CB 3041

Financial Statement Analysis

Lecture 3_Part 1
Asset Valuation and Income
Recognition
 Learning Objectives
➢ Apply the various valuation concepts in assessing
the values of the assets and liabilities
➢ Explain how changes in valuations of assets are
recognized on the income statement and the
statement of comprehensive income
➢ Understand revenue and expense recognition
criteria
➢ Understand the differences in recurring and non-
recurring earnings and its implications on
valuation of firms
Asset Valuation & Analysis
 Importance of Asset Valuation
➢ The definition of Asset (HKAS 38): a resource
controlled by a company as a result of past
events and a source of future (reasonably
estimated) economic benefits for the company
➢ Accurately measuring the value of assets should
indicate the expected future economic benefits
➢ The future economic benefits often manifest
themselves as increases in revenue, decreases
in expenses, or reductions in cash outflows
 Mixed Asset Valuation Models
➢ IFRS and GAAP require firms to use mixed attribute
measurement model to
• Provide the most relevant and representationally
faithful information
• Assess the risk, timing, and future cash flows
➢ Depending on the nature of the asset, companies measure
the value of the asset by
• Historical cost method
• Revaluation method
Why aren’t all assets/liabilities measured using the same
valuation method?
Wouldn’t that greatly simplify financial statement analysis?
 Relevance and Representational
Faithfulness
➢ Financial information is relevant if it can influence a
user’s decision.
➢ Information is representationally faithful if it represents
what it purports to represent.
➢ Accounting standards require that some assets and
liabilities be measured based on more relevant
information and others must be based on more
representationally faithful information.
➢ Under the mixed attribute measurement model,
valuations of assets and liabilities reflect various
combinations of historical costs, fair values, and present
values of future cash flows.
 Primary Valuation Alternatives
Valuation Methods

Historical Cost Revaluation

Liabilities Liabilities
Assets Assets

Initial Present Value Market (or Fair) Value

Acquisition Cost Current Replacement Cost

Adjusted Acquisition Cost Net Realizable Value

 Historical Cost Model
➢ Acquisition Cost
• Amount paid initially to acquire the asset.
• Includes all costs required to prepare the asset
for its intended use. (e.g., sales tax, shipping,
installation, modification)
• Excludes costs to operate the asset.
• E.g., Land
 Historical Cost Model
➢ Adjusted Historical Cost
• As the asset is used, companies calculate the
new carrying value (i.e., the value on the
balance sheet) of the asset
• The asset value is reduced and the amount of
the reduction appears on the income statement
as an expense
• E.g., Buildings, equipment and other
depreciable assets, intangibles with limited
lives, inventories.
 Historical Cost Model
➢ Initial Present Value
• Monetary asset or liability
• Present value computation uses appropriate
interest rates
• E.g., Investments in bonds held to maturity,
long-term receivables and payables
For example, assume Jordan’s Furniture sells a sofa to a customer on
January 1, permitting the customer to delay payment of the $500 selling
price for five years. An assessment of the customer’s credit standing
suggests that 6% per year is an appropriate interest rate for this credit.
The present value of $500 to be received in five years, when discounted
back at 6%, is $373.63.
 Historical Cost Model
➢ Is historical cost measurement relevant and
representationally faithful?
• At the time a firm acquires an asset?
• As time passes?
 Revaluation Model
➢ Market (or Fair) Value
• Referred to as “mark-to-market” accounting
• Market value is the price that a company
would be received to sell an asset or would
paid to transfer a liability in an orderly
transaction at the measurement date.
• Exit or Entry Price
• E.g., Financial assets and commodities, such
as investments in marketable securities,
financial (derivative) instruments
 Revaluation Model
➢ Fair value approaches to valuation for financial assets and
liabilities are commonplace within GAAP and IFRS.
➢ Reporting financial assets and liabilities at fair values is
also referred to as “mark-to-market” accounting.
➢ Obtaining fair value can require management to make
estimates when there is no quoted price in an active
market for an asset or a liability.
➢ There is a three-tiered hierarchy within GAAP and IFRS
that distinguishes among different sources of fair value
estimates.
 Revaluation Model
➢ Market (or Fair) Value
• Level 1: readily available prices for identical assets in
actively traded markets, such as securities exchanges.
• Level 2: quoted prices for similar assets markets, other
observable information or data available, such as yield
curves, price indexes.
• Level 3: a firm’s own assumptions about the fair value
of an asset, such as using data about expected future
cash flows and discount rates to estimate present
values.
 Revaluation Model
➢ Current Replacement Cost
• The amount a firm would have to pay
currently to acquire or produce an asset it now
holds.
• A special case of the fair value approach
• E.g., nonmonetary assets such as certain long-
lived assets
• Subjective when no active market exist (e.g.,
equipment specific to a firm) but less so when
active market exist (e.g., raw commodities)
 Revaluation Model
➢ Net Realizable Value
• The net amount a firm would receive if it sold
an asset, offset by any pertinent selling costs.
• A hybrid form of historical cost and fair value
measurement
• Lower of cost or net realizable value
• E.g., inventory for which current value has
declined below cost
 Revaluation Model
➢ Is revaluation based on fair value measurement
relevant and representationally faithful?
• Fair value (Level 1/2/3)?
• Current replacement cost?
 Historical Cost vs. Fair Value

