In the previous post, we covered the second part of the inventories series, LIFO reserve, and LIFO liquidation. From this post on, we start a new topic, long-lived assets, which we will cover in a series of posts. In today’s post, we will get introduced to tangible assets and intangible assets. So let’s begin our discussion….
Long-lived assets, also known as long-term assets, are assets that are expected to provide economic benefits over a future period, typically greater than one year. Long-lived assets may be tangible, intangible or financial assets. What are tangible assets? Tangible assets are those that have physical substance. Examples of tangible assets are plant, property, and machinery. Intangible assets are defined as those assets that do not have a physical form, such as patents and trademarks. Financial assets include investments in equity and debt.
When a firm undertakes expenditure, it can either capitalize it as an asset on the balance sheet or expense it in the income statement in the period incurred. (Click here to see the post on recognizing expense on the income statement) As a rule, we capitalize the expenditure that is expected to provide economic benefits over multiple future periods.
Therefore the cost incurred in acquiring long-lived assets is capitalized on the balance sheet. We capitalize at its fair value at acquisition plus any costs necessary to prepare the asset for use. Then we allocate the cost to the income statement as depreciation expense (tangible assets) or amortization expense (intangible assets with finite lives) over the life of the asset.
The costs of two types of long-lived assets do not get allocated to the income statement. They are land ( a tangible asset), which is not depreciated and intangible assets with indefinite lives such as acquisition goodwill. Intangible assets with indefinite lives are tested periodically for impairment. We record an impairment loss, if any, on the income statement. (Click here to see the post on goodwill)
Capitalization of expenditures related to Tangible Assets and Intangible Assets with Finite Lives
In addition to the cost of acquisition, we also capitalize the subsequent related expenditures that are expected to provide economic benefits. We expense the subsequent expenditures that merely serve to maintain the asset in the period incurred.
Effect of capitalization/expensing of costs related to long-lived assets on financial statements
When we capitalize expenditure, it increases the assets on the balance sheet. It also appears as an investing cash outflow on the cash flow statement. As the costs get allocated as depreciation or amortization expense over the life of the asset, net income stands reduced in the income statement. The value of the asset also stands reduced on the balance sheet. Depreciation and amortization expense are noncash expenses and therefore have no effect on the cash flow statement.
On the other hand, the expenditures expensed reduce the net income by the entire amount of expenditure in the period incurred. Reduced net income leads to reduced retained earnings on the balance sheet.
Expenditures expensed also get recorded as operating cash outflow on the cash flow statement. Expenditures expensed do not have any effect on financial statements in subsequent periods.
On capitalizing expenditure, the net income is higher in the period of expenditure and lower in subsequent periods. As against this, on expensing expenditure, net income is lower in the period of expenditure and higher in subsequent periods. The same applies to profitability ratios.
Likewise, on capitalizing expenditure, shareholder’s equity is higher in the period of expenditure (via retained earnings). On expensing it, shareholder’s equity is lower in the period of expenditure compared to subsequent periods.
Capitalizing expenditure rather than expensing it also results in higher cash from operations.
Tangible assets: Costs incurred at acquisition
The purchase price is the cost incurred to acquire a tangible asset such as property, plant, and equipment. We also add all expenditures incurred to get the asset ready for use to the cost of the asset.
In a monetary exchange, the purchase price is readily determinable. In a non-monetary exchange, the fair value of the asset given up or the fair value of the asset acquired, if it is readily determinable, is the cost of acquisition.
Capitalization of interest costs
When an asset is constructed either for own use or resale, we capitalize the costs that accrue during the construction period as part of the cost of the asset. We capitalize interest cost to better match costs with revenue generated from the asset.
Capitalized interest cost is allocated to the income statement through depreciation expense (if the asset is for own use) or through COGS (if it is for sale). It also gets reported as an investing cash outflow on the cash flow statement.
What are intangible assets? As already discussed, intangible assets are long-lived assets that do not have a physical form. For example, copyrights, patents, trademarks, brand names, etc. Some intangible assets have finite lives while others like goodwill have indefinite lives.
Finite-lived intangible assets get amortized over their lives, and an amortization expense gets recognized on the income statement. Indefinite-lived intangible assets, on the other hand, are tested for impairment at least annually and an impairment loss, if any, gets recognized in the income statement in the period of impairment.
Intangible assets are also considered to be identifiable or unidentifiable. Under IFRS an identifiable asset is that which is;
- Separable from the firm or arises from a legal or contractual right
- Controlled by the firm
An unidentifiable asset, on the other hand, is that which is not separable from the firm. It may also have an indefinite life. An example of an unidentifiable intangible asset is goodwill. Goodwill is the excess of purchase price over the fair value of the identifiable assets (net of liabilities) in a business combination. (Click here to read more on Goodwill).
Costs of intangible assets are to be expensed or capitalized depends on whether the assets were created internally, purchased or obtained in a business combination. We will see below the treatment in each scenario.
Intangible assets created internally
In the case of most intangible assets created internally, we expense costs as they incur. Some exceptions are research and development costs and software development costs.
Under IFRS, we expense research costs as incurred and capitalize development costs. Under GAAP, we expense both research and development costs.
In the case of software development, we expense costs incurred until the product’s technological feasibility gets established, after which we capitalize the costs.
Purchased intangible assets
Purchased intangible assets are recorded on the balance sheet at their fair value at acquisition.
Intangible assets obtained in a business combination
In the case of business combinations, we apply the acquisition method. Under this method, we record the excess of purchase price over the fair value of identifiable assets (net of liabilities) as goodwill. Goodwill is an unidentifiable intangible asset that is not separable from the business itself. Goodwill created in a business combination is capitalized on the balance sheet while goodwill created internally expensed.
That’s all in this post guys…in the next part of the series, we will cover depreciation and amortization methods for intangible assets…stay tuned…
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