Adjusting reported <a title="Financial Statements: Structures and Relationship" href="https://financetrain.com/financial-statements-structures-and-relationship/">financial statements</a> of public companies for the purposes of comparing them or assessing their stand alone valuations is long time <a title="CFA Exam Dashboard" href="https://financetrain.com/cfa-exam/">CFA exam material</a>.  Entry level equity and credit analyst jobs require proficiency in financial statement analysis.  Today is world of on-demand financial data, with services such as Bloomberg.  However, if an analyst is supporting a stock recommendation, merger valuation, or bond underwriting, he or she must be able to critically interpret the publicly reported financial statement data and revise it to reflect economic reality.  Revisions can be based on company disclosures in the footnotes to public financial statements; known market values may also be used to replace reported book values, when revising a company’s financials.  The footnotes of a <a title="Difference Between IFRS and US GAAP" href="https://financetrain.com/difference-between-ifrs-and-us-gaap/">US GAAP or IFRS-IAS</a> reporting company will discuss its inventory accounting methods, accounting for long-lived assets, and its accounting treatment of leases.  The items sets the test taker will see could potentially be nothing more than a set of financial statements followed by a series of footnotes.

This tutorial will explore issues in understanding inventory and long-lived asset accounting when analyzing company financial data.

In total, the test taker can reasonably expect three to four item sets (18-24 questions) on material related to financial reporting/financial statement analysis and financial reporting could possibly be the most tested section on the exam.  While studying accounting for inventories, long-lived assets, and leases, the student is strongly encouraged to think about how these issues could be presented within the item set format or a story, set of financial statements with footnotes, a table of accounting policies and ratios, or some other format.

Material Covered

I.          Inventory accounting issues with Financial Statements and Financial Ratios.

II.        Long-lived Asset accounting issues with Financial Statements Financial Ratios.

III.       Leases

Important Notes:

U.S. GAAP &amp; IFRS-IAS: While there are some specific standards references, this sheet is largely fundamental in nature and the candidate should refer to Study Session 5 of the 2012 Level II CFA Program Curriculum © to determine requirements in understanding formal discrepancies between U.S. generally accepted accounting principles (GAAP) and international standards (referred to in this study sheet as IFRS-IAS).

Financial Ratios: Many <a title="Common Ratios in Financial Analysis" href="https://financetrain.com/common-ratios-in-financial-analysis/">financial ratios</a> can be impacted by adjustments to a company’s inventory and long lived assets; some of the ratios will be used as examples in this study sheet and the student needs to refer to the official CFA curriculum for more additional of financial ratios.

CFA Level 2: Financial Reporting Part 1 - Introduction

Financial Reporting: The act of providing statutorily mandated financial information to the investing public; different countries have different requirements and standards.

<a title="Financial Statements: Structures and Relationship" href="https://financetrain.com/financial-statements-structures-and-relationship/">Financial Statements</a> Refer to a company’s: <a title="Understanding Income Statements" href="https://financetrain.com/understanding-income-statements/">income statement</a>, <a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/">balance sheet</a>, <a title="Understanding Cash Flow Statement" href="https://financetrain.com/understanding-cash-flow-statement/">statement of cash flows</a>, and/or statement of changes in owner’s equity.

Long-term Assets: Include long lived assets and long-term investments, both of which are reported on the balance sheet.

Long-lived Assets: Refer to fixed assets (property, plant, and equipment - PPE), natural resources, and intangible assets (such as patents or goodwill) carried on the balance sheet.  Note that this sheet primarily discusses long-lived assets as PPE, but there is some discussion of intangible assets.

Inflation: The scenario where an economy or business environment is experiencing rising prices.

Deflation: The scenario where an economy of business environment is experiencing falling prices.

Financial Reporting: Important Definitions

Inventory

Inventory refers to the short-term assets on a <a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/">company’s balance sheet</a>; example – a retail clothier’s stock of shirts, pants, etc.

FIFO

First-in, first-out accounting method, where the costs of the oldest items in inventory are used to compute the cost of goods sold (COGS) expense on a <a title="Understanding Income Statements" href="https://financetrain.com/understanding-income-statements/">company’s income statement</a>.

FIFO ending inventory for the balance sheet is calculated based on values of the most recent inventory goods purchased.

LIFO

Last-in, first-out accounting method, where the costs of the newest inventory items are used to compute the COGS expense on the income statement.

LIFO ending inventory for the balance sheet is calculated based on values of the first inventory goods purchased.

Average Cost

Weighted average cost method applied to a company’s purchases in determining COGS and the value of beginning and ending inventory.

COGS Expense Calculation
<div class="formula1">

Beginning Inventory (BI) + Purchases = Goods Available for Sale (GAS)

GAS – Ending Inventory (EI) = COGS

</div>
COGS is used in calculating a company’s gross profit and gross profit margin (the decimal is typically converted to a percentage)
<div class="formula1">

Gross Profit = Net Revenue - COGS

Gross Margin % = ((Net Revenue – COGS)/Net Revenue)*100

</div>
In some instances, the choice of LIFO or FIFO makes intuitive sense for a specific company.  A farmer’s market shop would conceptually be a FIFO business, as the oldest produce should be sold first, given that it will spoil the soonest compared to younger produce.

In reality a company’s management is usually allowed some degree of flexibility in determining its inventory accounting method.  If an analyst is comparing firms in a shared industry structure or market capitalization size, then differences in inventory accounting methods need to be reconciled through the financial statement adjustment process, so the analyst can be sure that the <a title="Common Ratios in Financial Analysis" href="https://financetrain.com/common-ratios-in-financial-analysis/">financial ratios</a> for the firms are truly comparable.

