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Level I CFA: Long Lived Assets Lecture 1 - YouTube
Channel: IFT
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long-lived assets
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long-lived assets are defined as those
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assets which are expected to provide
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future economic benefits extending more
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than one year these assets may be
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tangible intangible or financial the
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major questions we will address in this
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reading are as follows what value should
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be shown on the balance sheet when we
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acquired the asset and then what value
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should be shown on the balance sheet
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during the life of the asset we will
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also be concerned about how the cost
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should be allocated over the life of the
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asset let's first talk about the
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acquisition of long-lived assets upon
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acquisition long-term tangible assets
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such as property plant and equipment are
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recorded on the balance sheet at cost
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which is typically the same as fair
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value the assets cost might include
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expenditures in addition to purchase
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price and the question is whether these
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cost should be expensed or capitalized
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on the next slide we will talk about
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which cost should be capitalized and
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which costs should be expensed with
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intangible assets the valuation depends
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on how the intangible asset is acquired
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and we will discuss this later on
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property plant and equipment at
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acquisition property plant and equipment
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is recorded at cost cost includes all
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expenditures necessary to get the asset
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ready for intended use it is important
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to understand this because there is a
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good chance that you might get a
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question related to what cost must be
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expensed versus what cost needs to be
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capitalized say you purchase a machine
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for thousand clearly this cost needs to
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be capitalized and shown on the balance
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sheet in addition to thousand you pay a
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hundred to install the machine
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and get it ready for intended use that
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obviously will also be capitalized say
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you also pay 50 to get the factory ready
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for this machine as an example the floor
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needs to be reinforced in order to
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support this heavy equipment and that
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costs 50 this 50 is also going to be
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capitalized if you do a routine
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maintenance or you have your factory
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painted then those expenses are expensed
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that means they flow through the income
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statement they are not shown on the
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balance sheet if you train your staff to
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use this machine that also needs to be
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shown as a expense which flows through
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the income statement if there are any
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subsequent costs related to the
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equipment that you purchased and set up
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those costs are capitalized if they are
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expected to provide benefit beyond one
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year so if you make a major upgrade to
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the equipment and that upgrade is
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expected to provide a benefit for three
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years then that upgrade cost can be
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capitalized otherwise if you incur a
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cost where the expected benefit is less
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than one year then that cost has to be
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expensed as you might have gathered
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there will be some expenses or some
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costs where there is subjectivity as to
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whether the cost should be expensed or
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capitalized and different companies
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might make different expensing versus
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capitalizing decisions you as an analyst
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need to realize that the choice of
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whether to expense or capitalized has an
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impact on financial statements and hence
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on ratios let us now look at an example
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which deals with what expenses are
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capitalized versus which expenses are
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expensed Acme Inc purchased a machine
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for ten thousand in addition the
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following costs were incurred two
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hundred for delivery three hundred for
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installation hundred to train the staff
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thousand to reinforce the floor to
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support the machine and five hundred to
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have the factory painted which expenses
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will be capitalized and which will be
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expensed clearly this expense of ten
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thousand is going to be capitalized two
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hundred for delivery this is necessary
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to get the machine into a working form
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so this needs to be capitalized the
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installation cost also needs to be
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capitalized hundred to train staff to
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use the machine just remember the fact
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that the training cost is not
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capitalized this needs to be expensed
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the way you can think of this as
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training of staff is a routine activity
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that companies should be doing plus if
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the staff is trained and then they leave
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then obviously that doesn't provide a
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long-term benefit to the company so in
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general training cost is expensed a
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thousand to reinforce the flow to
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support the machine this needs to be
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capitalized because this cost has to be
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incurred for the machine to operate and
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this cost while not explicitly stated
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here is likely to provide a benefit over
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a period longer than one year five
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hundred to have the factory painted this
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clearly is going to be expensed so you
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simply add up these numbers ten thousand
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plus five hundred plus thousand and that
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will give you the amount that needs to
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be capitalized 100 plus five hundred is
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what needs to be expensed how will the
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treatment of these expenditures affect
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the company's financial statements we
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need to look at the balance sheet here
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the income statement and the cash flow
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statement on the balance sheet the
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property plant and equipment will go up
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by eleven thousand five hundred which is
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simply the sum of all the capitalized
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expenses and obviously if you are paying
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using cash then
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goes down by the same amount on the
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income statement we will show the
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expenses hundred to train the staff and
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then 500 to have the factory painted so
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these go to the income statement we will
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also show a depreciation expense over
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the life of the asset on the income
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statement as far as the cash flow
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statement is concerned this cost of
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eleven thousand five hundred is going to
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be shown as part of CFI whereas the
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expenses that are expensed one hundred
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and five hundred these are going to be
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shown as part of cash flow from
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operations capitalizing of interest
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costs for constructed assets interest
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cost during construction are capitalized
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as part of the asset cost the idea is
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straightforward let's say that you are
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constructing a building and the
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construction period is two years to
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create this building let's say you
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borrowed some money and you are paying
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interest on that money the interest cost
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can be thought of as just another cost
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the way material is a cost labor is a
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cost the same way interest is a cost and
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since material and labor are being
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capitalized it makes sense to also
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capitalized the interest cost associated
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with creating this building but the
