CFA Level 1 (2009) - 3

StuJy Sessioll ')

Cross-Reference to CFA Institute Assigned Reading #36 - Long-Lived Assets

Answer:

Adjusted total assets: The capitalized interest, net of the related depreciation, is removed from total assets (net property, plant, and equipment). Adjusted total assets are $2,045 ($2,060 total assets - $20 capitalized interest + $5 related depreciation).

Adjusted net profit margin: The capitaliz.ed interest is treated as interest expense and the related depreciation is eliminated hom operating expense. Adjusted net profit margin is 4.6% [($200 net income - $20 interest expense + $5 related depreciation) / $4,000 revenue].

Adjusted interest coverage ratio: The capitalized interest is treated as interest expense and the related depreciation is eliminated from EBIT. The adjusted interest coverage ratio (EBIT / interest expense) is 5.1 [($350 EBIT + $5 related depreciation) / ($50 interest expense + $20 capitalized interest)].

Adjusted operating cash Row: The capitalized interest is subtracted from operating cash flow. Adjusted operating cash Aow is $200 ($220 reported operating cash Aow - $20 capitalized interest).

Adjusted investing cash flow: The capitalized interest is added back to investing cash Aow. Adjusted investing cash flow is -$80 ( -$100 reported investing cash Aow + $20 capitalized interest).

TOtal cash flow does not change. We have simply reclassified the interest from an investing cash flow to an operating cash flow.

Note: We ignored the income tax effecrs in this example for simplicity.

Adjusted long-term debt-to-equity: The capitalized interest, net of the related depreciation expense, is subtracted from net income; thus, shareholders' equity (retained earnings) decreases by the same amount. Adjusted long-term debt-to-equity is 60.7% [$610/ ($1,020 reported equity- $20 capitalized interest + $5 related depreciation)] .

LOS 36.c: Explain the circumstances in which software development costs anel research and development costs are capitalized.

Intangible assets are long-term assets that lack physical substance, such as patents, brand names, copyrights, and franchises. The value of an identifiable intangible asset is based on the rights or privileges granted to the firm using the asset over a finite period. Consequently, the cost of an intangible asset is amortized over its useful life. Not all intangible assets are reported on the balance sheet.

An unidentifiable intangible asset is one that cannot be purchased separately and may have an infinite life. Intangible assets with infinite lives are not amortized bm arc tested for impairment at least annually. The most common example of an unidelltifiable intangible asset is goodwill. Goodwill is the excess of purchase price over the fair value of the identifiable assets (net of liabilities) acquired in a business acquisition.

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #36 - Long-Lived Assets

Created internally. With some exceptions, costs incurred by the firm to create intangible assets are expen;ed as incurred. Important exceptions arc research and development costs and software development costs.

Under U.S. GAAP, research and development costs are generally expensed as incurred. Under IFRS, research costS (costs incurred during the research phase of an internal project) are expensed as incurred. However, development costs (costs incurred during the development phase of an internal project) are capitalized.

CostS incurred to develop software for sale to others are expensed as incurred until the product's technological feasibility has been established. Once technological feasibility occurs, U.S. GAAP requires subsequent costs to be capitalized. Of course, judgment is involved in determining technological feasibility. Costs incurred when a firm develops software for its own internal use are also capitalized.

Purchased externally. An intangible asset purchased from another party is initially recorded on the balance sheet at cost, presumably its fair value at acquisition.

Obtained in a business acquisition. The purchase method is used to account for business acquisitions. Under the purchase method, the purchase price is allocated to the "identifiable" assets and liabilities of the acquired firm on the basis of fair value. Any remaining amount of the purchase price is recorded as goodwill. Goodwill is said to be an "unidentifiable" asset that cannot be separated from the business itself.

Only goodwill created in a business acquisition is capitalized on the balance sheet.

Internally generated goodwill is not.

Under U.S. GAAP, a fair value of the acquired firm's in-process research and development (IPR&D) must be estimated before computing goodwill. IPR&D is the amount related to a project that is incomplete at the acquisition date. IPR&D is expensed in the period when the acquisition takes place. By assigning a higher value to IPR&D, the firm will recognize less goodwill, higher expense, and lower earnings in the period of the acquisition, and higher earnings in the future. IPR&D is usually

not considered a recurring item. Thus, analysts will often remove this expense from the income statement when forecasting future earnings.

Under IFRS, IPR&D is not immediately expensed. Rather, the acquiring firm may report IPR&D as a separate "finite-lived" asset. Alternatively, IPR&D may be included as a part of goodwill.

Professor's Note: Recently, the Financial Accounting Standards Board issued

~SFAS No. 141 (R), effective December 15, 2008. Under the new standard, the

~treatment ofIPR&D differs significantly. You are not expected to know the new standard for the exam.