FIFO and LIFO Methods for Inventory Expensing

Inventory accounting directly impacts a company’s income statement and balance sheet.  There are also tax implications for the choice of inventory accounting method, which impacts after-tax cash flows.

Income Statement 

<a title="Understanding Income Statements" href="https://financetrain.com/understanding-income-statements/">Income statement</a> represents a company’s financial performance over a period of time.  A company’s LIFO gross margin could be materially different that its FIFO gross margin, if the cost of the first goods purchased for inventory is materially different from the cost of the most recent goods purchased for inventory.

Balance Sheet

<a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/">Balance Sheet</a> represents a company’s financial position at a point in time.  Management’s choice of inventory accounting method directly impacts the value of short-term assets and any financial metrics that include short term assets in their calculation.  Choice of <a title="FIFO and LIFO Methods for Inventory Expensing" href="https://financetrain.com/fifo-and-lifo-methods-for-inventory-expensing/">LIFO or FIFO</a> can overstate or understate the real economic value of short-term assets on the balance sheet.

Inventory Accounting and Financial Statements

Inflation and <a title="FIFO and LIFO Methods for Inventory Expensing" href="https://financetrain.com/fifo-and-lifo-methods-for-inventory-expensing/">inventory accounting</a> analysis
<ul>
	<li>LIFO income statement in a rising price environment – LIFO method will lower reported margins.  Most recent goods are the most expensive and LIFO will calculate higher COGS and thus a lower gross profit.</li>
	<li>LIFO balance sheet in a rising pricing environment – LIFO method lowers the value of inventory and thus the value of short term assets reported on the balance sheet.</li>
	<li>FIFO income statement in a rising price environment – FIFO method will increase reported profit margins.  Oldest goods are the least expensive and FIFO will calculate lower COGS and thus a higher gross margin.</li>
	<li>FIFO balance sheet in a rising pricing environment – FIFO method raises the value of inventory, as the least expensive items are taken off the balance sheet first</li>
</ul>
Deflation and inventory accounting analysis
<ul>
	<li>LIFO income statement in a falling price environment – LIFO method will raise reported margins.  Most recent goods are the least expensive and LIFO will calculate lower COGS and thus a higher gross margin.</li>
	<li>LIFO balance sheet in a falling pricing environment – LIFO method raises the value of inventory because the cheapest items have been taken off the balance sheet first.</li>
	<li>Example: If an analyst knows that a company employs LIFO and the prices of its goods have fallen due to weakening market demand, then the analyst may look to revise the balance sheet based on FIFO, as the real value of the company’s short-term assets is likely over-stated.</li>
	<li>FIFO income statement in a falling price environment – FIFO method will lower reported margins.  Oldest goods are the most expensive because prices have fallen over time and FIFO will calculate higher COGS and thus a lower gross margin.</li>
	<li>FIFO balance sheet in a falling pricing environment – FIFO method lowers the value of inventory, as the oldest and most expensive items are taken off the balance sheet first.</li>
</ul>

LIFO, FIFO, and Economic Reality
<ul>
	<li>FIFO and the Balance Sheet – Regardless of an inflationary or deflationary environment, FIFO should best approximate the fair market value of balance sheet inventory as the value is based on more recent prices; the oldest goods have been sold out of inventory under FIFO.</li>
</ul>
<ul>
	<li>LIFO and the Income Statement – Regardless of an inflationary or deflationary environment, LIFO should best approximate a company’s current gross profit performance.  The most recent goods purchased have been applied to cost of goods sold and this best approximates the company’s near term inventory replacement cost.</li>
</ul>

Inflation/Deflation and Inventory Accounting Analysis

A company’s pre-tax cash flows are not affected by the choice of <a title="FIFO and LIFO Methods for Inventory Expensing" href="https://financetrain.com/fifo-and-lifo-methods-for-inventory-expensing/">LIFO versus FIFO</a>.

In the US, a tax law known as the “LIFO conformity rule” mandates that if a US company uses LIFO for tax reporting, it must also use LIFO for public financial reporting (i.e. U.S. GAAP reporting).

<img class="alignright size-full wp-image-5833" title="tax" src="https://financetrain.com/wp-content/uploads/tax.gif" alt="" />When prices are rising, LIFO accounting creates lower taxable income, which in turn increases after tax cash flow.

The management of a company may prefer to show a high net income to investors, but LIFO will generate more cash in an inflationary environment.

This legal/regulatory policy keeps companies from “getting the best of both worlds” by using LIFO for taxes to increase real cash flows, but then using FIFO for public financial reporting to show investors a higher net income than the net income reported to tax authorities under the LIFO method.

LIFO – Tax and Cash Flow Note

When a company uses the LIFO method, accounting standards may require a footnote disclosing what inventory values would be under the FIFO accounting method.
<img class="aligncenter wp-image-5836" title="lifo-fifo" src="https://financetrain.com/wp-content/uploads/lifo-fifo.gif" alt="" width="632" height="212" />
A company’s LIFO reserve may increase yearly due to rising inventories and rising price levels, but sometimes the LIFO reserve declines.

