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Assets - Elements of Balance Sheet
As noted in "FASB Definitions of Assets, Liabilities, and Owners’ Equity" in the previous section Definitions of Assets, Liabilities, and Owners’ Equity, assets represent “probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events.” Future economic benefits come in many forms. For example, cash is an asset because it represents purchasing power; the firm can use cash to acquire goods and services, to repay debts, or to make distributions to owners. Inventories are assets because they are merchandise intended for sale to customers for cash and other assets. The firm’s buildings and equipment are assets because they enable the firm to perform its operations and to earn profits in the future.
Assets typically represent tangible economic resources, such as cash, buildings, and trucks. On the other hand, some economic resources are intangible, such as patent rights and copyrights to a text or musical score. Assets may also be represented by promises of future payments from customers who bought goods or services on credit. Assets can be created by contract or acquisition of property rights, and yet they may not be visible to the human eye. All assets, however, have a common characteristic in that they represent probable future economic benefits to the firm.
Asset Classifications
Assets are classified into two overall categories: current assets and noncurrent assets. This distinction is based on the length of time before the asset is expected to be consumed or converted to cash. Current assets include cash and other assets that will typically become cash or be consumed in one year or one operating cycle, whichever is longer. Current assets are used quickly and repeatedly during a firm’s normal operations. This notion of using assets on a cyclical basis corresponds to a concept called turnover. Current assets turn over quickly, anywhere from daily to annually, and are usually generated in the normal course of business operations. The notion of turnover is used to differentiate current assets from other asset categories that are used (turn over) much more slowly over a number of years.
To illustrate, Sample Company’s balance sheet in Figure 2.1 in the section "Elements of the Balance Sheet" shows that the firm’s total assets of $2,057,000 are comprised of $1,420,000 in current assets and $637,000 in noncurrent assets. The balance sheet equation is easily expanded to show this additional detail:
This classification of assets is useful to the analyst concerned with the liquidity of the firm. Liquidity reflects the ability of the firm to generate sufficient cash to meet its operating cash needs and to pay its obligations as they become due. This focus on liquidity will become clear as we discuss the ordering and valuation of individual current assets in the next section.
Current Assets
Current assets are listed in the order in which they are expected to be consumed or converted to cash. For example, Sample Company’s current assets are listed (in figure 2.1 in section "Elements of the Balance Sheet") in the following typical order of maturity or collectibility:
- cash and cash equivalents,
- accounts receivable,
- inventories, and
- prepaid expenses.
Cash and cash equivalents include currency, bank deposits, and various marketable securities that can be turned into cash on short notice merely by contacting a bank or broker. These amounts are presently available to meet the firm’s cash payment requirements. Note that only securities that are purchased within 90 days of their maturity dates, or are scheduled to be converted to cash within the next 90 days, may be classified as cash equivalents.
Accounts receivable represent credit sales that have not been collected yet. They are converted into cash as soon as the customers or clients pay their bills (their accounts). Accounts receivable should turn over, or be collected, within the firm’s normal collection period, which is usually 30 or 60 days. A slower accounts receivable turnover embodies more risk to the organization because the probability of nonpayment usually increases as turnover decreases. Overdue accounts may imply that the customer is either unable to pay or is unwilling to pay because of disagreement over the amounts billed. Both cases imply that the amount of cash that will ultimately be collected is less than the amount originally billed to the customer. Managers are interested less in the total amount of accounts receivable than in the estimated cash to be generated from collections of the accounts. For this reason, accounts receivable are listed on the balance sheet at the amounts estimated to be actually collectible. This amount is termed the net realizable value of the receivables. For example, if management estimates that some portion of the amounts billed to customers will ultimately be uncollectible, then the estimated uncollectible portion will be deducted in valuing the accounts receivable on the balance sheet. The uncollectible portion of the receivables is termed an allowance account and is discussed in Chapter, “Current Assets.”
Inventory represents items that have been purchased or manufactured for sale to customers. That is, inventory can either be created through the manufacturing and assembly efforts of the organization or be acquired from others and held for resale. Inventory is the “stuff of commerce” dating back to merchants on camels and pirates raiding the high seas looking for bounty. Inventory can be as prosaic as black tea or salt, or it can be as glamorous as gold bullion or silver coins. Today, inventory is often “high tech,”such as silicon wafers, memory chips, or disk drives. Should the company discover that some of its inventory is unsalable, or marketable only at a greatly reduced price, the reported value of the inventory should be reduced accordingly.
