Question 1: Development cost
Look at the 2016 reports of the Italian car manufacturer Fiat, which uses IFRS:
Fiat capitalizes development costs as required in IFRS.
Look into the income results for 2016 in page 56. What was the research and development expense in the income statement for 2016?
What are the components of the research and development expense (see page 58)? (include both the descriptions and the numbers).
How much development expenditures did the company capitalize in 2016 (can also be found in page 58)?
In US GAAP development cost cannot be capitalized (except for special cases discussed in class like software, etc.). Taking that into account, use the information you found in parts a, b, and c to see what would have been the research and development expense under US GAAP. (hint: development cost cannot be capitalized in US GAAP, and so they would also not require any future amortization or write-down).
Compare the research and development expense in IFRS (from part a) and in US GAAP (which you found on part d) and calculate the difference. Would Fiat’s profit go up or down in 2016 if it used US GAAP? Look up Fiat’s annual profit before tax for 2016 (look at the line that says “Profit Before Taxes”). What is the profit before tax for the year? Would the change in profit be significant (calculate the percentage change)?
Question 2: Component Depreciation
Keep looking at Carnival’s 2016 reports. The company needs every few years to dry-dock its ships and perform major repairs.
a.What is the accounting treatment that Carnival uses for the dry-docking expenditures? (Look in note 2, in the section about PP&E).
b.What would be the appropriate accounting treatment under IFRS? (Recall our discussion on component depreciation and non-physical parts).
c.Assume Carnival buys a new ship for $255 million. The useful life of the ship is 30 years and the residual value is 15% of the cost assigned to the ship. The company needs every 2.5 years to dry-dock the ship and perform major repairs at an expected cost of $15 million. If the company used IFRS:
i.What would be the depreciation expense for the first year?
ii.Assume now that because of some technical difficulties with the ship it had to be dry-docked 2 years after purchase (instead of 2.5 years) and repairs were made in the sum of $15 million. What are the journal entries required at the time of the dry-docking?
In class we saw the effect of revaluation of PP&E on a Greek shipping company. Assume we want to estimate how revaluation would affect a similar U.S. company (although revaluation of PP&E is not permitted in U.S. GAAP). Look at the 10-K filing for 11/30/2016 (the end of the financial year) of the cruise lines company Carnival (the company uses U.S. GAAP):
a. What is the useful life of ships? What is their residual value (in % of cost)? (see note 2 to the financial statements, ignore ship improvements)
b. Look in note 4 to find what the gross cost of the ships at the end of 2016 is and what their accumulated depreciation is (ignore ships in construction, and also assume for simplicity that all of the accumulated depreciation is associated with the ships and not with the other assets).
c. Using your answers from parts a and b, what is your estimate of the average age of the ships in the fleet? (hint: as the ships are depreciated on a straight line, the ratio of accumulated depreciation to the total cost minus residual is the percentage of useful life already used.)
d. Now assume that the company wants to switch to the revaluation model for the ships and perform the revaluation at the end of the 2016 financial year (11/30/2016). Assume that on average the fair value of the ships goes up 3% every year (3% was chosen for the example because this is the average rate of inflation in the U.S. for the last couple of decades). What would be the revaluation surplus that will be created at the end of 2016? (hint: to get the net revalued amount you should multiply the net historical cost of the ships by 1.03 in the power of the average age of the ships you found in part c. The revaluation surplus will be the difference between the net historical cost and the net revalued amount).
e. What would be the journal entry recorded for the revaluation? Assume that the company will use the proportionate restatement method we studied in class (so both the gross and the accumulated depreciation amounts are restated proportionately).
f. How would the revaluation change the ratio of (Total equity)/(Total assets) for the end of 2016? Calculate the ratio before and after, and determine if the company looks more risky or less risky after the revaluation.
g. What would be the expected additional depreciation expense in 2017 due to the revaluation? (assume Carnival keeps all the ships it has at the end of 2016, and no additional revaluations were done in 2017). Looking at the 2016 earnings before tax, would that decrease in earnings be significant (calculate the percentage change in earnings before tax)? What would be the journal entries required to record the annual depreciation expense under the revaluation model (hint: remember that the revaluation surplus should also be adjusted)?
h. Assume the company did revalue its ships on 11/30/2016 as described above. If on 12/1/2016 (a day after the 2016 balance sheet) Carnival sells 25% of its fleet for $12 Billion, what are the journal entries required (hint: remember to also adjust the revaluation surplus)?