Financial Reporting – Presentati ...
The presentation choices adopted by a company when preparing its financial statements can... Read More
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.
Financial statement disclosures can be used to compute various financial ratios. The ratios can be useful in analyzing aspects of fixed assets, such as the fixed asset turnover ratio and several asset age ratios.
The fixed asset turnover ratio, 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 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 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. 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 productivity capacity is being maintained. It is a general indicator of the rate at which a company replaces 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:
$$ \begin{array}{l|r|r}
\text{Estimates} & \text{Company ABC} & \text{Company XYZ} \\ \hline
\text{Estimated total useful life (years)} & 10.4 & 21.3 \\ \hline
\text{Estimated age (years)} & 5.7 & 11.0 \\ \hline
\text{Estimated remaining life (years)} & 4.7 & 9.4
\end{array} $$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.
$$ \begin{align*} \text{Remaining useful life} & =\frac {\text{Asset’s carrying value}}{\text{Annual depreciation expense}} \\ & =\frac {\$650,000}{\$50,000} \\ & = 13 \text{ years} \\
\text{Asset’s holding period} & = \frac {\text{Accumulated depreciation expense}}{\text{Annual depreciation expense}} \\ & = \frac {\$200,000}{\$50,000} \\ & = 4 \text{ years} \end{align*} $$