CHAPTER 10

LONG-LIVED ASSETS

Elaine Henry, CFA

Coral Gables, FL, U.S.A.

Elizabeth A. Gordon

Philadelphia, PA, U.S.A.

LEARNING OUTCOMES

After completing this reading, you will be able to do the following:

• Distinguish between costs that are capitalized and costs that are expensed in the period in which they are incurred.
• Compare the financial reporting of the following classifications of intangible assets: purchased, internally developed, acquired in a business combination.
• Explain and evaluate the effects on financial statements and ratios of capitalizing versus expensing costs in the period in which they are incurred.
• Describe the different depreciation methods for property, plant, and equipment and the effects of the choice of depreciation method and the assumptions concerning useful life and residual value on depreciation expense, financial statements, and ratios.
• Calculate depreciation expense.
• Describe the different amortization methods for intangible assets with finite lives and the effects of the choice of amortization method and the assumptions concerning useful life and residual value on amortization expense, financial statements, and ratios.
• Calculate amortization expense.
• Describe the revaluation model.
• Describe the impairment of property, plant, and equipment and intangible assets.
• Describe the derecognition of property, plant, and equipment and intangible assets.
• Explain and evaluate the effects on financial statements and ratios of impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets.
• Describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets.
• Analyze and interpret the financial statement disclosures regarding property, plant, and equipment and intangible assets.
• Compare the financial reporting of investment property with that of property, plant, and equipment.
• Explain and evaluate the effects on financial statements and ratios of leasing assets instead of purchasing them.
• Explain and evaluate the effects on financial statements and ratios of finance leases and operating leases from the perspective of both the lessor and the lessee.

1. INTRODUCTION

Long-lived assets, also referred to as noncurrent assets or long-term assets, are assets that are expected to provide economic benefits over a future period of time, typically greater than one year.1 Long-lived assets may be tangible, intangible, or financial assets. Examples of long-lived tangible assets, typically referred to as property, plant, and equipment and sometimes as fixed assets, include land, buildings, furniture and fixtures, machinery and equipment, and vehicles; examples of long-lived intangible assets (assets lacking physical substance) include patents and trademarks; and examples of long-lived financial assets include investments in equity or debt securities issued by other companies. The scope of this reading is limited to long-lived tangible and intangible assets (hereafter, referred to for simplicity as long-lived assets).

The first issue in accounting for a long-lived asset is determining its cost at acquisition. The second issue is how to allocate the cost to expense over time. The costs of most long-lived assets are capitalized and then allocated as expenses in the profit or loss (income) statement over the period of time during which they are expected to provide economic benefits. The two main types of long-lived assets with costs that are typically not allocated over time are land, which is not depreciated, and those intangible assets with indefinite useful lives. Additional issues that arise are the treatment of subsequent costs incurred related to the asset, the use of the cost model versus the revaluation model, unexpected declines in the value of the asset, classification of the asset with respect to intent (for example, held for use or held for sale), and the derecognition of the asset.

This reading is organized as follows. Section 2 describes and illustrates accounting for the acquisition of long-lived assets, with particular attention to the impact of capitalizing versus expensing expenditures. Section 3 describes the allocation of the costs of long-lived assets over their useful lives. Section 4 discusses the revaluation model that is based on changes in the fair value of an asset. Section 5 covers the concepts of impairment (unexpected decline in the value of an asset). Section 6 describes accounting for the derecognition of long-lived assets. Section 7 describes financial statement presentation, disclosures, and analysis of long-lived assets. Section 8 discusses differences in financial reporting of investment property compared with property, plant, and equipment. Section 9 describes accounting for leases. A summary is followed by practice problems.

2. ACQUISITION OF LONG-LIVED ASSETS

Upon acquisition, property, plant, and equipment (tangible assets with an economic life of longer than one year and intended to be held for the company’s own use) are recorded on the balance sheet at cost, which is typically the same as their fair value.2 Accounting for an intangible asset depends on how the asset is acquired. If several assets are acquired as part of a group, the purchase price is allocated to each asset on the basis of its fair value. An asset’s cost potentially includes expenditures additional to the purchase price.

A key concept in accounting for expenditures related to long-lived assets is whether and when such expenditures are capitalized (i.e., included in the asset shown on the balance sheet) versus expensed (i.e., treated as an expense of the period on the income statement). After examining the specific treatment of certain expenditures, we will consider the general financial statement impact of capitalizing versus expensing and two analytical issues related to the decision—namely, the effects on an individual company’s trend analysis and on comparability across companies.

2.1. Property, Plant, and Equipment

This section primarily discusses the accounting treatment for the acquisition of long-lived tangible assets (property, plant, and equipment) through purchase. Assets can be acquired by methods other than purchase.3 When an asset is exchanged for another asset, the asset acquired is recorded at fair value if reliable measures of fair value exist. Fair value is the fair value of the asset given up unless the fair value of the asset acquired is more clearly evident. If there is no reliable measure of fair value, the acquired asset is measured at the carrying amount of the asset given up. In this case, the carrying amount of the assets is unchanged, and no gain or loss is reported.

Typically, accounting for the exchange involves removing the carrying amount of the asset given up, adding a fair value for the asset acquired, and reporting any difference between the carrying amount and the fair value as a gain or loss. A gain would be reported when the fair value used for the newly acquired asset exceeds the carrying amount of the asset given up. A loss would be reported when the fair value used for the newly acquired asset is less than the carrying amount of the asset given up.

When property, plant, or equipment is purchased, the buyer records the asset at cost. In addition to the purchase price, the buyer also includes, as part of the cost of an asset, all the expenditures necessary to get the asset ready for its intended use. For example, freight costs borne by the purchaser to get the asset to the purchaser’s place of business and special installation and testing costs required to make the asset usable are included in the total cost of the asset.

Subsequent expenditures related to long-lived assets are included as part of the recorded value of the assets on the balance sheet (i.e., capitalized) if they are expected to provide benefits beyond one year in the future and are expensed if they are not expected to provide benefits in future periods. Expenditures that extend the original life of the asset are typically capitalized. Example 10-1 illustrates the difference between costs that are capitalized and costs that are expensed in a period.

Example 10-1 describes capitalizing versus expensing in the context of purchasing property, plant, and equipment. When a company constructs an asset (or acquires an asset that requires a long period of time to get ready for its intended use), borrowing costs incurred directly related to the construction are generally capitalized. Constructing a building, whether for sale (in which case, the building is classified as inventory) or for the company’s own use (in which case, the building is classified as a long-lived asset), typically requires a substantial amount of time. To finance construction, any borrowing costs incurred prior to the asset being ready for its intended use are capitalized as part of the cost of the asset. The company determines the interest rate to use on the basis of its existing borrowings or, if applicable, on a borrowing specifically incurred for constructing the asset. If a company takes out a loan specifically to construct a building, the interest cost on that loan during the time of construction would be capitalized as part of the building’s cost. Under IFRS, but not under U.S. GAAP, income earned on temporarily investing the borrowed monies decreases the amount of borrowing costs eligible for capitalization.

Thus, a company’s interest costs for a period are included either on the balance sheet (to the extent they are capitalized as part of an asset) or on the income statement (to the extent they are expensed). If the interest expenditure is incurred in connection with constructing an asset for the company’s own use, the capitalized interest appears on the balance sheet as a part of the relevant long-lived asset (i.e., property, plant, and equipment). The capitalized interest is expensed over time as the property is depreciated and is thus part of subsequent years’ depreciation expense rather than interest expense of the current period. If the interest expenditure is incurred in connection with constructing an asset to sell (for example, by a home builder), the capitalized interest appears on the company’s balance sheet as part of inventory. The capitalized interest is expensed as part of the cost of goods sold when the asset is sold. Interest payments made prior to completion of construction that are capitalized are classified as an investing cash outflow. Expensed interest may be classified as an operating or financing cash outflow under IFRS and is classified as an operating cash outflow under U.S. GAAP.

2.2. Intangible Assets

Intangible assets are assets lacking physical substance. Intangible assets include items that involve exclusive rights, such as patents, copyrights, trademarks, and franchises. Under IFRS, identifiable intangible assets must meet three definitional criteria. They must be (1) identifiable (either capable of being separated from the entity or arising from contractual or legal rights), (2) under the control of the company, and (3) expected to generate future economic benefits. In addition, two recognition criteria must be met: (1) It is probable that the expected future economic benefits of the asset will flow to the company, and (2) the cost of the asset can be reliably measured. Goodwill, which is not considered an identifiable intangible asset,4 arises when one company purchases another and the acquisition price exceeds the fair value of the identifiable assets (both the tangible assets and the identifiable intangible assets) acquired.

Accounting for an intangible asset depends on how it is acquired. The following sections describe accounting for intangible assets obtained in three ways: purchased in situations other than business combinations, developed internally, and acquired in business combinations.

2.2.1. Intangible Assets Purchased in Situations Other Than Business Combinations

Intangible assets purchased in situations other than business combinations, such as buying a patent, are treated at acquisition the same as long-lived tangible assets; they are recorded at their fair value when acquired, which is assumed to be equivalent to the purchase price. If several intangible assets are acquired as part of a group, the purchase price is allocated to each asset on the basis of its fair value.

In deciding how to treat individual intangible assets for analytical purposes, analysts are particularly aware that companies must use a substantial amount of judgment and numerous assumptions to determine the fair value of individual intangible assets. For analysis, therefore, understanding the types of intangible assets acquired can often be more useful than focusing on the values assigned to the individual assets. In other words, an analyst would typically be more interested in understanding what assets a company acquired (for example, franchise rights and a mailing list) than in the precise portion of the purchase price a company allocated to each asset. Understanding the types of assets a company acquires can offer insights into the company’s strategic direction and future operating potential.

2.2.2. Intangible Assets Developed Internally

In contrast with the treatment of construction costs of tangible assets, the costs to internally develop intangible assets are generally expensed when incurred. There are some situations, however, in which the costs incurred to internally develop an intangible asset are capitalized. The general analytical issues related to the capitalizing-versus-expensing decision apply here—namely, comparability across companies and the effect on an individual company’s trend analysis.

The general requirement that costs to internally develop intangible assets be expensed should be compared with capitalizing the cost of acquiring intangible assets in situations other than business combinations. Because costs associated with internally developing intangible assets are usually expensed, a company that has internally developed such intangible assets as patents, copyrights, or brands through expenditures on R&D or advertizing will recognize a lower amount of assets than a company that has obtained intangible assets through external purchase. In addition, on the statement of cash flows, costs of internally developing intangible assets are classified as operating cash outflows whereas costs of acquiring intangible assets are classified as investing cash outflows. Differences in strategy (developing versus acquiring intangible assets) can thus impact financial ratios.

