Back to Basics, Part 4
Last week we introduced the balance sheet
and reviewed some key categories that fall under current assets. I had
originally planned to dive next into current liabilities, but we'll
instead finish off the asset side of things by looking more closely
at noncurrent assets.
Property, Plant, and Equipment (PPE), often referred
to as "fixed assets," are noncurrent assets owned or controlled
by a company and used to produce or distribute the company's products.
PPE will generally appear on the balance sheet grouped together at original
cost, minus net accumulated depreciation. Original cost less depreciation
is used instead of current market value because usually a company does
not intend to sell these assets, so their current worth is not a relevant
figure. Also, current market value is somewhat subjective, while original
cost is easily verifiable.
Depreciation is the write-off for the reduction in
usefulness and value of a long-term tangible asset. It not only affects
the asset's value as stated on the balance sheet; it also affects the
amount of reported earnings on the income statement. There are generally
two categories of depreciation:
- Straight-Line Depreciation is the method of recording write-offs
in equal amounts during each year of the asset's estimated useful
- Accelerated Depreciation is the method of writing off the cost
of a capital asset in which the largest deductions are taken in the
early years of the asset's life. The goal here generally is to delay
taxes to a future date so that cash savings from the deferral can
be reinvested to earn additional income.
Since there is more than one way to report depreciation, the amount
recorded on financial statements may or may not be a good indication
of an asset's reduction in value for that individual time period. The
total depreciation for an asset over its useful life, however, will
be the same regardless of the method used. Keep in mind, though, that
similar companies within an industry may depreciate their assets using
different methods and timeframes, making a direct comparison difficult.
Leased Assets are assets that the company pays for
the use of for a portion of its useful economic life. Companies lease
assets to maintain flexibility over PPE and to preserve capital. There
are two kinds of leased assets:
- Operating Leases are generally short-term leases for which rental
payments are made by the lessee and full ownership rights are kept
by the lessor. Operating leases are not recorded on the balance sheet.
- Capital Leases are long-term leases that represent a purchase of
the asset by the company because the company will control the asset
for nearly all of its useful life. Accounting rules require that the
leased asset and the present value of the lease payments be recorded
on the lessee's balance sheet. Assets under lease will appear under
Intangible Assets are assets that have value even
though they cannot be seen, felt, jumped over, or swum in. Brand Name
is often the most important to a company's long-term success of the
intangible assets. Others include copyrights, patents, a mining claim,
or goodwill. Although intangible assets are difficult to quantify, it
does not mean that they do not have a tremendous effect on a company's
value. The main problem with companies that have a lot of value based
on intangible assets is that they tend to be treated more harshly by
the market at the first sign of trouble.
Goodwill is an asset that arises from the purchase
of one business by another at a price greater than book value (actual
net worth). When a company acquires another and the purchase price of
that business is higher than the net asset value of the acquired business,
the difference is transferred into an asset called "goodwill"
when the two consolidate.
If, for instance, your company wanted to acquire Gervin's Garage of
Groovy Gadgets, you'd be expected to pay more than book value because
Gervin has built enormous brand equity into his business' name over
the years. When people hear "Gervin's," they think "great
gadgets!" You would chalk up the amount you paid over GGGG's net
asset value to goodwill and amortize it over a period of time.
Amortization is the write-off of an intangible asset
over time. Similar to depreciation, amortization reflects the declining
value of an asset over its useful life. Under GAAP (generally accepted
accounting principles), intangibles should be amortized over at least
5 years and not more than 40 years.
Long-Term Investments will conclude our review of
noncurrent assets. Long-term investments are investments the company
plans on holding for more than one year. There are three methods of
accounting for investments:
- The Cost Method is for less than 20% ownership of another company.
This would be similar to how you would account for your personal investments.
Income (dividends, usually) are recorded on the balance sheet, and
gains or losses are not recognized until the asset is sold.
- The Equity Method is for ownership of 20% to 50% of another company.
The initial investment is recorded on the balance sheet to reflect
the initial cost plus a share of the investment's retained earnings,
less dividends. For example, if Elwood's Electric Elixirs takes a
20% stake in Gervin's Garage of Groovy Gadgets, and Gervin's earns
$3 million after taxes during the next year, EEE will increase the
carrying value of its investment by 20% of $3 million, or $600,000,
assuming no dividends were paid.
- The Consolidation Method is for ownership of at least 50% of another
company. This involves combining financial statements of the parent
and its controlled subsidiaries so that the assets of the parent and
its subsidiaries are reported together.
This wraps up the asset side of the universe for now. Next week, we'll
begin to tackle liabilities.
>> Current Liabilities >>