(07 36334) Financial Statement Analysis and

Business Valuation

Lecture 2:

Tangible non-current assets &

intangible assets

Week 2

Dr. Chun Yu Mak

Assistant Professor in Accounting & Finance
 Learning objectives

◼ Concepts of non-current assets

◼ Tangible non-current assets valuation & analysis

1. Cost model
2. Revaluation model

◼ Intangible assets valuation & analysis

◼ Off-balance-sheet assets
 Learning outcomes:

After this lecture, you must know:

◼ What are tangible non-current assets and intangible assets?

◼ What are conditions & effects of capitalising and expensing the

tangible and intangible assets?

◼ What are methods of cost allocation?

◼ Cost Model and Revaluation Model

◼ Aware of off-balance assets

 Non-current assets
◼ Resources or claims to resources used to generate operating revenues (or
reduce operating costs) for more than 1 year or operating cycle, which ever
is longer. They are not held for resale.

◼ Tangible non-current assets have physical substance and are held for the
purpose of generating operating revenue in the ordinary course of business
(i.e., natural resources, property, plant, equipment, machinery, vehicles
etc).

◼ Intangible assets (i) have no physical substance but are identifiable and
controlled by the entity through legal rights or physical custody (copyright,
licences, patents, trademarks, goodwill etc). (ii) They are inseparable from
a company. (iii) They have indefinite benefit periods. (iv) Their values
depend on changes in competitive environment.
◼ For tangible and intangible non-current/current assets deriving operating
revenue in the ordinary course of business, we classified them as
“operating assets” (Penman, 2013).
◼ Other tangible and intangible non-current/current assets deriving financial
income, we classified them “non-operating assets” (Penman, 2013).
 Capitalisation of tangible non-current assets
◼ It is a process of deferring a cost that is incurred in the current financial
year, but whose benefits are expected to extend to one or more financial
years. It creates an asset account.
◼ Historical cost principle is used for valuation. Justification includes: going
concern, conservatism, accountability & objectivity.
◼ Capitalised costs include (i) purchase price/market price/fair value, (ii) all
attributable costs necessary to bring a asset to usable or serviceable
condition and location (i.e. freight, installation, taxes, set-up, dismantling,
removal and restoration costs etc), and (iii) initial estimate of the costs of
dismantling and removing the item or restoring the site on which it is
located.

◼ Conditions of capitalization:
• It must arise from a past transaction or event
• It must yield identifiable & reasonably probable future benefits
• It must allow owner (restrictive) control over future benefits
• The cost of transaction can be measured reliably (IAS 16, para. 7)
• The cost will increase future economic benefits associated with the assets
(IAS 16, para. 7)
Transactions do no meet above conditions will be expensed.
 Capitalisation vs. expensing
◼ Effects on income
-Income in the year of capitalising an asset is higher, but lower in
subsequent periods as comparing with expensing the costs. Second,
capitalisation yields a smoother income series as it allocates asset cost
over benefit periods (depreciation/depletion) rather than expensing
the cost in 1 year.
◼ Effects on return on investment (ROI)
-Capitalising-less volatile ROI, expensing-more volatile ROI.
◼ Effects on operating cash flows
-Assets costs immediately expensed—operating cash outflow,
-Assets costs capitalised-investing cash outflow.
-Expensing of asset costs causes overstating of operating cash outflows
and understating investment cash outflows.
◼ Effects on solvency ratio (debt to equity)
-Expensing-poor solvency.
 Comparative patterns of net income With and
Without Capitalisation
500
Net Income (£'000)

400

300

200

100

0
1 3 5 7 9 11 13 15 17 19 21 23 25
Years Expensed
Capitalised

Source: Subramanyam (2014), Financial Statement Analysis, 11th Ed. McGraw Hill.
 Comparative patterns of ROI With and Without
Capitalisation
50%
45%
40%
35%
30%
ROI

