Chapter 09: Long- lived Assets

Land 5,000 Debt X

100,000
Additional 15K
CASH 100,000
MACHINE 30 or 52 Equity
X +15,000 (asset appreciation)

ASSET>>> SALES

This additional 15K is unrealized, ut has no impact on your capacity

Asset utilization ratio = Sales+0/Asset +15K = will go down

Firms want a leaner asset base:

LEASE

MACHINE= 30K + 10K + 10K +2 = 52K

Cost 1.5 lac

Any cost that add values to the assets will be part of that asset value.

Expense or asset value addition’

B/S:

Warehouse = 1 + 1.5

Long-lived assets are non-current assets or long-term assets, which are expected to
provide economic benefits over a future period of time, typically greater than one
year.

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 so sometimes as fixed assets, include land, buildings, furniture and
fixtures, machinery and equipment, and vehicles.

Examples of long-lived intangible assets include patents, trademarks, software,

applications, DATA etc; and

examples of long-lived financial assets include investments in equity or debt

securities issued by other companies.
Issues: Figuring out cost at acquisition, and how to allocate the cost to
expense over time. The main issue that accountants face is allocating the
cost of asset. This basically means what should be the value of asset
mentioned or reported in in your book (balance sheet)
Assets are reported in 2 ways:

 Historical method
o Accepted by both IFRS and GAAP
o Mostly used across the globe
o Equipment 2019 @10,000>>>>>>>2023 equipment gross 10,000
o Reporting of intangible assets (software)::: please refer to slide for
this part
 Revaluation method (Fair value method)
o Is accepted under IFRS, but not under GAAP
o Seldomly used
o Every you reassess the asset value based on market value and re
report.
o Equipment 2019 @10,000>>>>>>>2023 market value is 8000; then
reported value in B/S in 2023 will be 8000

Cost 10,000; annual dep 1000; At the end of year 3, acmlt dep exp = 3000 taka

What is remaining value/book value of the asset at the end of year 3 = 10,000 –
3000 = 7000

At that point you salvaged that asset in the market: 9000

Salvage value > book value: the gain on sale

Every cost can be reported in the follow 2 manners:

 Costs (outflows) can be either expensed or

o Expense: any outflow related to operations
 Costs (outflow) can be capitalized
o Capitalization: any outflow related to buying asset
 Asset value: gross value of asset + any expense required to
make the asset usable.
 any expense required to make the asset usable should be
capitalized
 Inventory> car 14,000

How do accountants value assets: assigning respective amount on B/S

Firstly, accounts try to see how the asset (long-lived) was acquired:
There are 3 ways a fixed asset can be acquired in a company?

 Purchase
 Develop internally (intangible)
 Through acquisitions and mergers

Capitalizing vs. Expensing:

Capitalizing Expensing
Asset H L
Net income (1st year) H L
Net income (subsequent L H
year)
Equity H L
Connected with NI
CFO (Y1) H L
CFO is connected with NI
CFI L H
Connected with assets Cash outflow on
investment is increasing
D/E L H

Revenue/Profit has a positive correlation with shareholder’s equity

A = L + E; If A goes up, then E will also go up, because equity holders own assets

Example:

 CAP and NOW start with 1000 Cash and 1000 Equity
 Revenue: 1500 (yearly)
 Equipment purchased: 900 (useful life 3 years) (this expense incurred in 0)
 CAP Decides to capitalize the equipment purchase, whereas NOW decided to
expense the purchase
 Other operational Expense: 500 (yearly)
 CAP does straight line depreciation over 3 years
 Tax 30%

What is their CFO, CFI, NI, Net changes in cash for Year 1, 2 & 3?

Solution:
Assets>>>>>profit, asset

Why do shareholder invest money at times in loss companies? They are prioritizing
assets over profit.

CAP NOW
  Asset L   Asset L
Cash 1000-900   Cash 1000-900  

Equipment 900 E Equipment 0 E 1000 - 900

 Total  1000 1000  Total  100 100

Debtor-in-possession (DIP) financing is a special kind of financing meant for

companies that are in bankruptcy. Only companies that have filed for bankruptcy
protection under Chapter 11 are allowed to access DIP financing, which usually
happens at the start of a filing. DIP financing is used to facilitate the reorganization
of a debtor-in-possession (the status of a company that has filed for bankruptcy) by
allowing it to raise capital to fund its operations as its bankruptcy case runs its
course. DIP financing is unique from other financing methods in that it usually has
priority over existing debt, equity, and other claims. 

Citigroup, J.P. Morgan, and G.E. Capital, the company would survive as a going
concern when it emerged from bankruptcy in 2003 as MCI—a telecom company
WorldCom had acquired in 1997. However, tens of thousands of workers lost their
jobs.

Revelation Model

Under this model, we constantly change the asset value based on the market value,
whereas, under the cost model we do not change reported gross value of asset.

