Long-Lived Assets.
Long-lived assets are defined as those assets which are expected to provide
future economic benefits extending more than one year. These assets may be
tangible, intangible or financial. The major questions we will address in this
reading are as follows; what value should be shown on the balance sheet when we
acquired the asset, and then what value should be shown on the balance sheet
during the life of the asset? We will also be concerned about how the cost
should be allocated over the life of the asset. Let's first talk about the
acquisition of long-lived assets. Upon acquisition, long-term, tangible assets
such as property, plant and equipment are recorded on the balance sheet at cost
which is typically the same as fair value. The assets cost might include
expenditures in addition to purchase price, and the question is whether these
cost should be expensed or capitalized. On the next slide we will talk about
which cost should be capitalized and which costs should be expensed. With
intangible assets the valuation depends on how the intangible asset is acquired
and we will discuss this later on. Property, Plant and Equipment. At
acquisition, property, plant and equipment is recorded at cost.
Cost includes all
expenditures necessary to get the asset ready for intended use. It is important
to understand this because there is a good chance that you might get a
question related to what cost must be expensed versus what cost needs to be
capitalized. Say you purchase a machine for 1000, clearly this cost needs to
be capitalized and shown on the balance sheet. In addition to 1000 you pay a
100 to install the machine and get it ready for intended use, that
obviously will also be capitalized. Say you also pay 50 to get the factory ready
for this machine. As an example the floor needs to be reinforced in order to
support this heavy equipment and that costs 50, this 50 is also going to be
capitalized. If you do a routine maintenance or you have your factory
painted then those expenses are expensed that means they flow through the income
statement, they are not shown on the balance sheet. If you train your staff to
use this machine, that also needs to be shown as an expense which flows through
the income statement. If there are any subsequent costs related to the
equipment that you purchased and set up, those costs are capitalized if they are
expected to provide benefit beyond one year so if you make a major upgrade to
the equipment and that upgrade is expected to provide a benefit for 3
years then that upgrade cost can be capitalized; otherwise if you incur a
cost where the expected benefit is less than one year then that cost has to be
expensed. As you might have gathered there will be some expenses or some
costs where there is subjectivity as to whether the cost should be expensed or
capitalized and different companies might make different expensing versus
capitalizing decisions. You, as an analyst, need to realize that the choice of
whether to expense or capitalize has an impact on financial statements and hence
on ratios. With the expensing firm we will not have any depreciation expense.
Let us now look at an example which deals with what expenses are capitalized
versus which expenses are expensed. Acme Inc. purchased a machine for
10,000. In addition the following costs were incurred: 200 for delivery,
300 for installation, 100 to train the staff, 1000 to reinforce
the floor to support the machine, and 500 to have the factory painted.
Which expenses will be capitalized and which will be expensed? Clearly this
expense of 10,000 is going to be capitalized. 200 for delivery,
this is necessary to get the machine into a working form so this needs to be
capitalized. The installation cost also needs to be capitalized, 100 to
train staff to use the machine. Just remember the fact that the training cost
is not capitalized, this needs to be expensed. The way you can think of this
as training of staff is a routine activity that companies should be doing
plus if the staff is trained and then they leave then obviously that doesn't
provide a long-term benefit to the company so in general training cost is
expensed. A 1000 to reinforce the floor to support the machine. This needs
to be capitalized because this cost has to be incurred for the machine to
operate and this cost, while not explicitly stated here, is likely to
provide a benefit over a period longer than one year. 500 to have the
factory painted. This clearly is going to be expensed so you simply add up these
numbers; 10,000 + 500 + 1000 and that will give you the
amount that needs to be capitalized. 100+ 500 is what needs
to be expensed. How will the treatment of these expenditures affect the
company's financial statements? We need to look at the balance sheet here, the
income statement, and the cash flow statement. On the balance sheet the
property, plant and equipment will go up by 11,500 which is
simply the sum of all the capitalized expenses, and obviously
if you are paying using cash then cash goes down by the same amount. On the
income statement we will show the expenses; 100 to train the staff and
then 500 to have the factory painted so these go to the income statement. We will
also show a depreciation expense over the life of the asset on the income
statement. As far as the cash flow statement is concerned this cost of
11,500 is going to be shown as part of CFI whereas the
expenses that are expensed, 100 and 500, these are going to be
shown as part of cash flow from operations. Capitalizing of Interest
Costs. For constructed assets interest cost during construction are capitalized
as part of the asset cost. The idea is straightforward. Let's say that you are
constructing a building and the construction period is two years. To
create this building, let's say, you borrowed some money and you are paying
interest on that money. The interest cost can be thought of as just another cost--
the way material is a cost, labor is a cost, the same way interest is a cost. And
since material and labor are being capitalized, it makes sense to also
capitalize the interest cost associated with creating this building, but the
