Cfa Level 1 - Section 8 Assets

CFA Level 1 - Assets Email to Friend Comments

8.1 - Introduction Section 8 focuses on the asset side of the balance sheet. We will discuss current and long term assets, including inventory analysis. We have provided many examples throughout the section that will aid your learning experience. Note how changes in these accounts affect the ratios – pay careful attention as to what constitutes a credit vs. debit. In Section 9 we will discuss the liability side of the balance sheet. 8.2 - Choosing the Appropriate Accounting Method Choosing the appropriate accounting method for investment securities Classification & accounting treatment •

Trading securities – These are securities held by a company that it intends to buy and sell for a short-term profit. These securities are reported at their fair market value. Gains and losses will be included on the income statement. They are classified as unrealized holding gains or losses on the income statement, and the counter account on the balance sheet is allowance for adjusted short-term investments to market.

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Available for sale – This is generally a default category. The accounting for available-for-sale securities looks quite similar to the accounting-for-trading securities. There is one big difference between the accounting-for-trading securities and available-for-sale securities. This difference pertains to the recognition of the changes in value. For trading securities, the changes in value are recorded in operating income. However, for available-for-sale securities the changes in value go into a special account, which is called “unrealized gain/loss in other comprehensive income”, which is located in stockholders’ equity. The income statement will be unaffected. The counter account to unrealized gain/loss in other comprehensive income is short-term available-for-sales fair market adjustment.

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Held to maturity – These are securities held by a company that it intends to buy and hold to maturity. These securities are record at cost (Purchase price + communions or other fees) and gain or losses are only recognized after the company has sold the securities.

Accounting Impact Classification

Assessment Guidelines

Initially

Subsequently

Trading

Intent to buy/sell for short-term profits

Record at fair market Attribute gains and losses to operating value income

Available for Sale

Default Category

Record at fair market Attribute gains and losses to value stockholders' equity

Held to Maturity

Intent to buy and hold until fixed future Original cost maturity date

No record

8.3 - Accounting for Credit Transactions Most businesses give customers a certain number of days (30 to 60 days) to pay for delivered products and services. This is referred to as “extending credit to customers”. Under accrual accounting, sales made on credit are recorded on the income statement. The notyet-collected money is recorded under accounts receivable. Unfortunately, some customers will not want or be able to pay (because of bankruptcy) the company. Company’s can utilize two different approaches to account for these uncollectible accounts. The first is to account for them as they occur. Companies mostly use this method for income tax calculations and/or because its bad debts are immaterial. This method is called the “direct write-off method of accounting for bad debts”. Once the company determines that an account is uncollectible, it will debit (which is an increase) the bad debt expense and credit accounts receivable (which is a decrease) The second method used by companies, which is more consistent with the matching accounting principle, is to estimate the bad debt on an ongoing basis. This is referred to as the “allowance method for bad debt”, and it is accounted for in allowance for doubtful accounts. Accounting for Credit Sales 1) The direct write-off method ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay. Here’s the accounting record:

The 3C account has been overdue for six months and will most likely be uncollectible. The company decides to write it off:

2) Allowance method for bad debt ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay. Accounting record:

The company estimates that 1% of accounts receivable will become uncollectible:

Unfortunately, 3C has declared Chapter 7 bankruptcy. The 3C account needs to be written off. Currently the Company has 400,000 in allowance for doubtful accounts:

8.4 - Basics of Inventories INVENTORIES - BASICS Inventory Processing Systems Inventory-processing systems relate to the timing of the assessment of inventory. They can be valued on a continuous basis (physical count of inventory will be done after each sale) or periodically (physical count of inventory will be done at the end of each period). For most businesses, continuous revaluation of their inventory is too expensive and generates little value. As a result, most companies evaluate their inventory periodically. The inventory-costing methods used relate to the way management has decided to evaluate the cost of their inventory, for example, specific identification, average cost, first in first out (FIFO), or last in first out (LIFO). The costing method will have an impact on the estimated value of the inventory on hand and the estimated cost of goods sold (COGS) reported on the income statement. The valuation method is the process by which the inventory is valued. GAAP requires inventory to be valued at

the lower of cost to market (LCM) valuation. Market valuation is defined as replacement cost. The choices made by management with the inventory- processing systems, the inventory-costing method and the valuation method used will affect what is reported on a company's balance sheet, net income statement (profits) and cash flow statement. All these choices should be driven by the application of the matching principle. Unfortunately, these choices are sometimes driven by the owner/management tax implications (usually among private companies), or by the intention to artificially increase a company's profitability (usually among public companies). Inventory Cost Inventory cost is the net invoice price (less discounts) plus any freight and transit insurance plus taxes and tariffs. Inventory includes not only inventory on hand but also inventory in transit. Furthermore, inventory does not have to be a finished product to the included. The cost of inventory can be calculated based on: 1) the specific identification method, 2) the average-cost method, 3) first in, first out (FIFO), and 4) last in, first out (LIFO) GAAP allows management to use four methods to evaluate inventory. We will use the following example to illustrate each of these methods. Example: Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1) The Specific-identification Inventory Method Under this inventory method each unit purchased for resale is identified and accounted for by its invoice. Companies that use this method carry a small number of units. Cost of goods sold: $75 (ID: 102 and 103) Ending inventory: $55 (ID: 101 and 104) Gross profit: $300-$75 = $225 2) Average-cost Method Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry a large number of units. Total cost: $130 Average cost: $33 per unit (total cost / total number of units) Cost of goods sold: $66 ($33*2 units sold) Ending inventory: $66 ($33*2 units left) Gross profit: $300-$66 = $234 3) First-in, First-out (FIFO)

