capital asset planning and property accounting kent allen northrop grumman

Capital Asset Planning and Property Accounting

Kent AllenNorthrop Grumman

Key Subjects

• Reasons for Capital Investment• Key Elements of Capital Investment• The Capital Planning Process• Predicting and Measuring Investment

Effectiveness• Capitalization Issues• Depreciation and Other Accounting Principles

Main Financial Components

CAPITAL ASSET PLANNING

PROPERTY ACCOUNTING&

Highly Interrelated

PROPERTY MANAGEMENT

Planning & Analysis

BudgetingImplementationOversight &Reporting

Capitalization, Control & Utilization

Disposition

The Three Critical Phases for Traditional Property Management

Capital Asset Life Cycle

1960

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PROGRESS CHANGE

The Ongoing Cycle of Asset Management

PropertyManagement

Dynamics of Capital Investment

• Technological Advances

• Changing Markets or Service Populations

• Process Changes

• Legal and Regulatory Changes

• Aging of Existing Assets

Capital Planning - Points to Consider

• Not limited to Private Sector businesses.• Seeks to maximize the efficient use of

financial resources.

• Major impact on profitability and

effectiveness.

Related Funding Categories

• Capital Budget• Funding associated directly with the asset’s

intrinsic value.

• Associated Burden• Funding for other costs not directly related

to the asset’s value.

Key Characteristics of Burden• Items Below Cost and Longevity Thresholds• Administrative Expenses• Support of Requirements Not Adding to Asset Value.

• Examples:• Demolition Costs• Architect and Accounting Fees• Insurance Premiums • Closing Costs• Damage Payments

Capital Project Features

• Capital Project is defined chiefly by two characteristics:• Larger Cash Requirements (Greater than

a Defined Cost Threshold).• Longer Asset Life as Compared to

Burden (Expense) Items.• These are precisely defined in the

Disclosure Statement .

Capital Project Thresholds

0

2

4

6

8

10

12

- 2 4 6 8 10 12

CAPITAL

EXPENSE

VA

LUE

ASSET LIFE

>

>

Other Resource Requirements

• Budget for Unanticipated Costs

• Overruns of Total Project Cost

• Both Capital and Burden budgets are affected.

• Inadequate EAC cost estimates cause shortfalls.

• Scope Creep

• Over time, many projects tend to expand in terms

of purpose, application and cost.

Other Resource Requirements• Time

• Realistic Schedules

• All projects require adequate time to complete.

• Cash Cost and Availability• Expenditure patterns must be accurately

forecast.

• Unanticipated cash requirements cost money.• Business practices may include reliance on

short-term credit for funding of day-to-day cash needs.

• Unexpected demand drives the cost of money.

Reducing Resource Requirements• Alternative Funding – Contract-Direct vs.

Capital• Wherever possible, seek to obtain items as

direct-charge contract assets• “One Purpose” items with no use other than

contract support.• Must have customer approval.• Results in better financial results.

• Fewer assets to track and account for.• Improved returns on assets employed.

P u b l i c l y T r a d e d C o r p o r a t i o n s

Sarbanes OxleyP u b l i c l y T r a d e d C o r p o r a t i o n s

GASB 34S t a t e & L o c a l G o v t . ’ s

OMB A-87L o c a l G o v e r n m e n t s

CFO Act

Legal Environment

Capital Projects - Broad Categories:

• Strategic Needs • Anticipated Markets or Service

Challenges (Capacity)• Use and Development of Emerging

Technologies

Capital Projects - Broad Categories:

• Operational Needs

• Safety, Legal and Environmental

• Productivity Improvement

• Maintenance, Repair or

Replacement of Aging Assets

Uses of Capital Funding• Provide equipment to support current contracts.

• Maintain existing technology levels.

• Establish strategic capabilities.

• Meet all regulatory obligations.

• Maintain, modernize, and expand infrastructure.

• Buildings

• Grounds

• Support Systems.

Strategic Perspective

• Investments in land, equipment, buildings and other assets for future economic gain are part of an organization’s strategic direction which must be periodically revisited.

• Business investment decisions cannot be made lightly, because a significant commitment of funds is made over the long term.

Strategic Perspective

• Limited resources require that various alternatives must be narrowed down.

• The process of identifying, analyzing and selecting capital investment opportunities is known as capital budgeting.

• The capital budget is comprised of those projects selected to provide economic returns that meet the goals

set by management.

Key Aspects of Capital Budgeting • Timing:

• Define an effective time interval for budgeting.

• Standard Process:• Establish consistent and effective practices for gathering and processing capital requests.• Apply process across the board for all requesters.