IFRS require that expenditures on research (or during the research phase of an internal project) be expensed rather than capitalized as an intangible asset.5 Research is defined as “original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding.”6 The “research phase of an internal project” refers to the period during which a company cannot demonstrate that an intangible asset is being created—for example, the search for alternative materials or systems to use in a production process. IFRS allow companies to recognize an intangible asset arising from development (or the development phase of an internal project) if certain criteria are met, including a demonstration of the technical feasibility of completing the intangible asset and the intent to use or sell the asset. Development is defined as “the application of research findings or other knowledge to a plan or design for the production of new or substantially improved materials, devices, products, processes, systems or services before the start of commercial production or use.”7

Generally, U.S. GAAP require that both research and development costs be expensed as incurred but require capitalization of certain costs related to software development.8 Costs incurred to develop a software product for sale are expensed until the product’s technological feasibility is established and are capitalized thereafter. Similarly, companies expense costs related to the development of software for internal use until it is probable that the project will be completed and that the software will be used as intended. Thereafter, development costs are capitalized. The probability that the project will be completed is easier to demonstrate than is technological feasibility. The capitalized costs, related directly to developing software for sale or internal use, include the costs of employees who help build and test the software. The treatment of software development costs under U.S. GAAP is similar to the treatment of all costs of internally developed intangible assets under IFRS.

2.2.3. Intangible Assets Acquired in a Business Combination

When one company acquires another company, the transaction is accounted for using the acquisition method of accounting.9 Under the acquisition method, the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value. If the purchase price exceeds the sum of the amounts that can be allocated to individual identifiable assets and liabilities, the excess is recorded as goodwill. Goodwill cannot be identified separately from the business as a whole.

Under IFRS, the acquired individual assets include identifiable intangible assets that meet the definitional and recognition criteria.10 Otherwise, if the item is acquired in a business combination and cannot be recognized as a tangible or identifiable intangible asset, it is recognized as goodwill. Under U.S. GAAP, there are two criteria to judge whether an intangible asset acquired in a business combination should be recognized separately from goodwill: The asset must be either an item arising from contractual or legal rights or an item that can be separated from the acquired company. Examples of intangible assets treated separately from goodwill include the intangible assets previously mentioned that involve exclusive rights (patents, copyrights, franchises, licenses), as well as such items as internet domain names and video and audiovisual materials.

Exhibit 10-1 describes how InBev allocated the €40.3 billion purchase price for its acquisition of Anheuser-Busch. The majority of the identifiable intangible asset valuation (€16.473 billion) relates to brands with indefinite life. Another €256 million or €0.256 billion was for the identifiable intangible assets with definite useful lives—distribution agreements and favorable contracts. These assets are being amortized over the life of the associated contracts. In addition, €24.7 billion of goodwill was recognized.

EXHIBIT 10-1 Acquisition of Intangible Assets through a Business Combination

Excerpt from the 2008 annual report of AB InBev (BRU: ABI):

On 18 November, InBev has completed the acquisition of Anheuser-Busch, following approval from shareholders of both companies.. . . Effective the date of the closing, InBev has changed its name to AB InBev to reflect the heritage and traditions of Anheuser-Busch. Under the terms of the merger agreement, all shares of Anheuser-Busch were acquired for 70 U.S. dollar per share in cash for an aggregate amount of approximately 52.5b U.S. dollar or 40.3b euro.

The transaction resulted in 24.7b euro goodwill provisionally allocated primarily to the U.S. business on the basis of expected synergies.. . . The valuation of the property, plant and equipment, intangible assets, investment in associates, interest bearing loans and borrowings and employee benefits is based on the valuation performed by independent valuation specialist. The other assets and liabilities are based on the current best estimates of AB InBev’s management.

The majority of the intangible asset valuation relates to brands with indefinite life. The valuation of the brands with indefinite life is based on a series of factors, including the brand history, the operating plan and the countries in which the brands are sold. The brands with indefinite life include the Budweiser family (including Bud and Bud Light), the Michelob brand family, the Busch brand family and the Natural brand family and have been fair valued for a total amount of 16,473m euro. Distribution agreements and favorable contracts have been fair valued for a total amount of 256m euro. These are being amortised over the term of the associated contracts ranging from 3 to 18 years.

Source: AB InBev 2008 Annual Report, pp. 74–75.

2.3. Capitalizing versus Expensing—Impact on Financial Statements and Ratios

This section discusses the implications for financial statements and ratios of capitalizing versus expensing costs in the period in which they are incurred. We first summarize the general financial statement impact of capitalizing versus expensing and two analytical issues related to the decision—namely the effect on an individual company’s trend analysis and on comparability across companies.

In the period of the expenditure, an expenditure that is capitalized increases the amount of assets on the balance sheet and appears as an investing cash outflow on the statement of cash flows. In subsequent periods, a company allocates the capitalized amount over the asset’s useful life as depreciation or amortization expense (except assets that are not depreciated, i.e., land, or amortized, e.g., intangible assets with indefinite lives). This expense reduces net income on the income statement and reduces the value of the asset on the balance sheet. Depreciation and amortization are noncash expenses and therefore, apart from their effect on taxable income and taxes payable, have no impact on the cash flow statement. In the section of the statement of cash flows that reconciles net income to operating cash flow, depreciation and amortization expenses are added back to net income.

Alternatively, an expenditure that is expensed reduces net income by the after-tax amount of the expenditure in the period it is made. No asset is recorded on the balance sheet and thus no depreciation or amortization occurs in subsequent periods. The lower amount of net income is reflected in lower retained earnings on the balance sheet. An expenditure that is expensed appears as an operating cash outflow in the period it is made. There is no effect on the financial statements of subsequent periods.

Example 10-4 illustrates the impact on the financial statements of capitalizing versus expensing an expenditure.

As shown, discretion regarding whether to expense or capitalize expenditures can impede comparability across companies. Example 10-4 assumes the companies purchase a single asset in one year. Because the sum of net income over the three-year period is identical whether the asset is capitalized or expensed, it illustrates that although capitalizing results in higher profitability compared to expensing in the first year, it results in lower profitability ratios in the subsequent years. Conversely, expensing results in lower profitability in the first year but higher profitability in later years, indicating a favorable trend.

Similarly, shareholders’ equity for a company that capitalizes the expenditure will be higher in the early years because the initially higher profits result in initially higher retained earnings. Example 10-4 assumes the companies purchase a single asset in one year and report identical amounts of total net income over the three-year period, so shareholders’ equity (and retained earnings) for the firm that expenses will be identical to shareholders’ equity (and retained earnings) for the capitalizing firm at the end of the three-year period.

Although Example 10-4 shows companies purchasing an asset only in the first year, if a company continues to purchase similar or increasing amounts of assets each year, the profitability-enhancing effect of capitalizing continues if the amount of the expenditures in a period continues to be more than the depreciation expense. Example 10-5 illustrates this point.

Compared to expensing an expenditure, capitalizing the expenditure typically results in greater amounts reported as cash from operations. Capitalized expenditures are typically treated as an investment cash outflow whereas expenses reduce operating cash flows. Because cash flow from operating activities is an important consideration in some valuation models, companies may try to maximize reported cash flow from operations by capitalizing expenditures that should be expensed. Valuation models that use free cash flow will consider not only operating cash flows but also investing cash flows. Analysts should be alert to evidence of companies manipulating reported cash flow from operations by capitalizing expenditures that should be expensed.

In summary, holding all else constant, capitalizing an expenditure enhances current profitability and increases reported cash flow from operations. The profitability-enhancing effect of capitalizing continues so long as capital expenditures exceed the depreciation expense. Profitability-enhancing motivations for decisions to capitalize should be considered when analyzing performance. For example, a company may choose to capitalize more expenditures (within the allowable bounds of accounting standards) to achieve earnings targets for a given period. Expensing a cost in the period reduces current period profits but enhances future profitability and thus enhances the profit trend. Profit trend-enhancing motivations should also be considered when analyzing performance. If the company is in a reporting environment which requires identical accounting methods for financial reporting and taxes (unlike the United States, which permits companies to use depreciation methods for reporting purposes that differ from the depreciation method required by tax purposes), then expensing will have a more favorable cash flow impact because paying lower taxes in an earlier period creates an opportunity to earn interest income on the cash saved.

In contrast with the relatively simple examples given previously, it is generally neither possible nor desirable to identify individual instances involving discretion about whether to capitalize or expense expenditures. An analyst can, however, typically identify significant items of expenditure treated differently across companies. The items of expenditure giving rise to the most relevant differences across companies will vary by industry. This cross-industry variation is apparent in the following discussion of the capitalization of expenditures.

2.4. Capitalization of Interest Costs

As noted earlier, companies generally must capitalize interest costs associated with acquiring or constructing an asset that requires a long period of time to get ready for its intended use.11 As a consequence of this accounting treatment, a company’s interest costs for a period can appear either on the balance sheet (to the extent they are capitalized) or on the income statement (to the extent they are expensed).

If the interest expenditure is incurred in connection with constructing an asset for the company’s own use, the capitalized interest appears on the balance sheet as a part of the relevant long-lived asset. The capitalized interest is expensed over time as the property is depreciated—and is thus part of depreciation expense rather than interest expense. If the interest expenditure is incurred in connection with constructing an asset to sell, for example by a real estate construction company, the capitalized interest appears on the company’s balance sheet as part of inventory. The capitalized interest is then expensed as part of the cost of sales when the asset is sold.

The treatment of capitalized interest poses certain issues that analysts should consider. First, capitalized interest appears as part of investing cash outflows, whereas expensed interest reduces operating cash flow. Although the treatment is consistent with accounting standards, an analyst may want to examine the impact on reported cash flows. Second, interest coverage ratios are solvency indicators measuring the extent to which a company’s earnings (or cash flow) in a period covered its interest costs. To provide a true picture of a company’s interest coverage, the entire amount of interest expenditure, both the capitalized portion and the expensed portion, should be used in calculating interest coverage ratios. Additionally, if a company is depreciating interest that it capitalized in a previous period, income should be adjusted to eliminate the effect of that depreciation. Example 10-6 illustrates the calculation.

The treatment of capitalized interest raises issues for consideration by an analyst. First, capitalized interest appears as part of investing cash outflows, whereas expensed interest reduces operating or financing cash flow under IFRS and operating cash flow under U.S. GAAP. An analyst may want to examine the impact on reported cash flows of interest expenditures when comparing companies. Second, interest coverage ratios are solvency indicators measuring the extent to which a company’s earnings (or cash flow) in a period covered its interest costs. To provide a true picture of a company’s interest coverage, the entire amount of interest, both the capitalized portion and the expensed portion, should be used in calculating interest coverage ratios.

Generally, including capitalized interest in the calculation of interest coverage ratios provides a better assessment of a company’s solvency. In assigning credit ratings, rating agencies include capitalized interest in coverage ratios. For example, Standard & Poor’s calculates the EBIT interest coverage ratio as EBIT divided by gross interest (defined as interest prior to deductions for capitalized interest or interest income).

