CFA Level 1 - Assets

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8.1 - Introduction
Section 8 focuses on the asset side of the balance sheet. We will discuss current and long term assets, including
inventory analysis. We have provided many examples throughout the section that will aid your learning
experience. Note how changes in these accounts affect the ratios – pay careful attention as to what constitutes a
credit vs. debit.

In Section 9 we will discuss the liability side of the

balance sheet.

8.2 - Choosing the Appropriate Accounting Method

Choosing the appropriate accounting method for
investment securities

Classification & accounting treatment

• Trading securities – These are securities held by

a company that it intends to buy and sell for a
short-term profit. These securities are reported at
their fair market value. Gains and losses will be included on the income statement. They are classified as
unrealized holding gains or losses on the income statement, and the counter account on the balance sheet
is allowance for adjusted short-term investments to market.

• Available for sale – This is generally a default category. The accounting for available-for-sale securities
looks quite similar to the accounting-for-trading securities. There is one big difference between the
accounting-for-trading securities and available-for-sale securities. This difference pertains to the
recognition of the changes in value. For trading securities, the changes in value are recorded in operating
income. However, for available-for-sale securities the changes in value go into a special account, which
is called “unrealized gain/loss in other comprehensive income”, which is located in stockholders’ equity.
The income statement will be unaffected. The counter account to unrealized gain/loss in other
comprehensive income is short-term available-for-sales fair market adjustment.

• Held to maturity – These are securities held by a company that it intends to buy and hold to maturity.
These securities are record at cost (Purchase price + communions or other fees) and gain or losses are
only recognized after the company has sold the securities.

Accounting Impact

Classification Assessment Guidelines Initially Subsequently

 Record at fair market Attribute gains and losses to operating
Trading Intent to buy/sell for short-term profits
value income

Available for Record at fair market Attribute gains and losses to

Default Category
Sale value stockholders' equity

Intent to buy and hold until fixed future

Held to Maturity Original cost No record
maturity date

8.3 - Accounting for Credit Transactions

Most businesses give customers a certain number of
days (30 to 60 days) to pay for delivered products and
services. This is referred to as “extending credit to
customers”. Under accrual accounting, sales made on
credit are recorded on the income statement. The not-
yet-collected money is recorded under accounts
receivable. Unfortunately, some customers will not
want or be able to pay (because of bankruptcy) the
company.

Company’s can utilize two different approaches to

account for these uncollectible accounts. The first is to
account for them as they occur. Companies mostly use
this method for income tax calculations and/or because
its bad debts are immaterial. This method is called the
“direct write-off method of accounting for bad debts”.
Once the company determines that an account is
uncollectible, it will debit (which is an increase) the
bad debt expense and credit accounts receivable
(which is a decrease)

The second method used by companies, which is more

consistent with the matching accounting principle, is
to estimate the bad debt on an ongoing basis. This is
referred to as the “allowance method for bad debt”,
and it is accounted for in allowance for doubtful
accounts.

Accounting for Credit Sales

1) The direct write-off method

ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay.

Here’s the accounting record:

The 3C account has been overdue for six months and will most likely be uncollectible. The company decides to
write it off:

2) Allowance method for bad debt

ABC sells and delivers $200,000 in products to 3C, which has 30 days to pay.

Accounting record:

The company estimates that 1% of accounts receivable will become uncollectible:

Unfortunately, 3C has declared Chapter 7 bankruptcy. The 3C account needs to be written off. Currently the
Company has 400,000 in allowance for doubtful accounts:

8.4 - Basics of Inventories

INVENTORIES - BASICS

Inventory Processing Systems

Inventory-processing systems relate to the timing of the assessment of inventory. They can be valued on a
continuous basis (physical count of inventory will be done after each sale) or periodically (physical count of
inventory will be done at the end of each period). For most businesses, continuous revaluation of their inventory
is too expensive and generates little value. As a result, most
companies evaluate their inventory periodically.

The inventory-costing methods used relate to the way

management has decided to evaluate the cost of their inventory,
for example, specific identification, average cost, first in first out (FIFO), or last in first out (LIFO). The costing
method will have an impact on the estimated value of the inventory on hand and the estimated cost of goods
sold (COGS) reported on the income statement.

The valuation method is the process by which the inventory is valued. GAAP requires inventory to be valued at
the lower of cost to market (LCM) valuation. Market valuation is defined as replacement cost. The choices
made by management with the inventory- processing systems, the inventory-costing method and the valuation
method used will affect what is reported on a company's balance sheet, net income statement (profits) and cash
flow statement. All these choices should be driven by the application of the matching principle. Unfortunately,
these choices are sometimes driven by the owner/management tax implications (usually among private
companies), or by the intention to artificially increase a company's profitability (usually among public
companies).

Inventory Cost
Inventory cost is the net invoice price (less discounts) plus any freight and transit insurance plus taxes and
tariffs. Inventory includes not only inventory on hand but also inventory in transit. Furthermore, inventory does
not have to be a finished product to the included.

The cost of inventory can be calculated based on:

1) the specific identification method,
2) the average-cost method,
3) first in, first out (FIFO), and
4) last in, first out (LIFO)

GAAP allows management to use four methods to evaluate inventory. We will use the following example to
illustrate each of these methods.

Example: Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1) The Specific-identification Inventory Method

Under this inventory method each unit purchased for resale is identified and accounted for by its invoice.
Companies that use this method carry a small number of units.

Cost of goods sold: $75 (ID: 102 and 103)

Ending inventory: $55 (ID: 101 and 104)
Gross profit: $300-$75 = $225

2) Average-cost Method
Under this inventory method the units in inventory are considered as a whole and their cost is averaged out.
Companies that use this method carry a large number of units.

