Analyze and Intperret Financial Statement Disclosures

Users of financial statements can use financial statement disclosures to deepen their understanding of a company’s investments in tangible and intangible assets.  Financial statement disclosures divulge such details as how those investments have changed during a reporting period, how the changes have affected the company’s current financial performance, and the implications the changes might have on the expected future performance of the company.

Analysis and Interpretation of Financial Statement Disclosures Relating to Property, Plant, Equipment, and Intangible Assets

Financial statement disclosures can be used to compute various financial ratios. The ratios can be useful in the analysis of aspects of fixed assets such as the fixed asset turnover ratio and several asset age ratios.

The fixed asset turnover ratio, which is computed by dividing total revenue by average net fixed assets, reflects the relationship between total revenues and investment in property, plant, and equipment (PPE). The higher the ratio, the more sales a company can generate with a given amount of investment in fixed assets.

Asset age ratios rely on the relationship between historical cost and depreciation. The asset age, and remaining useful life ratios, are two significant indicators of a company’s need to reinvest in its production capacity. The older the assets and the shorter the remaining useful life, the more a company may need to reinvest to maintain production capacity.

The average age of a company’s asset base can be estimated as accumulated depreciation divided by depreciation expense.  And to estimate the average remaining life of a company’s asset base, the net PPE is divided by depreciation expense.

Comparing a company’s annual capital expenditures to its annual depreciation expense can also indicate whether or not the company’s production capacity is being maintained. It acts as a very general indicator of the rate at which a company is replacing its PPE relative to the PPE depreciation rate.

Question 1

Assuming that the historical cost of PPE for companies ABC and XYZ are the same, and the companies use the same depreciation method, consider the following information on their PPE:

$$ \begin{array}{|c|c|c|}
\hline
\textbf{Estimates} & \textbf{Company ABC} & \textbf{Company XYZ} \\ \hline
{\text{Estimated total useful life }(\text{years}) } & {10.4} & {21.3} \\\hline
{\text{Estimated age }(\text{years}) } & {5.7} & {11.0} \\\hline
{\text{Estimated remaining life }(\text{years}) } & {4.7} & {9.4} \\\hline
\end{array}
$$

Which of the following statements is the least accurate?

1. The estimates suggest that more than 50% of each company’s useful life has passed.
2. The estimated age of the equipment suggests that company ABC has newer PPE than company XYZ.
3. The estimated total useful life suggests that company XYZ depreciates PPE over a much shorter period than company ABC.

Solution

The correct answer is C.

The estimated total useful life suggests that company ABC depreciates PPE over a much longer (not shorter) period than company XYZ. The estimated total useful life of PPE is total historical cost of PPE divided by annual depreciation expense. If the historical cost of both companies’ PPE is the same, and they use the same depreciation method, then the company with the lower estimated total useful life – company ABC – must have a higher depreciation expense which would stem from the choice to depreciate PPE over a shorter period of time than company XYZ.

Question 2

XYZ company follows a straight line depreciation method, and reports the information below for its production machines:

annual depreciation expense: $50,000;

accumulated depreciation expense: $200,000;

carrying value: $650,000.

What is the estimated remaining useful life of the machines and for how long has the company held them?

1. The remaining useful life is 5 years and the company has held the machines for 3 years.
2. The remaining useful life is 8 years and the company has held the machines for 4 years.
3. The remaining useful life is 13 years and the company has held the machines for 4 years.

Solution

The correct answer is C.

Remaining useful life = Asset’s carrying value/Annual depreciation expense = $650,000/$50,000 = 13 years

Asset’s holding period = Accumulated depreciation expense/Annual depreciation expense = $200,000/$50,000 = 4 years