Under this inventory method the units that were first purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 101 and 102) Ending inventory: $65 (ID: 103 and 104) Gross profit: $300-$65= $235 4) Last-in, First-out (LIFO) Under this inventory method the units that were last purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 103 and 104) Ending inventory: $65 (ID: 101 and 102) Gross profit: $300-$65 = $235 8.5 - Effects of Misstated Inventory Overstating (O) or understanding (U) inventory has an effect not only on the balance sheet but also on reported income and cash flow. O and U occur when the purchase price and value of inventory change over time. Let's take, for example, a company that trades scrap steel. The best way to illustrate O and U is to do it through an example. Basic concept: Formula 8.1 COGS = beginning inventory + purchases – ending inventory If the price of a company's inputs (such as steel, lumber, etc.) is rising: FIFO method:

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COGS will be understated. Income will be overstated. The company will pay more income tax and have a lower cash flow. Assets on the balance sheet will be more reflective of the actual market value. Working capital and current ratio will be increased.

LIFO method • • • • •

COGS will be more reflective of current market environment. Income will be lower. The company will pay less income tax and cash flow would be higher. Assets would be understated and not reflective of its market value. Working capital and current ratio will be decreased.

Average-cost method •

Since it's an average, it would be in between LIFO and FIFO

Specific identification method •

If this method is used, it is extremely hard to tell, since each product has been accounted for individually.

Look Out! The CFA institute focuses mostly on differences between LIFO and FIFO, hence our focus in this discussion.

8.6 - Inventory Valuation GAAP requires inventory to be valued at the lower of cost to market. LCM can be calculated by using the itemby-item method or the major-category method. 1. The item-by-item method – This methods will look at each item and determine the LCM. Example:

2.The major-category method – Under this method, each category is grouped and the lower of the cost to market is taken. Example – Assume that our prior example represents a category.

Under this method the LCM should be $850. 8.7 - Inventory Analysis Computing Inventory Balances In computing ending inventory balances under the various methods we will use the following example. Example: Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1.Average-cost method - Under this inventory method the units in inventory are considered as a whole and their cost is averaged out. Companies that use this method carry large amount of units. Total cost: $130 Average cost: $33 per unit (total cost / total number of units) Cost of goods sold: $66 ($33*2 units sold) Ending inventory: $66 ($33*2 units left) Gross profit: $300-$66 = $234 2.First in first out - Under this inventory method, the units that were first purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 101 and 102) Ending inventory: $65 (ID: 103 and 104) Gross profit: $300-$65 = $235 3.Last in first out - Under this inventory method the units that were last purchased are assumed to be sold first. Cost of goods sold: $65 (ID: 103 and 104) Ending inventory: $65 (ID: 101 and 102) Gross profit: $300-$65 = $235 Usefulness of Inventory Data When Prices Are Stable or Changing

If the cost of purchasing inventory remains stable, the method used to calculate the cost of goods sold (by FIFO, LIFO or average cost) will yield similar results. On the other hand, in a changing environment this can distort the reported income, cash flow and inventory. Rising Price (Inflationary) Environment FIFO method • • • • • •

COGS will be understated. Income will be overstated. The company will pay more income tax and have a lower cash flow. Assets on the balance sheet will be more reflective of the actual market value. Working capital and current ratio will be increased. Inventory turnover (COGS / average inventory) will worsen (decrease).

LIFO method • • • • • •

COGS will be more reflective of current market environment. Income will be lower. The company will pay less income tax and cash flow will be higher. Assets will be understated and not reflective of its market value. Working capital and current ratio will be decreased. Inventory turnover (COGS / average inventory) will improve (increase).

Average-cost method •

Since it's an average, it would be in between LIFO and FIFO.

Decreasing Price (Deflation) Environment FIFO method • • • • • •

COGS will be more reflective of current market environment. Income will be lower. The company will pay less income tax, and cash flow would be higher. Assets will be understated and not reflective of its market value. Working capital and current ratio will be decreased. Inventory turnover (COGS / average inventory) will improve (increase).

LIFO method • • • • • •

COGS will be understated. Income will be overstated. The company will pay more income tax and have a lower cash flow. Assets on the balance sheet will be more reflective of the actual market value. Working capital and current ratio will be increased. Inventory turnover (COGS / average inventory) will worsen (decrease).

Look Out! Make sure you understand this concept very well.