Total cost: $130

Average cost: $33 per unit (total cost / total number of units)
Cost of goods sold: $66 ($33*2 units sold)
Ending inventory: $66 ($33*2 units left)
Gross profit: $300-$66 = $234

3) First-in, First-out (FIFO)

Under this inventory method the units that were first purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 101 and 102)

Ending inventory: $65 (ID: 103 and 104)
Gross profit: $300-$65= $235

4) Last-in, First-out (LIFO)

Under this inventory method the units that were last
purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 103 and 104)

Ending inventory: $65 (ID: 101 and 102)
Gross profit: $300-$65 = $235

8.5 - Effects of Misstated Inventory

Overstating (O) or understanding (U) inventory has an
effect not only on the balance sheet but also on
reported income and cash flow. O and U occur when
the purchase price and value of inventory change over
time. Let's take, for example, a company that trades
scrap steel.

The best way to illustrate O and U is to do it through

an example.

Basic concept:

Formula 8.1
COGS = beginning inventory + purchases – ending inventory
If the price of a company's inputs (such as steel, lumber, etc.)
is rising:

FIFO method:

• COGS will be understated.

• Income will be overstated.
• The company will pay more income tax and have a lower cash flow.
• Assets on the balance sheet will be more reflective of the actual market value.
• Working capital and current ratio will be increased.

LIFO method

• COGS will be more reflective of current market environment.

• Income will be lower.
• The company will pay less income tax and cash flow would be higher.
• Assets would be understated and not reflective of its market value.
• Working capital and current ratio will be decreased.
Average-cost method

• Since it's an average, it would be in between LIFO and FIFO

Specific identification method

• If this method is used, it is extremely hard to tell, since each product has been accounted for
individually.

Look Out!
The CFA institute focuses mostly on differences between LIFO and FIFO,
hence our focus in this discussion.

8.6 - Inventory Valuation

GAAP requires inventory to be valued at the lower of cost to market. LCM can be calculated by using the item-
by-item method or the major-category method.

1. The item-by-item method – This methods will look at each

item and determine the LCM.

Example:

2.The major-category method – Under this method, each category is grouped and the lower of the cost to
market is taken.

Example – Assume that our prior example represents a category.

Under this method the LCM should be $850.

8.7 - Inventory Analysis

Computing Inventory Balances
In computing ending inventory balances under the various
methods we will use the following example.

Example:
Company ABC purchased these items in May, and sold item 102 and 103 for a total of $300:

1.Average-cost method - Under this inventory method the units in inventory are considered as a whole and
their cost is averaged out. Companies that use this method carry large amount of units.

Total cost: $130

Average cost: $33 per unit (total cost / total number of units)
Cost of goods sold: $66 ($33*2 units sold)
Ending inventory: $66 ($33*2 units left)
Gross profit: $300-$66 = $234

2.First in first out - Under this inventory method, the units that were first purchased are assumed to be sold
first.

Cost of goods sold: $65 (ID: 101 and 102)

Ending inventory: $65 (ID: 103 and 104)
Gross profit: $300-$65 = $235

3.Last in first out - Under this inventory method the units that were last purchased are assumed to be sold first.

Cost of goods sold: $65 (ID: 103 and 104)

Ending inventory: $65 (ID: 101 and 102)
Gross profit: $300-$65 = $235

Usefulness of Inventory Data When Prices Are Stable or Changing

If the cost of purchasing inventory remains stable, the method used to calculate the cost of goods sold (by FIFO,
LIFO or average cost) will yield similar results. On the other hand, in a changing environment this can distort
the reported income, cash flow and inventory.

Rising Price (Inflationary) Environment

FIFO method

• COGS will be understated.

• Income will be overstated.
• The company will pay more income tax and have a lower cash flow.
• Assets on the balance sheet will be more reflective of the actual market value.
• Working capital and current ratio will be increased.
• Inventory turnover (COGS / average inventory) will worsen (decrease).

LIFO method

• COGS will be more reflective of current market environment.

• Income will be lower.
• The company will pay less income tax and cash flow will be higher.
• Assets will be understated and not reflective of its market value.
• Working capital and current ratio will be decreased.
• Inventory turnover (COGS / average inventory) will improve (increase).

Average-cost method

• Since it's an average, it would be in between LIFO and FIFO.

Decreasing Price (Deflation) Environment

FIFO method

• COGS will be more reflective of current market environment.

• Income will be lower.
• The company will pay less income tax, and cash flow would be higher.
• Assets will be understated and not reflective of its market value.
• Working capital and current ratio will be decreased.
• Inventory turnover (COGS / average inventory) will improve (increase).

LIFO method

• COGS will be understated.

• Income will be overstated.
• The company will pay more income tax and have a lower cash flow.
• Assets on the balance sheet will be more reflective of the actual market value.
• Working capital and current ratio will be increased.
• Inventory turnover (COGS / average inventory) will worsen (decrease).
 Look Out!

Make sure you understand this concept very well.

Analysts should be aware that companies that operate in a rising-price environment and utilize the LIFO method
could manipulate their earnings. To manipulate the earnings management could simply stop purchasing new
inventory and start dipping into their old and cheap inventory. This is call "LIFO liquidation".

Most U.S. companies use LIFO as opposed to FIFO. Given the fact that the U.S. has seen cost of inventory rise
over the last 30 years (inflation) these companies were able to save on taxes. One should know that the Internal
Revenue Service (IRS) does not allow companies to report LIFO for tax purposes and then FIFO on their
general-purpose statements.