In general, historical cost amounts lose

relevance as valuations become old and do not
reflect current economic conditions, whereas
fair value amounts are more relevant despite
the risk that such amounts might be less
representationally faithful than historical
valuations.
 Quick Check Question 1
➢ Which of the following is most likely an essential
characteristic of an asset?
a. An asset is tangible
b. An asset is obtained at a cost
c. An asset provides future benefits
 Quick Check Question 2
➢ One valuation method that is a hybrid of historical and fair
value is the:

a. Adjusted historical cost method

b. Market (or fair) value method
c. Net realizable value method
d. Initial present value method
 Quick Check Question 3
➢ Suppose a manufacturing company has investments in (1)
privately placed bonds; (2) private equity funds. Consider
how the portfolio manager would estimate the fair values of
each of those assets, and characterize the inputs you
identify as Level 1, Level 2, or Level 3.

a. (1) Level 1, (2) Level 1

b. (1) Level 1, (2) Level 2
c. (1) Level 2, (2) Level 2
d. (1) Level 2, (2) Level 3
Accounting Standards for Asset Valuation
➢ HKAS 16 – Property, Plant & Equipment
• Cost method: Cost less depreciation
• Revaluation method: Fair value less
depreciation and recognize value changes in
OCI
➢ HKAS 40 – Investment Properties
• Cost method: Cost less depreciation
• Fair value method: Fair value and recognize fair
value changes in profit & loss account
Accounting Standards for Asset Valuation

(Source: https://www.cpdbox.com)
 Long-Lived Assets
➢These assets:
• Mainly consist of property, plant, and equipment (PPE).
• Often makeup the largest asset amounts.
• Can be measured using either cost method and
revaluation method.
• Future expenses arising from these long-term assets
often makeup the larger expense amounts.
• E.g., depreciation expense, asset write-downs, repair &
maintenance expenses.
 Cost Method Example
Building with useful Carrying Journal Entry in ‘000
life of 10 yrs Amount
in ‘000
Y0 Buy for
$3,000,000 at 31 Dec
Y1 Market value
$3,600,000
Y2 Market value
$2,800,000
Y3 Market value
$1,700,000
 Revaluation Method Example
Building with Carrying Journal Entry in ‘000
useful life of Amount
10 yrs in ‘000 in ‘000
Y0 Buy for
$3,000 at 31
Dec
Y1 Market
value $3,600

