70 Lesson 1: Acquisition of Long-Lived Assets: Property, Plant, and Equipment, and Intangible Assets

Define long-lived assets

Long-lived assets provide economic benefits over a period longer than one year.

Most long-lived assets are depreciated or amortized over their expected useful life.

What are the three types of long-lived assets?

1. Tangible assets: Have physical substance (e.g., land, plant, equipment).

2. Intangible assets: Lack physical substance (e.g., patents, trademarks).

3. Financial assets: Include securities issued by other companies.

What is the exception with land and intangible assets with indefinite useful lives?

Land and intangible assets with indefinite useful lives are exceptions; their costs are not expensed over time.

How are tangible assets intended for the company's use recorded on the balance sheet?

They are recorded at cost (often fair value) on the balance sheet

What happens when a company acquires multiple assets as a group, and how is the purchase price allocated in such cases?

The purchase price is allocated to each asset based on its fair value.

What is the criteria for capitalizing a cost, and how is it recorded on the balance sheet?

Costs that are expected to benefit the company for more than one year are capitalized. Capitalized costs are recorded as noncurrent assets on the balance sheet.

What is the criteria for expensed cost?

Costs that are expected to benefit the company within the period are expensed. Capitalized costs are recorded on the income statement.

How are capitalized costs allocated over time for tangible and intangible assets with finite lives, and what impact do they have on net income and the book value of the asset?

They are allocated over time as depreciation expense for tangible assets and amortization expense for intangible assets with finite lives.

These expenses reduce net income and the book value of the asset.

What are depreciation and amortization expenses, and how do they affect future cash flows?

Depreciation and amortization expenses are non-cash items that have no impact on future cash flows, except for reducing taxes payable.

hat is the accounting treatment for costs that are expensed immediately, and how do they impact net income and retained earnings?

Costs that are expensed immediately reduce net income for the current period by the entire after-tax amount. This results in lower income and lower retained earnings for the related period. No related asset is recognized on the balance sheet, and there are no depreciation or amortization charges in future periods.

How are long-lived tangible assets acquired through a nonmonetary exchange accounted for on the balance sheet?

The recognized amount on the balance sheet equals the fair value of the acquired asset.

When accounting for exchanges, the carrying amount of the asset given up is removed from noncurrent assets on the balance sheet, and the fair value of the acquired asset is added.

Any difference between these values results in a gain or loss on the income statement.

A gain is recorded if the fair value of the acquired asset is greater than the value of the asset given up, while a loss is recorded if the fair value of the acquired asset is less than the value of the asset given up.

If the fair value can't be determined, the recognized amount equals the carrying amount of the asset given up, and no gain or loss is recognized.

How are long-lived tangible assets acquired through a purchase accounted for, and what additional expenses may be included in the asset's value on the balance sheet?

When purchasing a long-lived asset, any other expenses besides the purchase price, such as shipping, installation, and asset preparation costs, may be incurred. These costs are capitalized and included in the asset's value on the balance sheet.

Subsequent expenses should be capitalized if they are expected to provide benefits beyond one year and expensed if not expected to provide benefits beyond one year. Expenditures that extend an asset's useful life are typically capitalized.

What are some impacts of the expense decision in accounting, and how does it affect earnings, taxes, and cash flow?

Choosing to expense a cost creates the impression of greater earnings growth in the current year, as it results in higher expenses for that period and no related expenses in the future. It also lowers taxable income, reducing taxes and conserving cash.

What are some impacts of the capitalization decision in accounting, and how does it affect achieving earnings targets and operating cash flow?

Capitalizing a cost may make it easier to achieve earnings targets for a specific period. It also allows the reporting of higher operating cash flow, which is an essential valuation metric.

What should analysts consider regarding companies' accounting choices for expenses and capitalization?

Analysts should be aware that companies may inflate reported cash flow from operations by capitalizing expenditures that should be expensed, inflate profits to meet earnings targets by capitalizing costs that should be expensed, and depress current period income by expensing costs that should be capitalized. These choices can create the appearance of impressive profitability growth without actual performance improvement.

How does the capitalization of expenditures affect long-term profits, and when does this trend continue?