interest cost will be capitalized during the construction period. The question
then becomes what interest rate to use? The answer is, use the rate on borrowing
related to construction so if your construction costs a hundred million and
you have borrowed one hundred million specifically for this construction at a
rate of 10 percent, then you use the 10 percent rate, so your capitalized amount
will be based on 10 percent. If no construction debt is out-
standing, the interest rate is based on existing unrelated debt. It is also
possible that a company has issued a bond and raised 200 million
through that issue. The 200 million that is raised is used to pay for the
building plus it is used to pay for other expenditures, given that in this
example we don't have a borrowing that is specific to construction. We can then
use the rate that is relevant for this bond issue, let's say that rate is 12%, we
can then use the 12% number to calculate the capitalized interest. The capitalized
interest is not reported as an expense on the income statement and that's
obvious since we are capitalizing that means
that the amount is going on the balance sheet. Even though, we are making interest
payments and that's important, you are borrowing money and let's say you are
borrowing money from a bank, you need to make payments to the bank, but the
interest expense is not shown on the income statement initially, it is shown
as an asset, but then as the asset is depreciated then essentially the
interest expense is shown as a depreciation expense over the life of
the asset. Just as a subtle distinction between IFRS and US GAAP, IFRS says that
the interest on short-term lending offsets capital costs. This is not
allowed under US GAAP. This will become clear in the example that we will look
at shortly, but just to give you a quick sense let's say that you borrow 100
million at 10 percent and that means that over the two-year period you are
going to make payments of 10 million and 10 million, so your capitalized interest
according to US GAAP is going to be 20 million. What IFRS says is that when you
get this 100 million you are obviously going to invest it in
an operating bank account and when you invest this money or place this money in
the bank you are going to get some interest, let's say that the interest
amount that you get is equal to 1 million then the 1 million offsets the
20 million that we are capitalizing, so the capitalized interest then becomes 20
million minus 1 million, which is 19 million, that is according to IFRS. US GAAP says
that the entire 20 million needs to be capitalized. Let us look at a few
conceptual issues related to capitalized interest. Capitalized interest causes
higher net income and greater interest coverage ratios during the period of
capitalization. Notice that when we capitalize interest then it is not
showing up on the income statement. As we've discussed up here, the interest
expense is capitalized so it causes the asset value to go up which means that
the expenses on the income statement are relatively low which means that the net
income is relatively high for the firm that is capitalizing interest. The
interest coverage ratio is going to be high, the interest coverage ratio is
essentially EBIT over the interest expense. If we are showing a relatively
low interest experience then EBIT over interest expense is going to be high.
Notice that the lower or higher interest expense does not impact EBIT because
EBIT is earnings before interest and taxes so therefore, our interest coverage
ratio is going to be high during the period of capitalization, but then what
happens in subsequent periods? Higher asset values and depreciation lead to
lower net income, and lower EBIT, and interest coverage. Again this should be
fairly clear, in the year that we capitalize or in the years of
capitalization, let's say that back to our original example, it takes two years
to construct our building, so in these years we are capitalizing interest
expenses. Because of that capitalization, our value of the asset, the building in
this case, is relatively high because that value includes the capitalized
interest, this means that in subsequent years the depreciation amount is going
to be high which means that our expense is going to be relatively high because
this will include the depreciation of the capitalized interest. Since the
expense is relatively high the net income is going to be relatively low,
EBIT is going to be low because depreciation is considered operating
expense. If you look at your basic income statement you subtract depreciation in
order to come up with EBIT so if depreciation is relatively high that
would mean that EBIT is relatively low and your interest coverage ratio, which
is EBIT divided by the interest expense, is also going to be relatively low
because after construction you are going to actually show your interest expense
as an expense on the income statement, and your EBIT is also lower because of
the extra depreciation therefore, the overall interest coverage ratio is low.
Given what we just talked about I want you to do this example. Here is what you
should get, two million at 5% over a two-year period means that the
interest that is being paid over the two-year construction period is
200,000, this needs to be capitalized according to US GAAP, so US GAAP says
that the entire 200,000 is capitalized.
What IFRS says is the following; you are paying this much interest based on your
borrowing, but when you borrow money you put the money in an operating account and you
get interest worth 20,000. This 20,000 needs to be knitted out from the 200,000
and that gives you a 180,000 so according to IFRS a
180,000 is what is going to be capitalized.
Where will the capitalized borrowing cost appear on the company's financial
statements? Initially the capitalized amount is going to appear on the balance
sheet and then after the construction is complete then we will have this entire
capitalized amount as part of the asset value. Once the asset is depreciated then
the capitalized interest is also expensed out through the depreciation
process via the income statement over the life of the asset.