CHAPTER 10

LONG-LIVED ASSETS

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.

SUMMARY OVERVIEW

• 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

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:

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?

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:

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:

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

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:

21. Investment property is most likely to:

22. A company is most likely to:

The following information relates to Questions 23 through 28.1

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:

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