Analyzing the Financial Statements of Companies That Use Different Inventory Accounting Methods

When comparing two companies, one must ensure that they are comparing apples with apples. If the first
company uses the FIFO method and the other the LIFO
method, then there is a problem. To make the comparison
relevant, one must convert LIFO to FIFO or FIFO to IFO.

8.8 - Converting LIFO to FIFO

To make the conversion possible, U.S. GAAP requires
companies that use LIFO to report a LIFO reserve (found
in footnotes). The LIFO reserve is the difference between
what their ending inventory would have been if they used
FIFO.

Formula 8.2
LIFO reserve = FIFO inventory - LIFO inventory
Or:

FIFO inventory = LIFO inventory + LIFO reserve

Recall:

COGS = beginning inventory + purchases – ending inventory

Or:
COGS = change in inventory levels

So:

Formula 8.3

COGS (LIFO) – change in LIFO reserve

COGS (LIFO) – (LIFO reserve at the end of the period - LIFO reserve at the beginning of the period)
Long Conversion
A longer way to convert LIFO to FIFO is to calculate purchases, convert both beginning and ending inventory
to FIFO levels, and then calculate COGS using the FIFO inventory levels and purchases.

COGS = beginning inventory + purchases – ending inventory

Rearrange the terms:

Purchases = ending inventory - beginning inventory + COGS (LIFO)

We also know that:

Ending inventory (FIFO) = Ending inventory (LIFO) + ending period LIFO reserve

Beginning inventory (FIFO) = Beginning inventory (LIFO) + Beginning LIFO reserve

Example:

Company ABC uses LIFO.

Year-end inventory = $2m

Beginning inventory = $3m
LIFO reserve at year-end = $1m
LIFO reserve at the beginning of the years = $500,000
COSG = $5m

Simple way to convert LIFO to FIFO

COGS (FIFO) = COGS (LIFO) – change in LIFO reserve

COGS (FIFO) = $5m – ($1m - $0.5m) = $4.5m

Complex way
Purchases = ending inventory - beginning inventory + COGS (LIFO)
Purchases = $2m – 3m + $5m = $4m

Ending inventory (FIFO) = ending inventory (LIFO) + ending period LIFO reserve
Ending inventory (FIFO) = $2m + $1m = $3m

Beginning inventory (FIFO) = beginning inventory (LIFO) + beginning LIFO reserve

Beginning inventory (FIFO) = $3m + $0.5m = $3.5m
COGS (FIFO) = purchases + beginning inventory (FIFO) - ending inventory (FIFO)
COGS (FIFO) = $4m + $3.5m – $3m = $4.5m

To make the two companies comparable, we need to do some additional adjustments.

• Under different methods COGS will vary and as a result net income should be adjusted.

• If COGS under the LIFO was higher than the COGS under the FIFO method:
o That would mean this company would have used the FIFO method, it would have declared a
higher gross profit and hence a higher net income. But it would have also had to pay higher taxes
and reduce its cash flow. A simple way to account for that is to take the positive difference in
COGS and multiply it by (1-tax rate).
o This difference would also be included in shareholders' equity.
o The additional tax would be recorded in income tax liability.

• If COGS under the LIFO was lower than the COGS under the FIFO method:
o That would mean this company would have used the FIFO method, it would have declared a
lower gross profit and hence lower net income. But it would have also had to pay lower taxes
and increase its cash flow. A simple way to account for that is to take the negative difference in
COGS, divide the COGS by (1-tax rate).
o This difference would also be included in shareholders' equity.
o The additional tax would be recorded in income tax asset.

8.9 - Converting FIFO to LIFO

There is no precise mathematical equation to convert FIFO accounting to LIFO because the equivalent of the
FIFO reserve does not exist. Furthermore, there is little value in converting inventory under FIFO to LIFO,
since LIFO inventory is not a reflection of the true economic value of inventory. Nonetheless, analysts can
estimate what the inventory and COGS would have been if the company used the LIFO accounting method.

Analysts would first need to estimate what the beginning

inventory would have been under LIFO. Inventory can be
affected by economic inflation, inflation of raw assets
with a particular industry, among others. As a result,
COGS (LIFO) can be estimated by using this formula:

COGS (LIFO) = COGS (FIFO) + [beginning inventory

(FIFO) * (adjustment or inflation rate)]

Looking at a company within a similar industry that uses

the LIFO method can also be done to derive the
adjustment rate.

Adjustment rate = LIFO reserve / beginning inventory

(LIFO)

Converting Average-cost Method to LIFO

As stated previously, since the average-cost method is a simple average of COGS, COGS would be in between
LIFO and FIFO.

COGS (LIFO) = COGS (average) – ½ * (beginning inventory (Average) * (adjustment or inflation rate)
8.10 - Effects of Inventory Accounting
A company's choice of inventory accounting will affect the company's income, cash flow and balance sheet.

• Income effect – Inventory and cost of goods sold are

interdependent. As a result, if LIFO method is used in a
rising-price and increasing-inventory environment, more
of the higher-cost goods (last ones in) will be accounted
for in COGS as opposed to FIFO. Under this scenario, net income will be lower compared to a company
that used FIFO accounting.
• Cash flow effect – If we lived in a tax-free world, there would be no cash flow difference between
inventory-accounting methods. Unfortunately, we do pay taxes. As a result, if a company uses the FIFO
method in a rising-price and increasing-inventory environment, it will have to generate a lower COGS
and a higher net taxable income, and pay higher taxes. Tax expenses are a real cash expense and lower a
company's cash flow.
• Working Capital – Working capital is defined as current assets minus current liabilities. If one method
produces a higher inventory value in the income statement, the working capital will increase.

