Non-Current Assets | CFA Level I FSA
Overview of Non-Current Assets
- 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.
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.
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.
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.
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.
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.
- 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.
- 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)
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:
- Measured at cost or amortized cost.
- Measured at fair value through other comprehensive income (FVOCI).
- 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, 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.
A 3-year, $100 par, 4% semi-annual fixed coupon bond: The bond was purchased at $100 par, received a $2 coupon after 6 months, and the market price at reporting is $97.50.
- Held-to-maturity: The bond is reported on the balance sheet at its amortized cost of $100. Unrealized loss due to the market value drop to $97.50 is not reported.
- Trading securities: The bond’s book value in the balance sheet is $97.50, and the loss of $2.50 is reported in the income statement.
- Available-for-sale: The bond’s book value in the balance sheet is $97.50, and the loss of $2.50 is reported under other comprehensive income as part of shareholders’ equity.
For all three classifications, dividend and interest income and realized gains and losses are recognized in the income statement. The $2 coupon that has already been collected is recognized as a realized gain in the income statement.