Download “Analysis of Long-Lived Assets, Part I: The Capitalization Decision”

Analysis of Long-Lived Assets
FIBD - Fall, 2006
Expensing vs. Capitalizing
– One of the key issues surrounding
assets is when to expense a cost and when to capitalize a cost. Expensing
involves charging the entire cost of an item to the current period. Capitalizing
involves recording the costs on the balance sheet as an asset and depreciating
or amortizing the cost over time. The issue centers on when the cost will be
recognized as an expense in the income statement. By capitalizing, the item is
recorded as an asset and the cost is amortized or depreciated over the current
and subsequent years. While the total cost is eventually charged against
revenue, the timing of the expensing of the cost is different. All three statements
are affected by these capitalizing, versus expensing, decisions and as a result, it
has implications for ratio analysis.
By capitalizing a cost, the income of the current period is only affected by the
amount of amortization or depreciation that is written off. Capitalizing results in
smoother earnings since the costs are amortized over a number of years. Assets
are increased on the balance sheet. Cash flows in total are the same under
either approach but the costs appear in different parts of the cash flow statement.
If expensed immediately they affect cash flows from operations; if capitalized
they are recorded as a cash outflow under investing activities.
Capitalization is justified on the basis of the “going concern” concept - cost can
be matched against future revenues generated by those costs. If capitalized, it is
assumed that the asset benefits more than one period. To be capitalized, a cost
must meet the definition of an asset as defined by the FASB – future benefit as a
result of a past transaction. There must be an indication that the capitalized
costs will generate future revenues.
Quality of Earnings - Capitalizing versus expensing a cost is another
example of “quality of earnings.” By capitalizing a cost, it shifts the cost from the
income statement to the balance sheet. There is NO cash flow effect of
capitalizing versus expensing unless it affects taxes paid. There is no effect on
total cash flows but as noted above it does get reported differently in the cash
flow statement. If a company capitalizes a cost, it increases cash flow from
operating activities, since the expense is not reported on the income statement,
but it does result in a cash outflow under cash flow from investing activities.
Copyright © Robert M. Turner
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Impact of Capitalization vs. Expensing Decision on Ratios
Capitalize
Lower smoothes earnings
Expense
Higher
Profitability ROA
Increases NI
but assets
increase.
Decreases NI
but assets lower. In
later years, ROE
and ROA higher
due to lower assets.
Total Cash Flows
Same
Same
Cash Flow from Operations
Higher since capitalized
costs are reported
as investing cash
outflows
Lower since
expensed costs
are reported as
cash flows from
operating activities
Leverage (debt/assets and
debt/equity)
Lower since assets
are higher and equity
is higher.
Higher since assets
and equity accounts
are lower.
Income Variability
Analysts need to adjust ratios when one company expenses and another
capitalizes so ratios are comparable. As always, accounting choices affect ratio
analysis and the financial statements of the company.
Since accounting choices affect the financial statements and ratio analysis, these
choices affect the decision making of a company’s management. For example,
since most R&D and advertising must be expensed, companies facing borrowing
implications (debt covenants) may choose to cut these expenses to meet certain
required ratio targets. Accounting changes may not have real economic effects
but the behavioral response to them does affect the company.
Intangible Assets
For many companies, intangible assets represent a significant portion of the total
assets of the company. As a result, the FASB recently issued a new standard on
how these assets should be recorded and amortized. Key issues affected by this
new standard include
 Research and Development (R&D) – with the exception of tangible assets
purchased for research that have alternate future uses, all research and
development expenses are expensed immediately due to uncertainty of future
benefit. R&D purchased is written off immediately after purchase. In mergers
and acquisitions, SEC is concerned about percentage of purchase price
allocated to R&D, and hence qualifying for immediate write-off. This has an
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impact on financial analysis since ratios will be different in the future due to
the write-off.
Patents and Copyrights – costs to research and develop patents and
copyrights are expensed. Legal costs to register patents and copyrights can
be capitalized as can the purchase of patents and copyrights since they meet
the definition of an asset, “…future benefit resulting from a past transaction.”