Maintaining a minimum interest coverage ratio is a financial covenant often included in lending agreements, for example, bank loans and bond indentures. The definition of the coverage ratio can be found in the company’s credit agreement. The definition is relevant because treatment of capitalized interest in calculating coverage ratios would affect an assessment of how close a company’s actual ratios are to the levels specified by its financial covenants and thus the probability of breaching those covenants.

2.5. Capitalization of Internal Development Costs

As noted previously, accounting standards require companies to capitalize software development costs after a product’s feasibility is established. Despite this requirement, judgment in determining feasibility means that companies’ capitalization practices may differ. For example, as illustrated in Exhibit 10-4, Microsoft judges product feasibility to be established very shortly before manufacturing begins and, therefore, effectively expenses—rather than capitalizes—research and development costs.

EXHIBIT 10-4 Disclosure on Software Development Costs

Excerpt from Management’s Discussion and Analysis (MD&A) of Microsoft Corporation (NasdaqGS: MSFT), Application of Critical Accounting Policies, Research and Development Costs:

SFAS No.86 specifies that costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to manufacturing. The amortization of these costs is included in cost of revenue over the estimated life of the products.

Source: Microsoft Corporation Annual Report 2009, p. 36.

Expensing rather than capitalizing development costs results in lower net income in the current period. Expensing rather than capitalizing will continue to result in lower net income so long as the amount of the current-period development expenses is higher than the amortization expense that would have resulted from amortizing prior periods’ capitalized development costs—the typical situation when a company’s development costs are increasing. On the statement of cash flows, expensing rather than capitalizing development costs results in lower net operating cash flows and higher net investing cash flows. This is because the development costs are reflected as operating cash outflows rather than investing cash outflows.

In comparing the financial performance of a company that expenses most or all software development costs, such as Microsoft, with another company that capitalizes software development costs, adjustments can be made to make the two comparable. For the company that capitalizes software development costs, an analyst can adjust (a) the income statement to include software development costs as an expense and to exclude amortization of prior years’ software development costs; (b) the balance sheet to exclude capitalized software (decrease assets and equity); and (c) the statement of cash flows to decrease operating cash flows and decrease cash used in investing by the amount of the current period development costs. Any ratios that include income, long-lived assets, or cash flow from operations—such as return on equity—will also be affected.

For the company in Example 10-7, current period software development expenditures exceed the amortization of prior periods’ capitalized software development expenditures. As a result, expensing rather than capitalizing software development costs would have the effect of lowering income. If, however, software development expenditures slowed such that current expenditures were lower than the amortization of prior periods’ capitalized software development expenditures, then expensing software development costs would have the effect of increasing income relative to capitalizing it.

This section illustrated how decisions about capitalizing versus expensing impact financial statements and ratios. Earlier expensing lowers current profits but enhances trends, whereas capitalizing now and expensing later enhances current profits. Having described the accounting for acquisition of long-lived assets, we now turn to the topic of measuring long-lived assets in subsequent periods.

3. DEPRECIATION AND AMORTIZATION OF LONG-LIVED ASSETS

Under the cost model of reporting long-lived assets, which is permitted under IFRS and required under U.S. GAAP, the capitalized costs of long-lived tangible assets (other than land, which is not depreciated) and intangible assets with finite useful lives are allocated to subsequent periods as depreciation and amortization expenses. Depreciation and amortization are effectively the same concept, with the term depreciation referring to the process of allocating tangible assets’ costs and the term amortization referring to the process of allocating intangible assets’ costs.12 The alternative model of reporting long-lived assets is the revaluation model, which is permitted under IFRS but not under U.S. GAAP. Under the revaluation model, a company reports the long-lived asset at fair value rather than at acquisition cost (historical cost) less accumulated depreciation or amortization, as in the cost model.

An asset’s carrying amount is the amount at which the asset is reported on the balance sheet. Under the cost model, at any point in time, the carrying amount (also called carrying value or net book value) of a long-lived asset is equal to its historical cost minus the amount of depreciation or amortization that has been accumulated since the asset’s purchase (assuming that the asset has not been impaired, a topic which will be addressed in Section 5). Companies may present on the balance sheet the total net amount of property, plant, and equipment and the total net amount of intangible assets. However, more detail is disclosed in the notes to financial statements. The details disclosed typically include the acquisition costs, the depreciation and amortization expenses, the accumulated depreciation and amortization amounts, the depreciation and amortization methods used, and information on the assumptions used to depreciate and amortize long-lived assets.

3.1. Depreciation Methods and Calculation of Depreciation Expense

Depreciation methods include the straight-line method, in which the cost of an asset is allocated to expense evenly over its useful life; accelerated methods, in which the allocation of cost is greater in earlier years; and the units-of-production method, in which the allocation of cost corresponds to the actual use of an asset in a particular period. The choice of depreciation method affects the amounts reported on the financial statements, including the amounts for reported assets and operating and net income. This, in turn, affects a variety of financial ratios, including fixed asset turnover, total asset turnover, operating profit margin, operating return on assets, and return on assets.

Using the straight-line method, depreciation expense is calculated as depreciable cost divided by estimated useful life and is the same for each period. Depreciable cost is the historical cost of the tangible asset minus the estimated residual (salvage) value.13 A commonly used accelerated method is the declining balance method, in which the amount of depreciation expense for a period is calculated as some percentage of the carrying amount (i.e., cost net of accumulated depreciation at the beginning of the period). When an accelerated method is used, depreciable cost is not used to calculate the depreciation expense but the carrying amount should not be reduced below the estimated residual value. In the units-of-production method, the amount of depreciation expense for a period is based on the proportion of the asset’s production during the period compared with the total estimated productive capacity of the asset over its useful life. The depreciation expense is calculated as depreciable cost times production in the period divided by estimated productive capacity over the life of the asset. Equivalently, the company may estimate a depreciation cost per unit (depreciable cost divided by estimated productive capacity) and calculate depreciation expense as depreciation cost per unit times production in the period. Regardless of the depreciation method used, the carrying amount of the asset is not reduced below the estimated residual value. Example 10-8 provides an example of these depreciation methods.

In many countries, a company must use the same depreciation methods for both financial and tax reporting. In other countries, including the United States, a company need not use the same depreciation method for financial reporting and taxes. As a result of using different depreciation methods for financial and tax reporting, pretax income on the income statement and taxable income on the tax return may differ. Thus, the amount of tax expense computed on the basis of pretax income and the amount of taxes actually owed on the basis of taxable income may differ. Although these differences eventually reverse because the total depreciation is the same regardless of the timing of its recognition in financial statements versus on tax returns, during the period of the difference, the balance sheet will show what is known as deferred taxes. For instance, if a company uses straight-line depreciation for financial reporting and an accelerated depreciation method for tax purposes, the company’s financial statements will report lower depreciation expense and higher pretax income in the first year, compared with the amount of depreciation expense and taxable income in its tax reporting. (Compare the depreciation expense in Year 1 for EVEN-LI Co. and SOONER Inc. in the previous example.) Tax expense calculated on the basis of the financial statements’ pretax income will be higher than taxes payable on the basis of taxable income; the difference between the two amounts represents a deferred tax liability. The deferred tax liability will be reduced as the difference reverses (i.e., when depreciation for financial reporting is higher than the depreciation for tax purposes) and the income tax is paid.

Significant estimates required for calculating depreciation include the useful life of the asset (or its total lifetime productive capacity) and its expected residual value at the end of that useful life. A longer useful life and higher expected residual value decrease the amount of annual depreciation expense relative to a shorter useful life and lower expected residual value. Companies should review their estimates periodically to ensure they remain reasonable. IFRS require companies to review estimates annually.

Although no significant differences exist between IFRS and U.S. GAAP with respect to the definition of depreciation and the acceptable depreciation methods, IFRS require companies to use a component method of depreciation.14 Companies are required to separately depreciate the significant components of an asset (parts of an item with a cost that is significant in relation to the total cost and/or with different useful lives) and thus require additional estimates for the various components. For instance, it may be appropriate to depreciate separately the engine, frame, and interior furnishings of an aircraft. Under U.S. GAAP, the component method of depreciation is allowed but is seldom used in practice.15 The following example illustrates depreciating components of an asset.

Total depreciation expense may be allocated between the cost of sales and other expenses. Within the income statement, depreciation expense of assets used in production is usually allocated to the cost of sales, and the depreciation expense of assets not used in production may be allocated to some other expense category. For instance, depreciation expense may be allocated to selling, general, and administrative expenses if depreciable assets are used in those functional areas. Notes to the financial statements sometimes disclose information regarding which income statement line items include depreciation expense, although the exact amount of detail disclosed by individual companies varies.

3.2. Amortization Methods and Calculation of Amortization Expense

Amortization is similar in concept to depreciation. The term amortization applies to intangible assets, and the term depreciation applies to tangible assets. Both terms refer to the process of allocating the cost of an asset over the asset’s useful life. Only those intangible assets assumed to have finite useful lives are amortized over their useful lives, following the pattern in which the benefits are used up. Acceptable amortization methods are the same as the methods acceptable for depreciation. Assets assumed to have an indefinite useful life (in other words, without a finite useful life) are not amortized. An intangible asset is considered to have an indefinite useful life when there is “no foreseeable limit to the period over which the asset is expected to generate net cash inflows” for the company.16

Intangible assets with finite useful lives include an acquired customer list expected to provide benefits to a direct-mail marketing company for two to three years, an acquired patent or copyright with a specific expiration date, an acquired license with a specific expiration date and no right to renew the license, and an acquired trademark for a product that a company plans to phase out over a specific number of years. Examples of intangible assets with indefinite useful lives include an acquired license that, although it has a specific expiration date, can be renewed at little or no cost and an acquired trademark that, although it has a specific expiration, can be renewed at a minimal cost and relates to a product that a company plans to continue selling for the foreseeable future.

As with depreciation for a tangible asset, the calculation of amortization for an intangible asset requires the original amount at which the intangible asset is recognized and estimates of the length of its useful life and its residual value at the end of its useful life. Useful lives are estimated on the basis of the expected use of the asset, considering any factors that may limit the life of the asset, such as legal, regulatory, contractual, competitive, or economic factors.

4. THE REVALUATION MODEL

The revaluation model is an alternative to the cost model for the periodic valuation and reporting of long-lived assets. IFRS permit the use of either the revaluation model or the cost model, but the revaluation model is not allowed under U.S. GAAP. Revaluation changes the carrying amounts of classes of long-lived assets to fair value (the fair value must be measured reliably). Under the cost model, carrying amounts are historical costs less accumulated depreciation or amortization. Under the revaluation model, carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortization.

IFRS allow companies to value long-lived assets either under a cost model at historical cost minus accumulated depreciation or amortization or under a revaluation model at fair value. In contrast, U.S. accounting standards require that the cost model be used. A key difference between the two models is that the cost model allows only decreases in the values of long-lived assets compared with historical costs but the revaluation model may result in increases in the values of long-lived assets to amounts greater than historical costs.