Analysts should be aware that companies that operate in a rising-price environment and utilize the LIFO method could manipulate their earnings. To manipulate the earnings management could simply stop purchasing new inventory and start dipping into their old and cheap inventory. This is call "LIFO liquidation". Most U.S. companies use LIFO as opposed to FIFO. Given the fact that the U.S. has seen cost of inventory rise over the last 30 years (inflation) these companies were able to save on taxes. One should know that the Internal Revenue Service (IRS) does not allow companies to report LIFO for tax purposes and then FIFO on their general-purpose statements. Analyzing the Financial Statements of Companies That Use Different Inventory Accounting Methods When comparing two companies, one must ensure that they are comparing apples with apples. If the first company uses the FIFO method and the other the LIFO method, then there is a problem. To make the comparison relevant, one must convert LIFO to FIFO or FIFO to IFO. 8.8 - Converting LIFO to FIFO To make the conversion possible, U.S. GAAP requires companies that use LIFO to report a LIFO reserve (found in footnotes). The LIFO reserve is the difference between what their ending inventory would have been if they used FIFO. Formula 8.2 LIFO reserve = FIFO inventory - LIFO inventory Or: FIFO inventory = LIFO inventory + LIFO reserve Recall: COGS = beginning inventory + purchases – ending inventory Or: COGS = change in inventory levels So: Formula 8.3

COGS (LIFO) – change in LIFO reserve

COGS (LIFO) – (LIFO reserve at the end of the period - LIFO reserve at the beginning of the period)

Long Conversion A longer way to convert LIFO to FIFO is to calculate purchases, convert both beginning and ending inventory to FIFO levels, and then calculate COGS using the FIFO inventory levels and purchases. COGS = beginning inventory + purchases – ending inventory Rearrange the terms:

Purchases = ending inventory - beginning inventory + COGS (LIFO) We also know that: Ending inventory (FIFO) = Ending inventory (LIFO) + ending period LIFO reserve Beginning inventory (FIFO) = Beginning inventory (LIFO) + Beginning LIFO reserve

Example: Company ABC uses LIFO. Year-end inventory = $2m Beginning inventory = $3m LIFO reserve at year-end = $1m LIFO reserve at the beginning of the years = $500,000 COSG = $5m Simple way to convert LIFO to FIFO COGS (FIFO) = COGS (LIFO) – change in LIFO reserve COGS (FIFO) = $5m – ($1m - $0.5m) = $4.5m Complex way Purchases = ending inventory - beginning inventory + COGS (LIFO) Purchases = $2m – 3m + $5m = $4m Ending inventory (FIFO) = ending inventory (LIFO) + ending period LIFO reserve Ending inventory (FIFO) = $2m + $1m = $3m Beginning inventory (FIFO) = beginning inventory (LIFO) + beginning LIFO reserve Beginning inventory (FIFO) = $3m + $0.5m = $3.5m

COGS (FIFO) = purchases + beginning inventory (FIFO) - ending inventory (FIFO) COGS (FIFO) = $4m + $3.5m – $3m = $4.5m To make the two companies comparable, we need to do some additional adjustments. •

Under different methods COGS will vary and as a result net income should be adjusted.

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If COGS under the LIFO was higher than the COGS under the FIFO method: o That would mean this company would have used the FIFO method, it would have declared a higher gross profit and hence a higher net income. But it would have also had to pay higher taxes and reduce its cash flow. A simple way to account for that is to take the positive difference in COGS and multiply it by (1-tax rate). o This difference would also be included in shareholders' equity. o The additional tax would be recorded in income tax liability.

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If COGS under the LIFO was lower than the COGS under the FIFO method: o That would mean this company would have used the FIFO method, it would have declared a lower gross profit and hence lower net income. But it would have also had to pay lower taxes and increase its cash flow. A simple way to account for that is to take the negative difference in COGS, divide the COGS by (1-tax rate). o This difference would also be included in shareholders' equity. o The additional tax would be recorded in income tax asset.

8.9 - Converting FIFO to LIFO There is no precise mathematical equation to convert FIFO accounting to LIFO because the equivalent of the FIFO reserve does not exist. Furthermore, there is little value in converting inventory under FIFO to LIFO, since LIFO inventory is not a reflection of the true economic value of inventory. Nonetheless, analysts can estimate what the inventory and COGS would have been if the company used the LIFO accounting method. Analysts would first need to estimate what the beginning inventory would have been under LIFO. Inventory can be affected by economic inflation, inflation of raw assets with a particular industry, among others. As a result, COGS (LIFO) can be estimated by using this formula: COGS (LIFO) = COGS (FIFO) + [beginning inventory (FIFO) * (adjustment or inflation rate)] Looking at a company within a similar industry that uses the LIFO method can also be done to derive the adjustment rate. Adjustment rate = LIFO reserve / beginning inventory (LIFO) Converting Average-cost Method to LIFO As stated previously, since the average-cost method is a simple average of COGS, COGS would be in between LIFO and FIFO. COGS (LIFO) = COGS (average) – ½ * (beginning inventory (Average) * (adjustment or inflation rate)

8.10 - Effects of Inventory Accounting A company's choice of inventory accounting will affect the company's income, cash flow and balance sheet. •

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Income effect – Inventory and cost of goods sold are interdependent. As a result, if LIFO method is used in a rising-price and increasing-inventory environment, more of the higher-cost goods (last ones in) will be accounted for in COGS as opposed to FIFO. Under this scenario, net income will be lower compared to a company that used FIFO accounting. Cash flow effect – If we lived in a tax-free world, there would be no cash flow difference between inventory-accounting methods. Unfortunately, we do pay taxes. As a result, if a company uses the FIFO method in a rising-price and increasing-inventory environment, it will have to generate a lower COGS and a higher net taxable income, and pay higher taxes. Tax expenses are a real cash expense and lower a company's cash flow. Working Capital – Working capital is defined as current assets minus current liabilities. If one method produces a higher inventory value in the income statement, the working capital will increase.