Table 8.1 Summary of effects given a rising-prices environment and stable or increasing inventories

The Effects of the Inventory Method On Ratios

Since the accounting method used to account for inventory has an effect on the income statement, balance sheet
and cash flow statement, it will ultimately have an effect on the ratios used to measure and compare a
company's profitability, liquidity, activity and solvency.

Computing Profitability Effects

In a rising-price and stable- or increasing-inventory environment,LIFO will have a higher COGS, but it will also
be more representative of the current economic reality. As a result, profitability will be more accurate, and a
better indicator of future profitability. FIFO will use the cost of the old stock to determine the COGS, making
the profitability ratio less reflective of the current economic reality.

As a general rule, in a rising-price and stable- or increasing-inventory environment,using profitability measures

based on LIFO is better.

Look Out!

Most questions relating to the differences under LIFO and

FIFO will include a descriptive effect on financial ratios.
Students need to understand what each ratio is composed of.
 Look Out!

Before starting this section remember what changes:

• Inventory – current assets and total assets

• COGS - profitability
• Income – stockholder equity

• Taxes – CFO and cash account on the balance sheet

Liquidity Ratio Changes

Look Out!
From an analytical perspective, in a rising-price and stable- or increasing-
inventory environment, it is better to use FIFO liquidity ratios because the
LIFO ending inventory is composed of older, cheaper inventory.

Activity ratios

From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, the LIFO
inventory turnover ratio will trend higher. On the other hand, if we use FIFO, the COGS does not represent the
current economic reality. In this case the best thing to do is to use the COGS found under LIFO and divide it by
the average inventory found in FIFO. This is called "current-cost method".

Look Out!

From an analytical perspective, in a rising-price and stable-

or increasing-inventory environment, it is better to use FIFO
total asset turnover ratios because LIFO ending inventory is
the older, cheaper inventory.

Solvency ratios
From an analytical perspective, in a rising-price and stable- or increasing-inventory environment, it is better to
use LIFO debt-to-equity ratio because the retained earnings are more representative of the current economic
reality. For the time, interest-earned ratio is more relevant
to use LIFO because EBIT will be lower and more
representative of future interest-coverage protection. If
the company is currently using FIFO, it is better they use
the CFO generated by FIFO because the company cannot
change the fact that it will have to continue paying higher
taxes under this method.

8.11 - Causes a Decline in LIFO Reserve

LIFO reserves decline because a company is doing the
following:

• liquidating its inventory (lower quantities / selling

cheap/old stock)
• is purchasing inventory at lower prices (price
decline)

The liquidation of inventory is called "LIFO liquidation". This happens when a company is no longer
purchasing additional inventory (prices are high) and is depleting its old and cheap cost-base inventory. This
can produce large increases in profitability (COGS abnormally low). This increase in profitability is temporary
(paper profit). Once it runs out of cheap inventory, it will have to purchase new inventory at a mush higher cost
base. This will also decrease a company's cash flow because it will have to pay more taxes. Profits from LIFO
liquidation are non-operating in nature and should be excluded from earnings in an analysis.

A decline in price reduces the COGS under LIFO, but though COGS is lower it is a better indication of the
economic reality. So no adjustments are necessary on the income statement. That said, the ending inventory
under LIFO is too high and is no longer representative of its true economic value. The ending inventory should
be adjusted to FIFO.

Look Out!
Companies must report inventories at the lower of cost (determined by
their LIFO, FIFO or other inventory accounting method) or market value.

Market value is essentially the net realizable value of the assets.

8.12 - Long Term Asset Basics

I. Basics

Distinguishing Features of Long Term Assets

Long-term assets are assets that are typically used in the
production process of a company and have a useful life of more
then one year.

Long-term assets typically include property, plant (building and land) and equipment (PP&E). These assets are
reported at cost (book value) at initiation, and are depreciated over time (except for land). Once an asset has
started to depreciate, it is said to be reported at its carrying value. If an asset becomes obsolete before its time
or it has lost its revenue-generating ability, it must be written off and this is referred to as asset impairment.

Property, Plant and Equipment (PP&E)

The cost of PP&E includes all costs related to their acquisition and all necessary expenses required to make
them useful for the company.

Example 1:
Company ABC purchased a machine for $2m. To get this machine ready for use, it paid a total of $200,000 for
transportation and insurance, brokerage fees, set-up costs and legal fees, among others. So the total cost is
$2.2m.

Journal entry:

Company ABC bought a piece of land for $2m and an additional $100,000 went to expenses resulting from the
search for the land, real estate commission, title transfer, surveying and landscaping. Total cost is $2.1m.

Journal entry:

Company ABC incurred a total of $20m in additional costs to build on this land. This included, among others,
costs for materials, labor, construction plans and interest cost incurred during the construction phase.

Journal entry:

8.13 - Depreciation Accounting

Depreciation is defined as the reduction in the value of a product arising from the passage of time due to use or
abuse, wear and tear. Depreciation is not a method of valuation but of cost allocation. This cost allocation can
be based on a number of factors, but it is always related to the estimated period of time the product can generate
revenues for the company (economic life). Depreciation expense is the amount of cost allocation within an
accounting period. Only items that lose useful value over time can be depreciated. That said, land can't be
depreciated because it can always be used for a purpose.

Straight-line Depreciation
The simplest and most commonly used method, straight-line
depreciation is calculated by taking the purchase or acquisition
price of an asset, subtracting by the salvage value (value at
which it can be sold once the company no longer needs it) and
dividing by the total productive years for which the asset can be reasonably expected to benefit the company, or
its useful life.

