Long-Lived Assets

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2023 Curriculum CFA Program Level I Financial Reporting and Analysis

Introduction

Long-lived assets, also referred to as non-current assets or long-term assets, are assets that are expected to provide economic benefits over a future period of time, typically greater than one year. Long-lived assets may be tangible, intangible, or financial assets. Examples of long-lived tangible assets, typically referred to as and sometimes as fixed assets, include land, buildings, furniture and fixtures, machinery and equipment, and vehicles; examples of long-lived (assets lacking physical substance) include patents and trademarks; and examples of long-lived financial assets include investments in equity or debt securities issued by other entities. The scope of this reading is limited to long-lived tangible and intangible assets (hereafter, referred to for simplicity as long-lived assets).

The first issue in accounting for a long-lived asset is determining its cost at acquisition. The second issue is how to allocate the cost to expense over time. The costs of most long-lived assets are capitalised and then allocated as expenses in the profit or loss (income) statement over the period of time during which they are expected to provide economic benefits. The two main types of long-lived assets with costs that are typically not allocated over time are land, which is not depreciated, and those intangible assets with indefinite useful lives. Additional issues that arise are the treatment of subsequent costs incurred related to the asset, the use of the cost model versus the revaluation model, unexpected declines in the value of the asset, classification of the asset with respect to intent (for example, held for use or held for sale), and the derecognition of the asset.

This reading is organised as follows. Section 2 describes and illustrates accounting for the acquisition of long-lived assets, with particular attention to the impact of capitalizing versus expensing expenditures. Section 3 describes the allocation of the costs of long-lived assets over their useful lives. Section 4 discusses the revaluation model that is based on changes in the fair value of an asset. Section 5 covers the concepts of impairment (unexpected decline in the value of an asset). Section 6 describes accounting for the derecognition of long-lived assets. Section 7 describes financial statement presentation, disclosures, and analysis of long-lived assets. Section 8 discusses differences in financial reporting of investment property compared with property, plant, and equipment. A summary is followed by practice problems.

Learning Outcomes

The member should be able to:

1. distinguish between costs that are capitalised and costs that are expensed in the period in which they are incurred;
2. compare the financial reporting of the following types of intangible assets: purchased, internally developed, acquired in a business combination;
3. explain and evaluate how capitalising versus expensing costs in the period in which they are incurred affects financial statements and ratios;
4. describe the different depreciation methods for property, plant, and equipment and calculate depreciation expense;
5. describe how the choice of depreciation method and assumptions concerning useful life and residual value affect depreciation expense, financial statements, and ratios;
6. describe the different amortisation methods for intangible assets with finite lives and calculate amortisation expense;
7. describe how the choice of amortisation method and assumptions concerning useful life and residual value affect amortisation expense, financial statements, and ratios;
8. describe the revaluation model;
9. explain the impairment of property, plant, and equipment and intangible assets;
10. explain the derecognition of property, plant, and equipment and intangible assets;
11. explain and evaluate how impairment, revaluation, and derecognition of property, plant, and equipment and intangible assets affect financial statements and ratios;
12. describe the financial statement presentation of and disclosures relating to property, plant, and equipment and intangible assets;
13. analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets;
14. compare the financial reporting of investment property with that of property, plant, and equipment.

Summary

Understanding the reporting of long-lived assets at inception requires distinguishing between expenditures that are capitalised (i.e., reported as long-lived assets) and those that are expensed. Once a long-lived asset is recognised, it is reported under the cost model at its historical cost less accumulated depreciation (amortisation) and less any impairment or under the revaluation model at its fair value. IFRS permit the use of either the cost model or the revaluation model, whereas US GAAP require the use of the cost model. Most companies reporting under IFRS use the cost model. The choice of different methods to depreciate (amortise) long-lived assets can create challenges for analysts comparing companies.

Key points include the following:

• Expenditures related to long-lived assets are capitalised as part of the cost of assets if they are expected to provide future benefits, typically beyond one year. Otherwise, expenditures related to long-lived assets are expensed as incurred.
• Although capitalising expenditures, rather than expensing them, results in higher reported profitability in the initial year, it results in lower profitability in subsequent years; however, if a company continues to purchase similar or increasing amounts of assets each year, the profitability-enhancing effect of capitalisation continues.
• Capitalising an expenditure rather than expensing it results in a greater amount reported as cash from operations because capitalised expenditures are classified as an investing cash outflow rather than an operating cash outflow.
• Companies must capitalise interest costs associated with acquiring or constructing an asset that requires a long period of time to prepare for its intended use.
• Including capitalised interest in the calculation of interest coverage ratios provides a better assessment of a company’s solvency.
• IFRS require research costs be expensed but allow all development costs (not only software development costs) to be capitalised under certain conditions. Generally, US accounting standards require that research and development costs be expensed; however, certain costs related to software development are required to be capitalised.
• When one company acquires another company, the transaction is accounted for using the acquisition method of accounting in which the company identified as the acquirer allocates the purchase price to each asset acquired (and each liability assumed) on the basis of its fair value. Under acquisition accounting, if the purchase price of an acquisition exceeds the sum of the amounts that can be allocated to individual identifiable assets and liabilities, the excess is recorded as goodwill.
• The capitalised costs of long-lived tangible assets and of intangible assets with finite useful lives are allocated to expense in subsequent periods over their useful lives. For tangible assets, this process is referred to as depreciation, and for intangible assets, it is referred to as amortisation.
• Long-lived tangible assets and intangible assets with finite useful lives are reviewed for impairment whenever changes in events or circumstances indicate that the carrying amount of an asset may not be recoverable.
• Intangible assets with an indefinite useful life are not amortised but are reviewed for impairment annually.
• Impairment disclosures can provide useful information about a company’s expected cash flows.
• Methods of calculating depreciation or amortisation expense include the straight-line method, in which the cost of an asset is allocated to expense in equal amounts each year over its useful life; accelerated methods, in which the allocation of cost is greater in earlier years; and the units-of-production method, in which the allocation of cost corresponds to the actual use of an asset in a particular period.
• Estimates required for depreciation and amortisation calculations include the useful life of the equipment (or its total lifetime productive capacity) and its expected residual value at the end of that useful life. A longer useful life and higher expected residual value result in a smaller amount of annual depreciation relative to a shorter useful life and lower expected residual value.
• IFRS permit the use of either the cost model or the revaluation model for the valuation and reporting of long-lived assets, but the revaluation model is not allowed under US GAAP.
• Under the revaluation model, carrying amounts are the fair values at the date of revaluation less any subsequent accumulated depreciation or amortisation.
• In contrast with depreciation and amortisation charges, which serve to allocate the cost of a long-lived asset over its useful life, impairment charges reflect an unexpected decline in the fair value of an asset to an amount lower than its carrying amount.
• IFRS permit impairment losses to be reversed, with the reversal reported in profit. US GAAP do not permit the reversal of impairment losses.
• The gain or loss on the sale of long-lived assets is computed as the sales proceeds minus the carrying amount of the asset at the time of sale.
• Estimates of average age and remaining useful life of a company’s assets reflect the relationship between assets accounted for on a historical cost basis and depreciation amounts.
• The average remaining useful life of a company’s assets can be estimated as net PPE divided by depreciation expense, although the accounting useful life may not necessarily correspond to the economic useful life.
• Long-lived assets reclassified as held for sale cease to be depreciated or amortised. Long-lived assets to be disposed of other than by a sale (e.g., by abandonment, exchange for another asset, or distribution to owners in a spin-off) are classified as held for use until disposal. Thus, they continue to be depreciated and tested for impairment.
• Investment property is defined as property that is owned (or, in some cases, leased under a finance lease) for the purpose of earning rentals, capital appreciation, or both.
• Under IFRS, companies are allowed to value investment properties using either a cost model or a fair value model. The cost model is identical to the cost model used for property, plant, and equipment, but the fair value model differs from the revaluation model used for property, plant, and equipment. Unlike the revaluation model, under the fair value model, all changes in the fair value of investment property affect net income.
• Under US GAAP, investment properties are generally measured using the cost model.