IFRS allow a company to use the cost model for some classes of assets and the revaluation model for others, but the company must apply the same model to all assets within a particular class of assets and must revalue all items within a class to avoid selective revaluation. Examples of different classes of assets include land, land and buildings, machinery, motor vehicles, furniture and fixtures, and office equipment. The revaluation model may be used for classes of intangible assets but only if an active market for the assets exists, because the revaluation model may only be used if the fair values of the assets can be measured reliably. For practical purposes, the revaluation model is rarely used for either tangible or intangible assets, but its use is especially rare for intangible assets.

Under the revaluation model, whether an asset revaluation affects earnings depends on whether the revaluation initially increases or decreases an asset class’ carrying amount. If a revaluation initially decreases the carrying amount of the asset class, the decrease is recognized in profit or loss. Later, if the carrying amount of the asset class increases, the increase is recognized in profit or loss to the extent that it reverses a revaluation decrease of the same asset class previously recognized in profit or loss. Any increase in excess of the reversal amount will not be recognized in the income statement but will be recorded directly to equity in a revaluation surplus account. An upward revaluation is treated the same as the amount in excess of the reversal amount. In other words, if a revaluation initially increases the carrying amount of the asset class, the increase in the carrying amount of the asset class bypasses the income statement and goes directly to equity under the heading of revaluation surplus. Any subsequent decrease in the asset’s value first decreases the revaluation surplus and then goes to income. When an asset is retired or disposed of, any related amount of revaluation surplus included in equity is transferred directly to retained earnings.

Asset revaluations offer several considerations for financial statement analyses. First, an increase in the carrying amount of depreciable long-lived assets increases total assets and shareholders’ equity, so asset revaluations that increase the carrying amount of an asset can be used to reduce reported leverage. Defining leverage as average total assets divided by average shareholders’ equity, increasing both the numerator (assets) and denominator (equity) by the same amount leads to a decline in the ratio. (Mathematically, when a ratio is greater than one, as in this case, an increase in both the numerator and the denominator by the same amount leads to a decline in the ratio.) Therefore, the leverage motivation for the revaluation should be considered in analysis. For example, a company may revalue assets up if it is seeking new capital or approaching leverage limitations set by financial covenants.

Second, assets revaluations that decrease the carrying amount of the assets reduce net income. In the year of the revaluation, profitability measures such as return on assets and return on equity decline. However, because total assets and shareholders’ equity are also lower, the company may appear more profitable in future years. Additionally, reversals of downward revaluations also go through income, thus increasing earnings. Managers can then opportunistically time the reversals to manage earnings and increase income. Third, asset revaluations that increase the carrying amount of an asset initially increase depreciation expense, total assets, and shareholders’ equity. Therefore, profitability measures, such as return on assets and return on equity, would decline. Although upward asset revaluations also generally decrease income (through higher depreciation expense), the increase in the value of the long-lived asset is presumably based on increases in the operating capacity of the asset, which will likely be evidenced in increased future revenues.

Finally, an analyst should consider who did the appraisal—that is, an independent external appraiser or management—and how often revaluations are made. Appraisals of the fair value of long-lived assets involve considerable judgment and discretion. Presumably, appraisals of assets from independent external sources are more reliable. How often assets are revalued can provide an indicator of whether their reported value continues to be representative of their fair values.

The next two examples illustrate revaluation of long-lived assets under IFRS.

Exhibit 10-6 provides an example of a company’s disclosures concerning revaluation. The exhibit shows an excerpt from the 2006 annual report of KPN, a Dutch telecommunications and multimedia company. The excerpt is from the section of the annual report in which the company explains differences between its reporting under IFRS and its reporting under U.S. GAAP.17 One of these differences, as previously noted, is that U.S. GAAP do not allow revaluation of fixed assets held for use. KPN elected to report a class of fixed assets (cables) at fair value and explained that under U.S. GAAP, using the cost model, the value of the class at the end of 2006 would have been €350 million lower.

Clearly, the use of the revaluation model as opposed to the cost model can have a significant impact on the financial statements of companies. This has potential consequences for comparing financial performance using financial ratios of companies that use different models.

5. IMPAIRMENT OF ASSETS

In contrast with depreciation and amortization charges, which serve to allocate the depreciable cost of a long-lived asset over its useful life, impairment charges reflect an unanticipated decline in the value of an asset. Both IFRS and U.S. GAAP require companies to write down the carrying amount of impaired assets. Impairment reversals are permitted under IFRS but not under U.S. GAAP.

An asset is considered to be impaired when its carrying amount exceeds its recoverable amount (“the higher of fair value less cost to sell or value in use” according to IAS 36 Impairment of Assets) or under U.S. GAAP when its carrying amount exceeds its fair value. Under U.S. GAAP, however, impairment losses are only recognizable when the carrying amount of the impaired asset is determined to be not recoverable. Therefore, in general, impairment losses are recognized when the asset’s carrying amount is not recoverable. However, IFRS and U.S. GAAP define recoverability differently. The following paragraphs describe accounting for impairment for different categories of assets.

5.1. Impairment of Property, Plant, and Equipment

Accounting standards do not require that property, plant, and equipment be tested annually for impairment. Rather, at the end of each reporting period (generally, a fiscal year), a company assesses whether there are indications of asset impairment. If there is no indication of impairment, the asset is not tested for impairment. If there is an indication of impairment, such as evidence of obsolescence, decline in demand for products, or technological advancements, the recoverable amount of the asset should be measured in order to test for impairment. For property, plant, and equipment, impairment losses are recognized when the asset’s carrying amount is not recoverable; the carrying amount is more than the recoverable amount. The amount of the impairment loss will reduce the carrying amount of the asset on the balance sheet and will reduce net income on the income statement. The impairment loss is a noncash item and will not affect cash from operations.

IFRS and U.S. GAAP differ somewhat both in the guidelines for determining that impairment has occurred and in the measurement of an impairment loss. Under IAS 36, an impairment loss is measured as the excess of carrying amount over the recoverable amount of the asset. The recoverable amount of an asset is defined as “the higher of its fair value less costs to sell and its value in use.” Value in use is a discounted measure of expected future cash flows. Under U.S. GAAP, assessing recoverability is separate from measuring the impairment loss. An asset’s carrying amount is considered not recoverable when it exceeds the undiscounted expected future cash flows. If the asset’s carrying amount is considered not recoverable, the impairment loss is measured as the difference between the asset’s fair value and carrying amount.

5.2. Impairment of Intangible Assets with a Finite Life

Intangible assets with a finite life are amortized (carrying amount decreases over time) and may become impaired. As is the case with property, plant, and equipment, the assets are not tested annually for impairment. Instead, they are tested only when significant events suggest the need to test. The company assesses at the end of each reporting period whether a significant event suggesting the need to test for impairment has occurred. Examples of such events include a significant decrease in the market price or a significant adverse change in legal or economic factors. Impairment accounting for intangible assets with a finite life is essentially the same as for tangible assets; the amount of the impairment loss will reduce the carrying amount of the asset on the balance sheet and will reduce net income on the income statement.

5.3. Impairment of Intangibles with Indefinite Lives

Intangible assets with indefinite lives are not amortized. Instead, they are carried on the balance sheet at historical cost but are tested at least annually for impairment. Impairment exists when the carrying amount exceeds its fair value.

5.4. Impairment of Long-Lived Assets Held for Sale

A long-lived (noncurrent) asset is reclassified as held for sale rather than held for use when it ceases to be used and management’s intent is to sell it. For instance, if a building ceases to be used and management’s intent is to sell it, the building is reclassified from property, plant, and equipment to noncurrent assets held for sale. At the time of reclassification, assets previously held for use are tested for impairment. If the carrying amount at the time of reclassification exceeds the fair value less costs to sell, an impairment loss is recognized and the asset is written down to fair value less costs to sell. Long-lived assets held for sale cease to be depreciated or amortized.

5.5. Reversals of Impairments of Long-Lived Assets

After an asset has been deemed impaired and an impairment loss has been reported, the asset’s recoverable amount could potentially increase. For instance, a lawsuit appeal may successfully challenge a patent infringement by another company, with the result that a patent previously written down has a higher recoverable amount. IFRS permit impairment losses to be reversed if the recoverable amount of an asset increases regardless of whether the asset is classified as held for use or held for sale. Note that IFRS permit the reversal of impairment losses only. IFRS do not permit the revaluation to the recoverable amount if the recoverable amount exceeds the previous carrying amount. Under U.S. GAAP, the accounting for reversals of impairments depends on whether the asset is classified as held for use or held for sale.18 Under U.S. GAAP, once an impairment loss has been recognized for assets held for use, it cannot be reversed. In other words, once the value of an asset held for use has been decreased by an impairment charge, it cannot be increased. For assets held for sale, if the fair value increases after an impairment loss, the loss can be reversed.

6. DERECOGNITION

A company derecognizes an asset (i.e., removes it from the financial statements) when the asset is disposed of or is expected to provide no future benefits from either use or disposal. A company may dispose of a long-lived operating asset by selling it, exchanging it, or abandoning it. As previously described, noncurrent assets that are no longer in use and are to be sold are reclassified as noncurrent assets held for sale.

6.1. Sale of Long-Lived Assets

The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying amount of the asset at the time of sale. An asset’s carrying amount is typically the net book value (i.e., the historical cost minus accumulated depreciation), unless the asset’s carrying amount has been changed to reflect impairment and/or revaluation, as previously discussed.

A gain or loss on the sale of an asset is disclosed on the income statement, either as a component of other gains and losses or in a separate line item when the amount is material. A company typically discloses further detail about the sale in the management discussion and analysis and/or financial statement footnotes. In addition, a statement of cash flows prepared using the indirect method adjusts net income to remove any gain or loss on the sale from operating cash flow and to include the amount of proceeds from the sale in cash from investing activities. Recall that the indirect method of the statement of cash flows begins with net income and makes all adjustments to arrive at cash from operations, including removal of gains or losses from nonoperating activities.

6.2. Long-Lived Assets Disposed of Other Than by a Sale

Long-lived assets to be disposed of other than by a sale (e.g., abandoned, exchanged for another asset, or distributed to owners in a spin-off) are classified as held for use until disposal.19 Thus, the long-lived assets continue to be depreciated and tested for impairment, unless their carrying amount is zero, as required for other long-lived assets owned by the company.

When an asset is retired or abandoned, the accounting is similar to a sale, except that the company does not record cash proceeds. Assets are reduced by the carrying amount of the asset at the time of retirement or abandonment, and a loss equal to the asset’s carrying amount is recorded.