• Categorization• Employ well defined categories based on type of need.

Key Aspects, continued• Prioritization:

• Have well-defined methods for ranking competing requests by criticality.

• Allocation of Funding:• Establish clear affordability levels and distribute funding proportionately.

Key Aspects, continued• Budget Review:

• Develop a hierarchy for coordinating requests.

• Preliminary Budget Approval by Top Management• General Presentation of Preliminary Budget.• Coordination of Resultant Changes

• Prioritization• Timing• Inclusion vs. Exclusion

Review of Capital Requests• Consistency with Strategic Plan• Elimination of Duplication• Technical Effectiveness• Correct Asset Category

• Legal and Regulatory • Maintenance and Sustainment• Technology Development• Process Improvement

Selecting the Best Capital Project

• Given the cash frequency of need and the spectrum of investment categories, a system must be established for distributing cash most effectively by:

• Determining total affordability limit• Aligning competing projects with operational and strategic

objectives • Ranking projects within each investment category.

Legal / Regulatory

Operational Needs

Strategic Initiatives

Productivity Improvement

Other

• The type of investment largely determines its eventual selection for the budget proposal.

Legal / Regulatory

Operational Needs

Strategic Initiatives

Productivity Improvement

Other

INVESTMENT TYPE PRIORITY TIER PORTION SELECTED

ALL

MOST

SOME

DISCRETIONARY

Selecting the Best Capital ProjectAFFORDABILITY

Property Accounting Responsibilities

• Services Provided:– Asset Capitalization – Asset Transfers – Asset Retirements – Depreciation – PP&E Reporting

Property Accounting Responsibilities

• Assets Under Construction (AUC) • Capital Project Types :

• Capital Fabrication• Straight Buy

• Capitalization• Closure of Capital Projects• Initiation of Depreciation

Definitions of Depreciation

• Physical Depreciation - Decline in the economic potential of assets originating from normal wear and tear, environmental exposure, and technical obsolescence. (Asset deterioration).

• Financial Depreciation - Spreading of original cost over the estimated life of an asset. Different methods are employed based on a given asset’s typical patterns of use and its ability to maintain a stable value over time.

CASHCAPITALASSETS

CAPITALASSETS

DEP.EXPENSE

DEP.EXPENSE

CAPITALASSETS

CAPITALASSETS

DEP.EXPENSE

PROCUREMENT &CAPITALIZATION

ASSET USEFUL LIFE(DEPRECIATION PERIOD)

YEAR 0 YEAR 1 YEAR 2 YEAR 3

AUC (CASH TIED UP WITH NO BENEFIT)

DEPRECIATION CURVE

CAPITALIZATIONPROCUREMENT

Financial Depreciation Process

0 1 2 3 4 5 6 7 8 90

1

2

3

4

5

6

STRAIGHT LINE

DECLINING BALANCE

RESIDUAL VALUE

ACQUISITION VALUE

CO

ST

YEAR

Basic Depreciation MethodsStraight-Line vs. Declining Balance

• To ensure consistent accounting methods, asset classes are assigned to different types of assets, based on the asset’s estimated useful life and the general pattern of physical depreciation.

Asset Class Description Depreciation MethodLand No depreciationBuildings 39 Year Straight LineBuildings - Temporary/Portable 15 Year Straight LineOffice Machines 10 Year Variable Declining BalanceFactory Machinery & Equipment 18 Year Straight LineHeavy Trucks 10 Year Double Declining BalanceAutos 5 Year Double Declining BalanceFurniture & Fixtures 12 Year Straight LineElectronics Equipment 4 Year Declining BalanceAircraft & Aircraft Equipment 6 Year Variable Declining BalanceComputer Equipment 3 Year Double Declining BalanceLeasehold Improvements Straight Line spread over remaining term of the leaseAssets Under Construction No depreciation

Depreciation Based on Asset Class

Investment Analysis

• A wide choice of capital investments are typically available: Some examples:

– Invest in new facilities for expansion (new volume)

– Upgrade outmoded facilities (improve cost effectiveness, cost savings)

– New equipment for potential new opportunities

• Various alternatives/choices must be narrowed down (limited resources)

Capital projects can be assessed by their Return on Investment (ROI), generally achieved through one or both of the following processes:

• Cost Reduction

• Better Use of Limited Resources (Limiting or Reducing

Cash Outflows).

• Does not include cost avoidance.

• Cash Generation

• Realizing Greater Cash Inflows due to Increased Markets

and/or Service Populations.

Measures of Capital Investment Effectiveness

Cash Inflows Should Exceed OutflowsMUST

• Two basic measures of projected investment value:– Return on Investment (ROI)

• Best applied on an individual project basis, typically before investment.