Y2 Market
value $2,800

Y3 Market
value $1,700
 Accounting Standards for Asset Valuation
➢ HKAS 38 – Intangible Assets
• Recognize purchased intangibles (separate
acquisition or acquisition as a part of a business
combination )
• Internally generated intangibles are usually not
recognized if does not meet stringent criteria.
• Reports at cost less amortization (cost method)/
fair value less amortization and recognize value
changes in OCI (revaluation method)
 Accounting Standards for Asset Valuation
➢ HKFRS 3 – Goodwill
• From business combination (M&A) -- The
acquirer shall measure the identifiable assets and
liabilities at the acquisition-date fair values, and
recognise goodwill as the excess of the
consideration transferred over the fair value of
the net assets acquired.
• Afterwards, goodwill is tested for impairment.
https://www.wsj.com/articles/companies-wrote-down-goodwill-in-spades-last-year-
as-the-pandemic-took-a-toll-11614780000?mod=djemCFO
WSJ, Mar 3 2021

• U.S. public companies last year wrote down the largest amount of
goodwill in more than a decade as the value of certain assets declined
during the Covid-19 pandemic.
• Companies report goodwill on their balance sheets when they buy a
business for more than the value of its net assets. The acquiring business
must measure the fair value of its reporting units annually. If that figure is
less than the amount recorded on the books, the company reduces the
value of the goodwill.
• Economic recessions historically lead to an increase in goodwill
impairments. Most recently, business across many industries slowed
during the pandemic.
WSJ, Mar 3 2021

• AT&T Inc. last month disclosed a $10.47

billion impairment for the year, the second
largest charge of any U.S. company in
2020. The telecommunications giant said
the write-downs were related to its pay-
television and Vrio Corp. businesses.
Cord-cutting was upending the pay-TV
market long before the pandemic, but
consumers’ shift to digital media
accelerated over the past year. AT&T paid
$49 billion for DirecTV in 2015.
Accounting Standards for Asset Valuation
➢ HKAS 2 – Inventories
• Inventories should be measured at the lower of
cost and net realizable value
(i.e., Min {cost, net realizable value})
• If net realizable value < costs → Write-down
• When the circumstances that previously caused
inventories to be written down no longer exist,
the amount of the write-down is reversed, but
limited to the amount of the original write-
down.
Accounting Standards for Asset Valuation
➢ HKAS 2 – Inventories
• What is the impact to B/S if the inventories
increase rocket high in value?
• Suppose that the historical cost of inventory is
$100, but last year, the net realizable value was
$80. Now, this year, the market for inventory
has been improved, the market price goes up to
$110. What is the value of your inventory?
 Quick Check Question 4
➢ Two years ago, Dark Rabbit Co. purchased machinery for
$500,000. At the end of last year, the machinery had a fair
value of $420,000. Assuming Dark Rabbit uses the
revaluation model, what amount, if any, is recognized in
Dark Rabbit’s net income this year if the machinery’s fair
value is $510,000? (Ignore depreciation)
a. $0
b. $80,000
c. $90,000
Effects of Asset Valuation Methods
on Financial Statements and
Financial Ratios
 Cost vs Fair Value
A Ltd. B Ltd.

Profits $30,000,000 $30,000,000

Total Assets $10,000,000 $120,000,000

ROA 300% 25%

(Return on Assets)

Which firm performs better?

 Cost vs Fair Value
A Ltd. B Ltd.
(cost basis) (fair value basis)

Profits $30,000,000 $30,000,000

Total Assets $10,000,000 $120,000,000

ROA 300% 25%

(Return on Assets)

Which firm performs better?

 Capitalization vs Expense Example 1
➢ Manufacturer Inc bought a machine and paid the following
costs in cash: $20,000 for the purchase of the machine;
$400 for delivery; $100 for installation; $5,000 for training
employees to provide maintenance on the machine; $7,000
to modify the building to accommodate and operate the
machine; and $3,000 to paint the building a more
aesthetically pleasing color.

• How much should be capitalized and how much

should expensed?

• How will these costs appear on the financial

statements?
 Capitalization vs Expense Example 1
How much should be capitalized and how much should
expensed?

