Advance Accounting Ebook - Part 11

Advanced Accounting E-Book part 11 of 12
Advanced Accounting E-Book

Part 11 of 12
All Rights Reserved. Corporate Bridge
TM
www.educorporatebridge.com
Discussion topics Advanced Accounting E-Book part 11 of 12

Introduction to Capitalization versus expensing
Case of WorldCom
Financial Statement effect of capitalization versus expensing
Analytical adjustments to Balance Sheet effect

Analytical adjustments to Income Statement effect Cash Flow effect
Capitalization of Interest
Qualifying assets for capitalized interest Capitalization period Calculation of Avoidable Interest
Capitalization of Intangibles
Patents
Goodwill Advertisements
Research & Development

Software Development
Calpine Corp Case Study Sum up..
TM
Capitalization vs Expensing
TM
Capitalization versus expensing Advanced Accounting E-Book part 11 of 12

Capitalize
Means show the cost as an asset on the balance sheet These assets have future benefits
Expense
Benefits are immediate Or future benefits are too uncertain or immaterial
Costs flow through the financial statements
Cost incurred
Capitalization
Expensing
Balance Sheet
Income Statement
Net Income (Depreciation or Amortization Expense) CFI Outflow
Net Income (Expense)
CFO outflow
Management discretion in exercising these choices can significantly impact the financial statements and the ratios
TM
WorldCom Case Advanced Accounting E-Book part 11 of 12

Most infamous example of inflating earnings through improper capitalization of expenses
Transaction
$3.8bn 2001-02 expenditure on line costs
Regulators?
What was required as per GAAP
What WorldCom did?
WorldCom declared bankruptcy in July 2002. Chief accounting and finance executives charged with securities fraud
Accounting Treatment
$3.8bn must be treated as operating expense
WorldCom capitalized the costs
Financial Statement Effects
Pre-tax Income should be deducted by $3.8bn
$3.8bn was capitalized and put on the balance sheet (for amortization)
TM
Effect on Financial Statements
TM
Financial Statement Effects Advanced Accounting E-Book part 11 of 12

Income Statement Effects
Income Statement
Income Variability
Expensing
Greater variability
Capitalizing
Smoothening effect on net income from year to year
Matching of revenues
Profitability (Early years) Profitability (Later years)
Less matching of revenues and costs

Lower as all expenses flow through the IS Higher as all cost has been expensed
Cost deferred and matched with revenues

Higher as cost is amortized Lower due to amortization of capitalized cost
Balance Sheet Effects

Balance Sheet Asset and Liability Expensing Lower Capitalizing Higher
Leverage Ratios (debt/equity, debt/asset)

Book Value/Share
Higher
Lower
Lower due to higher base

Higher
Cash flow effects

Cash Flow Cash Flow from Operations Expensing Lower Capitalizing Higher
Cash Flow from Investing

Total Cash Flows
Higher
Same
Lower
Same
TM
Analytical adjustments Advanced Accounting E-Book part 11 of 12

Example: Capitalize versus expense During 2007, the company discovered that $2,250 of its operating expenses should have been capitalized, which would also have increased depreciation expense by $300
Example: Capitalize versus expense Balance Sheet Assets Total Current assets Net property, plant and equiptment Total Assets Balance Sheet Liabilities Total current liabilities Long-term debt Deferred taxes Common shareholder's equity Total liabilities and Equity
Calculate the following: Ratios calculation Profit Margin Return on capital Cash flow from operations Cash flow from investing Total cash flow Long term Debt/Equity
TM
2007 $9,300 $21,600 $30,900 2007 $4,875 $9,150 $1,575 $15,300 $30,900
2006 $8,700 $20,400 $29,100 2006 $4,125 $10,350 $1,425 $13,200 $29,100
Income Statement
Sales COGS Gross profit Operating expense Operating profit Interest expense Earnings before taxes Taxes (@ 30%) Net Income
2007 $60,000 ($45,000) $15,000 ($9,750) $5,250 ($750) $4,500 ($1,350) $3,150
Before Afer capitalization capitalization 5.3% 13.0% $3,300 ($1,500) $150 59.8%
Calculate?
Effects of Capitalization versus expensing Advanced Accounting E-Book part 11 of 12

Calculate the Adjusted Net Income
Calculation of Adjusted Net Income Earnings before taxes Add: Operating expense incorrectly deducted Less: Additional depreciation Adjusted EBT Tax @ 30% Adjusted Net Income
2007 $4,500 $2,250 ($300) $6,450 ($1,935) $4,515
Operating expense added back Additional depreciation expensed
Calculate the Adjusted Total Assets

