advance accounting ebook - part 11
TRANSCRIPT
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8/13/2019 Advance Accounting eBook - Part 11
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Advanced Accounting E-Book
Part 11 of 12
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Discussion topics
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
AdvertisementsResearch & Development
Software Development
Calpine Corp Case Study
Sum up..
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Capitalization vs Expensing
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Capitalization versus expensing
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
Management discretion in exercising these choices can significantly impact the financialstatements and the ratios
Cost incurred
Balance Sheet
Net Income(Depreciation or
AmortizationExpense)
CFI Outflow
IncomeStatement
Net Income(Expense)
CFO outflow
Capitalization Expensing
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WorldCom Case
Most infamous example of inflating earnings through improper capitalization ofexpenses
FinancialStatement
Effects
AccountingTreatment
Regulators?
Transaction$3.8bn 2001-02expenditure on
line costs
What wasrequired as per
GAAP
$3.8bn must betreated asoperatingexpense
Pre-tax Incomeshould be
deducted by$3.8bn
What WorldComdid?
WorldComcapitalized the
costs
$3.8bn wascapitalized and
put on thebalance sheet
(foramortization)
WorldCom declaredbankruptcy in July 2002.
Chief accounting andfinance executives charged
with securities fraud
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Effect on Financial Statements
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Financial Statement Effects
Income Statement Effects
Balance Sheet Effects
Cash flow effects
Income Statement Expensing Capitalizing
Income Variability Greater variability Smoothening effect on netincome from year to year
Matching of revenues Less matching of revenues andcosts
Cost deferred and matched withrevenues
Profitability (Early years) Lower as all expenses flowthrough the IS
Higher as cost is amortized
Profitability (Later years) Higher as all cost has beenexpensed
Lower due to amortization ofcapitalized cost
Balance Sheet Expensing Capitalizing
Asset and Liability Lower Higher
Leverage Ratios (debt/equity,debt/asset)
Higher Lower due to higher base
Book Value/Share Lower Higher
Cash Flow Expensing Capitalizing
Cash Flow from Operations Lower Higher
Cash Flow from Investing Higher Lower
Total Cash Flows Same Same
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Analytical adjustments
Calculate?
Example: Capitalize versus expense
Balance Sheet Assets 2007 2006Total Current assets $9,300 $8,700Net property, plant and equiptment $21,600 $20,400Total Assets $30,900 $29,100
Balance Sheet Liabilities 2007 2006Total current liabilities $4,875 $4,125Long-term debt $9,150 $10,350Deferred taxes $1,575 $1,425Common shareholder's equity $15,300 $13,200Total liabilities and Equity $30,900 $29,100
Income Statement 2007Sales $60,000COGS ($45,000)Gross profit $15,000
Operating expense ($9,750)Operating profit $5,250Interest expense ($750)Earnings before taxes $4,500Taxes (@ 30%) ($1,350)Net Income $3,150
Example: Capitalize versus expense
During 2007, the company discovered that $2,250 of its operating expenses shouldhave been capitalized, which would also have increased depreciation expense by $300
Calculate the following:
Ratios calculation Before
capitalizationAfer
capitalizationProfit Margin 5.3%Return on capital 13.0%Cash flow from operations $3,300Cash flow from investing ($1,500)Total cash flow $150Long term Debt/Equity 59.8%
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Effects of Capitalization versus expensing
Calculate the Adjusted Net Income
Calculate the Adjusted Total Assets
Calculate the Ratios Adjusted income is used for thecalculations
Total cash outflow remains the same(ignoring the effect of tax)
Ratios calculation Before
capitalizationAfer
capitalization
Profit Margin 5.0% 7.5%Return on capital 12.5% 17.0%Cash flow from operations $3,300 $5,550Cash flow from investing ($1,500) ($3,750)Total cash flow $150 $150Long term Debt/Equity 59.8% 53.0%
Note: Cash flow calculation ignore tax impact
Operating expense added back
Additional depreciation expensed
Calculation of Adjusted Net Income 2007Earnings before taxes $4,500
Add: Operating expense incorrectly deducted $2,250Less: Additional depreciation ($300)Adjusted EBT $6,450Tax @ 30% ($1,935)Adjusted Net Income $4,515
Adjusted Total Assets 2007Total Asset $30,900Capitalized expense $2,250Depreciation expense ($300)Total adjusted debt $32,850
Total Adjusted Equity $17,250
Capitalized expense added to TotalAsset in the balance sheet
Equity needs to be adjusted:$15,300+ $2,250 - $300
