Non-Current Assets | CFA Level I FSA

Still on the topic of understanding balance sheets, let’s move on to the next major component – non-current assets.

Overview of Non-Current Assets

Assets, other than current assets, are collectively known as non-current or long-lived assets. Non-current assets can be sub-divided into 3 main categories:

• Tangible assets – physical assets such as plant, property, equipment, and investment property
• Intangible assets – non-physical items like patents, trademarks, and goodwill
• Financial assets

Plant, Property, and Equipment (PP&E)

PP&E are tangible assets used in the production of goods and services. It includes land and buildings, machinery and equipment, furniture, and natural resources. PP&E can be reported in the balance sheet using the cost model or the revaluation model.

Cost Model

Under the cost model, PP&E other than land is reported at amortized cost.

Amortized cost is defined as historical cost minus accumulated depreciation, amortization, depletion, or impairment losses. As we have learned earlier, PP&E can be depreciated using methods such as the straight-line or double declining balance methods.

Almost all plant, property, and equipment needs to be depreciated because their value reduces over time or through depletion. One exception is land. Land is not depreciated because it has an indefinite life.

Historical cost includes the purchase price plus any cost necessary to get the asset ready for use, such as delivery and installation costs.

Also, under the cost model, PP&E must be tested for impairment. The recoverable amount of an asset is the greater of fair value less any selling costs or the asset’s value in use. Value in use is the present value of the asset’s future cash flow stream.

If an asset’s carrying value exceeds the recoverable amount, the asset is written down to its recoverable amount. The amount of write down is recognized as a loss and is recognized in the income statement.

Loss recoveries are allowed under IFRS but not under U.S. GAAP.

Revaluation Model

Under the revaluation model, PP&E is reported at fair value less any accumulated depreciation. Changes in fair value are reflected in shareholders’ equity and may be recognized in the income statement in certain circumstances. The revaluation model is not permitted under US GAAP.

Investment Property

Under IFRS, investment property includes assets that generate rental income or capital appreciation. U.S. GAAP does not have a specific definition of investment property. Investment property can be reported at amortized cost just like PP&E, or at fair value.

Under the fair value model, the investment property’s value is not depreciated. Any change in fair value is recognized directly in the income statement.

Intangible Assets

Intangible assets are non-monetary assets that lack physical substance. They can either be identifiable or unidentifiable.

• Identifiable intangible assets can be acquired separately or are the result of rights or privileges conveyed to their owner. Examples of identifiable intangibles are patents, trademarks, and copyrights.
• Unidentifiable intangible assets cannot be acquired separately and may have an unlimited life. The best example of an unidentifiable intangible asset is goodwill.

Identifiable Intangible Assets

Identifiable intangible assets may be purchased from external sources or created internally.

Identifiable intangibles that are purchased can be reported on the balance sheet using the cost model or the revaluation model. Finite-lived intangible assets are amortized over their useful lives and tested for impairment in the same way as PP&E.

The amortization method and useful life estimates are reviewed at least annually. Intangible assets with infinite lives are not amortized but are tested for impairment at least annually.

The revaluation model can only be used if an active market for the intangible asset exists.

Determining the cost of internally created intangible assets can be difficult and subjective. For these reasons, under IFRS and US GAAP, the general requirement is that internally created identifiable intangibles are expensed rather than reported on the balance sheet.

IFRS provides that for internally created intangible assets, the company must separately identify the research phase and the development phase.

• The research phase includes activities that seek new knowledge or products.
• The development phase occurs after the research phase and includes design or testing of prototypes and models.

IFRS require that costs to internally generate intangible assets during the research phase must be expensed in the income statement. Costs incurred in the development phase can be capitalized as intangible assets if certain criteria are met. This includes technological feasibility, the ability to use or sell the resulting asset, and the ability to complete the project.

US GAAP prohibits the capitalization of most internally developed intangibles costs, research, and development costs. All such costs are usually to be expensed.

Under IFRS and U.S. GAAP, all of the following should be expensed as incurred:

• Internally generated brands, mastheads, publishing titles, customer lists, etc.
• Start-up costs
• Training costs
• Administrative and other general overhead costs
• Advertising and promotion
• Relocation and reorganization expenses
• Redundancy and other termination costs

Unidentifiable Intangible Assets (Goodwill)

In contrast, unidentifiable intangible assets like goodwill that have an unlimited life are not amortized. However, they must be tested for impairment at least annually.

If impaired, goodwill is reduced and a loss is recognized in the income statement. The impairment loss does not affect cash flow. As long as goodwill is not impaired, it can remain on the balance sheet indefinitely.

Goodwill is the excess of purchase price over the fair value of the identifiable net assets acquired in a business acquisition. It comes about when acquirers pay more than the fair value of the target’s identifiable net assets.

Goodwill is only created in a purchase acquisition. This is also known as accounting goodwill. Accounting goodwill should not be confused with economic goodwill. Economic goodwill derives from the expected future performance of the firm, while accounting goodwill is the result of past acquisitions. Internally generated goodwill is expensed as incurred.

Since goodwill is generally not amortized, firms can manipulate net income upward by allocating more of the acquisition price to goodwill and less to the identifiable assets. The result is less depreciation and amortization expense, resulting in higher net income.

Financial Assets and Their Classification

Financial assets, which include stocks, bonds, derivatives, loans, and receivables, are classified based on a company’s intent for their eventual sale. In this second part of the non-current assets topic, we’ll explore the different classes and accounting methods for valuing financial assets.

Financial assets can be classified into three main classes:

• Held-to-maturity: Debt securities purchased with the intent to be held until they mature.
• Available-for-sale: Securities with reliable market values that are bought without the intent to trade or hold until maturity.
• Trading securities: Securities bought with the intent to profit over the near term.

Accounting Methods for Financial Assets

There are three general methods for valuing financial assets:

1. Measured at cost or amortized cost.
2. Measured at fair value through other comprehensive income (FVOCI).
3. Measured at fair value through profit and loss (FVPL).

Securities without reliable market values should be valued at cost. Debt securities intended to be held until maturity should be valued at amortized cost, and unrealized gains or losses are not recorded for these securities.

Securities with reliable market values and intent for short-term profit should be valued at FVPL. Unrealized gains and losses are reported on the income statement.

Securities with reliable market values, but without a specific intent for trading or holding until maturity, should be valued at FVOCI. Unrealized gains and losses are reported as other comprehensive income.

Deferred tax assets, another type of non-current asset, will be covered later in the topic on income taxes.

With this lesson on non-current assets completed, it’s time to move on next to non-current liabilities.