Archive for May, 2007

Upward Revaluation of Assets

Under U.S. GAAP, assets must be carried at historical cost, less any charges for depreciation, amortization and impairment. Under no circumstances can assets be revalued to a higher value.

International Standards permit upward revaluation of assets if the fair value of the assets increases. Typically the new value is based on an appraisal.

Upward revaluations can affect comparisons between companies that have revalued and those that have not. Further, upward revaluation results in more favorable leverage and solvency ratios. As a result, investors may wish to adjust the financial statements to remove the impact of upward revaluation.

Posted on 29th May 2007
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Asset Impairment Charges

Depreciation and amortization expense allocates an assets purchase price over its useful life. In essence, the expense is intended to reflect the declining value of the asset due to normal wear and tear.

However, sometimes the value of an asset can decline suddenly. Examples include a vehicle destroyed in an accident (a tangible asset) or losing a patent lawsuit (intangible asset). In such cases the asset is said to be impaired, and the accounting treatment depends on the type of asset and the accounting standards in use.

  • Tangible Assets Held for Use U.S. standards require impairment when the undiscounted value of expected future cash flows is less than the carrying value of the asset. Once this is determined, the cash flows are discounted to arrive at the appropriate asset value and the impairment charge represents the difference between the revaluation and the carrying value. The impairment test should be performed whenever events suggest impairment is possible. International Accounting Standards are similar except with regard to the mechanics of revaluation.
  • Goodwill and Other Intangible Assets with Indefinite Lives must be tested at least annually for impairment, and the charge reflects any difference between the carrying value and the fair or recoverable value.
  • Amortizable Intangible Assets are treated similarly to tangible assets held for use.
  • Tangible Assets Held for Sale are tested for impairment when the decision is made to sell the asset. The impairment charge is the difference between the fair value, less any selling costs, and the carrying value.

Once impaired, under U.S. standards the asset cannot be revalued upward even if the conditions of impairment are reversed (say, a court decision overturned on appeal.) Under IAS, upward revaluations are permitted, and in the case of previously impaired assets the reversal would increase profits in the period the reversal occurs.

Posted on 28th May 2007
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Asset Retirement Obligations – US Cellular Case Study

As of December 31, 2006 US Cellular Corporation (USM) reported long-term debt of $1.0 billion and total assets of $5.7 billion, resulting in a debt/assets ratio of 17.5%. It also recorded interest expense of $94 million and Earnings Before Interest and Taxes (EBIT) of $407 million, resulting in interest coverage of 4.3x.

In US Cellular’s 10K, the following disclosures are made regarding asset retirement obligations:

U.S. Cellular is subject to asset retirement obligations associated primarily with its cell sites, retail sites and office locations. Asset retirement obligations generally include obligations to remediate leased land on which U.S. Cellular’s cell sites and switching offices are located. Also, U.S. Cellular is generally required to return leased retail store premises and office space to their pre-existing conditions. The asset retirement obligation is included in Deferred Liabilities and Credits in the Consolidated Balance Sheets.

During the third quarter of 2006, U.S. Cellular reviewed the assumptions related to its asset retirement obligations and, as a result of the review, revised certain of those assumptions. Estimated retirement obligations for cell sites were revised to reflect higher estimated costs for removal of radio and power equipment, and estimated retirement obligations for retail stores were revised to reflect a shift to larger stores and slightly higher estimated costs for removal of fixtures. These changes are reflected in “Revision in estimated cash flows” below. The table below also summarizes other changes in asset retirement obligations during the year ended December 31, 2006 and 2005.

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We can use this disclosure to adjust the financial statements and treat the ARO as equivalent to financial obligations. Since there are no offsetting trust funds, the process is as follows:

  1. Reduce the $128 million ARO as of 12/31/06 by the company’s 38.5% tax rate, to $79 million.
  2. Add the $79 million to reported long-term debt of $1 billion.
  3. Add the $7 million accretion expense to both EBIT and Interest expense.

As a result of these adjustments we can recalculate the ratios as follows:

Debt/Assets = (1.0 + 0.08)/5.7 = 18.9%
Interest coverage = (407 + 7)/(94 + 7) = 4.1x

The resulting ratios are noticeably different from the unadjusted ratios, but in this instance probably would not significantly impact the evaluator’s opinion.

Posted on 25th May 2007
Under: Accounting, Adjusting Reported Financial Statements, Case Studies, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis | No Comments »

Analyzing Asset Retirement Obligations

The accounting treatment of Asset Retirement Obligations (AROs) differs from that of other obligations, particularly financial obligations. However, the economic consequenses are similar. As a result, analysts often adjust a company’s financial statements to treat the AROs as financial obligations as follows:

  1. The ARO is reduced by the amount of any offsetting trust funds or escrow accounts.
  2. The ARO is reduced by the tax rate to account for the tax savings that will result when the obligation is met.
  3. The remaining value of the ARO is added to long-term debt.
  4. Accretion expense is reclassified from operating expenses to interest expense.