25%
20%
15%
10%
5%
0%
1 3 5 7 9 11 13 15 17 19 21 23 25

Years
Expensed
Capitalised

Source: Subramanyam (2014), Financial Statement Analysis, 11th Ed. McGraw Hill.
 Comparative patterns of cash flows from
operations With and Without Capitalisation
600
Cash flows from operations

500

400
(£'000)

300

200

100

0
1 3 5 7 9 11 13 15 17 19 21 23 25
Years Expensed
Capitalised

Source: Subramanyam (2014), Financial Statement Analysis, 11th Ed. McGraw Hill.
 Comparative patterns of debt to equity ratios With
and Without Capitalisation
4.5
4
Debt to equity ratio

3.5
3
2.5
2
1.5
1
0.5
0
1 3 5 7 9 11 13 15 17 19 21 23 25

Years Expensed
Capitalised

Source: Subramanyam (2014), Financial Statement Analysis, 11th Ed. McGraw Hill.
 Cost model: Cost allocation of non-current assets
◼ It is a process of allocating the cost of a non-current asset to
expense in the accounting periods benefiting from its use.
Justification-accrual concept/matching principle. Cost allocation
only.
◼ (i) useful economic life, (ii) depreciation methods and assumptions,
(iii) residual/salvage value, & (iv) acquisition/developed costs.
◼ However, assets held as investment and ready for trading purpose-
no depreciation is required.
◼ Depreciation rates of non-current assets [UK FRS 15 (and IAS 16 Property
Plant and Equipment)]:
Freehold land Nil
Freehold building 2% -50yrs (IAS 16: 40 years)
Long lease >50yrs 2% -50yrs
Short lease Over life of the lease
Tenants’ improvement Over life of the lease
Plant & machinery 10% -10yrs (IAS 16: 5 to 15 years)
Vehicles 20% -5yrs (IAS 16: 5 to 15 years)
Ships, according to type 4-10% -10-25yrs (IAS 16: 5 to 15 years)
Furniture & equipment 10% -10yrs (IAS 16: 5 to 15 years)
 Methods of Cost Allocation:

Straight-line/non-current instalment method

➢ (83% of US, 80% of UK).

➢ Annual depreciation
= (Costs – Residual value) / Useful economic life

Diminishing/Reducing balance method

➢Depreciation rate (DepR), where n is useful economic
life. 1
 1  (Residual value  Cost) n

Annual depreciation = DepR x Opening B/S of non-current

assets
Sum-of-years’-digits method

➢Annual depreciation (for example a asset’s economic life

is 5 years)
= (Costs – Residual Value) x 5/[5(5+1)/2]

Unit of production method (for natural resources)

➢ Depreciation per unit

= (Costs – Residual value) / Total units of prod./extract

➢ Annual depreciation
= Depreciation per unit x Prod./extract units in the period
 Depreciation/depletion analysis
➢ Analyze plant asset age—measures include

Average total life span = Gross plant and equipment assets /

Current year depreciation expense.
Average age = Accumulated depreciation /
Current year depreciation expense.
Average remaining life = Net plant and equipment assets /
Current year depreciation expense.
Average total life span = Average age + Average remaining life

➢ Assess reasonableness of depreciable base: (i) useful economic life, (iii)

depreciation methods and assumptions, (iii) residual/salvage value, (iv)
acquisition/developed costs, and (v) changes in technology.

➢ Opportunity of earning management: optimistic at estimating assets

lives, salvage values and depreciation schedule, then, operating profit
increase. Otherwise decrease.

➢ Evaluate adequacy of depreciation—ratio of depreciation to total assets

or to another size-related factors
 Change in expected useful life

➢ UK FRS 15, the revised amount should be depreciated over the

revised life.
➢ US, the same.
➢ IAS 8 Changes in Accounting Estimates, paragraph 14, same
requirement.

