3.3 Long-term assets and liabilities

Types of Long-Term Assets

Long-term assets are resources a company expects to use for more than one year. They're the backbone of operations and future revenue generation. How you classify them determines their accounting treatment on the balance sheet.

Tangible vs. Intangible Assets

Tangible assets have a physical form you can see and touch: machinery, buildings, vehicles, land. Intangible assets lack physical substance but still hold real value: patents, trademarks, copyrights, and goodwill.

The accounting treatment differs between the two. Tangible assets are generally depreciated (except land), while intangible assets with finite lives are amortized. Intangible assets with indefinite lives (like goodwill) aren't amortized but are tested for impairment annually.

Depreciable vs. Non-Depreciable Assets

• Depreciable assets lose value over time through wear, tear, or obsolescence. Equipment, vehicles, and buildings all fall here. You recognize depreciation expense each period to allocate the cost over the asset's useful life.
• Non-depreciable assets maintain or increase their value. Land is the classic example. Because land doesn't wear out or become obsolete, you don't depreciate it.

A common mistake: if you buy land with a building on it, you need to allocate the purchase price between the two. The land portion is not depreciated; the building portion is.

Held for Use vs. Held for Investment

Assets held for use are actively employed in operations to generate revenue, like a factory's production equipment. Assets held for investment sit outside normal operations and are expected to generate income or appreciate in value, like a rental property owned by a manufacturing company.

This classification matters because it affects where the asset appears on the balance sheet and how gains or losses are reported when the asset is eventually sold.

Acquisition of Long-Term Assets

When a company acquires a long-term asset, the central question is: what costs get included in the asset's recorded amount? Getting this right affects every future period's depreciation expense.

Cost of Acquisition

The recorded cost includes everything necessary to get the asset ready for its intended use:

• Purchase price (minus any discounts or rebates)
• Non-refundable taxes and duties
• Delivery and handling charges
• Installation and setup costs
• Professional fees directly tied to the acquisition (e.g., legal fees for a land purchase)

Costs that do not get capitalized include general administrative overhead, training costs for employees to use the asset, and costs incurred after the asset is already operational.

Capitalization of Interest Costs

When a company constructs an asset (or has one built), interest costs incurred during the construction period are capitalized as part of the asset's cost rather than expensed immediately. This only applies to qualifying assets, which are assets that require a substantial period of time to get ready for use.

Three conditions control the capitalization period:

1. Start capitalizing when expenditures have been made, borrowing costs are being incurred, and construction activities are underway.
2. Suspend capitalization during extended periods when active construction is interrupted.
3. Stop capitalizing when the asset is substantially complete and ready for its intended use.

The amount capitalized is limited to the actual interest cost incurred during the period. You cannot capitalize more interest than you actually paid.

Asset Retirement Obligations

An asset retirement obligation (ARO) is a legal obligation to dismantle, remove, or restore a long-lived asset at the end of its useful life. Think of a mining company required to restore land after extraction, or a company obligated to remove an oil platform.

• The ARO is measured at its present value when initially recognized.
• That present value amount gets added to the cost of the related asset (increasing the depreciable base).
• Over time, the liability grows through accretion expense (essentially unwinding the discount as the obligation gets closer to settlement), while the added asset cost is depreciated over the asset's useful life.

Depreciation of Long-Term Assets

Depreciation is the systematic allocation of a depreciable asset's cost (minus salvage value) over its useful life. It's not about tracking the asset's market value; it's about matching the cost of the asset to the periods that benefit from its use.

Depreciation Methods

Straight-line is the simplest: you spread the depreciable amount evenly across each period.

$\text{Depreciation Expense} = \frac{\text{Cost} - \text{Salvage Value}}{\text{Useful Life}}$

Declining balance is an accelerated method that applies a fixed percentage to the asset's carrying amount (not the original depreciable base) each period. Double-declining balance uses twice the straight-line rate:

$\text{Depreciation Expense} = \text{Carrying Amount} \times \frac{2}{\text{Useful Life}}$

Sum-of-the-years' digits is another accelerated method that applies a decreasing fraction to the depreciable base each year.

The choice of method should reflect how the asset's economic benefits are consumed. If benefits are consumed evenly, straight-line makes sense. If the asset is most productive early on, an accelerated method is more appropriate.

Useful Life Estimation

Useful life is the period over which an asset is expected to contribute to operations. It's based on judgment and influenced by:

• Physical wear and tear from use
• Technological obsolescence (a computer may physically last 10 years but be outdated in 3)
• Legal or contractual limits (a lease on equipment may cap useful life)

These estimates should be reviewed periodically. If circumstances change, the remaining depreciable amount is allocated over the revised remaining useful life on a prospective basis (you don't go back and restate prior periods).

Salvage Value Considerations

Salvage value (also called residual value) is the estimated amount a company expects to receive when it disposes of the asset at the end of its useful life. You subtract salvage value from cost to get the depreciable base.