Table 8.1 Summary of effects given a rising-prices environment and stable or increasing inventories

The Effects of the Inventory Method On Ratios Since the accounting method used to account for inventory has an effect on the income statement, balance sheet and cash flow statement, it will ultimately have an effect on the ratios used to measure and compare a company's profitability, liquidity, activity and solvency. Computing Profitability Effects In a rising-price and stable- or increasing-inventory environment,LIFO will have a higher COGS, but it will also be more representative of the current economic reality. As a result, profitability will be more accurate, and a better indicator of future profitability. FIFO will use the cost of the old stock to determine the COGS, making the profitability ratio less reflective of the current economic reality. As a general rule, in a rising-price and stable- or increasing-inventory environment,using profitability measures based on LIFO is better. Look Out! Most questions relating to the differences under LIFO and FIFO will include a descriptive effect on financial ratios. Students need to understand what each ratio is composed of.

Look Out! Before starting this section remember what changes: • • •

Inventory – current assets and total assets COGS - profitability Income – stockholder equity

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Taxes – CFO and cash account on the balance sheet

Liquidity Ratio Changes

Look Out! From an analytical perspective, in a rising-price and stable- or increasinginventory environment, it is better to use FIFO liquidity ratios because the LIFO ending inventory is composed of older, cheaper inventory. Activity ratios

From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, the LIFO inventory turnover ratio will trend higher. On the other hand, if we use FIFO, the COGS does not represent the current economic reality. In this case the best thing to do is to use the COGS found under LIFO and divide it by the average inventory found in FIFO. This is called "current-cost method". Look Out! From an analytical perspective, in a rising-price and stableor increasing-inventory environment, it is better to use FIFO total asset turnover ratios because LIFO ending inventory is the older, cheaper inventory. Solvency ratios

From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, it is better to use LIFO debt-to-equity ratio because the retained earnings are more representative of the current economic reality. For the time, interest-earned ratio is more relevant to use LIFO because EBIT will be lower and more representative of future interest-coverage protection. If the company is currently using FIFO, it is better they use the CFO generated by FIFO because the company cannot change the fact that it will have to continue paying higher taxes under this method. 8.11 - Causes a Decline in LIFO Reserve LIFO reserves decline because a company is doing the following: • •

liquidating its inventory (lower quantities / selling cheap/old stock) is purchasing inventory at lower prices (price decline)

The liquidation of inventory is called "LIFO liquidation". This happens when a company is no longer purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. This can produce large increases in profitability (COGS abnormally low). This increase in profitability is temporary (paper profit). Once it runs out of cheap inventory, it will have to purchase new inventory at a mush higher cost base. This will also decrease a company's cash flow because it will have to pay more taxes. Profits from LIFO liquidation are non-operating in nature and should be excluded from earnings in an analysis. A decline in price reduces the COGS under LIFO, but though COGS is lower it is a better indication of the economic reality. So no adjustments are necessary on the income statement. That said, the ending inventory under LIFO is too high and is no longer representative of its true economic value. The ending inventory should be adjusted to FIFO.

Look Out! Companies must report inventories at the lower of cost (determined by their LIFO, FIFO or other inventory accounting method) or market value. Market value is essentially the net realizable value of the assets. 8.12 - Long Term Asset Basics

I. Basics Distinguishing Features of Long Term Assets Long-term assets are assets that are typically used in the production process of a company and have a useful life of more then one year. Long-term assets typically include property, plant (building and land) and equipment (PP&E). These assets are

reported at cost (book value) at initiation, and are depreciated over time (except for land). Once an asset has started to depreciate, it is said to be reported at its carrying value. If an asset becomes obsolete before its time or it has lost its revenue-generating ability, it must be written off and this is referred to as asset impairment. Property, Plant and Equipment (PP&E) The cost of PP&E includes all costs related to their acquisition and all necessary expenses required to make them useful for the company. Example 1: Company ABC purchased a machine for $2m. To get this machine ready for use, it paid a total of $200,000 for transportation and insurance, brokerage fees, set-up costs and legal fees, among others. So the total cost is $2.2m. Journal entry:

Company ABC bought a piece of land for $2m and an additional $100,000 went to expenses resulting from the search for the land, real estate commission, title transfer, surveying and landscaping. Total cost is $2.1m. Journal entry:

Company ABC incurred a total of $20m in additional costs to build on this land. This included, among others, costs for materials, labor, construction plans and interest cost incurred during the construction phase. Journal entry:

8.13 - Depreciation Accounting Depreciation is defined as the reduction in the value of a product arising from the passage of time due to use or abuse, wear and tear. Depreciation is not a method of valuation but of cost allocation. This cost allocation can be based on a number of factors, but it is always related to the estimated period of time the product can generate revenues for the company (economic life). Depreciation expense is the amount of cost allocation within an accounting period. Only items that lose useful value over time can be depreciated. That said, land can't be depreciated because it can always be used for a purpose. Straight-line Depreciation The simplest and most commonly used method, straight-line depreciation is calculated by taking the purchase or acquisition price of an asset, subtracting by the salvage value (value at which it can be sold once the company no longer needs it) and dividing by the total productive years for which the asset can be reasonably expected to benefit the company, or

its useful life. Example: For $2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts. Formula 8.4 Depreciation expense = total acquisition cost – salvage value useful life

Look Out! Know that this method of depreciation produces a constant depreciation expense, and at the end of its useful life, this asset will be accounted for in the balance sheet at its salvage value.