Change in method of cost allocation

➢ UK FRS 15, the change is allowed only if the new method

will give a fairer presentation of the results and of the
financial position. Such changes does not constitute a
change of accounting policy.
➢ US GAAP, the same (textbook Ch. 6 pp.312-314).
➢ IAS 8, paragraph 14, same requirement.
 Fair value
What is fair value?
 It is the amount for which an asset could be exchanged between
knowledgeable, willing parties in an arm’s-length transaction.

How to measure fair value?

⚫ Basically, it is market value; in economic term, it represents the
opportunity cost of giving up an assets or assuming a liability (IAS 16)
⚫ The process of determining it necessarily involves judgement and
estimation. The company is not actually selling the asset in market place
for cash, but just try to estimate the amount it would be if it was sold.

What conditions for measuring fair value?

⚫ Nature of the product market: highly volatile with prices changes or not.
⚫ Availability of the product market: if no, estimation is required with
referring to complement asset or similar goods.
 Revaluation model for tangible non-current assets

 The conditions for capitalization and expensing remain the same.

 Tangible non-current assets are valued at fair value, regular

revaluations are required (IAS 16), para. 31).

 Incremental value => revaluation reserve account under equity in B/S

 Decrement in value => income statement if fair value < original cost.

 This valuation model is NOT permitted by US GAAP

 See example.
 Example of revaluation model for tangible non-current assets (IAS 16)
On 31/12/2005, a machine was bought, market price was £10,000. Its economic useful live is 10
years, no residual value.
Dr. Machine £10,000
Cr. Cash £10,000

On 31/12/2006, assuming the fair value of it is £9,500.

Dr. Depreciation – (then to income statement) £1,000
Cr. Accumulated depreciation £1,000

Dr. Accumulated deprecation £1,000

Cr. Machine £500
Cr. Revaluation reserve £500

(Machine value after revaluation = £10,000 - £500 = £ 9,500)

* The company must reassess the economic useful life and residual value of revalue assets.
Assuming that the new economic live is 10 years and no residual value, so the annual
depreciation is £9,500 / 10 = £950.

On 31/12/2007, assuming the fair value of it is £7,550 – asset impairment UK FRS 11, US SFAS 144,
IASC IAS 36.
Dr. Depreciation – (to the income statement) £950
Cr. Accumulated depreciation £950
Dr. Revaluation reserve £500
Dr. Income statement £500
Dr. Accumulated depreciation £950
Cr. Machine £1950
(Machine value after revaluation on 31/12/2007 = £9500 - £950 - £1000 = £7,550)
 Discussion:
What are the effects of revaluation models?
(1) increments are presented in B/S, not income statement
(2) decrements are presented in income statement, not B/S
(3) It should be class-by-class base revaluation of assets, not asset-by-
asset base in order to avoid managers’ manipulation.
What are the advantages and limitations of revaluation models?
Advantage: more relevant information on B/S
Limitations:
(1) High implementing costs: surveyor, reviewing necessary of
revaluation, extra recording/reporting costs.
(2) Harmonization of US GAAP is difficult, because US GAAP does not
allow revaluation. Same situation in China, Brazil and other
Latin American countries.
(3) Comparability of information is difficult for financial analysts
(4) Managers’ intention at revaluation
 Capitalisation of intangible assets
◼ The effects of capitalisation and expensing are the same for
intangible assets.
◼ Research & Development (R&D) costs—UK SSAP13, US GAAP &
IAS 38: normally expense at income statement
◼ However, Development expenditure could be capitalised if
(i) There is clearly defined projects.
(ii) Expenditure is separately identifiable.
(iii) Commercial success is reasonably certain.
(iv) It is expected to be profitable, having considered all current
and future costs.
(v) The company has the resources to complete the project.

Investors appreciate the firms with R&D costs.

◼ Software development costs
➢ Internal use-capitalise & amortise, external use-technological
feasibility, before this stage-expensing (US GAAP).
➢ Opportunity of earnings management: Microsoft expense its
software R&D costs. It pays less tax.