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #36 - Long-Lived Assets

lOS 36.d: Idcnti(v the dilTerent lkpreciation methods for long-lived tangible assets and discuss how the choicc of mcthod, uscfullives, and salvage values :dlcCl a company's financial statCI1lcnts, rat ios, and taxcs.

Depreciation is the systematic allocation of the asset's cost over time. Two important terms are:

Carrying (book) value. The net value of an asset or liability on the balance sheet. For property, plant, and equipment, carrying value equals historical cost minus accumulated depreciation.

•Historical cost. The original purchase price of the asset including installation and transportation costs. The gross investment in the asset is the same as its historical cost.

Depreciation is a real and significant operating expense. Even though depreciation doesn't req uire current cash expenditllres (the cash outflow was made in the past when the asset was purchased), it is an expense nonetheless and cannot be ignored.

The analyst must decide whether the reported depreciation expense is more or less than economic depreciation, which is the actllal decline in the value of the asset over the period. One chain of video rental stores was found to be overstating income by depreciating its stock of movies by equal amounts each year. In fact, a greater

portion of the decrease in the value of newly released movies occurs in the first year. Depreciating the rental assets by a greater amount during the first year would have better approximated actual economic depreciation.

Review of Depreciation Methods

Depreciation may be reported using straight-line, accelerated, or units-of-production methods.

Straight-line (SL) depreciation is the dominant method of computing depreciation for financial reporting. Depreciation is the same amount each year over the asset's estimated life:

With an accelerated depreciation method, more depreciation expense is recognized in the early years of an asset's life and less depreciation expense in the later years of its life. Accelerated depreciation methods result in lower net income in the early years of an asset's life and greater net income in the later years of an asset's life, compared to

straight-line depreciation. No additional depreciation expense is charged once the asset's book value reaches its estimated salvage value. Firms may use an accelerated method initially for an asset, and then switch to the straight-line method.

Study Session ')

Cross-Rcfcrencc (0 CFA Institutc Assigncd Reading #36 - Long-Lived Asscts

One often-used accelerated depreciation method is the double-declining balance (DDB)

Depreciation under the units-of-production method is based on usage rather than time. The depreciable cost of the asset (cOSt - estimated salvage value) is divided by the number of units the asset is expected to produce over its useful life (0 get depreciation per unit. Each year the nUIllber of units produced is multiplied by depreciation per unit to get the depreciation expense for the year. No additional depreciation expense is charged once the asset's book value reaches its estimated salvage value.

Choice of Method

Under U.S. C;\;\P, a flrm Illay usc dilTcrent depreciation Illethods Cor financial reporling and for tax reponing. In many countries this is nor the case. U.S. firms will uften use straight-line depreciation for financial statements and an accelerated method for tax reponing in order to reduce taxable income (and taxes paid) in the early years of an asset's life, effectively deferring payment of some taxes until the later years of the asset's life. The U.S. income tax code allows the lise of an accelerated method referred to as Modified Accelerated Cost Recovery System (MACRS) depreciation.

For a firm using straight-line depreciation for financial reponing, using an accelerated method for tax reporting does not change income tax expense reported on the income statement. The difference hetween income tax expense and income taxes payable in the early years is reported as an addition to the 1-irm's deferred tax liability (on the balance sheet). In the later years, when depreciation for tax is less than depreciation reported on the income statement, the excess of taxes payable over income tax expense reduces the deferred tax liability.

Note that total depreciation expense over an asset's life is the same under all methods. The partern of depreciarion expense and of net income (or taxable income) is different, not their totals over the asset's life. The differences in depreciation, net income, and reported net profit margin for the three methods are illustrated in the following example.

Study S<:ssiol1 l)

Cross-ReCer<:llce 10 CFA Illstiw(e Assigned Reading #36 - Long-Lived Assets

Example: Effcct of depreciation methods on nct incolpe

Sackett Laboratories purchases chemical processing machinery for $550,000. The equipment has an cstimated useful life of five years and an estimated salvage value of $50,000. The company expects to produce 20,000 units of output using this machinery, with 6,000 units in each of the [irst (WO years, 3,000 units in the next two years, and 2,000 units in the fifth year. The company's effective tax rate is 30%. Revenues are $600,000 per year, and expenses other than depreciation are $300,000 in each year. Calculatc Sackett's net income and net profit margin if the company

depreciates the machinery using a.) the straight-line method, b.) the double declining balance method, changing to the straight-line method after two years, and c.) the units of production method.

Answer

Using the straight-lille method, depreciation expense in each year is ($550,000- $50,0(0)/5 = $100,000.

Using (he double declining b,zlflilce method, each year's depreciation is 2/5 of the book value. In year 1, depreciation expense is $550,000 x 2/5 = $220,000, and in year 2, depreciation expense is ($550,000 - $220,000) x 2/5 = $132,000. Straightline depreciation expense for the remaining three years is ($550,000 - $220,000- $132,000 - $50,000) / 3 = $49,333.

