Chapters 7 and 8

Long-term Assets

Long-Term Assets

Long-term assets mainly consist of property, plant, and equipment (PPE).

These assets often makeup the largest asset amounts.

Future expenses arising from these long-term assets often makeup the larger expense amounts—typically reflected in depreciation expense and asset write-downs.

What is Included in Cost?

All expenditures necessary to make asset ready for its intended use.

Postacquisition Expenditures:Betterments or Maintenance? Betterments:

Increase asset’s useful life Improve quality of asset’s output Increase quantity of asset’s output Reduce asset’s operating costs

Accounting treatment Betterments are capitalized Maintenance expenditures are expensed

Depreciation Factors and Process

Depreciation requires the following estimates:

1. Useful life – period of time over which the asset is expected to generate cash inflows

2. Salvage value – Expected disposal amount for the asset at the end of its useful life

3. Depreciation rate – an estimate of how the asset will be used up over its useful life.

Variance in Depreciation

A company can depreciate different assets using different depreciation rates (and different useful lives).

Whatever depreciation rate is chosen, however, it must generally be used throughout the useful life of that asset.

Changes to depreciation rates can be made, but they must be justified as providing “better quality” financial reports.

Depreciation Methods

Depreciation Methods:1. Straight-line method

2. Accelerated Methods (Double-declining-balance method)

Straight-line Method

Straight-line method: Under the straight-line (SL) method, depreciation expense is recognized evenly over the estimated useful life of the asset.

Consider the following example

An asset (machine) with the following details:

(1) cost of $100,000

(2) salvage value of $10,000

(3) useful life of 5 years

Straight-line Depreciation Example For the straight-line method, we use our

illustrative asset to assign the following amounts to the depreciation formula:

SL Example

For the asset’s first year of usage, $18,000 ($90,000 * 20%) of depreciation expense is reported in the income statement. At the end of that first year the asset is reported on the balance sheet as follows:

Net book value (NBV) is cost less accumulated depreciation. At the end of year 2, the net book value will be reduced by

another $18,000 to $64,000.

Double-declining-balance method Double-declining-balance method. For the

double-declining-balance (DDB) method, we use our illustrative asset to assign the following amounts to the depreciation formula: (2 x BV) / Useful Life

Double-declining-balance method The asset is reported on the balance sheet

as follows:

In the second year, $24,000 ($60,000 40%) of depreciation expense is recorded in the income statement and the NBV of the asset on the balance sheet follows:

DDB Depreciation Schedule

Comparison of Depreciation Methods

Asset Sales

Asset Impairments Impairment of plant assets is determined by comparing

the sum of the expected future (undiscounted) cash flows generated by the asset with its net book value.

Companies must recognize a loss if the asset is deemed to be impaired.

When a company takes an impairment charge, assets are reduced by the amount of the write-down and the loss is recognized in the income statement, which

reduces current period income.

Accumulated Depreciation

Does not represent the accumulation of any tangible thing.

Sum of the original cost that has been expensed.

Funding the purchase of new assets is usually unrelated to depreciation.

Can distort ROA calculations!

1/1/99 12/31/99 12/31/00 12/31/01 12/31/02 12/31/03Book Value 1,000,000 900,000 800,000 700,000 600,000 500,000EBITDA 220,000 220,000 220,000 220,000 220,000Depreciation 100,000 100,000 100,000 100,000 100,000Net Income 120,000 120,000 120,000 120,000 120,000ROA 12.6% 14.1% 16.0% 18.5% 21.8%Age of assets 1 2 3 4 5

Analysis of Useful life and Percent Used Up Estimated useful life =

Percent used up =

Intangibles

Goodwill What is it? Impairment test

R&D Patents, copyrights

Marketing

Natural Resources

Depletion

Equity Securities What is an equity investment?

Why would a firm invest in the equity of another firm?

Accounting for Investments GAAP identifies three levels of

influence/control: Passive Significant influence Control

Passive Passive. In this case the purchasing company is

merely an investor and cannot exert any influence over the investee company. Its goal for the investment is to realize dividend and capital gain income. Generally, passive investor status is presumed if the investor company owns less than 20% of the outstanding voting stock of the investee company.

Significant influence Significant influence. In certain circumstances, a

company can exert significant influence over, but not control, the activities of the investee company. Generally, significant influence is presumed if the investor company owns 20-50% of the voting stock of the investee company.