LIFO Reserve and Converting LIFO Net Income to FIFO Net Income

LIFO Liquidation and a Declining LIFO Reserve

A declining LIFO reserve can indicate inventory liquidation or falling prices.  If <a title="LIFO Reserve and Converting LIFO Net Income to FIFO Net Income" href="https://financetrain.com/lifo-reserve-and-converting-lifo-net-income-to-fifo-net-income/">LIFO reserve</a> declines in a rising price environment, then the analyst might become suspicious that current profit margins are over-stated because older goods are being sold and not replaced.  Replacing these goods at current cost might be higher than COGS is indicating.

The company, for whatever reason, may have stopped purchasing new, more expensive products, and in anticipation of a business slowdown and has begun selling off older inventory.

LIFO Inventory Liquidation in a Falling Price Environment

LIFO will show higher profit in a falling price environment.  If prices continue falling (possibly due to business cycle changes), then a company may cease to purchase new inventory.  As a LIFO business depletes its recent low cost inventory in a deflationary climate, profit margins will later go through a period of contraction when the company begins to sell its older, higher cost inventory.

LIFO Liquidation

<ul>
	<li>International and U.S. accounting standards require companies to carry inventory on the <a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/">balance sheet</a> at the lower of cost or market (LCM).</li>
	<li>With LCM an unrealized loss caused by a change that materially disconnects the in the fair market value of current inventory from the most recently reported book value of inventory must be immediately recognized.</li>
<ul>
	<li>This will lower the book value of assets on the balance sheet and reduce profit.</li>
	<li>Example: The feature music file sharing device sold by an electronics chain has just become obsolete due to the advances offered by a new device that is not sold by this chain.  Regardless of <a title="FIFO and LIFO Methods for Inventory Expensing" href="https://financetrain.com/fifo-and-lifo-methods-for-inventory-expensing/">inventory accounting method</a>, the electronics chain must write down its inventory and take a write down charge on its income statement to more accurately reflect true financial position and performance.</li>
</ul>
	<li>Internationally (IFRS-IAS), net realizable value represents the cost to finalize and sell inventory.</li>
	<li>In the US (GAAP), market value is generally estimated as the present replacement cost of the inventory.</li>
</ul>

Inventory at Net Realizable Value

<table class="mytable">
<tbody>
<tr>
<th scope="colspan">FINANCIAL STATEMENT/RATIO</th>
<th scope="colspan">FIFO</th>
<th scope="colspan">LIFO</th>
</tr>
<tr>
<th class="spec" scope="row">Net Income and Profit Margins</th>
<td>Usually higher in a rising price environment.</td>
<td>Usually lower in a rising price environment.</td>
</tr>
<tr>
<th class="specalt" scope="row">Pre-tax Cash Flow</th>
<td class="alt">Same.</td>
<td class="alt">Same.</td>
</tr>
<tr>
<th class="spec" scope="row">After-tax Cash Flow</th>
<td>Usually lower in a rising price environment because a company is reporting higher net income due to lower COGS.</td>
<td>Usually higher in a rising price environment because a company is reporting lower net income due to higher COGS.</td>
</tr>
<tr>
<th class="specalt" scope="row">Current Ratio = Current Assets/Current Liabilities</th>
<td class="alt">Usually higher in a rising price environment because reported inventories are more valuable and COGS is lower.</td>
<td class="alt">Usually lower in a rising price environment because reported inventories are based on lower cost purchases and higher COGS.</td>
</tr>
<tr>
<th class="spec" scope="row">Inventory Turnover = COGS/Avg. Inventory</th>
<td>Usually lower in a rising price environment because the average cost of inventory will be higher.</td>
<td>Usually higher in a rising price environment because the average cost of inventory will be lower.</td>
</tr>
<tr>
<th class="specalt" scope="row">Debt-to-Equity Ratio = Total Interest Bearing Debt/Total Shareholders' Equity</th>
<td class="alt">Usually lower in a rising price environment.</td>
<td class="alt">Usually higher in a rising price environment.</td>
</tr>
<tr>
<th class="spec" scope="row">Return on Assets
=Net Income/ Avg. Total Assets
Return on Equity
= Net Income / Avg. Total Equity</th>
<td>Usually higher in a rising price environment because net income is higher.</td>
<td>Usually lower in a rising price environment because net income is lower.</td>
</tr>
</tbody>
</table>

Impacts of LIFO and FIFO Inventory Methods on Selected Financial Ratios

Long-lived assets refer to PPE, natural resources, and intangible assets.  This section largely focuses on property, plant and equipment (PPE), but there will be some discussion of intangible assets.

