Study Session 9 Assets

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Study Session 9
Assets



A. Analysis of Inventories

a. compute ending inventory balances and cost of goods sold using the LIFO, FIFO,
and average cost methods to account for product inventory.

The inventory account is aIIected by two events: the purchase oI goods (P) and their
subsequent sale (COGS). The relationship between these events and the balance oI
beginning inventory(BI) and ending inventory(EI) can be expressed as:

COGS BI + P - EI
Note:
No matter what inventory cost method is chosen, the dollar amount oI purchases
is the same.
The number that varies is the inventory.

For examples please check basic questions. For explanations oI LIFO, FIFO and average
cost methods please reIer to Study Session 7 - Section D - LOS c.

GAAP requires the use oI the lower-oI-cost-or-market-valuation basis (LCM) Ior
inventories. The LCM Iollows the principles oI conservation where increases are reported
only when inventory is sold, but losses are recognized once they occur.






b. adjust the financial statements of companies using different inventory accounting
methods to compare and describe the effect of the different methods on reported
earnings and inventory balances.

Adjusting Financial Statements Irom LIFO to FIFO

Note that:
LIFO reserve Inventory (FIFO basis) - Inventory (LIFO basis)

It represents the cumulative eIIect over time oI undervalued ending inventory under LIFO
vs FIFO. It can also be interpreted as the cumulative eIIect oI proIit not recognized and
taxes not paid under LIFO. LIFO Iinancial statements can be adjusted to their FIFO
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equivalent using the LIFO reserve. The balance sheer adjustment Iocuses on the
cumulative effect oI LIFO versus FIFO, while the income statement adjustment Iocuses
only on the current vears eIIect.
Adjust LIFO inventory by adding the LIFO reserve: Inventory (FIFO basis)
Inventory (LIFO basis) LIFO reserve.
Retained earnings (FIFO basis) Retained earnings (LIFO basis) LIFO reserve
x (1 - tax rate).
DeIerred tax liability LIFO reserve x tax rate.
COGS (FIFO basis) COGS (LIFO basis) - (Year-end LIFO reserve - Beginning-
oI-year LIFO reserve).

Adjusting Financial Statements Irom FIFO to LIFO

For Iirms using FIFO, only the adjustment oI the income statement Irom FIFO to LIFO is
necessary. Adjustment oI the balance sheet is not necessary, since the LIFO inventory
costs are outdated (assuming that prices are rising and inventory quantities are stable or
growing). As Iirms using FIFO do not disclose the inIormation needed to adjust the
income statement, an approximate adjustment can be made using the speciIic inIlation
rate appropriate to the Iirm:

COGS(LIFO basis) COGS (FIFO basis) Beginning-oI-year inventory (FIFO basis) x
inIlation rate






c. explain the relationship among and the usefulness of inventory and cost-of-goods-
sold data provided by the LIFO, FIFO, and average cost methods when prices are 1)
stable, or 2) changing.

Inventory data is useIul iI it reIlects the current cost oI replacing the inventory. COGS
data is useIul iI it reIlects the current cost oI replacing the inventory items to continue
operations.

During periods oI stable prices, all three methods will generate the same results
Ior inventory, COGS and earnings.

During periods oI rising prices and stable or growing inventories, FIFO measures
assets better (the most useIul inventory data), but LIFO measures income better.

Under LIFO, the cost of ending inventorv is based on the earliest purchase
prices, and thus are well below current replacement cost. For many Iirms
using LIFO, their cost oI inventory may be decades old and almost useless
Ior analysis purposes. However, cost of goods sold is based on the most
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recent purchase prices, and thus closely reIlects current replacement cost.
As a result, LIFO provides a better measurement oI current income and
Iuture proIitability.

Under FIFO, the cost of ending inventorv is based on the most recent
purchase prices, and thus closely reIlects current replacement cost.
However, costs of goods sold is based on the earliest purchase prices, and
this is well below the current replacement cost. The gain is actually
holding gain or inventory proIit. It is debatable whether it should be
considered income, or at least we can say the underestimated COGS leads
to inIlated net income.

