Accounting for investments and long-term assets
I sit for Part One of the CMA exam at the end of June, and I'm at the point of my preparation where (already having gone through all the units and taking notes) I'm going back to the beginning and doing practice problems.
Practice problems for the first few sections--accounting cycle, financial statement analysis, asset valuation--have been fairly straightforward. But, man, practice problems centered on investments and long-term assets have shined a spotlight on my knowledge gap in these areas. I clearly haven't mastered the material yet, so I figured writing a blog post on the topic could help.
This will be a boring blog post that interests no one besides me. Not sure why I felt compelled to write that previous sentence since that describes every post on this blog.
Investments in debt securities
Important to note that accounting rules differ for investments in debt securities and equity securities. So equity securities will be next.
Debt securities represent a creditor relationship with an entity. This includes:
Redeemable preferred stock
Government securities, e.g. T-bills and T bonds
Derivatives, i.e. options, futures, forwards
Notes receivable (even though they seem like it)
Investments in debt securities can be classified in 3 distinct ways:
Held-to-maturity (HTM): for these you need a positive intent to hold to maturity + the ability to hold to maturity. Based on the time to maturity, these are current (<1 year to maturity) or non-current (>1 year to maturity) assets
Trading: bought and held with intent to sell in near term, generally recorded as current assets
Available-for-sale (AFS): sort of in the middle of trading and HTM, generally non-current assets, ultimately based on intent
Trading and AFS debt securities are reported at fair value. HTM debt securities are reported at amortized cost.
For the two reported at fair value, there's a difference in how gains/losses are recognized. Unrealized gains/losses on trading securities are recognized right away in Net Income, no need to wait for gains/losses to become realized via a sale.
But for AFS securities, unrealized gains/losses are recognized in Other Comprehensive Income (OCI) until they are sold, at which point the gain/losses becomes realized and recognized in Net Income. However, there is an exception for credit losses, if the value of the AFS security declines due to expected credit losses, that loss should be booked to Net Income not OCI.
For HTM securities reported at amortized cost, no unrealized gains/losses are recognized. And no realized holding gains/losses from sale of HTM securities because they are held to maturity, it's right there in the name.
There could be situations where investments in debt securities ought to be transferred between classifications. Obviously transfers should only occur when justified, i.e. when there's a change in intent to hold a particular security to maturity.
These reclassifications are all accounted for at fair value, we just need to understand what we do with any unrealized holding gains. Here are the 4 scenarios:
From trading to any other classification - any unrealized gains/losses have already been recognized, so no adjustment is needed, easy breezy
From any other classification to trading - unrealized gains/losses recognized in current period earning, i.e. Net Income
From HTM to AFS - unrealized gains/losses recorded in OCI
From AFS to HTM - you need to amortize the unrealized gains/losses from OCI with any bond premium/discount amortization (not gonna lie, not sure what this looks like in practice, haven't seen any review problems that detail this, if I do later on, I'll come back and update this)
For debt securities, a credit loss is recognized if it's determined that all principal and interest won't be collected. Using Current Expected Credit Loss (CECL) model, we recognize this as a period expense, essentially an allowance against the investment. Hence, impairment.
For HTM, we have to consider if we are going to collect all the principal and all the interest. If the answer is no, the security should be reported at the present value of the principal and interest we expect to collect. The difference between this and the amortized cost is recognized as a credit loss.
For AFS, credit losses are limited by the amount the fair value falls below the amortized cost. Because if all else fails, you won't sell, you'll just hold to maturity as that's the best value you can get, so it doesn't make sense to mark it below that point.
For trading, no need to worry about impairment because trading securities are always marked to fair value.
*Sale of debt securities*
For trading, difference between book value and selling price is recognized as realized gain/loss. This is just about timing as book value equals fair value but as of last period end. Think if security was marked to market at end of period 2, but we sell the middle of period of 3, we have to mark to market for whatever is unrealized mid-period.
For AFS, difference between original cost and selling price gets recognized as realized gain/loss in Net Income and accumulated OCI for unrealized gain/loss is written off.
Investment in equity securities
Wow, I took too long writing the debt securities section. Hopefully, this section is simpler.
Equity securities represent ownership interest or right to acquire or dispose an ownership interest. This includes:
Warrants/rights/call options (rights to acquire)
Put options (rights to dispose)
Preferred stock redeemable at the investor's option
Mandatorily redeemable stock
FVTNI - Fair Value through Net Income, this is generally applicable to all equity securities, think trading.
