Asset Analysis

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Asset Analysis

• Chapter 2

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Learning objectives

• Concept of Asset
• The key principles used to identify and value
  assethistorical cost and conservatism
• The process of asset of analysis
• Decide whether an outlay should be
  capitalized or be expensed
• Evaluate the value of the asset

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Historical Cost

• GAAP requires that the assets be accounted for
  and reported on the basis of acquisition price
• Advantages more easily verified reliable
  Limiting managers ability to overstate the value
  of the asset.
• Disadvantage Limiting the information about
  current value of asset.
• Trends Mixed attribute system of valuation

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Conservatism

• Conservatism involves reporting the least
  optimistic view when faced with uncertainty in
  measurement.
• Establish one exception to the use of historical
  cost
• Provides important implications for analysis
• Additional assurance for investor
• Additional margin of safety for creditor

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Criteria for recognizing assets and
implementation challenges
Second Criterion Resources are expected to
provide future Economic benefits sufficient to
recover their cost
Third Criterion The future economic Benefits are
Measurable With a reasonable Degree of
certainty

• First Criterion
• Resources are owned
• by the firm.

Record an asset
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Challenging Transactions

• Ownership of the resource of uncertain
• Future benefits from outlay are uncertain or
  difficult to measure
• Resource values have changed

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Ownership of resources is uncertainleased
resources

• A lease is considered a capital lease if any of
  the following conditions apply (SFAS 13)
• Essential transfer of ownership at the end of
  lease term
• Minimum present value if lease payments at least
  90 of assets market value
• Lease term is 75 of assets remaining useful life

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Ownership of resources is uncertainleased
resources

• Assessing whether a lease arrangement is a
  purchase or rental depends on whether the lessee
  has effectively accepted risks of ownership.
• Operating lease- lessee rents the property.
  Lessee accrues rent expense.
• Capital lease- lessee essentially owns the
  property. Lessee records the leased asset in the
  balance sheet together with the corresponding
  lease obligation.

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Comparison of capital lease with operating lease

• Capital v Operating Lease I/S Effects
• expenses

Interest expense depreciation Expense (capital
lease)
Rent expense (operating expense)
year
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Comparison of capital lease with operating lease

• If a capital lease instead of an operating lease
  is employed, the following differences occur
• An increase in the amount of reported debt
• An increase in the amount if total asset
• A lower income early in the life of the lease and
  therefore, lower retained earnings.

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Comparison of capital lease with operating lease

• Capital leases have a adverse impact on their
  financial position
• (1) Debt to total equity ratio increases
• (2) Rate of return on total asset decreases
• As a result, managers resist capitalizing leases
• Managers circumvent the spirit of the
  distinction between capital lease and operating
  leasesoff balance sheet financing.
  
  

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Human capital

• Formal employee training by U.S. firms is
  estimated to be 30-148 billion per year.
• Training program range
• Enhancement of firm-specific skill
• Upgrade an employees general training
• The effect of training programlong term benefits
• How to deal with training cost be written off

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Economic benefits are uncertain or difficult to
measure--goodwill
Goodwill is the value assigned to a rate of
earnings above the norm-it translates into
excess earnings called superearnings Goodwill
(1) can be a sizable asset, (2) is recorded only
upon purchase of another entity or segment, and
(3) varies considerably in composition
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Economic benefits are uncertain or difficult to
measure--goodwill
Occurs when onecompany buysanother company.
Only purchased goodwill is an intangible asset.
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Economic benefits are uncertain or difficult to
measure--goodwill

• Multi-Diversified inc. decides that it needs to
  buy Tractoring company
• Balance Sheet as of Dec. 31, 2000
• Tractoring Company
• Cash 25000 Current
  liabilities 55000
• Receivable 35000 Capital stock
  100000
• Inventories 42000 Retained Earning
  100000
• PPE 153000
• Total asset 255000 Total equities
  255000

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Goodwillexample(cont.)
Tractoring Com. Accepts Multi-Diversifieds offer
of 400,000
Fair Market Value of Tractorings Net
Asset
Cash 25000 Receivable 35000
Inventories 122000 PPE 205000 Patents
18000 Liabilities (55000) Fair
Market Value of Net Assets 350000 The
difference 50000 between the purchase price of
400000 and the FMV 350000 is labeled goodwill.
After the acquisition, Multi-diversified Co.
is required under U.S. accounting to amortize the
goodwill over a maximum of forty years
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Two challenges arise from goodwill accounting