The useIulness oI inventory data reported using the average-cost method
lies between LIFO and FIFO.

Study Session 7 - Section D - LOS a provides a detailed comparison between LIFO and
FIFO.






d. discuss how a company's choice of inventory accounting method affects other
financial items such as income, cash flow, and working capital.

Assume prices are rising:

COGS and Income: Since LIFO allocates the most recent purchase prices to
COGS, the use oI LIFO results in higher COGS and lower reported income. In
contrast, FIFO allocates the earliest purchase prices to COGS, resulting in lower
COGS and higher income.

Cash Flows: The choice oI LIFO vs FIFO has no eIIect on pretax cash Ilows. The
pretax cash Ilow is determined by the cash inIlow Irom sales and cash outIlow Ior
purchases, neither oI which is aIIected by the method oI inventory accounting.
However, the choice oI LIFO vs FIFO aIIects tax payments. In the US IRS
requires the same inventory methods Ior Iinancial reporting and tax reporting.
Since LIFO generates lower pretax income (when prices are rising), it will result
in lower tax payments and thereIore higher aIter-tax cash Ilows than FIFO.

Working Capital: Working capital is deIined as current assets less current
liabilities. Since LIFO reports lower inventory than FIFO, working capital will be
lower under LIFO.


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e. compute and describe the effects of the choice of inventory method on profitability,
liquidity, activity, and solvency ratios.

During periods oI rising prices and stable or growing inventories:

ProIitability: ProIit margin net income / sales. Sales is not aIIected by the
choice oI LIFO or FIFO. Since FIFO results in lower COGS and thereIore higher
net income, proIit margin will be higher under FIFO. The net income provided by
LIFO is more useIul and the lower proIit margin reported under LIFO should be
used in analysis.

Liquidity: Current ratio current assets / current liabilities. Current liabilities are
not aIIected by the choice oI FIFO or LIFO. Since LIFO results in lower
inventory and thereIore lower current assets, current ratio will be lower under
LIFO. However, since the inventory provided by FIFO is more useIul, the higher
current ratio reported under FIFO is better Ior analytical purposes.

Activity: Inventory turnover COGS / average inventory. LIFO provides the
more useIul COGS while FIFO provides the more useIul inventory measure. For
analytical purposes, a current cost inventory turnover should be computed using
LIFO-basis COGS and FIFO-basis inventory: Inventory Turnover (Current Cost)
COGS (LIFO) / Average Inventory (FIFO).

Solvency: Debt-to-equity ratio long-term debt / equity. The choice oI LIFO or
FIFO has no impact on debt. Since FIFO results in higher inventory value, it
reports higher equity so as to reconcile the balance sheet. ThereIore, debt-to-
equity ratio will be lower under FIFO. The lower debt-to-equity ratio reported
under FIFO should be used in analysis.

However, a Iirm that uses FIFO usually does not disclose the equity under FIFO.
In this case, the equity under FIFO can be approximated by adding the LIFO
reserve to the equity under LIFO: Equity under FIFO Equity under LIFO
LIFO reserve. Note that the LIFO reserve is not adjusted Ior taxes because the tax
eIIect would be insigniIicant during periods oI rising prices and stable or growing
inventories.

The general guideline is to use LIFO numbers Ior components that are income-related
and FIFO-based data Ior components that are balance-sheet-related. Ideally Iirms could
have used FIFO to prepare the balance sheet and LIFO to prepare the income statement.
In reality this "perIect" combination is not permitted by accounting rules. Analysts should
adjust Iinancial statements between FIFO and LIFO to meet their analytic purposes.





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f. discuss the reasons why a LIFO reserve might decline during a given period and
discuss the implications of such a decline for financial analysis.

