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. 10-2

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. 10-3

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. 10-4

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 10-5

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. 10-6

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. $$ CapitalizedExpensed 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 $ Joint costs incurred in acquiring more than one asset are apportioned among the acquired assets. 10-7

Initial asset measurement rules: Example Special GAAP rules apply Purchase price Preparation costs Joint cost Construction costs Joint cost 10-8

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,

 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 Avoidable interest Actual interest Interest capitalized 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 LandBuilding Allocation 1: $500 $100 Lower depreciation Higher net income Higher taxes LandBuilding Allocation 2: 10-11

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

10-13 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 10-14

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  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

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 BeforeAfter 10-17

Asset impairment: Long-lived Asset Impairment G uidelines Figure 10.2

Asset impairment: Example Impairment possible? Undiscounted net cash flows expected Are cash flows lower than carrying amount? Impairment loss Yes! $1,500,000 $1,250,000 ($2,000,000 - $750,000) Yes! 10-19

Asset impairment: Case Study of Impairment Recognition and Disclosure: Krispy Kreme Doughnuts 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: 10-21

Obligations arising from retiring long-lived assets 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 middle of 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 valueExpected cost to sell  So, these assets would be shown on the balance sheet at $2,304,

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 10-24

Depreciation: Straight-line example 10-25

Depreciation: Units of Production (UP) example 10-26

Depreciation: Double-declining balance example 10-27

Depreciation: Sum-of-the-years’ digits example 10-28

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 10-29

Financial Analysis and Depreciation Differences 10-30

Financial Analysis and Depreciation Differences 10-31

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 10-32

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 10-33

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 10-34

 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

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) 10-36

Global Vantage Point Comparison 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)

Global Vantage Point Comparison 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 10-38

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

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