When an asset is exchanged, accounting for the exchange typically involves removing the carrying amount of the asset given up, adding a fair value for the asset acquired, and reporting any difference between the carrying amount and the fair value as a gain or loss. The fair value used is the fair value of the asset given up unless the fair value of the asset acquired is more clearly evident. If no reliable measure of fair value exists, the acquired asset is measured at the carrying amount of the asset given up. A gain is reported when the fair value used for the newly acquired asset exceeds the carrying amount of the asset given up. A loss is reported when the fair value used for the newly acquired asset is less than the carrying amount of the asset given up. If the acquired asset is valued at the carrying amount of the asset given up because no reliable measure of fair value exists, no gain or loss is reported.

When a spin-off occurs, typically, an entire cash-generating unit of a company with all its assets is spun off. As an illustration of a spin-off, Altria Group Inc. effected a spin-off of Kraft Foods on 30 March 2007 by distributing about 89 percent of Kraft’s shares to Altria’s shareholders. The company prepared unaudited pro forma income statements and balance sheets (for illustrative purposes only) as if the spin-off had occurred at the beginning of the year. Exhibit 10-7 summarizes information from the asset portion of the company’s pro forma balance sheets. The items in the column labeled “Spin-Off of Kraft” reflect Kraft’s assets being removed from Altria’s balance sheet at the time of the spin-off. For example, Kraft’s property, plant, and equipment (net of depreciation) totaled $9.7 billion.

EXHIBIT 10-7 Altria Group, Inc. and Subsidiaries Pro Forma Condensed Consolidated Balance Sheet [partial]

7. PRESENTATION AND DISCLOSURES

Under IFRS, for each class of property, plant, and equipment, a company must disclose the measurement bases, the depreciation method, the useful lives (or, equivalently, the depreciation rate) used, the gross carrying amount and the accumulated depreciation at the beginning and end of the period, and a reconciliation of the carrying amount at the beginning and end of the period.20 In addition, disclosures of restrictions on title and pledges as security of property, plant, and equipment and contractual agreements to acquire property, plant, and equipment are required. If the revaluation model is used, the date of revaluation, details of how the fair value was obtained, the carrying amount under the cost model, and the revaluation surplus must be disclosed.

The disclosure requirements under U.S. GAAP are less exhaustive.21 A company must disclose the depreciation expense for the period, the balances of major classes of depreciable assets, accumulated depreciation by major classes or in total, and a general description of the depreciation method(s) used in computing depreciation expense with respect to the major classes of depreciable assets.

Under IFRS, for each class of intangible assets, a company must disclose whether the useful lives are indefinite or finite. If finite, for each class of intangible asset, a company must disclose the useful lives (or, equivalently, the amortization rate) used, the amortization methods used, the gross carrying amount and the accumulated amortization at the beginning and end of the period, where amortization is included on the income statement, and a reconciliation of the carrying amount at the beginning and end of the period.22 If an asset has an indefinite life, the company must disclose the carrying amount of the asset and why it is considered to have an indefinite life. Similar to property, plant, and equipment, disclosures of restrictions on title and pledges as security of intangible assets and contractual agreements to acquire intangible assets are required. If the revaluation model is used, the date of revaluation, details of how the fair value was obtained, the carrying amount under the cost model, and the revaluation surplus must be disclosed.

Under U.S. GAAP, companies are required to disclose the gross carrying amounts and accumulated amortization in total and by major class of intangible assets, the aggregate amortization expense for the period, and the estimated amortization expense for the next five fiscal years.23

The disclosures related to impairment losses also differ under IFRS and U.S. GAAP. Under IFRS, a company must disclose for each class of assets the amounts of impairment losses and reversals of impairment losses recognized in the period and where those are recognized on the financial statements.24 The company must also disclose in aggregate the main classes of assets affected by impairment losses and reversals of impairment losses and the main events and circumstances leading to recognition of these impairment losses and reversals of impairment losses. Under U.S. GAAP, there is no reversal of impairment losses. The company must disclose a description of the impaired asset, what led to the impairment, the method of determining fair value, the amount of the impairment loss, and where the loss is recognized on the financial statements.25

Disclosures about long-lived assets appear throughout the financial statements: in the balance sheet, the income statement, the statement of cash flows, and the notes. The balance sheet reports the carrying value of the asset. For the income statement, depreciation expense may or may not appear as a separate line item. Under IFRS, whether the income statement discloses depreciation expense separately depends on whether the company is using a “nature of expense” method or a “function of expense” method. Under the nature of expense method, a company aggregates expenses “according to their nature (for example, depreciation, purchases of materials, transport costs, employee benefits and advertising costs), and does not reallocate them among functions within the entity.”26 Under the function of expense method, a company classifies expenses according to the function, for example as part of cost of sales or of SG&A (selling, general, and administrative expenses). At a minimum, a company using the function of expense method must disclose cost of sales, but the other line items vary.

The statement of cash flows reflects acquisitions and disposals of fixed assets in the investing section. In addition, when prepared using the indirect method, the statement of cash flowstypically shows depreciation expense (or depreciation plus amortization) as a line item in the adjustments of net income to cash flow from operations. The notes to the financial statements describe the company’s accounting method(s), the range of estimated useful lives, historical cost by main category of fixed asset, accumulated depreciation, and annual depreciation expense.

To illustrate financial statement presentation and disclosures, the following example provides excerpts relating to intangible assets and property, plant, and equipment from the annual report of Vodafone Group Plc for the year ended 31 March 2009.

Note that the exhibits in the previous example contain relatively brief excerpts from the company’s disclosures. The complete text of the disclosures concerning the company’s noncurrent assets spans seven different footnotes, most of which are several pages long. In addition to information about the discount rate and other assumptions used to calculate impairment charges, the disclosures provide information about the sensitivity of impairment charges to changes in the assumptions.

Overall, an analyst can use the disclosures to understand a company’s investments in tangible and intangible assets, how those investments changed during a reporting period, how those changes affected current performance, and what those changes might indicate about future performance.

Ratios used in analyzing fixed assets include the fixed asset turnover ratio and several asset age ratios. The fixed asset turnover ratio (total revenue divided by average net fixed assets) reflects the relationship between total revenues and investment in PPE. The higher this ratio, the higher the amount of sales a company is able to generate with a given amount of investment in fixed assets. A higher asset turnover ratio is often interpreted as an indicator of greater efficiency.

Asset age ratios generally rely on the relationship between historical cost and depreciation. Under the revaluation model (permitted under IFRS but not U.S. GAAP), the relationship between carrying amount, accumulated depreciation, and depreciation expense will differ when the carrying amount differs significantly from the depreciated historical cost. Therefore, the following discussion of asset age ratios applies primarily to PPE reported under the cost model.

Asset age and remaining useful life, two asset age ratios, are important indicators of a company’s need to reinvest in productive capacity. The older the assets and the shorter the remaining life, the more a company may need to reinvest to maintain productive capacity. The average age of a company’s asset base can be estimated as accumulated depreciation divided by depreciation expense. The average remaining life of a company’s asset base can be estimated as net PPE divided by depreciation expense. These estimates simply reflect the following relationships for assets accounted for on a historical cost basis: total historical cost minus accumulated depreciation equals net PPE; and, under straight-line depreciation, total historical cost less salvage value divided by estimated useful life equals annual depreciation expense. Equivalently, total historical cost less salvage value divided by annual depreciation expense equals estimated useful life. Assuming straight-line depreciation and no salvage value (for simplicity), we have the following:

The application of these estimates can be illustrated by a hypothetical example of a company with a single depreciable asset. Assume the asset initially cost $100, had an estimated useful life of 10 years, and an estimated salvage value of $0. Each year, the company records a depreciation expense of $10, so accumulated depreciation will equal $10 times the number of years since the asset was acquired (when the asset is 7 years old, accumulated depreciation will be $70). Equivalently, the age of the asset will equal accumulated depreciation divided by the annual depreciation expense.

In practice, such estimates are difficult to make with great precision. Companies use depreciation methods other than the straight-line method and have numerous assets with varying useful lives and salvage values, including some assets that are fully depreciated, so this approach produces an estimate only. Moreover, fixed asset disclosures are often quite general. Consequently, these estimates may be primarily useful to identify areas for further investigation.

One further measure compares a company’s current reinvestment in productive capacity. Comparing annual capital expenditures to annual depreciation expense provides an indication of whether productive capacity is being maintained. It is a very general indicator of the rate at which a company is replacing its PPE relative to the rate at which PPE is being depreciated.

8. INVESTMENT PROPERTY

Investment property is defined under IFRS as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rentals or capital appreciation or both.27 An example of investment property is a building owned by a company and leased out to tenants. In contrast, other long-lived tangible assets (i.e., property considered to be property, plant, and equipment) are owner-occupied properties used for producing the company’s goods and services or for housing the company’s administrative activities. Investment properties do not include long-lived tangible assets held for sale in the ordinary course of business. For example, the houses and property owned by a housing construction company are considered to be its inventory.

Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model. The cost model is identical to the cost model used for property, plant, and equipment. The fair value model, however, differs from the revaluation model used for property, plant, and equipment. Under the revaluation model, whether an asset revaluation affects net income depends on whether the revaluation initially increases or decreases the carrying amount of the asset. In contrast, under the fair value model, all changes in the fair value of the asset affect net income. To use the fair value model, a company must be able to reliably determine the property’s fair value on a continuing basis.28 Under U.S. GAAP, there is no specific definition of investment property. Most operating companies and real estate companies in the United States that hold investment-type property use the historical cost model.

Example 10-17 presents an excerpt from the annual report of a property company reporting under IFRS.

In general, a company must apply its chosen model (cost or fair value) to all of its investment property. If a company chooses the fair value model for its investment property, it must continue to use the fair value model until it disposes of the property or changes its use such that it is no longer considered investment property (e.g., it becomes owner-occupied property or part of inventory). The company must continue to use the fair value model for that property even if transactions on comparable properties, used to estimate fair value, become less frequent.

Certain valuation issues arise when a company changes the use of property such that it moves from being an investment property to owner-occupied property or part of inventory. If a company’s chosen model for investment property is the cost model, such transfers do not change the carrying amount of the property transferred. If a company’s chosen model is the fair value model, transfers from investment property to owner-occupied property or to inventory are made at fair value. In other words, the property’s fair value at the time of transfer is considered to be its cost for ongoing accounting for the property. If a company’s chosen model for investment property is the fair value model and it transfers a property from owner-occupied to investment property, the change in measurement of the property from depreciated cost to fair value is treated like a revaluation. If a company’s chosen model is the fair value model and it transfers a property from inventory to investment property, any difference between the inventory carrying amount and the property’s fair value at the time of transfer is recognized as profit or loss.

Investment property appears as a separate line item on the balance sheet. Companies are required to disclose whether they use the fair value model or the cost model for their investment property. If the company uses the fair value model, it must make additional disclosures about how it determines fair value and must provide reconciliation between the beginning and ending carrying amounts of investment property. If the company uses the cost model, it must make additional disclosures similar to those for property, plant, and equipment—for example, the depreciation method and useful lives must be disclosed. In addition, if the company uses the cost model, it must also disclose the fair value of investment property.