LIFO reserve is the diIIerence between the inventory balance shown on the balance
sheet and the amount that would have been reported had the Iirm used FIFO. That is:
Inventory
F
Inventory
L
+ LIFO Reserve. It represents the cumulative eIIect over time
oI ending inventory under LIFO vs FIFO. In the US Iirms that use LIFO must report a
LIFO reserve.

When adjusting COGS Irom LIFO to FIFO: COGS
F
COGS
L
- Change in LIFO
Reserve.

So Iar our discussions are based on the assumptions oI rising prices and stable or growing
inventory quantity. As a result, the LIFO reserve increases over time. However, LIFO
reserves can decline Ior either oI the Iollowing two reasons. In either case, the COGS will
be smaller and the reported income will be higher relative to what they would have been
iI the LIFO reserve had not declined. However, the implications oI a decline in the LIFO
reserve on Iinancial analysis vary depending on the reason oI the decline.

Liquidation oI inventories: when a Iirm reduces its inventory, the old assets Ilow
into income. The COGS Iigure no longer reIlects the current cost oI inventory
sold. This is called LIFO liquidation. Gross proIit margin will be abnormally
high and unsustainable. To deIer taxes indeIinitely, purchases must always be
greater than or equal to sales. A LIFO liquidation may signal that a company is
entering an extended period oI decline (and need the "proIit" to show as income).
Analysts should exclude this proIit Irom recurring earnings as it is not operating
in nature: the reported COGS should be restated by adding back the decline in the
LIFO reserve to remove the artiIicial boost to net income.

Price declines: the lower-cost current purchases enter reported LFO COGS when
purchase prices Iall, reducing the cost diIIerences between LIFO and FIFO ending
inventories. As a result, the LIFO reserve declines. Such a decline is not
considered a LIFO liquidation. Amounts on balance sheet are still outdated but
those on income statement are still current. However, the tax beneIits are lost
under LIFO. For analytical purposes, no adfustment is required Ior declining
prices since price decreases are a normal business situation.




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B. Analysis of Long-Lived Assets: The Capitalization Decision

a. compute and describe the effects of capitalizing versus expensing on net income
variability, profitability, cash flow from operations, and leverage ratios.

The costs oI acquiring resources that provide services over more than one operating cycle
should be capitalized and carried as assets on the balance sheet. Costs oI the long-lived
asset should be allocated over current and Iuture periods. In contrast, iI these assets are
expensed, their entire costs are written oII as expense in the income statement in the
current period.

Accounting rules on capitalization are not clear cut. As a result, management have
considerable discretion in making decisions such as whether to capitalize or expense the
cost oI an asset, whether to include interest costs incurred during construction in the
capitalized cost, and what types oI costs to capitalize Ior intangible assets. The choice oI
capitalization or expensing aIIects the balance sheet, income and cash Ilow statements,
and ratios both in the year the choice is made and over the liIe oI the asset.

All costs incurred until the asset is ready Ior use must be capitalized, including the
invoice price, applicable sales tax, Ireight and insurance costs incurred delivering the
equipment, and any installation costs.

Here we summarize diIIerent eIIects oI capitalization versus expensing:

Income variability: Iirms that capitalize costs and depreciate them over time show
"smoother" patterns oI reported income. Firms that expense those costs as
incurred tend to have higher variability oI net income.

ProIitability: in the early years expensing lowers proIitability because the entire
cost oI the asset is expensed. In later years expensing results in higher net income
because no more expense is charged in those years. This results in higher ROA
and ROE because these expensing Iirms report lower assets and equity.

CFO: the net cash Ilow remains the same, but the compositions oI cash Ilows
diIIer. Cash expenditures Ior capitalized assets are included in investing cash
Ilows and never classiIied as CFO. In contrast, cash expenditures Ior expensed
outlays are included in CFO and never classiIied as investing cash Ilows.
Capitalization results in higher CFO but lower investing cash Ilows, and the
cumulative diIIerence increases over time.

Leverage ratios: capitalization Iirms have better (lower) debt-to-equity and debt-
to-assets ratios since they report higher assets and equities.