PPE on the <a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/">balance sheet</a> is may be shown on a gross (total amount paid to acquire and ready the equipment for use) and net basis.
<ul>
	<li>Gross: Property, Plant, &amp; Equipment</li>
	<li>Less: Accumulated Depreciation</li>
	<li>Net: PP&amp;E</li>
</ul>
Expensing to the income statement vs. Capitalizing to the balance sheet
<ul>
	<li>Management typically has some discretion in determining if the cost of an item should be capitalized to the balance sheet and depreciated (or amortized if it is an intangible asset) to the <a title="Understanding Income Statements" href="https://financetrain.com/understanding-income-statements/">income statement</a> over time or if the cost of the item should be fully expensed to the income statement in the current period.</li>
	<li>Example: A company may capitalize production facility upgrade investments above $100,000 and expense a facility related purchases below this amount.</li>
	<li>Capitalization of Interest Expenses: US GAAP and IFRS-IAS provide treatment of the capitalization of interest expenses associated with the construction of long-lived assets.</li>
	<li>The following table provides examples of the effects on a company’s financial statements and ratios when expensing in-year versus capitalizing in-year.</li>
</ul>
<table class="mytable" style="margin-left: 20px;">
<tbody>
<tr>
<th scope="colspan">IMPACTED ITEM</th>
<th scope="colspan">EXPENSING</th>
<th scope="colspan">CAPITALIZING</th>
</tr>
<tr>
<th class="spec" scope="row">Net Income, Profit Margins, Equity</th>
<td>Lower</td>
<td>Higher</td>
</tr>
<tr>
<th class="specalt" scope="row">Asset Turnover</th>
<td class="alt">Higher</td>
<td>Lower</td>
</tr>
<tr>
<th class="spec" scope="row">Debt to Equity Ratio</th>
<td>Higher (Equity is Lower)</td>
<td>Lower (Equity is Higher)</td>
</tr>
<tr>
<th class="specalt" scope="row">ROA and ROE</th>
<td class="alt">Lower</td>
<td>Higher</td>
</tr>
</tbody>
</table>
Cash Flows and Expensing vs. Capitalizing of Purchases
<ul>
	<li>On a total <a title="Understanding Cash Flow Statement" href="https://financetrain.com/understanding-cash-flow-statement/">cash flow</a> basis, the decision to expense or capitalize has no impact because depreciation is a non-cash expense.  However, when Cash Flows are separated by: Operating Activities, Investing Activities, and Financing Activities, the decision to expense or capitalize takes on more meaning.</li>
	<li>Cash Generated by Operating Activities – when a company expenses an item paid with cash, instead of capitalizing it, the firm will show lower operating cash flows.</li>
	<li>Cash Generated by Investing Activities – when a company expenses an item paid with cash, instead of capitalizing it, there will be NO CHANGE to investing cash flows.  However, if the company capitalizes the item as a physical investment in PPE, investing cash flows will be lower.</li>
</ul>

Accounting of Long-lived Assets - Expensing vs. Capitalizing

Straight-Line Method

The straight-line method associates the long-lived asset’s usefulness with its age.
<div class="formula1">

Straight-Line Expense = (Cost – Salvage Value)/n

where n = number of years in asset’s useful life

</div>
Accelerated Methods of Depreciation

Accelerated methods of depreciation include:
<ul>
	<li>Sum-of-the-Years Digits (SYD) expensing.</li>
	<li>Double Declining Balance (DDB) expensing.</li>
</ul>
SYD Method

SYD method treats an asset as more useful in its early life by raising the depreciation expense for the early years.

SYD Example: If a company’s factory has a new conveyor belt with a useful life of 5 years, then SYD = 1+2+3+4+5 = 15.  This conveyor belt cost $100,000 and has a salvage value = $0.  The year two depreciation expense under the SYD method for the company will be calculated as follows:
<div class="formula1">

($100,000 - $0) * (5 – 2 +1)/15 = $100,000*(4/15) = $26,667

SYD Depreciation Expense for Year “i” = (Cost – Salvage Value) * ((n – “# of the ith year” +1))/SYD

</div>
DDB Methods

DDB method accelerates the depreciation rate of the straight line method.
<div class="formula1">DDB Expense = (Cost – Accumulated Depreciation) * (2/n)</div>
Unlike the time based methods of straight line and accelerated depreciation, the Units-of-Production (U-O-P) depreciation method is activity based.  A year’s depreciation expense on an annual income statement will include that year’s production as a fraction of total estimated lifetime production from the asset.
<div class="formula1">U-O-P Expense = ((Cost – Salvage Value)/# of Total Lifetime Units Estimated)* # of Units Produced in the Accounting Period.</div>
Once a company has invested in a long-lived asset, it must:
<ul>
	<li>Choose a depreciation method;</li>
	<li>Estimate the useful life of the asset over which the depreciation will take place; and</li>
	<li>Determine if the asset will have a salvage value at the end of its depreciable life.</li>
</ul>
 

&nbsp;

Depreciation Methods for Property, Plant, and Equipment (PPE)

The table below summarizes the early year impacts on selected financial reporting items by choosing the straight-line method versus an accelerated depreciation method.
<table class="mytable">
<tbody>
<tr>
<th scope="colspan">ITEM IMPACTED</th>
<th scope="colspan">STRAIGHT-LINE</th>
<th scope="colspan">ACCELERATED</th>
</tr>
<tr>
<th class="spec" scope="row">Earnings, Equity, Profit Margins</th>
<td>Higher, as depreciation expense is lower in early years.</td>
<td>Lower, as depreciation expense is higher in early years.</td>
</tr>
<tr>
<th class="specalt" scope="row">Current Ratio</th>
<td class="alt">No impact because the current ratio relates to short-term assets.</td>
<td>No impact because the current ratio relates to short-term assets.</td>
</tr>
<tr>
<th class="spec" scope="row">Total Pre-Tax Cash Flow</th>
<td>No change.</td>
<td>No change.</td>
</tr>
<tr>
<th class="specalt" scope="row">Asset Turnover</th>
<td class="alt">Lower, as asset values are higher in the early years.</td>
<td>Higher, as asset values are depreciated up front.</td>
</tr>
<tr>
<th class="spec" scope="row">Debt-to-Equity Ratio</th>
<td>Lower, as equity is higher driven by higher earnings in the early years.</td>
<td>Higher, as equity is lowered in the early years with an elevated depreciation expense.</td>
</tr>
</tbody>
</table>

