impact of Worldcom’s Misapplication of Asset Capitalization Rules

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Intangible assets:Overview

Intangible assets are long-lived assets that do not have physical substance. They include:

The accounting for acquired intangible assets is straight-forward: The asset is first recorded at the arm’s length transaction price. Then amortized (think “depreciation”) over its expected useful

life. Difficult financial reporting issues arise when the intangible asset is

developed internally instead of being purchased.

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Patents Copyrights Trademarks Brand names Customer lists

Licenses Technology Franchises Employment contracts

Intangible assets:Research and development (R&D)

Recoverability of R&D expenditures (i.e., the future benefit) is highly uncertain at the start of a project.

So, GAAP requires virtually all R&D expenditures to be expensed as incurred.

In the pre-Codification document for research and development costs, the FASB justified expensing all R&D for three reasons:1. The future benefits are highly uncertain and difficult to predict.

2. A causal relationship between current R&D and future revenue (the benefit) has not been demonstrated.

3. Whatever benefits may arise cannot be objectively measured.

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Intangible assets:Software development

Authoritative accounting literature extends the accounting treatment for R&D to internal expenditures for software development.

Expensed as incurred

Capitalized and amortized

Development expenditures $$

Development expenditures $$

Software project time line

Technological feasibility established

Before After

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Asset impairment:Long-lived Asset Impairment Guidelines

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Figure 10.2

Asset impairment:Example

Impairment possible?

Undiscounted net cash flows expected

Are cash flows lowerthan carrying amount?

Impairment loss

Yes!

$1,500,000

$1,250,000 ($2,000,000 - $750,000)

Yes!

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Asset impairment:Case Study of Impairment Recognition and Disclosure: Krispy Kreme Doughnuts

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Krispy made the following aggregate journal entry to record its new 2011 impairment losses

Obligations arising from retiring long-lived assets

Kali records the asset retirement obligation (ARO) when the asset is placed into service:

This results in additional depreciation expense:

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Obligations arising from retiring long-lived assets

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The entry to record the increase in the liability in 2014

Assume that an outside contractor dismantles the rig early in January 2019 at a cost of $11,750,000.

Assets held for sale

Table from middleof page 531

When firms actively try to sell assets they own, the asset groups should be classified on the balance sheet as “held for sale”.

When assets are held for sale, they are reported at the lower of book value or fair market value minus costs to sell.

$2,500,000

Book value

$2,350,000$46,000

$2,304,000

Fair value Expected cost to sell

So, these assets would be shown on the balance sheet at $2,304,000.

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Depreciation:Basic concepts

The costs of productive assets must be apportioned to the periods in which they provide benefits (matching principle).

The cost to be allocated to periods is the asset’s original historical cost minus its expected salvage value.

Depreciation is not intended to track the asset’s declining market value.

Depreciation• Buildings• Equipment

Amortization • Intangibles

Depletion• Mineral deposits• Wasting assets

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Depreciation:Straight-line example

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Depreciation:Units of Production (UP) example

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Depreciation:Double-declining balance example

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Depreciation:Sum-of-the-years’ digits example

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Depreciation:Alternative patterns

Figure 10.3 Alternative depreciation methods

Annual depreciation charges

Net book value

Total depreciation expenses will be the same

Ending book values will be the same

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Financial Analysis and Depreciation Differences

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Financial Analysis and Depreciation Differences

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Exchanges of Nonmonetary assets

Sometimes firms exchange one nonmonetary asset like inventory or equipment for another nonmonetary asset.

Unless certain exceptions apply, the recorded cost of the acquired asset is the fair market value of the asset given up.

FMV of truck plus cash

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Exchanges recorded at book value:Fair value not determinable

Because neither crane’s FMV is known, the new crane is recorded as:

BV of old crane plus cash

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Recall the Rohan Department Store example:

GAAP requires that the exchange must possess commercial substance:

The firm’s future cash flows are expected to change as a result of the transaction;

And, the amount of cash flow is significant relative to the fair value of the assets exchanged.

If the exchange lacks commercial substance, then book value must be used. No gain or loss is recorded.

Exchanges recorded at book value:Fair value is determinable

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Because the exchange does not culminate an earnings process, the plasma sets are recorded as:

Exchanges recorded at book value:Exchange transaction to facilitate sale

Book value of asset surrendered with no gain

or loss recorded

The $12,000 gain on the swap ($52,000 fair value minus $40,000 book value) will be recognized only when the plasma sets are ultimately sold to customers.

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Exchanges recorded at book value:Cash received—a special case

Lee also receives $5,778 cash from Bonnie.

10% of ($52,000 + $5,778 - $40,000)

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Global Vantage PointComparison of IRFS and GAAP Long-Lived Asset Accounting

Tangible Long-Lived Assets

IAS 16 allows two different models• Cost Method – same as U.S. GAAP• Revaluation Method – asset is carried at a revalued amount reflecting

fair market value at the revaluation date. Subsequent depreciation is based on fair value, not original cost. The amount of the write-up is credited to an owners’ equity account called Revaluation Surplus (equivalent to Accumulated other comprehensive income).

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Global Vantage PointComparison of IRFS and GAAP Long-Lived Asset Accounting

Tangible Long-Lived Assets

IAS 16 allows two different models

Cost Method – same as U.S. GAAP

Revaluation Method – asset is carried at a revalued amount reflecting fair market value at the revaluation date. Subsequent depreciation is based on fair value, not original cost. The amount of the write-up is credited to an owners’ equity account called Revaluation Surplus (equivalent to Accumulated other comprehensive income).

Intangible Long-Lived Assets Similar to U.S. GAAP except that a revaluation method is allowed,

but an active market must be available for the intangible. IAS 38 distinguishes between research and development

Research is expensed Development may be capitalized if certain criteria is met.

Impairment of Assets Similar to U.S. GAAP unless the impairment loss occurs if the

carrying value exceeds the recoverable amount

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Summary

The need for reliable and verifiable numbers causes long-lived assets to be measured using historical cost.

The balance sheet amounts for intangible assets often differ from their real value.

Changes in the amount of capitalized interest from one period to another can distort earnings trends.

When comparing return on assets (ROA) ratios across firms, remember that ROA drifts upward as assets age.

Asset impairment write-downs depend on subjective forecasts and could be used to manage earnings.

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Summary concluded

Depreciation differences can complicate comparisons across firms. Note disclosures can be used to improve these comparisons.

International practices for long-lived assets are sometimes very different from those in the United States.

Some of the key differences between IFRS and GAAP relate to the revaluation of tangible assets, investment property, capitalization of intangible development costs, and impairment losses.

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