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Capitalization on Interest
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Capitalization of interest
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 ofbeing 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)
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Capitalization of interest
Calculation of Avoidable Interest
Illustration:
Weighted-average accumulatedexpenditures (WAEE)
Avoidable interest
Appropriate interest rate
Capitalize the avoidable interest expense
X
Example : Capitalized Interest
During the current year, RKDF construction has been constructing a building to be used for productionRKDF makes the two payments in 2007 Following debt was outstanding throughout 2007
Date Payment Amount Outstanding Rate1-Feb-07 $50,000 $60,000 10%1-Aug-07 $75,000 $75,000 8%
Calculate the following:a) Appropriate interest rateb) Actual interestc) Avoidable interest
This note is specifically for thecurrent project
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Capitalization of interest
Calculation of Weighted Average Expenditure
Calculation of Actual interest expense
Calculation of Avoidable interest expense
Avoidable interest ($7,367), should be capitalized in the balance sheet
Date Expenditure1-Feb-07 $45,8331-Aug-07 $31,250
WAEE $77,083
$50,000 x (11/12)
$75,000 x (5/12)
Debt Amount InterestNote @ 10% $60,000 $6,000Note @ 8% $17,083 $1,367WAEE $77,083 $7,367
Upto $60,000 project specificloan @ 10%; Remaining loan
$17,083 @ 8%
Debt Amount InterestNote @ 10% $60,000 $6,000Note @ 8% $75,000 $6,000
$135,000 $12,000
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Intangibles Capitalized or Expensed
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
GoodwillGoodwill 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 suchbenefits are very difficult to measure
GAAP requires immediate expensing of most advertising costs
More conservative than capitalization!
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Intangibles Capitalized or Expensed
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 apportionedamong the individual assets acquired
SFAS 2 requires that a portion of purchase price be allocated to in-process R&D and beimmediately written off
Managers have a strong incentive to allocate a large portion of the purchase price topurchased in-process R&D
$4,000
$600
$400
In-process R&D withalmost certain future
Tangible Assets
Purchase price
$5,000
In-processR&D (no future
alternative)
Immediately written off
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Intangibles Capitalized or Expensed
BMW Group
Example : Research & Development Costs
BMW Group (in euro million) 2007 2006Revenues $46,656 $44,335Cost of sales (35,992) (34,040)Gross profit $10,664 $10,295Sales and administrative costs (4,762) (4,648)Research and development costs (2,464) (2,334)
Other operating income & expenses 355 461Profit before financial result $3,793 $3,774Financial result (506) (191)Profit before tax $3,287 $3,583Income taxes (1,048) (1,341)Net profit $2,239 $2,242
BMW Group (in euro million) 2005 2004
Research and development costs $2,464 $2,334Amortisation (745) (637)New expenditure for capitalised development costs 1,396 1,121Research and development costs $3,115 $2,818
R&D as a separate line item inIncome Statement
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Intangibles Capitalized or Expensed
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 andthats their main asset
This prompted FASB to be more liberal while formulating SFAS 86
Research
expenditures
Development
expenditures
Technologically feasibleExpensed asincurred
Capitalized andamortized
Before After
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Intangibles: Capitalize/ Expense
Intangible Asset Treatment as per US GAAP
Research and development Expensed as incurred
Patents and copyrights Costs incurred in development are expensed but if a patent orcopyright is purchased then the cost is capitalized
Franchise and license costs Capitalized by the purchasing firm
Brands and trademarks Capitalized by the purchasing firm
Advertising costsExpensed as incurred (exception being direct responseadvertising costs which are capitalized)
Goodwill May be recognized and capitalized only in purchase transactions.Under US GAAP goodwill is subject to an impairment test
Computer software &development costs
All costs incurred in feasibility studies are expensed but subsequentdevelopment costs of an established product can be capitalized
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Calpine Case Study
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Calpine Case Study
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?
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Sum Up..
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