Example: For $2m, Company ABC purchased a machine that will have an estimated useful life of five years.
The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.

Formula 8.4
Depreciation expense = total acquisition cost – salvage value
useful life

Look Out!

Know that this method of depreciation produces a constant

depreciation expense, and at the end of its useful life, this
asset will be accounted for in the balance sheet at its salvage
value.

Unit-of-production Depreciation
This method provides for depreciation by means of a fixed rate per unit of production. Under this method, one
must first determine the cost per one production unit and then multiply that cost per unit with the total number
of units the company produced within an accounting period to determine its depreciation expense.

Formula 8.5
Depreciation expense = total acquisition cost – salvage value
estimated total units

Estimated total units = the total units this machine can produce over its lifetime

Depreciation expense = depreciation per unit * number of units produced during an accounting period

Example:
Company ABC purchased a machine that can produce 300,000 products over its useful life for $2m. The company also
estimates that this machine has a salvage value of $200,000.
 Look Out!
Know that this depreciation method produces a variable depreciation
expense and is more reflective of production-to-cost (matching principle).

At the end of the useful life of the asset, its accumulated depreciation is equal to its total cost minus its salvage value.
Furthermore, its accumulated production units equal the total estimated production capacity. One of the drawbacks of this
method is that if the units of products decrease (slowing demand for the product), the depreciation expense also decreases.
This results in an overstatement of reported income and asset value.

Hours-of-service Depreciation
This is the same concept as unit of production depreciation except that the depreciation expense is a function of total hours of
service used during an accounting period.
8.14 - Accelerated Depreciation
Accelerated depreciation allows companies to write off their assets faster in earlier years than the straight-line
depreciation method and to write off a smaller amount in the later years. The major benefit of using this method
is the tax shield it provides. Companies with a large tax burden might like to use the accelerated-depreciation
method, even if it reduces the income shown on the
financial statement.

This depreciation method is popular for writing off

equipment that might be replaced before the end of its
useful life since the equipment might be obsolete (e.g.
computers).

Companies that have used accelerated depreciation will

declare fewer earnings in the beginning years and will
seem more profitable in the later years. Companies that
will be raising financing (via an IPO or venture capital)
are more likely to use accelerated depreciation in the first
years of operation and raise financing in the later years to
create the illusion of increased profitability (higher
valuation).

The two most common accelerated-depreciation methods are the sum-of-year (SYD) method and double-
declining-balance method (DDB):

Sum-of-year Method:
Depreciation in year i = (n-i+1) * (total acquisition cost – salvage value)
n!
Example: For $2m, Company ABC purchased a machine that will have an estimated useful life of five years.
The company also estimates that in five years, the company will be able to sell it for $200,000 for scrap parts.

n! = 1+2+3+4+5 = 15
n=5

Look Out!
Know that this depreciation method produces a variable depreciation
expense. At the end of the useful life of the asset, its accumulated
depreciation is equal to the accumulated depreciation under the straight-
line depreciation.

Double-declining-balance method
The DDB method simply doubles the straight-line depreciation amount that is taken in the first year, and then that same
percentage is applied to the un-depreciated amount in subsequent years.

DDB in year i = 2 * (total acquisition cost – accumulated depreciation)

n
n = number of years

Example
For $2m, Company ABC purchased a machine that will have an estimated useful life of five years. The
company also estimates that in five years the company will be able to sell it for $200,000 for scrap parts.
 Look Out!
Know that this depreciation method produces a very aggressive
depreciation schedule. The asset cannot be depreciated beyond its salvage
value.

Change in Useful life or Salvage Value

All depreciation methods estimate both the useful life of an asset and its salvage value. As time passes the
useful life of a company's equipment may be cut short (new technology), and its salvage value may also be
affected. Once this happens there is asset impairment.

Companies can do two things:

1) They can accelerate the asset's depreciation and fix the reduction in useful life or salvage value over time or

2) They can do the recommended thing, which is to recognize the impairment and report it on the income
statement right away.

Look Out!
Note that changes in useful life and salvage value are considered changes
in accounting estimates, not changes in accounting principle. The result is
this: no need to restate past financial statements.

Sale, Exchange, or Disposal of Depreciable Assets

Companies that are in the business of exploring and/or extracting and/or transforming natural resources such as timber, gold,
silver, oil and gas, among other resources are known as "natural resource companies". The main assets these companies have
are their inventory of natural resources. These assets must be reported at their cost of carry (or carrying cost). The carrying
costs for natural resources include the cost of acquiring the lands or mines, cost of timber-cutting rights and the cost of
exploration and development of the natural resources. These costs can be capitalized or expensed. The costs that are
capitalized are included in the cost of carry. The cost of carry does not include the cost of machinery and equipment used in
the extraction process.

When a resource company purchases a plot of land, it not only pays for the physical asset but also pays a large premium
because of what is contained in the plot of land. That said, once a company starts extracting the oil or natural resource from
the land, the land loses value, because the natural resources extracted from a plot of land will never regenerate. That loss in
value is called "depletion". That is why cost of carry is depleted over time. The depletion of these assets must be included in
the income statement's accounting period. This is the only time land can be depleted.

The carrying costs of natural resources are allocated to an accounting period by means of the units-of-production method.

Example:
A company acquired cutting rights for $1m. With these cutting rights, the company will be able to cut 5,000 trees. In its first
year of operation, the company cut 200 trees.