9. LEASING

A lease is a contract between the owner of an asset—the lessor—and another party seeking use of the assets—the lessee. Through the lease, the lessor grants the right to use the asset to the lessee. The right to use the asset can be a long period, such as 20 years, or a much shorter period, such as a month. In exchange for the right to use the asset, the lessee makes periodic lease payments to the lessor. A lease, then, is a form of financing to the lessee provided by the lessor that enables the lessee to purchase the use of the leased asset.

9.1. The Lease versus Buy Decision

There are several advantages to leasing an asset compared to purchasing it. Leases can provide less costly financing, usually require little, if any, down payment, and are often at fixed interest rates. The negotiated lease contract may contain less restrictive provisions than other forms of borrowing. A lease can also reduce the risks of obsolescence, residual value, and disposition to the lessee because the lessee does not own the asset. The lessor may be better positioned to manage servicing the asset and to take advantage of tax benefits of ownership. As a result, leasing the asset may be less costly than owning the asset for the lessee.

Leases also have perceived financial and tax reporting advantages. While providing a form of financing, certain types of leases are not reported as debt on the balance sheet. The items leased under these types of leases also do not appear as assets on the balance sheet. Therefore, no interest expense or depreciation expense is included in the income statement. Additionally, in some countries such as the United States, financial reporting standards may differ from reporting under tax regulations; thus, in some cases, a company may own an asset for tax purposes (and thus obtain deductions for depreciation expense for tax purposes) while not reflecting the ownership in its financial statements. A lease that is structured to provide a company with the tax benefits of ownership while not requiring the asset to be reflected on the company’s financial statements is known as a synthetic lease.

9.2. Finance versus Operating Leases

Differences in economic substance and accounting exist for two main types of leases—finance and operating. The economic substance of a finance (or capital)29 lease is different from an operating lease, as are the implications of each for the financial statements of the lessee and lessor. In substance, a finance lease is equivalent to the purchase of some asset (lease to own) by the buyer (lessee) that is directly financed by the seller (lessor). An operating lease is an agreement allowing the lessee to use the asset for a period of time, essentially a rental.

Under IFRS, if substantially all the risks and rewards incidental to ownership are transferred to the lessee, the lease is classified as a finance lease and the lessee reports a leased asset and a lease obligation on the balance sheet.30 Otherwise, the lease is reported as an operating lease. While a similar principle of the transfer of benefits and risks guides U.S. GAAP, U.S. accounting standards are currently more prescriptive in their criteria for classifying finance and operating leases. Under U.S. GAAP, a lease that meets any one of four specific requirements is classified as a finance lease; however, recently proposed accounting standards would eliminate those criteria.31

The example following illustrates and compares the accounting and financial statement effects of buying an asset using debt, leasing an asset under an operating lease, and leasing an asset under a finance lease.

9.2.1. Accounting and Reporting by the Lessee

A finance lease is economically similar to borrowing money and buying an asset; therefore, a company that enters into a finance lease as the lessee reports an asset (leased asset) and related debt (lease payable) on the balance sheet. The initial value of both the leased asset and the lease payable is the lower of the fair value of the leased asset or the present value of future lease payments. On the income statement, the company reports interest expense on the debt; and if the asset acquired is depreciable, the company reports depreciation expense. (The lessor, as we illustrate in Section 9.2.2, reports the sale of an asset and the lease as a receivable.)

Because an operating lease is economically similar to renting an asset, the lessee records a lease expense on its income statement during the period it uses the asset. No asset or liability is recorded on its balance sheet. The main accounting differences between a finance lease and an operating lease are that under a finance lease, reported debt and assets are higher and expenses are generally higher in the early years. Because of the higher reported assets, debt and expenses—and therefore the lower ROA, all else equal—lessees often prefer operating leases to finance leases. As we illustrate in the next section, lessors’ preferences generally differ. Lessors would prefer a finance lease because, under an operating lease, lessors continue to show the asset and its associated financing on their balance sheets.

On the lessee’s statement of cash flows, for an operating lease, the full lease payment is shown as an operating cash outflow. For a finance lease, only the portion of the lease payment relating to interest expense potentially reduces operating cash flows,32 the portion of the lease payment that reduces the lease liability appears as a cash outflow in the financing section.

A company reporting a lease as an operating lease will typically show higher profits in early years, higher return measures in early years, and a stronger solvency position than an identical company reporting an identical lease as a finance lease. However, the company reporting the lease as a finance lease will show higher operating cash flows because a portion of the lease payment will be reflected as a financing cash outflow rather than an operating cash outflow.

The following example illustrates the effect on a lessee’s income, debt, and cash flows when reporting a lease as a finance lease versus an operating lease.

In summary, a company reporting a lease as an operating lease will typically show higher profits in early years, higher return measures in early years, and a stronger solvency position than an identical company reporting an identical lease as a finance lease.34 However, the company reporting the lease as a finance lease will show higher operating cash flows because a portion of the lease payment will be reflected as a financing cash outflow rather than an operating cash outflow.

The precisely defined accounting standards in the United States that determine when a company should report a capital (finance) versus an operating lease enable a company to structure a lease so as to avoid meeting any of the four capital lease criteria and thereby record an operating lease. Similar to debt disclosures, lease disclosures show payments under both capital and operating leases for the next five years and afterwards. Future payments under U.S. GAAP are disclosed year by year for the first five years and then aggregated for all subsequent years. Under IFRS, future payments are disclosed for the first year, in aggregate for years two through five, and then in aggregate for all subsequent years. These disclosures can help to estimate the extent of a company’s off-balance-sheet lease financing through operating leases. Example 10-20 illustrates the disclosures and how these disclosures can be used to determine the effect on the financial statements if all operating leases were capitalized.

9.2.2. Accounting and Reporting by the Lessor

Lessors that report under U.S. GAAP determine whether a lease is a finance (also called “capital lease”) or operating lease using the same four criteria as a lessee, plus additional revenue recognition criteria. If a lessor enters into an operating lease, the lessor records any lease revenue when earned. The lessor also continues to report the leased asset on the balance sheet and the asset’s associated depreciation expense on the income statement.

Under a finance lease, the lessor reports a lease receivable based on the present value of future lease payments, and the lessor also reduces its assets by the carrying amount of the asset leased. Under U.S. GAAP, the carrying amount of the asset leased relative to the present value of lease payments distinguishes a direct financing lease from a sales-type lease. The income statement will show interest revenue on the lease.

U.S. GAAP make a further distinction in defining two types of nonoperating leases: (1) direct financing leases, and (2) sales-type leases from the lessor’s perspective.36 A direct financing lease results when the present value of lease payments (and thus the amount recorded as a lease receivable) equals the carrying amount of the leased asset. Because there is no “profit” on the asset itself, the lessor is essentially providing financing to the lessee, and the revenues earned by the lessor are financing in nature (i.e., interest revenue). If, however, the present value of lease payments (and thus the amount recorded as a lease receivable) exceeds the carrying value of the leased asset, the lease is treated as a sale.

When a company enters into a sales-type lease, a lease agreement where the present value of lease payment is greater than the value of the leased asset to the lessor, it will show a profit on the transaction in the year of inception and interest revenue over the life of the lease.

10. SUMMARY

Understanding the reporting of long-lived assets at inception requires distinguishing between expenditures that are capitalized (i.e., reported as long-lived assets) and those that are expensed. Once a long-lived asset is recognized, it is reported under the cost model at its historical cost less accumulated depreciation (amortization) and less any impairment or under the revaluation model at its fair value. IFRS permit the use of either the cost model or the revaluation model, whereas U.S. GAAP require the use of the cost model. Most companies reporting under IFRS use the cost model. The choice of different methods to depreciate (amortize) long-lived assets can create challenges for analysts comparing companies.

Key points include the following:

• Expenditures related to long-lived assets are capitalized as part of the cost of assets if they are expected to provide future benefits, typically beyond one year. Otherwise, expenditures related to long-lived assets are expensed as incurred.
• Although capitalizing expenditures, rather than expensing them, results in higher reported profitability in the initial year, it results in lower profitability in subsequent years; however, if a company continues to purchase similar or increasing amounts of assets each year, the profitability-enhancing effect of capitalization continues.
• Capitalizing an expenditure rather than expensing it results in a greater amount reported as cash from operations because capitalized expenditures are classified as an investing cash outflow rather than an operating cash outflow.
• Companies must capitalize interest costs associated with acquiring or constructing an asset that requires a long period of time to prepare for its intended use.
• Including capitalized interest in the calculation of interest coverage ratios provides a better assessment of a company’s solvency.
• IFRS require research costs be expensed but allow all development costs (not only software development costs) to be capitalized under certain conditions. Generally, U.S. accounting standards require that research and development costs be expensed; however, certain costs related to software development are required to be capitalized.
• When one company acquires another company, the transaction is accounted for using the acquisition method of accounting in which the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value. Under acquisition accounting, if the purchase price of an acquisition exceeds the sum of the amounts that can be allocated to individual identifiable assets and liabilities, the excess is recorded as goodwill.
• The capitalized costs of long-lived tangible assets and of intangible assets with finite useful lives are allocated to expense in subsequent periods over their useful lives. For tangible assets, this process is referred to as depreciation, and for intangible assets, it is referred to as amortization.
• Long-lived tangible assets and intangible assets with finite useful lives are reviewed for impairment whenever changes in events or circumstances indicate that the carrying amount of an asset may not be recoverable.
• Intangible assets with an indefinite useful life are not amortized but are reviewed for impairment annually.
• Impairment disclosures can provide useful information about a company’s expected cash flows.
• Methods of calculating depreciation or amortization expense include the straight-line method, in which the cost of an asset is allocated to expense in equal amounts each year over its useful life; accelerated methods, in which the allocation of cost is greater in earlier years; and the units-of-production method, in which the allocation of cost corresponds to the actual use of an asset in a particular period.
• Estimates required for depreciation and amortization calculations include the useful life of the equipment (or its total lifetime productive capacity) and its expected residual value at the end of that useful life. A longer useful life and higher expected residual value result in a smaller amount of annual depreciation relative to a shorter useful life and lower expected residual value.
• IFRS permit the use of either the cost model or the revaluation model for the valuation and reporting of long-lived assets, but the revaluation model is not allowed under U.S. GAAP.
• Under the revaluation model, carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortization.
• In contrast with depreciation and amortization charges, which serve to allocate the cost of a long-lived asset over its useful life, impairment charges reflect an unexpected decline in the fair value of an asset to an amount lower than its carrying amount.
• IFRS permit impairment losses to be reversed, with the reversal reported in profit. U.S. GAAP do not permit the reversal of impairment losses.
• The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying amount of the asset at the time of sale.
• Estimates of average age and remaining useful life of a company’s assets reflect the relationship between assets accounted for on a historical cost basis and depreciation amounts.
• The average remaining useful life of a company’s assets can be estimated as net PPE divided by depreciation expense, although the accounting useful life may not necessarily correspond to the economic useful life.
• Long-lived assets reclassified as held for sale cease to be depreciated or amortized. Long-lived assets to be disposed of other than by a sale (e.g., by abandonment, exchange for another asset, or distribution to owners in a spin-off) are classified as held for use until disposal. Thus, they continue to be depreciated and tested for impairment.
• Investment property is defined as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rentals, capital appreciation, or both.
• Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model. The cost model is identical to the cost model used for property, plant, and equipment, but the fair value model differs from the revaluation model used for property, plant, and equipment. Under the fair value model, all changes in the fair value of investment property affect net income.
• Under U.S. GAAP, investment properties are generally measured using the cost model.
• Accounting standards generally define two types of leases: operating leases and finance (or capital) leases. Current U.S. GAAP specify four criteria to determine when a lease is classified as a capital lease, although proposed standards would eliminate those specific criteria. IFRS are less prescriptive in determining the classification of a lease as a finance lease.
• When a lessee reports a lease as an operating lease rather than a finance lease, it usually appears more profitable in early years of the lease and less so later, and it appears less leveraged over the entire lease period.
• When a lessor reports a lease as a finance lease rather than an operating lease, it usually appears more profitable in early years of the lease.