Using the units o/production method, depreciation expense in the first two years

The accelerated depreciation methods result in pretax income, tax expense, net income, and net profit margins that are lower in the early years and higher in the later years, compared to straight-line depreciation. Over the entire period, however, depreciation expense, tax expense, pretax income, net income, and net profit margin are unaffected by the depreciation method chosen.

Useful Lives and Salvage Values

In general, a longer estimated useful life decreases annual depreciation and increases reported net income, while a shorter estimated useful life will have the opposite effect. A higher estimate of the residual (salvage) value will also decrease depreciation and increase net income, while a lower estimate of the salvage value will increase depreciation and decrease net income.

Although companies are required to disclose information on depreciable lives, such disclosures are often given as ranges and cover groups of assets rather than specific assets. The choice of estimated lives and residual values gives companies some ability to manage earnings, and an analyst should be alert to instances of excessively long

depreciable life assumptions or excessively high salvage values, both of which will lead to an overstatement of net income.

•Management could estimate a useful life longer than warranted (thus reducing depreciation expense and increasing income) and then write down the overstated assets in a restructuring process.

•Management might also write down assets, taking an immediate charge against income, and then record less future depreciation expense based on the reduced carrying value. This results in higher future net income in exchange for a one-time charge to current income.

5mdy Session 9

Cross-Reference to CFA Institute Assigned Reading #36 - Long-Lived Assets

•'rhe life of a depreciable asset or the residual valuc could be significanrly overstatcd, thus understatiflg depreciation expcnse during dH: lift: of the assct and increasing the loss when the assct is retired.

Under IFRS, a company may adjust the estimated residual value either up or down as new information is used to update this estimatc. Under U.S. GAAP, the initial estimate of an asset's residual value may be revised downward, but may not bc increased.

Dcprcciation expcnse may be allocated betwecn COGS and 5C&A expenses. While this allocation will not affect operating margins, it will affect thc gross margin (which is computed before SG&A expense) and operating expenses (which arc in addition to COGS).

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lOS ,,)6.e: Discuss the use of fixed asset disclosures to compare companies' average age of depreciable assets, and calculate, using such disclosures, the average age and average depreciable life of fixed assets.

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The footllotcS to thc financial statcments typically provide the <uJalyst considerable information about the company's fixed assets and depreciation methods. An analyst can use this data to estimate the average age of thc firm's assets. The ave:rage age is useful for two reasons:

•It helps idenrify older, less eFficient assets, which may make the firm less compctitive:.

•An analyst can estimate when major capital expenditures will be required, which will help the analyst forecast when the firm will face significant financing requiremcnts.

Different companies provide different lcvels of detail inthcir foornotc disclosures regarding fixed assets and depreciation, and groupings of assets with differenr useful lives arc common, As a result, the following methods of estimating average age of assets do not produce precise values, but can provide indications of areas that require more investigation by the analyst.

There are three llseful calculations regarding a firm's fixed assets:

•Average age (in years) is approximated by:

accumulated depreciation

annual depreciation expense

This calculation is more accurate with straight-line depreciation. The calculation can be significantly affected by the mix of assets.

•Average depreciable life is approximated by:

ending gross investment

annual depreciation expense

Gross investment is the original cost of the asset. Gross investmenr excludes accumulated depreciation and any impairment charges.

Study Session ')

Cross-Reference 1O CFA Institute Assigned Reading 1/36 - Long-Lived Assets

•Remaining useful life is approxilllared by:

ending nCI invcstlllcnt

--- . -------

annual dcprcciarion cxpcnsc

Nct invcSrlllclll is clju;d 10 original cost (gross invcstIllclll) minus accumulatcd dcpreciation.

Proji';sor's Note: ifJe remainillg IlSljid 11Ji' ((Ill also be approximated by subtmcting thf al)f1"llge age ii'o}f/ thl' r/u('l"ilge dfprtciablc Ii/e.

Example: Calculating average age and average depreciable life

At the end of 20X8, a company has gross fixed assets of $3 million and accumulated depreciation of $] million. During the year, depreciation expense W;lS

Another popular metric is to compare annual capital expenditures ro depreciation expense, This gives all illdicarioll of whether the firm is replacing its PP&E at the same ratc that its vallie is deprcciating.

LOS 36.f: Describe amonization of intangible assets with finite useful lives, and the estimates that affect the amortization calculations.

The allocation of an intangible asset's cost to the income statement is known as amortization expense. Amortizing an intangible asset is the same concept as depreciating a tangible asset.