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b. explain the effects on financial statements of capitalizing interest costs.

Under SFAS 34, interest is capitalized Ior certain assets and then only iI the Iirm is
leveraged. ThereIore, the carrying amount oI a selI-constructed asset depends on the
Iirm's Iinancial decisions. The capitalized interest cost is added to the value oI the asset
being constructed.

The amount oI interest cost to be capitalized has two components:
Any interest on borrowed Iunds made speciIically to Iinance the construction oI
the asset. The interest rate applicable is the interest rate on each borrowing.
The interest on other debt oI the Iirm, up to the amount invested in the
construction project. The interest rate applicable is the weighted-average interest
rate on all outstanding debt not speciIically borrowed Ior the asset under
construction.

ThereIore, the total interest cost incurred during the accounting period has two parts:
Capitalized interest cost, which is reported as part oI the asset on the balance
sheet. Payments Ior capitalized interest cost are classiIied as an investing cash
outIlow, and never as CFO.
Other interest cost, which is charged to expense in the income statement.
Payments Ior such noncapitalized interest cost are reported as CFO.
The total interest cost, along with the amount capitalized, must be disclosed as
part oI the notes to the Iinancial statements.
Once the construction is complete, capitalized interest costs will be written oII as
part oI depreciation over the useIul liIe oI the asset. From now on, any Iuture
interest cost on remaining borrowings made Ior the construction oI the asset must
be expensed.

For analytical and adjustment purposes, you probably need to expense all interest in selI-
constructed assets (that is, the income statement capitalization oI interest should be
reversed).

During the construction period this would result in:
lower Iixed and total assets as the capitalized interest would be converted to
interest expense.
lower net income as the interest expense would be higher.
lower CFO and higher CIO as payments Ior capitalized interest would be
classiIied as investing cash Ilows, and be reversed to be operating cash Ilows.
lower interest coverage ratio as the adjustment would produce lower earnings
beIore interest and tax but higher interest expense.
same net cash Ilows as capitalization and expensing are accounting adjustments
only. They don't aIIect net cash Ilows.

During the useIul liIe oI the asset this would result in:
higher net income due to lower depreciation amount.
same interest CFO and CIO as all interest costs would be expensed.
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higher interest coverage ratio due to higher earnings beIore interest and tax (same
interest expense).





c. explain the circumstances under which intangible assets, including software
development costs and research and development costs, are capitalized.

Intangible assets are identiIiable, nonmonetary resources controlled by Iirms.

The cost oI acquiring intangible assts Irom unrelated entities is capitalized at acquisition,
measured by the amount paid. Cost includes purchase price, legal Iees, and other
expenses that make the intangibles ready Ior use. For example, Iees paid to obtain a
license or Iranchise are capitalized. Another example: expenditures oI Patents and
Copyrights purchased Irom another party are capitalized. They are amortized over their
remaining legal lives, or 40 years, whichever is less.

For internally generated intangible assets, it is diIIicult to measure costs, beneIits and
economic lives. Generally, internal generated assets, such as costs oI R&D, patents and
copyrights, brands and trademarks, advertising and goodwill must be expensed in the
period incurred, except Ior the legal fees incurred in registering internally developed
patents and copyrights.

There are some exceptions.

Research and Development (R&D) expenditures are risking investment with
uncertainty Iuture economic beneIits. As a result they must be expensed as incurred in
most countries (including the US). However, in Canada and the UK Iirms are permitted
to capitalize them when certain conditions are met.

Advertising costs are generally expensed as incurred. However, iI both oI the Iollowing
two conditions are met they should be capitalized and amortized over the estimated liIe oI
the Iuture beneIits:
The cost oI direct-response advertising results in probable Iuture beneIits.
No additional marketing eIIorts are required to convert the leads generated by the
advertising into sales.