Unit-of-production Depreciation This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one must first determine the cost per one production unit and then multiply that cost per unit with the total number of units the company produced within an accounting period to determine its depreciation expense. Formula 8.5 Depreciation expense = total acquisition cost – salvage value estimated total units Estimated total units = the total units this machine can produce over its lifetime Depreciation expense = depreciation per unit * number of units produced during an accounting period Example: Company ABC purchased a machine that can produce 300,000 products over its useful life for $2m. The company also estimates that this machine has a salvage value of $200,000.

Look Out! Know that this depreciation method produces a variable depreciation expense and is more reflective of production-to-cost (matching principle).

At the end of the useful life of the asset, its accumulated depreciation is equal to its total cost minus its salvage value. Furthermore, its accumulated production units equal the total estimated production capacity. One of the drawbacks of this method is that if the units of products decrease (slowing demand for the product), the depreciation expense also decreases. This results in an overstatement of reported income and asset value. Hours-of-service Depreciation This is the same concept as unit of production depreciation except that the depreciation expense is a function of total hours of service used during an accounting period.

8.14 - Accelerated Depreciation Accelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line depreciation method and to write off a smaller amount in the later years. The major benefit of using this method is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-depreciation method, even if it reduces the income shown on the financial statement. This depreciation method is popular for writing off equipment that might be replaced before the end of its useful life since the equipment might be obsolete (e.g. computers). Companies that have used accelerated depreciation will declare fewer earnings in the beginning years and will seem more profitable in the later years. Companies that will be raising financing (via an IPO or venture capital) are more likely to use accelerated depreciation in the first years of operation and raise financing in the later years to create the illusion of increased profitability (higher valuation). The two most common accelerated-depreciation methods are the sum-of-year (SYD) method and doubledeclining-balance method (DDB): Sum-of-year Method: Depreciation in year i = (n-i+1) * (total acquisition cost – salvage value) n!

Example: For $2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts. n! = 1+2+3+4+5 = 15 n=5

Look Out! Know that this depreciation method produces a variable depreciation expense. At the end of the useful life of the asset, its accumulated depreciation is equal to the accumulated depreciation under the straightline depreciation. Double-declining-balance method The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same percentage is applied to the un-depreciated amount in subsequent years.

DDB in year i = 2 * (total acquisition cost – accumulated depreciation) n n = number of years

Example For $2m, Company ABC purchased a machine that will have an estimated useful life of five years. The company also estimates that in five years the company will be able to sell it for $200,000 for scrap parts.

Look Out! Know that this depreciation method produces a very aggressive depreciation schedule. The asset cannot be depreciated beyond its salvage value.

Change in Useful life or Salvage Value All depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the useful life of a company's equipment may be cut short (new technology), and its salvage value may also be affected. Once this happens there is asset impairment. Companies can do two things: 1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time or 2) They can do the recommended thing, which is to recognize the impairment and report it on the income statement right away.

Look Out! Note that changes in useful life and salvage value are considered changes in accounting estimates, not changes in accounting principle. The result is this: no need to restate past financial statements. Sale, Exchange, or Disposal of Depreciable Assets Companies that are in the business of exploring and/or extracting and/or transforming natural resources such as timber, gold, silver, oil and gas, among other resources are known as "natural resource companies". The main assets these companies have are their inventory of natural resources. These assets must be reported at their cost of carry (or carrying cost). The carrying costs for natural resources include the cost of acquiring the lands or mines, cost of timber-cutting rights and the cost of exploration and development of the natural resources. These costs can be capitalized or expensed. The costs that are capitalized are included in the cost of carry. The cost of carry does not include the cost of machinery and equipment used in the extraction process. When a resource company purchases a plot of land, it not only pays for the physical asset but also pays a large premium because of what is contained in the plot of land. That said, once a company starts extracting the oil or natural resource from the land, the land loses value, because the natural resources extracted from a plot of land will never regenerate. That loss in value is called "depletion". That is why cost of carry is depleted over time. The depletion of these assets must be included in

the income statement's accounting period. This is the only time land can be depleted. The carrying costs of natural resources are allocated to an accounting period by means of the units-of-production method. Example: A company acquired cutting rights for $1m. With these cutting rights, the company will be able to cut 5,000 trees. In its first year of operation, the company cut 200 trees. Journal entries:

