Intangible Assets. Intangible assets lack physical
substance. Classic examples include software,
customer lists, patents, copyrights, and trademarks.
Accounting for an intangible asset depends on how it is
acquired. Broadly speaking there are three
ways in which we can acquire an intangible
asset; number one, acquired in a business combination. This simply means that you
have a company A which is the acquirer. This
acquires a company T, which is the target
company, let's say that company T has some patterns and
the fair value of these patterns is 100. Once T is acquired
and all assets of T come to the balance sheet of A,
including the patent. The patent needs to be
shown at fair value and that's important because
it is possible that the value of the patent
on the books over here is equal to 0, perhaps the patent was developed
internally and there is no book value because
all costs associated with the patent were
expensed so the book value would be 0, but if the fair value of the patent is
100 then when this patent is shown on the
balance sheet of company A ,it needs to be shown at fair value which
is 100. As you can imagine the determination of
this fair value requires judgment. An
analyst needs to figure out whether this fair value is appropriate or not.
The second scenario is as follows; purchased in
situation other than business combinations.
This is a long-winded way of saying that a company simply
purchased the intangible asset such as a patent. Here, obviously
the intangible asset will be recorded at fair value which most probably
is the amount that was paid for the intangible asset. Developed internally.
This is where the intangible asset is developed internally by the
company and we will see this on the next slide.
intangible assets developed internally. Under IFRS research costs are
expensed as incurred and development costs
are capitalized. This is important, the research phase means that a company
is spending money on a given intangible asset but is not sure whether that
intangible asset will actually have a long-term
benefit for the company. Since it is not clear
that the intangible asset will have a long-term
benefit therefore, all cost incurred during the research phase
needs to be expensed. Once it is clear that the intangible asset
being created is going to have a future benefit. Say we have created the
prototype, we know it will work, and now we need to develop that into a
proper product then we are in the development phase and
the development costs according to IFRS can be
capitalized. US GAAP is more strict. US GAAP says that both research and
development costs are to be expensed as
incurred. As an analyst you need to be careful about this
because if you are comparing a US GAAP company with an
IFRS company then the IFRS company is likely to have a higher
asset value because it is capitalizing the
development cost whereas the US GAAP company
is likely to have lower asset values and higher expenses because this company
is expensing development costs. Coming now to software. Software is an
important sub category under intangible assets,
and with software there are two possible situations;
one is the cost incurred to develop software for sale to others,
and the other is software for internal use.
Let's look at the sale to others scenario first.
Here the cost incurred needs to be expensed until the product's
technological feasibility has been established; subsequent costs should be
capitalized. So if you are a software company
and you are creating a new software until such time as you are clear that
this product will be saleable you are
supposed to expense. Once the technological feasibility is
established and you know you can sell this product
then you can capitalize. Now clearly there is a lot of subjectivity involved
here. When can we say that a product is now
technologically feasible so that decision point
can depend or can be different from company to company.
You as a analyst need to be aware of that when you are
evaluating different software companies. Under IFRS costs incurred to develop
software for internal use should be capitalized once feasibility is
established. US GAAP says that we need to capitalize
all development costs. Make sure you learn the material on the
slide because the next slide will be a question based
on what you are looking at here. Okay, now try to do this.
The first thing you need to recognize is that we are talking about
an internal software development project so from the previous slide this is the
third category. The project starts
on 1st January 2012 so that's the start of the year.
It incurs expenditures of 10,000 per month
during the fiscal year ended 31st December 2012.
So the cost is being incurred throughout the year.
By March 31st, so at the end of month 3, it is clear that the product will be
developed successfully and will be used as intended. So
the cost incurred during this period is going to be
expensed according to IFRS and then from 3 to 12 this cost will be
capitalized according to IFRS. The expense therefore would be
10,000 into 3, which is 30,000 and the amount
capitalized would be 10,000 into 9
which would be 90,000. What US GAAP says
is that the entire cost for the year needs to be capitalized. So we have
10,000 over a 12 month period, so
120,000 is capitalized. This is a very important table for you to
understand and it's quite testable when you are comparing a
company which capitalizes versus a company which
expenses. The total assets are going to be higher
for the company which is capitalizing obviously because
that's what capitalization means. All these
other numbers are fairly self-evident, and
I want you to go through this and make sure you
understand and remember them.
Some of these items and ratios that you might have an issue with,
so let's look at CFO. why is CFO higher for the
capitalizing firm? The reason is that if a firm
is capitalizing then the money spent, let's take the example that
we just saw--the 900 spent, this is going to go in the
investing bucket and not in the operating budget so
the cash flow from operations will be higher for the
capitalizing firm and using the same logic
the cash flow from investing would be lower
for the capitalizing firm because this 900
is going in the CFI, cash flow from investing bucket, and
reducing the CFI because it is money out. Debt to equity ratio.