Impact of Depreciation Method

<ul>
	<li>Choosing a Useful Life – In isolation, the shorter the useful life, the higher the depreciation expense.  A company’s management may attempt to show higher earnings in the near-term by increasing the useful life estimates for its long lived assets.</li>
	<li>Estimating Salvage Value – A high salvage value lowers depreciation expense, raising income and equity value.  A company’s management may decide to assign a $0 salvage value to its long-lived assets in order to show higher profitability.</li>
	<li>A company’s management may decide to change its depreciation method.  The reason could be legitimate or it may signal an attempt to “window dress” (present an artificially optimistic financial report).</li>
<ul>
	<li>An analyst is expected to be able to read the financial statement footnotes to understand the company’s choice of depreciation method.</li>
	<li>The disclosure by management of a change in depreciation method should serve as a red flag to a skilled financial analyst and he or she must calculate the impacts of the depreciation method change on key financial ratios.</li>
</ul>
	<li>Depreciation Accounting and Inflation – when a company depreciates PPE at historical cost during a period of rising prices, the true depreciation expense is likely understated.  If the historical cost basis for a firm’s depreciation expense is lower than its replacement cost, then an analyst may believe that the company is over reporting net income.</li>
</ul>

Depreciation - Important Points

A long-lived asset has become impaired when the book value of the asset as recorded on the <a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/">balance sheet</a> is not expected to be recovered during future operations.

Example: 

A call center operator recently capitalized a $2 million investment in production fixtures at a leased building.  The call center company’s primary client in this site cancels the existing business contract two months after the investment is made.  The call center firm’s capitalized assets associated with this building may have become impaired, if the company feels that it cannot place new business in this site and must cease operations there.

Events that may cause a “lack of asset value recoverability” could be:
<ul>
	<li>A decrease in the asset’s market value.</li>
	<li>Adverse changes in the law.</li>
	<li>Adverse changes in the business climate involving the asset.</li>
	<li>Cost overruns on a project associated with the asset.</li>
	<li>The experience or anticipation of <a title="Understanding Income Statements" href="https://financetrain.com/understanding-income-statements/">income statement</a> or cash flow losses associated with the asset.</li>
</ul>
US GAAP - Determining Asset Impairment Charge

US GAAP has a two-step process for determining if an asset impairment charge is required:
<ol>
	<li>Recoverability Test – An asset impairment must be recognized once the UNDISCOUNTED future cash flows from an asset fall below the book value of the asset on the balance sheet.</li>
	<li>Loss Measurement – The amount by which an impaired asset it to be reduced equals the difference between its book value and its fair market value (this can be called “mark to market accounting”).  A charge is taken on the income statement equal to the reduction in asset value on the balance sheet.</li>
</ol>
Types of Asset Impairment
<ul>
	<li>Write-downs – Asset values have changed as a result of changing market conditions.</li>
	<li>Restructurings – Asset value declines associated with the re-organization of business operations.</li>
</ul>
The US approach to impairment of long-lived assets has flaws because company management retains the ability to determine the assumptions, which go into performing a recoverability test.

In a period of economic recession, an analyst should be suspicious of a firm that does not experience any asset impairment, as management may be sticking to older, more optimistic assumptions about the expected future cash flows generated by its assets.

Impairment of Long-lived Assets

In the previous article we learned about the <a href="https://financetrain.com/impairment-of-long-lived-assets/">Impairment of Long-lived Assets</a>. Let’s now look at the impact of asset impairment.

In the initial period following an asset impairment, a firm’s:
<ul>
	<li><a title="Fixed Asset and Total Asset Turnover Ratio" href="https://financetrain.com/fixed-asset-and-total-asset-turnover-ratio/">Asset turnover ratios</a> will rise because the asset base is lower.</li>
	<li>Debt-to-Equity ratio will rise because the impairment has lowered the value of equity.</li>
	<li>Profit margins will show a one-time dip due to the write-down expense (assuming all needed write-downs have taken place).</li>
	<li>Book value of equity will drop.</li>
</ul>
In the future accounting periods, after the asset impairment has been recognized, a firm’s:
<ul>
	<li>Future <a title="Depreciation Methods for Property, Plant, and Equipment (PPE)" href="https://financetrain.com/depreciation-methods-for-property-plant-and-equipment-ppe/">depreciation</a> expense will decline because the book value of the depreciable asset base is now lower.</li>
	<li>Future profitability should rise because depreciation expense is lower.</li>
	<li>Return on Assets (ROA) and Return on Equity (ROE) should rise because the firm is more profitable and has a lower asset base.</li>
</ul>

Impact of Asset Impairment

<ul>
	<li>US GAAP does not permit firms to revalue the fixed assets on their balance sheets.</li>
	<li>International standards may allow for revaluation if certain conditions are met or guidelines are followed, but the analyst may face challenges if companies regulated by different standards apply different techniques to revalue assets.</li>
	<li>A <a title="Financial Analyst: A Rapidly Growing Career Option in Finance" href="https://financetrain.com/financial-analyst-a-rapidly-growing-career-option-in-finance/">financial analyst</a> may need to revalue a company’s reported asset base in order to perform proper due-diligence when analyzing the firm for debt and/or equity valuation purposes.</li>
	<li>If the analyst revises a company’s <a title="Understanding Balance Sheets" href="https://financetrain.com/understanding-balance-sheets/">balance sheet</a> asset values in an upward manner, then the analyst’s near term financial forecast for the company should show a decline in profit and asset turnover, as the firm is believed to be publicly reporting an insufficient <a title="Depreciation Methods for Property, Plant, and Equipment (PPE)" href="https://financetrain.com/depreciation-methods-for-property-plant-and-equipment-ppe/">depreciation expense</a>.  The higher asset base will drive a lower ROA.</li>
</ul>

