FSA 7 Analysis of Long-Term Assets

Property, plant, and equipment (PPE) together with intangible assets usually form the largest slice of what a company owns, and they earn their keep across many reporting periods rather than a single one. A purely economic view of the balance sheet would list everything of value, including a firm’s reputation and the skill of its people, yet the rules under IFRS and US GAAP admit only a fairly narrow band of items to the statements. That gap between economic worth and reported worth is the first thing an analyst has to keep in mind.

Once a long-lived asset qualifies for recognition, a company measures it afterward under one of two approaches. The cost model carries the asset at historical cost less accumulated depreciation (or amortization) and any impairment. The revaluation model restates the asset to fair value at the revaluation date. IFRS lets a company choose either model; US GAAP allows only the cost model. Because firms may pick different models and different estimates, comparing two companies that hold similar assets is rarely a like-for-like exercise.

Allocating cost, and when value simply falls

The capitalized cost of a tangible asset, and of an intangible asset that has a finite life, is spread across the periods that benefit from it. For tangible assets that spreading is called depreciation; for finite-life intangibles it is called amortization. An intangible judged to have an indefinite life is not amortized at all; instead it faces an annual impairment test.

Depreciation and amortization are planned, gradual charges. Impairment is different in kind: it records a sudden, unplanned drop in an asset’s value once its carrying amount can no longer be justified. The two ideas should not be confused. One more contrast between the standards matters here: IFRS lets a company reverse an impairment loss later and run the recovery back through profit, whereas US GAAP generally forbids reversing an impairment on an asset that is still in use.

Three common patterns describe how depreciation is charged. Straight-line spreads the depreciable cost evenly, so the annual charge stays constant. Accelerated methods, such as declining balance, load more of the charge into the early years and less into the later ones. The units-of-production method ties each period’s charge to actual output, so it rises and falls with usage.

When the asset is eventually sold, the profit or loss recorded is simply the sale proceeds less whatever the asset was carried at on the day of sale.

PPE: property, plant, and equipment.

Intangible assets are items of value that have no physical form and are not money, such as patents, copyrights, trademarks, and franchise rights, each of which grants its holder some exclusive privilege. Under IFRS an item counts as an identifiable intangible asset only if it clears three definitional tests: it can be separated from the business or springs from legal or contractual rights, the company controls it, and it is expected to bring future economic benefits. Two recognition tests then apply: those benefits must be probable, and the cost must be capable of reliable measurement.

Goodwill sits apart from all of this. IFRS does not treat it as an identifiable intangible, and it appears only when one company buys another for more than the fair value of the target’s net identifiable assets. US GAAP, by contrast, folds goodwill into its broader definition of intangible assets.

How an intangible is accounted for turns on how the company got it. There are three routes: buying it on its own, building it internally, or picking it up while buying another business.

Bought separately

An intangible purchased outside a business combination, a single patent for instance, is handled just like a piece of equipment bought outright: it goes on the books at fair value, which is taken to equal the price paid. When several intangibles are bought together as a package, the total price is split among them in proportion to their individual fair values. Because assigning those values takes heavy judgement and many assumptions, an analyst usually learns more from knowing what kinds of rights were acquired, franchise rights say, than from the exact figure booked against each one. The mix of assets hints at where the company is heading.

Built internally

The costs of creating an intangible in-house are, as a rule, expensed as they occur, the opposite of how the construction cost of a tangible asset is treated. IFRS divides an internal project into two phases. Spending in the research phase, the stage at which the company cannot yet show that an asset is taking shape, must be expensed. Spending in the development phase may be capitalized once the company can demonstrate, among other conditions, that finishing the asset is technically feasible and that it intends to use or sell it.

US GAAP takes a firmer line: it expenses both research and development as incurred, with a carve-out for certain software. Costs of software meant for sale are expensed until the product reaches technological feasibility and capitalized after that; costs of software for internal use are expensed until completion becomes probable and capitalized from then on. One practical result is that a company which grows its patents or brands through in-house R&D or advertising shows fewer assets than a rival that buys the same rights. There is a cash-flow angle too: money spent developing intangibles is an operating outflow, while money spent acquiring them is an investing outflow, so a build-versus-buy choice can quietly shift several ratios.