◼ Exploration & development costs

➢Successful effort accounting:
Exploration costs are capitalised when incurred. If natural
resources are discovered, then amortise them over expected
useful life. Otherwise, expense them at income statement.
➢Full-cost accounting
Exploration costs are capitalised up to a ceiling (Present Value of
company reserves). Exceeding amount-expense at income
statement. (No formal requirement for ceiling test in the UK).
◼ Copyright, publishing rights
--For literary (compilations and computer programs), dramatic, musical
and artistic works, expires 70 years from the end of the year in which
the author died.
--Full acquisition/development cost capitalised when purchased

◼ Licences & Franchises

--capitalised the purchased costs.

◼ Patent and trademarks

--acquisition cost capitalised in all countries, amortised over
their useful lives, but directors are allowed to make their own
decisions.

◼ Advertising & training costs

--expensed as uncertainty at realising future benefits.
◼ Goodwill
--Internally developed goodwill is not capitalised on B/S. (US GAAP, IAS 38
paragraph 49)
--Purchased goodwill
= Purchase price – value of acquiree’s assets & liabs.
--Goodwill is the value assigned to a rate of earnings above the norm-it
translates into excess earnings called superearnings.
Amortisation of intangibles & goodwill
◼In the UK, FRS 10 & 11: intangibles & purchased goodwill must be amortised
over their useful economic lives in 20 years. If their useful economic lives >20
years, or no amortised, their value must be reviewed annually for impairment.
◼In the US SFAS 142, amortising identifiable intangibles over shorter of
economic life or legal life, subject to a maximum of 40 years by using straight-
line method. Goodwill does not require amortisation!!
◼IAS 38, amortising intangible assets on a straight-line basis over the following
periods: Patent (5 to 10 years), Copyright (10 years), R&D (5 to 10 years)
 Implications of analysis

◼ Examine for super earnings power as evidence of goodwill.

Goodwill is written off if super earnings power disappears.

◼ Review amortization periods—any bias likely is in the direction

of less amortization and can call for adjustments

◼ Recognize goodwill has a limited useful life—whatever the

advantages of location, market dominance, competitive stance,
sales skill, or product acceptance, they are affected by changes
in business.
 Off-balance-sheet assets
Efficient sales forces, developed drugs, TV programs,
experience, skills and continuous learning of employees,
brand names, etc.
firm value firm value
Brand names ($billion) (%) Brand names ($billion) (%)
Star bucks 1,757 19 Nokia 35,035 34
Coca-Cola 69,945 61 Nike 7,589 71
Budweiser 10,838 32 Intel 34,655 17
Microsoft 65,068 17 Disney 32,591 54
Wrigley's 4,530 59 Kellogg's 7,005 61
Dell 8,269 7 Ford 30,092 66
Jack Daniels 1,583 41 Mercedes 21,728 48
IBM 52,752 27 Citibank 19,005 7
Barbie 2,037 41 Gucci 5,363 53
GE 42,396 9

Source: Subramanyam (2014), Financial Statement Analysis, 11th Ed. McGraw Hill.
 Off-balance-sheet assets (Cont.)

 The Environmental, Social and Governance (ESG)

policies of a company.
 How do these affect a firm’s operating, investing, and
financing activities?
 See BT annual report 2024 as an example
 Lecture review

◼ Concepts of Non-current assets

◼ Tangible Non-current assets valuation & analysis

1. Cost model
2. Revaluation model

◼ Intangible assets valuation & analysis

◼ Off-balance-sheet assets
References:
-Text book Ch.4, pp.243-262, Ch.2 pp.97-106.
- Alfredson, K., et al. (2009), Appling International Financial Reporting
Standard, 2nd edition, Wiley, ISBN 0-470-81967-7, Chs. 10, 11.
- Palepu, Healy and Bernard, (2013), Business Analysis & Valuation: IFRS
Edition, 3rd Ed., Ch.4, pp.136-142.

Class questions for the tutorial class:

Exercise 4-7, Problems 4-5, 4-6.

Canvas:
All handouts, tutorial class questions and answers, past exam papers can be
downloaded on Canvas.