Journal entries:

8.15 - Natural Recource Assets

Classification of Natural Resource Assets
Intangible assets are identifiable non-monetary resources that have no physical substance but provide the
company controlling them with a benefit. Intangible assets can be internally created or acquired from a third
party. If intangible assets are acquired in an arm's length transaction, their recognition and measurement will be
similar to those of tangible assets. Internally developed intangible assets are accounted for in a wide range of
ways. Intangible assets include research and development costs, patents, trademarks and goodwill. Intangible
assets are depreciated over their estimated life and they are done so by the use the straight-line depreciation
method. Intangible assets cannot have an estimated life of more then 40 years.

Unlike other intangible assets, goodwill is no longer an asset that

can be depreciated. As of July 2001, the Financial Accounting
Standards Board (FASB) adopted the Statement of Financial
Accounting Standards (SFAS) No. 142, Goodwill and Other
Intangible Assets, which sets new rules for goodwill accounting. SFAS 142 eliminates goodwill amortization
and instead requires companies to identify reporting units and perform goodwill impairment tests.

Example
Company ABC acquires a company for $20m. The acquired company's fair market value was $18m. ABC has
also acquired a patent for $2m that has an estimated remaining life of 10 years.

Journal entries:

8.16 - Effects of Capitalizing vs.Expensing

EFFECTS OF CAPITALIZING VS. EXPENSING
Expenses can be expensed as they are incurred, or they can be capitalized. A company is able to capitalize the
cost of acquiring a resource only if the resource provides the company with a tangible benefit for more than one
operating cycle. In this regard, these expenses represent an asset for the company and are recorded on the
balance sheet.

Effects of Capitalization on Key Figures

The decision to capitalize or expense some items depends on
management. As such, this choice will have an impact on a company's balance sheet, income statement and cash
flow statement. It will also have an impact on a company's financial ratios.

Here is what the decision will have an impact on:

• Net income - Capitalizing costs and depreciating them over time will show a smoother pattern of
reported incomes. Expensing firms have higher variability in reported income. In terms of profitability,
in the early years, a company that capitalizes costs will have a higher profitability than it would have
had if it expensed them. In later years, the company that expenses costs will have a higher profitability
than it would have had if it capitalized them.

• Stockholders' equity – Over a long time frame, the choice of expensing a cost or capitalizing it will
have little effect on a shareholders' total equity. That said, expensing firms will have a lower
stockholders' equity at first (less profit, thus smaller retained earnings).

• Cash flow from operations – A company that capitalizes its costs will display higher net profits in the
first years and will have to pay higher taxes than it would've had to pay if it expensed all of its costs.
That said, over a long period of time, the tax implications would be the same. But the choice for
capitalizing over expensing have a much larger effect on the reported cash flow from operations and
cash flow from investing. If a company expenses its cost it will be included in cash flow from
operations. If it capitalizes, then it will be included in cash flow from investing (lower investment cash
flow and higher cash flow from operations).

• Assets reported on the balance sheet - A company that capitalizes its costs will display higher total
assets.

• Financial ratios – A company that capitalizes its costs will display higher profitability ratios at the
onset and lower ratios in the later stages. Liquidity ratios will experience little impact, except for the
CFO ratio, which will be higher under the capitalization method. Operation-efficiency ratios such as
total asset and fixed-asset turnover will be lower under the capitalization method, due to higher reported
fixed assets. Furthermore, at the onset, equity turnover will be higher under the capitalization method
(lower total equity due to lower net profit). Companies that capitalize their costs will initially report
higher net income, lower equity and higher total assets. Remember that, on average, an equal dollar
effect on a numerator and denominator will produce a higher net result. That said, on average, ROE &
ROA will initially be higher for capitalizing firms. Solvency ratios are better for firms that capitalize
their costs because they have higher assets, EBIT and stockholders' equity.

Consider figure 8.2 below for an overview of the effect of capitalizing and expensing on key financial ratios.

Figure 8.2 Impact of Assets, Profitability on Financial Ratios

8.17 - Computing the Effect of Capitalizing vs. Expensing
If interest is capitalized, it is included in the cost of carry. Capitalizing interest is common in construction
projects. The interest cost is included as an asset versus being expensed on the income statement for the period
it occurred.

In the U.S., SFAS 34 governs the capitalization of interest cost during an accounting period. SFAS 34 requires
that the interest cost incurred during a construction period is accounted for as a long-lived asset. To be
capitalized, the interest must be from borrowed money. If no specific borrowing is identified, interest can be
estimated by means of a weighted average interest rate on
outstanding debt for the amount invested.

Example:
A company built a building for $1m. It borrowed
$500,000 at 5% to build the building. In this case the
interest capitalized will amount to $25,000.

Another company built a building for $1m. It borrowed

$500,000 at 5% to build the building; it also had an
outstanding debenture of $3m at 10% and a $1M
mortgage at 15%. In this case, the interest capitalized will
amount to:

500,000 * 5% = 25,000
500,000 * 10% = 50,000
Total 75,000
Interest to be expensed = total interest paid – capitalized interest

= 25,000+300,000+150,000-75,000
= 400,000

The total capitalized interest is $75,000 because we assume the $500,000 balance was financed through the
debenture. The reason we do not consider the mortgage is that it is already assigned to another identifiable asset.

Some argue that the capitalization costs of self-financed assets should not be included.

The decision to capitalize interest will have an effect on a company's:

• Net income – In the current period earnings will be higher (overstated).

• CFO – In the current period, CFO will be higher (overstated) because the interest expense will be
included in CFI.
• CFI - In the current period, CFI will be lower (understated).
• Assets – Total assets will be overstated because they include the capitalized interest.
• Solvency ratios – Since assets, EBIT and stockholders' equity will be higher, all solvency ratios will be
overstated.