Acquired in a business combination

When a company takes over another, the deal is recorded using the acquisition method. The buyer, identified as the acquirer, spreads the purchase price across every asset acquired and liability assumed at fair value. Whatever part of the price cannot be pinned to identifiable items becomes goodwill, which cannot be separated and sold on its own. Under IFRS the acquired assets take in any identifiable intangibles that clear the definitional and recognition tests, while anything that fails becomes part of goodwill. US GAAP recognizes an acquired intangible separately from goodwill when it either arises from contractual or legal rights or can be split off from the business, which covers items such as patents, copyrights, franchises, licenses, internet domain names, and audiovisual material.

When AB InBev acquired the SABMiller Group in 2016 for USD103 billion, the way it carved up that price shows the mechanics in action. Brands with an indefinite life accounted for almost all of the intangible value, USD19.9 billion of the USD20.0 billion total, and goodwill of USD74.1 billion was recognized on the deal.

Provisional allocation; subtotals shown as reported. Figures from the acquirer’s 2016 annual report.

Impairment and derecognition are the two events that pull a long-lived asset’s value down, or take it off the books entirely, outside the normal rhythm of depreciation and amortization.

When an asset is impaired

An asset is impaired once its carrying amount climbs above its recoverable amount, and both IFRS and US GAAP then require a write-down. The frameworks define recoverability differently and measure the loss differently, but the trigger is the same idea. PPE is not tested for impairment every year; instead, at each period-end the company looks for signs of trouble, such as obsolescence, falling demand, or a technological leap by competitors. Only when such a sign appears does it measure the recoverable amount and run the test.

Under IAS 36, IFRS sets the loss at the amount by which carrying value exceeds the recoverable amount, where the recoverable amount is the higher of fair value less costs to sell and value in use. Value in use itself equals the present value of the cash flows the asset is expected to generate. US GAAP separates the two questions. First comes recoverability: a carrying amount is deemed unrecoverable once it rises above the asset group’s undiscounted future cash flows. Only if it fails that test is a loss booked, measured as carrying amount less fair value. The write-down cuts the asset on the balance sheet and net income on the income statement, but because it moves no cash, operating cash flow is untouched.

Intangibles, finite and indefinite

Finite-life intangibles are amortized and can be impaired; like PPE they are tested only when a significant event, such as a steep drop in market price or an adverse legal or economic shift, suggests the carrying amount may be too high, and the accounting mirrors that for tangible assets. Indefinite-life intangibles are not amortized; they stay at historical cost but must be tested at least once a year, with impairment arising when carrying amount exceeds fair value. Goodwill follows the same annual-test logic.

Assets held for sale

A non-current asset is moved from held for use to held for sale when management means to sell it, the sale is highly probable, and the asset is ready for immediate sale as it stands. At that moment it is tested for impairment, and if its carrying amount sits above fair value less costs to sell it is written down to that figure. Once reclassified, it is no longer depreciated or amortized.

Reversing an impairment

A recoverable amount can later recover, for example if an appeal overturns a patent challenge. IFRS allows the earlier loss to be reversed through profit, whether the asset is held for use or held for sale, but only up to the earlier carrying amount; it does not permit writing the asset up beyond that. US GAAP splits by classification: for an asset held for use, a recognized impairment can never be reversed, while for an asset held for sale a later rise in fair value can reverse a prior loss.

Derecognition and disposal

An asset is derecognized, taken off the statements, when it is disposed of or can no longer deliver benefits from use or sale. Disposal can mean selling the asset, swapping it, abandoning it, or handing it to shareholders. For a straight sale, the gain or loss is proceeds minus carrying amount, where carrying amount is normally net book value (historical cost less accumulated depreciation) unless impairment or revaluation has already changed it. The gain or loss shows up on the income statement, either inside other gains and losses or on its own line when the amount is large. In an indirect-method cash flow statement, the gain or loss is stripped back out of operating cash flow and the sale proceeds are placed in investing activities.

Other disposals work a little differently. An asset that is retired or abandoned is treated much like a sale but with no cash coming in, so the whole carrying amount is written off as a loss. In an exchange, the company removes the carrying amount of the asset handed over, brings in the acquired asset at fair value, and books the difference as a gain or loss; the value applied is normally that of the asset surrendered unless the incoming asset’s value is clearer, and if no fair value can be measured reliably the new asset is recorded at the old asset’s carrying amount, so no gain or loss arises. In a spin-off, an entire cash-generating unit leaves with its assets and no gain or loss is recognized. When Fiat Chrysler Automobiles spun off Ferrari in early 2016, an earlier sale of a 10 percent stake through an IPO had lifted shareholders’ equity by EUR873 million, the gap between the EUR866 million received and the EUR7 million carrying amount of the interest sold, yet the spin-off itself produced no gain or loss. Ahead of it, the group reported EUR3,650 million of assets and EUR3,584 million of liabilities as held for distribution.

Disclosure rules give an analyst the raw material to see what a company owns, how it is being used up, and how those figures are changing. They differ in detail between the frameworks.

What IFRS requires

For each class of PPE, IFRS calls for the depreciation method, the measurement basis, the useful life or depreciation rate, the gross carrying amount and accumulated depreciation at both the start and the close of the period, plus a reconciliation of the carrying amount over the year. Companies must also flag restrictions on title, assets pledged as security, and commitments to buy PPE. A firm using the revaluation model adds the revaluation date, how fair value was arrived at, the carrying amount that the cost model would have shown, and the revaluation surplus.

For each class of intangible assets, IFRS asks whether useful lives are finite or indefinite. Finite-life classes require the useful lives or amortization rate, the amortization method, gross carrying amount and accumulated amortization at start and end, the income-statement line that holds the amortization, and a reconciliation. An indefinite-life asset requires its carrying amount and the reasons the life is treated as indefinite. The same restriction, pledge, commitment, and revaluation disclosures apply as for PPE.

What US GAAP requires

US GAAP asks for gross carrying amounts and accumulated amortization, both in total and broken out by major intangible class, the total amortization charge for the period, and the amortization expense projected for each of the next five fiscal years. On impairment, the two frameworks part ways: IFRS wants the losses and reversals by class and where they sit in the statements, plus the main asset classes and events involved, whereas US GAAP, which allows no reversal for assets held for use, wants a description of the impaired asset, the cause, the method used to find fair value, the loss amount, and where it is recognized.

Where the numbers appear

Long-lived asset information is scattered across the statements. The balance sheet shows carrying value. On the income statement, depreciation may or may not stand as its own line: under IFRS that depends on whether the firm groups expenses by nature (depreciation, materials, employee costs) or by function (cost of sales, selling, general, and administrative expenses). The cash flow statement records purchases and disposals in investing, and, under the indirect method, adds depreciation and amortization back in the reconciliation from net income to operating cash flow. The notes fill in methods, useful-life ranges, historical cost by category, accumulated depreciation, and annual depreciation expense.

The same disclosures feed a small set of ratios that describe how efficiently a company uses its fixed assets and how old that asset base has become.

Fixed asset turnover

Fixed asset turnover divides total revenue by average net fixed assets. A higher figure means the company squeezes more sales out of each unit of money tied up in PPE, which usually reads as greater efficiency.

How old are the assets

Asset-age measures lean on the link between historical cost and depreciation, so they work best for assets carried under the cost model; the revaluation model breaks the tidy relationship among carrying amount, accumulated depreciation, and depreciation expense. Assuming straight-line depreciation and, for simplicity, no salvage value, three estimates fall out of the disclosures.

The three tie together neatly: total historical cost equals accumulated depreciation plus net PPE, so estimated total useful life equals estimated age plus estimated remaining life. Picture a company with one asset costing USD100, a ten-year life, and no salvage value. It records USD10 of depreciation a year, so after seven years accumulated depreciation is USD70, and the age estimate, USD70 divided by USD10, correctly returns seven years.

These are rough estimates only. Real companies mix depreciation methods, hold many assets with different lives and salvage values, and disclose in broad strokes, so the figures are best used to flag places worth a closer look rather than as precise readings. Ideally the calculation excludes land, which is not depreciable, when the disclosures allow it. A companion check compares annual capital expenditure with depreciation expense: if capex runs above depreciation, the firm is roughly replacing capacity faster than it is wearing out.

How the depreciation method shapes the trend

Because the methods release cost differently, they leave different marks on the net profit margin. Straight-line, with its constant charge, produces the steadiest margin over time. An accelerated method front-loads the charge, so the annual expense falls year after year and the margin tends to improve, not deteriorate, as the asset ages, a point that is easy to get backwards. Units-of-production ties the charge to output, so the margin can swing with production volumes.

Capitalizing versus expensing, revisited

The capitalize-or-expense choice ripples through the same ratios. Expensing an outlay that could have been capitalized lowers current net income and net profit margin and leaves total assets smaller; because no depreciation on that outlay burdens later years, subsequent profit growth looks stronger. Capitalizing interest during construction parks the interest inside the asset on the balance sheet, so fixed assets are larger and fixed asset turnover is lower than under expensing. Interest coverage, though, should be measured against the total interest actually incurred, the capitalized part plus the expensed part, so a properly calculated coverage ratio is not flattered by capitalizing.