Valuation at Acquisition - Operational Assets - Essay Example

Valuation at Acquisition (Operational Assets) Introduction The term operational assets imply assets used to earn revenue for the entity. Operationalassets may be tangible or intangible assets but during acquisition proceedings the concern is of long term or non- current operational assets that are revenue yielding. The valuation of assets is the major issue in any acquisition process as the consideration to acquire is fully dependent on the value of assets on the date of acquisition. Hence the issue covered by this write up is the process used to value operational assets at the time of their acquisitions or internal development. Contents Introduction Contents Classifications of operational assets Costs to be capitalized Property Plant & Equipments. Intangible Assets Lump sun purchases Non- cash acquisitions Conclusion References Classifications of operational assets Operational assets are long term income yielding assets. Such assets may be tangible or intangible. Tangible operational assets generally include assets that may be covered under the broad category of ‘Property Plant and Equipment’ like land and buildings, machineries and equipments, vehicles, and others. Such assets may be acquired by purchase or gift, or the entity may construct its own assets. Regardless of the method of acquisition, decisions need to be made as to which costs should be capitalized and which cost which should be expensed with. In addition the amounts at which such assets should be capitalize is not clear. Intangible assets have the main characteristic is that they lack physical substance. It is generally difficult to estimate the value of intangibles and there is high degree of uncertainty regarding the length of time over which they will provide revenue or future benefits to the entity. “In general, the value of an intangible asset lies in its future use, and can be estimated from the incremental profits that such use will through off.”(Farok J. Contractor,2001, page 10)1 The initial accounting for intangibles is largely dependent on whether they are purchased or developed internally. Intangible assets include patents, goodwill, copyrights, trademarks, franchises, organizational costs and others. Costs to be capitalized The general rule to capitalized costs is that the purchase price of an asset and all costs incurred in preparing the asset for its intended use are capitalized as part of cost of the asset. Let us examine the capitalization aspect under both tangible (Property Plant and Equipment) and intangible assets a) Property Plant and Equipment i)Land and Building Cost of Land that needed to be capitalized is all the expenditure on its acquisition that is incurred for getting it ready for its intended use. Such costs are purchase price and the closing costs like legal fees, fee of the attorney and registration charges. Some time an old structure exists on land being acquired. Then costs of demolishing such structure and also the expenditure relating to clearing, filling, and draining also needed to be capitalized. The idea is that any expenditure that brings the land for its intended use will be capitalized. But a land improvement is altogether a separate issue. Cost of land improvements include building costs of parking lots, driveways, fencing, lawn and garden, and other. These land and improvement costs are separate assets than land and thus are not included in the cost of land. Land improvement costs are capitalized separately. In case of buildings the acquisition costs normally include purchase price, commission of the agent, and legal fee. But when building is required to be refurbished or modified for intended use, then such costs are also capitalized along with above mentioned costs of the building. A company will often acquire a land and building at the same time. When this is the case, and the company intends to use the building, the total cost of the acquisition and related costs will be allocated between land and building. The total cost may include some or all of these attributes like purchase price, delinquent taxes assumed by the buyer, legal fees related to the acquisition, and title guarantee insurance. Once the total amount to be capitalized is determined, it is allocated between land and building on the basis of their relative fair value. This approach can also be used whenever two or more assets are acquired at the same time for a lump sum price. ii) Construction When land is acquired for the purpose of constructing a new building, the amount that will be capitalized to the building will include those costs that relate directly to the building or the construction. These will include architects’ fees, insurance during construction, and actual construction costs. In addition, interest may also be capitalized. Interest may be capitalized on an plant asset that is constructed for the company’s own use. Interest may not be capitalized on an asset that is manufactured for resale in the ordinary course of business. The amount of interest that may be capitalized as part of the cost of a plant asset will include: Interest on borrowings that is incurred specifically for the construction. Interest on other borrowings that could have been avoided if the asset had not been built. The maximum amount of interest to be calculated is interest computed on the weighted average amount of accumulated expenditure for the asset. Any interest incurred after the completion of construction is not capitalized. It is recognized as interest expense. iii) Equipments The term ‘Equipments’ are treated very broadly under the category of long lived assets ‘Property Plant and Equipments’. It almost includes every asset that is not Land and Building or Natural Resources. Machinery, computers, office equipments, vehicles, and furniture and fixtures all come under the category of Equipments. When equipment is acquired, the cost that will be capitalize include the purchase price of the equipment and the following costs of preparing the equipment for the use to earn revenue for the entity: Shipping costs of equipment Insurance costs while in transit Installation costs of equipment to be operational Testing fee that verify the quality of operations of equipment. There may be a case in equipments when one asset is disposed of and replaced with new one. Disposal and replacements are treated as independent transactions. The disposal of old asset is recorded as a sale with a gain or loss recognized as appropriate. The amount capitalized for the new asset is not affected by the disposal of old asset. iv) Natural Resources Under Property, Plant, and Equipment category a special type assets called ‘Natural Resources’ are also categorized by companies in their financial statements. The character of natural resources is that those are physically diminished as they are used, and this quite contrary to other assets under Property Plant and Equipment category. Take the case of minerals, those are to be extracted from mines to be used for the purpose of earning revenues for the entity. The valuation at the time of acquisition of minerals the value paid to acquire rights to explore or extracts natural resources. Besides this acquisition costs the exploration costs and the developments costs