8.18 - Capitalizing Intangible Assets

Intangible assets are identifiable non-monetary resources
that have no physical substance but provide the company
controlling them with a benefit and, as a result, have a
higher degree of uncertainty regarding future benefits.
When intangible assets are acquired through an arm's
length transaction, they are recorded at cost. SFAS
classifies intangible assets in different categories and
provides a guideline in regards to their expense or
capitalization.

1.Research and development costs

• SFAS requires virtually all R&D costs to be

expensed in the period they were incurred and the amount to be disclosed.
• The main exception to the expensing rule is contract R&D performed for unrelated entities.

2.Software development

• SFAS requires all costs that were incurred in order to establish technological and/or economic feasibility
of software to be viewed as R&D costs and expensed as they are incurred.
• ONCE economic feasibility has been established, subsequent costs can be capitalized (but are not
required to be) as part of product inventory and amortized based on product revenues or on sales–per-
license basis.

Other Intangibles

1. Patents and copyrights

• All costs in developing these are expensed in conformity with the treatment of R&D costs (legal fees
incurred in registering can be capitalized).
 • Full acquisition costs are capitalized when purchased from other entities.

2. Brands and trademarks

• All costs in developing a brand or trademark are

expensed in conformity with treatment of R&D costs
(legal fees incurred in registering can be capitalized).
• Full acquisition costs are capitalized when brands and
trademarks are purchased from other entities.

8.19 - Depreciation
Depreciation Methods
Identification of depreciation methods:

• Straight-line depreciation
• Per unit of production
• Per hour of service
• Declining balance
• Sinking-fund depreciation

The only depreciation method that was not previously explained is the sinking-fund depreciation. The sinking-
fund depreciation is rarely used and is prohibited in the U.S. and some other countries. Under this depreciation
method, the amount of depreciation increases every year to maintain a fixed internal rate of return (IRR).

Formula 8.6

Depreciation in year i =
CF in year i – (IRR * book value at beginning of the year)

CF is defined as the cash derived every year from a particular asset.

Effect of depreciation on financial statements, ratios and taxes:

• Straight-line depreciation – This method will create a steady income stream, tax expense and ratios.
Return on assets will increase over time if the equipment continues to generate the same products and
price per unit remains constant.
• Per unit of production and per hour of service - These depreciation methods produce a variable
depreciation expense. Net income will vary but it could be more reflective of production-to-cost
(matching principle). One of the drawbacks of this method is that if units of products decrease (slowing
demand for the product), depreciation expense also decreases, resulting in an overstatement of reported
income and asset value.
• Declining balance – Income will be lower in the first years. As a result taxes will be lower and CFO
will be higher. If production and selling prices of goods remain constant, ROA will be much higher in
later years.
• Sinking-fund depreciation – The only benefit of this method is that the income reported should reflect
ROI earned by assets.
Depreciable Life
Depreciable life, whether it is defined by years of useful life or by production units, is the most significant
estimate that must be made in the determination of the depreciation expense.

The estimated salvage value of an asset is also important but not as significant. The role of depreciable life and
salvage value is important because it is an estimation given by management. As such, management can use this
estimation choice to manipulate current and future earnings.

The most common form of manipulation is an overstatement in the write-down of assets during a restructuring
process, which will be reported as an extraordinary item and will result in the inflation of future net profits.

Changing Depreciation Methods

Changes in depreciation methods can be done in three ways:

1. Change the depreciation method for all newly acquired assets.

2. Change the depreciation method for current and all new assets.
3. Change in depreciable life or salvage value.

Changing the Depreciation Method for All Newly Acquired Assets

The change in depreciation method will only affect future acquired assets. As a result, no past adjustment need
to be made; the only thing that will change is future depreciation expense.

That said, the change in depreciation expense will be gradual, and the change in ratios will also be gradual.

Change the Depreciation Method for Current and All New Assets
This is a much more complex change and will require all past assets to be restated to reflect the new
depreciation accounting method. For all new assets it's not really a problem, but for the past assets the
cumulative effect of the changes on past income statements must be reported (net of tax) on the current income
statement. Furthermore, these changes must be included in net income from continuing operations.

Example of effect:
Say a company changes its depreciation method, the straight-line method, to one that would have previously
created a larger depreciation expense, the double-declining method).

This will cause past expenses to be higher and income to be lower. At the time of recognition, net income from
continuing operations will decrease. Future depreciation expense will decrease (they would have already been
expensed) but will increase in future years once all of the old assets are replaced.

Look Out!
ROE and ROA will decrease even though assets and equity will decrease;
the larger impact will come from a large decrease in net income.

Change in Depreciable Life or Salvage Value

A change in depreciable life and/or salvage value is not considered an acting policy change; it is a change in estimate. As a
result, a company is not required to restate it in financial statements. The only thing that will change is the current and future
net income.
For example, if an asset's life is shortened, this will increase the company's current and future depreciation expense, and
decrease net income, ROA and ROE.
8.20 - Fixed Asset Disclosures
FIXED ASSET DISCLOSURES

The disclosure found in a company's footnote section of

its financial statements provides useful information about
the age and possible usefulness of the assets held by the
company. Using the information contained in the
footnote, an analyst can estimate the total age of the
assets held by a company.

There are three ways to estimate the average age of a

company's fixed assets:

1. Average age = accumulated depreciation / current depreciation expense = X years

2. Relative age = accumulated depreciation / ending gross investment = % of age
3. Average depreciable life = ending gross investment / depreciation expense

Look Out!
Note: All these estimations are affected by what is included in fixed assets
(asset mix). Relative age can be used only when the assets analyzed use a
straight-line depreciation method.

