Capitalized costs vs period expenses =
expenditure is capitalized as an asset on the BS if expected to provide benefit over multiple periods.
Capitalized at fair value at acquisition, incl costs necessary to prepare it for use.
It is then depreciated/amortized (excl land/intangible assets w indefinite lives).
OTHERWISE - expenditure is expensed immediately and current period pretax income is reduced (when future benefit is uncertain or unlikely)
subsequent expenditures that provide more economic benefits: CAPITALIZED
subsequent expenditures to maintain the asset's usefulness: EXPENSED
NOTE: choice to capitalize or expense won't affect operation, but will change financial values and ratios (net income, equity etc)
Expense recognition: Effect on net income =
When expenses are capitalized, net income will be creater in that period and lower in others (as depreciation expense increases) - reduces variability of net income, spreads expenses out.
Over the life of the asset, TOTAL NET INCOME is the same under either method
Expense recognition: Effect on Owners' Equity =
Capitalization -> higher net income -> higher RE -> higher OEq.
Assets are also greater, and liabilities are unaffected, so A = L + E remains balanced.
This is balanced out of subsequent periods.
Expense recognition: CFO =
Capitalizing an expenditure -> higher CFO (no outflow is reported, as would be if expense is incurred in the period)
TOTAL cash flow will be the same under both methods, as long as tax treatment is the SAME.
HOWEVER, if the asset is capitalized, depreciation expense will be recognized in following periods - which is a NON CASH EXPENSE and does not affect CFO
Expense recognition: financial ratios =
When an expense is CAPITALIZED debt-to-assets and debt-to-equity are lower, as assets and equity are higher
Higher net income will result in higher ROA and ROE initially, and lower in following years
Immediately expensing an expense gives the appearance of growth after the first year - net income is higher and A + E are lower, RATIOS GROW.
Capitalized Interest =
Interest expense for construction of an asset (for its own use, sometimes for onward sale) is capitalized as part of the asset's cost.
IFRS: capitalized interest can be reduced by income earned through investing the borrowed funds (not under GAAP)
CI goes through the Income Statement as DEPRECIATION on the constructed asset, or COGS if the asset is sold
NOTE - interest expense is generally an OCF (IFRS: OCF or FCF), but CI is ICF
Capitalized Interest: Interest coverage =
Ebit/interest expense will be higher when assets are capitalized, as interest expense will be lower (in the year or expenditure)
Analysts may include capitalized interest to get a better picture of true interest expense/coverage ratio
Capitalizing vs Expensing: Cheat Sheet =
Identifiable Intangible Asset =
- able to be separated from the firm or 'arise from a contractual or legal right'
- Controlled by the firm
- expected to provide future economic benefits (probable)
- Asset's cost must be reliably measurable
Unidentifiable intangible asset =
cannot be purchased separately and amy have an indefinite life
Goodwill is an example
Note: not all intangible assets are reported on the balance sheet - depends on how it eventuated
Intangible assets created internally =
costs are expensed as incurred
except development costs (part of R&D) [only IFRS] and software development costs [both]
NOTE - before software is deemed technologically feasible it is expensed (ONCE WE KNOW ITS USEFUL WE CAN CAPITALIZE THAT PUPPY)
NOTE - GAAP allows capitalization of ALL costs when the firm will use the software FOR ITSELF (regardless of any time where the technological feasibility is undetermined)
Purchased intangible assets =
reported on the balance sheet at cost, typically fair value at purchase
Intangible assets obtained in a business combination =
acquisition method: remaining amount of purchase price, after subtracting the fair value of identifiable A +L, is goodwill - an unidentifiable asset.
this goodwill is CAPITALIZED
NOTE: internally created goodwill is expensed
systematic allocation of an asset's cost over time.
OPERATING EXPENSE, but NON CASH EXPENSE
Analysts must determine if reported depreciation expense is more or less than what is reported (economic depreciation)
NOTE: over the entire depreciation period, depreciation expense, tax expense, pretax income, net income, net profit margin will be the same no matter what depreciation method is chosen
Carrying (book) value =
net value of an A or L on the BS.
For PPE, carrying value equals historical cost minus accumulated depreciation
Historical Cost =
original purchase price including installation and transport cost - AKA gross investment in the asset
Useful life and salvage value =
increasing/decreasing will affect depreciation expense and net income
Changes to these values are applied in the current period and prospectively - asset's carrying value and depreciation is calculated using the new estimate going forward
PREVIOUS PERIODS ARE NOT CHANGED/AFFECTED
Manufacturing firms may allocate depreciation expense to COGS and/or SGA - which can change gross profit/margin and operating expense (COGS is subtracted to get gross profit, SGA to get operating profit)
Component depreciation =
IFRS: requires depreciation to be split out amongst components of an asset.
this requires separate useful life estimates for each component to find component depreciation expense
GAAP: component depreciation is allowed but seldom used
only finite life intangibles are amortized - same as depreciation of tangible assets.