By increasing the amount of long-term debt and interest expense without affecting either sales or net income, this reclassification has the effect of increasing leverage ratios such as debt/equity and reducing solvency ratios such as interest coverage.

Posted on 24th May 2007
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Accounting for Asset Retirement Obligations

Certain assets result in obligations that must be filled at the end of the asset’s service life. For example, disposal of the asset may require environmental cleanup expenses. As soon as such obligations (asset retirement obligations or AROs) can be reasonably estimated they must be recognized in the company’s financial statements as follows:

  1. The liability is estimated as the discounted value of the future expense.
  2. The balancing offset to this liability is an increase in the carrying value of the asset.
  3. The increase in asset value is depreciated on the income statement over the asset’s remaining service life, thus reducing equity through retained earnings.
  4. The liability itself increases over time by the discount rate used in estimating the initial liability.
  5. The increase in the liability is charged to the income statement as accretion expense.

Particularly in the case of regulated industries, companies facing asset retirement obligations often have funds set aside to cover the obligations. However, the size of the fund and timing of cash flows to the fund usually differ somewhat from the accounting accruals established regarding the liability.

Posted on 23rd May 2007
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Estimating the Average Remaining Useful Life of a Company’s Assets

At the time of purchase, assets are recorded on the balance sheet at historical cost. Over time, the reported value is reduced by the total (accumulated) depreciation expense, resulting in a net property and equipment value. The notes to the financial statements will provide both the historical cost and the accumulated depreciation if it is not on the face of the balance sheet. In addition, either the cash flow statement or the income statement should provide the depreciation expense recorded in the most recent period.

Consider a company that reports the following:
depreciation.jpg

The average remaining useful life of the assets can be estimated by dividing historical cost by annual depreciation expense. In this case, 10,655/575 = 18.5 years.

This estimate works best for companies that use straight-line depreciation, and comparisons among companies that use different depreciation methods or estimated useful lives will be affected by those choices.

Posted on 18th May 2007
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Estimating the Average Age of a Company’s Assets

At the time of purchase, assets are recorded on the balance sheet at historical cost. Over time, the reported value is reduced by the total (accumulated) depreciation expense, resulting in a net property and equipment value. The notes to the financial statements will provide both the historical cost and the accumulated depreciation if it is not on the face of the balance sheet. In addition, either the cash flow statement or the income statement should provide the depreciation expense recorded in the most recent period.

Consider a company that reports the following:
depreciation.jpg

The average age of the assets can be estimated by dividing accumulated depreciation by annual depreciation expense. In this case, 6,584/575 = 11.5 years.

This estimate works best for companies that use straight-line depreciation, and comparisons among companies that use different depreciation methods or estimated useful lives will be affected by those choices.

Posted on 17th May 2007
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Determining the Average Useful Life of Assets

At the time of purchase, assets are recorded on the balance sheet at historical cost. Over time, the reported value is reduced by the total (accumulated) depreciation expense, resulting in a net property and equipment value. The notes to the financial statements will provide both the historical cost and the accumulated depreciation if it is not on the face of the balance sheet. In addition, either the cash flow statement or the income statement should provide the depreciation expense recorded in the most recent period.

Consider a company that reports the following:
depreciation.jpg

The average useful life of the assets can be estimated by dividing historical cost by annual depreciation expense. In this case, 17,239/575 = 29.9 years.

This estimate works best for companies that use straight-line depreciation, and comparisons among companies that use different depreciation methods or estimated useful lives will be affected by those choices.

Posted on 17th May 2007
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Accounting for Long-Term Intangible Assets: Capitalization vs. Expensing

The way companies account for intangible assets depends both on the accounting principles used and the method under which the assets were acquired or developed. Of critical importance to analysts and investors is whether the costs are expensed on the income statement as incurred or capitalized on the balance sheet (either permanently or reduced over time as an amortization expense). The choice also affects the statement of cash flows, as expensed items reduce operating cash flow while capitalized items are treated as investing cash flows.

While the accounting treatments are somewhat complicated, the table below outlines the general treatment of various items according to the applicable standard and the means of acquisition.

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Other factors to consider include the length of time (if any) over which a capitalized asset will be amortized.

Posted on 16th May 2007
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Using the Residual Income Approach to Predict Country Returns

In the March/April 2007 Financial Analysts Journal, Desrossiers, Lemaire and L’Her examine whether the residual income model is useful in predicting the relative returns for developed country indices. Zero-investment strategies (long the countries with the highest residual income and short those with the lowest) posted significant positive performance over various holding periods during the sample period 1988-2005.

These returns remained significant after adjusting for factors such as market, size, book-market ratio and momentum. They were also robust to various long-term growth estimates, different country-universe subsamples and transaction costs. Average monthly excess returns from the long-short strategy ranged from 0.47% to 0.67% depending on time horizon and optimization strategy, and all were significant at the 5% level.

The results suggest investors may be better off allocating assets to attractively-valued markets rather than adopting a passive asset allocation approach.

Posted on 9th May 2007
Under: Asset Allocation, Research, Security Selection, Valuation | No Comments »