These costs are amortized based on the legal life of the patent or its useful
life if it is less than its legal life. For example, while the patent might be good
for twenty years, if it is evident that new technologies may make the patent
obsolete in a shorter period of time, the shorter period should be used for
amortization.
Franchises and Licenses – franchisee/licensee capitalizes the cost of
purchasing these rights and amortizes these over the benefit of the
license/franchise. If the franchise has an indefinite life, then it should be
carried at cost and not be amortized.
Brands and Trademarks – capitalize the cost of purchasing a brand or
trademark. A company can also capitalize costs involved with the
development of a trade name including attorney fees, registration fees, design
costs, consulting fees, and defense of the trademark. Since in most cases, a
trademark has an indefinite life its cost is not amortized.
Advertising Costs – expensed – again, future benefit is uncertain as is the
case with R&D.
Oil and gas costs – full cost vs. successful efforts – can capitalize all the
costs of drilling and allocate over successful wells, known as full costing
approach, or expense immediately the cost of drilling when oil or gas is not
discovered, known as successful efforts. Cash flow is the same but impact
on the income statement and balance sheet, as well as profitability ratios,
could be significant.
Goodwill – difference between fair market value of assets acquired, and the
overall cost of the acquisition, is recorded as Goodwill. Goodwill must be
purchased to be recorded. The new accounting standard requires that
goodwill is no longer amortized but is kept as an asset since it has an
indefinite life. If it becomes impaired, it must be written down.
Software costs – costs for development of software beyond the point of
“technological feasibility” can be capitalized. Technological feasibility implies
that the product has moved out of the research and development stage
(including coding and testing) and is now a viable product. Software
companies argued for this standard due to the effect of these costs on net
income. Again, cash flows are the same under either method. It should be
noted that this is not the treatment to be followed for software developed for
internal use. In the latter case, only costs incurred after the preliminary
development stage are capitalized.
In summary, intangible assets are only amortized if there is a definite life to the
asset. Intangibles with indefinite lives are capitalized and only written off if they
become impaired. Amortization of intangibles, like depreciation expense, does
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not affect cash flows so the amortization is added back to cash flows from
operating activities, assuming the indirect method is used.
Depreciation
– Fixed assets are depreciation over their useful lives.
Depreciation is a cost allocation system, not a valuation method. Depreciation
involves allocating the cost of the asset over the useful life of the asset. It is
subjective due to estimated useful life, residual (salvage) value, and
method of calculating depreciation. Estimated useful life refers to that period
of time over which the asset is expected to be used and generate revenue.
Residual value is the estimated amount that is expected to be realizable at the
end of the use of the asset.
Choice of depreciation method affects the calculation of ratios.
Since
depreciation is an allocation of previous cash flows, choice of depreciation
method has no impact on the cash flow statement. It does however affect the
income statement and balance sheet. Unlike the choice of inventory costing
methods, companies can use one method for calculating book income, the
straight-line method, and an accelerated method for the calculation of taxable
income. The choice of an accelerated method of depreciation results in lower
taxable income. The choice of an accelerated method DOES affect cash flows
since it reduces taxes paid in the earlier years of the life of the asset. Unless the
company also uses an accelerated method for book income, it has no impact on
net income since the accelerated method is only used to calculate taxable
income on the tax return of the company. Companies that use shorter lives and
lower salvage values to compute depreciation will show lower net income and
hence more conservative earnings.
Quality of Earnings - Depreciation is another accounting issue that affects
“quality of earnings.” As noted above, by using a shorter life and lower salvage
value, the company will report a higher depreciation expense and lower net
income. This would be considered a more conservative net income. Choice of
number of years and salvage values are estimates and therefore require
professional judgement.
Methods of Depreciation:
 Straight-line – asset is depreciated evenly over life of asset.
 Units of production – depreciation is charged according to the use of the
asset. Estimated output for an asset is estimated and cost of asset is divided
by estimated output to determine depreciation per unit.
