Explain the Derecognition of Debt
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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 company’s expected future performance.
Under IFRS, companies must disclose for each class of property, plant, and equipment the basis of measurement, depreciation methods, useful lives or depreciation rates, the gross carrying amounts, and the accumulated depreciation at both the start and end of the period. Additionally, companies must provide a reconciliation of the carrying amounts from the beginning to the end of the period.
Further disclosures required include any restrictions on title, pledges of property, plant, and equipment as security, and contractual obligations to acquire such assets. If the revaluation model is adopted, details such as the date of revaluation, how the fair value was determined, the carrying amount under the cost model, and any revaluation surplus must be reported.
Companies must also disclose the depreciation expense for the period, the balances of major classes of depreciable assets, total accumulated depreciation, and a general description of the depreciation methods applied.
For intangible assets under IFRS, companies need to state whether the useful lives are indefinite or finite. For assets with finite lives, disclosures should include the amortization methods, useful lives or amortization rates, the gross carrying amount, and accumulated amortization at the beginning and end of the period, including a reconciliation of these amounts. Where amortization affects the income statement, this must be indicated. For assets with indefinite lives, the carrying amount and the rationale for classifying the life as indefinite should be disclosed.
Similar to tangible assets, information on any restrictions, security interests, and future acquisition agreements of intangible assets is required. If using the revaluation model, the same details as tangible assets should be disclosed regarding fair value assessment and surplus.
Disclosure requirements for impairment losses also vary between IFRS and US GAAP. Under IFRS, companies must report the amounts of impairment losses and reversals by asset class, including where these are recognized in the financial statements. They should also aggregate the main asset classes affected by impairments and reversals, and describe the key events and circumstances leading to these losses and reversals.
Under US GAAP, where impairment losses are not reversible for assets held for use, companies must describe the impaired asset, the cause of impairment, the method of fair value determination, the amount of the impairment loss, and its recognition in the financial statements.
Financial statement disclosures concerning long-lived assets include their carrying values on the balance sheet, while the income statement may show depreciation expenses either separately or integrated depending on whether a ‘nature of expense’ or ‘function of expense’ method is used. The statement of cash flows, especially when prepared using the indirect method, typically includes depreciation or amortization as an adjustment to reconcile net income to cash flow from operations.
Notes to the financial statements detail the company’s accounting methods, estimated useful life ranges, historical cost by main asset category, accumulated depreciation, and annual depreciation expense.
Ratios utilized in analyzing fixed assets include the fixed asset turnover ratio and various asset age ratios.
The fixed asset turnover ratio, calculated as follows:
$$\text{Fixed asset turnover ratio}=\frac{\text{Total Revenue}}{\text{Average net fixed assets}}$$
Intuitively, from the above formula, the fixed asset turnover ratio measures the relationship between total revenues and investment in property, plant, and equipment (PPE). As such, a higher ratio indicates that a company executes more sales with a given amount of investment in fixed assets, often interpreted as a sign of greater efficiency.
Asset age ratios generally depend on the relationship between historical cost and depreciation. Under IFRS’s revaluation model, this relationship may differ when carrying amounts significantly diverge from depreciated historical costs, as such we apply the age ratios to PPE reported under the cost model.
Two important asset age ratios are asset age and remaining useful life. Age ratios indicate a company’s need to reinvest in productive capacity. Older assets and shorter remaining lives suggest a greater need for reinvestment.
The Average Age of a company’s asset base is approximated as:
$$\text{Average Age of a company’s asset base}=\frac{\text{Accumulated depreciation}}{ \text{Depreciation expense}}.$$
On the other hand, the average remaining life of a company’s asset base is estimated as:
$$\text{Average Remaining life of a company’s asset base}=\frac{\text{Net PPE}}{ \text{depreciation expense}}.$$
The average age and average remaining life ratio estimates reflect the relationships for assets accounted for on a historical cost basis:
$$\text{Net PPE = Total historical cost – Accumulated depreciation}$$
Moreover, under straight-line depreciation:
$$\text{Annual depreciation expense}=\frac{\text{Total historical cost – Salvage value}}{\text{Estimated useful life}}$$
In summary, assuming straight-line depreciation and no salvage value, the following relationships suffice:
$$\begin{align}\begin{matrix}\text{Estimated Total}\\\text{ Useful Life}\end{matrix}&=\text{Time elapsed since purchase (age)} + \begin{matrix}\text{Estimated}\\\text{ remaining life}\end{matrix}\\ \begin{matrix}\text{Estimated Total}\\\text{ Useful Life}\end{matrix}&=\frac{\text{Historical Cost}}{\text{Annual Depreciation}}\\ \text{Historical Cost}& =\text{ Accumulated Depreciation + Net PPE} \end{align}$$
Conversely,
$$\begin{align}
\begin{matrix}\text{Estimated Total}\\\text{ Useful Life}\end{matrix} &= \begin{matrix}\text{Estimated Age}\\\text{of Equipment}\end{matrix} + \text{Estimated Remaining Life} \\
\frac{\text{Historical cost}}{\begin{matrix}\text{Annual}\\\text{depreciation expense}\end{matrix}} &= \frac{\text{Accumulated depreciation}}{\begin{matrix}\text{Annual}\\\text{depreciation expense}\end{matrix}} + \frac{\text{Net PPE}}{\begin{matrix}\text{Annual}\\\text{depreciation expense}\end{matrix}}
\end{align}$$
Accurately making the above approximations is challenging due to the use of various depreciation methods, different asset useful lives and salvage values, and the presence of fully depreciated assets. Moreover, fixed asset disclosures tend to be general, making precise estimates challenging but useful for identifying areas needing further investigation.
Comparing annual capital expenditures to annual depreciation expenses provides a general indication of whether a company maintains its productive capacity. This comparison indicates the rate at which PPE is being replaced relative to the rate at which it is being depreciated.
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:
$$ \begin{array}{l|r|r}
\text{Estimates} & \text{Company ABC} & \text{Company XYZ} \\ \hline
\text{Estimated total useful life (years)} & 10.4 & 21.3 \\ \hline
\text{Estimated age (years)} & 5.7 & 11.0 \\ \hline
\text{Estimated remaining life (years)} & 4.7 & 9.4
\end{array} $$Which of the following statements is the least accurate?
- The estimates suggest over 50% of each company’s useful life has passed.
- The estimated age of the equipment suggests that company ABC has newer PPE than company XYZ.
- 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 the 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 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 machines’ estimated remaining useful life, and how long has the company held them?
- The remaining useful life is five years, and the company has held the machines for three years.
- The remaining useful life is eight years, and the company has held the machines for four years.
- The remaining useful life is 13 years, and the company has held the machines for four years.
Solution
The correct answer is C.
$$ \begin{align*} \text{Remaining useful life} & =\frac {\text{Asset’s carrying value}}{\text{Annual depreciation expense}} \\ & =\frac {\$650,000}{\$50,000} \\ & = 13 \text{ years} \\
\text{Asset’s holding period} & = \frac {\text{Accumulated depreciation expense}}{\text{Annual depreciation expense}} \\ & = \frac {\$200,000}{\$50,000} \\ & = 4 \text{ years} \end{align*} $$