Property, Plant, and Equipment (PPE), often referred to as "fixed assets," are noncurrent assets owned or controlled by a company and used to produce or distribute the company's products. PPE will generally appear on the balance sheet grouped together at original cost, minus net accumulated depreciation. Original cost less depreciation is used instead of current market value because usually a company does not intend to sell these assets, so their current worth is not a relevant figure. Also, current market value is somewhat subjective, while original cost is easily verifiable.
Depreciation is the write-off for the reduction in usefulness and value of a long-term tangible asset. It not only affects the asset's value as stated on the balance sheet; it also affects the amount of reported earnings on the income statement. There are generally two categories of depreciation:
- Straight-Line Depreciation is the method of recording write-offs in equal amounts during each year of the asset's estimated useful life.
- Accelerated Depreciation is the method of writing off the cost of a capital asset in which the largest deductions are taken in the early years of the asset's life. The goal here generally is to delay taxes to a future date so that cash savings from the deferral can be reinvested to earn additional income.
Since there is more than one way to report depreciation, the amount recorded on financial statements may or may not be a good indication of an asset's reduction in value for that individual time period. The total depreciation for an asset over its useful life, however, will be the same regardless of the method used. Keep in mind, though, that similar companies within an industry may depreciate their assets using different methods and timeframes, making a direct comparison difficult.
Leased Assets are assets that the company pays for the use of for a portion of its useful economic life. Companies lease assets to maintain flexibility over PPE and to preserve capital. There are two kinds of leased assets:
- Operating Leases are generally short-term leases for which rental payments are made by the lessee and full ownership rights are kept by the lessor. Operating leases are not recorded on the balance sheet.
- Capital Leases are long-term leases that represent a purchase of the asset by the company because the company will control the asset for nearly all of its useful life. Accounting rules require that the leased asset and the present value of the lease payments be recorded on the lessee's balance sheet. Assets under lease will appear under PPE.
Intangible Assets are assets that have value even though they cannot be seen, felt, jumped over, or swum in. Brand Name is often the most important to a company's long-term success of the intangible assets. Others include copyrights, patents, a mining claim, or goodwill. Although intangible assets are difficult to quantify, it does not mean that they do not have a tremendous effect on a company's value. The main problem with companies that have a lot of value based on intangible assets is that they tend to be treated more harshly by the market at the first sign of trouble.
Goodwill is an asset that arises from the purchase of one business by another at a price greater than book value (actual net worth). When a company acquires another and the purchase price of that business is higher than the net asset value of the acquired business, the difference is transferred into an asset called "goodwill" when the two consolidate.
If, for instance, your company wanted to acquire Gervin's Garage of Groovy Gadgets, you'd be expected to pay more than book value because Gervin has built enormous brand equity into his business' name over the years. When people hear "Gervin's," they think "great gadgets!" You would chalk up the amount you paid over GGGG's net asset value to goodwill and amortize it over a period of time.
Amortization is the write-off of an intangible asset over time. Similar to depreciation, amortization reflects the declining value of an asset over its useful life. Under GAAP (generally accepted accounting principles), intangibles should be amortized over at least 5 years and not more than 40 years.
Long-Term Investments will conclude our review of noncurrent assets. Long-term investments are investments the company plans on holding for more than one year. There are three methods of accounting for investments:
- The Cost Method is for less than 20% ownership of another company. This would be similar to how you would account for your personal investments. Income (dividends, usually) are recorded on the balance sheet, and gains or losses are not recognized until the asset is sold.
- The Equity Method is for ownership of 20% to 50% of another company. The initial investment is recorded on the balance sheet to reflect the initial cost plus a share of the investment's retained earnings, less dividends. For example, if Elwood's Electric Elixirs takes a 20% stake in Gervin's Garage of Groovy Gadgets, and Gervin's earns $3 million after taxes during the next year, EEE will increase the carrying value of its investment by 20% of $3 million, or $600,000, assuming no dividends were paid.
- The Consolidation Method is for ownership of at least 50% of another company. This involves combining financial statements of the parent and its controlled subsidiaries so that the assets of the parent and its subsidiaries are reported together.
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