PROBLEMS

1. JOOVI Inc. has recently purchased and installed a new machine for its manufacturing plant. The company incurred the following costs:

Purchase price	$12,980
Freight and insurance	$1,200
Installation	$700
Testing	$100
Maintenance staff training costs	$500

The total cost of the machine to be shown on JOOVI’s balance sheet is closest to:

A. $14,180.

B. $14,980.

C. $15,480.

2. BAURU, S.A., a Brazilian corporation, borrows capital from a local bank to finance the construction of its manufacturing plant. The loan has the following conditions:

Borrowing date	1 January 2009
Amount borrowed	500 million Brazilian real (BRL)
Annual interest rate	14 percent
Term of the loan	3 years
Payment method	Annual payment of interest only. Principal amortization is due at the end of the loan term.

A. 130

B. 140

C. 210

3. After reading the financial statements and footnotes of a company that follows IFRS, an analyst identified the following intangible assets:

• product patent expiring in 40 years
• copyright with no expiration date
• goodwill acquired 2 years ago in a business combination

Which of these assets is an intangible asset with a finite useful life?

4. Intangible assets with finite useful lives mostly differ from intangible assets with infinite useful lives with respect to accounting treatment of:

A. revaluation.

B. impairment.

C. amortization.

5. A financial analyst is studying the income statement effect of two alternative depreciation methods for a recently acquired piece of equipment. She gathers the following information about the equipment’s expected production life and use:

A. lower.

B. higher.

C. the same.

6. Juan Martinez, CFO of VIRMIN, S.A., is selecting the depreciation method to use for a new machine. The machine has an expected useful life of six years. Production is expected to be relatively low initially but to increase over time. The method chosen for tax reporting must be the same as the method used for financial reporting. If Martinez wants to minimize tax payments in the first year of the machine’s life, which of the following depreciation methods is Martinez most likely to use?

A. Straight-line method

B. Units-of-production method

C. Double-declining balance method

The following information relates to Questions 7 and 8.

Miguel Rodriguez of MARIO, S.A., an Uruguayan corporation, is computing the depreciation expense of a piece of manufacturing equipment for the fiscal year ended 31 December 2009. The equipment was acquired on 1 January 2009. Rodriguez gathers the following information (currency in Uruguayan pesos, UYP):

Cost of the equipment	UYP 1,200,000
Estimated residual value	UYP 200,000
Expected useful life	8 years
Total productive capacity	800,000 units
Production in FY 2009	135,000 units
Expected production for the next 7 years	95,000 units each year

7. If MARIO uses the straight-line method, the amount of depreciation expense on MARIO’s income statement related to the manufacturing equipment is closest to:

A. 125,000.

B. 150,000.

C. 168,750.

8. If MARIO uses the units-of-production method, the amount of depreciation expense (in UYP) on MARIO’s income statement related to the manufacturing equipment is closest to:

A. 118,750.

B. 168,750.

C. 202,500.

9. Which of the following amortization methods is most likely to evenly distribute the cost of an intangible asset over its useful life?

A. Straight-line method

B. Units-of-production method

C. Double-declining balance method

10. Which of the following will cause a company to show a lower amount of amortization of intangible assets in the first year after acquisition?

A. A higher residual value

B. A higher amortization rate

C. A shorter useful life

11. An analyst in the finance department of BOOLDO, S.A., a French corporation, is computing the amortization of a customer list, an intangible asset, for the fiscal year ended 31 December 2009. She gathers the following information about the asset:

Acquisition cost	€2,300,000
Acquisition date	1 January 2008
Expected residual value at time of acquisition	€500,000
The customer list is expected to result in extra sales for three years after acquisition. The present value of these expected extra sales exceeds the cost of the list.

A. €600,000.

B. €1,200,000.

C. €1,533,333.

12. A financial analyst is analyzing the amortization of a product patent acquired by MAKETTI S.p.A., an Italian corporation. He gathers the following information about the patent:

Acquisition cost	€5,800,000
Acquisition date	1 January 2009
Patent expiration date	31 December 2015
Total plant capacity of patented product	40,000 units per year
Production of patented product in fiscal year ended 31 December 2009	20,000 units
Expected production of patented product during life of the patent	175,000 units

A. €414,286.

B. €662,857.

C. €828,571.

13. MARU S.A. de C.V., a Mexican corporation that follows IFRS, has elected to use the revaluation model for its property, plant, and equipment. One of MARU’s machines was purchased for 2,500,000 Mexican pesos (MXN) at the beginning of the fiscal year ended 31 March 2010. As of 31 March 2010, the machine has a fair value of MXN 3,000,000. Should MARU show a profit for the revaluation of the machine?

A. Yes.

B. No, because this revaluation is recorded directly in equity.

C. No, because value increases resulting from revaluation can never be recognized as a profit.

14. An analyst is studying the impairment of the manufacturing equipment of WLP Corp., a U.K.-based corporation that follows IFRS. He gathers the following information about the equipment:

Fair value	£16,800,000
Costs to sell	£800,000
Value in use	£14,500,000
Net carrying amount	£19,100,000

A. £2,300,000.

B. £3,100,000.

C. £4,600,000.

15. A financial analyst at BETTO, S.A. is analyzing the result of the sale of a vehicle for 85,000 Argentine pesos (ARP) on 31 December 2009. The analyst compiles the following information about the vehicle:

Acquisition cost of the vehicle	ARP 100,000
Acquisition date	1 January 2007
Estimated residual value at acquisition date	ARP 10,000
Expected useful life	9 years
Depreciation method	Straight-line

A. a loss of ARP 15,000.

B. a gain of ARP 15,000.

C. a gain of ARP 18,333.

16. CROCO S.p.A. sells an intangible asset with a historical acquisition cost of €12 million and an accumulated depreciation of €2 million and reports a loss on the sale of €3.2 million. Which of the following amounts is most likely the sale price of the asset?

A. €6.8 million

B. €8.8 million

C. €13.2 million

17. According to IFRS, all of the following pieces of information about property, plant, and equipment must be disclosed in a company’s financial statements and footnotes except for:

A. useful lives.

B. acquisition dates.

C. amount of disposals.

18. According to IFRS, all of the following pieces of information about intangible assets must be disclosed in a company’s financial statements and footnotes except for:

A. fair value.

B. impairment loss.

C. amortization rate.

19. Which of the following characteristics is most likely to differentiate investment property from property, plant, and equipment?

A. It is tangible.

B. It earns rent.

C. It is long-lived.

20. If a company uses the fair value model to value investment property, changes in the fair value of the asset are least likely to affect:

A. net income.

B. net operating income.

C. other comprehensive income.

21. Investment property is most likely to:

A. earn rent.

B. be held for resale.

C. be used in the production of goods and services.

22. A company is most likely to:

A. use a fair value model for some investment property and a cost model for other investment property.

B. change from the fair value model when transactions on comparable properties become less frequent.

C. change from the fair value model when the company transfers investment property to property, plant, and equipment.

The following information relates to Questions 23 through 28.37

Melanie Hart, CFA, is a transportation analyst. Hart has been asked to write a research report on Altai Mountain Rail Company (AMRC). Like other companies in the railroad industry, AMRC’s operations are capital intensive, with significant investments in such long-lived tangible assets as property, plant, and equipment. In November of 2008, AMRC’s board of directors hired a new team to manage the company. In reviewing the company’s 2009 annual report, Hart is concerned about some of the accounting choices that the new management has made. These choices differ from those of the previous management and from common industry practice. Hart has highlighted the following statements from the company’s annual report:

Statement 1:	“In 2009, AMRC spent significant amounts on track replacement and similar improvements. AMRC expensed rather than capitalized a significant proportion of these expenditures.”
Statement 2:	“AMRC uses the straight-line method of depreciation for both financial and tax reporting purposes to account for plant and equipment.”
Statement 3:	“In 2009, AMRC recognized an impairment loss of €50 million on a fleet of locomotives. The impairment loss was reported as ‘other income’ in the income statement and reduced the carrying amount of the assets on the balance sheet.”
Statement 4:	“AMRC acquires the use of many of its assets, including a large portion of its fleet of rail cars, under long-term lease contracts. In 2009, AMRC acquired the use of equipment with a fair value of €200 million under 20-year lease contracts. These leases were classified as operating leases. Prior to 2009, most of these lease contracts were classified as finance leases.”

Exhibits A and B contain AMRC’s 2009 consolidated income statement and balance sheet. AMRC prepares its financial statements in accordance with International Financial Reporting Standards.

EXHIBIT A Consolidated Statement of Income

EXHIBIT B Consolidated Balance Sheet

23. With respect to Statement 1, which of the following is the most likely effect of management’s decision to expense rather than capitalize these expenditures?

A. 2009 net profit margin is higher than if the expenditures had been capitalized.

B. 2009 total asset turnover is lower than if the expenditures had been capitalized.

C. Future profit growth will be higher than if the expenditures had been capitalized.

24. With respect to Statement 2, what would be the most likely effect in 2010 if AMRC were to switch to an accelerated depreciation method for both financial and tax reporting?

