Longlived Assets

1
Long-lived Assets

• REMARKS

2
Issues

• Recognition
• Tangible versus Intangible
• Cost of Acquisition Cash Noncash
• Consumption Patterns
• Expenditures Subsequent to Acquisition
• Assets Disposal
• Periodic Impairment Tests

3
Recognition

• Internally acquired
• Externally acqured
• Tangible Asset
• Intangible Asset

4
Textbook, Page 422
5
Cost of Acquisition

• All expenditures necessary to acquire and ready
  an asset for use
• Invoice cost
• Insurance during transit
• Transportation
• Installation
• Testing/Debugging
• What about maintenance or service contracts
  acquired in conjunction with a long-live asset

6
Non-Cash Acquisition

• Firms can acquire equipment or entire
  subsidiaries by issuing new shares of their own
  common stock. See the supplementary information
  on a Cash Flow Statement
• In 2003 Pfizer spent 2.6b on PPE but acquired
  Pharmacia in a non-cash transactions for over 55b.

7
What is Depreciation Expense?

• Is depreciation expense capacity consumption?
• Is depreciation expense change in asset
  valuation downward?
• Is depreciation expense allocation of
  acquisition cost?

8
Depreciation Patterns

• Non-systematic
• Systematic
• Straight-line
• Production or Use
• Accelerated
• Declining balance
• Sum-of-the-years-digits
• For tax purposes- MACRS

9
Simple Example

• Acquire equipment costing 20000 with a 1000
  estimated residual value and an estimated useful
  life of 5 years.

10
Straight-line

• 20000-1000/5 years equals
• 3800 depreciation expense per year for each of
  the next five years
• Total Accumulated Depreciation over five years is
  19000 3800 times 5
• Book Value at end of 5th year is 1000
  (20000-19000)

11
SYD
12
DDB
13
DDB No Plug Needed
14
MACRS

15
(No Transcript)
16
Expenditures Subsequent to Acquisition

• Expenditures that prevent a decline in originally
  expected benefit are expenses e.g. routine
  repairs and maintenance
• Expenditures that increase originally expected
  benefit should be capitalized and treated as
  assets

17
Value

• Value is Future Cash Flow divided by appropriate
  discount rate percentage
• How can a subsequent expenditure on a long-live
  asset increase cash flows?
• An expenditure could
• Increase the number of years of life
• Increase the output per period (more sales)
• Decrease operating costs per period (cost savings)

18
Asset Disposals

• What happens when an asset currently in use is no
  longer needed and it is sold off?
• Assume that a asset originally costing 9000 with
  accumulated depreciation of 7000 is sold for
• A) 2000 Cash
• B) 3000 Cash
• C) 1000 Cash

19
Scenario A, Dispose for 2000 Cash
20
Scenario B, Dispose for 3000 Cash
21
Scenario C, Dispose for 1000 Cash
22
Do we Recognize PPE Changes Other Than
Depreciation?

• Yes, in recent years rulemakers have introduced
  Impairment Tests for Tangible and Intangible
  Assets
• The dot.com boom of the late 90s has produced
  some large charges to the income statement for
  goodwill impairment.

23
5. The following are examples of events or
changes in circumstances that indicate that the
recoverability of the carrying amount of an asset
should be assessed a. A significant decrease in
the market value of an asset b. A significant
change in the extent or manner in which an asset
is used or a significant physical change in an
asset c. A significant adverse change in legal
factors or in the business climate that could
affect the value of an asset or an adverse action
or assessment by a regulator d. An accumulation
of costs significantly in excess of the amount
originally expected to acquire or construct an
asset e. A current period operating or cash flow
loss combined with a history of operating or cash
flow losses or a projection or forecast that
demonstrates continuing losses associated with an
asset used for the purpose of producing revenue.
24
Asset Consumption, Impairment Recognition

• Tangible PPE
• Intangible Assets Subject to Amortization, Finite
  Life Assets
• Intangible Assets Not Subject to Amortization,
  Indefinite Life Assets
• Goodwill Assets

25
Impairment Tangible PPE, SFAS 121

• Whenever external events raise the possibility
  the asset has been impaired
• Estimate undiscounted net cash flows expected
  from the asset
• Are these future undiscounted net cash flows
  lower than the carrying amount (Book Value) of
  the asset?
• If yes there is an impairment
• Impairment loss is the difference between
  carrying value of the asset and its fair value
  (or the discounted net cash flows if fair value
  is not available)

26
Intangibles Subject Amortization, Impairments

• 15. An intangible asset that is subject to
  amortization shall be reviewed for impairment in
  accordance with Statement 121 by applying the
  recognition and measurement provisions in
  paragraphs 411 of that Statement. In accordance
  with Statement 121, an impairment loss shall be
  recognized if the carrying amount of an
  intangible asset is not recoverable and its
  carrying amount exceeds its fair value. After an
  impairment loss is recognized, the adjusted
  carrying amount of the intangible asset shall be
  its new accounting basis. Subsequent reversal of
  a previously recognized impairment loss is
  prohibited.