Adjusted Total Assets Total Asset Capitalized expense Depreciation expense Total adjusted debt Total Adjusted Equity
2007 $30,900 $2,250 ($300) $32,850 $17,250
Adjusted income is used for the calculations Capitalized expense added to Total Asset in the balance sheet
Equity needs to be adjusted: $15,300+ $2,250 - $300
Calculate the Ratios

Ratios calculation Profit Margin Return on capital Cash flow from operations Cash flow from investing Total cash flow Long term Debt/Equity Before capitalization 5.0% 12.5% $3,300 ($1,500) $150 59.8% Afer capitalization 7.5% 17.0% $5,550 ($3,750) $150 53.0%
Total cash outflow remains the same (ignoring the effect of tax)
Note: Cash flow calculation ignore tax impact
TM
Capitalization on Interest
TM
Capitalization of interest Advanced Accounting E-Book part 11 of 12

Capitalized interest is the interest incurred during the construction of long-lived assets. Capitalized interest is included as the initial cost of the asset on the balance sheet instead of being charged off as interest expense on the income statement Qualifying assets for capitalized interest
They must require a period of time to make them ready for use Assets under construction for use in operations Discrete assets intended for sale or lease
What is the Capitalization period?

Capitalization period begins when
Expenditures for the asset have been made Activities for readying the asset are in progress
Interest costs are being incurred
Capitalization period ends when

Asset is substantially complete and ready for its intended use
Amount of interest to be capitalized?

Calculation of Avoidable Interest (please see next slide)
TM

Calculation of Avoidable Interest
Weighted-average accumulated expenditures (WAEE)
Appropriate interest rate
Avoidable interest
Capitalize the avoidable interest expense
Illustration:
Example : Capitalized Interest
During the current year, RKDF construction has been constructing a building to be used for production RKDF makes the two payments in 2007 Following debt was outstanding throughout 2007 Date 1-Feb-07 1-Aug-07 Payment $50,000 $75,000 Amount Outstanding $60,000 $75,000 Rate 10% 8%
This note is specifically for the current project
Calculate the following: a) Appropriate interest rate b) Actual interest c) Avoidable interest
TM

Calculation of Weighted Average Expenditure
Date 1-Feb-07 1-Aug-07 WAEE Expenditure $45,833 $31,250 $77,083
$50,000 x (11/12)
$75,000 x (5/12)
Calculation of Actual interest expense

Debt Note @ 10% Note @ 8% Amount $60,000 $75,000 $135,000 Interest $6,000 $6,000 $12,000
Calculation of Avoidable interest expense

Debt Note @ 10% Note @ 8% WAEE Amount $60,000 $17,083 $77,083 Interest $6,000 $1,367 $7,367
Upto $60,000 project specific loan @ 10%; Remaining loan $17,083 @ 8%
Avoidable interest ($7,367), should be capitalized in the balance sheet
TM
Intangibles Assets
TM
Intangibles Capitalized or Expensed Advanced Accounting E-Book part 11 of 12

Patents
Internally developed patents dont show up in the Balance Sheet SFAS 2 requires all costs incurred with the development of the patents be expensed as they are incurred Patents acquired in an arms length transaction will show up in the balance sheet at the cost paid to buy it Patents are amortized using the legal life or the useful life, whichever is shorter Legal life of patents is currently 17 years
Goodwill
Goodwill can only be recorded when a firm buys another firm Arms length transaction is evidence of the value of Goodwill Under SFAS 142, Goodwill is no longer amortized, but tested for impairment When Goodwill is impaired, it is written down & loss passed through income statement in current period Managers may have incentives to write down a lot of goodwill, or never write down goodwill at all
Advertisements
Advertising is expenditures to inform potential customers about the product or services of the firm. The benefits of successful advertising may extend for many periods into the future, however, any such benefits are very difficult to measure GAAP requires immediate expensing of most advertising costs More conservative than capitalization!
TM

Accounting for Research and Development Future benefits from R&D expenditures is highly uncertain at the start of a project SFAS 2 requires virtually all R&D expenditures to be expensed as incurred
Principle of conservatism is applied in case of R&D

However, when one firm buys another firm, the total purchase price must be apportioned among the individual assets acquired
Immediately written off $4,000
In-process R&D (no future alternative)
$5,000
$600
In-process R&D with almost certain future Tangible Assets
$400 Purchase price
SFAS 2 requires that a portion of purchase price be allocated to in-process R&D and be immediately written off
Managers have a strong incentive to allocate a large portion of the purchase price to purchased in-process R&D
TM