Notice that the debt is not impacted by the decision of whether to capitalize or
expense.
so the liability is not impacted, the asset
number is going to be higher for the capitalizing firm. If the
asset number is higher that means that the
equity number is higher, if the equity number is higher then the debt to equity
is lower for the capitalizing firm. Interest
coverage ratio is important. Initially when the money is
spent, your interest coverage ratio is higher for the capitalizing firm so what
is the interest coverage ratio? It is your operating profit or EBIT
divided by the interest expense. In the initial year, EBIT is going to be
higher for the capitalizing firm, since EBIT is higher, the interest
coverage is higher, but what about subsequent years? In
subsequent years, the EBIT is going to be lower for the
capitalizing firm because depreciation is included in EBIT,
and depreciation reduces EBIT, therefore we have a lower number for the
capitalizing firm. Return on Assets. Return on assets
is net income over assets. In the initial year, the year where the
money is spent, the net income is going to be
higher for the capitalizing firm, the asset is also going to be higher, but
generally the percentage increase in net income is
much more than the percentage increase in assets so overall
this ratio will increase. Example illustrates a scenario where you
have two companies that are very similar; one expenses and the other capitalizes,
so the company called CAP will capitalize, the company called
NOW is going to expense. Now they both start with 1000 cash
and 1000 equity. They have the same revenue. The first company
and the second company both companies purchase equipment for
900. Both companies have expenses other than this of 500 per year.
CAP does straight line depreciation over three years
which means that it purchased this equipment for 900
so what is it going to show? It is going to show a depreciation expense of 300,
300, and 300 over years 1, 2, and 3. What we'll now do now is
going to show the entire 900 as an expense in
year 1, all right. We are also given the tax rate and then here are the questions;
which company reports higher net income over the three years?
What is the difference in total cash flow? What is the difference in cash from
operations? Do you think there'll be differences in
the numbers reported over the three years?
Yes, there will be. Is there any economic difference between the two companies?
Not really, from an investment perspective they are identical, but
clearly because they are using different methods, the numbers are different.
The return on equity, profit margins so these ratios are also going to be
different over the years. The taxes paid
over the years are also going to be different.
In many case you will notice that the cumulative effect over three years
is the same, but each year when looked at separately you will have
different numbers. I am going to highlight the important
points over here and then there'll be a separate video
going into details, but I think this is fairly straightforward,
and I actually want you to try solving this on your own before you
look at the solution. The first question is which company
reports higher net income over the three years?
And then we also want to look at the cash flow numbers on the recording
so here we are looking at the numbers for CAP on the left and now
on the right. Notice that the cash expense
other than the expense related to the 900 equipment is the same but
with CAP the depreciation is 300 spread over three years, so total is 900 whereas
with NOW the total 900 is shown as a cash expense
so that is why the net income, or actually let's look at the
income before tax first, the income before tax is only 100 for
NOW in year 1, and it is 700
for CAP, okay CAP has a higher
income because only 300 is being taken as an expense but then what about the
tax?
CAP is paying the higher tax over here because the earnings before tax is
higher whereas NOW is paying a
lower tax. Net income is 490 for CAP and net income
is only 70 for NOW. What about over the three years?
If you take numbers over the three years 490 + 490 + 490,
so in both cases the numbers over the three years will be the same. Here you
have 70 + 700 and 700, so you are going to
have 1470 in both cases,
but when you take time value of money into account
then this would be better but accountants who don't worry about time
value of money will say that we have the same situation. also notice
that the income variability is higher over here
because we are taking a big lumpy expense
in the NOW scenario whereas in the CAP scenario,
the expense is spread over a period of time.
You can figure out the other numbers over here. they are fairly
straightforward, and then I'll also make a separate
video available on this.
Question two deals with ROE and net profit margins. What you will see on the
left is the calculation of equity, time
0, equity is the same for both companies,
but then the equity numbers are different after that.
On the previous slide we calculated the net income numbers.
Here we are calculating the equity numbers,
so the ROE numbers are going to be different. The ROE
for the capitalized company is going to be higher in the first year relative to
the expense company and this is intuitive
because with the capitalized company in the year of the expense
we are only taking the depreciation number so the net
income is higher, but in subsequent years
the ROE is going to be higher for NOW because there is no
depreciation expense involved for the NOW company all right, and with net
profit margin, notice that the net profit margin
is the same for all three years for CAP whereas for NOW there is more
variability, very low profit margin in the first year
because we take the big hit, but then the profit margin numbers are
better in subsequent years. I want you to also do these calculations,
they are fairly straightforward.
Why does NOW report a change in cash of 70
versus CAP which reports a change of cash
of -110. You can work through the numbers here but the big
difference is the tax.
Who is paying more tax? Actually CAP is going to pay more tax in
year 1 because CAP has a higher
profit, so when the profit is higher obviously it is paying more tax.
So will that impact the cash flow? It will because the tax payment is a very
real cash flow so that explains the
difference.