But this is accounting so there are, of course, exceptions:
Equity method investments - if you own at least 20%
Consolidated investees - you own greater than 50%
Practicability exception - if fair value is not readily determinable, investment reported at cost less impairment +/- the observable price changes
Unrealized holding gains/losses are recognized in Net Income as they occur. Normal dividends are recognized in Net Income as they occur.
A liquidating dividend, however, is a return of capital, thus reduces my investment basis. That's giving me back some of my original investment, that's not income.
And of course, when you sell an equity security, any remaining changes in fair value are recognized as a gain/loss.
Property, Plant, and Equipment
These are assets with physical substance, acquired for use in operations, not for resale. They include land, building and equipment--generally subject to depreciation. Classified in these buckets:
Accumulated depreciation (contra-asset)
Historical cost = costs to acquire + cost to bring to locations and intended use, e.g. transportation, installation
GAAP and IFRS used the following cost model:
Carrying value = historical cost - accumulated depreciation - impairment
IFRS only allows for revaluation model:
Carrying value = fair value at revaluation date - subsequent accumulated depreciation - subsequent impairment
Revaluation losses run through P&L (unless you are reversing prior gains in OCI). More or less the same as impairment, just not permanant.
Revaluation gains run through OCI (unless you are reversing prior losses in P&L).
Impairment reverses revaluation gains first, then reporting through P&L.
Check out this amazing illustration to demonstrate:
Why does depreciation exist? The matching principle, we are trying to match income to expense. Doesn't the asset generate income over it's life? Yes, ok then, we match revenue and expense over its life.
The depreciation method doesn't have to be perfect, but it must be systematic and rational.
The need to depreciate an asset can be physical (related to wear and tear) or functional (related to obsolescence or inadequacy). Regardless, we come up with an estimated useful life. And usually at that point, the asset has some salvage value.
We can depreciate at the asset level. Or we can go narrower and depreciate at the component level, separating each part of the fixed asset, e.g. motor needs replaced every 5 years, whole machine lasts 20.
Or we can go broader and depreciate at the composite level, averaging useful lives for an asset class and depreciate as a group. Note: there is no gain/loss recognized when one asset in a composite is sold; instead, the gain/loss is absorbed in the accumulated depreciation account when the average service life of the group of assets has not been reached. No ideas what MACRS is, but it's not compatible with composite depreciation.
Ok, these involve some math, so hopefully I do them justice in a mere bullet point list:
Straight-Line: (cost - salvage value) / estimated useful life = depreciation ... simple, depreciation expense is same amount each period
Sum-of-the-Years'-Digits: this is an accelerated method, best described via example. Say it's 5 years, 1 + 2 + 3 + 4 + 5 = 15. Year 1 depreciation is 5/15 of total, year 2 is 4/15, year 3 is 3/15, year 4 is 2/15, year 5 is 1/15
Units of production: based on usage, e.g. copier is good for number of copies, this is the most accurate to matching principle. So (cost - salvage value) / estimated units = rate per unit; then rate per unit * number of units = depreciation expense
Declining balance: another accelerated method, most common is double. Importantly, salvage value is not part of calculation, just used as floor. So for double, calculate straight-line without salvage value, double that for year one. Year 2 take what's left, straight-line then double. For instance, $10m asset, 5 year life, $2m salvage value. Year 1 is $10m / 5 * 2 = $4m. $6m left to go. Year 2 is $6m / 5 * 2 = $2.4m. $3.6m left to go. Year 3 is $3.6m / 5 * 2 = $1.44m, $2.16m left to go. Don't need to do the math for Year 4, just take it down to $2m, thus $0.16m and stop as we hit the salvage value floor. I think I did that right.
These are not physical but used in operations, for instance, long-lived legal rights, competitive advantages, acquisitions to be used.
They can be specifically identified, e.g. patents. Or they can't be, e.g. goodwill.
They can be purchased, e.g. legal and registration fees. Or they can be internally developed, e.g. trademarks.
What about R&D? GAAP says no, just expense it. IFRS says, expense research, but capitalize development. The line between research and development is technological feasibility. More precisely, IFRS allows you to capitalize development if you prove
Technological feasibility
Will generate future economic benefits
Resources are available to complete
*Capitalization of costs*
Cost are capitalized and measured by:
Cash paid or fair value of other assets
Present value of liability incurred
Fair value of consideration for issued stock
Costs may be determined by whichever is more evident:
Fair value of the consideration given
Fair value of property acquired
Cost of unidentifiable intangible assets = total cost of assets acquired - sum of identifiable assets acquired. Cost of identifiable assets should not include goodwill.