BMW Group
Example : Research & Development Costs
BMW Group (in euro million) Revenues Cost of sales Gross profit Sales and administrative costs Research and development costs Other operating income & expenses Profit before financial result Financial result Profit before tax Income taxes Net profit
2007 $46,656 (35,992) $10,664 (4,762) (2,464) 355 $3,793 (506) $3,287 (1,048) $2,239
2006 $44,335 (34,040) $10,295 (4,648) (2,334) 461 $3,774 (191) $3,583 (1,341) $2,242
R&D as a separate line item in Income Statement
BMW Group (in euro million) Research and development costs Amortisation New expenditure for capitalised development costs Research and development costs
2005 $2,464 (745) 1,396 $3,115
2004 $2,334 (637) 1,121 $2,818
TM

Accounting for Software Development Costs More liberal for accounting internal expenditures for software development Software development cost is a major costs for many small, growth service companies and thats their main asset This prompted FASB to be more liberal while formulating SFAS 86
Expensed as incurred
Research expenditures
Technologically feasible
Capitalized and amortized Development expenditures After
Before
TM
Intangibles: Capitalize/ Expense Advanced Accounting E-Book part 11 of 12
Intangible Asset Research and development Patents and copyrights Franchise and license costs Brands and trademarks Advertising costs
Treatment as per US GAAP Expensed as incurred Costs incurred in development are expensed but if a patent or copyright is purchased then the cost is capitalized Capitalized by the purchasing firm Capitalized by the purchasing firm Expensed as incurred (exception being direct response advertising costs which are capitalized) May be recognized and capitalized only in purchase transactions. Under US GAAP goodwill is subject to an impairment test All costs incurred in feasibility studies are expensed but subsequent development costs of an established product can be capitalized
Goodwill
Computer software & development costs
TM
Calpine Case Study
TM
Calpine Case Study Advanced Accounting E-Book part 11 of 12

Please look at the 10K of Calpine Corp
What is the interest rate expense? Should the capitalization of interest be reversed? Is Cash Flow from operations overstated?
TM
Sum Up..
TM
For FREE Resources

https://www.educorporatebridge.com/freebies.php
Corporate Bridge Blog

Finance News, Articles, Interview Tips etc
https://www.educorporatebridge.com/blog
For Online Finance Courses

https://www.educoporatebridge.com
For any other enquiry / information

Email support@cbacademy.in
TM

Advance Accounting Ebook - Part 11

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Advance Accounting Ebook - Part 11

Uploaded by

Copyright:

Available Formats

Advanced Accounting E-Book part 11 of 12

Advanced Accounting E-Book

All Rights Reserved. Corporate Bridge

Discussion topics Advanced Accounting E-Book part 11 of 12

Financial Statement effect of capitalization versus expensing

Analytical adjustments to Balance Sheet effect

Research & Development

Calpine Corp Case Study Sum up..

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 11 of 12

All Rights Reserved. Corporate Bridge

Capitalization versus expensing Advanced Accounting E-Book part 11 of 12

Costs flow through the financial statements

Net Income (Depreciation or Amortization Expense) CFI Outflow

Net Income (Expense)

All Rights Reserved. Corporate Bridge

WorldCom Case Advanced Accounting E-Book part 11 of 12

$3.8bn 2001-02 expenditure on line costs

What was required as per GAAP

What WorldCom did?

$3.8bn must be treated as operating expense

WorldCom capitalized the costs

Financial Statement Effects

Pre-tax Income should be deducted by $3.8bn

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 11 of 12

Effect on Financial Statements

All Rights Reserved. Corporate Bridge

Financial Statement Effects Advanced Accounting E-Book part 11 of 12

Less matching of revenues and costs

Cost deferred and matched with revenues

Balance Sheet Effects

Leverage Ratios (debt/equity, debt/asset)

Lower due to higher base

Cash flow effects

Cash Flow from Investing

All Rights Reserved. Corporate Bridge

Analytical adjustments Advanced Accounting E-Book part 11 of 12

Effects of Capitalization versus expensing Advanced Accounting E-Book part 11 of 12

Calculate the Adjusted Total Assets

Equity needs to be adjusted: $15,300+ $2,250 - $300

Calculate the Ratios

Note: Cash flow calculation ignore tax impact

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 11 of 12

All Rights Reserved. Corporate Bridge

Capitalization of interest Advanced Accounting E-Book part 11 of 12

What is the Capitalization period?

Interest costs are being incurred

Capitalization period ends when

Amount of interest to be capitalized?

All Rights Reserved. Corporate Bridge

Capitalization of interest Advanced Accounting E-Book part 11 of 12

Appropriate interest rate

Capitalize the avoidable interest expense

This note is specifically for the current project

Capitalization of interest Advanced Accounting E-Book part 11 of 12

Calculation of Actual interest expense

Calculation of Avoidable interest expense

Avoidable interest ($7,367), should be capitalized in the balance sheet

All Rights Reserved. Corporate Bridge

Advanced Accounting E-Book part 11 of 12

All Rights Reserved. Corporate Bridge