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interest cost will be capitalized during
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the construction period the question
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then becomes what interest rate to use
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the answer is use the rate on borrowing
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related to construction so if your
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construction costs a hundred million and
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you have borrowed 100 million
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specifically for this construction at a
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rate of 10 percent then you use the 10
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percent read so your capitalized amount
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will be based on ten percent if no
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construction debt is outstanding the
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interest rate is based on existing
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unrelated debt it is also possible
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a company has issued a bond and raised
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200 million through that issue the 200
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million that is raised is used to pay
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for the building plus it is used to pay
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for other expenditures given that in
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this example we don't have a borrowing
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that is specific to construction we can
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then use the rate that is relevant for
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this bond issue let's say that rate is
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12% we can then use the 12% number to
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calculate the capitalized interest the
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capitalized interest is not reported as
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an expense on the income statement and
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that's obvious
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since we are capitalizing that means
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that the amount is going on the balance
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sheet even though we are making interest
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payments and that's important you are
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borrowing money and let's say you are
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borrowing money from a bank you need to
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make payments to the bank but the
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interest expense is not shown on the
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income statement initially it is shown
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as a asset but then as the asset is
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depreciated then essentially the
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interest expense is shown as a
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depreciation expense over the life of
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the asset just as a subtle distinction
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between IFRS and US GAAP IFRS is that
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the interest on short-term lending
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offsets capital costs this is not
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allowed under US GAAP this will become
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clear in the example that we will look
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at shortly but just to give you a quick
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sense let's say that you borrow 100
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million at 10% and that means that over
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the two-year period you are going to
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make payments of 10 million and 10
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million so your capitalized interest
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according to US GAAP is going to be 20
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million what IFRS says is that when you
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get this hundred million you are
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obviously going to invest it in you know
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operating bank account and when you
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invest this money or place this money in
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the bank you are going to get some
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interest
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let's say that the interest amount that
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you get is equal to 1 million then the 1
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million offsets the 20 million that we
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are capitalizing so the capitalized
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interest then becomes 20 million - 1
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million which is 19 million that is
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according to IFRS US GAAP says that the
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entire 20 million needs to be
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capitalized let us look at a few
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conceptual issues related to capitalized
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interest capitalized interest causes
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higher net income and greater interest
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coverage ratios during the period of
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capitalization notice that when we
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capitalized interest then it is not
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showing up on the income statement as
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we've discussed a player the interest
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expense is capitalized so it causes the
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asset value to go up which means that
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the expenses on the income statement are
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relatively low which means that the net
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income is relatively high for the firm
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that is capitalizing interest the
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interest coverage ratio is going to be
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high the interest coverage ratio is
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essentially EBIT over the interest
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expense if we are showing a relatively
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low interest expense then EBIT over
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interest expense is going to be high
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notice that the law of higher interest
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expense does not impact EBIT because
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EBIT is earnings before interest and
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taxes so therefore interest coverage
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ratio is going to be high during the
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period of capitalization but then what
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happens in subsequent periods higher
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asset values and depreciation lead to
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lower net income and lower EBIT and
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interest coverage again this should be
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fairly clear in the year that we
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capitalize or in the years of
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capitalization let's say that back to
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our original example it takes 2 years to
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construct
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building so in these years we are
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capitalizing interest expenses because
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of that capitalization our value of the
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asset the building in this case is
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relatively high because that value
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includes the capitalized interest this
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means that in subsequent years the
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depreciation amount is going to be high
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which means that our expense is going to
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be relatively high because this will
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include the depreciation of the
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capitalized interest since the expense
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is relatively high the net income is
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going to be relatively low EBIT is going
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to be low because depreciation is
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considered operating expense if you look
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at your basic income statement you
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subtract depreciation in order to come
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up with EBIT
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so if depreciation is relatively high
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that would mean that EBIT is relatively
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low and your interest coverage ratio
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which is EBIT divided by the interest
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expense is also going to be relatively
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low because after construction you are
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going to actually show your interest
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expense as an expense on the income
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statement and your EBIT is also lower
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because of the extra depreciation
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therefore the overall interest coverage
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ratio is low given what we just talked
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about I want you to do this example here
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is what you should get 2 million at 5%
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over a two year period means that the
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interest that is being paid over the
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two-year construction period is 200,000
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this needs to be capitalized according
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to US GAAP so US GAAP says that the
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entire 200,000 is capitalized
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what IFRS says is the following you are
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paying this much interest based on your
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borrowing but when you borrow money you
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put the money in a operating account and
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you get interest worth 20,000
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this 20,000 needs to be knitted out from
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the 200,000 and that gives you a hundred
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and eighty thousand so according to IFRS
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a hundred and eighty thousand is what is
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going to be capitalized
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where will the capitalized borrowing
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cost appear on the company's financial
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statements initially the capitalized
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amount is going to appear on the balance
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sheet and then after the construction is
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complete then we will have this entire
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capitalized amount as part of the asset
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value once the asset is depreciated then
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the capitalized interest is also
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expensed out through the depreciation
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process via the income statement over
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the life of the asset
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you
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