 Accelerated methods - Accelerated methods allow for more depreciation in
earlier years with a corresponding tax benefit. Unlike the FIFO/LIFO tradeoff, companies can use straight-line for book purposes and accelerated
depreciation for tax purposes. Therefore company can report higher book
income, using straight-line depreciation, and lower tax income, using
accelerated depreciation, resulting in lower cash outflows for taxes. For tax
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purposes companies use the modified accelerated cost recovery schedules
(MACRS), a form of declining balance depreciation.
DEPRECIATION EXAMPLE
Purchase Price = $195,000
Useful life = 10 years
Residual value estimated at $15,000
Units of output estimated at 240,000; first year output is 48,000.
Calculation of depreciation under different methods:
 STRAIGHT LINE
$195,000 - $15,000 = $180,000 /10 = $18,000 per year
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DOUBLE DECLINING BALANCE
$195,000 X .2 = $39,000 for the first year
($195,000 - $39,000) X .2 = $31,200 depreciation for the second year
NOTE: The residual value is NOT subtracted at the beginning. The name of the
method indicates how the depreciation is done. “Double” the straight-line rate
and apply it to a “Declining Balance,” defined as book value. Since the asset has
a 10-year life, under straight-line depreciation, the company would take 10% a
year. Doubling that results in a rate of 20%. The declining book value, carrying
value, at the beginning would be the purchase price of $195,000. For the second
year it would be a book value of $156,000 ($195,000-$39,000).
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UNITS OF PRODUCTION
$180,000/240,000 = $.75 X 48,000 = $36,000 for the first year
Impact on earnings of even a change in number of years over which asset is
depreciated can have a significant effect on earnings. Changing number of years
or salvage value is considered a change in estimate and is not disclosed on the
face of the financial statements. Number of years used to calculate depreciation
is often not specifically disclosed in the footnotes. Rather, a range of years is
provided for depreciable assets.
Using the information from the depreciation problem above, assume that at the
beginning of year 6, the company changed the useful life from 10 to 15 years.
Since the company has already taken $90,000 in depreciation ($18,000 X 5
years), there is $90,000 remaining to be depreciated. Since the life of the asset
has been extended another five years, the $90,000 will be allocated over the next
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ten years at $9,000 per year. As a result, in year 6, net income will be $9,000
higher since the depreciation expense has been reduced from $18,000 to
$9,000. This would affect all the profitability ratios and return ratios for the
company. This is considered a “change in estimate” and is not disclosed
separately in the financial statements.
Quality of Earnings - Changing the number of years over which an asset is
depreciated does represent a “quality of earnings” issue. If the asset really does
have added years of usefulness then the estimate should be changed. However
it does create an increase in income. If the number of years is increased,
depreciation expense will decrease and net income will increase, improving
profitability ratios. Since depreciation is a noncash event, the change would
have no impact on operating cash flows. Depreciation is added back to cash
flows from operating activities, assuming the indirect method is used. Therefore,
since depreciation is a noncash expense, it has no impact on cash flows.
Using the example from above, assume that the company chose to use the
straight-line method versus the double declining balance method. In year one,
the straight-line depreciation was $18,000 and the double declining balance
method was $39,000. If the straight-line method was used, net income would be
reduced by $18,000. Therefore the effect on the balance sheet and income
statement is as follows:
Decrease in net income
Fixed assets on balance sheet
Cost
Less: Accumulated Depreciation
Net fixed assets
Double Declining
$39,000
Straight-line
$18,000
$195,000
39,000
$156,000
$195,000
18,000
$177,000
Therefore, net income and assets will be less under the double declining method
which will decrease profitability ratios, return ratios, and debt/equity ratios. Since
assets are less, asset turnover will be higher.
Use of an accelerated depreciation method will lower net income and produce a
more conservative earnings number. Also, using a shorter time period over
which an asset is depreciated, and a lower salvage value, will result in lower
earnings. Changing the number of years over which an asset is depreciated has
NO cash flow implication. The only cash flow effect of depreciation is the tax
effect of using an accelerated depreciation method on the tax return.