• Since it is different to assess whether the
  merger is achieving the expected benefits, It is
  difficult to estimate whether goodwill has become
  badwill
• The creation of an arbitrary period for
  amortizing goodwill make it difficult for firms
  to distinguish themselves with others

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Challenges arise from deferred tax asset

• Realization of the future tax benefits is
  dependent on future earnings, but the prospective
  may be highly uncertain
• For example, Amazon.comthe internet retailer
  of books, music, and video products had generated
  operating losses of 207 million, equivalent to
  73.1 million of future tax savings since its
  inception.

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Economic benefits are uncertain or difficult to
measureDeferred Tax Assets

• Two main reasons for deferred tax assets
• Tax reporting realizes income prior to financial
  reportingprepaid revenues and warranty expenses
• The tax effect of a loss carryforwardrepresenting
  future tax savings
• FASB requires that U.S. firms show a deferred
  tax asset for the value of operating loss
  carryforwards, net of a valuation allowance for
  the portion of the asset that is unlikely to be
  realized

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Challenge ThreeChanges in Future Economic
Benefits

• Accounting Standards for changes in values of
  operating assets
• Dont permit the recognition of any increases in
  operating asset values beyond historical cost
• Requires operating assets whose value is impaired
  to be written down to their market value, below
  cost.

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Changes in values of operating assets

• Management discretion in deciding when to
  recognize that an asset has been impaired and how
  much to write it down
• Firms delay recording asset impairments or
  underestimate the effect of impairments.
• Use impairment charges to write down asset to
  improve future reported performance.

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Changes in financial instrument values

• Changes in financial instrument depend on the
  owners motives
• Control over another company
  
• Own between 20-50 Equity method
• Own more than 50 Purchase accounting or
  pooling
• Short-term alternative to holding cash
• Intend to sell or make available for
  sale--Fair value
• Intend to hold to maturityCost
• Hedge fair values of assets or liabilities or
  hedge to uncertainty future cash flowFair value

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Changes in values of foreign subsidiaries

• Are assets of foreign subsidiaries translated
  into local current at the historical rates or at
  current rates ?
• Historical rates
• (1) A foreign subsidiary is insulated from
  the effect of exchange rates.
• (2) A foreign subsidiarys operation occurs
  in the local currency
• (3) Few transaction between the parent and
  subsidiary
• Current rates
• (1) The subsidiarys sales or costs are
  incurred in the parents currency
• (2) Frequent transactions between the two
• Monetary/Non-monetary method
• Monetary asset and liabilitycurrent rate
• Non- Monetary asset and liabilityhistorical
  rate

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Study and Questions

• Question 1. In 1991 ATT, the largest
  long-distance telephone operator in the U.S.,
  paid 7.5 billion to acquire NCR, a computer
  manufacturer. Prior to the acquisition, the book
  value of NCRs assets was 4.5 billion, and its
  liabilities were 1.5 billion. Assuming that
  there was little significant difference between
  the fair value and the book value of NCRs
  assets, show the effect of the acquisition on
  ATTs balance sheet from using (a) the pooling
  of interests method and (b) the purchase method.
•  
•  

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Study and Questions

• Question 2. ATTs managers had a strong
  preference for recording the acquisition of NCR
  under the pooling of interests method. Indeed,
  the offer was actually contingent on approval for
  pooling. Why do you think AT Ts managers were
  so concerned about the accounting used for the
  transaction? As a financial analyst, what
  questions would you raise with the firms CFO?

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Study and Questions

• Question 3. As the CFO of a company, what
  indicators would you look at to assess whether
  your firms long-term assets were impaired? What
  approaches could be used, either by management or
  an independent valuation firm, to assess the
  dollar value of any asset impairment? As a
  financial analyst, what indicators would you look
  at to assess whether a firms long-term assets
  were impaired? What questions would you raise
  with the firms CFO about any charges taken for
  asset impairment?