Amortization with definite life is determined by: shorter of estimated life or remaining legal life. For instance, if patent lasts for 10 years, but useful life is 5, we amortize for 5. While if patent lasts for 10, but useful life is 20, we amortize for 10. Straight-line method should be applied unless you can demonstrate that another systematic method is more appropriate.
With indefinite life, you need to test for impairment annually. IFRS allows intangible to be marked to market like fixed assets, GAAP does not.
Pretty obvious: selling price vs. carrying value to determine gain/loss.
Under GAAP, use the cost model:
Finite life: cost less amortization and impairment
Infinite life: cost less impairment
IFRS allows for cost model or revaluation model. Revaluation model is just what it sounds like, intangible assets are revalued to fair value at a subsequent revaluation date:
Revaluation model carrying value = fair value on revaluation date - subsequent amortization - subsequent impairment
(Subsequent amortization obviously only applies to finite life intangible assets)
Revaluations must be performed regularly so carrying value doesn't differ materially from fair value. If you revalue one intangible asset, you have to do so for all other assets in its asset class, unless there is no active market for the intangible assets. Treatment as follows:
Gains: in OCI (unless reversing prior loss in Net Income) accumulating in Equity as "Revaluation Surplus"
Losses: in Net Income (unless reversing prior gain in OCI)
Impairment: first reduces Revaluation Surplus to zero, then hitting Net Income
Mostly we are talking property, plant, and equipment here.
Is there impairment? Compare undiscounted future net cash flows to net carrying value:
If positive, no impairment
If negative, yes impairment
Impairment on assets held for use, take fair value (aka present value of future net cash flows) less net carrying value to get impairment loss, then:
Restoration is not permitted
Impairment on assets held for disposal, same impairment loss calculation but have to add cost of disposal to get total impairment loss, then:
Impairment loss is reported as a component of income from continuing operations before income taxes.
Under IFRS, fixed asset impairment loss is: calculated using one-step model comparing:
Recoverable Amount is greater of:
Fair Value less Cost to Sell
Future Cash Flows from the Fixed Asset
*Intangible assets other than goodwill*
Indefinite useful life, tested for impairment at least annually. Finite useful life, whenever circumstances change that indicate carrying value may not be recoverable.
Under GAAP, finite life amortized over its life, infinite life not amoritized.
Two-step impairment test for FINITE life intangible assets:
Carrying amount of asset compared to sum of undiscounted cash flows expected to result from use of asset and its eventual disposition
If carrying amount exceeds those undiscounted cash flows, then asset is impaired and impairment loss = difference between carrying value and fair value
Determine impairment: use undiscounted future cash flows
Amount of impairment: use fair value
One-step impairment test for INDEFINITE life intangible assets:
Generally not able to estimate future cash flows here, so simply compare carrying value to fair value. Though it's probably not that simple.
Again, impairment loss is reported as a component of income from continuing operations before income taxes. (Unless, of course, the impairment loss is related to discontinued operations.)
The impairment test of intangible assets is the same as the test for property, plant, and equipment above...but there is a initial qualitative test for indefinite life intangibles that you do first to skip the rigamarole when it's obvious there's impairment when fair value is below carrying value.
Under GAAP, calculated at the reporting unit level. Again, occurs when carrying value exceeds fair value. A reporting unit is an operating segment or one level below an operating segment.
Under IFRS, calculated at the cash-generating unit.
Quantitative test isn't necessary, GAAP allows for qualitative test, as long as >50% chance fair value is less than carrying value based on factor such as these:
Overall financial performance
Bankruptcy, litigation, or changes in management/strategy/customers
Industry or market conditions
Sustained decrease in share price
Cost factors that could have negative effect on earning and cash flows
Recapping asset differences between GAAP and IFRS
More details on most of this above...
Development costs: GAAP no but for software for external use, IFRS yes with technical/economic feasibility
Revaluation: GAAP no, IFRS yes if active market exists (but not goodwill)
Long-lived assets and revaluation:
Revaluation: GAAP no, IFRS yes
Component depreciation: GAAP permitted, IFRS required
Revision of depreciation methods, residual values, or estimated life: GAAP if appropriate, IFRS at least every year
Capitalization of borrowing costs: GAAP on interest paid during construction/do not offset interest income/average interest on average accumulated expenditures capitalized, IFRS interest and other ancillary costs and changes to FX rates regarded as adjustments to interest are eligible/interest expense is offset against interest income/actual borrowing cost capitalized
Impairment: GAAP two-step test (see above), IFRS one-step test (see above)
Reversal of impairment loss: GAAP yes up to previously recorded losses but only if asset held for disposal/not permitted if asset held for use, IFRS yes/gains to OCI/losses to Net Income
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