All costs related to the acquisition and preparation of the

machine for its intended use should be capitalized: $20,000
purchase price; $400 delivery; $100 installation; and $7,000
building modification

Costs that are not related to the acquisition and preparation of

the machine for its intended use should be expensed: $5,000
for employee training related to maintenance and $3,000 for
painting. Neither of these costs is necessary for the
preparation of the machine. Maintenance, for example, is an
ordinary day-to-day activity to operate the machine.
 Capitalization vs Expense Example 1
How will these costs appear on the financial statements?

The capitalized costs increase property, plant, and equipment

on the balance sheet and appear as investing cash outflows on
the statement of cash flows.

The expensed costs decrease net income on the income

statement (and lower retained earnings on the statement of
shareholders’ equity) and appear as operating cash outflows
on the statement of cash flows.
 Capitalization vs Expense Example 2
CapEx Inc and Exp Corp begin the period with the same shareholders’
equity and have the same 25% tax rate. They each buy the same piece of
equipment for $30,000 at the beginning of the year. The two companies
are identical in all ways except one. CapEx capitalizes the equipment
purchase and assumes that the equipment has a life of 3 years and $0
salvage value. CapEx uses straight-line depreciation. Exp Corp expenses
the purchase immediately. The relevant end-of-year financial information
for CapEx Inc is presented below.

What is Exp Corp’s ROE? For this

calculation, use only the end-of-year
shareholders’ equity.
 Capitalization vs Expense Example 2
➢ The difference in pre-tax income between CapEx and Exp
is $20,000 = $30,000 (acquisition cost) - $10,000
(depreciation). That is the pre-tax income for Exp will be
$20,000 lower than CapEx.
➢ The tax rate for both companies is 25%, so Exp Corp will
have lower net income by (1 – tax rate) * 20,000 = .75 *
20000 = 15,000.
➢ The reduced net income will also lower the shareholders’
equity for Exp by $15,000.
➢ Therefore, Exp’s ROE = $60,000 / $985,000 = 6.1%.
 Capitalization vs Expense Example 3
Suppose that Computer Inc buys a new asset this year for $600. It
estimates that the asset has a useful life of 3 years and a salvage value of
$0. The company uses straight-line depreciation to calculate the
depreciation expense. The pre-tax profits are $400 greater than the
corresponding pre-tax profits if the company were to expense the cost
immediately. (The depreciation expense is $200 but the remaining $400 is
net PP&E.)
• Suppose that Computer Inc buys a $600 asset in Years 2 and 3 and
capitalizes the cost. Would the company still appear more
profitable in Years 2 and 3 compared to immediately expensing
the purchases?
• If the company purchases a new $600 asset and capitalizes the cost
each year after Year 3 (i.e., Year 4, Year 5, etc.), would
capitalization enhance the pre-tax profits (relative to immediately
expensing the costs)?
 Capitalization vs Expense Example 3
Suppose that Computer Inc buys a $600 asset in Years 2 and 3 and
capitalizes the cost. Would the company still appear more profitable
in Years 2 and 3 compared to immediately expensing the purchases?

In Year 2, the depreciation expense would be $200 from the first computer
and $200 from the second computer. Capitalizing the second computer
would generate an additional $200 in Year 2 (relative to immediately
expensing the cost). However, in Year 3, the capital expenditure of $600
would be exactly offset by the cumulative depreciation from the 3 assets.
 Capitalization vs Expense Example 3
If the company purchases a new $600 asset and capitalizes the cost
each year after Year 3 (i.e., Year 4, Year 5, etc.), would capitalization
enhance the pre-tax profits (relative to immediately expensing the
costs)?