8.15 - Natural Recource Assets Classification of Natural Resource Assets Intangible assets are identifiable non-monetary resources that have no physical substance but provide the company controlling them with a benefit. Intangible assets can be internally created or acquired from a third party. If intangible assets are acquired in an arm's length transaction, their recognition and measurement will be similar to those of tangible assets. Internally developed intangible assets are accounted for in a wide range of ways. Intangible assets include research and development costs, patents, trademarks and goodwill. Intangible assets are depreciated over their estimated life and they are done so by the use the straight-line depreciation method. Intangible assets cannot have an estimated life of more then 40 years. Unlike other intangible assets, goodwill is no longer an asset that can be depreciated. As of July 2001, the Financial Accounting Standards Board (FASB) adopted the Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets, which sets new rules for goodwill accounting. SFAS 142 eliminates goodwill amortization and instead requires companies to identify reporting units and perform goodwill impairment tests. Example Company ABC acquires a company for $20m. The acquired company's fair market value was $18m. ABC has also acquired a patent for $2m that has an estimated remaining life of 10 years. Journal entries:

8.16 - Effects of Capitalizing vs.Expensing EFFECTS OF CAPITALIZING VS. EXPENSING

Expenses can be expensed as they are incurred, or they can be capitalized. A company is able to capitalize the cost of acquiring a resource only if the resource provides the company with a tangible benefit for more than one operating cycle. In this regard, these expenses represent an asset for the company and are recorded on the balance sheet. Effects of Capitalization on Key Figures The decision to capitalize or expense some items depends on management. As such, this choice will have an impact on a company's balance sheet, income statement and cash flow statement. It will also have an impact on a company's financial ratios. Here is what the decision will have an impact on: •

Net income - Capitalizing costs and depreciating them over time will show a smoother pattern of reported incomes. Expensing firms have higher variability in reported income. In terms of profitability, in the early years, a company that capitalizes costs will have a higher profitability than it would have had if it expensed them. In later years, the company that expenses costs will have a higher profitability than it would have had if it capitalized them.

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Stockholders' equity – Over a long time frame, the choice of expensing a cost or capitalizing it will have little effect on a shareholders' total equity. That said, expensing firms will have a lower stockholders' equity at first (less profit, thus smaller retained earnings).

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Cash flow from operations – A company that capitalizes its costs will display higher net profits in the first years and will have to pay higher taxes than it would've had to pay if it expensed all of its costs. That said, over a long period of time, the tax implications would be the same. But the choice for capitalizing over expensing have a much larger effect on the reported cash flow from operations and cash flow from investing. If a company expenses its cost it will be included in cash flow from operations. If it capitalizes, then it will be included in cash flow from investing (lower investment cash flow and higher cash flow from operations).

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Assets reported on the balance sheet - A company that capitalizes its costs will display higher total assets.

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Financial ratios – A company that capitalizes its costs will display higher profitability ratios at the onset and lower ratios in the later stages. Liquidity ratios will experience little impact, except for the CFO ratio, which will be higher under the capitalization method. Operation-efficiency ratios such as total asset and fixed-asset turnover will be lower under the capitalization method, due to higher reported fixed assets. Furthermore, at the onset, equity turnover will be higher under the capitalization method (lower total equity due to lower net profit). Companies that capitalize their costs will initially report higher net income, lower equity and higher total assets. Remember that, on average, an equal dollar effect on a numerator and denominator will produce a higher net result. That said, on average, ROE & ROA will initially be higher for capitalizing firms. Solvency ratios are better for firms that capitalize their costs because they have higher assets, EBIT and stockholders' equity.

Consider figure 8.2 below for an overview of the effect of capitalizing and expensing on key financial ratios. Figure 8.2 Impact of Assets, Profitability on Financial Ratios

8.17 - Computing the Effect of Capitalizing vs. Expensing If interest is capitalized, it is included in the cost of carry. Capitalizing interest is common in construction projects. The interest cost is included as an asset versus being expensed on the income statement for the period it occurred. In the U.S., SFAS 34 governs the capitalization of interest cost during an accounting period. SFAS 34 requires that the interest cost incurred during a construction period is accounted for as a long-lived asset. To be capitalized, the interest must be from borrowed money. If no specific borrowing is identified, interest can be estimated by means of a weighted average interest rate on outstanding debt for the amount invested. Example: A company built a building for $1m. It borrowed $500,000 at 5% to build the building. In this case the interest capitalized will amount to $25,000. Another company built a building for $1m. It borrowed $500,000 at 5% to build the building; it also had an outstanding debenture of $3m at 10% and a $1M mortgage at 15%. In this case, the interest capitalized will amount to: 500,000 * 5% = 500,000 * 10% = Total

25,000 50,000 75,000

Interest to be expensed = total interest paid – capitalized interest = 25,000+300,000+150,000-75,000 = 400,000 The total capitalized interest is $75,000 because we assume the $500,000 balance was financed through the debenture. The reason we do not consider the mortgage is that it is already assigned to another identifiable asset. Some argue that the capitalization costs of self-financed assets should not be included. The decision to capitalize interest will have an effect on a company's: • • • • •

Net income – In the current period earnings will be higher (overstated). CFO – In the current period, CFO will be higher (overstated) because the interest expense will be included in CFI. CFI - In the current period, CFI will be lower (understated). Assets – Total assets will be overstated because they include the capitalized interest. Solvency ratios – Since assets, EBIT and stockholders' equity will be higher, all solvency ratios will be overstated.