Estimating useful lives is complicated by many legal, regulatory, contractual, competitive and economic factors that may limit the use of intangible assets
As with depreciation - total amortization is the same under all methods - timing of amortization expense on the IS is the only difference
COVERED IN ANOTHER SECTION - infinite life intangibles are tested for impairment at least annually
Reporting long lived assets on the BS =
GAAP: cost model: reported at depreciated cost
IFRS: cost model
or REVALUATION MODEL, which allows reporting at fair value given an active market to allow estimation of a fair value.
- same method must be used for similar assets (can't use the revaluation model just for those that are likely to increase in value)
- rarely used in practice
Revaluation Model -
fair value reporting on the BS for long lived assets.
Fair value decreases below historical cost, and subsequent increases up to historical cost, are reported on the INCOME STATEMENT AS A LOSS/GAIN, DECREASING/INCREASING NET INCOME AND SHAREHOLDERS' EQUITY
but increases above historical cost are reported as REVALUATION SURPLUS, A COMPONENT OF SHAREHOLDERS' EQUITY (subsequent decreases will reduce revaluation surplus until historical cost is reached and surplus is ZERO)
Revaluing an asset upwards:
- INCREASES TOTAL ASSETS AND SHAREHOLDERS' EQUITY
- HIGHER DEPRECIATION EXPENSE, LOWER PROFITABILITY (margins)
Impairment of PPE & intangibles =
all points apply to both tangible and intangible long lived assets with finite lives that are held for use
Firms must write down impaired assest via a loss on the income statement
IFRS: annual test, or when circumstances suggest impairment may have occurred (significant decline in market val of the asset or physical condition)
impaired when CARRYING VALUE (original cost - depr) exceeds the RECOVERABLE AMOUNT [or the recoverable amount falls below the carrying value] (greater of fair value - selling costs and value in use, where value in use is PV of future CFs from continued use)
Reversals allowed up to the original amount of impairment loss (which was the difference between carrying value and recovery amount)
GAAP: tested when the firm may not be able to recover the carrying value through future use.
Determining impairment/loss may involve two stes: RECOVERABILITY and LOSS MEASUREMENT
loss recoveries are not permitted
Impairment under GAAP =
Recoverability: impaired = if carrying value is greater than future UNDISCOUNTED cash flows.
as this uses undiscounted cash flows a) considerable management discretion is required b) an asset cannot become impaired from loss of value caused by an increase in the discount rate (when interest rates rise)
Loss Measurement: if impaired, asset's value is written down to fair value on the BS, and a loss is recognized on the IS
the loss is the difference between the carrying value and fair value or DISCOUNTED FUTRE CFs IF FAIR VALUE IS NOT KNOWN
Intangible assets with indefinite lives =
Impaired when carrying value exceeds fair value (details are covered in level 2)
Long lived assets held for sale -
when an asset is changed from held for use to held for sale it is tested for impairment
no longer depreciated or amortized.
asset is impaired if carrying value exceeds net realizable value
reversals are allowed under both GAAP and IFRS - up to the original carrying value
Derecognition (of PPE and intangible assets) =
when long lived assets are sold, exchanged or abandoned
When sold: G&L recognized on IS.
Sale of a long-lived asset will be an ICF on the CFS (indirect method)
Abandoned: same as sale, loss recognized on IS.
Exchange: G&L is calculated on the old asset (carrying val - fair val) and the new asset is added to the BS at fair value (doesnt seem particularly clear why it's done this way)
PPE: IFRS Disclosures =
For each class of PPE:
- basis for measurement (usualy historical cost)
- Useful Lives and depreciation rates
- Gross carrying value and acc depr
- reconciliation of carrying amounts from start to end of period
- title restrictions and assets pledged as collateral
- agreements to acquire PPE in the future
If revaluation method was used:
- revaluation date
- how fair value was determined
- carrying value using the historical cost model
Intangible Assets: IFRS disclosures =
similar to PPE, also:
whether the useful lives of the assets are finite or indefinite
Impaired Assets: IFRS Disclosures =
Amounts of impairment losses and reversals by asset class
where the losses and reversales are recognized in the income statement
circumstances that caused loss/reversals
PPE: GAAP disclosures =
Depreciation expense by period
balances of major asset classes by nature and function (land, machinery etc)
accumulated depreciation by asset classes or total
general description of depr methods used
Intangible Assets: GAAP Disclosures =
similar to PPE
PLUS estimate of amortization expense for the next 5 years
Impaired assets: GAAP =
description of the impaired asset
circumstances causing impairment
how fair value was determined
amount of the loss
where the loss is recognized in the income statement
Investment property vs PPE: GAAP =
Investment property vs PPE: IFRS =
investment property: owned for purpose of earning cap appreciation, or collecting rental income
valuation: fair value model (if it can be reasonably determined) or cost model
cost model is the same as PPE.
DISCLOSURES: fair value of investment property + regular disclosures for long lived assets
fair value model: revaluation above historical cost is recognized as a gain on the IS (not as revaluation surplus in owners equity, as in revaluation model)
DISCLOSURES: how fair value is determined + how beginning and ending values are reconciled
the chosen model must be disclosed
CHANGES FROM/TO INVESTMENT PROPERTY: under cost model the carrying value does not change if property is reclassified as investment, or no longer investment.
under fair value model: see table