Intangible assets with finite lives are amortized over their expected useful lives. The expense should match the benefits of owning rhe asset as they are used up during the period. Examples of intangible assets with finite lives include franchise rights granted for a specific period, acquired patents or copyrights, and a license that the finn plans to stop llsing after a period of years.

Study Session ')

Cross-Rcfcrencc to CFA lnstitlltc Assigned Rcading #36 - Long-Lived Assets

Intangible assets with inddlnite lives are not amortized, so no expense is reported on the income statemenr unless the asset is subject ro an impairment charge. (Jmpairmellt is explained later in this review.) Examples of intangible assets without finite lives include goodwill, a trademark that cm be renewed at minimal cost, and a license that can be renewed at little or no cost.

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LOS :)6.g: Discuss the liability For closure, removal, and environmental el'fects or long-lived operating assets, and discuss the financial statement impact and ratio dlects of that liability.

Companies often own or operare assets that cause environmental damage, including strip mines, nuclear power plants, offshore oil platforms, and production plallls that produce roxic waste as a by-product. Covernments often require the company ro clean lip the site and/or return it to its original condition once rhe company ceases using the asset. These obligations are known as asset retirement obligations (ARO).

The company initially measures the ARO at flir \·~due llSing a discounted cash How approach. The preselH value of the obligation, discounted at a rate based on the {ltm's credit standing, is reported on the balance sheet as a liability. The same amount is added to the carrying value of the specific asset. This keeps the accounting equation in balance \vithout causing an immediate reduction in equity.

Subsequenrly, the ARO amount is depreciated on the income statement over the remaining life of the related asset. In addition, the company will recognize accretion expense on the liability. The accretion expense is equal to the increase in the liability due to the passage of time.

At maturity, the ARO liability is equal to the full amount of tbe obJigarion and the related asset is fully depreciared. At this point, tbe obligation has been fully recognized in the income sratement.

Example: Accounting for an asset retirement obligation

An oil company is obligated to remediate a property once produccion is complere in 5 years. The future obligation is estimated at $1 million. Assuming a discount rate of 8%, discuss the financial statement impact of the ARG.

Answer:

At a discount fate of 8%, the present value of the obligation is $680,583. The present value of the obligation is added to the balance sheet value of the related asset and

is also reported as a liability. The oil company will then depreciate the asset and recognize accretion expense (at 8%) on the liability.

Professors Note: Adding an amount equaL to the present vaLue ofthe estimated

~future asset retil'ement costs to the purchase cost ofthe asset may seem a bit

~strange. This increase in asset vaLue serves to perfectly offset the ARO Liability at acquisition so that equity is not affected by the ARO Liability.

Study Session 9

Cross-Reference to CFA Institute Assigned Reading #36 - Long-Lived Assets

At the end of the first year, the oil company will recognize additionaL depreciation expense (above what it would have been withollt the ARO) of $136,117 ($680,583/ I 5 years) because of the increase in asset value to offset the ARO liability. In addition, accretion expense of $54,447 is recognized in the income statement ($680,583 X 8%), which represents the movement of the ARO liability toward its estimated future value of $1 million. At the end of the first year, the ARO liability has a balance of ($680,583 + $54,447 or $680,583 X 1.08). The liability has simply increased by 8%, the amount of the accretion expel1Se.

Professor's Note: We can aLso caLcuLate the baLance of the ARO Liability at the end of the first year as the present vaLue of$1 miLLion discounted for the remaining 4 years at 8%.

The accounting equation balances, as assets decrease by the depreciation expense of $136,117, liabilities increase by rhe accretion expense of $54,447, and stockholders' eq uiry decreases by the rotal expense of $190,564 ($136,117 depreciation expense + $54,447 accretion expense).

Over time, accrerion expense increases as rhe liability increases toward its face amount. Hence, at the end of the second year, accretion expense is equal to

ARO balance X 8%).

Ar the end of the asset's life, the ARO liabiliry will have a balance of $1 million and the value that was added to the asset initially will have been depreciated to zero.

Ratio Effects and Analytical Issues

Recognizing an ARO will increase both assets and liabilities by the same amount. Earnings will be lower as borh additional depreciation expense and accretion expense on the ARO liability are recognized in the income statement.

For analytical purposes, it is recommended that rhe ARO be treated as debt on rhe balance sheer and when calculating solvency ratios, such as the debt ratio and debr-to- equity rario. Note that any related offsetting amounts such as dedicated asset retirement funds, trust funds, escrow accounts, and the present value any tax savings expected when the asset retirement costs are actually paid (tax rate times current ARO) should be subtracted from the liability to get the adjustment to debt. In any event, treating the net ARO as debt will increase the debt ratio and debt-tO-equity ratio.

In addition, the accretion expense should be treated as interest when calculating the interest coverage ratio. This adjustment is accomplished by adding the accretion expense to borh EBIT and interest expense, which will typically decrease the interest coverage rano.