Goodwill is the diIIerence between the purchase price and the Iair market value oI the
acquired Iirm's net assets. It represents the amount paid Ior the acquired Iirm's ability to
earn excess proIits, or the value that cannot be assigned to tangible assets. Under US
GAAP, as oI January 1, 2002, goodwill is no longer amortized; instead it is kept as an
asset with indeIinite liIe.

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SFAS 86 requires that all R&D costs to establish the technological and/or economic
Ieasibility oI the soItware must be expensed. Subsequent costs that beyond the point of
"technological feasibility" can be (but don't have to be) capitalized as part oI product
inventory and amortized based on revenues or on a straight-line basis. The "point oI
technological Ieasibility" is the point in the process where the soItware prototype has
been proved to be technologically Ieasible, as evidenced by the existence oI a working
model oI the soItware.



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C. Analysis of Long-Lived Assets: Analysis of Depreciation and
Impairment

a. identify the different depreciation methods and discuss how the choice of
depreciation method affects a company's financial statements, ratios, and taxes.

For accountants, depreciation is an allocation process, not a valuation process. It is
important Ior analysts to diIIerentiate between accounting depreciation and economic
depreciation. Two Iactors aIIect the computation oI depreciation: depreciable cost
(acquisition cost - salvage or residual value), and estimated useIul liIe (depreciable life).
Note that it is depreciable cost, not acquisition cost, that is allocated over the useIul liIe
oI an asset.

The diIIerent depreciation methods are:

Sinking Fund (or Annuity) Depreciation

From an economic perspective, the income reported each year should reIlect the rate
oI return by the asset. This logic, with the amount oI depreciation increasing every
year, is known as annuity or sinking Iund depreciation. It charges depreciation
expense such that asset generates a constant rate oI return over its useIul liIe.
However, it is not accepted by the US GAAP.


Straight Line Depreciation
It is the dominant method in the US and most countries worldwide. It is based on the
assumption that depreciation depends solely on the passage oI time. The amount oI
depreciation expense is computed as:
Depreciation Expense (Cost - Salvage Value) / Estimated UseIul LiIe

II income is constant, SLD will cause the asset base to decline causing ROA to
increase over time. For assets whose beneIit may decline over time, the matching
principle supports using an accelerated depreciation method.


Accelerated Depreciation Methods
Accelerated depreciation method are consistent with the matching principle, because
beneIits Irom most depreciable assets are higher in the earlier years as the assets wear
out. ThereIore, more depreciation should be allocated to earlier years than to later
years.

Under the sum-of-the-years digit (SYD) method, the depreciation expense is based
on a decreasing Iraction oI depreciable cost. The numerator decreases year by year
but the denominator remains constant. As a result, this method applies higher
depreciation expense in the early years and lower depreciation expense in later years.
Sum oI Years Digits (cost - salvage value)(years remaining)/(sum oI years).
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Where sum oI years (1 2 3 ... n) n x (n 1)/2, and years remaining n - t
1 (n: the estimated useIul liIe, and t is the index Ior current year).

Double Declining Balance 2 x (cost - accumulated depreciation)/(assets liIe).

Note that (cost - accumulated depreciation) is the book value at the beginning oI the
year t, and salvage value is not shown in the Iormula. For each year, however,
depreciation is limited to the amount necessary to reduce book value to salvage value.

With SOYD and DDB methods, book value, net income, tax expense and equity will
be lower than with SLD in the earlier years oI the asset's liIe. The percentage eIIect
on net income is usually greater than the eIIects on assets and shareholders' equity.
Consequently:
proIit margin is lower as net income is lower.
asset turnover ratio is higher as assets are lower.
Debt-to-equity ratio is higher as equity is lower.
Return on assets ratio is lower: both net income and total assets are lower,
but net income is lower by a larger percentage.
Return on equity ration is lower: both net income and equity are lower, but
net income is lower by a larger percentage.

In later years the situation will reverse and income and book values will increase.
This is true Ior individual assets. For a Iirm with stable or rising capital expenditures,
however, the early year impact oI newly acquired assets dominates. ThereIore, an
accelerated depreciation method will continuously result in lower reported earnings
and tax expense Ior these Iirms.