The pre-tax profits would be the same under either accounting regime
from Year 3. Because capital expenditures appear under cash from
investing while expensing immediately appears under cash from
operations, the cash from operations appears greater for capitalization.
 Depreciation
➢ The costs of productive assets must be recorded in the
periods in which they provide benefits.
• Why? Matching Principle
• For buildings, equipment, etc.: Depreciation
• For intangible assets: Amortization
• For mineral deposits, natural resources, etc.: Depletion

➢ Depreciation requires the following estimates:

• Useful life: Period of time over which the asset is expected to generate
cash.
• Salvage value: Expected disposal amount at the end of its useful life.
• Depreciation rate: Estimate of how the asset will be used up over its
useful life.
 Depreciation Methods under Cost Model

➢ Straight-Line method:
• Depreciation expense = (original cost – salvage value)/depreciable
life
➢ Double Declining Balance method:
• DDB depreciation in year y = (2/depreciable life) x book value at
beginning of year y
➢ Units-of-production method:
• Units-of-production depreciation = (original cost – salvage value) x
(output units in the period/output units over life)
 Depreciation Methods under Cost Model
Straight-Line vs. Diminishing Balance Method
➢ Example:
• Purchase price (cost): $100,000
• Salvage value (residual value): $10,000
• Useful life 5 years
• SL: Annual depreciation expense = (100,000–10,000)/5 = $18,000
• DB: Rate = 2 * (1/5) = 2*20% = 40%
SL DB (Double Declining Balance)
Year Net Book Depreciation Net Book Net Book Depreciation Net Book
Value Beg Exp Value End Value Beg Exp Value End
1 100,000 18,000 82,000 100,000 40,000 60,000
2 82,000 18,000 64,000 60,000 24,000 36,000
3 64,000 18,000 46,000 36,000 14,400 21,600
4 46,000 18,000 28,000 21,600 8,640 12,960
5 28,000 18,000 10,000 12,960 2,960 10,000
 Depreciation Methods under Cost Model
Straight-Line vs. Diminishing Balance Method
Annual Depreciation Charges
45,000 Question 1:
40,000
Which method gives a greater
35,000
amount of total depreciation
30,000
expenses over the life of the asset?
25,000
SL
20,000
DDB
15,000
10,000
Net Book Value
5,000
90,000
0
80,000
1 2 3 4 5
70,000
60,000
50,000
SL
40,000
Question 2: DDB
30,000
Which method gives a greater 20,000
amount of ending net book value? 10,000
0
1 2 3 4 5
 ROA Distortion – Example
Company A
• Purchase of $1,000,000 of fixed assets on Jan. 1, 2016.
• Straight-line depreciation over 10 years, with no residual value.
• No capital expenditures.
• Gross profit (before depreciation and taxes) is $220,000 every
year.
25.0%

20.0%

15.0%

10.0%

ROA improves over time. 5.0%

0.0%
2016 2017 2018 2019 2020

Return on assets
 ROA Distortion – Example
Company A
Jan. 1 Dec. 31 Dec. 31 Dec. 31 Dec. 31 Dec. 31
2016 2016 2017 2018 2019 2020
PP&E, gross 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000
Accum Dep 0 100,000 200,000 300,000 400,000 500,000
PP&E, net 1,000,000 900,000 800,000 700,000 600,000 500,000
Capex 0 0 0 0 0

Gross Profit 220,000 220,000 220,000 220,000 220,000

Depreciation (10% of PP&E, gross) 100,000 100,000 100,000 100,000 100,000
Pre-tax Profit 120,000 120,000 120,000 120,000 120,000

Avg Assets 950,000 850,000 750,000 650,000 550,000

ROA 12.6% 14.1% 16.0% 18.5% 21.8%
Avg Age of Assets (in yrs) 1 2 3 4 5
 ROA Distortion – Example
Company B
• Purchase of $1,000,000 of fixed assets on Jan. 1, 2008.
• Straight-line depreciation over 10 years, with no residual value.
• Capital expenditures of 5% of asset base.
• Gross profit (before depreciation and taxes) is $220,000 every
year.
25.0%

20.0%

ROA does NOT improve over

15.0%
time.
10.0%

5.0%

0.0%
2016 2017 2018 2019 2020

Return on assets
ROA Distortion – Example
Company B
 ROA Distortion – Example
25.0%

20.0%

15.0%

10.0%

5.0%
ROA of Co B
0.0% 25.0%
2016 2017 2018 2019 2020
20.0%
ROA of Co A
15.0%

10.0%

5.0%

0.0%
2016 2017 2018 2019 2020

Is Company A more profitable than Company B?

