Impact
· CFO - Higher (more +ve) Interest expense removed
· CFI- Lower (more -ve) Interest expense added
· Net cash position -No impact CFO and CFI balance out
· Assets -Higher Interest added to fixed assets
· Liabilities- No impact
· Equity -Higher Due to higher income
· Net income -Higher Lower expense now (higher later)
· Volatility of income- Lower Amortization smoothens expense
· Profitability (ROE, ROA)- Higher Higher NI outweighs high equity
· Leverage (Debt/Equity) -Lower Due to higher equity
· Coverage (EBIT/Interest expense) -Healthier Due to lower interest, higher CFO
· Liquidity (Current ratio)- No impact No change in CR or CL
Showing posts with label Analysis of Long-Lived Assets - Capitalization Decision. Show all posts
Showing posts with label Analysis of Long-Lived Assets - Capitalization Decision. Show all posts
Friday, November 21
Expenditures or Capitalization of Intangibles
Expenditures or Capitalization of Intangibles, R&D, Licenses, Goodwill, Advertising and Software Development
Cost of intangibles
Cost of intangibles purchased from a third party may be capitalized, while the cost of intangibles developed internally or government grants must be expensed (capitalize only the cost of production)
Research & Development
In US, research & development must be expensed;
Outside US, some development costs may be capitalized if various conditions are met.
In Canada, capitalize if product process, cost, market are clearly defined & technical feasibility established & firm has sufficient resources to complete the process & will produce the product ;
In UK, similar to Canada but most co expensed the cost.
Franchise/license costs
may be capitalized and expensed over the period of contract.
Goodwill
The diff between acquired value and fair market value. Generated in the purchase method acquisition is capitalized. US GAAP does not permit amortization of this goodwill unless aforesaid purchase method acquisition, while IASB GAAP does.
Advertising costs
Generally expensed, except the cost of the direct response advertising program , which may be capitalized if ad directly to produce future benefit
Software development costs
must be expensed if the software has not yet reached the point of economic feasibility. After this point, further costs may be capitalized.
Notes:
· Don’t confuse capitalization of expense with capitalization of leases.
Cost of intangibles
Cost of intangibles purchased from a third party may be capitalized, while the cost of intangibles developed internally or government grants must be expensed (capitalize only the cost of production)
Research & Development
In US, research & development must be expensed;
Outside US, some development costs may be capitalized if various conditions are met.
In Canada, capitalize if product process, cost, market are clearly defined & technical feasibility established & firm has sufficient resources to complete the process & will produce the product ;
In UK, similar to Canada but most co expensed the cost.
Franchise/license costs
may be capitalized and expensed over the period of contract.
Goodwill
The diff between acquired value and fair market value. Generated in the purchase method acquisition is capitalized. US GAAP does not permit amortization of this goodwill unless aforesaid purchase method acquisition, while IASB GAAP does.
Advertising costs
Generally expensed, except the cost of the direct response advertising program , which may be capitalized if ad directly to produce future benefit
Software development costs
must be expensed if the software has not yet reached the point of economic feasibility. After this point, further costs may be capitalized.
Notes:
· Don’t confuse capitalization of expense with capitalization of leases.
Capitalization of interest costs
In general, interest costs are expensed, exept for a loan taken for construction of a long-lived asset, the interest costs during the construction period can be capitalized. Due to its distortion in income statement, analyst need to adjust.
Rules for capitalization of interest:
· Only the interest incurred during construction period can be capitalized.
· If the firm has no debt, it cannot capitalize any interest costs.
· If a loan has been taken specifically for the construction, only the interest on that loan may be capitalized.
· If no specific loan can be linked to the construction, capitalization must be based on weighted average cost of borrowing.
Adjustment
· Interest Expense adjustment – add capitalized interest (disclosed in footnote) during the year to interest expense
· Depreciation adjustment – deducted the amortized interest in previous years to depreciation expense (may need estimate as the information not disclosed in footnote, ignore if small)
· CF adjustment – add capitalized interest during the year to CFI and substracted from CFO
· Ratio adjustment – eg interest coverage/profitability ratio- should recalculate with restated figures
Rules for capitalization of interest:
· Only the interest incurred during construction period can be capitalized.
· If the firm has no debt, it cannot capitalize any interest costs.
· If a loan has been taken specifically for the construction, only the interest on that loan may be capitalized.
· If no specific loan can be linked to the construction, capitalization must be based on weighted average cost of borrowing.
Adjustment
· Interest Expense adjustment – add capitalized interest (disclosed in footnote) during the year to interest expense
· Depreciation adjustment – deducted the amortized interest in previous years to depreciation expense (may need estimate as the information not disclosed in footnote, ignore if small)
· CF adjustment – add capitalized interest during the year to CFI and substracted from CFO
· Ratio adjustment – eg interest coverage/profitability ratio- should recalculate with restated figures
Capitalization of long-lived assets
· When a firm concludes that a resource being acquired is a long-lived asset, its cost can be capitalized and then amortized over its life.
· Long-lived 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.
Some implications:
· Expenditure is over 1 year in general and in form of depreciation -> NI variability lower;
· Profitability-return on sales higher,
· profitability-ROA/ROE higher in early year but lower in later years;
· CF higher due to tax, if ignore tax->no change in net CF as expense-> decrease CFO & captization-> decrease CFI; Leverage ratio Lower
· Long-lived 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.
Some implications:
· Expenditure is over 1 year in general and in form of depreciation -> NI variability lower;
· Profitability-return on sales higher,
· profitability-ROA/ROE higher in early year but lower in later years;
· CF higher due to tax, if ignore tax->no change in net CF as expense-> decrease CFO & captization-> decrease CFI; Leverage ratio Lower
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