Units of Production and Service Hours Method:
They assume that depreciation depends solely on the use oI the asset, and base
depreciation on actual service usage:
UOP depreciation |per period| output |per period| x unit cost
unit cost (Cost - Salvage Value)/Estimated Production Capacity or
Estimated Service LiIe
ThereIore, more depreciation expense is charged in years oI higher production.
The advantage is that they make depreciation expense a variable rather than a
Iixed cost, decreasing the volatility oI reported earnings as compared to straight-
line or accelerated methods. A drawback occurs when the Iirm's productive
capacity becomes obsolete as it loses business to more eIIicient competitors.
These methods will reduce depreciation expense during periods oI low production,
resulting in overstated reported income and asset value. However, low production
is oIten caused by intensiIied competition, which tends to reduce the economic
value oI the asset and thus requires higher rate oI depreciation.

Note that in the US diIIerent depreciation methods have the same eIIect on taxes payable,
as the depreciation method (MACRS) used Ior tax reporting is independent oI the method
chosen by management Ior Iinancial reporting. It's taxes payable, not tax expense, that
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determine cash outlay Ior tax payment. ThereIore, the choice oI depreciation methods has
no impact on the statement oI cash Ilows.





b. explain the role of depreciable lives and salvage values in the computation of
depreciation expenses.

Depreciable life, also called useful life, is the total number oI service units expected
Irom a depreciable asset. It can be measured in terms oI units expected to be produced,
or hours oI service to be provided by the asset, or years the asset is expected to be used.
The longer the depreciable liIe, the lower the annual depreciation expense.

Reducing the depreciable liIe oI an asset has the Iollowing impact on Iinancial statements
over its depreciable liIe:
Higher depreciation expense.
Lower book value oI the asset.
Lower net income. The percentage eIIect on net income is usually greater than the
eIIects on assets and shareholders' equity.
Lower shareholders' equity (caused by lower retained earnings).

Consequently, a shorter depreciable liIe tends to reduce proIit margin, returns on assets,
and returns on equity, while raising asset turnovers and debt-to-equity ratio. However,
changing the depreciable liIe has no eIIect on cash Ilows, since depreciation is a noncash
charge.

Salvage value, also called residual value, is the estimated amount that will be received
when the asset is sold or removed Irom service.

For depreciation methods such as straight-line, units-oI-production, service-hour
and sum-oI-the-years' digit, the higher the salvage value, the lower the annual
depreciation expense, as salvage value is deducted Irom the original cost to
compute annual depreciation expense.

For depreciation methods such as double-declining-balance, units-oI-production
and service hour depreciation, salvage value serves as a Iloor Ior net book value.

Note that MACRS assumes there is no salvage value.

The eIIects oI choosing a lower salvage value are similar to those oI a shorter depreciable
liIe or an accelerated depreciation method. However, the eIIects do not reverse in the
later years oI the asset's useIul liIe.

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Shorter lives and lower salvage values are considered conservative in that they lead to
higher depreciation expense. These Iactors interact with the depreciation method to
determine the expense; Ior example, use oI the straight-line method with short
depreciation lives may result in depreciation expense similar to that obtained Irom the use
oI an accelerated method with longer lives.






c. compute and describe how changing depreciation methods or changing the
estimated useful life or salvage value of an asset affects financial statements and ratios.

Whenever a change in depreciation method (principle) or lives (estimate) is reported, the
impact oI the change on the current years' earnings should be analyzed. Companies may
change the reported depreciation oI Iixed assets in diIIerent ways, and each type oI these
changes has diIIerent impact on Iinancial statements and ratios:

Change in method applicable to newly acquired assets only:
A company can change its depreciation methods only Ior newly acquired assets,
while previously acquired assets are depreciated using the same method as in the past.
Such a change aIIects Iuture depreciation expense and reported income, and current
depreciation expense and reported income will be aIIected only iI new assets are
acquired in the current period. The impact oI the new method will be gradual,
increasing as Iixed assets acquired aIter the change grow in relative importance. This
is a common method oI changing accounting principles, as it does not require the
restatement oI past earnings.