A. Net profit margin would decrease.

B. Total asset turnover would increase.

C. Cash flow from operating activities would increase.

25. With respect to Statement 3, what is the most likely effect of the impairment loss?

A. Net income in years prior to 2009 was likely understated.

B. Net profit margins in years after 2009 will likely exceed the 2009 net profit margin.

C. Cash flow from operating activities in 2009 was likely lower due to the impairment loss.

26. Based on Exhibits A and B, the best estimate of the average remaining useful life of the company’s plant and equipment at the end of 2009 is:

A. 20.75 years.

B. 24.25 years.

C. 30.00 years.

27. With respect to Statement 4, if AMRC had used its old classification method for its leases instead of its new classification method, its 2009 total asset turnover ratio would most likely be:

A. lower.

B. higher.

C. the same.

28. With respect to Statement 4 and Exhibit A, if AMRC had used its old classification method for its leases instead of its new classification method, the most likely effect on its 2009 ratios would be a:

A. higher net profit margin.

B. higher fixed asset turnover.

C. higher total liabilities-to-total assets ratio.

The following information relates to Questions 29 through 35.38

Brian Jordan is interviewing for a junior equity analyst position at Orion Investment Advisors. As part of the interview process, Mary Benn, Orion’s Director of Research, provides Jordan with information about two hypothetical companies, Alpha and Beta, and asks him to comment on the information on their financial statements and ratios. Both companies prepare their financial statements in accordance with International Financial Reporting Standards (IFRS) and are identical in all respects except for their accounting choices.

Jordan is told that at the beginning of the current fiscal year, both companies purchased a major new computer system and began building new manufacturing plants for their own use. Alpha capitalized and Beta expensed the cost of the computer system; Alpha capitalized and Beta expensed the interest costs associated with the construction of the manufacturing plants. In mid-year, both companies leased new office headquarters. Alpha classified the lease as an operating lease, and Beta classified it as a finance lease.

Benn asks Jordan, “What was the impact of these decisions on each company’s current fiscal year financial statements and ratios?”

Jordan responds, “Alpha’s decision to capitalize the cost of its new computer system instead of expensing it results in lower net income, lower total assets, and higher cash flow from operating activities in the current fiscal year. Alpha’s decision to capitalize its interest costs instead of expensing them results in a lower fixed asset turnover ratio and a higher interest coverage ratio. Alpha’s decision to classify its lease as an operating lease instead of a finance lease results in higher net income, higher cash flow from operating activities, and stronger solvency and activity ratios compared to Beta.”

Jordan is told that Alpha uses the straight-line depreciation method and Beta uses an accelerated depreciation method; both companies estimate the same useful lives for long-lived assets. Many companies in their industry use the units-of-production method.

Benn asks Jordan, “What are the financial statement implications of each depreciation method, and how do you determine a company’s need to reinvest in its productive capacity?”

Jordan replies, “All other things being equal, the straight-line depreciation method results in the least variability of net profit margin over time, while an accelerated depreciation method results in a declining trend in net profit margin over time. The units-of-production can result in a net profit margin trend that is quite variable. I use a three-step approach to estimate a company’s need to reinvest in its productive capacity. First, I estimate the average age of the assets by dividing net property, plant, and equipment by annual depreciation expense. Second, I estimate the average remaining useful life of the assets by dividing accumulated depreciation by depreciation expense. Third, I add the estimates of the average remaining useful life and the average age of the assets in order to determine the total useful life.”

Jordan is told that at the end of the current fiscal year, Alpha revalued a manufacturing plant; this increased its reported carrying amount by 15 percent. There was no previous downward revaluation of the plant. Beta recorded an impairment loss on a manufacturing plant; this reduced its carrying by 10 percent.

Benn asks Jordan “What was the impact of these decisions on each company’s current fiscal year financial ratios?”

Jordan responds, “Beta’s impairment loss increases its debt to total assets and fixed asset turnover ratios, and lowers its cash flow from operating activities. Alpha’s revaluation increases its debt to capital and return on assets ratios, and reduces its return on equity.”

At the end of the interview, Benn thanks Jordan for his time and states that a hiring decision will be made shortly.

29. Jordan’s response about the financial statement impact of Alpha’s decision to capitalize the cost of its new computer system is most likely correct with respect to:

A. lower net income.

B. lower total assets.

C. higher cash flow from operating activities.

30. Jordan’s response about the ratio impact of Alpha’s decision to capitalize interest costs is most likely correct with respect to the:

A. interest coverage ratio.

B. fixed asset turnover ratio.

C. interest coverage and fixed asset turnover ratios.

31. Jordan’s response about the impact of Alpha’s decision to classify its lease as an operating lease instead of finance lease is most likely incorrect with respect to:

A. net income.

B. solvency and activity ratios.

C. cash flow from operating activities.

32. Jordan’s response about the impact of the different depreciation methods on net profit margin is most likely incorrect with respect to:

A. accelerated depreciation.

B. straight-line depreciation.

C. units-of-production depreciation.

33. Jordan’s response about his approach to estimating a company’s need to reinvest in its productive capacity is most likely correct regarding:

A. estimating the average age of the asset base.

B. estimating the total useful life of the asset base.

C. estimating the average remaining useful life of the asset base.

34. Jordan’s response about the effect of Beta’s impairment loss is most likely incorrect with respect to the impact on its:

A. debt to total assets.

B. fixed asset turnover.

C. cash flow from operating activities.

35. Jordan’s response about the effect of Alpha’s revaluation is most likely correct with respect to the impact on its:

A. return on equity.

B. return on assets.

C. debt to capital ratio.

1In some instances, industry practice is to include as current assets (inventory) some assets that will be held longer than one year (e.g., leaf tobacco, which is cured and aged over a period longer than one year, and whiskey, which is barrel aged for a period longer than one year).

2Fair value is defined in International Financial Reporting Standards (IFRS) and under U.S. generally accepted accounting principles (U.S. GAAP) in the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date” [IFRS 13 and FASB ASC Topic 820].

3IAS 16 Property, Plant and Equipment, paragraphs 24–26 [Measurement of Cost]; IAS 38 Intangible Assets, paragraphs 45–47 [Exchange of Assets]; and FASB ASC Section 845-10-30 [Nonmonetary Transactions − Overall − Initial Measurement].

4The IFRS definition of an intangible asset as an “identifiable nonmonetary asset without physical substance” applies to intangible assets not specifically dealt with in standards other than IAS 38. The definition of intangible assets under U.S. GAAP—“assets (other than financial assets) that lack physical substance”—includes goodwill in the definition of an intangible asset.

5IAS 38 Intangible Assets.

6IAS 38 Intangible Assets, paragraph 8 [Definitions].

7IAS 38 Intangible Assets, paragraph 8 [Definitions].

8FASB ASC Section 350-40-25 [Intangibles—Goodwill and Other − Internal-Use Software − Recognition] and FASB ASC Section 985-20-25 [Software − Costs of Software to be Sold, Leased, or Marketed − Recognition] specify U.S. GAAP accounting for software development costs for software for internal use and for software to be sold, respectively.

9Both IFRS and U.S. GAAP require the use of the acquisition method in accounting for business combinations (IFRS 3 and FASB ASC Section 805).

10As previously described, the definitional criteria are identifiability, control by the company, and expected future benefits. The recognition criteria are probable flows of the expected economic benefits to the company and measurability.

11IAS 23 [Borrowing Costs] and FASB ASC Subtopic 835-20 [Interest − Capitalization of Interest] specify respectively IFRS and U.S. GAAP for capitalization of interest costs. Although the standards are not completely converged, the standards are in general agreement.

12Depletion is the term applied to a similar concept for natural resources; costs associated with those resources are allocated to a period on the basis of the usage or extraction of those resources.

13The residual value is the estimated amount that an entity will obtain from disposal of the asset at the end of its useful life.

14IAS 16 Property, Plant and Equipment, paragraphs 43–47 [Depreciation].

15According to the Ernst & Young Academic Resource Center.

16IAS 38 Intangible Assets, paragraph 88.

17On 15 November 2007, the SEC approved rule amendments under which financial statements from foreign private issuers in the United States will be accepted without reconciliation to U.S. GAAP if the financial statements are prepared in accordance with IFRS as issued by the International Accounting Standards Board. The new rule is effective for the 2007 fiscal year. As a result, companies such as KPN no longer need to provide reconciliations to U.S. GAAP.

18FASB ASC Section 360-10-35 [Property, Plant, and Equipment − Overall − Subsequent Measurement].

19In a spin-off, shareholders of the parent company receive a proportional number of shares in a new, separate entity.

20IAS 16 Property, Plant and Equipment, paragraphs 73–78 [Disclosure].

21FASB ASC Section 360-10-50 [Property, Plant, and Equipment − Overall − Disclosure].

22IAS 38 Intangible Assets, paragraphs 118–128 [Disclosure].

23FASB ASC Section 350-30-50 [Intangibles − General − Disclosure].

24IAS 36 Impairment of Assets, paragraphs 126–131 [Disclosure].

25FASB ASC Section 360-10-50 [Property, Plant, and Equipment − Overall − Disclosure] and FASB ASC Section 350-30-50 [Intangibles − General − Disclosure].

26IAS 1 paragraph 102.

27IAS 40 Investment Property prescribes the accounting treatment for investment property.

28Fair value of investment property is defined as the price at which the property could be exchanged between knowledgeable, willing parties in an arm’s length transaction (IAS 40 Investment Property, paragraph 36).

29Finance lease is IFRS terminology and capital lease is U.S. GAAP terminology. IAS 17 [Leases] and FASB ASC Topic 840 [Leases].

30International accounting for leases is prescribed under IAS 17 [Leases].

31The four criteria are: (1) ownership of the leased asset transfers to lessee at end of lease, (2) the lease contains an option for the lessee to purchase the leased asset cheaply (bargain purchase option), (3) the lease term is 75 percent or more of the useful life of the leased asset, and (4) the present value of lease payments is 90 percent or more of the fair value of the leased asset (ASC 840-10-25-1). An Exposure Draft, Leasing, issued jointly by the FASB and IASB in August 2010 would eliminate these criteria from U.S. GAAP.

32Interest expense may be classified as a financing cash flow or an operating cash flow under IFRS (IAS 7 paragraph 33) but is classified as an operating cash flow under U.S. GAAP (FASB ASC paragraph 230-10-45-17).

33The computations included throughout the example were made using an Excel worksheet; small discrepancies in the calculations are due to rounding.

34Example 11 assumes the company uses the straight-line depreciation method, which is common under IFRS and U.S. GAAP. If the company estimated depreciation expense based on the “economic” depreciation of the leased asset, there would be no difference in reported income under a finance lease and operating lease.

35The computations included throughout the example were made using an Excel worksheet; small apparent discrepancies in the calculations are due to the rounding.

36IFRS does not make the distinction between a sales-type lease and a direct financing lease. However, a similar treatment to “sales-type” is allowed for finance leases originated by “manufacturer or dealer lessors,” within the general provisions for finance leases.

37Item set developed by Christopher Anderson, CFA (Lawrence, Kansas, U.S.A.)

38Item set developed by Philip Fanara Jr., CFA (Hyattsville, Maryland, U.S.A.)