Prepaid expenses, the final category of current assets shown in figure 2.1 in the section "Elements of the Balance Sheet", represents unexpired assets such as insurance premiums.Insurance policies, for example, are frequently paid ahead on an annual basis. The unexpired portion, the portion of the policy paid for but not yet used, is shown as part of prepaid expenses, which are interpreted as current assets. Prepaids are usually minor elements of the balance sheet, and, in the usual course of events, prepaids will not be converted or turned into cash. Instead, the rights to future benefits will be used up in future periods.
The Operating Cycle and Liquidity
Manufacturing and merchandising firms’ operating cycles include turning inventory into cash. Using three of the current assets discussed earlier, the operating cycle evolves from the purchase of inventory, to the exchange of inventory for a promised payment by a customer (an account receivable), and finally to the conversion of the receivable into cash. Operating cycles may vary in length from just a few days (in the case of food retailers) to months (consumer appliance sellers) or even years (defense contractors). Figure 2.2 illustrates the operating cycle.
Figure 2.2 - The Operating Cycle
The more quickly this cycle is completed, the more quickly the inventory is turned into cash, and liquidity is higher. When the operating cycle becomes longer, the firm’s liquidity usually is lower. Should the operating cycle become too long, the firm will be forced to incur debt in order to pay its suppliers of inventory. To some extent, the length of the operating cycle is outside management’s control. The length of time permitted customers to pay their accounts, for example, may be governed by industry practice. To attract and retain customers, the firm may need to offer credit terms as liberal as those offered by its competitors. Likewise, the amount of inventory that the firm keeps on hand may be related to the length of its “production pipeline.” Some products require a lengthy production process that entails a substantial investment in inventory at various stages of completion.
On the other hand, the turnover of accounts receivable and inventory may be influenced by management. For instance, managers may have considerable leeway in offering credit terms to customers or in deciding how much inventory to keep on hand. The analyst, in attempting to assess the firm’s liquidity, needs to understand these underlying factors that cause differences in the amounts of accounts receivable and inventories across firms and industries. Case Study 2.1 illustrates how the composition of current assets differs for two firms engaged in different industries.
Case Study 2.1
The following schedule summarizes the current assets from the end of 1996 balance sheets for Kmart, a national retailer of consumer products, and HBO, a producer and distributor of cable television programming:
Required
a. Identify the major differences between these two firms in the composition of current assets. Try to explain these differences in terms of the types of goods and services that each company produces.
b. Based solely on the information provided here, which company appears to be more liquid?
Solution
a. The major differences in the composition of current assets are the amounts invested in inventories and accounts receivable.
Inventories: Kmart is a retailer of consumer products and maintains inventories of merchandise in regional warehouses and retail stores. HBO is a service firm and, hence, does not require inventories.
Accounts receivable: HBO invests about 34.3% of its total assets in customer accounts receivable ($291 / $848 = 34.3%), and Kmart has no significant accounts receivable. Providers of subscription cable services such as HBO sell primarily on credit and have relatively large accounts receivable balances, while retailing firms such as Kmart derive much of their revenues from cash and credit card sales and require smaller (if any) accounts receivable balances.
b. Kmart’s current assets include a substantial proportion in inventories, while HBO’s current assets consist primarily of cash and accounts receivable. As a result, most analysts would consider HBO to be more liquid, based solely on the information provided.
Noncurrent Assets
Noncurrent assets are long-term assets that are used in the conduct of the business. Whereas current assets are liquid and turn over in relatively short time periods, noncurrent assets usually turn over very slowly, on the order of once in several years. In other words, while the operating cycle for current assets is usually less than a year, the replacement cycle for noncurrent assets is longer than a year. In a high-tech organization, however, some noncurrent assets may be replaced more frequently.
All noncurrent assets are recorded on the balance sheet at their historical acquisition costs. The disadvantage of this is that as time passes the historical costs of many noncurrent assets become out of date relative to their current market values. Consequently, they indicate little about the market value of the organization and about the future resources necessary to replace the assets. However, the historical costs listed on the balance sheet do represent the costs of these assets that will eventually be consumed by future operations.
