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Mandatory capital expenditures capex encompass health, safety, and environmental projects which have to be done irrespective of their return on investment ROI.
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For this category the usual economic analysis as to future benefits and cash flow is usually omitted. If the Environmental Protection Agency tells you to clean up a site, and you have exhausted your legal defenses, you probably are going to have to spend the money. Expansion existing products. Expansion projects are usually justified on the basis of incremental profits expected from the increased sales of current products that are already doing well.
Inasmuch as these are usually based on current production methods, only scaling them up, the types of assets to be acquired are familiar. New product. Capex for new products involves more risk and possibly unknown technology. The ultimate success of any new venture is far less secure than the expansion of presently successful activities.
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For this reason most companies have a higher hurdle rate for this type of proposal. Cost reduction. Thus there is some risk in terms of making the project work. Replacement projects are where existing equipment simply is worn out and it is uneconomical to try and fix it. This is the phenomenon we as consumers have with cars and consumer electronics and appliances. After six years it is probably time to trade in your car and in ten years it probably is time to get a new washing machine.
But in practice these are fairly rare. It is our observation over many years in the business world that there is a very low percentage of replacement capex compared to the other four categories.
Good maintenance can keep equipment working for many years. This of course is why companies have so many fully depreciated assets physically still in use. The original life fell short of the actual economic utility. The point of this brief digression is to put into perspective that there are few replacements, relative to all other capex. Unlike individuals who get a new washing machine after ten years, most production managers and plant engineers can get 20, 30, or more years usage out of production equipment.
The conclusion we draw from this analysis is that companies should adopt a new approach to setting financial reporting lives for new capex. In Chapter 8 we take another look at the actual remaining lives for assets already on the books. But for new acquisitions, the time to start is now, from here forward. Take a sample of those items that had too short a life originally assigned, then determine what the real economic life is likely to be.
This will involve dialog between the fixed-asset accountant and the appropriate production or IT managers responsible for actually using the asset. We hate to say it, but the level of knowledge about manufacturing processes for most financial workers ranges from abysmal to none. Accountants really should not be setting expected lives at all—other than for tax purposes.
For replacement capex it would be appropriate to use as a life for the newly acquired asset, the actual elapsed time between the acquisition of the original asset and the current date when it is being replaced. If the new asset replaces a similar asset acquired 25 years ago, then assign a year life to the new asset. There have been many studies that suggest simply projecting what has happened in the past is the best estimate of the future. If it rained today, the best forecast for tomorrow is that it will rain then.
This does not mean that it will rain continuously from here, but for a one-day forecast it may beat any other forecast. Assigning a year life to the new asset on the basis that the old asset lasted 25 years is as supportable, if not more so, than any other choice. Taking this approach, in effect lengthening the accounting lives of replacement assets, will have no effect on cash flow, but will have the impact of reporting increased income.
Earnings before interest, taxes, depreciation, and amortization EBITDA , as well as earnings before depreciation, is also not affected by the choice of accounting lives for calculating depreciation. But having correct economic depreciation will give a better picture of true profitability. Many accountants have been brought up with an expectation that they should always be conservative. In this context, with respect to depreciation expense, conservative is assumed to be that the faster you write off an asset the better.
Why it is better, however, has never been made clear, at least to the author. Understating profitability the result of overly aggressive depreciation charges may lead to incorrect product pricing, as well as incorrect financial analysis of the relative profitability of different product lines.
This is a point made strongly in cost accounting courses in colleges and universities. It does not say to choose a life that will write the asset off as quickly as possible. It does say exactly what we are recommending. Use the expected useful life.
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Thus, what we have to do is anticipate economic lives in order to determine accounting lives. The thought process looks at the economics of the operation, taking into consideration current maintenance policies, and how well they are practiced. Machinery and equipment appraisers typically disregard accounting lives and book balances original cost less accumulated financial depreciation. This actually is common sense, once one considers this.