form part of the valuation of natural resources at the time of their acquisition. Exploration cost is the cost incurred for drilling a well or excavating a mine. Development costs are the costs that are incurred after the discovery of resources and before the start of production. For example costs of tunnel, wells and shafts. Accordingly valuation of natural resources on their acquisition includes their acquisition costs, exploration costs, and development costs before the start of production. v) Special acquisitions under Property Plant & Equipments Although most plants are obtained through purchase or construction, there are other means by which they may be acquired and accordingly capitalization of costs in each case is treated as under: Assets acquired by gift are recorded at their fair value with an increase in income. Assets acquired as a result of capital lease are recorded at the present value of the payments made under the lease provided the amount does not exceed the fair value of the property. When a plant asset is acquired for a specific research or development project, with no alternative use contemplated, the cost is recognized as research and development expense and it is not capitalize. When a plant asset is acquired for general research and development activities, the cost is capitalized and the depreciation is charged to research and development expense. b) Intangible Assets The main characteristic of intangibles is that they lack physical substance. It is generally difficult to estimate the value of intangibles and there is high degree of uncertainty regarding the length of time over which they will provide future benefits. The initial accounting is largely dependent on whether they are purchased or developed internally. When intangibles are purchased from others, they are initially recorded at their cost. The amount capitalized will include the purchase price and costs of preparing them for their intended use. As a result, costs of registration or legal fees related to acquisition are also capitalized. When intangibles are developed internally, it is often difficult to distinguish between the cost of developing the intangible and costs associated with current operations of the company. As a result most costs associated with internal development of intangibles is recognized as expense in the period incurred. Once the intangible can be identified, however, costs of preparing it for use, such as legal costs associated with registering a patent, would be capitalized. Goodwill may be developed internally or may be acquired from others, and therefore the method of accounting for goodwill is accordingly. Goodwill can only be acquired as part of the acquisition of a company. In fact, the only time the cost og goodwill can be capitalized is as the result of a business combination accounted for as a purchase. When a company is involved in a purchase, they will allocate the amount paid for the other company based on the fair value of the underlying net identifiable assets. When the amount paid for the company exceeds that amount, the excess is reported as goodwill. Patents are often the result of a variety of activities. Some companies may acquire patents from others. When a company acquires a patent the cost is capitalized. Any costs associated with transfer, such as legal fees or registration costs are also capitalized. When patents result from internal developments of a product or process, the costs that are capitalized are limited to legal and registration fees paid. There may be situations when the patent rights are violated by others and the company may incur legal fees to defend the patent. If the company is successful in defending the patent, the cost of the defense is capitalized and added to the carrying value. When the company in defense is unsuccessful, the cost of defense is recognized as expense. Franchises Initial fees paid for the franchisees are generally capitalized. Subsequent payments are based on revenue or earnings are recognized as expense in the period that revenue or earnings are recognized. Software development is like research and development expenditure. Costs incurred during development phase, until such time as technological feasibility has been established are not capitalized and instead those are expensed with. But once the technological feasibility has been established, costs of coding and testing, along with costs of producing masters , are capitalized as software costs. Lump- sum Purchases Operational assets may be purchased some times at making lump sum costs. Valuation of each asset is easy when such assets are indistinguishable. For example when ten cars are purchased for say $200000, it is easy to calculate that each car will be capitalized at $20000. But when different assets are acquired at lump sum costs, then each asset is allocated a cost that is proportionate to relative market value of each asset. For example a company has acquired a business with four following assets and no liability at lump sum price of say $200000, and the relative market value of each asset is as under: Land $ 90000 Building $ 60000 Machinery $ 70000 Inventory $ 30000 Total Market value $250000 The cost to be capitalized will be calculated as under: Land = 200000 * (90000/250000) = $72000 Building = 200000 * (60000/250000) = $48000 Machinery = 200000 * (70000/250000) = $56000 Land = 200000 * (30000/250000) = $24000 Total = $200000 Non- cash acquisitions a) Non- cash payment Non cash transactions in case of operational assets may take the shape of issuance of securities to seller, receiving assets as donation, or exchanging of other assets. The basic principle to determine the costs of such acquired assets is the determination of fair value. However the fair value is determined first on the basis of assets give or exchanges, e.g., market value of securities issued or other assets. When it is difficult to find the fair value of assets given, then efforts are made to find the fair value of assets received. In case the fair value of assets received is very clearly and fairly available, then that may used for capitalization purposes of assets acquired through non cash payments. b) Issue of equity, securities As stated in above section of non cash payments, when assets are acquired by issuance of equities or other securities the cost to be capitalized of acquired assets is the fair market value of such issued equities or other securities as at the date of acquisition of such assets. c) Donated assets Assets that are acquired by way of donations are capitalized at their market value as on the date of donation of such assets. Market value of such asset is treated as fair value of donated assets. Conclusion Valuation of acquisition costs of assets depend upon the type of assets being acquired. Tangible assets are valued generally at costs of acquisition and related expenses to bring assets to intended use. However different circumstances of acquisition change the valuation process of tangibles. Intangibles are valued at cost incurred on their purchase or incurred on internal development, subject however to be valued differently for different intangibles. Acquisitions of assets at non cash payment are valued at fair market value of assets given or assets acquired. References: Read More