$\text{Depreciable Base} = \text{Cost} - \text{Salvage Value}$

If salvage value is expected to be zero or immaterial, the entire cost is depreciated. Like useful life, salvage value estimates should be reviewed regularly and updated prospectively if expectations change.

Impairment of Long-Term Assets

Impairment happens when an asset's carrying amount (cost minus accumulated depreciation) exceeds its recoverable amount. In other words, the asset is on the books for more than it's actually worth. Recognizing impairment prevents the balance sheet from overstating asset values.

Indicators of Impairment

You don't test every asset for impairment every period. Instead, you watch for triggering events:

• A significant decline in the asset's market value
• Adverse changes in the business environment, technology, or legal landscape
• Evidence that the asset's physical condition has deteriorated beyond expectations
• A noticeable decline in the asset's economic performance or cash flows
• Plans to dispose of the asset earlier than originally expected

When any of these indicators are present, impairment testing is required.

Impairment Testing Process

1. Identify the specific asset or cash-generating unit (CGU) to test.

2. Determine the recoverable amount, which is the higher of:

   • Fair value less costs of disposal
   • Value in use (the present value of expected future cash flows from the asset)

3. Compare the recoverable amount to the carrying amount.

4. If the carrying amount exceeds the recoverable amount, recognize an impairment loss for the difference.

Measurement of Impairment Loss

$\text{Impairment Loss} = \text{Carrying Amount} - \text{Recoverable Amount}$

The loss is recognized in profit or loss and reduces the asset's carrying amount on the balance sheet. Going forward, depreciation is recalculated based on the new (lower) carrying amount.

Under IFRS, impairment losses on assets other than goodwill can be reversed in future periods if conditions improve. Under U.S. GAAP, reversals of impairment losses are generally not permitted for assets held for use. This is a distinction worth remembering for exams.

Derecognition of Long-Term Assets

Derecognition means removing an asset from the balance sheet. This happens when the asset is disposed of or when no future economic benefits are expected from its use.

Disposal of Long-Term Assets

Disposal can take several forms:

• Sale to another party for cash or other consideration
• Abandonment when the asset is simply taken out of service with no proceeds
• Exchange for another asset (nonmonetary exchange rules apply)

At the point of disposal, you remove both the asset's cost and its accumulated depreciation from the books.

Gains or Losses on Disposal

$\text{Gain or Loss} = \text{Net Disposal Proceeds} - \text{Carrying Amount}$

• If proceeds exceed carrying amount, you recognize a gain (reported as income).
• If carrying amount exceeds proceeds, you recognize a loss (reported as an expense).
• If the asset is abandoned with no proceeds, the entire remaining carrying amount is written off as a loss.

Make sure depreciation is recorded up to the date of disposal before calculating the gain or loss. A common exam error is forgetting to update accumulated depreciation before derecognizing the asset.

Types of Long-Term Liabilities

Long-term liabilities are obligations a company expects to settle beyond one year (or beyond the operating cycle, if longer). They represent a major part of a firm's capital structure and directly affect financial leverage.

Bonds Payable

Bonds are debt securities issued to raise capital from investors. Every bond has three key features:

• Face value (par value): the amount repaid at maturity
• Stated interest rate (coupon rate): determines the periodic cash interest payments
• Maturity date: when the principal must be repaid

Bonds can be issued at par (market rate equals coupon rate), at a discount (market rate exceeds coupon rate, so investors pay less than face value), or at a premium (coupon rate exceeds market rate, so investors pay more than face value).

Notes Payable

Notes payable are written promises to pay a specified amount at a future date. They differ from bonds mainly in that they're typically issued to a single lender (like a bank) rather than sold to multiple investors.

• Secured notes are backed by collateral (specific assets pledged).
• Unsecured notes rely solely on the borrower's creditworthiness.
• Interest is usually paid periodically, with the principal due at maturity.

Leases

Under current standards (ASC 842 / IFRS 16), leases are contracts that convey the right to use an asset for a period in exchange for payments.

• Finance leases (called "capital leases" under older terminology) transfer substantially all the risks and rewards of ownership to the lessee. The lessee records both a right-of-use asset and a lease liability.
• Operating leases also result in a right-of-use asset and lease liability on the balance sheet under current standards, but the expense recognition pattern differs: operating leases recognize a single straight-line lease expense, while finance leases split the expense into depreciation and interest components.

Initial Recognition of Long-Term Liabilities

When a long-term liability is first recorded, it's measured at its fair value (typically the present value of future cash flows). Getting the initial measurement right is critical because it sets the baseline for all subsequent interest expense calculations.

Present Value Concepts

Present value is the current worth of cash flows you'll pay (or receive) in the future, discounted at an appropriate rate. The core idea is the time value of money: a dollar today is worth more than a dollar a year from now because today's dollar can be invested.