8.18 - Capitalizing Intangible Assets Intangible assets are identifiable non-monetary resources that have no physical substance but provide the company controlling them with a benefit and, as a result, have a higher degree of uncertainty regarding future benefits. When intangible assets are acquired through an arm's length transaction, they are recorded at cost. SFAS classifies intangible assets in different categories and provides a guideline in regards to their expense or capitalization. 1.Research and development costs • •

SFAS requires virtually all R&D costs to be expensed in the period they were incurred and the amount to be disclosed. The main exception to the expensing rule is contract R&D performed for unrelated entities.

2.Software development • •

SFAS requires all costs that were incurred in order to establish technological and/or economic feasibility of software to be viewed as R&D costs and expensed as they are incurred. ONCE economic feasibility has been established, subsequent costs can be capitalized (but are not required to be) as part of product inventory and amortized based on product revenues or on sales–perlicense basis.

Other Intangibles 1.

Patents and copyrights •

All costs in developing these are expensed in conformity with the treatment of R&D costs (legal fees incurred in registering can be capitalized).

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2.

Full acquisition costs are capitalized when purchased from other entities.

Brands and trademarks •

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All costs in developing a brand or trademark are expensed in conformity with treatment of R&D costs (legal fees incurred in registering can be capitalized). Full acquisition costs are capitalized when brands and trademarks are purchased from other entities.

8.19 - Depreciation Depreciation Methods Identification of depreciation methods: • • • • •

Straight-line depreciation Per unit of production Per hour of service Declining balance Sinking-fund depreciation

The only depreciation method that was not previously explained is the sinking-fund depreciation. The sinkingfund depreciation is rarely used and is prohibited in the U.S. and some other countries. Under this depreciation method, the amount of depreciation increases every year to maintain a fixed internal rate of return (IRR). Formula 8.6

Depreciation in year i = CF in year i – (IRR * book value at beginning of the year) CF is defined as the cash derived every year from a particular asset. Effect of depreciation on financial statements, ratios and taxes: •

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•

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Straight-line depreciation – This method will create a steady income stream, tax expense and ratios. Return on assets will increase over time if the equipment continues to generate the same products and price per unit remains constant. Per unit of production and per hour of service - These depreciation methods produce a variable depreciation expense. Net income will vary but it could be more reflective of production-to-cost (matching principle). One of the drawbacks of this method is that if units of products decrease (slowing demand for the product), depreciation expense also decreases, resulting in an overstatement of reported income and asset value. Declining balance – Income will be lower in the first years. As a result taxes will be lower and CFO will be higher. If production and selling prices of goods remain constant, ROA will be much higher in later years. Sinking-fund depreciation – The only benefit of this method is that the income reported should reflect ROI earned by assets.

Depreciable Life Depreciable life, whether it is defined by years of useful life or by production units, is the most significant estimate that must be made in the determination of the depreciation expense. The estimated salvage value of an asset is also important but not as significant. The role of depreciable life and salvage value is important because it is an estimation given by management. As such, management can use this estimation choice to manipulate current and future earnings. The most common form of manipulation is an overstatement in the write-down of assets during a restructuring process, which will be reported as an extraordinary item and will result in the inflation of future net profits. Changing Depreciation Methods Changes in depreciation methods can be done in three ways: 1. Change the depreciation method for all newly acquired assets. 2. Change the depreciation method for current and all new assets. 3. Change in depreciable life or salvage value. Changing the Depreciation Method for All Newly Acquired Assets The change in depreciation method will only affect future acquired assets. As a result, no past adjustment need to be made; the only thing that will change is future depreciation expense. That said, the change in depreciation expense will be gradual, and the change in ratios will also be gradual. Change the Depreciation Method for Current and All New Assets This is a much more complex change and will require all past assets to be restated to reflect the new depreciation accounting method. For all new assets it's not really a problem, but for the past assets the cumulative effect of the changes on past income statements must be reported (net of tax) on the current income statement. Furthermore, these changes must be included in net income from continuing operations. Example of effect: Say a company changes its depreciation method, the straight-line method, to one that would have previously created a larger depreciation expense, the double-declining method). This will cause past expenses to be higher and income to be lower. At the time of recognition, net income from continuing operations will decrease. Future depreciation expense will decrease (they would have already been expensed) but will increase in future years once all of the old assets are replaced.

Look Out! ROE and ROA will decrease even though assets and equity will decrease; the larger impact will come from a large decrease in net income. Change in Depreciable Life or Salvage Value A change in depreciable life and/or salvage value is not considered an acting policy change; it is a change in estimate. As a result, a company is not required to restate it in financial statements. The only thing that will change is the current and future net income.

For example, if an asset's life is shortened, this will increase the company's current and future depreciation expense, and decrease net income, ROA and ROE.

8.20 - Fixed Asset Disclosures FIXED ASSET DISCLOSURES The disclosure found in a company's footnote section of its financial statements provides useful information about the age and possible usefulness of the assets held by the company. Using the information contained in the footnote, an analyst can estimate the total age of the assets held by a company. There are three ways to estimate the average age of a company's fixed assets: 1. Average age = accumulated depreciation / current depreciation expense = X years 2. Relative age = accumulated depreciation / ending gross investment = % of age 3. Average depreciable life = ending gross investment / depreciation expense

Look Out! Note: All these estimations are affected by what is included in fixed assets (asset mix). Relative age can be used only when the assets analyzed use a straight-line depreciation method.