Property, Plant, and Equipment. For most firms, noncurrent assets consist mainly of property, plant, and equipment.These assets are widely referred to as fixed assets. Property usually represents the land on which the firm’s offices, factories, and other facilities are located. In most cases, property is a relatively minor portion of the total noncurrent assets, yet in some cases, such as firms engaged in mining, logging, or oil and gas exploration, property constitutes a major operating asset. Property is also valued on the balance sheet at its historical acquisition cost, and because property is usually one of the oldest assets held by an organization, its recorded historical cost is often the most out of date in terms of current market values.
Buildings and equipment represent the largest category of noncurrent assets, as shown in figure 2.1 in the section "Elements of the Balance Sheet". Buildings or plant may be office, retail, or factory buildings; warehouses or supply depots; or hospitals or health clinics. Equipment includes office desks and chairs, tools, drill presses, robots, computers, x-ray and other scanners, podiums, and so on. In other words, buildings and equipment are the primary productive assets of many organizations. Whether widgets or rings are produced, whether knowledge or health is improved, buildings and equipment are necessary to produce most goods and services.
Because buildings and equipment are long-lived assets, it would not make sense to treat their entire cost as expenses in the year they are acquired. On the other hand, because buildings and equipment gradually lose their economic value over time, it does not make sense to wait until the end of their service lives to recognize their declining usefulness to the firm. As a consequence, accountants gradually and systematically reduce the reported values of buildings and equipment on successive balance sheets in order to allocate expenses to individual years of asset use. The reduction in the reported value of buildings and equipment during a period is called depreciation expense.
On the balance sheet, the total amount of depreciation expense recognized to that date is called accumulated depreciation. It is subtracted from the initial cost of the asset. The resulting carrying value is referred to as the net book value of the asset. In figure 2.1 in the section "Elements of the Balance Sheet", the net book value of $552,000 for buildings and equipment is calculated by subtracting the $313,000 of accumulated depreciation from the original cost of $865,000:
In other words, of the original cost of $865,000, a total of $313,000 has been expensed, or written off, in previous periods. The net book value of these assets is unlikely to reflect their current resale value because of changes in technology, price inflation, and many other factors. Accumulated depreciation is not an attempt to adjust carrying values to current resale values. It also does not represent any cash or other investments that the company has set aside for replacing the buildings and equipment.
Rather, depreciating an asset is an attempt to apportion or allocate its original cost as an expense to the periods that benefit from the asset’s use. The net book value of buildings and equipment can be used to estimate the remaining productive capacity of the organization. For example, Sample Company’s buildings and equipment are about 36% depreciated ($313,000 accumulated depreciation divided by $865,000 initial cost). If Sample Company does not purchase additional buildings and equipment, then each successive balance sheet will show a lower net book value for these assets. Such a declining net book value will signal to analysts that Sample Company is not replenishing its productive capacity on a regular basis.
As a practical matter, most firms regularly invest in new plant and equipment and, as a result, the net book value of these assets usually increases over time. The percentage relationships between the initial cost and the accumulated depreciation of these assets may give analysts a rough gauge of the overall age of the firm’s productive capacity. However, the analyst must usually refer to other disclosures in the financial statements to evaluate the firm’s productive capacity.
Other Noncurrent Assets
In addition to property, plant, and equipment, many firms possess other noncurrent assets such as intangibles. Intangibles are noncurrent assets that lack physical substance and yet are important resources in the regular operations of a business. Intangibles often consist of legal rights, such as patents or copyrights. Such legal rights are vital to the operations of many firms and, in some cases, may be the most valuable resources owned by the organization.
Consider, for example, the importance of copyrights to computer software developers or book publishers. The value of such firms depends almost entirely on the value of the copyrights that protect their legal rights to the products they have developed. Accounting for intangible assets is similar to that of buildings and equipment because the initial costs are systematically recognized as expenses over the years that benefit from the use of the assets. Intangible assets are valued on the balance sheet at their historical costs, minus any amounts subsequently recognized as expenses. The term amortization is used in place of depreciation when referring to the consumption of intangible assets.
Another important type of intangible asset is goodwill. Goodwill is a general label used by accountants to denote the economic value of an acquired firm in excess of the value of its identifiable net assets (assets minus liabilities). Goodwill reflects the adage that “the value of the whole differs from the sum of its parts.”This economic value is largely due to factors such as customer loyalty, employee competence and morale, management expertise, and so on. In other words, the value of a successful business firm is usually much greater than the total values of its individual assets.