For a single future payment:

$PV = \frac{FV}{(1 + r)^n}$

For an annuity (a series of equal payments):

$PV = PMT \times \frac{1 - (1 + r)^{-n}}{r}$

When measuring a bond's issue price, you calculate the present value of both the periodic interest payments (annuity) and the lump-sum principal repayment at maturity, using the market rate as the discount rate.

Effective Interest Method

The effective interest method amortizes any discount or premium on a liability so that interest expense reflects a constant rate applied to the carrying amount each period.

1. Calculate interest expense for the period: Carrying Amount × Effective (Market) Interest Rate.
2. Determine the cash interest payment: Face Value × Stated (Coupon) Rate.
3. The difference between interest expense and the cash payment is the amortization of the discount or premium.

For a discount, interest expense exceeds the cash payment, so the carrying amount increases each period toward face value. For a premium, the cash payment exceeds interest expense, so the carrying amount decreases toward face value.

Debt Issuance Costs

Debt issuance costs are incremental costs directly tied to issuing debt: legal fees, underwriting fees, registration costs, and similar charges.

• These costs are deducted from the initial carrying amount of the liability (they're presented as a contra-liability, not as a separate asset).
• They're amortized over the life of the debt using the effective interest method, which slightly increases the effective interest rate.

Subsequent Measurement of Long-Term Liabilities

After initial recognition, you update the carrying amount of long-term liabilities at each reporting date. This involves amortizing discounts or premiums, accruing interest, and accounting for any changes to the debt's terms.

Amortization of Discount or Premium

A discount exists when the liability's initial carrying amount is below face value. A premium exists when it's above face value. Through amortization, the carrying amount gradually converges to face value by the maturity date.

Using the effective interest method ensures that the interest rate recognized in each period stays constant, even though the dollar amount of interest expense changes as the carrying amount changes.

Accrual of Interest Expense

Each period, interest expense is recognized based on the carrying amount of the liability multiplied by the effective interest rate. If the reporting date falls between interest payment dates, the company records accrued interest payable as a current liability for the portion of interest that has been incurred but not yet paid.

When the next cash interest payment is made, it reduces the accrued interest liability.

Modifications or Exchanges of Debt

Sometimes a borrower renegotiates the terms of existing debt (changing the interest rate, extending the maturity, or adjusting the principal). Other times, old debt is replaced entirely with new debt.

The accounting treatment hinges on whether the change is substantial:

• Apply the 10% test: if the present value of cash flows under the new terms differs by 10% or more from the present value of remaining cash flows under the old terms, the modification is treated as an extinguishment of the old debt and recognition of new debt.
• If the difference is less than 10%, the modification is accounted for prospectively by adjusting the carrying amount and recalculating the effective interest rate.

Derecognition of Long-Term Liabilities

Derecognition of a liability occurs when the obligation is extinguished, meaning the company is released from the responsibility to pay.

Extinguishment of Debt

Debt can be extinguished through:

• Repayment at maturity (paying face value)
• Early repayment or open-market repurchase before maturity
• Legal release by the creditor
• Substantial modification of terms (which triggers derecognition of the old liability under the 10% test)

Upon extinguishment, the carrying amount of the liability is removed from the balance sheet.

Gains or Losses on Extinguishment

$\text{Gain or Loss} = \text{Carrying Amount of Liability} - \text{Consideration Paid}$

• If you pay less than the carrying amount, you recognize a gain.
• If you pay more than the carrying amount, you recognize a loss.

For example, if a bond has a carrying amount of $\$980{,}000$ and the company repurchases it on the open market for $\$950{,}000$, the company recognizes a $\$30{,}000$ gain on extinguishment. Any unamortized debt issuance costs must also be written off at the time of extinguishment.

Presentation and Disclosure

Financial statement users need enough information to assess a company's long-term commitments and the assets supporting its operations. Presentation and disclosure requirements serve that purpose.

Balance Sheet Classification

Long-term assets and liabilities are presented separately from current items. Typical asset classifications on the balance sheet include:

• Current assets (cash, receivables, inventory)
• Long-term investments (equity investments, held-to-maturity securities)
• Property, plant, and equipment (tangible operating assets, shown net of accumulated depreciation)
• Intangible assets (patents, goodwill, shown net of accumulated amortization where applicable)

Liabilities are split into current (due within one year or the operating cycle) and non-current (due beyond that). If a portion of long-term debt matures within the next year, that portion is reclassified as a current liability.

Notes to Financial Statements

The notes supplement the numbers on the face of the financial statements. For long-term assets and liabilities, required disclosures typically include:

• Assets: depreciation/amortization methods used, useful life estimates, carrying amounts by category, details of any impairment losses recognized
• Liabilities: maturity dates and repayment schedules, interest rates (stated and effective), collateral pledged, covenants and restrictions, details of any debt modifications or extinguishments

These disclosures give users the context they need to evaluate the numbers on the balance sheet and understand the assumptions behind them.