Change in method applicable to all assets:
The impact on depreciation expense and reported income is greater in this case and
can be signiIicant in the year oI switch as well as in Iuture years. The cumulative
eIIect oI the change is considered a change in accounting principal. The new method
is applied retroactively to depreciation expenses oI all past periods. The cumulative
diIIerence between originally reported depreciation and the restated depreciation Ior
past periods is shown net of taxes on the current period income statement.


Changes in asset lives or salvage value:
These are changes in accounting estimates, and are not considered changes in
accounting principle. Such a change aIIects both current and Iuture depreciation
expense and reported income. However, its impact is only prospective, and no
retroactive or cumulative eIIects are recognized.



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d. discuss the use of fixed asset disclosures to compare companies' average age of
depreciable assets and use such a disclosure to calculate the average age and average
depreciable life of fixed assets.
Make sure you remember these Iormulas:

Relative Age (in ) Accumulated Depreciation / Ending Gross Investment
Average Depreciable LiIe Ending Gross Investment / Depreciation Expense
Average Age (in years) Accumulated Depreciation / Depreciation Expense

Average age data, either in absolute terms or as a percentage oI gross investment, are
useIul in comparing the quality oI Iixed assets across companies. Newer assets are likely
to be more eIIicient. Thus, Iirms with newer assets are more competitive. An analyst can
use average age data to Iorecast major capital expenditures and the corresponding
Iinancing requirements in the Iuture.

However, the average age data are subject to several limitations.
Computations Ior average age, relative age and average depreciable liIe are
accurate estimates only iI straight-line depreciation is used.
Computations Ior average age and average depreciable liIe may be distorted by
changes in asset mix (that is, additions with longer or shorter lives than existing
assets).
Computation Ior relative age is aIIected by the Iirm's choices in depreciation lives
and salvage values.

Check basic questions Ior examples oI computing these ratios.





e. define impairment of long-lived assets and explain what effect such impairment has
on a company's financial statements and ratios.

SFAS 121 requires the recognition oI impairment when there is evidence that the
carrying amount (book value) oI an asset or a group oI assets can no longer be
recovered Irom Iuture operations. For example:
A signiIicant decrease in the market value, physical change, or use oI the assets.
Adverse changes in the legal or business climate.
SigniIicant cost overruns.
Current period operating or cash Ilow losses combined with a history oI operating
or cash Ilow losses and a Iorecast oI a signiIicant decline in the long-term
proIitability oI the asset.

Occurrence oI an impairment diIIers Irom recognition oI an impairment. An impairment,
whether recognized in Iinancial reports or not, occurs as long as an asset's carrying value
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cannot be Iully recovered in the Iuture. However, only impairments that meet certain
conditions are recognized in Iinancial reports. SFAS 121 provides a two-step process:

Recoverability test: impairment must be recognized when the carrying value oI
the assets exceeds the undiscounted Iuture cash Ilows Irom their use and disposal.

Loss measurement: the excess oI the carrying amount over the Iair value oI the
assets. II Iair value is not available, the present value oI Iuture cash Ilows
discounted at the Iirm's incremental borrowing rate should be used. That is:
Impairment Loss Book Value
Either Fair Value or Present Value oI Future Cash Flows

The carrying value oI the long-lived assets should be written down to Iair value (less cost
oI disposal iI intended Ior sale). The impairment loss is reported pretax as a component oI
income Irom continuing operations. Once recognized, the impairment loss cannot be
restored.

For assets held Ior sale, subsequent increases in Iair value less cost oI disposal is
recognized as gains only to the extent oI previously recognized writedowns. Assets held
Ior sale should cease to be depreciated aIter reclassiIication as held Ior sale.