27
Intangible Assets Not Subject to
Amortization 16. If an intangible asset is
determined to have an indefinite useful life, it
shall not be amortized until its useful life is
determined to be no longer indefinite. An entity
shall evaluate the remaining useful life of an
intangible asset that is not being amortized each
reporting period to determine whether events and
circumstances continue to support an indefinite
useful life. If an intangible asset that is not
being amortized is subsequently determined to
have a finite useful life, the asset shall be
tested for impairment in accordance with
paragraph 17. That intangible asset shall then
be amortized prospectively over its estimated
remaining useful life and accounted for in the
same manner as other intangible assets that are
subject to amortization.
28
Recognition and Measurement of an Impairment
Loss 17. An intangible asset that is not
subject to amortization shall be tested for
impairment annually, or more frequently if events
or changes in circumstances indicate that the
asset might be impaired. (Paragraph 5 of
Statement 121 includes examples of impairment
indicators.) The impairment test shall consist
of a comparison of the fair value of an
intangible asset with its carrying amount. 12 If
the carrying amount of an intangible asset
exceeds its fair value, an impairment loss shall
be recognized in an amount equal to that excess.
After an impairment loss is recognized, the
adjusted carrying amount of the intangible asset
shall be its new accounting basis. Subsequent
reversal of a previously recognized impairment
loss is prohibited.
29
What is goodwill?

• ?????????????????

30
2 Ideas of Goodwill

• Annual Excess Earnings Industry Rate of Return
• Consideration Given greater than Fair Market
  Value of Net Identifiable Assets received
  (Goodwill is a plug or a Residual Concept)
• Consideration Given can consist of Cash and/or
  newly issued common stock from the acquiring firm
  given to the shareholders of the target firm
• The Fair Market Value of the targets net
  identifiable assets is the FMV of the targets
  Tangible and Identifiable Intangible assets less
  the FMV of the targets liabilities

31
Big, Inc. Buys Small,Inc.
32
Big Issues new shares of its Common Stock

• MV of Common Stock Issued is 650
• Carrying Value of Smalls Net Assets is
• Asset less Liabilities
• 400 less 200
• Carrying Value or BV is 200
• Assume FMV of Assets and Liab BV
• Why would Big give up 650 to get 200?

33
Why would Big give up 650 to get 200?

• It was a mistake
• 650 consideration given up is wrong
• The FMV of net assets of Small is wrong
• Or the difference is the residual intangible
  asset called goodwill
• 650 (Consideration) less 200 (FMV of Smalls
  net assets) equal 450 Goodwill

34
Assume

• Big acquires Small but leaves Small as a separate
  legal corporation
• Also assume that Big prepares a Consolidated
  Balance Sheet
• What would the Consolidate Balance Sheet look
  like?

35
Big, Inc. Buys Small,Inc.Before Consolidation
36
Big, Inc. Buys Small,Inc.After Consolidation
37
After Consolidation

• BV of Consolidated Entity is 1,150 (850 300)
• Of this 1,150 the book value or carrying value,
  650 is attributable to Small (Assets of 850
  less liabilities of 200)

38
Wear Tear on Goodwill

• Does Goodwill last forever or does it wear out?
• If it wears out, how?
• A systematic wasting asset
• A random or event triggered adverse economic
  event
• Old rule A wasting assets of 40 or less years
• New rule Regular annual impairment review

39
Possible Impairment

• What happens if after acquisition the products
  that Small makes and sells to its customers loses
  market share
• Small is less valuable and the previously
  recognized goodwill might be impairment
• What if,it can be determined that the MV of Small
  as a firm is 500 after the loss of market share,
  (Note MV was 650 at acquisiton)

40
Goodwill Impairment Tests

• Step 1 Compare Market Value of Target Firm with
  Book Value or carrying value of Target Firms net
  assets including Goodwill, if MV is less than BV,
  then there is an impairment.
• Step 2 Calculate the Implied Goodwill. Compare
  Market Value of Target Firm with Book Value or
  carrying value of Target Firms net assets
  excluding Goodwill. The excess of MV over BV is
  implied Goodwill.
• Step 3 Write down recorded goodwill to implied
  goodwill.

41
Step 1

• MV (a given in slide 39) of Firm Small is
  500
• Carrying Value, Net Assets of
• Firm Small with goodwill
• 400PPE 450GW 200Liab 650
• Deficiency (150)
• Yes, an Impairment exists because of decrease in
  MV of Firm Small

42
Step 2

• Calculate Implied Goodwill
• MV (a given in slide 39) of Firm Small is
  500
• Carrying Value, Net Assets of
• Firm Small without recorded
• Goodwill
• 400PPE - 200Liab 200
• Implied goodwill is difference 300

43
Step 3

• Carrying Value of Goodwill 450
• Implied Goodwill 300
• Amount of Goodwill Write Down 150

44
Big, Inc. Buys Small,Inc.After Consolidation
Before Write Down
45
Big, Inc. Buys Small,Inc.After Consolidation
After Write Down