For reporting purposes, companies use straight-line depreciation to report book
income and use an accelerated method for tax purposes. Currently the required
accelerated method in the U.S. is the Modified Accelerated Cost Recovery
System (MACRS). It is a form of double declining balance. Companies therefore
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can report lower depreciation in their published reports to show higher net
income and use the accelerated method on their tax returns to decrease their tax
liability. Over the life of the asset, total depreciation will be the same and the
total tax liability will be the same. This again is a timing difference which does
reduce the tax liability in the early years of the asset.
Fixed asset disclosures allow an analyst to compare average age of
depreciable assets. The footnote to the financial statements discloses the cost of
the asset, the amount of depreciation taken in the current year, and the total
accumulated depreciation to date. The age of the asset can be determined by
dividing the accumulated depreciation by the depreciation expense. The analyst
can also determine the number of years over which a company is depreciating its
assets by dividing the cost of the asset by the depreciation expense. The is a
rough estimate since a company is buying and selling assets continually but it
does give an indication of these numbers. Knowing the age of the assets allows
an analyst to gage how soon the company will need to replace the assets which
is an indication of future cash flow needs.
Impact of Inflation -
Since depreciation is one of the last remaining
historical costs on the balance sheet, it tends to result in income being overstated
especially in periods of high inflation. The older the asset, the lower the
deprecation cost will be relative to what depreciation would be if the assets had
been replaced at higher current costs. It also overstates return ratios since total
assets will be lower and net income will be higher. For example, in the previous
example, in year 9 the company would still be reporting depreciation of $18,000
per year under the straight-line method and the book value of the asset at the
end of year 9 would be $33,000 ($195,000 – [9 X $18,000]). All the return ratios
would be based on a low asset value. If the cost to replace this asset in year 9 is
$400,000, then comparing income and return ratios for this company versus
another one that had recently replaced similar assets at the higher cost, would be
meaningless. Net income would be lower and assets higher. Yet the company
that replaced the assets would be in a better position for generating future
earnings. Economic depreciation would look at the replacement cost of the asset
and hence the higher depreciation resulting from it.
In the example just given, if it is assumed it will cost $400,000 to replace the
asset and if it is also assumed to have a ten-year life with no salvage, then
depreciation would be $40,000 per year versus the $18,000 that is still being
taken on the older asset. Therefore, net income would decline by an additional
$22,000 ($40,000 - $18,000). The asset on the balance sheet, at the end of the
first year of its purchase, would be $360,000 ($400,000 - $40,000) versus the
book value of $33,000 shown for the old asset. This would have a significant
impact on return ratios, profitability ratios and asset turnover as well as solvency
ratios.
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Impairment of long-lived assets
- Impairments can be caused by
changes in technology, changing markets, etc. Companies must write down the
book value of assets when they have become impaired.
 Asset must be written down when undiscounted expected future cash flows
are less than the carrying value of the asset. The loss is the difference
between the fair value and the carrying value. When fair value cannot be
determined, the loss would be the difference between the carrying value and
the discounted present value of future cash flows.
 Write-downs can often be like the “big bath” phenomenon - often
accompanying poor financial performance. They are somewhat subjective
and the timing of the write-down is also subjective. A write down can improve
future earnings, since depreciation in the future would be less. It also
decreases total assets, which can result in “improvement” in return ratios.
 Restructurings also fall within this category. The SEC has also looked more
carefully at costs included in restructurings, also due to the “big bath” issue.
The concern is with companies that attempt to take future costs and roll them
into the restructuring charge so that future earnings look better. It results in
poor matching of expenses with revenue.
 Assets are not written up for increases in value. Asset impairments allow for
a good deal of management discretion as to timing and amount of the writedown.
An impairment write-down affects both the income statement and balance sheet,
but not cash flows. The write-down lowers net income and hence stockholders’
equity. Going forward,
 asset turnover ratios will be higher due to the lower asset base;
 debt/equity ratios will be higher since the write-down reduces stockholders’
equity;
 deferred taxes will be reduced since book income will be less than taxable
income resulting in taxes paid exceeding tax expense;
 future earnings will be higher since the write-down will reduce future
depreciation expense;
 and, therefore, both ROA and ROE will improve in future years due to higher
earnings and lower assets and stockholders’ equity.
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