Generally the most significant non-current asset in terms of value is a company’s investment in property and equipment. These are the assets that companies commit millions of dollars to and when purchased are often referred to in the business press as a company’s “capital expenditures“. Capital expenditures represent a company expenditure that will provide benefits over more than one period. Let’s say Royal Bali Cemerlang’s balance sheet reports accumulated capital expenditures of $15.232 billion. This value represents the historical acquisition cost of many investments— not necessarily made in the most recent year, but rather over several years and possibly decades.
Property and Equipment
In general, Property and equipment classification is comprised of land, buildings, furniture, fixtures, and equipment, as well as leasehold improvements, construction in progress, and capital leases. Most of the cost reported here will be allocated to future periods using some chosen method of depreciation or amortization.
A growth business will typically show a continued pattern of investing in property and equipment. Land investment represents the only asset within the property and equipment group that will not be depreciated in current and future periods. Land is considered an asset that retains economic value as well as productive value. Therefore it does not need to be expensed over time.
Now let’s break them down…..
Land – The cost of land includes all expenditures that relate to its acquisition and preparation for use. This amount typically includes purchase price, attorney fees, real estate costs, document filing fees, and so on. Special assessments levied by a government authority for sidewalks and streetlights or impact fees will also be included in the capitalized cost of land, as well as general preparation costs such as grading, soil removal, drainage, and demolition of existing buildings.
Building – The cost of buildings can be determined in a number of ways. For example, let’s say Royal Bali Cemerlang purchases a building previously owned by a competitor. The purchase would generally include both the land and building. If this occurs Royal Bali Cemerlang must allocate part of the purchase price to land and the remainder to the building. The allocation of cost is essential because land represents a non-depreciable asset, while the cost of the building is depreciable. Once acquired, the building may need some additional expenditure to make the building ready for its intended use. These are often referred to as make-ready costs and are included in the cost of the building.
In many instances, a company constructs a new building. The determination of a new building’s cost is simpler than that of a group purchase, as in the previous example. Here costs are more easily traceable to the asset. Contractor costs, architects’ fees, building permit costs, and excavation costs are examples of costs associated with new construction.
Furniture, Fixtures, And Equipment
Typically, a company that maintains more than 1,100 stores with an indoor lumberyard and warehouse merchandise displays must invest heavily in furniture, fixtures, and equipment. Narrow-aisle forklift trucks, rental vehicles, customer shopping carts and flatbeds, and movable ladder systems are examples of a company’s investment in equipment.
Probably the most significant investment in fixtures by a retail company is evident as customers walk between the product aisles. The heavy-gauge, steel storage systems throughout the store constitute an enormous investment in fixtures. This racking system not only has to be strong, but much of it has to be designed to be safe for consumers. For example, a steel shovel that can drop down and injure someone is set within a steel retaining system to prevent such an occurrence. Specially designed components of this nature are expensive to acquire.
Furniture, by contrast, would include a retail company’s investment in checkout counters, desks, chairs, and so on that are needed throughout the store, as well as furniture necessary to support its administrative headquarters.
Since assets within the furniture, fixtures, and equipment category have varying useful lives, they must be depreciated individually. All companies maintain separate records of these assets for depreciation purposes but often combine these values when reporting to the public.
A lease is a contract between two or more individuals that authorizes the use of a specific asset (e.g., a building) for an identified period of time. If a company needs to modify the leased asset for any reason, the cost of the modification is termed leasehold improvements.
Leasehold improvements have a determinable period of benefit. Therefore, they are written off over the term of the lease or the life of the improvement, whichever is shorter. The write-off of leasehold improvements is termed amortization rather than depreciation. Amortization, similar to depreciation, is a method of cost allocation. Generally leasehold improvements are viewed as intangible assets.
Construction In Progress
During any given year a company may have several, if not more, new facilities under construction. Therefore, throughout the year, the company is required to make periodic progress payments to its general contractors. When the books are closed at the end of the year, much of the new construction will be at varying stages of completion. If this occurs, the company must report an “asset under construction” in its balance sheet. At some future time the costs associated with construction in progress will be transferred to the building account.
The leasing of assets is common to most business organizations. One study conducted by the American Institute of Certified Public Accountants found that more than 90 percent of surveyed companies use one form of leasing or another.
Most lease agreements are classified into two general categories: “operating leases” and “capital leases“. On the one hand, operating leases are often viewed as temporary rentals, with rent expense being reported in the income statement of the company needing the asset. This company renting is referred to as the lessee. Operating leases can be short-term relative to the total life of the asset being rented.
In addition, the rentals over the lease period do not provide a significant recovery of the asset’s value over the term of the lease for the company providing the asset. Regardless of this fact, minimum lease payments under operating lease agreements often represent a substantial fixed charge awaiting the lessee.