When a company continuously purchases fixed assets and capitalizes expenditures, it results in higher profits over an extended period. This trend continues until the value of fixed assets purchased becomes lower than the depreciation charged on capitalized assets.

Why is it important to account for differences in expenditure capitalizing policies when comparing companies?

It's crucial to account for differences in expenditure capitalizing policies when comparing companies because these policies can significantly impact reported financial metrics and can lead to misleading comparisons if not considered.

When is the capitalization of interest costs required, and what is an example of a situation where this is necessary?

The capitalization of interest costs is required for assets with extended periods to become ready for intended use. For example, when a company constructs its own building, interest expenses for construction must be capitalized along with construction costs.

How is capitalized interest treated under IFRS and U.S. GAAP, and what happens when the asset is in use?

Under IFRS (but not U.S. GAAP), income earned from temporarily investing borrowed funds for asset financing must be subtracted from interest expense. Capitalized interest for self-use assets becomes part of the asset's cost on the balance sheet.

After the asset is in use, the total cost (including capitalized interest) is depreciated over time, and capitalized interest becomes a part of depreciation expense, not interest expense.

Where can capitalized interest costs and expensed interest costs appear in financial reporting?

Capitalized interest can appear on the balance sheet, while expensed interest costs appear on the income statement.

How are capitalized interest costs handled for firms constructing buildings for sale, and where do they appear in financial statements?

Capitalized interest costs are included in inventory as current assets. Capitalized interest is expensed as a part of the Cost of Goods Sold (COGS) when the building is sold.

How are interest payments classified in terms of cash flow, and how do they differ under IFRS and U.S. GAAP?

Capitalized interest payments made before construction completion are classified as "cash flow from investing activities." Expensed interest payments may be classified as operating or financing cash outflows under IFRS and as operating cash outflows under U.S. GAAP.

What is the impact of capitalization of interest costs on cash flow, and why is it important for analysts to assess the effect of classification on reported cash flows?

Capitalized interest reduces investing cash flow, while expensed interest reduces operating cash flow. Analysts should assess the effect of classification on reported cash flows to understand how a company's cash is being used.

What is the Interest Coverage Ratio, and how is it calculated? What does it measure, and what does a higher ratio indicate?

The Interest Coverage Ratio is calculated as (EBIT / Interest expense) and measures how many times a company's operating profits (EBIT) cover its interest expense. A higher ratio indicates the company's ability to comfortably service its debt with operating earnings.

How should adjustments be made for net income when calculating the Interest Coverage Ratio to provide a more accurate picture?

To provide a true picture of the interest coverage ratio, use the total interest expense for the period, whether capitalized or expensed, in the denominator.

If interest that was previously capitalized is being depreciated, adjust net income to remove the impact of depreciation of capitalized interest.

Any interest costs capitalized in the current period should be treated as interest expense, reducing net income.

What defines intangible assets, and what are some examples of such assets?

Intangible assets lack physical substance and include items with exclusive rights like patents, copyrights, and trademarks. Some have finite lives, while others have indefinite lives.

How are finite-life intangible assets, like patents, accounted for, and what is the process of amortization?

Finite-life intangible assets are amortized over their useful life, which involves allocating their cost over time.

What is the process of impairment testing for indefinite-life intangible assets, like goodwill, and when is it conducted?

Indefinite-life intangible assets are not amortized. They are tested for impairment at least annually. If impaired, the asset's balance sheet value is reduced, and a loss is recognized on the income statement.

How are intangible assets classified, and what are the criteria for identifiable intangible assets under IFRS?

Intangible assets can be classified as identifiable or unidentifiable. Under IFRS, identifiable intangible assets must meet definitional and recognition criteria

• Definitional criteria:

  • Identifiability (separable or arising from legal rights).

  • Under the company's control.

  • Expected to earn future economic benefits.

• Recognition criteria:

  • Probability of future economic benefits flowing to the entity.

  • Reliable measurement of the asset's cost.

Unidentifiable intangible assets, like goodwill, cannot be purchased separately and may have an indefinite life.

What does the accounting for an intangible asset depend on?

The accounting for an intangible asset depends on how it was acquired.

How are intangible assets acquired in situations other than business combinations recorded on the balance sheet, and how are the costs of acquisition classified on the cash flow statement?