 Your benchmark is the fair price you had spent to purchase the asset
originally. That price is the base of revaluation.
 Any movement under the base price will be considered as a loss and will be
reported on your income statement.
 Any movement above the base price will be considered as a surplus of asset
valuation and will directly affect the shareholder’s equity as surplus of value.
 If there’s a surplus of asset value then we create a new account called
revaluation surplus. We will add this amount to equity.
 Any loss on asset revaluation has to come from Income statement through a
loss account.

Land 10,000>12,000>8000

Equity: XXXXXX
- reverse revaluation surplus 2000
- reduced RE of 2000
- 4000
-4000

I/S

Sales

Loss on asset (2000)

Net profit: will go down by 2000

Any loss reduces owner’s equity account.

Example from Slide:

• Scenario 1: Machine costs $10,000 at the start of period 1. At the end of

Period 1 the fair value of the machine is $12,000. At the end of Period 2 the
fair value is $8000. Show the impact on financial statements
Solution:

Scenario 1:

End of Year 1

Asset +2000 from last year

+2000 from last year

12000 Equity:
Revaluation surplus 2000

Any asset value appreciation basically maximizes owner’s value by that proportion.

End of Year 2

Asset -4000 from last year

-4000 from last year After reversing the surplus I still have
to subtract 2000. However, I can’t
directly subtract 2000. Now total 4000
has been subtracted from R.H.S

8000 Equity:
Revaluation surplus 2000
Reverse Revaluation surplus (2000)
Reduced Retained Earnings (2000)
8000

End of Year 2

Income Statement
Expenses:

Loss on revaluation -2000

If exp goes up by 2000, the NP goes down by 2000.

If NP goes down by 2000 then RE will also go down by 2000, which in-turn will
reduce OE by 2000

Any fall of asset value from historical base price is considered as an operational
failure. Hence I will consider it as an expense.

And if NP goes down by 2000, then owner’s equity will also go down by 2000.

Scenario 2: Machine costs $10,000 at the start of period 1. At the end of Period 1
the fair value of the machine is $8,000. At the end of Period 2 the fair value is
$12000. Show the impact on financial statements

End of Year 1

Asset Reduction of 2000

Reduction of 2000

8000 Equity:

- Reduced retained earnings (2000)

 End of Year 1

Income Statement

Expenses:

Loss on revaluation -2000

If exp goes up by 2000, the NP goes down by 2000.

End of Year 2

Asset
An addition of 4000 An addition of 4000

8000 > 12000 Equity:

Through increased RE 2000
+ Revaluation surplus 2000
 End of Year 2

Income Statement

Gain on revaluation 2000

If my gain goes up by 2000, the NP goes up by 2000.

Depreciation:

 Straight-line (base)
 Accelerated/double declining
 Unit cost

Asset utility low >>>>Sales

Cost = 10,000

Useful life = 10 years ; salvage value = 0

Depreciable amount = historical cost – salvage value (if any)

Can you depreciate salvage value? NO NO

Annual depreciation expense = depreciable amount/ useful life

10,000 – 0 / 10 = 1000

Annual depreciation rate = depreciation expense/ depreciable amount =

1000/10,000 = 10%

Double-declining = annual depreciation rate = base rate * 2 = 10% * 2 = 20%

Under accelerated method, my annual deprivation expense will be = depreciable

value * depreciation rate = 10,000 * 20% = 2000

Next year; remaning value * dep rte = 8000 * 20% = 1600

Salvage value = whether we can salvage the asset in the market get some monetary
return @ the end of useful life.
Impairment of Asset:

Whether an asset is impaired or not: you have to check the market value. Let’s say a
particular equipment was supposed to price at 10,000; for some reason due to a
new technology the equipment has become obsolete. And the current value is 7000
instead of expected 10K. Let’s the Book value is also::::3000 is my loss amount.

Impairment Loss = Book value – Market Value

Machine 900 (3 years useful life); I’ve used it for 2 years. What is my carrying value
of the machine? 300

Market is willing to give you only 200. On top of this, you have to pay 50 dollar to
the brocker who is helping you sell the asset. Carrying value – market value = 300 –
(200-50) = 100

Carrying value = book value -acmlt depreciation

Equipment 10,000; annual depreciation exp =1000; then at the end of Y3, what will
be the carrying value of asset = 10,000 – (1000*3) = 7000

Recoverable amount= the money you can get by selling the asset in the market

Calculation under IFRS:

Impairment Loss = Carrying Value – Recoverable amount

The more you can recover from the market the lower will be your loss amount.