Though not accurate, the estimated average age of a company's fixed assets is useful and allows an analyst to:

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Estimate if the company has old assets and will need to invest heavily in new equipment in the near future. If that is the case, the company would be currently reporting an overstated net income that is not reflective of future profitability. Reveal whether a company is losing its competitive advantage compared to another company that has invested heavily in new technology.

8.21 - Asset Impairment ASSET IMPAIRMENT What is Impairment? Assets are said to be impaired when their net carrying value, (acquisition cost – accumulated depreciation), is

greater than the future undiscounted cash flow that these assets can provide and be disposed for. Under U.S. GAAP impaired assets must be recognized once there is evidence of a lack of recoverability of the net carrying amount. Once impairment has been recognized it cannot be restored. Analysts must know that some foreign countries and the IASB allow companies to recognize increases in previously impaired assets. Asset impairment occurs when there are: • • • •

Changes in regulation and business climate Declines in usage rate Technology changes Forecasts of a significant decline in the long-term profitability of the asset

Once a company has determined that an asset is impaired, it can write down the asset or classify it as an asset for sale. Assets will be written down if the company keeps on using this asset. Write-downs are sometimes included as part of a restructuring cost. It is important to be able to distinguish asset write-downs, which are non-cash expenses, from cash expenses like severance packages. Write-downs affect past reported income. The loss should be reported on the income statement before tax as a component of continuing operations. Generally impairment recognized for financial reporting is not deductible for tax purposes until the affected assets are disposed of. That said, in most cases recognition of an impairment leads to a deferred tax asset. Impaired assets held for sale are assets that are no longer in use and are expected to be disposed of or abandoned. The disposition decision differs from a write-down because once a company classifies impaired assets as assets for sale or abandonment, it is actually severing these assets from assets of continuing operations as they are no longer expected to contribute to ongoing operations. This is the accounting impact: assets held for sales must be written down to fair value less the cost of selling them. These assets can no longer be depreciated. Assets Impairment - Effects on Financial Statements and Ratios • •

• • • • • • •

Past income statements are not restated. The current income statement will include an impairment loss in income before tax from continuing operations. Net income will also be lower. On the balance sheet, long-term assets are reduced by the impairment. A deferred-tax asset is created (if there was a deferred tax liability it is reduced). Stockholders' equity is reduced as a result of the impairment loss included in the income statement. Current and future fixed-asset turnover will increase (lower fixed assets). Since stockholders' equity will be lower, debt-to-equity will be lower. Debt-to-assets will be higher. Cash flow based ratios will remain unaffected (no cash implications). Future net income will be higher as there will be lower asset value, and thus a smaller depreciation expense. Future ROA and ROE will increase. Past ratios that evaluated fixed assets and depreciation policy are distorted by impairment write-downs.

8.22 - SFAS 143 Requirements SFAS 143 was developed to account for the future obligation that will arise once an asset is sold. This is best understood through an example. A company buys a plot of land that will be used for the treatment of lumber. Over time, the chemicals used to treat the lumber will contaminate the land. The federal government requires

these companies to decontaminate the soil before it can be sold. This soil decontamination costs money and represents a future liability for the company. That is precisely why SFAS 143 was developed. Requirements of SFAS 143 or Asset Retirement Obligation (ARO) to be recognized: •

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Legal requirements to remove an asset or component part must exist before any ARO is recognized for removal costs. However, if there is no legal obligation to remove a component, then no ARO is required. A legal obligation may exist to dispose of a component part of an asset: "Any legal obligations that require disposal of the replaced part are within the scope of this Statement". All ARO liabilities must meet the liability criteria in FAS Concepts Statement Number 6, "Elements of Financial Statements." Only present (current) obligations meet these criteria.

The Standard identifies examples of potential AROs, including landfill closure and nuclear decommissioning. Accounting Implications of SFAS 143 At initiation: • • •

The present value (PV) of the total future cash flow obligation must be added to the balance value of the acquired asset. The discount rate used in the PV calculation in the current risk-free rate plus adjustments for the credit risk of the company. The present value obligation is also added in the long-term liability section of the company's balance sheet.

After initiation (subsequent years): •

• • • •

The liability portion is accreted using the rate-based accretion method. This means that each year the liability section increases at the same rate at which it was discounted. This enables the liability section to equal its total future value at the end of the estimated useful life of the asset. The annual accreted portion is expensed on the income statement and in most cases is included in the reported interest-expense portion of the income statement. Since the value of the asset has increased at initiation, the depreciation will be higher than it otherwise would have been. Changes in estimated liability are accounted prospectively, so prior periods are not restated. Disclosures required: a description of ARO and asset, reconciliation of liability, show effect of new liabilities incurred and liabilities extinguished.

Likely effects on financial statements and ratios: • •

Since depreciation expense is higher, net income will be lower. Net interest will most likely be higher since the accreted portion is reported in this consolidated account.

• • • • • • •

Cash flow will be unaffected. Value of assets will be higher since ARO will be included. Long-term liability portion will be higher. Stockholders' equity will be lower due to lower net income. The debt-to-equity ratio will be higher because long-term liability increases, and stockholders' equity will be lower. Asset turnover will be lower (higher asset value). Solvency ratios will be negatively affected (times interest earned, lower EBIT).