Intangible assets acquired in situations other than business combinations are recorded at fair value when acquired, often equal to the purchase price, and recognized on the balance sheet.

The costs of acquisition are classified as investing activities on the cash flow statement.

If multiple intangible assets are acquired as a group, the purchase price is allocated to each based on fair value.

What is the typical accounting treatment for intangible assets developed internally, and how does it affect financial ratios?

Intangible assets developed internally are generally expensed when incurred but can be capitalized in certain situations.

The choice between expensing and capitalizing impacts financial ratios. When a company develops intangible assets internally, it expenses development costs, recognizes no related assets, and classifies development-related cash outflows under operating activities on the cash flow statement.

A firm acquiring intangible assets recognizes them as assets and classifies development costs under investing activities on the cash flow statement.

How can a company's strategy for intangible assets (developing vs. acquiring) impact its reported financial ratios?

A company's strategy for intangible assets, whether it develops them internally or acquires them, can significantly impact its reported financial ratios. The choice affects how costs are treated and classified on the cash flow statement, which in turn influences financial metrics.

How are expenditures on research or during the research phase of an internal project treated in IFRS, and when can intangible assets be recognized from development?

In IFRS, expenditures on research or during the research phase of an internal project are expensed. Intangible assets can be recognized from the development phase if certain criteria are met, including demonstrating technical feasibility and an intent to use or sell the asset.

What is the definition of development, and when does it occur in the context of intangible assets?

Development is the application of research findings to create new or improved materials, devices, products, etc., before commercial production or use begins.

How are R&D costs generally treated in U.S. GAAP, and under what conditions can certain software development costs be capitalized?

In U.S. GAAP, R&D costs are generally expensed when incurred. Certain software development costs can be capitalized when technological feasibility for external sale is established, and there is a probability of project completion and intended use for internal use. Capitalized costs may include employee costs for software development.

What are the implications of expensing development costs in terms of current-period net income, operating cash flow, and investing cash flow?

Expensing development costs results in lower current-period net income, lower operating cash flow, and higher investing cash flow. Note that if current period software development costs exceed amortization of prior periods' capitalized development costs, net income would be lower under expensing. If software development expenditures were to slow down such that current year expenses are lower than amortization of prior periods' capitalized costs, net income would be higher under expensing.

Explain the treatment of Software development costs for internal use under IFRS and U.S. GAAP

• IFRS: expense these costs until the recognition criteria is met and capitalize them thereafter

• U.S. GAAP: these costs can be capitalize once it has been demonstrated that is probable that the project will be completed.

How is the acquisition method used for intangible assets when one company acquires another, and what is the treatment of excess purchase price in the case of goodwill?

The acquisition method is used when one company acquires another, both under IFRS and U.S. GAAP.

If the purchase price exceeds the fair value of net assets, the excess is recorded as goodwill. Goodwill is an intangible asset that is inseparable from the acquired business. Only goodwill created in a business acquisition can be recognized on the balance sheet; internally generated goodwill cannot be capitalized.

What are the key differences in the treatment of acquired intangible assets under IFRS and U.S. GAAP?

Under IFRS, acquired intangible assets are recognized as identifiable if they meet definitional and recognition criteria; otherwise, they are part of goodwill.

Under U.S. GAAP, intangible assets are recognized separately from goodwill if they arise from legal or contractual rights or can be separated from the acquired company. Examples include patents, copyrights, franchises, licenses, and Internet domain names.

Why might analysts need to make adjustments when comparing companies with differing capitalization practices for intangible assets, and what are the steps to make these adjustments for companies capitalizing software development costs?

Analysts need to make adjustments to account for differences in capitalization practices when comparing companies. For companies capitalizing software development costs, analysts should:

• Include related software development costs as expenses in the income statement for the current period.

• Exclude amortization of development costs capitalized in prior periods from the income statement.

• Remove the capitalized asset from the balance sheet, decreasing assets and equity.

• Reduce(ouflow) operating cash flow and increase(inflow) investing cash flow by the amount of development costs capitalized in the current period.

• Recalculate ratios involving income, long-lived assets, or cash flow from operations using adjusted values.