Some impacts on current Iinancial statements:
Lower Iixed assets and total assets.
Both net income and tax expense are reduced due to the impairment loss.
Tax payable: the impairment loss is not recognized Ior tax purposes until the
property is disposed oI. It leads to a deIerred tax asset (a Iuture tax beneIits), not a
current reIund.
Stockholders' equity is reduced, and thus debt-to-equity ratio is increased.
Impairment write-down has no eIIect on cash Ilows since it is a noncash charge.
Asset turnover ratios tend to increase due to the lower asset base.
Return on assets and return on equity are reduced because oI the impairment loss.

The write-down aIIects Iuture Iinancial statements and ratios in the same way as it aIIects
the current period, except in the Iollowing aspects:
Future depreciation expenses are reduced due to the reduced book value oI the
asset.
As a result, Iuture net income and proIit margin increases. Note that impairment
loss is a one-time loss, and does not aIIect the income statements oI Iuture periods.
Future return on assets and return on equity will both increase because oI higher
Iuture proIitability and lower asset and equity base.





Study Session 9 Assets
CFACENTER.COM 16
f. list the requirements of SFAS 143 and explain the likely financial statement and
ratio effects for most firms.

Owners oI operating assets may have the obligations to remedy the environmental
damage caused by those assets or restore land to its preexisting condition. Examples
include tearing down a manuIacturing Iacility upon retirement, or decontaminating a
nuclear plant at the end oI its operating liIe. The Asset Retirement Obligations (AROs)
in the Iormer example would be incurred upon the construction oI the manuIacturing
Iacility, and the ARO in the latter example would be incurred throughout the operating
liIe oI the power plant because it is contaminated with nuclear waste over the entire
period.

In June 2001 the FASB issued SFAS 142 to address the accounting treatment oI asset
retirement obligations. It applies to all entities and to all legal obligations associated with
the retirement oI tangible Iixed assets.

Initial recognition: Iirms must recognize the Iair value oI an ARO in the period in
which it is incurred (typically at acquisition). Generally, Iair value equals the
present value oI the expected cash Ilows required to extinguish the liability. When
Iirms recognize a liability Ior an ARO, they should also recognize an equal
amount as an increase to the carrying value oI the associated asset.

Subsequent-period accounting: Iirms will recognize depreciation expense on the
amount oI the ARO capitalized as part oI the long-lived asset. Generally, Iirms
will simply spread the total depreciable amount over remaining useIul liIe oI the
asset. Firms will recognize interest expense on the ARO liability by multiplying
the beginning carrying amount by the discount rate used to initially measure the
Iair value oI the liability. Such interest expense is called accretion expense,
classiIied as an operating item on the income statement.

Changes in the estimated ARO liability: iI the estimated liability changes, the
carrying amount oI the liability and the carrying amount oI the asset should be
adjusted accordingly. Prior period amounts are not restated.

Required disclosures:
description oI the AROs and associated assets.
Reconciliation oI the ARO liabilities, disclosing new AROs incurred,
AROs extinguished, Accretion expense, revisions oI the estimated AROs.
Fair value oI restricted assets, iI any, set aside Ior AROs.

EIIects oI SFAS 143 on Iinancial statements:
Balance sheet:
Increase in the carrying value oI Iixed assets due to the capitalization oI
the AROs as part oI the long-lived assets.
Increase in liabilities due to the recognition oI the ARO liabilities.

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CFACENTER.COM 17
Income statement:
Higher depreciation expense due to the depreciation oI AROs capitalized
as part oI the long-lived assets.
Higher interest expense due to accretion expense recognized periodically.
Lower net income due to higher depreciation and interest expenses.

Financial ratios:
Lower asset turnover ratio due to higher asset levels.
Lower debt-to-equity ratio as decline in net income reduces retained earnings;
thereby resulting in lower equity. The Iirm's debt level also increases, iI ARO
liabilities are considered long-term debt.
Lower return on assets due to lower net income and higher asset levels.
Lower interest coverage ratio as recognition oI AROs increases interest expense,
and higher depreciation results in lower net income.