Reading 22: Long-lived Assets: Implications for Financial Sta property, equipment, statements, 2011, class

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Session 5: Financial Reporting and Analysis: Inventories and Long-lived Assets
Reading 22: Long-lived Assets: Implications for Financial Statements and Ratios

LOS c: Discuss the implications for financial statements and ratios of impairment and revaluation of property, plant, and equipment, and intangible assets.

 

 

Lakeside Co. recently determined that one of its processing machines has become obsolete three years early and, unexpectedly, has no salvage value. Which of the following statements is most consistent with this discovery?

A) Historically, economic depreciation was understated.

B) Historically, economic depreciation was overstated.

C) Lakeside Co. will owe back taxes.

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Historically, economic depreciation was understated. If an asset becomes obsolete and its useful life is less than expected, accounting methods for depreciation have understated the economic depreciation. In addition, if there is no salvage value when positive salvage value was expected, the understatement problem is compounded.

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As part of a major restructuring of business units, General Security (an industrial conglomerate operating solely in the U.S. and subject to U.S. GAAP) recognizes significant impairment losses. The Investor Relations group is preparing an informational packet for shareholders, employees, and the media. Which of the following statements is least accurate?

A) The write-downs are reported as a component of income from continuing operations.

B) During the year of the write-downs, retained earnings and deferred taxes will decrease.

C) Write-downs taken on asset values can be reversed in later years if market conditions improve.

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Impairments cannot be restored under U.S. GAAP. Both remaining statements are correct.

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Under U.S. GAAP, an asset is impaired when:

A) accumulated depreciation plus salvage value exceeds acquisition costs.

B) the firm can no longer fully recover the carrying amount of the asset.

C) the present value of future cash flows exceeds the carrying amount of the asset.

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An asset is impaired if its future cash flows (undiscounted) are less than its carrying value.

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An analyst determined the following information concerning Franklin, Inc.’s stamping machine:

• Acquired seven years ago for $22 million
• Straight line method used for depreciation
• Useful life estimated to be 12 years
• Salvage value originally estimated to be $4 million

The stamping machine is expected to generate $1,500,000 per year for five more years and will then be sold for $1,000,000. Under U.S. GAAP, the stamping machine is:

A) impaired because its carrying value exceeds expected future cash flows.

B) not impaired.

C) impaired because expected salvage value has declined.

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The carrying value of the stamping machine is its cost less accumulated depreciation. Depreciation taken through 7 years was ($22,000,000 - $4,000,000) / 12 × 7 = $10,500,000, so carrying value is $22,000,000 - $10,500,000 = $11,500,000. Because the $11,500,000 carrying value is more than expected future cash flows of (5 × $1,500,000) + $1,000,000 = $8,500,000, the stamping machine is impaired.

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An impairment write-down is least likely to decrease a company's:

A) debt-to-equity ratio.

B) assets.

C) future depreciation expense.

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An impairment write-down reduces equity and has no effect on debt. The debt-to- equity ratio would therefore increase.

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Taking an impairment of long-lived assets will result in:

A) increased deferred tax liabilities.

B) increased future ROA.

C) decreased debt/equity ratio.

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In future years, less depreciation expense is recognized on the written-down asset resulting in higher net income and return on assets since ROA = NI/Total Assets. Deferred tax liabilities related to the asset decrease because the impairment cannot be deducted from taxable income until the asset is sold or disposed of. The debt/equity ratio increases because equity decreases while debt is unchanged.

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Marcel Inc. is a large manufacturing company based in the U.S. but also operating in several European countries. Marcel has long-lived assets currently in use that are valued on the balance sheet at $600 million. This includes previously recognized impairment losses of $80 million. The original cost of the assets was $750 million. The fair value of the assets was determined in a professional appraisal to be $690 million. Assuming that Marcel reports under U.S. GAAP, the new appraisal of the assets’ value most likely results in:

A) a $90 million gain in other comprehensive income.

B) an $80 million gain on income statement and $10 million gain in other comprehensive income.

C) no change to Marcel’s financial statements.

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Under U.S. GAAP, long-lived assets are reported on the balance sheet at depreciated cost less any impairment losses ($750 million original cost less $70 million accumulated depreciation and less $80 million impairment loss, for a net amount of $600 million). Increases are generally prohibited with the exception of assets held for sale. Since these assets are currently in use, this exception does not apply. Therefore, Marcel may not revalue the assets upward.

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Davis Inc. is a large manufacturing company operating in several European countries. Davis has long-lived assets currently in use that are valued on the balance sheet at $600 million. This includes previously recognized impairment losses of $80 million. The original cost of the assets was $750 million. The fair value of the assets was determined by in independent appraisal to be $690 million. Which of the following entries may Davis record under IFRS?

A) $80 million gain on income statement and a $10 million revaluation surplus.

B) $90 million gain on income statement.

C) $90 million revaluation surplus.

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Under IFRS, firms may choose to report long-lived assets at fair value. Upward revaluations are permitted and will result in a gain recognized on the income statement to the extent it reverses a previously recognized loss. Any excess is reported as a revaluation surplus, a direct adjustment to equity. In this case, the carrying value of the assets is $600 million ($750 million original cost less $70 million accumulated depreciation and less $80 million impairment loss). The fair value is $690 million. Of the $90 million excess of fair value over carrying value, $80 million is recognized as a gain on the income statement to reverse the $80 million impairment loss that was previously recognized. The remaining $10 million is recorded as a revaluation surplus in shareholders' equity.

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A firm revalues its long-lived assets upward. All other things equal, which of the following financial impacts is least likely to occur?

A) Higher earnings in the revaluation period.

B) Higher profitability in the periods after revaluation.

C) Lower leverage ratios.

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Because the asset has now been increased to a higher depreciable base, there will now be higher depreciation expense and therefore, lower profitability in the periods after revaluation. There could be higher earnings in the revaluation period because there may be impairment losses that can be reversed on the income statement. Otherwise, there will be an adjustment to earnings through other comprehensive income. Leverage ratios (i.e. debt to equity) will decrease since the increase in assets will be balanced by an increase in equity. Higher denominators and unchanged numerators will result in lower leverage ratios.

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Selected information from Ingot Company’s financial statements for the year ended December 31, 20X4, was as follows prior to the consideration of its impaired asset write-down (in $):

Cash	120,000		Short-term Debt	290,000
Accounts Receivable	200,000		Long-term Debt	740,000
Inventory	300,000		Common Stock	800,000
Property Plant & Eq. (net)	1,700,000		Retained Earnings	490,000
	2,320,000			2,320,000

Ingot Company’s excavation machine is permanently impaired. Its purchase price was $1,600,000 and its accumulated depreciation was $800,000 through 20X4. The present value of its future cash flows is $500,000.

The write-down of the excavation machine will cause Ingot’s total debt ratio (total debt-to-total capital) to:

A) decrease from 0.44 to 0.40.

B) increase from 0.44 to 0.51.

C) increase from 0.44 to 0.48.

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The write-down of the excavation machine in the amount of ((($1,600,000 ? $800,000) ? $500,000) =) $300,000 decreases retained earnings from $490,000 to $190,000. The total debt to equity ratio increases from (($290,000 + $740,000) / ($290,000 + $740,000 + $800,000 + $490,000) =) 0.44 to (($290,000 + $740,000) / ($290,000 + $740,000 + $800,000 + $190,000) =) 0.51.