Revaluation of Property, Plant, & Equipment (PPE)

<ul>
	<li>A firm may choose to purchase outright a <a title="Accounting of Long-lived Assets – Expensing vs. Capitalizing" href="https://financetrain.com/accounting-of-long-lived-assets-expensing-vs-capitalizing/">long-lived asset</a>, such as an airplane or an office building, giving the firm full benefit and risk from asset ownership; however it may also enter into a lease agreement with another firm, to lease an asset and assume partial benefit and risk associated with the asset.</li>
	<li>Lessee – “borrower” of the leased asset.</li>
	<li>Lessor – “lender” of the leased asset.</li>
	<li>Operating Lease – typically a short-term lease where the lessor retains most of the benefits and risks associated with owning the asset.</li>
	<li>Capital Lease – typically a long-term lease where the lessee assumes most of the benefits and risks associated with owning the asset.</li>
	<li>In capitalizing a lease, an equal balance sheet asset and liability are created and both are reduced over the term of the lease; these reductions are expensed to the income statement.</li>
	<li>Lessees and Operating Leases – a company may be incented to treat leases as operating leases because the financial commitment associated with the operating lease contract is not recorded on the balance sheet as a liability.  Operating leases can be seen as a form of off-balance sheet financing for a company.  If a lease is capitalized by a lessee, the resulting liability will have debt-like impacts on a company’s financial ratios.</li>
	<li>Lessors and Capital Leases – companies who act as lessors may be incented to treat leases as sales-type capital leases in order to show higher net income.</li>
</ul>

Leasing versus Purchasing Assets

A lessee is required to capitalize a lease if ANY of the following conditions are met:
<ul>
	<li>Lease ownership is transferred to the lessee at the end of the lease term.</li>
	<li>There is a bargain purchase option in the lease contract where the lessee may buy the asset at or below fair market value at the end of the lease.</li>
	<li>The present value of the lessee’s minimum payments, over the life of the lease, equal 90% or more of the asset’s fair market value.</li>
	<li>The lease’s term is equal to 75% or more of the useful economic life of the asset.</li>
</ul>
<img class="aligncenter size-full wp-image-5836" title="lifo-fifo" src="https://financetrain.com/wp-content/uploads/lease1.gif" alt="" />

Operating Lease Accounting for the Lessee

The annual rental expense appears on the lessee’s income statement and there is no balance sheet asset and liability associated with the lease.
<ul>
	<li>An operating lease affects the lessee’s balance sheet only in an indirect matter.  The rental expense lowers net income, which in turn lowers the company’s retained earnings in the equity section of the balance sheet.</li>
	<li>Rental payments on an operating lease are treated as part of operating cash flows.</li>
</ul>
Capital Lease Accounting for the Lessee

If one of the above four conditions is met in the US, the lessee is required to account for the transaction as if it were a long-lived asset purchased on credit.
<ul>
	<li>The lessee’s capital lease creates journal entries for interest expense, lease repayment (which decreases the lease obligation on the balance sheet over time), and depreciation.</li>
	<li>Typically, a capital lease will front load expenses associated with the asset, which causes the lessee’s net income to rise over time.</li>
	<li>At a capital lease’s expiration, the lessee’s balance sheet will be no different than the balance sheet where the lease was classified as operating, but in the time between lease initiation and expiration, the capital lease creates a balance sheet asset and liability.</li>
	<li>Under a capital lease, the interest expense attributed to the lease payment is an operating cash flow, but the principal repayment of the lease obligation is a financing cash outflow.</li>
	<li>The capital lease payment to be made within one year is separated as a short-term liability and the remaining lease balance is classified as a long-term liability on the balance sheet.</li>
</ul>
U.S. and international accounting standards may require some form of financial statement footnote disclosure regarding the company’s lease accounting practices.

A <a title="Financial Statements: Structures and Relationship" href="https://financetrain.com/financial-statements-structures-and-relationship/">common financial statement</a> adjustment made by analysts is to capitalize operating leases presented in the footnotes, creating a balance sheet asset and liability equal to the future payments required by the operating leases.

