advance accounting ebook - part 11

8/13/2019 Advance Accounting eBook - Part 11

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www.educorporatebridge.comAll Rights Reserved. Corporate BridgeTM

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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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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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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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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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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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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advance accounting ebook - part 11

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