A capital lease, on the other hand, is generally long-term. It requires rentals that are significant and approximate the value (excluding future interest) of the asset being rented. When this type of agreement is executed, the lessee must view the leased asset as if it had been purchased using a long-term financing arrangement. The company that owns the asset is willing to receive installment payments over the lease term, and in this case provides the financing. Keep in mind that there is no transfer of title to the lessee. The transaction is simply accounted for as if it were a capital asset acquisition.
The rationale for this accounting treatment is to prevent companies from not reporting the liability that parallels a lease agreement of this nature. Since the lease agreement emulates a purchase with long-term financing, companies are required to account for them in a manner similar to a purchase. Therefore, leases of this nature require balance sheet recognition of a capitalized leased asset and the associated long-term liability.
Capital lease obligations are reported in both the current and long-term liability sections of the balance sheet. As the leased assets are used in a company’s operations, they will decline in usefulness similar to a purchased asset. Therefore, capitalized leased assets are depreciated as well. In most instances, assets of this nature are written off over the lease term. Upon the termination of the lease agreement, the leased asset should be fully depreciated and the lease obligation fulfilled by the lessee. At this point, the asset simply transfers back to the lessor, or is sold to the lessee at a bargain purchase price.
Long-term investments, discussed along with their short-term counterpart, are recorded when a company invests in another company’s debt or equity. If management intends to hold these investments beyond one year, these investments must be categorized under the heading long-term investments. Occasionally management reclassifies long-term investments as market conditions change from one period to the next.
Long-term stock investments can be accounted for under the: (1) cost, (2) fair value, (3) equity, or (4) consolidation approach. A careful review of the investments footnote (following the financial statements) may identify the types of investments and their related valuation. On occasion, if the reported investment is minimal, the note will provide little assistance.
AFS investments are classified as short- or long-term investments, depending on management’s intent. In either case, changes in market value are recognized in stockholders’ equity as unrealized gain or loss on AFS securities. Upon careful review we find no mention of gain or loss under other comprehensive income. This suggests that no material change in the market value of the AFS securities has taken place.
A note receivable is a written promise to pay a specific amount or amounts at some point forward. Most notes receivable are loans but can result from a conventional sales arrangement that allows for extended terms. Occasionally, accounts receivable can be converted to a note receivable to extend the original terms of the agreement, generate a rate of return for the holder of the note, and strengthen legally the agreement between the parties.
Previous classifications included assets that were generally tangible in nature. Intangible assets, however, generally lack physical substance and possess a greater degree of uncertainty in regard to future benefits than do tangible assets. They represent: rights, privileges, and competitive advantages, backed by a legal agreement. Nonetheless, intangible assets, when properly created or acquired, can enhance the profitability of the enterprise for years to come. Once recorded, these assets operate no differently than tangible assets such as property, buildings, equipment, or fixtures. Their costs are capitalized and generally allocated to future periods through a method known as amortization. Amortization of intangible assets and depreciation of fixed assets both represent cost allocation processes that satisfy the matching principle. Here are examples of intangible assets include patents, copyrights, trademarks, organizational costs, and goodwill more explained:
- Patents grant to the organization the exclusive right to manufacture, sell, or control a product or process for a specific period of time.
- Copyrights give the owner the right to reproduce and sell a published work or artistic creation.
- Trademarks are rights that relate to brand or trade names.
- Organizational costs include : all costs incurred in the formation of the enterprise and would include attorney and accounting fees, national and local government filing costs, underwriting costs, and so on. They are regarded as expenditures that will benefit the organization over its life. These costs are capitalized and generally written off over a period of 5 to 10 years (5-year write-off period for taxable entities).
- Goodwill is recognized when one company acquires another company and pays more than the value of its net identifiable assets (assets less liabilities). It is often said that goodwill is the most intangible of the intangible assets group. Please note: Goodwill can only result from the purchase of another company and represents the expected value of better-than-normal future operating performance. It is measured as the difference between the purchase price of an acquired firm and the fair value of its identifiable net assets. Goodwill has traditionally been written off over a period not to exceed 40 years. This write-off can place a significant drag on earnings for an extended period of time. A recent change in accounting for goodwill by the Financial Accounting Standards Board (FASB) requires companies to no longer write off newly acquired goodwill. The FASB believes that companies should write down goodwill only when its value appears to be “permanently impaired“. The Board’s rationale is that the synergistic benefits derived through business combinations often have indefinite lives. To arbitrarily write down goodwill does not follow the matching principle. In a sense, the FASB is suggesting that goodwill is similar to land in that it need not be written off unless its value becomes impaired.
Read also part of this “Classification and Element Of Balance Sheet” post series are: