In our initial discussion of assets, we were introduced to current assets. These are assets that are converted into cash within one year or the operating cycle, whichever is longer. Current assets are Cash, Receivables, Inventory, Prepaids and Other Assets. These assets are necessary for operations of a business (i.e. assets needed to run a business.) Now we will begin discussing Long Lived or Productive Assets. These assets are the productive resources of a company. To McDonalds: they are the restaurants, to Boeing: the huge factory in Seattle, to Exxon: the refineries and service stations they own across America and to a utility the power plant, transmission lines and cables needed to transport power across the service area.

When an asset is acquired we record it at its historical cost. The asset remains on the books at that cost and is then depreciated over its useful life. The recorded asset amount is not increased, as we have discussed, conservatism requires an exchange occur before any asset is revalued. However, depreciation recognizes that productive assets decline in value, wear out or become obsolete. Accountants consider depreciation as the systematic and rational allocation of the cost of an asset over its useful life. It is important to understand that depreciation does not attempt to precisely measure an assets decline in value rather depreciation transfers (allocates) the cost of the asset from the balance sheet to the income statement over the life of the asset.

There are several different types of long lived assets accounts, Property Plant and Equipment, Land and Natural Resources. These assets are considered tangible while patents and copyrights, some leases, goodwill and software development costs are classified as intangibles.

One problem we face with long lived asset is the determination of whether the expenditure is an expense in the current period or an amount to be capitalized and expensed in future periods. We look to the underlying nature of the item in question. If we overhaul a truck engine and extend its useful life, then we capitalize the expenditure. However, a tune-up, keeps the vehicle running in good operating condition is an expense.

Interest capitalization, we briefly discussed the subject of interest capitalization in a chapter three forum. The subject of interest capitalization is quite controversial to accountants. Some believe that if you bought an asset (like a bridge or power plant) included in the purchase price is the interest cost the builder incurred. Therefore, if you build the asset yourself (self constructed asset) it is justified to include the cost of borrowing (interest), during the construction period in the assets valuation. A problem occurred in the Marble Hill example (Marble Hill was a nuclear power plant constructed but never completed in Southern Indiana) when a utility is capitalizing hundreds of millions and even billions of dollars of interest costs years before the plant comes on line. The asset is shown at several billion dollars of cost and yet is essentially worthless unless it becomes a productive facility. In the case of Marble Hill, it was eventually abandoned and all the construction costs were written off. Shareholders, creditors and current customers all shared in the loss.

The theory of interest capitalization becomes interesting, because, if you are a current customer you like capitalization because it defers to the future the burden of building new productive facilities. Utilities also like interest capitalization since their rate base is linked to a ROA figure. Shareholders may also see more profit, therefore higher dividends. Creditors are the group most at risk since fewer real resources exist to collateralize the borrowing.

GAAP permits the capitalization of interest costs on self constructed assets, however, if you are analyzing a company consider whether these cost should be expensed and what would net income look like with all interest cost being expensed in the period incurred.

After reviewing the concept of depreciation, we need to discuss the methods of depreciation.

What do we need to know before calculating depreciation expense.

The cost of the asset, including all costs reasonable and necessary to get the asset where you want it, when you want and in the condition you want it in.

The service life of the asset. Not necessarily how long it will last. Basketball arenas around the country are being replaced after 15 years not because they are worn out rather because they functionally no longer serve the needs of the basketball franchises. Therefore, functional life is more important than physical life. Computers are another example of assets they still work but are often obsolete.

Value at the end of the functional life. Salvage value or (residual value) is our best guess as to what the asset will be worth at the end of its useful life.

What depreciation method will we choose to use.

Which depreciation method is the most appropriate to select. It should be the method that does the best job of measuring the true pattern of economic decline the value of the asset. Which method is actually selected? Since management has discretion over which method to choose they frequently choose the method that most favorably effects income. Note that unlike the LIFO method of inventory valuation, a company can have a different method of depreciation for tax purposes than the method used in the financial statements.

As an asset depreciates its book value declines. When the asset is disposed, retired or written-off then we must record the event. The event may generate a gain or loss on the transaction. For example:

Chapter 7 Special Topics

This section gives a brief review of special topics covered in the Long Lived asset section.

Impaired Assets: If an asset no longer can generate future cash flows sufficient to equal its book value then the asset must be permanently written down to lower of cost or fair value. This is very significant in the oil and gas industry when an oil well runs out of recoverable reserves sooner than expected.

Exchanges: When we trade one asset or another we generally measure a loss if the fair market value of the asset is less than its book value at the time of exchange. Gains are only recognized in dissimilar exchanges. Page 198 provides an example of the journal entries. Problem 7-3 gives an additional review problem.

Tax Depreciation and Investment Credits: These topics are fairly narrow and I don’t plan to spend time on them. Conceptually, I favor a tax break specifically associated with a purchase to be an adjustment to the purchase price of the asset rather than a reduction in tax expense. If you wish to discuss these tax issues further because of an issue you confront, let me know.

Natural Resources: Very similar to units of production method for depreciation. The expensing of natural resources is called depletion and we have no accumulated depletion account.

Intangibles: Intangibles are long lived assets that have no physical structure. Several issues with intangible do occur and will be briefly discussed here.

Goodwill: Goodwill is only created when one company purchases another company. Normally, when accounting for an acquisition, the price paid should approximate the value of the tangible assets. In the normal case, we allocate the purchase price to all the tangible assets acquired. However, companies sometimes pay more than the measured value of the company. Reasons could be superior management, elimination of a competitor, or some hidden value that can not be assigned to physical assets. The excess paid over the value of the tangible assets acquired is goodwill. The creation of goodwill was once a real problem because it was not deductible for tax purposes, now however, since 1993, goodwill is deductible if certain conditions are met over a period of 15 years. Accountants permit amortization of goodwill over a period no to exceed 40 years, however, we should see 15 years as a common period for most goodwill.

To the analyst goodwill has little or no value and is almost a nuisance on the balance sheet.

Patents, copyrights, and franchise rights are very important to companies. If developed internally they are expensed, if purchased from an external transaction then they are classified as assets and amortized over legal lives. 17 years for patents, life of the artist + 50 years after 1974 for copyrights (formally 28 years, so you can now record your favorite Beatles song).

Research and Development: R&D is expensed when incurred, although conceptually inaccurate, since there is no objective way to measure future value, conservatism gives rise to this treatment. Many complicated transactions have been created to manipulate this accounting treatment. It is not unusual for large R&D companies to form separate entities (limited partnerships) expressly for the purpose of internally developing R&D and then buying back the outcome when the work is competed. When evaluating these type of companies, look closely at the way R&D is handled and if affiliated companies formed for development.

Software Development: One significant exception to the R&D rule is software development costs. The development costs of software that is to be sold, leased or licensed is to be expensed until the point of technological feasibility. Between the point of feasibility and actual sale the costs are capitalized and then amortized. Companies like Microsoft are able to show substantially higher incomes because of this exception. Essentially during the beta testing phase of Windows or Office Suite software, all these costs were being deferred and expensed over the first few years of product sale.

Leased Assets: Leases are a way to simultaneously acquire and finance asset acquisition in one transaction. I argue that leasing is simply another way to finance a purchase, therefore we will cover leases in chapter 8, with the other ways to raise capital.