Traditional Lessee Accounting in US GAAP

The table below summarizes the effects of operating and capital leases on selected financial reporting items for lessees.
<table class="mytable">
<tbody>
<tr>
<th scope="colspan">ITEM</th>
<th scope="colspan">OPERATING LEASE</th>
<th scope="colspan">CAPITAL LEASE</th>
</tr>
<tr>
<th class="spec" scope="row">Balance Sheet</th>
<td>No impact.</td>
<td>Leased asset and lease liability are created.</td>
</tr>
<tr>
<th class="specalt" scope="row">Income Statement</th>
<td class="alt">Rent expense occurs over the life of the least; this may be a constant value.</td>
<td class="alt">Interest and depreciation expenses are recognized. In the initial years expenses will be higher than an operating lease, but over the full lease term the two lease types have the name total effect.</td>
</tr>
<tr>
<th class="spec" scope="row">Cash Flows</th>
<td>Total change in cash is the same, but the full rent expense is treated as an operating cash flow.</td>
<td>Total change in cash is the same, but the lease payment is divided between an interest component (an operating cash flow) and a principal repayment (a financing cash flow). The amount assigned to deprecation is a non-cash charge.</td>
</tr>
<tr>
<th class="specalt" scope="row">Profit Margin</th>
<td class="alt">Higher in the early years, but lower in the later years, as compared to a capital lease.</td>
<td class="alt">Lower in the early years because the total expense associated with the lease is higher than the actual payment, but profit margin will climb in later years of the capital lease.</td>
</tr>
<tr>
<th class="spec" scope="row">Asset Turnover Ratios</th>
<td>Higher because the operating lease records no balance sheet assets.</td>
<td>Lower because a balance sheet asset is recorded, but the ratio will rise over time as the asset is depreciated.</td>
</tr>
<tr>
<th class="specalt" scope="row">Debt-to-Equity Ratio</th>
<td class="alt">Lower because there is no liability recorded on the balance sheet for an operating lease.</td>
<td class="alt">Higher because a lease obligation liability is recorded on the balance sheet, but the ratio will decline over time as the lease is repaid.</td>
</tr>
<tr>
<th class="spec" scope="row">ROA &amp; ROE</th>
<td>Higher in the early years because assets are lower and earnings are higher.</td>
<td>Lower in the early years because earnings are lower and assets are higher.</td>
</tr>
<tr>
<th class="specalt" scope="row">Interest Coverage Ratios</th>
<td class="alt">Higher because a firm incurs no interest expense from an operating lease.</td>
<td class="alt">Lower because a firm allocates a portion of the lease expense to interest.</td>
</tr>
</tbody>
</table>
A company may prefer to account for leases as operating leases when:
<ul>
	<li>Management is partially compensated based on return on assets.</li>
	<li>A firm wants to keep debt-like liabilities off its balance sheet.</li>
</ul>
A company may prefer to account for leases as capital leases when it wants to show a higher cash flow from operations.

Effects of Leases on Selected Financial Reporting Items for Lessees

A lessor must capitalize a <a title="Leasing versus Purchasing Assets" href="https://financetrain.com/leasing-versus-purchasing-assets/">lease</a> if any of the four lessee conditions for capitalization are present, PLUS BOTH of the following requirements are met:
<ol>
	<li>The lessor can reasonably expect to collect the minimum lease payments; and</li>
	<li>The lessor has no material uncertainties regarding the amount of un-reimbursable costs yet to be incurred, as part of the lease agreement.</li>
</ol>
If these conditions are not met, then the lessor normally must classify the lease as an operating lease.  In reality, it is common for the lessor and lessee to use the same accounting treatment for leases.

Lessor Accounting for Operating Leases

Payments received from the lessee are treated as rental revenue on the lessor’s income statement and the lessor continues to account for the leased asset as a fixed asset on its balance sheet.

<img class="aligncenter size-full wp-image-5833" title="lease" src="https://financetrain.com/wp-content/uploads/lease2.gif" alt="" />

Lessor Accounting for Capital Leases

There are two types of lessor capital leases:
<ol>
	<li>Sales-Type Lease: The lessor firm is typically a dealer or manufacturer who leases its equipment rather than selling the equipment outright.  Under a sales-type lease, the lessor will recognize a profit or loss on the sale of the leased product and recognize on-going interest income from the capitalized lease over the lifetime of the lease.</li>
	<li>Direct Financing Lease: The lessor firm leases to other companies at cost and the income from the lease is interest income.  An example of this business model would be a financial institution that owns an aircraft leasing unit which leases aircrafts to other companies at a rate the covers the cost of the airplane plus interest.  The income from the lease is recognized as interest income on the lessor’s income statement, representing the lessor’s return on investment in the capital lease.</li>
</ol>
Classifying a lease as a capital lease or operating lease by a lessor is a materially significant accounting policy, as the balance sheet, the income statement, the statement of cash flows, and key financial ratios will be different under the different methods.

Lessor Accounting for Leases

When a lessor enters a sales-type capital lease, several journal entries will be made to account for the transaction:
<ul>
	<li>An investment in lease asset is created on the balance sheet (NOTE: this value is greater than the reduction to inventory, so the lessor’s assets on the balance sheet have grown as a result of the transaction).</li>
	<li>A cost of goods sold expense is calculated and recognized (NOTE: COGS is netted against sales revenue to determine gross profit or loss on the “sale”).</li>
	<li>Sales revenue is recognized.</li>
	<li>The inventory asset account on the balance sheet is reduced.</li>
</ul>
Cash Flows for Lessor’s with Sales-Type Capital Leases

NOTE: local accounting regulations may vary in treatment of these cash flows for a sales-type capital lease, so the student is directed to confirm Level II exam treatment in the official curriculum.
<ul>
	<li>Over the term of the lease, most of the lessee’s payment is applied to reducing the investment in lease asset (as the lessee is fulfilling its financial obligation to repay principal).  The remaining portion of the lessee’s payment is treated as interest income by the lessor.</li>
	<li>At lease signature, it is quite possible that no cash flows occur, however with the sales-type method, the lessor shows the investment in the lease as an investing cash outflow and the gross profit on the sale as an operating cash inflow.</li>
	<li>As the lessee pays the lessor during the lease term, the interest income portion of the payment may be treated as an operating cash inflow and the principal pay-down portion of the lessee’s payment may be treated as an investing cash inflow.</li>
</ul>

Lessors and Sales-Type Capital Leases

When a financing firm enters into a direct financing capital lease, the lessor reduces PPE shown on its balance sheet and creates an investment in lease asset; the total value of assets on the lessor’s balance sheet is unchanged.