The balance sheet recognition of goodwill depends on whether the firm’s goodwill is internally generated or externally acquired. Internally generated goodwill evolves gradually as the firm develops a good reputation and customer base. It also evolves as the firm cultivates successful relationships with its suppliers, trains and retains a skilled labor force, and conducts other value-enhancing activities. The costs incurred in generating this goodwill are generally not recorded as assets by the firm and instead are recognized as expenses when incurred. The argument used to support the immediate expensing of these costs is the uncertainty and subjectivity involved in identifying future benefits. Externally acquired goodwill, on the other hand, usually arises when one business firm acquires another. In this case, the amount that the purchaser is paying for the goodwill of the seller can be more objectively determined by appraisers.
The composition of noncurrent assets, and the relative amounts of current to noncurrent assets, varies across industries. Case study 2.2 shows how noncurrent assets differ between two firms in different industries.
Case Study 2.2
The following schedule summarizes the noncurrent assets reported in the end-of-1997 balance sheets of Hewlett-Packard, a company that designs, manufactures, and services electronic data and communications systems, and Bethlehem Steel, a major steel fabricator.
Required
a. Identify the major differences between these two firms in the composition of noncurrent assets. Try to explain these differences based on the types of products that each company produces.
b. Based solely on the information provided here, which company appears to have the older assets?
Solution
a. Bethlehem Steel invests 69.5% of its resources in noncurrent assets ($3,339 / $4,803 = 69.5%), and the corresponding amount for Hewlett-Packard is just 34.0% ($10,802 / $31,749 = 34.0%). Bethlehem Steel is a highly capital-intensive firm because the technology of steel production requires large investments in plant and equipment. Steel firms also usually invest in properties containing natural resources (such as coal or iron ore) used in steel fabrication. In comparison, Hewlett-Packard is moderately capital intensive because of the property, plant, and equipment required by its product development and manufacturing activities.
b. Bethlehem Steel appears to have the older assets, which are about 63.5% depreciated ($4,096 / $6,454 = 63.5%), while Hewlett-Packard’s are about 46.4% depreciated ($5,464 / $11,776 = 46.4%). These percentages are only approximations, however, because these amounts include property (land) that is not being depreciated.
Assets: Summary and Evaluation
Before leaving the asset side of the balance sheet, it is helpful to summarize the conventions used by accountants to define and value the firm’s assets. We also identify here some of the limitations faced by analysts who must use asset values shown in the balance sheet to evaluate the firm’s liquidity and productive capacity.
As we have seen, accountants classify assets into two broad groups: current and noncurrent. In reporting current assets, the focus is on liquidity. For this reason, current assets are generally valued at the lower of their acquisition costs or present resale values. An exception to this rule is made for investments in the securities of other firms, as we discuss in Chapter, “Current Assets”. These practices are useful to the analyst concerned with the ability of the firm to meet its short-term cash needs.
Noncurrent assets, on the other hand, are generally valued at their acquisition costs minus amounts that have been recognized as expenses in previous periods. These previously recognized expenses will have been shown as depreciation of buildings and equipment or as amortization of intangibles such as patents or good will. In reporting noncurrent assets, the focus is on the operating capacity of the firm; that is, the firm must focus on the structure of its long-lived assets, both tangible and intangible, which are necessary in order for the firm to produce goods or services. The carrying values of these noncurrent assets represent the portion of their original acquisition costs that will be recognized as expenses in future periods. The carrying values of noncurrent assets rarely reflect their market values because inflation has usually caused asset replacement costs to increase beyond their reported values.
The experienced financial statement analyst is alert to two central issues in examining a firm’s asset structure as reported on the balance sheet:
-
Different valuation methods are used for various types of assets (cost, market values, lower of cost or market value).
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Many assets that are critical to the firm’s successful operations are not shown on the balance sheet.
With respect to these “missing”assets, chief executive officers (CEOs) are fond of proclaiming:
- “Our employees are our most important resource.”
- “Research today provides profits tomorrow.”
- “Our reputation for quality ensures our success.”
Regardless of these lofty statements, resources such as employee morale, productivity, research and development expertise, and a loyal and satisfied network of customers and suppliers are absent from the balance sheet. Accountants justify these omissions either because these valuable resources do not meet the conditions stated in the FASB’s definition of assets (refer to Figure 2.2 above) or because there is no reliable method for measuring or valuing such resources.
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