Reading 33

Prerequisite: capitalization vs. expensing, types of long-term assets (PP&E and intangibles), cost vs. revaluation models (U.S. GAAP requires cost; IFRS allows either by asset class), depreciation/amortization methods.

Intangible assets lack physical substance — patents, brand names, copyrights, franchises. Finite-lived intangibles are amortized over useful life. Indefinite-lived intangibles are not amortized but tested for impairment at least annually.

Under IFRS, an identifiable intangible asset must:

• Be capable of being separated from the firm or arise from a contractual/legal right
• Be controlled by the firm
• Be expected to provide future economic benefits
• Future benefits must be probable and cost must be reliably measurable

An unidentifiable intangible cannot be purchased separately and may have indefinite life — most common example: goodwill (purchase price excess over fair value of identifiable net assets in a business combination).

Internally Created Intangibles

Generally expensed as incurred. Exceptions:

• IFRS: research costs expensed; development costs may be capitalized if criteria met.
• U.S. GAAP: both research and development expensed; exception: software for sale — capitalized after technological feasibility is established. Software for internal use — capitalized after it is probable the project will be completed and used as intended (a lower bar than technological feasibility).

Purchased Intangibles

Recorded at cost (fair value at acquisition). If purchased as a group, allocate price by fair value. Capitalizing yields higher first-year NI, assets, equity, CFO (lower CFI) than expensing. Firms generating intangibles internally have lower B/S assets than those that purchase them — significant impact on ratios.

Intangibles Acquired in Business Combinations

Use the acquisition method: purchase price allocated to identifiable assets and liabilities at fair value. Previously expensed identifiable intangibles of the target are now capitalized on the acquirer's balance sheet at fair value. Remaining excess = goodwill.

Only goodwill created in a business combination is capitalized; internally generated "goodwill" is expensed.

D&A is the planned write-down of cost over the asset's life. An impairment is an unanticipated decline below carrying value. Derecognition occurs when an asset is disposed of or retired.

Both IFRS and U.S. GAAP require firms to write down impaired assets via I/S loss. Material impairments may appear as an unusual or infrequent item.

Impairments Under IFRS

Annually assess whether events/circumstances indicate impairment (significant market value decline, change in physical condition). If so, test:

Impaired if carrying value > recoverable amount, where:

\[\text{Recoverable amount} = \max(\text{fair value} - \text{selling costs},\ \text{value in use})\]

Value in use = PV of future cash flows from continued use and disposal.

If impaired, write down to recoverable amount; recognize loss in I/S.

Loss reversals allowed if value recovers — capped at original impairment loss.

Impairments Under U.S. GAAP

Tested only when events/circumstances suggest carrying value may not be recoverable. Two steps:

1. Recoverability test: impaired if carrying value > undiscounted future cash flows.
2. Loss measurement: if impaired, write down to fair value (or discounted future CFs if FV unavailable). Loss = carrying value − fair value.

No subsequent recoveries allowed (assets held for use).

Effects of Impairment

• Year of impairment: NI, assets, equity ↓; ROA & ROE ↓.
• Subsequent years: lower asset base → lower D&A → higher NI; ROA & ROE typically ↑ (lower denominators too); asset turnover ↑.
• No cash flow impact — unrealized loss until disposal.

Impairment essentially says past depreciation was insufficient (earnings overstated). Discretion in timing & size enables earnings smoothing or "big bath" by new management.

Indefinite-Lived Intangibles

Not amortized. Impairment loss recognized when carrying amount > fair value.

Long-Lived Assets Held for Sale

Reclassified from held for use to held for sale when (1) firm intends to sell, (2) sale is probable, (3) asset available for immediate sale. Once reclassified: no longer depreciated/amortized. Impaired if carrying value > fair value − selling costs → write down to NRV. Loss reversals are allowed under both IFRS & U.S. GAAP, capped at original impairment.

Derecognition

Occurs via sale, exchange, or abandonment.

If indirect-method CFS: gain/loss removed from NI in CFO (proceeds are CFI).

Abandonment: no proceeds → carrying value removed → loss equal to carrying value.

Exchange: gain/loss = fair value of disposed − carrying value of disposed (or use fair value of new asset if more clearly evident). New asset recorded at fair value. If no reliable fair value exists, new asset at old carrying value (no gain/loss).

Spinoff

Transfer of assets constituting a division/subsidiary into a new legal entity; spinnee shares distributed to spinnor shareholders (no surrender of spinnor shares). Once probable, spinnee assets/liabilities move from "held for use" to "held for sale" (or "held for distribution"). No gain or loss recognized on disposal in I/S.

IFRS Disclosures (PP&E)

• Basis for measurement (usually historical cost)
• Depreciation method, useful lives or rates
• Depreciation expense in the period
• Gross carrying value and accumulated depreciation at start and end
• Reconciliation of carrying amounts beginning to end
• Title restrictions and assets pledged as collateral
• Agreements to acquire PP&E in the future

If revaluation model: revaluation date, FV determination method, carrying value under historical-cost model, revaluation surplus in OCI.

Intangibles: similar requirements + state whether useful lives are finite or indefinite.

Impaired assets: amounts of impairment losses and reversals by asset class, where recognized in I/S, circumstances causing impairment/reversal.

U.S. GAAP Disclosures (PP&E)

• Depreciation expense by period
• Balances of major classes (land, improvements, buildings, machinery, furniture)
• Accumulated depreciation by class or total
• General description of depreciation methods

Intangibles: similar + estimate of amortization expense for the next five years.

Impaired assets: description, circumstances, FV determination, loss amount, where in I/S. (No reversals required since GAAP doesn't allow them for held-for-use assets.)

Under IFRS, D&A may appear on the face of the I/S if using nature-of-expense format; if using function-of-expense format, D&A is rolled into COGS/SG&A. Under indirect-method CFS, D&A appears as noncash charges.

Fixed Asset Turnover

\[\text{Fixed asset turnover} = \dfrac{\text{revenue}}{\text{average fixed assets}}\]

Higher = greater efficiency in using long-term assets to generate sales.

Average Age / Useful Life Estimates

Assuming straight-line depreciation and zero salvage:

\[\text{Average age} = \dfrac{\text{accumulated depreciation}}{\text{annual depreciation expense}}\]

\[\text{Total useful life} = \dfrac{\text{historical cost (gross)}}{\text{annual depreciation expense}}\]

\[\text{Remaining useful life} = \dfrac{\text{ending net PP\&E}}{\text{annual depreciation expense}}\]

Remaining useful life ≈ total useful life − average age.

Another useful metric: annual capex / depreciation expense — indicates whether the firm is replacing assets at the same rate they're being depreciated (maintaining capacity).

Older, less-efficient assets may hurt competitiveness; average age helps estimate timing of major capex and future financing needs.