NOTE: Local accounting regulations may vary in treatment of these cash flows for a direct financing capital lease.
<ul>
	<li>Over the life of the direct financing capital lease, the lessor receives a payment from the lessee.  A portion of the payment is classified as interest income on the income statement and the remaining portion of the payment is used to reduce the investment in lease asset on the balance sheet.</li>
	<li>Unlike the cash flows described in the sales-type lease above, the statement of cash flows are not impacted at the time the lease is entered for a direct financing lease.</li>
	<li>When the regular payments are made by the lessee towards the direct finance lease, the lessor reports the interest income as an operating cash flow and the investment in lease asset pay down as an investing cash inflow.</li>
</ul>

Lessors and Direct Financing Capital Leases

The table below summarizes the effects of <a title="Lessor Accounting for Leases" href="https://financetrain.com/lessor-accounting-for-leases/">operating</a>, <a title="Lessors and Sales-Type Capital Leases" href="https://financetrain.com/lessors-and-sales-type-capital-leases/">sales type capital leases</a>, and <a title="Lessors and Direct Financing Capital Leases" href="https://financetrain.com/lessors-and-direct-financing-capital-leases/">direct financing capital lease</a> on financial statements for lessor firms at lease initiation.
<table class="mytable">
<tbody>
<tr>
<th scope="colspan">ITEM</th>
<th scope="colspan">OPERATING LEASE</th>
<th scope="colspan">SALES TYPE CAPITAL LEASE</th>
<th scope="colspan">DIRECT FINANCE CAPITAL LEASE</th>
</tr>
<tr>
<th class="spec" scope="row">Asset size on balance sheet at initiation.</th>
<td>No change because no asset is recorded.</td>
<td>Increase because the investment in lease asset is larger than the reduction to inventory.</td>
<td>No change because the investment in lease asset is equal to the reduction to PPE.</td>
</tr>
<tr>
<th class="specalt" scope="row">Income during year of lease initiation.</th>
<td class="alt">No change because no gain on sale is recognized.</td>
<td class="alt">Higher than an operating or direct finance capital lease because lessor recognizes a gain on the sale.</td>
<td class="alt">Higher than an operating or direct finance capital lease because lessor recognizes a gain on the sale.</td>
</tr>
<tr>
<th class="spec" scope="row">Operating cash flow impact upon lease initiation.</th>
<td>No impact, as no cash changes hand on initiation.</td>
<td>Higher than the other two methods; while no cash may change hands at lease initiation, the lessor will recognize a gross profit on the "sale" of the asset, but this is offset by an outflow to investing cash flows for the investment in leased asset.</td>
<td>No impact, as no cash changes hands on initiation.</td>
</tr>
</tbody>
</table>

Effect of Leases on Financial Statements for Lessors

<ul>
	<li>2005: SEC report on off-balance sheet financing stated that lease standards should be revised.</li>
	<li>2006: FASB and IASB agreed to incorporate lease accounting into their project plans.</li>
	<li>General Sentiment: Current lease accounting model is broken and current rules for distinguishing between operating and capital leases provides firms with the opportunity to structure their balance sheets.</li>
	<li>Future: Operating leases are expected to be eliminated and firms will gross up their balance sheets with assets and liabilities.</li>
</ul>

Future of Lease Accounting 

<ul>
	<li>Spend five to six hours reading Study Session 5 of the Level II CFA Program Curriculum © taking notes.</li>
</ul>
<ul>
	<li>Spend two hours creating flash cards from this study sheet and the official material.
<ul>
	<li>Flash cards do not need to be limited to pure formulas.  For example, some Financial Reporting flash cards may walk through the steps of a complicated accounting method or financial statement revision process.</li>
</ul>
</li>
</ul>
<ul>
	<li>Spend five hours taking practice questions.
<ul>
	<li>On the practice questions, the exam taker is recommended to study as many item sets as possible.</li>
	<li>There may be problems which require multiple steps (for example adjusting a financial statement and then recalculating a financial ratio based on the adjusted date).</li>
	<li>Repetition can tremendously help a student become comfortable with more difficult financial reporting questions.</li>
	<li>There is no need to begin practicing under pressure.  Start by doing practice problems open note or open book.  As one develops confidence through practice, then he or she can transition to doing these problems without help.</li>
</ul>
</li>
</ul>
<ul>
	<li>Dedicate small parts of future weeks to staying refreshed on Financial Reporting.  This subject is simply too important to study in January or February and then put down until completing the rest of the material in late April or early May.</li>
</ul>
This series gets into the first leg of Financial Reporting and this is premium material for the Level II exam.  Scoring above 70% on Financial Reporting goes a long way towards achieving a pass.  Alternatively, scoring below 50% on Financial Reporting puts a lot of pressure on the candidate to score very high in other sections.

In the first leg of Financial Reporting, we looked at <a title="FIFO and LIFO Methods for Inventory Expensing" href="https://financetrain.com/fifo-and-lifo-methods-for-inventory-expensing/">accounting for inventories</a>, <a title="Accounting of Long-lived Assets – Expensing vs. Capitalizing" href="https://financetrain.com/accounting-of-long-lived-assets-expensing-vs-capitalizing/">accounting for long-lived assets</a>, and <a title="Leasing versus Purchasing Assets" href="https://financetrain.com/leasing-versus-purchasing-assets/">accounting for leases</a>.  While each of these topics could easily cover an entire item set, a reasonable expectation is that two or all three of these subjects will appear over the course of one or two item sets.  Many students consider leases to be the most challenging of the three topics and unfortunately, a test taker should expect to see some test questions on the subject.

CFA Level 2: Financial Reporting 1 - Recommendations

Financial Reporting Part 1

This frontmatter description will appear below the title

COURSE

Financial Reporting Part 1

Lessons

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