Though not accurate, the estimated average age of a

company's fixed assets is useful and allows an analyst to:

• Estimate if the company has old assets and will

need to invest heavily in new equipment in the
near future. If that is the case, the company
would be currently reporting an overstated net
income that is not reflective of future
profitability.
• Reveal whether a company is losing its
competitive advantage compared to another
company that has invested heavily in new
technology.

8.21 - Asset Impairment

ASSET IMPAIRMENT

What is Impairment?
Assets are said to be impaired when their net carrying
value, (acquisition cost – accumulated depreciation), is
greater than the future undiscounted cash flow that these assets can provide and be disposed for.

Under U.S. GAAP impaired assets must be recognized once there is evidence of a lack of recoverability of the
net carrying amount. Once impairment has been recognized it cannot be restored. Analysts must know that
some foreign countries and the IASB allow companies to recognize increases in previously impaired assets.

Asset impairment occurs when there are:

• Changes in regulation and business climate

• Declines in usage rate
• Technology changes
• Forecasts of a significant decline in the long-term profitability of the asset

Once a company has determined that an asset is impaired, it can write down the asset or classify it as an asset
for sale. Assets will be written down if the company keeps on using this asset. Write-downs are sometimes
included as part of a restructuring cost. It is important to be able to distinguish asset write-downs, which are
non-cash expenses, from cash expenses like severance packages.

Write-downs affect past reported income. The loss should be reported on the income statement before tax as a
component of continuing operations. Generally impairment recognized for financial reporting is not deductible
for tax purposes until the affected assets are disposed of. That said, in most cases recognition of an impairment
leads to a deferred tax asset.

Impaired assets held for sale are assets that are no longer in use and are expected to be disposed of or
abandoned. The disposition decision differs from a write-down because once a company classifies impaired
assets as assets for sale or abandonment, it is actually severing these assets from assets of continuing operations
as they are no longer expected to contribute to ongoing operations. This is the accounting impact: assets held for
sales must be written down to fair value less the cost of selling them. These assets can no longer be
depreciated.

Assets Impairment - Effects on Financial Statements and Ratios

• Past income statements are not restated. The current income statement will include an impairment loss in
income before tax from continuing operations. Net income will also be lower.
• On the balance sheet, long-term assets are reduced by the impairment. A deferred-tax asset is created (if
there was a deferred tax liability it is reduced). Stockholders' equity is reduced as a result of the
impairment loss included in the income statement.
• Current and future fixed-asset turnover will increase (lower fixed assets).
• Since stockholders' equity will be lower, debt-to-equity will be lower.
• Debt-to-assets will be higher.
• Cash flow based ratios will remain unaffected (no cash implications).
• Future net income will be higher as there will be lower asset value, and thus a smaller depreciation
expense.
• Future ROA and ROE will increase.
• Past ratios that evaluated fixed assets and depreciation policy are distorted by impairment write-downs.

8.22 - SFAS 143 Requirements

SFAS 143 was developed to account for the future obligation that will arise once an asset is sold. This is best
understood through an example. A company buys a plot of land that will be used for the treatment of lumber.
Over time, the chemicals used to treat the lumber will contaminate the land. The federal government requires
these companies to decontaminate the soil before it can be
sold. This soil decontamination costs money and
represents a future liability for the company. That is
precisely why SFAS 143 was developed.

Requirements of SFAS 143 or Asset Retirement

Obligation (ARO) to be recognized:

• Legal requirements to remove an asset or

component part must exist before any ARO is
recognized for removal costs. However, if there is
no legal obligation to remove a component, then no ARO is required.
• A legal obligation may exist to dispose of a component part of an asset: "Any legal obligations that
require disposal of the replaced part are within the scope of this Statement".
• All ARO liabilities must meet the liability criteria in FAS Concepts Statement Number 6, "Elements of
Financial Statements." Only present (current) obligations meet these criteria.

The Standard identifies examples of potential AROs, including landfill closure and nuclear decommissioning.

Accounting Implications of SFAS 143

At initiation:

• The present value (PV) of the total future cash flow obligation must be added to the balance value of the
acquired asset.
• The discount rate used in the PV calculation in the current risk-free rate plus adjustments for the credit
risk of the company.
• The present value obligation is also added in the long-term liability section of the company's balance
sheet.

After initiation (subsequent years):

• The liability portion is accreted using the rate-based accretion method. This means that each year the
liability section increases at the same rate at which it was discounted. This enables the liability section to
equal its total future value at the end of the estimated useful life of the asset.
• The annual accreted portion is expensed on the income statement and in most cases is included in the
reported interest-expense portion of the income statement.
• Since the value of the asset has increased at initiation, the depreciation will be higher than it otherwise
would have been.
• Changes in estimated liability are accounted prospectively, so prior periods are not restated.
• Disclosures required: a description of ARO and asset, reconciliation of liability, show effect of new
liabilities incurred and liabilities extinguished.

Likely effects on financial statements and ratios:

• Since depreciation expense is higher, net income will be lower.

• Net interest will most likely be higher since the accreted portion is reported in this consolidated account.
• Cash flow will be unaffected.
• Value of assets will be higher since ARO will be included.
• Long-term liability portion will be higher.
• Stockholders' equity will be lower due to lower net income.
• The debt-to-equity ratio will be higher because long-term liability increases, and stockholders' equity
will be lower.
• Asset turnover will be lower (higher asset value).
• Solvency ratios will be negatively affected (times interest earned, lower EBIT).