 Depreciation Methods Example 1
➢ Two companies—StraightLine Inc and Declining Inc—each buy
identical equipment at the beginning of Year 1. The cost of the
equipment for each company is $2,300. Two companies have the same
estimations for the useful life, salvage value, and productive capacity of
the equipment. Two companies produce the same number of units each
year and operate identically. The companies, however, employ different
depreciation methods.
➢ The residual value is $100, and the useful life is 4 years. The total
productive capacity is 800 units. Actual annual productions are the
following for all three companies: 200, 300, 200, and 100.
➢ StraightLine Inc uses straight-line method. Declining Inc uses double-
declining balance method (twice the rate of the straight-line method is
applied to the carrying value.)
 Depreciation Methods Example 1
➢ For each of the two companies, fill out a depreciation schedule.
StraightLin Beginning Net Book Depreciation Accumulated Ending Net Book
e Inc. Value (Carrying Expense Depreciation Value (Ending
Amount) Carrying Amount)
Year 1
Year 2
Year 3
Year 4

Declining Beginning Net Book Depreciation Accumulated Ending Net Book

Inc. Value (Carrying Expense Depreciation Value (Ending
Amount) Carrying Amount)
Year 1
Year 2
Year 3
Year 4
 Depreciation Methods Example 1
➢ For each of the two companies, fill out a depreciation schedule.
• Straight-line method
Depreciation Expense = (2300 – 100)/4 = $550
This implies that depreciable expense is 25% per year (1/4 = .25).
 Depreciation Methods Example 1
➢ For each of the two companies, fill out a depreciation schedule.
• Double-declining method
Depreciation Expense = 2*.25 = .5 of carrying amount.
Depreciation expense cannot lower book value below salvage value
 Depreciation Methods Example 1
➢ Does the method of depreciation affect the ending net book value at
the end of Y4 or the accumulated depreciation? Which method
produces the smoother earnings over the four years?

No, the ending net book value is the same for all the depreciation
methods. The straight-line method produces consistent depreciation. If
all other factors are constant, then straight-line depreciation produces
the smoother earnings.
 Quick Check Question 5
➢ United Van Lines purchased a truck with a list price of
$250,000 subject to a 6% discount if paid within 30 days.
United Van Lines paid within the discount period. It paid
$4,000 to obtain title to the truck with the state and an $800
license fee for the first year of operation. It paid $1,500
to paint the firm's name on the truck and $2,500 for
property and liability insurance for the first year of
operation
 Quick Check Question 5
➢ What acquisition cost of this truck should United Van Lines
record in its accounting records?

a. $255,500
b. $240,500
c. $243,800
d. $258,800
 Quick Check Question 6
➢ In the early years of an asset’s life, a firm using the double-
declining balance method, as compared to a firm using
straight-line depreciation, will report lower:

a. Depreciation expense
b. Operating cash flow
c. Retained earnings
 Quick Check Question 7
➢ East Company purchased a new truck at the beginning of
this year for $100,000. The truck has a useful life of eight
years or 150,000 miles, and an estimated salvage value of
$10,000. If the truck is driven 16,500 miles this year, how
much depreciation will East report under the double-
declining (DDB) method and the units-of-production
(UOP) method?
DDB UOP
a. $25,000 $9,900
b. $25,000 $11,000
c. $22,500 $9,900
 Take Away
• The need for reliable and verifiable numbers makes many
firms measure long-lived assets using historical cost.
• Depreciation differences can complicate comparisons
across firms.
• Footnote details can be used to improve these
comparisons.
• Asset impairment write-downs depend on subjective
forecasts and could be used to manage earnings.
• When comparing return on assets (ROA) ratios across
firms, remember that ROA drifts upward as assets age.