If you maintain your car, changing the oil every 5, miles, and so forth, the car will last a lot longer than if you simply fill it up with gas and drive it until it falls apart. The same holds true in a manufacturing environment. Take airplanes, where preventive maintenance is scrupulously followed, occasional complaints by the Federal Aviation Administration FAA notwithstanding. The U. But if it is not the original aircraft, thoroughly maintained, then what is it? The point here is that with good maintenance assets can, and do, last a lot longer than is usually thought.
This has implications for the lives assigned to new asset acquisitions.
What we recommend is simple and straightforward: Instead of an accountant setting the economic lives, have the owner or user of the asset determine the life. That is, the individual or department, which will bear the depreciation charge. The cost of an asset has to be reflected in the selling price of the assets made from that asset. Assets have a cost, and the per-unit cost is a function of the expected future use.
Underestimating that use, or useful life, throws off all cost and profit analyses. Therefore, go to the most knowledgeable people in the company, the users of the assets. This means that for computers and related gear, go to the head of IT. For buildings, ask the real estate manager. For machinery and equipment the experts are in production and maintenance, not sitting in the accounting department. In fact the only asset that accountants should determine the life of is office furniture and HP calculators! And the latter should have been charged to expense, not capitalized.
There is no choice: 15 years, no more and no less. The IRS had not allowed goodwill to be amortized for tax purposes, but did allow amortization for intangible assets where the taxpayer could demonstrate a definitive life and a definitive value. Thus, there was pressure by taxpayers to try and carve out of goodwill any number of identifiable intangibles and valuation firms were hired to value these and determine a specific life. The IRS, seeing tax revenues drain away, almost invariably challenged these intangibles, such as customer relationships or assembled workforce, and alleged they were simply components of goodwill and hence not amortizable.
The disputes ended up in court, consuming real resources in what was essentially a zero-sum game between taxpayers and the IRS. Finally, both sides threw in the towel and agreed that 15 years for everything, including goodwill, was a reasonable compromise.
This year rule does have some unexpected consequences, however. A five-year noncompete contract obviously has no value after five years. Where lives for intangible assets do become critical is in financial reporting. This distinction becomes important and is discussed ahead. Nonamortization of goodwill, following a business combination, is highly prized by CFOs and controllers, who thereby do not have a charge reducing earnings and hence earnings per share EPS. This initial determination of the amount of goodwill occurs in an allocation of purchase price. Since most other intangible assets with a specific life do have to be amortized, and such amortization reduces EPS, financial officers usually want as much of the total purchase price allocated to goodwill and as little as possible to amortizable intangibles.
Now we get to the critical element of this section. What is the appropriate life to be assigned to specific intangible assets? The rule that is supposed to be followed is to assign a life for reporting purposes that is commensurate with the useful life or expected utility of the asset, just as with fixed assets. This certainly leads immediately to the next question, of how do you determine the useful life of an asset?
We mentioned above a five-year covenant not to compete, and the useful life would in most cases be determined as five years.
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Similarly, a patent with seven years remaining before expiration would ordinarily be assigned a seven-year life. These examples beg the question for assets that do not have clearly defined or delineated terms until expiration. The issue here is that the assigned life at times directly affects the value. The length of an income stream directly corresponds on a discounted basis to the anticipated life.
In terms of internal controls, the main subject of this book, it is critical that the estimates of lives of intangibles be assessed as accurately as possible.
Internal Control of Fixed Assets: A Controller and Auditor's Guide - Alfred M. King - Google книги
It is true that a longer life does reduce the charge to expense in the early years, at the expense of having the amortization charge go on for a long period of time. However, deliberately underestimating the life of the intangible, and hence underestimating the value of the asset risks putting too much of the purchase price into goodwill. While not directly impacting short-run EPS, an overstatement of goodwill may cause an impairment charge for goodwill.
As was seen in the — downturn, with stock prices depressed, many companies were forced to take unanticipated goodwill impairment charges. We have seen a number of instances where the goodwill impairment charge was higher than it need to have been because of prior errors in correctly estimating the lives and hence the amount of amortizable intangibles.