Both GAAP and IFRS required you to calculate impairment loss amount. Reversal of
impairment is only allowed under IFRS. GAAP doesn’t allow you to reverse your
impairment

 Recoverable amount = greater of: 1) fair value less cost to sell and 2) value
in use
o Fair value is basically the market value. The amount you can get by
selling the asset in the market. IFRS also requires you to subtract the
cost to sell the asset, if any.
o Value in use is present value of cash flow from asset from the point of
calculation. PV of all remaining CFs.
o Higher the amount one car recover, lower will be the impairment loss
amount. Hence, IFRS allows you to take the greater of above-
mentioned values.
Example: Given the following data, what is the reported value under IFRS

Carrying amount = 8000 (BV)

Undiscounted expected future cash flows = 9000
Total PV of expected future cash flows = 6000 (this is the risk adjusted/discounte
value of 9000) = value in use
Fair value if sold = 7000
Cost to sell = 200

As market amt is greater than value in use, so recoverable amount will markt amt
instead of value in use

Impairment loss (IFRS) = carrying value – recoverable amount = 8000 – 6800 =

1200

Fair value minus cost to sell = 7000 -200 = 6800 VS Value in use 6000

0 (20,000)

1 5000

2 7000

3 10000

4 8000

5 10,000

Total inflow 40000

Total inflow is 40,000 – 20,000 = net value of investment is positive 20,000

Discounting basically means adjusting the future CFs with your perceived risk.
Impairment Loss under GAAP:

First you’ve to make sure actually asset is impaired.

Under US GAAP: First do the recoverability test to determine whether the asset is
impaired. Asset is impaired if the carrying value is greater than the asset’s future
undiscounted cash flows

- If your book value/carrying value > undiscounted expected CFs, in that case you
may consider your asset as impaired. Only then you may calculate impairment loss.

- Impairment loss = Carrying amount – (Fair value – cost to sell) =

Example: Given the following data, what is the reported value under GAAP

Carrying amount = 8000 (BV)

Undiscounted expected future cash flows = 9000
PV of expected future cash flows = 6000 (this is the risk adjusted value of 9000)
Fair value if sold = 7000
Cost to sell = 200
Recoverable amt = fair value – cost = 7000 – 200 = 6800
Recoverability test = failed. No in this example we can’t consider this as an impaired
asset as 8000 is not greater than 9000.

Alternate Scenario:
Carrying amount = 8000 (BV)
Undiscounted expected future cash flows = 7900
PV of expected future cash flows = 6000 (this is the risk adjusted value of 9000)
Fair value if sold = 7000
Cost to sell = 200
Recoverable amt = fair value – cost = 7000 – 200 = 6800
Recoverability test = yes, impaired

Impairment loss = carrying value – market amt

8000 – (7000-200) = 1200

 Lease

Why we lease?

 I don't have enough capital

 I don’t need the asset for longer duration
 Asset may become obsolete (lease helps you avoid owning the obsolescence)
 Leaner balance sheet: huge amount assets might lead to lower asset
utilization. Hence many firms prefer to keep the asset section lean.
 In some cases, lase can actually be cheaper than financing and buying an
asset. In cases, cost of lease < cost of capital
 Lease restrictions are comparatively less.

There are 2 types of lease:

1. Operating Lease (renting out something)

a. Just like rent expense, you’ll report your lease expense in IS
b. The lessee will not own the asset
2. Capital Lease/ Finance Lease

Lessor: Who owns the asset and leases it out

Lessee: user of leased asset

Disadvantages of leasing: especially for the lessor

• One major disadvantage to leasing is the agency cost problem. In a lease, the
lessor will transfer all rights to the lessee for a specific period of time,
creating a moral hazard issue. Because the lessee who controls the asset is
not the owner of the asset, the lessee may not exercise enough care as if it
were his/her own asset. This separation between the asset’s ownership
(lessor) and control of the asset (lessee) is referred to as the agency cost of
leasing.  This is an important concept in lease accounting.

Capital Lease:

Let’s say I want to buy a machine for my company.

Equipment = 100,000

Yes, I can lease the asset, however if it’s OL, it won’t be added on my BS. Let’s say I
don’t want to lease the asset. I want to own the asset.

You’ll have to take a loan. Usefull life = 4 years and loan = 4 years @ 10%

Loan payment (using annuity CF) = 31547 per annum

This payment includes interest as well principal

Cash +100,000 +100,000 outstanding loan amt

- 100,000 - prin pmt

Equipment +100,000
-acmlt dep

And interest of the loan payment will go to your IS.

Let’s say I have a very bad credit rating. And I know I won’t be able to take a loan at
this rate.

Take my machine and give a lease payment each year (the payment will bear some
interest as well)

Lease payment = 31547

Capital lease works exactly like a loan, however instead of taking the loan from a
bank you are basically taking the loan from the lessor. The machine will leased out
as a loan, and the lessee will payback lease amount with interest through out the
lease period. And if all the conditions are fulfilled then this lease can be considered
as a capital lease, and then lessee can claim ownership of the asset and report it on
his/her BS.

Equipment +100,000 +100,000 outstanding lease liability

-acmlt dep