– Return on Net Assets (RONA)• Usually a measure of many combined projects.• Typically measured on the basis of all-up fixed asset

values.• May be a forecasting tool, but generally used as an

ongoing metric following project implementation.

Investment Analysis, Continued:

Application of Simple Payback Method4-Year Cost Recovery Scenario

Year 0 Year 1 Year 2 Year 3 Year 4

$25K

($75K)

$25K

($50K)

$25K

($25K)

$25K

($100K)

PAYBACKOUT

IN

BALANCE OF COST OUTSTANDING

Discounted Payback Method5-Year Cost Recovery Scenario

Year 0 Year 1 Year 2 Year 3 Year 4

($75K)

$25K

($53K)

$22K

($33K)

$20K

($100K)

PAYBACKOUT

IN

BALANCE OF COST OUTSTANDING

Year 5

$15K

($15K)

$18K

-100

-80

-60

-40

-20

0

20

40

60

80

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10

Cash Generation

Time Value of Money

CapExCompletion &

Asset Capitalization

“Simple”Cost

Recovery Point

Cash Flow

Capital Investment

Cash GenerationCash Return

on Investment

Cash UseDiscounted

Cost Recovery Point

Positive ROI

Cumulative Cash Flow and ROI

Comparative Return-On-Investment:

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1

1.2

1.4

1 2 3 4 5 6 7 8 9 10 11 12

Project A

Project B

Project C

CUMULATIVE CASH FLOW

1st

2nd

3rd

$M

Year

156% (9% IRR)

($K) ACASH OUT 500CASH IN 1800

B200

1000

C500950

IN/OUT 360%ROI 265%

500%390%

190%156%

IN/OUT 360%ROI 265%

390% (48% IRR)

265% (29% IRR)

DISCOUNTED ROI

Asset Turns(Asset Utilization)

RONA Return on Sales (Profitability)

=X

NOPAT=

Net Assets

(Net Operating Margin less tax rate)

Net Income=

Net Assets

Sales

NOPAT* Sales

Net Assets= X

* NOPAT = Net Operating Profit After Taxes

RONA Formula

Net Income

Net Assets

Capital Planning Effect on RONA

Net Income

Net Assets

Good Poor

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

1 2 3 4 5 6 7 8

Capital Project Value

AUC COST

NETBOOK VALUE

VA

LUE

TIME

RESIDUAL VALUE

NEGATIVE INVESTMENT

IMPACT

INVESTMENT EFFECTIVENESSUTILITY

VALUATION=

DISPOSITION POINT

REDEPLOYSELLDONATEABANDONSCRAP

(TOTAL BENEFIT FROM USE OF ASSET)

CA

PIT

AL

IZA

TIO

N

POSITIVE INVESTMENT

IMPACT

UTILITY

Investment Effectiveness Over Time

• Accumulated Cash Expenditures Against Projects Not Yet Completed/Received and Therefore Not Yet Capitalized

• Drains Assets (Cash) • Generates No Benefits or Depreciation

• Increased Revenue• Cost Savings• Improved Profit Margin

Assets Under Construction (AUC)

• Accelerate Procurement and Construction Processes

• Ensure that Capitalization Process is Efficient:• Speed• Accuracy

• Where Possible, Apply Progressive/Partial Capitalization

Most Common Approaches:

Limiting AUC Cost

• Ensure capital investments align with strategic objectives.– Better use of assets to generate revenue and expand

business base.

• Minimize capital commitments and expenditures.– Challenge requests for capital funding.– Conduct project analysis (ROI, etc.) to objectively assess

projects’ potential profitability/positive cash balance.

Improving Investment Effectiveness

Improving Investment Effectiveness

• Identify objectives and monitor efforts to eliminate aging and obsolete assets.

• Encourage redeployment of surplus assets where possible to reduce the quantity and cost of new commitments for similar assets.

Property Management’s Central Role

Questions

JIC

New CapEx CurrentDepreciation

CurrentDepreciation

CAPITALIZED

Prior-Period CapEx

CAPITALIZED

Current CapEx

Reinvestment Rate vs. Shareholder Value

Balanced Ratio

Asset Turns(Asset Utilization)

RONA

Return on Sales (Profitability)

=X

NOPAT=

Net Assets

(Net Operating Margin less tax rate)

Net Income=

Net Assets

CurrentDepreciation

Current CapEx

R a t i o > 1 . 0 R a t i o < 1 . 0

Current CapEx

CurrentDepreciation

Reinvestment Rate vs. Shareholder Value