Analyze and Interpret Financial Statement Disclosures

Introduction

Users of financial statements can use financial statement disclosures to better understand a company’s investments in tangible and intangible assets, how those investments have changed during a reporting period, how those changes have affected the company’s current financial performance, and what the changes might indicate about future expected performance.

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

Financial statement disclosures can be used to compute various financial ratios which can assist in analysing 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 is able to generate with a given amount of investment in fixed assets.

Asset age ratios typically 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 productive capacity. The older the assets and the shorter the remaining useful life, the more a company may need to reinvest in order to maintain productive capacity.

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

Comparing a company’s annual capital expenditures to its annual depreciation expense can also provide an indication of whether productive 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 rate at which PPE is being depreciated.

Question 1

Assuming 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:

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Which of the following statements is least accurate?

A. The estimated total useful life suggests that company XYZ depreciates PPE over a much shorter period that company ABC.

B. The estimated age of the equipment suggests that company ABC has newer PPE than company XYZ.

C. The estimates suggest that more than 50% of each company’s useful life has passed.

Solution

The correct answer is A.

The estimated total useful life suggests that company ABC depreciates PPE over a much longer (not shorter) period that 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, the company with the lower estimated total useful life i.e. 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 below information 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 how long has the company held these machines for?

A. The remaining useful life is 5 years and the company has held the machines for 3 years.

B. The remaining useful life is 8 years and the company has held the machines for 4 years.

C. 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

 

Reading 29 LOS 29m:

Analyze and interpret financial statement disclosures regarding property, plant, and equipment and intangible assets


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