Control Control. When a company has control over

another, it has the ability to elect a majority of the board of directors and, as a result, the ability to affect its strategic direction and hiring of executive management. Control is generally presumed if the investor company owns more than 50% of the outstanding voting stock of the investee company.

Intercorporate Investments

Some terms Mark-to-market Realized Recognized Ready market Trading security Available for sale security

Passive - No ready market Account for at cost No mark-to-market

Investment Classifications GAAP allows for two possible classification is equity

investments: Available-for-sale. Investments in securities that

management intends to hold for capital gains and dividend income; although it may sell them if the price is right.

Trading. Investments in securities that management intends to actively trade (buy and sell) for trading profits as market prices fluctuate.

Passive - Ready market Trading or Available for sale depending on

management’s intentions Both are marked-to-market For trading securities the gain/loss is recognized

prior to being realized (on income statement) For available for sale securities recognition is at

realization. Until then the holding gain/loss is kept in an the equity section of the balance sheet (not on income statement)

Are Changes in Asset Value Income? Changes in the carrying amount of the investment

(asset) has a corresponding effect on equity:Assets = Liabilities + Equity

The central issue in the accounting for investments is whether this change in equity is income.

The answer depends on the investment classification.

Example of Trading and Available for sale 10/1/98 Buy 10 shares @ $15 each

Record at cost

12/21/98 Market value rises to $18 Mark-to-market

02/20/99 Sell 10 shares @20 each Gain (loss) = Sales price – Book Value

Held To Maturity Investments

Equity Method Investments Equity Method accounting is required for

investments in which the investor company can exert “significant influence” over the investee.

Significant influence is the ability of the investor to affect the financial or operating policies of the investee.

Equity Method Investments Ownership levels of 20-50% of the outstanding common stock of

the investee company presume significant influence. Significant influence can also exist when ownership is less than

20% if, for example, the investor company is able to gain a seat on the board of

directors of the investee company, or when the investor controls technical know-how or patents that

are used by the investee company, or when the investor company is able to exert control by virtue of

legal contracts between it and the investee company.

Accounting for Equity Method Investments Initially record investment at cost. Increase asset to reflect proportionate share of net

income. Essentially treats their income as yours. Dividends decrease investment. Treated as a return

of investment. They are not considered income. No mark-to-market Income recognized rarely equals either cash flow or

actual change in market value.

Equity Method Accounting

Assume that HP acquires a 30% interest in Mitel Networks. On the date of acquisition, Mitel reports $1,000 of stockholders’ equity, and HP purchases its 30% stake for $300.

Assume that Mitel reports net income of $100 and pays dividends of $20 (30% or $6 to HP)

Equity Method Accounting

Following are the balance sheet and income statement impacts for Following are the balance sheet and income statement impacts for the preceding transactions: the preceding transactions:

Your turn Initially L purchases 30% of S for $9 when

the book value of S = $301. S has income of $20 and pays total

dividends of $102. S has a loss of $10 and pays total dividends

of $20 Record L’s yearly income from S and

investment in S

Equity method Why would a firm prefer using the equity

method over consolidation?

Blue and Yellow = Green example

Equity method cautions! Income shown on income statement is not

really income. The asset shown is not at market value. Potentially liabilities are “hidden” off balance

sheet.

Business Combinations (Over 50%) 2 companies brought together as single accounting

entity. Results in a combination of both the investor and

investment firm’s financial statements. Purchase method must be used for acquisition of

another company. Prior to 2002 and outside of U.S., under certain

conditions the pooling of interests method was/is used.

Investments with Control — Consolidation Accounting Accounting for business combinations

(acquisitions) involves one additional step to equity method accounting.

Consolidation accounting replaces the investment balance with the assets and liabilities to which it relates, and it replaces the equity income reported by the investor company with the sales and expenses of the investee company to which it relates.

Consolidation Accounting

Consolidation with Purchase Price Above Book Value

Foreign Currency Translation Many companies conduct operations, not only in

countries outside of the US, but also in currencies other than $US.

Many purchase assets in foreign currencies, borrow in foreign currencies, and transact business with their customers in foreign currencies.

US corporations can have subsidiaries whose entire balance sheets and income statements are stated in foreign currencies.

Foreign Currency Translation Adjustment at Ford Motor Company

Income Statement Effects of Currency Swings

McDonald’s: